CHAPTER COST TERM 5. CONCEPTS AND CLASSIFICATIONS LEARNING OBJECTIVES After studying this chapter, you should be able to... 1. 2. Explain the nature of cost, cost pools, cost objective and cost drivers. Identify and explain the various classifications of costs. Costs classified by Nature Costs classified according to the Timing of Recognition as Expense Costs classification on Financial Statements Cost classification for Predicting Cost Behavior Costs classified by Types of Inventory Costs classification according to Traceability to Cost Objective Costs classification according to Managerial Influence Cost Terminologies Used for Planning and Control Cost classification according to a Time-frame Perspective Costs classified according to Time Period for Which the Cost is Incurred Costs classifications for Decision-making and other Analytical Purposes 00404CHAPTER 2 COST TERMS, CONCEPTS AND CLASSIFICATIONS INTRODUCTION Chapter 1 indicated that managerial accounting deals with the information managers need for making decisions and for planning and performance evaluation. From an accounting point of view, this information often relates to the costs of the organization. “ An understanding of cost terms and concepts provides the foundation of how to best use the information provided as well as to avoid misuse of that information. This chapter discuss cost concepts and terms expressed in accounting information for internal and external reporting. Anyone who uses accounting information must also have a broad perspective and understanding of the system that provides the data. In Chapter 1, we provide an overview of cost flows by showing how costs are accumulated in the accounting systems of merchandising, manufacturing and service organization. NATURE OF COST, COST POOLS, COST OBJECTS AND COST DRIVERS Cost At the most basic level, a cost may be defined as the value foregone or sacrifice of resources for the purpose of achieving some economic benefit which will promote the profit-making ability of the firm. A cost is incurred when a resource is used for some purpose. It is also an outlay or expenditure of money to acquire goods and services that assist in performing operations. A costing system accounts for costs in two basic steps, namely, cost accumulation and cost assignment. Accounting costs are classified in numerous ways. To prepare financial statements, accountants must associate costs with specific time periods. The classification of costs into product and period costs allows accountant to do that. In managerial accounting, the term cost may be used in different ways because there are many types of costs that may be classified differently according to the immediate needs of management. For instance, external financial reports require the use of historical cost data whereas decision making may require current cost data.20 Chapter 2 Costs are als i osts © classified differently (lependi involved, i ou ly Wepending on the type a classified that 'S, merchandising, service, or manufacturing, Coot pipe 3 ang recorded in a particular way for one purpose may be inte ate for another use. Purpose may be inappropriate Cost Pools Cost pools are costs collect classified ed into meaningful groups. Cost pools may be (1) by type of cost (labor cost in one pool, materials costs in another) (2) by source (department 1, department 2 and so on) (3) by responsibility (manager 1, manager 2 and so on) and many more. Cost Object A cost object is any product, service or organizational unit to which costs are assigned for some management purpose. Products and services are generally cost objects, while manufacturing departments are considered either cost pools or cost objects, depending on whether management’s main focus is on the costs of the products or for the production department. Any item to where costs can bé traced and that has a key role in management strategy can be considered a cost object. Figure 2.1 provides examples of several different types of costs objects. Figure 2.1: Examples of Cost Objects Cost Object Illustration Program An athletic program of a university __ Department A department within a DENR that studies air emissions standards Aa 4 ivi A test to determine the quality level of television set___ cam ‘All soft drinks sold by a Pepsi-Cola bottling company with “Pepsi” in their name a All products purchased by Landmark (the customer) from Purefoods Inc. aos Project A special sportscar assembled by Toyela ie ‘An airline flight from NAIA to jongkong _ o le Product ‘A motoreyclaions_21 Cost cepts and Clas Cost Drivers age is to identify the key cost A critical first step for achieving a competitive advant tor that has the effect of drivers ina firm or organization. A cost driver is any fact cost drivers is changing the level of total cost. The management of the key a essential for a firm that competes on the basis of cost leadership. For a > achieve its low-cost leadership in manufacturing electronic products, Sony Manufacturing watches carefully the design and manufacturing factors that drive the costs in its products. For firms that are not cost leaders, the management of cost drivers may not be as critical but focusing attention to the key cost drivers contributes directly to the success of the firm, For example, an important cost driver for retailers is loss and damage to merchandise so most retailers have careful procedures for handling, displaying and storing merchandise. Figure 2.2 presents examples of cost drivers in each of the business functions in the Value Chain. Figure 2.2: Examples of Cost Drivers of business functions in a value chain Business Function Cost Driver Research and development |e Number of research projects Manpower hours on a project e Technical difficulties of projects Design of products, services e Number of products in design and processes © Number of parts per product e Number of engineering hours Production e Number of units produced e Direct manufacturing labor costs © Number of setups e Number of engineering change orders Marketing e Number of advertisements run ¢ Number of sales personnel e Peso sales Distribution © Number