CHAPTER TWO

COST TERMINOLOGE AND CLASSIFICATION

Overview of the chapter
Chapter2 introduces as a general concept and important cost terms. Cost objectives, direct costs
and indirect costs are defined and illustrated. The concepts of cost tracing and cost allocation are
introduced. Cost driver is defined and the relationships of cost driver, variable costs, and fixed
costs are explained. Several approaches are provided to illustrate the concept of cost behavior.
Major assumptions under underlying the definitions of variable and fixed costs are given and the
relevant range is defined. Uses and limitations of unit costs are explained.
Manufacturing firm and their related manufacturing cost categories are introduced. Prime and
conversion costs are defined and explained
The financial statements for service, merchandising and manufacturing sector companies are
compared with the cost of goods sold section being explained and illustrated in detail. Then costs
as assets and expenses are discussed. The three types of inventory appearing on a manufacturer’s
balance sheet are defined. The chapter concludes with a discussion of different meaning of
product cost
Cost terminology
Many accounting reports contain several cost terminologies. A good understanding of the
different cost terminology is essential at least for the following two reasons.
 It enables accounting information users to best use the information provided
 Uses of common terminology avoids confusion and misunderstanding
The following are some of the terms used in cost accounting.
Cost, expense, loss: Accountants usually define cost as resources scarified or forgone to achieve
a specific objective it refers to disbursement or expenditure of money to acquire goods and
services in the course of generating revenue. For instance purchase of raw martial represent a
cost as the raw material used to produce finished goods that generate revenue when sold.
How ever some disbursements are not costs. For example, the payment of dividend is
disbursement but it does not help to generating revenue, hence it is not a cost.
All cost initially represents an asset. As the asset is used in generating revenue, the amount
consumed becomes an expense. There for expense is expired cost the cost of asset used should

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then be recognized as expense to properly match revenue and expenses in the process of
determining the income of the organization over a given period. For instance insurance premium
paid in advance to serve the coming period are initially recognize as asset but as time pass on,
the asset is continually converted in to an expense. Another example may be motor vehicle
bought for uses for the coming five year is an asset when initially purchased. However as the
asset is used up in the process of generating revenue, the cost gradually become an expense.
Thus, expenses are expired costs or costs used up in the course of generating revenue.
Sometimes a firm may incur a cost that produces neither immediate nor future benefit. This is
called a loss.
Cost object: is any thing for which a separate measurement of costs is desired. To guide their
decisions, managers want to know how much a particular thing (such as a product, machine,
service, or process) costs.
E.g. Product, service, project, customer, brand category, activity department etc
Cost accumulation and cost assignment: a costing system typically account for costs in two basic
stages, accoumulation followed by assignment.
Cost accumulation- is the collection of cost data in some organized way by means of an
accounting system.
E.g. an organization that manufactures consumer commodities accumulates the costs incurred in
producing the commodities.
Cost assignment- is a general term that encompasses both (1) tracing accumulated costs to direct
relationship to a cost object, and (2) allocating accumulated costs that have an indirect
relationship to a cost object.
Cost driver: is any factor that affects total cost. That affects total cost. That is change in the cost
driver will cause a change in the level of the cost of a related cost object. Examples:
 Mile driven for transport cost
 Length of time of call for telephone cost
 Meter cub of water consumed for water cost
 Unit soled for cost of goods sold
Cost management: is the set of action that a manager takes to satisfy customers while
continuously reducing and controlling cost. Cost reduction efforts frequently focus on two key
areas

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  Doing only value added activities, that is those activities that customers perceive as
adding value to the product or service they purchase
 Efficiently managing the use of the cost drivers in the value added activities.

Classification of cost
Cost may be classified in different ways from different point of view. The same cost may be
included in several or in all of the following classification

