`Chapter 1

Basic Concepts and Cost Classification

Learning outcomes
At the end of this chapter, the student is expected to be able to:
1. Discuss the origin of cost accounting
2. Distinguish cost accounting from management accounting and financial
accounting
3. Explain the scope and objectives of cost accounting
4. Discuss the different kinds of costs in a manufacturing operation
5. Describe the cost components in a manufacturing company
6. Enumerate and explain the different systems of cost accumulation
7. Enumerate and discuss the kinds of inventories in a manufacturing company

1
The origin of cost accounting
Before the era of the industrial revolution, most of the costs and expenses of businesses
were what we now call the variable costs. These costs were materials, labor and other
costs that varied directly with the level of production.

The origin of cost accounting can be traced back to the age of industrialization. As
businesses in railroads, steel industry and other such large businesses developed, the
nature of the costs became more complex. The businesses were already having costs
with different nature. These costs were of fixed amounts that did not directly vary with the
amount of production such as rent, cost of storage and other similar costs.
Understanding these costs became more important to owners and managers for
allocation, product development, pricing and other decision making processes.

The businessmen saw a great need for keeping track of their costs and expenses. A
system of keeping a record of these costs and expenses was developed to help the
businessmen. This started the cost accounting that we have now in the modern world.

Cost accounting was previously for manufacturing businesses only. These days,
however, it extends to service businesses as well. A hospital, for example, will use cost
accounting to determine the cost of every clinical procedure. A bank will use cost
accounting to compute the cost of processing a current or savings account, maintaining
an account, processing of a loan or other services that it offers. Such information will be
helpful to management to find ways to reduce cost and improve efficiency and to be
used also in pricing any new service that it may offer in the future.

Cost accounting, management accounting and financial accounting

Cost accounting is an aspect of management accounting that involves the collection of
information about the costs incurred in the production of goods or in the provision of
services by a company to its customers.
Cost accounting establishes budget and actual costs of operations, processes,
departments or products and the analysis of variances or profitability. Managers use
management accounting to support decision making to cut company’s costs and
improve profitability.

As a form of management accounting, the primary users of cost accounting are the
internal managers. Cost accounting is more focused on the internal needs of the
managers to improve the company’s performance. While it is primarily for internal
purpose, cost accounting needs to follow standards such as the GAAP because the
information generated in cost accounting also form part of the set of reports in financial
accounting for outside parties such as investors, creditors and regulatory agencies. For

2
example, cost accounting will be used in costing the inventories which will go into the
computation of cost of sales, which is part of the statement of financial performance.
The inventories will also be part of the current assets that are presented in the
statement of financial position.

Aside from the difference in the users, the other differences between cost accounting
and financial accounting are the following:
1. While financial accounting deals only with the standard set of financial
statements for external parties, which are composed of the statement of
financial position, statement of financial performance, statement of changes
in equity, statement of cash flows and the notes to financial statements, cost
accounting deals with a wide range of reports that managers need in order
to control and improve the performance of the business. There is no
standard set of reports for the internal users. The managers may require
any report as they may deem necessary for their purpose. The reports
include budgets, variance analyses, expense reports comparing budgets
and actual, sales and profitability reports by product lines or by regions and
such other reports needed by management.

2. The set of reports in financial accounting has to follow a format required by

the generally accepted accounting principles and financial reporting
standards. In cost accounting, the reports are intended for internal use only
and can be in any format as may be specified by management as long as
they contain the information needed for a specific decision to be made or for
a specific situation to be analysed. Management can decide on what
information to include or exclude and can design a particular format that will
serve its need.

3. The reports in financial accounting deal with the financial performance,

financial position of the company as a whole or its ability to generate cash
flows. The reports are also less detailed as they contain only line items in
their aggregate amounts. In cost accounting, the reports are more detailed
and may cover any specific area or areas of operations that the managers
may want to focus on in its evaluation.

4. Cost accounting collects information about costs of the company’s products

such as raw materials, direct labor and manufacturing expenses and the
inventories like raw materials, work-in-process and finished goods. Financial
accounting collects various information that are eventually incorporated into
the financial reports particularly the income statement and the balance
sheet.

3
 5. The reports in financial accounting are generally issued at least once a year
at the end of the accounting period and they have to observe the generally
accepted accounting principles and financial reporting standards in their
preparation and presentation. The reports in cost accounting are issued at
any time of the year during any time period, which may be less than one
year depending on the need of management for such information. They are
not governed by regulatory frameworks.

6. Financial accounting deals with reporting for a period already completed.

Cost accounting may involve projection for future periods.