of items distributed e Number of customers © Weight of items distributed Customer service ¢ Number of service calls Number of products serviced Hours spent servicing products22 Chapter 2 Cost Accumulation and Cost Assignment of assigning costs to cost pools or from cost pools Cost assignment is the process to cost objects. Pa, ation bas. Cost allocation is the assignment of indirect costs to cost pools. Alloc es are cost drivers used to allocate costs. CLASSIFICATIONS OF COSTS Cost classifications are necessary for the development of cost information to serve the needs of management. Understanding these concepts and classifications enables the managerial accountant to provide appropriate cost data to the managers who need it, Basic cost classification and terminologies are presented in Figure 2.3 (Page 23). A. Costs classified by Nature or Management Function Manufacturing Costs Manufacturing costs are all the costs associated with production of goods. They are frequently classified as direct materials, direct labor, and factory overhead. Since costs attach to the product dr groups of products as they are manufactured, expenditures, regardless of their hature, usually are capitalized as inventory assets and do not become “expired costs” or “expenses” until the goods are sold. Direct Materials All raw material costs that become an integral part of the finished product and that can be conveniently and economically assigned to specific units manufactured. Materials cost includes the invoice price plus other costs paid to the vendor, shipping costs, sales taxes, duty, cost of delivery containers and pallets (less net of return refunds), and royalty payment based on direct materials quantities. Trade discounts and cash discounts (if they exceed reasonable interest rates) should reduce materials costs.Figure 2.3, Cost Classifie: Cost Data Nature or Management Function Timing of Recognition as Expense Financial Statements Cost Behavior ‘Types of Inventory Traceability to Cost Objective Managerial Influence Planning and Control Time Frame / Commitment to Cost Expenditure Period of Incurrence Decision Making and Other Analytical Purposes CS nvr Manufacturing costs Nonmanufacturing costs |__— Product (Inventoriable) costs | > Period costs Statoment of Financial Postion [-——® (inventory costs) J-——+ Income statement (Cost of Sales / Other Operating Costs) Variable costs + Fixed costs Semivariable costs Raw materials inventory Work in process inventory Finished goods inventory Merchandise inventory |_— Direct costs J > indirect costs > Controllable costs, Noncontrollable costs Standard costs Budgeted costs ‘Absorption costing Full costing Direct costing Variable costing Information costs Ordering costs Cutof pocket costs |___—-» Committed costs | ——> Discretionary costs |___—¥ Historical costs | > Future costs Relevant costs (Future/Differential) Sunk costs Opportunity costs Marginal costs Value-added costs24 Chapter waste, and normally ur in the ordinary ee of the ; iti f scrap, shrinkage, icipated quantities OF | : wae. should be included in manufacturing ihe period incurred. Also, routine duality ting should be assurance samples that are destroyed as part ot ae i te pea oe classified as materials. However, nonroutin a rE samples are taken due to manufacturing pro em fs marketing samples should not be added to materials costs. t should also ‘include scrap, Materials cost units that occ anticipated defective production process. n waste, or defective unt overhead or expensed in # Direct labor All labor costs related to time s conveniently and economically manufactured. Estimates of direct labor quantities and unit prices may be sufficiently accurate to be considered “specifically identified” with a cost object. pent on products that can be assigned to specific units Manufacturing Overhead Manufacturing overhead, the third element of manufacturing cost, includes all costs of manufacturing except direct materials and direct labor. Indirect materials, indirect labor, property taxes, insurance, supervisor’s salaries, depreciation of factory building and factory equipment, and power are examples of factory overhead. Costs of operating service departments are also part of overhead. Service departments are those that do not work directly on manufacturing products but are necessary for the manufacturing process to occur. An example is equipment-maintenance departments. Indirect materials. Indirect materials include materials and supplies used in the manufacturing operation that do not become part of the product, such as oil for the machine . i custodian. ty and cleaning fluids for the Indirect labor. Labor costs that cannot be identified or traced to specific units manufactured. Examples include supervision inspection, maintenance, personnel and material handling. P ,Cost Terms, Concepts and Classifications 25 Other Manufacturing Overhead To summarize, manufacturing costs include direct materials, direct labor and manufacturing overhead. Direct labor and overhead are often. called conversion costs since they are the costs of “converting or transforming” raw material into finished products. Direct materials and direct labor are often referred to as prime costs. Other manufacturing overhead costs include overtime premiums and the cost of idle time. An overtime premium is the extra compensation paid to an employee who works beyond the time normally scheduled. Nonmanufacturing Costs Nonmanufacturing costs generally include costs related to selling and other activities not related to the production of goods. Marketing costs Marketing or selling costs include all costs associated with marketing or selling a product or all costs incurred by the marketing division from the time the manufactu: ing process is completed until the product is delivered to the customer or all costs necessary to secure customer orders and get the finished product or service into to hands of the customer. These costs also called order-getting and order-filing costs. Examples of marketing costs are advertising, shipping, sales commissions and storage costs. General and administrative costs General