1. Time period point of view

From time period point of view costs are classified in to historical cost and budgeted cost
-historical costs are costs incurred in the past period where as budgeted costs are costs expected
to be incurred in the future period.
E.g. the 8,000 br cost of a computer acquired in 2005 is historical cost in the financial statement
of 2006. How ever the 10,000 br cost to acquire a new computer in 2007 to replace the existing
one is a future cost
2. Management function point of view
From management function point of view costs are classified in to:
Manufacturing cost: includes costs from the acquisition of raw material through production until
the product can be turned over to the marketing division to be sold. (eg material, labor and
manufacturing overhead).
Selling cost: are costs associated with marketing and selling a product. They include all costs
included by the marketing division from the time the manufacturing process is completed until
the product is delivered to customers.
These costs include advertising, promotion, transportation and ware house.
Administrative cost: are costs associated with the management of the company and include
expenditures for accounting, legal and administrative activities. Both selling and administrative
costs are non manufacturing cost.
3. Business function (value chain) point of view
Value chain refers to the sequence of business functions in which usefulness is added to the
product or service of a company.
From business function point of view cost is classified as follows:
- Research and development cost -Distribution cost
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 - Product design cost -Consumer service cost
- Production cost marketing cost
4. Generally accepted accounting treatment point of view
The alternatives in accounting for cost are to expense it or to capitalize it. Costs that are
expensed in the period in which they are incurred are called non capitalized cost or period cost.
These costs possess no future benefit and are generally associated with a non manufacturing cost.
Period costs (non inventor able cost)-are all costs in the income statement other than cost of
goods sold. These costs are treated as expenses of the period in which they are incurred because
they are presumed not to benefit future periods (or because there is not sufficient evidence to
conclude that such benefit exists).These costs are identified with the period of time in which they
are incurred. As such, period costs are not included as part of the cost of either purchased or
manufactured goods.
For manufacturing sector companies, period costs include all non manufacturing costs.
For merchandising companies, period costs include all costs not related to the cost of goods
purchased for resale in their same form.
For service-sector companies, since there is no inventor able cost, all their costs are period
costs.
Some examples of period costs are- research and development costs, Selling /marketing/ and
administrative expenses such as salary expense, advertising expenses, sales commission
expenses, depreciation expenses, supplies expense, interest expenses, and the like.
-Where as capital costs include to manufacturing a product (product cost) or to acquire long term
assets. These costs are recorded as an asset at the beginning of and expensed periodically. These
product cost is also called inventorable cost
Product or inventor able costs-are all cost of a product that are regarded as an asset when they are
incurred and then become cost of goods sold when the product is sold. For manufacturing sector
companies, all manufacturing costs are inventor able. Costs incurred for direct material, direct
manufacturing labor, and indirect manufacturing costs create new assets, first work-in process,
and then finished goods.
For merchandizing sector companies, inventor able cost are the costs of purchasing the goods
that are resold in their same form. These costs are the costs of the goods themselves and any
incoming freight costs for those goods. For service sector companies, since there is no inventory
of services, there are no inventor able costs.
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 5. Cost assignment point of view
From this point of view costs are classified as direct cost and indirect cost
Direct cost - are related to the particular cost object and can be traced to it in an economically
feasible (cost-effective) way. These are direct material E.g.-The cost of office supplies used in
the loan department is a direct cost of that department.
And direct labor E.g. -The salary of a manager of production department is a direct cost of that
department
The term cost- tracing is, therefore, used to describe the assignment of direct costs to the
particular cost object
Indirect cost -are related to the particular cost object but, can not be traced to it in an
economically feasible (cost-effective) way.
E.g. - Cost of quality-control personnel who conduct taste and content tests on multiple soft
drink products bottled at a Pepsi plant is an indirect cost of Pepsi soft drink.
-The cost of general advertising by the bank, which is allocated to the loan department.
The term cost allocation is, therefore, used to describe the assignment of indirect costs to the
particular cost object.
Some of indirect costs are: cost of electricity, depreciation of equipment, indirect labor indirect
material, cost of different utilities, cost of repair and maintenance insurance for the plant
6. Decision making point of view
A Decision involves making a choice among alternative courses of action
From decision making point of view costs are divided as relevant and irrelevant costs
Relevant cost: cost useful for decision making and it is a future cost which change among
alternative course of actions.
Irrelevant costs: are costs not useful for decision making, it is past or sunk which was already
incurred.
Sunk costs- are costs that have been incurred in the past. Consequently, they do not affect future
costs and cannot be changed by any current or future action. Examples of such costs include the
acquisition cost of equipment previously purchased, the manufacturing cost of inventory on
hand, and the like.
7. Management influence point of view
Management influence refers to the ability of a manager to control particular cost. Under this
point of view costs are classified as controllable and uncontrollable.
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If a manager can control or heavily influence the level of a cost, then that cost is classified as a
controllable cost of that manager.
Costs that a manager cannot influence significantly are classified as uncontrollable costs of that
manager.
Controllability of accost depends on the level of management and time period.
All costs are controllable by some one at some level in the organization if the period is longer
enough.
8. Cost behavior point of view
From their behavior point of view, costs are divided in to fixed cost and variable cost
Variable costs-are costs that vary in total, in direct proportion to changes in the level of activity
or cost driver i.e. if activity increase by n%, total variable cost also increase by n%, but the per
unit cost remains constant.
‘‘Activity’’can be expressed in many ways, such as units produced, units sold or purchased,
miles driven, hours worked, and so forth.
E.g. Direct material cost, direct labor cost, commission paid to sales personnel (at $30 per
commodity sold), cost of natural gas to heat factory, wages paid to employees who assemble the
goods in the assembly department.
Fixed costs-are costs that remain unchanged in total regardless of variation in the level of
activity (or cost driver), for a given relevant range. If activity increases or decreases by n%
within the given relevant range, total fixed cost remains the same; but the per unit fixed cost
changes.
E.g. Salary of plant manager, monthly rental cost of equipment and /or house,
depreciation of machines used to produce furniture’s at $10,000 per year and the like.
Total cost is sum of variable cost and fixed cost: (TC=TFC+TVC)
Average cost = Total cost
No. unit produced
Example 1 Student association has hired a musical group for graduation party. The fixed cost of
hiring a band for the party is br. 4,000. the hall in which the graduation ceremony is celebrated
can afford up to 2,000 attendee. It has been determined that the cost of refreshment consumed by
each person attending the party will be br 8.
Required: A) fill the following table based on the information provided
No. of attendee Total fixed Average fixed Total variable Total cost Total
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 cost cost cost average cost
500
1,000
1,500
2,000
B) Draw the graph of FC, VC, and TC D) what happen to the fixed cost if the no. of
C) Draw the of AFC, AVC, and TFC Attendee is 3, 000, 5, 000, 7,000