Objectives of cost accounting

Cost accounting is very crucial in managing the efficiency and profitability of the
company. Cost accounting helps management in planning and controlling the business
through preparation of budgets for operations; capital budgets; reporting, analyzing and
controlling variances; and primarily in the pricing of its product or service.

The profitability of the company will depend largely on the correctness of the costing of
its product or service and consequently the appropriateness of its pricing. A low price of
its product may result to losses. A high price on the other hand, may affect the
marketability of the product and consequently its over-all profitability.

Cost accounting involves collection of information about the costs related to the
company’s product or service for the purpose of planning and controlling such costs
essential for the improvement of the company’s profitability. Knowledge of the nature of
its costs and analysis of their behaviour enable the company to formulate strategies that
will help achieve the purpose.

Specifically, cost accounting involves the following:

1. Determining the cost and the amount of the company’s product or service,
activities, or projects for reporting in the company’s financial statements.

2. Analysing such costs and controlling them to improve the company’s operations
and raise it to a higher profitability level.

3. Assist the management in arriving at the best decisions in planning and control of
the business.

4. Developing strategies and plans for future operations

4
Manufacturing costs
Cost accounting is essential in a manufacturing company. As mentioned, cost
accounting involves the collection of information about the costs related to the
company’s product or service.

In a manufacturing company, the total cost to manufacture its products is composed of

direct materials, direct labor and manufacturing overhead. These items comprise
the total manufacturing costs.

1. Direct materials
The direct materials are those materials that can be found or can be traced
back to the product. In short, these materials physically form part of the product
like the yarn and embroidery in socks; fabric, buttons and accessories in a
garment; or leather and other trimming materials in a bag or a pair of footwear.
Materials that are used in production but do not form part of the product are not
considered as direct materials. They are indirect materials and are treated as a
factory expense or manufacturing overhead. An example of an indirect material
is a plastic wrapper of a garment or a shoe stiffener.

2. Direct labor
The direct labor is labor that is directly associated with the production of the
finished product. The employment of such labor helps directly in making the
product. Examples of direct labor are the labor of a knitting machine operator in
socks production; the labor of a sewer in garment manufacturing or that of a
leather cutter in footwear production.

Although the knitting machine operator is not the one doing the actual knitting
work, his work as a knitting machine operator is directly identified to the knitting
operation. A machine cannot operate on its own. It needs an operator to function.
Labor in the factory that is not used in a production operation but only in the
allied production services is not a direct labor. It is called indirect labor and is
treated as a factory expense or manufacturing overhead.

3. Manufacturing overhead
The manufacturing overhead includes all other expenses, other than the direct
materials and direct labor, that are incurred in running a factory.

Examples of manufacturing overhead or manufacturing expenses are the

following:

1. Indirect materials
2. Indirect labor.
5
 3. Salaries of the factory manager; supervisors; and factory staff and wages
of other factory workers that are not involved in actual production work
such as the quality inspectors; handlers and issuers of raw materials; and
factory cleaners to name a few..
4. Light, power and water
5. Depreciation of machines, factory building, equipment and other fixtures
used in the factory
6. Factory taxes
7. Insurance of factory building, machines and inventories
8. Rent of a factory, if the space used is a leased property
9. Other expenses in the production and production related areas

Raw materials that do not directly form part of the finished product are called
indirect materials. Examples of indirect materials are chemical solutions used to
remove stains on a finished product or the stickers used to identify the different
cut parts to be assembled into one item of the product. These materials cannot
be traced back to the product itself.

Labor that is not directly identified with a specific production operation is called
indirect labor. An example of this is the wage of a quality inspector or that of a
raw materials issuer. The labor employed by these workers on a unit of product
cannot be specifically determined or measured. For example, not all finished
units are cleaned of stains or dirt as some of them may not need cleaning. The
time spent by a raw material issuer cannot be practically measured to be charged
to a particular unit of product.

Indirect labor and indirect materials form part of the manufacturing overhead.

Direct costs, prime costs and conversion costs

The direct raw materials and direct labor are called the direct costs. They are also
called prime costs. They are called direct costs because they can be traced directly to
the product. They are also called prime costs because they are the primary costs
employed to manufacture the finished product.

The direct labor and manufacturing overhead are called the conversion costs because
they are the costs necessary to convert the raw materials into finished products. Without
them, the raw materials cannot be converted into finished product.
The direct labor, therefore, is the only manufacturing cost component that is both a
direct or prime cost and a conversion cost as well.