administrative costs include all executive, organizational and clerical costs associated with the general management of the organization rather than with manufacturing, marketing or selling. Production Costs in Service Industry Firms and Nonprofit Organizations Service industry firms such as schools, hotels, banks, airlines, accounting firms, and automotive repair shops and many nonprofit organizations are also engaged in production. What distinguishes these enterprises from manufacturers is that a service is consumed as it is produced, whereas a manufactured product can be stored in inventory while less commonly applied in service firms, the same cost classifications used in manufacturing companies can be applied. For example, an automotive repair shop produces repair services. Direct materials include such costs as new parts installed to replace the worn out parts, paint and other materials used. Direct labor26 Chapter Ww Overhead, costs include rvice cre the: $¢ d rental expense. depreciation of equipment and other tools used an’ , a cs Recording and classifying costs is important not ony eitions as well. Cost but for service industry firms and nonprofit orgal ae services, hotel and analysis is necessary in pricing, banking and insure aa sone travel rental agencies, setting tuition fees in schools an‘ y " d in scope of business operations, an even greater includes. the wages paid to imber ani As these organizations grow in nut SCO] of 2 to their activities take applying managerial accounting, importance. Costs classified according to the Timing of Recognition as Expense An expense is defined as the cost incurred when an asset is used up or sold for the purpose of generating revenue. The terms product cost and period cost are used to describe the timing with which various expenses are recognized. Product Costs Product costs include all the costs that are involved in acquiring or making a product. Also called inventoriable costs, they are costs that “attach” or cling to the units that are produced and are reported as assets until the goods are sold. In the case of manufactured goods, these costs consist of direct materials, direct labor, and manufacturing overhead. So initially, product costs are assigned to an inventory account on the statement of financial position. When the goods are sold, the costs are released from inventory as expenses (typically called cost of goods sold) and matched against sales revenue. This means that a product cost such as direct materials or direct labor might be incurred during one period but not treated as an expense until a following period when the completed product is sold, Period Costs Period costs are all the costs that are identified with accountit iods and not included in product costs. These costs are expen: ed ee . e. statement in the period in which they are incurred. Peri a neu ee included as part of the cost of either purchased of man coy nods Examples of period costs include selling and sdministaltne oaoreee sch as sales commissions, office rent, and transportation pea eeeCost Terms, Concepts and Classifications 27. C. Costs classification on Financial Statements The financial statements prepared by a manufacturing company are more complex than the statements prepared by a merchandising company. Manufacturing companies are more complex business firms than merchandising companies because the manufacturing company must produce its goods as well as market them. The production process gives rise to many costs that do not exist in a merchandising company. The manufacturing company’s product costs include not only the cost of purchasing but also the cost of converting materials into saleable products. These product costs are counted as assets until the product is sold and the revenue from the sales is recorded on the income statement. The Statement of Financial Position The statement of financial position of a manufacturing company is similar to that of a merchandising company. However, the inventory accounts differ between the two types of companies. A merchandising company has only one class of inventory called merchandise inventory. These are goods purchased from suppliers that are awaiting resale to’customers. In contrast, manufacturing companies have three classes of inventories, namely, raw materials, work in process and finished goods. Raw materials are materials that are used to make a product. Work in process consists of units of product that are only partially complete and will require further work before they are ready for sale to a customer. Finished goods consist of | units of product that have been completed but have not yet been sold to customers. The overall inventory figure is usually broken down into these three classes of inventory in footnote to the financial statements. The Income Statement the income statement of merchandising and manufacturing The only apparent difference is in the captions of some cost of goods sold. At first glance, x firms are very similar. I of the entries in the computation of28 Chapter 2 . ; hanidising company is determined ag The cost of goods sold for a merchan' follows: Pxx Beginning merchandise inventory x Add Purchases Pxx Total available for sale x Less: Ending merchandise inventory , be Cost of goods sold The cost of goods sold for a manufacturing company 1 determined as follows: Beginning finished goods inventory Add Cost of goods manufactured Total available for sale Less: Ending finished goods inventory Cost of goods sold The cost of goods manufactured contains the three elements of product costs namely direct materials, direct labor and manufacturing overhead (Figure 2.4). Pk vhf Illustrative Statements of a Merchandising Company Figure 2.4 shows the income statement and current assets section of the statement of financial position of a Merchandising Company. Figure 2.4 ABC Trading Company Income Statement For the Year Ended December 31, 20X1 Sales..... a P1,000,000 Cost of goods sol Beginning inventory. Add purchases...... Goods available for sale. Ending inventory..... Gross margin ni Less operating expenses: Selling expense .... Administrative expense Net income... P100,000 650,000 P750,000 150,000 __600,000 P 400,000 P100,000 200,000 __300,000Cost Terms, Concepts and Classifications_29 ABC Trading Company Current Assets Section of the Statement of Financial Position December 31, 20X1 Current Assets: Cash.. P 10,000 Accounts receivable. 