9. Commitment to cost expenditure

Commitment to cost expenditure focused on fixed cost as opposed to variable cost and budgeted
cost as opposed to historical cost
Budgeted fixed cost can be classified as committed cost and discretionary cost.
Committed cost: is one that is an inevitable consequence of a previous commitment.
E.g. Property tax on ware house budgeted for the coming year is an example of commitment cost
because it results from decision to construct the ware house last time
Discretionary cost (programmed or management cost): is one in which the amount of time of
incurrence is a matter of choice. These are non recurring costs for which a final commitment has
not yet been made and that can be postponed to future period or canceled entirely.
10. Other cost classification
In addition to accounting cost classifications, such as product costs and period costs, managerial
accountants also employ economic concepts in classifying costs. Such concepts are often useful
in helping accountants decide what cost information is relevant to the decisions faced by the
organization’s managers. Some of the most important economic cost concepts are:
 Opportunity costs
 Out-of- pocket costs
 Sunk costs
 Differential costs
 Marginal costs and Average costs
Opportunity costs-An opportunity cost is defined as the benefit that is sacrificed when the choice
of one action precludes taking an alternative course of action. E.g. if beef and fish are the
available choices for dinner, the opportunity cost of eating beef is the forgone pleasure
associated with eating fish.

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Out-of pocket costs- are those that require the payment of cash or other assets as a result of their
incurrence. The out of pocket costs associated with office equipment order is consists of the
manufacturing costs required to produce the equipments.
Differential costs- A differential cost is the amount by which the cost differs under two
alternative actions. It is also known as incremental costs. Suppose for example that Bulehora
University is considering two alternative means of providing accommodation for academic
staffs.
i) To provide a house and transport allowance and get the staffs reside elsewhere outside
the University compound. Assume that the total monthly cost to be incurred by
the university under this alternative is Br 150,000
ii) To provide all stuff with accommodation within the university compound and pay no
house and transport allowances. Let say that the total monthly cost to be incurred
by the university under this alternative is estimated to be Br 100,000
The monthly differential cost of accommodating the stuff by the university would
therefore be:
Cost of providing house and transport allowance Br 150,000
Cost of accommodating the stuff in the university compound 100,000
Monthly differential cost 50,000

Marginal costs and Average costs- marginal cost is the extra cost incurred when one additional
unit produced. The additional cost incurred to assemble one additional machinery by assembly
department is the marginal cost of assembling the machinery. The average cost per unit is the
total cost for whatever quantity is manufactured, divided by the number of units manufactured.

NB Many deferent cost concepts have been explored in this chapter. An important task of the
managerial accountant is to determine which of these cost concepts is most appropriate in each
situation. The accountant attempts to structure the organization’s accounting information system
to record data that will be useful for different purposes. The benefits of measuring and
classifying costs in a particular way are realized through the improvements in planning, control,
decision making and other management activities that the information facilitates.
Another important task of the managerial accountant is to weigh the benefits of providing
information against the costs of generating, communicating, and using that information.
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Moreover the management accountants are expected to decide on amount of information to be
provided. This is because, to process more information may lead to information overload, the
case where managers face a problem of properly identifying important facts out of what is
available.