6
Other classifications of cost
a. Cost classification as to its behaviour
There are other classifications of costs. In cost accounting, however, the most important
classification is based on how the costs behave in relation to the level of operation or
the volume of production. Costs are classified into variable and fixed costs. Knowledge
of cost behavior is important in decision making more particularly in controlling costs or
in the pricing of the product or service..

1. Variable cost varies in direct proportion to the production volume. If production

volume increases, the total variable cost also increases and conversely, when
the production level decreases, the total variable cost also decreases. Direct
materials and direct labor are variable costs.

2. Fixed cost, on the other hand as its name suggests, remains fixed regardless of
the volume of production. Most of the items in the manufacturing overhead are
fixed costs. For example, depreciation of factory building and machineries,
factory taxes and factory insurance remain the same regardless of the volume of
production.

3. Semi-variable cost. However, there are manufacturing overhead items that

remain fixed up to a certain level of production but they increase after that level.
As the volume further increases, these costs start to also increase. The salary of
a production supervisor, for example, is fixed per month regardless of the
production level. But if production volume needs to be increased furthermore,
additional workers may be needed and an additional supervisor may also be
needed to manage the additional worker requirements because the effectiveness
of a supervisor may be reduced if his span of control, or the number of people
that has to supervise, is expanded. These costs are called semi-variable costs.

Movement of fixed and variable costs in relation to the level of production

As mentioned in an earlier discussion, variable costs vary in direct proportion to the
level of operation. As the level of production increases, the variable cost also increases
and vice versa. The fixed costs, on the other hand, remain fixed regardless of the level
of production.

However, this difference in the movement of these costs is true only in so far as their
total amounts are concerned. On a per unit basis, the movement of these costs goes in
opposite direction, that is, the variable cost per unit is fixed while the fixed cost per unit
varies with the level of production as seen from the following illustration:

7
 Fixed cost
Level of production Total amount Unit
volume cost
100,000 1,000,000 100
200,000 1,000,000 50
250,000 1,000,000 40

Variable cost
Level of production Unit
volume cost Total amount
100,000 100 10,000,000
200,000 100 20,000,000
250,000 100 25,000,000

Cost classification as to timing of charging to expense

1. Period cost. Period costs are the costs that are charged to the period in which
they are incurred. They are identified with the period during which they are
incurred and are not carried on as part of the cost of inventory. Examples of
period costs are the selling and administrative expenses such as the salaries of
sales and office staff and utilities expense for the office. These costs are
immediately charged to expense in the period that they are incurred.

2. Product cost. The other name for product cost is inventoriable cost. As the
name implies, it involves all cost in connection with the acquisition or production
of goods. The cost follows the inventory to which it attaches. If the product
remains in inventory, the cost to which it attaches also remains in inventory. The
inventoriable costs are the manufacturing costs namely, direct materials, direct
labor and factory overhead. While the goods are not yet sold, these costs stay
with the product.

b. Other types of costs

There are other types of costs that are used mainly for making management decisions.
These costs are the following:

1. Opportunity cost. Opportunity cost is the benefit to be given up when making

decision in favour of another alternative. In other words, it is the benefit that is
sacrificed because a particular alternative was not chosen. For example, when a
property that can be rented out is held for own use, the rent that was foregone is
an opportunity cost.
8
 2. Sunk cost. Sunk cost is cost that has already been incurred and can no longer
be reversed. A sunk cost is not considered in any decision making process
because it will be the same whatever the decision of the management may be.
For example, a major repair was made on a machine. A new machine with much
higher capacity and better efficiency is now being offered to the company. The
company is considering whether to buy the machine or rent it. The repair cost on
the old machine is now a sunk cost. It can no longer be changed and it will not
matter on the decision making process to be made on the new machine.

3. Controllable cost. Controllable cost is cost that which is within the control of the
decision maker or over which he has the power to increase or decrease.
Controllable costs may not necessarily be avoidable costs

4. Avoidable cost. Avoidable cost is cost that can be avoided or can be eliminated
if an activity is not performed. An example of avoidable cost is the cost of repair
of a machine. It may or may not be incurred depending on the decision of the
management. Thus, an avoidable cost is a relevant cost.

5. Differential cost. Differential cost is also called incremental cost. It is the

difference in the cost between two alternatives. For example, the company is
deciding between continuation of manual production or adopting a fully
automated process. The differential cost will be the difference between the cost
of manual operation and that of using a machine.

6. Relevant cost. Relevant costs are costs that differ between alternatives. A cost
is relevant if it helps management in making a decision. For example, the
company wants to find out the better alternative between producing additional
quantity or merely buying the quantity from a supplier. The relevant costs are the
costs of in-house production and the cost of purchasing the items from a
supplier.