60,000 Merchandise inventory. 150,000 Prepaid expenses... 5,000 Total current assets. 225,000 Illustrative Statements of a Manufacturing Company Figure 2.5 shows the income statement and current assets section of the statement of financial position of a Manufacturing Company. Figure 2.5 XYZ Company Income Statement For the Year Ended December 31, 20X1 P1,500,000 Beginning finished goods inventory .. ‘Add cost of goods manufactured ... Goods available for sale Ending finished goods inventory Gross margin .. P 700,000 Less operating expense: Selling expense .. Administrative expense. Net income .... 175,000 __800,000 250,000 300,000 __550,000 P_150,00030 Chapter 2 XYZ Company , Statement of Cost of Goods Se OK For the Year Ended December 31, Direct materials Direct materials inventory, Purchases of direct materials. Jan. 1, 20X1. P_ 30,000 210,000 Total direct materials available 240,000 as Direct materials inventory, Dec. 31, 20X1 P2500 Direct materials used 250,000 Direct labor. * Manufacturing overhead Indirect materials P 35,000 Factory utilities Factory supervision. Property taxes on factory equipment .. 20,000 Factory maintenance and repairs. 20,000 Depreciation of plant and equipment...... __ 90,000 Total manufacturing overhead. 305,000 Total manufacturing costs... P780,000 Work in process inventory, Jan. 1, 20X. 130,000 Total... P910,000 Work in process inventory, Dec. 31, 20X 60,000 Cost of goods manufactured... P850,000 XYZ Company Current Assets Section of the Statement of Financial Position . December 31, 20X1 Current Assets: Cash..... P 15,000 Accounts receivable 100,000 Inventories: Raw materials... Work in process. 60,000 Finished good: - 175,000 250,000 Prepaid expense: _10,000 Total current assets... P375,000Cost Terms, Concepts and Classifications _31 Illustrative Statements of a Service Company Figure 2.6, shows the income statement and the current assets section of the statement of financial position of a service company. Figure 2.6 : EFG Consulting Company Income Statement For the Year Ended December 31, 20X1 Revenues * Fees for professional service... P500,000 Less: Direct costs Employees compensation & fringe benefits 245,000 Contribution to Indirect Cost... o 255.000 Less: Indirect costs Rent of office facilities .. 30,000 Training and research 20,000 Personnel recruiting... 10,000 Professional insurance and litigation. 6,000 Other 25,000 Total, —21.000 Operating income 164,000 EFG Consulting Company . Current AssetsSection of the Statement of Financial Position December 31, 20X1 Seca P 25,000 Accounts receivabl : 63.000 Unbilled services, at estimated billable rate. 50,000 Prepaid expenses... wi itte Total current assets.32_Chapter 2 . ‘ost Behavior D. Cost classification for Predicting C itt react or respond to changes in the Cost behavior refers to how sco rises and falls, a particular Cost may busi ivity, As the activity love. For planning pu rises and ‘fk well — or it may are cesta HeDpen; and ‘faces is manager must be able to anticipate which o} h it will change. To w mucl expected to change, the manager must know by ho} Deepa help make such distinction, costs are often catego semi-variable. Variable Costs Costs that change directly in proportion t Direct labor and direct materials are examp! Fixed Costs Costs that remain unchanged for a given time period regardless of change in activity (volume). Rent, insurance on property, maintenance, and repairs of buildings, and depreciation of factory equipment are examples of fixed costs, 0 changes in activity (volume), les of variable costs. Semivariable Costs or Mixed Costs Costs that contain both fixed and variable elements. Examples of social security taxes, materials handling, personnel services, heat, light, and power. These cost elements must be divided into their proper elements. Chapter 3 presents a more thorough discussion of these costs. E. Costs classified by Types of Inventory Raw Materials Inventory The cost of all raw material and production supplies that have been purchased but not used at the end of the accounting period, Work-in-process Inventory The cost associated with goods partially completed at the end of the accounting period. Finished Good Inventory Cost of completed goods that -have not been sold at the end of the accounting period. Merchandise Inventory urchased merchandise by retailers / wholesal re not Cost ae “he end of the accounting period, les that hav eenCost Terms, Concepts and Classifications 33 RC feats . ‘osts classification According to Traceability to Cost Objective Direct costs (traceable; separable) Costs that can be ec ‘Onomically traced to a single c ject (i. department Ca ly 0 a single cost object (i.e, product, Indirect costs Costs that are not directh i ject (i, 'Y Or easily traceable to t . comin 'Y traceable to the cost object (i.e. product, G. Costs classification according to Managerial Influence Controllable cost Cost that is subject to significant influence by a particular manager within the time period under consideration, Noncontrollable cost Cost over which a given manager does not have a significant influence. H. Cost Terminologies Used for Planning and Control ‘Standard Costs A predetermined cost estimate that should be attained; usually expressed in terms of costs per unit. Budgeted Cost Used to represent the expected/planned cost for a given period. For example, a company plans to manufacture 1,000 units of product X, which has a standard cost per unit of P4, would have budgeted cost for the period of P4,000 for product X. Absorption Costing A costing method that includes all manufacturing costs - direct materials, direct labor, and both variable and fixed manufacturing overhead - in the cost of a unit of product. It is also referred to as the full cost method. Direct Costing . A type of product costing where fixed costs are charged