MANUFACTURING COST
Manufacturing –sector companies purchase materials and components and convert them in to
different finished goods. They typically have one or more of the following three types of
inventories:
1. Direct material inventory-direct materials and in stock and awaiting use in the
manufacturing process.
2. Work-in-process inventory-Goods partially worked on but not yet fully completed. They
are also called Work-in-progress.
3. Finished goods inventory- Goods fully completed but not yet sold.
Merchandising-sector companies purchases and then sell tangible products with out changing
their basic form.
They hold only one type of inventory, which are the products in their original purchased form.
Service-sector companies provide only services or intangible products to their customers and
hence do not hold inventories of tangible products for sale
In manufacturing company production costs are grouped in to three categories these are
direct material, direct labor and manufacturing overhead cost. See the diagram below.
Prime costs and Conversion costs-These two terms are used in manufacturing companies. Prime
costs are all direct manufacturing costs i.e. the combination of direct material and direct
manufacturing labor costs. Conversion costs are all manufacturing costs other than direct
material costs. It is the combination of manufacturing labor costs and manufacturing overhead
costs. These costs are incurred to transform direct materials into finished goods.

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So, prime cost = direct material + direct labor
Conversion cost = direct labor + manufacturing overhead cost

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 Financial statement for manufacturing company
In order to prepare financial statement for manufacturing company, the following schedules are
necessary.
Schedule 1 Direct Material cost used
Direct Material beginning ------------------------------XX
Direct material purchase --------------------------------XX
Direct material available for use-------------------------XX
Direct material ending ---------------------------------- (XX)
Direct material cost used ---------------------------------XX
Schedule 2 Cost of goods manufacture
Direct material cost used ---------------------------------XX
Direct labor cost -------------------------------------------XX
Manufacturing over head cost ----------------------------XX
Cost incurred in current period --------------------------XX
Work in process beginning ------------------------------XX
Total cost incurred to date -------------------------------XX
Work in process ending --------------------------------- (XX)
Cost of goods manufactured -----------------------------XX
Schedule 3 Cost of good sold
Finished goods inventory --------------------------------XX
Cost of goods manufactured -----------------------------XX
Cost of goods available for sale ---------------------------XX
Finished goods ending ----------------------------------- (XX)
Cost of good sold ------------------------------------------XX
Schedule 4 Income statement for manufacturing company
Revenue ------------------------------------------------XX
Cost of good sold --------------------------------------XX
Gross profit----------------------------------------------XX
Operating expense ------------------------------------ (XX)
Operating income ---------------------------------------XX

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Example 1: consider the following account balance for ABC manufacturing company in the year
2004
Beginning balance End balance
Direct material inventory-----------22,000 -----------------------------------------26,000
WIP inventory------------------------21,000 -----------------------------------------20,000
Finished goods inventory-----------18,000------------------------------------------23,000
Purchase of direct material-------------------------------------------------- --------75,000
Direct labor cost -------------------------------------------------------------------- 25,000
Indirect labor cost1----------------------------------------------------------------------5,000
Plant insurance --------------------------------------------------------------------------9,000
Depreciation plant building and equipment -----------------------------------------11,000
Repair and maintenance ---------------------------------------------------------------- 4,000
Marketing, distribution and customer service cost ---------------------------------93,000
General and administrative cost -------------------------------------------------------29,000

Required:
a) Calculate cost of direct material used
b) Calculate cost of goods manufactured
c) Calculate cost of goods sold
d) If revenue for the year is $ 300,000, prepare income statement for the company.

Example 2: a fire destroyed XYZ manufacturing company completely on January 29,2004.

Fortunately certain accounting records were kept in another building. It revealed the following
for the period from January 1, 2004 to January 29, 2004.
Direct material purchased -----------------------------160,000
WIP January1-------------------------------------------34,000
Direct material January1, 2004 ------------------------16,000
Finished goods January 1, 2004------------------------30,000
MOH cost -----------------------------------------------40%of conversion cost
Revenue --------------------------------------------------500,000
Direct labor cost-------------------------------------------180,000
Prime cost -------------------------------------------------294,000
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 Gross profit based on sales--------------------------------20%
Cost of goods available-------------------------------------450,000

Requirement:
a) Direct material destroyed
b) Cost of goods manufacturing
c) Finished goods destroyed
d) WIP destroyed

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