Cost Concept and Classification of Cost

COST CONCEPT AND
CLASSIFICATION OF
COST
Lesson 1: Cost concepts and cost behavior
OBJECTIVES:
01 PROBLEM & SOLUTION

COST CONCEPT
02 COST OBJECT
Define and explain the term
Define and give examples of cost object and give examples
cost. relevant to different types of
decision.
03 TRACEABILITY OF COSTS
TO COST OBJECTS 04 CLASSIFICATION OF COSTS
Understand the different

Describe several degrees of
cost traceability implied by classification of cost.
the terms direct cost and
indirect cost.
01
COST CONCEPT
Accountants have defined cost as

“an exchange price, a forgoing, a
sacrifice made to secure benefit.”
COST CONCEPT
EXAMPLES:
● A service provider needs to purchase supplies and materials and pay

salaries to employees in order to render service and earn revenues.
● A merchandiser has to first purchase the goods that they need to sell in
order to earn revenues.
● A manufacturer spends for materials, labor payroll, and other factory

burden to transform raw materials to finished goods and eventually sells
those goods to earn revenue.
NO
DOES COST MEANS EXPENSE?
Every expense is a cost, but not every cost
is an expense.
EXPENSE
“Expense is measured by the amount of the decrease in assets or the
increase in liabilities related to the production and delivery of goods
and the rendering of services... expense in its broadest sense includes
all expired costs which are deductible from revenues.”
COST OBJECT
“ A cost object, or cost objective, is defined as
any item or activity for which cost are
accumulated and measured. “
02
COST OBJECT
The following items and activities • Process
can be cost objects:
• Department
• Product
• Division
• Batch of like units
• Project
• Customer order
• Strategic goal
• Contract
• Product line
COST OBJECT
WHY ASSIGN COSTS TO A COST OBJECT?
● Determine price to charge.

● Determine profitability.
● Evaluate performance.
● Make improvements/adjustments.
TRACEABILITY OF COSTS TO COST
OBJECTS
“The traceability of costs to a cost object varies by degree. A common way
of characterizing costs is to label them as either direct or indirect costs of
a particular cost object. “
Direct cost is the cost incurred by Indirect cost is the cost that cannot
the organization while performing be directly attributed to the
their core business activity and can production as these costs are
be attributed directly in the incurred in general.
product cost.
—DIRECT COST —INDIRECT COST

OBJECTS
DIRECT INDIRECT
COST COST
o Raw materials, • Rent,
o Wages paid to • General and

factory staff, Administrative
Expenses
o Supplies
OBJECTS
• Directly traceable costs are those items that can be physically or
contractually identified as components of the finished unit of product.
• Costs can be empirically traced to its unit’s production by observing the

production process.
• The next costs are those traceable to the process used in making the
product, then the costs traceable to the department in which the
process is carried out, then the costs traceable to the building or plant
location in which the department is located, and so on.
CLASSIFICATION
OF COST
1. The product (a single lot, batch, or unit of a
good or service)
2. The volume of production
3. The manufacturing departments, processes,
cost centers, or other subdivisions
4. The accounting period
5. A decision, action, or evaluation
COSTS IN RELATION TO THE PRODUCT
MANUFACTURING COSTS.
● Manufacturing cost also called production cost or factory cost - is

usually defined as the sum of three cost element: direct materials,
direct labor, and factory overhead. Direct materials and direct labor
together are called prime cost. Direct labor and factory overhead
together are called conversion cost.
Direct materials are all materials that form an integral part of the finished
product and that are included explicitly in calculating the cost of the product.
Ex. Direct materials are the lumber to make furniture and the crude oil to make
gasoline.
Direct labor is labor that converts direct materials into finished product and can
be assigned feasibly to a specific product.
Ex. The salaries of workers who cut and sand lumber and of those who assemble
the parts into finished chairs are considered direct labor costs. In the manufacturing of
clothing, the earnings of cutters and sewing machine operators are direct labor costs.
Factory overhead-also called manufacturing overhead, production overhead,

indirect production cost, manufacturing expenses, or factory burden consists of all
manufacturing costs not traced directly to specific output. Factory overhead generally
includes all manufacturing costs except directs materials and direct labor.
Ex. Factory rent, building insurance, utilities.
Indirect materials are those materials needed for the completion of a product but
not classified as direct materials because they do not become part of the product.
Ex. nails, screws, washer, glue, and staples

Brushes, oils, cleaning supplies (operating supplies)
Indirect labor is labor not directly traced to the construction or composition of

the finished product.
Ex. wages of supervisors, shop clerks, general helpers, maintenance workers,

and, usually, material handlers.
..
COMMERCIAL EXPENSES.
Marketing expenses begin at the point at which the factory costs end. That is,
when manufacturing has been completed and the product is in salable condition.
Ex. They include the expenses of promotion, selling, and delivery.
Administrative expenses include expenses incurred in directing and controlling

the organization. Not all such expenses are allocated as administrative expenses.
Ex. Administrative and office salaries, depreciation.