against revenue as incurred and are not assigned to specific units of product manufactured. Also referred to as variable costing.34 Chapter 2 Information Costs Costs of obtaining information, Ordering Costs Costs that increase with the number of orders placed for inventory. Out-of-pocket Costs Costs that must be met with a current expenditure or cash outlay. I. Cost classification according to a Time-frame Perspective Committed Cost Cost that is the inevitable consequence of a previous commitment. Discretionary Cost (programmed; managed cost) Cost for which the size or the time of incurrence is a matter of choice. J. Costs classified according to Time Period for Which the Cost is Incurred Historical costs (past costs) Costs that were incurred in a past period. Future costs Budgeted costs that are expected to be incurred in a future period. K. Costs classifications for Decision-making and other Analytical Purposes Relevant Costs ~ Future costs that are different under one decision alternative than under another decision alternative. Incremental Costs The difference in cost between two or more alternatives. In Sate 3 given alternative, incremental cost is the additional cost to mee feasibility of this particular alternative. To be an oes : must be a future cost and be different under various alternatives. Sunk Costs ; - .sts that have been incurred and are irrelevant to a future decision. Past co:Cost Terms, Concepts and Classifications 35 Opportunity Costs The value of the di i best alternative foregone as the result of selecting a ifferent use of res ‘ource or by choosing a particular strategy. Marginal Costs Costs associated with the next unit or the next project or incremental cost associated with an additional Project as opposed to the next discrete unit. Value-Added Costs Costs that add value to the product. These costs result from activities that are necessary to satisfy the requirements of the consumer. Effort should be made to eliminate those costs that do not add value to the product, such as storage and materials handling, Illustrative Problem on Cost Classifications Bettina Cabrera is the production manager of a ready-to-wear manufacturing outfit. A decision needs to be made about the type of clothing material or fabric to be used to make a shirt. The fabric that has been used in the previous production cost P40 per yard but it is not available currently. Similar material from another supplier will cost P50 per yard. The cost of the fabric can be classified as follows: 1. Time period : P40.00 — historical cost PS0.00 — future cost 2. Management function’ The cost of the fabric is a manufacturing cost. 3. Accounting treatment i a Whatever is paid for the fabric will be capitalized as a product'cost and carried in inventory until it is sold. 4, Traceability to product f oe , The fabric is a direct cost because it represents a significant portion of the cost of the product and can be traced to a specific unit of finished product. 5. Cost behavior i Both the P40.00 and P50.00 cost per yard are variable costs. As the number of yards purchased increases, the total fabric cost increases proportionately.ve Chapter 2 6. Decision Significance The PS0.00 cost j of other fabrics of similar ju: P40.00 cost is irrelevant, ‘ 7. Managerial influence The cost of the Cabrera has the 8. Others The fabric is an out-of-pocket cost associated until Producing additional skirts which will involve cash outlay in its acquisition. fabric to be acquired is a controllable Cost since Ms, authority to make production decisions, REVIEW QUESTIONS, EXERCISES AND PROBLEMS I. Questions 1. Define cost object and give three examples. 2. Define cost assignment, cost tracing, and cost allocation. How are these terms related? 3. .Describe two areas that cost reduction efforts frequently focus on. 4. Describe how service -, merchandising-, and manufacturing-sector companies differ from each other. 5. Distinguish between capitalized costs and noncapitalized costs. Give an example of each from the service, merchandising and manufacturing- sector companies differ from each other. 6. Define product costs. Describe three different purposes for computing product costs. 7. What is meant by the phrase “different costs for different purposes”? 8. Distinguish between fixed costs and variable costs. 9. List three direct costs of the food and beverage department in a hotel. List three indirect costs of the department. 10. Why is the cost of idle time treated as manufacturing overhead?14, 15. 16. 17. 18. 19. 20. 21. 22. + Which of the followin; Cost Terms, Concepts and Classifications 37 cost: i i nursing in a hospital? is 's are likely to be controllable by the chief of a. Cost of medication administered, b. Cost of overtime paid to nurses due to scheduling errors. €. Cost of depreciation of hospital beds, . Distinguish between product and period costs. . What is the most important difference between a manufacturing firm and aservice industry firm, with regard to the classification of costs as product costs or period costs? Why are product costs also called inventoriable costs? Define the terms sunk cost and differential cost. Indicate whether each of the following costs is a direct cost or an indirect cost of the restaurant in a hotel. a. Cost of food served. b. Chef's salary and fringe benefits. c. Part of the cost of maintaining the grounds around the hotel, which is allocated to the restaurant. d. Part of the cost of advertising the hotel, which is allocated to the restaurant. What are the two properties of a relevant cost? List and briefly describe the three types of product costs. List and briefly describe the three types of manufacturing inventories. Describe how the income statement of a manufacturing company differs from the income statement of a merchandising company. Why is manufacturing overhead considered an indirect cost of a unit of product? ha Angeles is employed by Angels Company. Last week she worked 34 Bbute assembling one of the company’s products and was idle 6 hours due to material shortages. Angels’ employees are engaged, +f oe workstations for a normal 40-hour