Systems of cost accumulation

In cost accounting, costs are accumulated for the purpose of valuing a company’s
product as basis for setting its selling price. Thus, the system by which costs are
accumulated has a very important part in managing the company’s profitability. Product
costs maybe accumulated using the following systems:

9
1. Actual costing
The recording of product costs is based on cost of materials, labor and overhead
that are actually incurred during the reporting period. Actual cost per unit is
arrived at by dividing the total product costs composed of the total cost of
materials, labor and actual overhead incurred during the period by the number of
units produced during the said period.
Example:
Raw materials P1,200,000
Direct labor 540,000
Manufacturing overhead 600,000
Total manufacturing costs P2,340,000
Number of units produced 300,000

Unit cost per unit P7.80

Tracking the cost involves the collection of actual cost of direct materials, direct
labor and manufacturing overhead.

Actual costing is the simplest costing method to be used by a company because

it does not require any pre-planning or setting of predetermined standards. This
cost system however, may result to huge cost variations due to fluctuations in
manufacturing costs and production volumes and may not be useful for decision
making purposes.

Thus, this method is ideal for a company whose monthly production volume is
relatively stable and manufacturing overhead items are more or less the same. In
this case, the cost variation is greatly minimized.

2. Normal costing
In this product costing system, the actual cost of materials, labor and applied
manufacturing costs are added together to comprise the product costs. Applied
overhead is the amount of overhead that is assigned to the goods produced.
Thus, in normal costing, the materials and labor are actual costs but the
manufacturing overhead is based on a standard overhead rate.

Normal costing is not as accurate as actual costing because of the applied

overhead which is based only on a predetermined or budgeted overhead rate.
However, it smoothens out the cost fluctuations on a per unit basis brought about
by fluctuations is actual overhead cost.

The use of this predetermined or budgeted overhead rate is what differentiates

normal costing from actual costing.

10
 In normal costing, the actual overhead costs are recorded in a general ledger
control account as they are incurred. Since the overhead costs are not directly
traceable to the products, they are allocated or assigned to the goods produced
through a predetermined overhead rate.

The overhead rate is determined in advance based on the company’s experience

or some other basis. The process of determining the overhead rate will be
discussed in another chapter.

3. Standard costing
In standard costing, the cost of materials, labor and overhead for each unit of
product is determined in advance even before the actual production run. The
determination of cost is, of course, based on a scientific process. The process of
cost determination includes determining the quantity of each and every unit of
materials to be used in each unit including the predetermined cost of each item of
material; the estimated number of hours to be used in producing each unit and
the wage rate of the labor to be used in production. The overhead rate is also
predetermined either based on the labor or machine hours used or such other
appropriate basis based on company’s experience.

The detailed procedures in setting up the standard costs will be discussed in

another chapter.

The distinction between the costs that are used in these costing systems are
summarized in the following table:
Production
Actual costing Standard Costing Normal Costing
Costs
Direct materials Actual Standard Actual
Direct labor Actual Standard Actual
Factory overhead Actual Standard Predetermined

Inventories in a manufacturing operation

Because of the production process, the inventories in a manufacturing company may be
found at different stages of completion at the end of the accounting period. Some units
may have been completely finished and transferred to the warehouse ready for selling
to customers, others may still be in the production floor and are partially processed or
partially completed while still others may be totally untouched and are still in their
original state when they were purchased. The inventory accounts in a manufacturing
concern based on their stage of completion are as follows:

11
 1. Finished Goods Inventory
This is the cost of the items that are fully completed but are still in the finished
goods warehouse and unsold at the end of the accounting period. These are the
items that are readily available for sale to the company’s customers - the
wholesalers and retailers.

The finished goods of one company may actually be raw materials for another
company. For example, the rolled or baled fabric is the finished product of a
textile factory but a raw material for a garment factory.

2. Work in Process Inventory

At the end of the accounting period, certain items in the production area may be
in their unfinished stage, that is, having been partially processed but not yet fully
completed. The cost of these items is charged to Work in Process Inventory.

3. Raw Materials Inventory

This account represents the cost of materials that are still in their untouched or
raw form or have not yet undergone any manufacturing process at the end of the
accounting period. They are still in their original condition when they were
purchased.

4. Factory and Engineering Supplies inventory

This represents the cost of other supplies that are used in the factory including
the cost of spare parts for the repairs and maintenance of machines.

These four groups of inventories are presented as current assets in the statement of
financial position.

12