COSTS IN RELATION TO THE VOLUME OF
PRODUCTION
VARIABLE COSTS.
● The total amounts of variable costs change in proportion to changes in activity

within a relevant range. Stated differently, variable costs show a relatively
constant amount per unit as activity changes within a relevant range. Variable
costs generally include direct materials and direct labor.
The following list identifies overhead costs usually classified as variable costs.
Supplies Fuel
Small tools Communication costs
Overtime premium Materials handling
PRODUCTION
FIXED COSTS.
● Fixed costs are constant in total amount within a relevant range of

activity. Stated differently, fixed costs per unit decrease as activity
increases within a relevant range.
The following factory overhead costs usually are classified as fixed costs:
Salaries of production executives Depreciation

Property tax Patent amortization Insurance property and liability
Wages of security guards and janitors Rent
Maintenance and repairs of buildings and grounds
PRODUCTION
SEMIVARIABLE COSTS.
● Some costs contain both fixed and variable elements, these are called
semivariable costs.
For example, the cost of electricity is usually semivariable. Electricity used

for lighting tends to be a fixed cost because lights are needed regardless
of the level of activity, while electricity used as power to operate
equipment will vary depending on the usage of the equipment.
COSTS IN RELATION TO MANUFACTURING
DEPARTMENTS OR OTHER SEGMENTS
A business can be divided into segments having any of a variety of names.

The division of a factory into departments, processes work cells, cost
centers, or cost pools also serves as the basis for classifying and
accumulating costs and assigning responsibility for cost control. As a
product passes through a department or cost center, it is charged with
directly traceable costs atypically direct materials and direct labor) and a
share of indirect costs (factory overhead).
PRODUCTION
PRODUCING AND SERVICE DEPARTMENTS.
● In a producing department, manual and machine operations such as

forming, and assembling are performed directly on the product or its
parts.
PRODUCTION
PRODUCING AND SERVICE DEPARTMENTS.
● In a service department, service is rendered for the benefit of other

departments. In some instances, these services benefit other service
departments as well as the producing departments. Although a service
department does not directly engage in production, its costs are part
of factory overhead and are a cost of the product Service departments
that are common to many organizations include maintenance, payroll,
cod accounting, data processing, and food services.
PRODUCTION
COMMON COSTS AND JOINT COSTS.
● Common costs are costs of facilities or services employed by two or

more operations Common costs are particularly prevalent in
organizations with many departments or segments.
PRODUCTION
COMMON COSTS AND JOINT COSTS.
● Joint costs occur when the production of one product makes it

inevitable that one or more other products are also produced. The
meat packing, oil and gas, and liquor industries are good examples of
production that involves joint costs.
COSTS IN RELATION TO AN ACCOUNTING
PERIOD
● A capital expenditure is intended to benefit future periods and is

reported as an asset.
● A revenue expenditure benefits the current period and is reported as

an expense.
COSTS IN RELATION TO A DECISION, ACTION,
OR EVALUATION
● Differential cost is one name for a cost that is relevant to a choice

among alternatives. It is the difference between cost of two alternative
decisions. Differential cost is sometimes called marginal cost or
incremental cost.
Out-of-pocket cost. If a differential cost will be incurred only if one

particular alternative is followed.
Opportunity cost. An amount of revenue or other benefit that will be

missed or lost if a particular alternative is followed.
COSTS IN RELATION TO A DECISION, ACTION,
OR EVALUATION
Sunk cost. A cost that has already been incurred and is therefore,
irrelevant to a decision.
Unavoidable costs. In a decision to discontinue a product or division,

some of the product’s or division’s costs may be unaffected by the
decision.
Avoidable costs, in contrast, are relevant to the decision.

COST CONCEPT AND
CLASSIFICATION OF
COST
JEMIMA C. SERRANO
BSAIS 2-1
REFERENCES:
Carter, Cost Accounting 14th edition, Thomson Asian Edition
Guerrero, Cost Accounting (2018)

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COST CONCEPT AND

01 PROBLEM & SOLUTION

Understand the different

Accountants have defined cost as

● A service provider needs to purchase supplies and materials and pay

● A manufacturer spends for materials, labor payroll, and other factory

WHY ASSIGN COSTS TO A COST OBJECT?

● Determine price to charge.

—DIRECT COST —INDIRECT COST

o Wages paid to • General and

• Costs can be empirically traced to its unit’s production by observing the

● Manufacturing cost also called production cost or factory cost - is

Factory overhead-also called manufacturing overhead, production overhead,

Ex. Factory rent, building insurance, utilities.

Ex. nails, screws, washer, glue, and staples

Indirect labor is labor not directly traced to the construction or composition of

Ex. wages of supervisors, shop clerks, general helpers, maintenance workers,

Ex. They include the expenses of promotion, selling, and delivery.

Administrative expenses include expenses incurred in directing and controlling

Ex. Administrative and office salaries, depreciation.

● The total amounts of variable costs change in proportion to changes in activity

● Fixed costs are constant in total amount within a relevant range of

Salaries of production executives Depreciation

For example, the cost of electricity is usually semivariable. Electricity used

A business can be divided into segments having any of a variety of names.

● In a producing department, manual and machine operations such as

● In a service department, service is rendered for the benefit of other

● Common costs are costs of facilities or services employed by two or

● Joint costs occur when the production of one product makes it

● A capital expenditure is intended to benefit future periods and is

● A revenue expenditure benefits the current period and is reported as

● Differential cost is one name for a cost that is relevant to a choice

Out-of-pocket cost. If a differential cost will be incurred only if one

Opportunity cost. An amount of revenue or other benefit that will be

Unavoidable costs. In a decision to discontinue a product or division,

Avoidable costs, in contrast, are relevant to the decision.

Guerrero, Cost Accounting (2018)

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