week. Ms. Angeles is pai . pe hour. Allocate her earnings between direct labor cost and manufacturing overhead cost.jne on the # p g machin’ Oscar 38_ Chapter 2 operates & stam| ck . . oh 23. Ole arta Company. Last ea time and a half for overtime (time ene is P14 per hour, wi locate Mr. Oscar’s wages for basic wage rate is sek). A ! ary i f-40 hours Pe ; ring overhead cost, worked in excess fi oe Saiand manufacturing the week between a IL. Exercises f Goods Manufactured and Sold; Income Exercise 1 (Schedule of Cost o! Statement) manufac! Amazing Aluminum Company, @ amt the following inventory balances at the beginning and turer of recyclable soda cans, had end of 20X1: December 31, 20X1 Inventory Classification January 1, 20X1 Raw mmatertal a P 60,000 P 70,000 Work in process 120,000 115,000 150,000 165,000 Finished goods During 20X1, the company purchased P250,000 of raw material and spent P400,000 on direct labor. Manufacturing overhead costs were as follows: Indirect material... P 10,000 Indirect labor ... 25,000 100,000 25,000 30,000 Sales revenue was P1,105,000 for the i inistrati 3105, year. Selli tive expenses for the year afnounted to P110,000. The firma te, teal Required: 1. Prepare a schedule of cost of goods manuf 2. Prepare a schedule of cost of goods sold wee 3. Prepare an income statement. ,Cost Terms, Concepts and Classifications _39 Exercise 2 For es of the following costs incurred in a manufacturing operation, indicate mu et her the costs would be fixed or variable (F or V) and whether they would ¢ period costs or product costs (P or R, respectively) under full-absorption costing. Transportation-in costs on materials purchased, Assembly-line worker’s wages. Property taxes on work in process inventories. Salaries of top executives in the company. Overtime premium for assembly workers. Sales commissions. Sales personnel office rental. Production supervisory salaries. Controller’s office supplies. Executive office heat and air conditioning. Executive office security personnel. Supplies used in assembly work. . Factory heat and air conditioning. Power to opeiate factory equipment. Depreciation on furniture for sales staff. . Varnish used for finishing product. Marketing personnel health insurance. Packaging materials for finished product. Salary of the quality control manager who checks work on the assembly line. t. Assembly-line workers’ dental insurance. Fe regan ges reo prepons40 Chapter 2 are listed below. For each best describes th cost item. cost, indicate which of the following classifications € cost. More than one classification may apply to the same Cost Classifications a. Variable g. Manufacturing b. Fi ixed h. Research and development c. Period i. Direct material d. Product j. Direct labor e. Administrative k. Manufacturing overhead f. Selling Cost Items Cost of fabric used in T-shirts. Wages of shirtmakers. Cost of new sign in front of retail T-shirt shop. Wages of the employee who repairs the firm’s sewing machines. Cost of electricity used in the sewing department. Wages of T-shirt designers and painters. Wages of sales personnel. Depreciation on sewing machines. Rént on the building. Part of the building’s first floor is used to make and paint T-shirts. Part of it is used for the retail sales shop. The second floor is used for administrative offices and storage of raw material and finished goods. 10. Cost of daily advertisements in local media. ; 11. Wages of designers who experiment with new fabrics, paints, and T-shirt designs. S. 12. Cost of hiring a pilot to fly along the beach pulling a banner advertising the shop. 13. Salary of the owner’s secretary. 14. Cost of repairing the gas furnace. 15. Cost of insurance for the production employees. PEN AVWAWHD =Cost Terms, Concepts and Classifications 41 Exercise 4 (Economic Characteristics of Costs) The following terms are used to describe various economic characteristics of Opportunity cost Differential cost Out-of- pocket cost Marginal cost Sunk cost Average cost Required: Choose one of the terms listed above to characterize each of the amounts described below. 1. The cost of including one extra child in a day-care center, 2. The cost of merchandise inventory purchased two years ago, which is now obsolete. 3. The cost of feeding 500 children in a public school cafeteria is P800 per day, or P1.60 per child per day. What economic term describes this P1.60 cost? : 4. The management of a high-rise office building uses 2,500 square feet of space in the building for its own management functions. This space could be rented for P250,000. What economic term describes this 250,000 in lost rental revenue? 5. The cost of building an automated assembly line in a factory is P800,000. The cost of building a manually operated assembly line is P375,000. What economic term is used to describe the difference between these two amounts? 6. Referring to the preceding question, what economic term is used to describe the P800,000 cost of building the automated assembly line? Exercise 5 (Cost Classifications; Hotel) Several costs incurred by Wow Hotel and Restaurant are listed below. For each cost, indicate which of the following classifications best describe the cost. More than one classification may apply to the same cost item. Cost Classifications Differential cost Marginal cost Opportunity cost Sunk cost pBeop42_ Chapter 2 e f. g h. i. i. Out-of-pocket cost Direct cost of the food and beverage department. Indirect cost of the food and beverage department. Controllable by the kitchen manager. Uncontrollable by the kitchen manager. Controllable by the hotel general manager. Uncontrollable by the hotel general manager. Cost Items 1 2. 10. 11, 13. 14, The cost of food used in the kitchen. The cost of general advertising by the hotel, which is allocated to the food and beverage department. The cost of space (depreciation) occupied by a sauna next to the pool. The space could otherwise have been used for a magazine and bookshop. The discount on room rates given as a special offer for a “Labor Day Gateway Special.” The wages earned by table-service personnel. The salary of the kitchen manager. The cost of leasing a computer used for reservations, payroll, and general hotel.accounting. The wages of the hotel’s maintenance employees, who spent 11 hours (at P14 per hour) repairing the dishwasher in the kitchen.” The difference in the total cost incurred by the hotel when one additional guest is registered. The cost of space (depreciation) occupied by the kitchen. The profit that would have been earned ina magazine and bookshop, if the hotel had one, - The cost of the refrigerator purchased 13 months ago. The unit was covered by a warranty for 12 months, during which time it worked perfectly. It conked out after 13 months, despite an original estimate that it would last five years, The cost of dishes broken by kitchen employees. aenoet of a pool service that cleans and maintains the hotel’s swimming Pool.Cost Terms, Concepts and Classifications _43 Exercise 6 TOP Pickups is an up-scale, higher-priced, specialty pickup truck maker based in Bifian, Laguna, The management accountant for TOP Pickups compiled information for various levels of pickup truck output: Pickup Truck Output 3,000 trucks _ 6,000 trucks _ 9,000 trucks Variable a production P 29,640,000 P- P costs Fixed production «39,200,000 costs Variable selling 4,500,000 costs Fixed selling 13,660,000 13,660,000 costs Total costs P P_ P Selling price per 46,000 40,100 35,900 truck Unit cost 29,000 Profit per truck ee ee Required: Rounding all calculations to the nearest peso, fill in the blanks with the correct figures. Exercise 7 Consider the following example: JH Corporation manufactures furniture, including tables. Selected costs are given below: 1. The tables are made of wood that costs P200 per table. 2. The tables are assembled by workers, at a wage cost of P80 per table. 3. Workers making the tables are supervised by a factory supervisor who is © paid P76,000 per year. 4. Electrical costs are P4 per machine-hour. Four machine-hours are required to produce a table.44 Chapter 2 5. The depreciation on the machines used to make the tables totals P20,000 per year. The machines have no resale value and do not wear out through use. The salary of the president of the company is P200,000 per year. The company spends P500,000 per year to advertise its products, Salespersons are paid a commission of P60 for each table sold. Instead of producing the tables, the company could rent its factory Space for P100,000 per year. ween Required: | ; Classify these costs according to the various cost terms used in the Chapter, Exercise 8 Love Ship, Inc., assembles custom sailboats from components supplied by various manufacturers. The company is very small and its assembly shop and retail sales store are housed in a boathouse. Below are listed some of the costs that are incurred at the company. Required: For each cost, indicate whether it would, most likely be classified as direct labor, direct materials, manufacturing overhead, selling, or an administrative cost. The wages of employees who build the sailboats. 3 2. The cost of advertising in the local newspapers. 3. The cost of an aluminum mast installed in a sailboat. 4. The wages of the assembly shop’s supervisor. 5. Rent on the boathouse. 6. The wages of the company’s bookkeeper. 7. Sales commissions paid to the company’s salespeople. 8. Depreciation on power tools. Exercise 9 The Antique Hotel is a four-star hotel located in Makati City. Required: 4 oe For each of the following costs incurred at the Antique Hotel, indicate vo cost it would most likely be a direct cost or an indirect cost of the spect object by placing an X in the appropriate column,Cost Terms, Concepts and Classifications 45 Con Cost Objet Direct | Indirect ; Cos ject Cost Cost Bs Room Service beverages |"A particular hotel guest | x 3p salary ofthe head chef] The hotel’s restaurant ~ | The salary of the head chef] A particular restaurant z 7 : 7 customer Room cleaning supplies — {A particular hotel guest | Flowers forthe reception | A particular hotel guest desk 5. | The wages of the ‘A particular hotel guest doorman 6. | Room cleaning supplies _ | The housecleaning — department 7. | Fire insurance on the The hotel’s gym hotel building 8. | Towels used in the gym | The hotel's gym Il. Multiple Choice 1. Which statement is TRUE? a. All variable costs are direct costs. b. Because of a cost-benefit tradeoff, some direct costs may be treated as indirect costs. c. All fixed costs are indirect costs. d. All direct costs are variable costs. Indirect manufacturing costs a. can be traced to the product that created the costs. b. can be easily identified with the cost object. c. generally include the cost of material and the cost of labor. d. may include both variable and fixed costs. Variable costs a. _ are always indirect costs. b. _ increase in total when the actual level of activity increases. c. include most personnel costs and depreciation on machinery. d. can always be traced directly to the cost object. Fixed costs p a. _ may include either direct or indirect costs. b. vary with production or sales volumes. c. _ include parts and materials used to manufacture a product. d. can be adjusted in the short run to meet actual demands.46 Chapter 2 3 Which one of the following is a variable cost in an insurance company? a. Rent b. President's salary ec. Sales commissions d. Property taxes Service-sector companies report a. only merchandise inventory. b. only finished goods inventory. ¢. direct materials inventory, work-in-process inventory, and finished goods inventory accounts. d. no inventory accounts. Manufacturing-sector companies report a. only merchandise inventory. b. only finished goods inventory. ¢. direct materials inventory, work-in-process inventory, and finished goods inventory accounts. d. no inventory accounts. For a manufacturing company, direct material costs may be included in a. direct materials inventory only. b. merchandise inventory only. ¢. both work-in-process inventory and finished goods inventory. 4. direct materials inventory, work-in-process inventory, and finished goods inventory accounts. For a manufacturing company, direct labor costs may be included in a. — direct materials inventory only. b. merchandise inventory only. c. both work-in-process inventory and finished goods inventory. d. direct materials inventory, work-in-process inventory, and finished goods inventory accounts. For a manufacturing company, indirect manufacturing costs may be included in a. — direct materials inventory only. b. merchandise inventory only. c.. both work-in-process inventory and finished goods inventory. d. — direct materials inventory, work-in-process inventory, and finished goods inventory accounts.Cost Terms, Concepts and Classifications 47 The income statement of a service-sector firm reports a. _ period costs only, b. inventoriable costs only, ¢. both period and inventoriale costs, d. Period and inventoriable costs but at different times, the reporting varies, ° Inventoriable costs are expensed on the income statement a, when direct materials for the product are purchased. b. after the products are manufactured. ¢. when the products are sold. d. not at any particular time, it varies. For merchandising companies, inventoriable costs include a. the cost of the goods themselves. b. incoming freight costs. ¢. insurance costs for the goods. d. all of the above. The following information applies to questions 14 through 17. The Awit Company manufactures several different products. Unit costs associated with Product ABC are as follows: 14. 15. Direct materials P 60 Direct manufacturing labor 10 Variable manufacturing overhead 18 Fixed manufacturing overhead 32 Sales commissions (2% of sales) 4 Administrative salaries Bie Total , P140 What are the variable costs per unit associated with Product ABC? a. PI8 b. P22 c. P88 d. P92 What are the fixed costs per unit associated with Product ABC? a. P102 ! b. PAB.xe _cnapter 2 20. ce P52 d. P32 What are the inventoriable Costs per unit associated with Product ABC? a. P120 b. P140 ec. PSO d. P88 What are the period costs per unit associated with Product ABC? a PA y c. P20 b. P16 d. P52 Alll of the cost categories listed below are usually found in a company’s accounting records, except for: a. sunk costs. ¢. opportunity costs. b. _ inventoriable costs, d. marketing costs. The term “committed costs” refers to those a. _ costs which are governed mainly by past decisions that established the present levels of operating and organizational capacity and which only change slowly in response to small changes in capacity. b. costs which are likely to respond to the amount of attention devoted to them by a specified manager. ¢. costs which fluctuate in total in response to small changes in the rate of utilization of capacity. d. amortization of costs which were capitalized in previous periods. (CMA, adapted) The term “discretionary costs” refers to those a. costs which management decides to incur in the current period to enable the company to achieve objectives other than the filling of orders placed by customers, b. _ costs which are likely to respond to the amount of attention devoted to them by a specified manager. c. amortization of costs which were capitalized in previous periods. d. costs which will be unaffected by current managerial decisions. (CMA, adapted)21. 22. 23. 24. 25. “e. Cost Terms, Concepts and Classifications 49 howe Gosts referred to as “controllable costs” are . ran ee eae decides to incur in the current period to pany to achieve objectives other than the filli orders placed by customers. cic costs which are likely to res i spond to the amount of attention devot to them by a specified manager, ae a can : 4 costs which fluctuate in total in response to small changes in the rate of utilization of capacity. : d. costs which will be unaffected by current managerial decisions. ‘ (CMA, adapted) In the Preparation of the schedule of Cost of Goods Manufactured, the accountant incorrectly included as part of manufacturing overhead the rental expense on the firm’s retail facilities. This inclusion would: a. overstate period expenses on the income statement. b. overstate the cost of goods sold on the income statement. c. understate the cost of goods manufactured. d. have no effect on the cost of goods manufactured. Cost of goods manufactured will usually include: a. only costs incurred during the current period. b. _ only direct labor and direct materials costs. c. some costs incurred during’ the prior period as well as costs incurred during the current period. d. some period costs as well as some product costs. An example of a fixed cost that would be considered a direct cost is: a. acost accountant’s salary when the cost object is a unit of product. b. _ the rental cost of a warehouse to store finished goods when the cost object is the Purchasing Department. a production supervisor’s salary when the cost 0 Production Department. d. Board of Directors’ fees when tment. : a (CMA, adapted) ° bjective is the the cost object is the Marketing Buffy Company rents out a small unused portion of its factory to another 1 agreement will expire next company for P1,000 per month. The rental >xpire ne vionth, and rather than renew the agreement Buffy Company is thinking about using the space itself to store materials. The term to describe the P1,000 per month is:50_Chapter 2 26. 27. 28. 29. 30. a su Hy ink cost. ¢. opportunity cost. period cost, d. variable cost. The Cost associated with idle time should be: a. _ included as part of direct labor cost. b. treated as Part of manufacturing overhead, c. added directly to cost of goods sold for the period. d. included as Part of selling and administrative expenses. A direct labor overtime premium should be charged to a specific job when the overtime is caused by the: a. _ increased overall level of activity in the factory. b. _ customer’s requirement for early completion of the job. ¢. management’s failure to include the job in the production schedule. d. management’s requirement that the job be completed before the annual factory closure due to vacation. Costs which are inventoriable are a. manufacturing costs incurred to produce units of output. b. all costs associated with manufacturing other than direct labor costs and raw material costs, ¢. costs which are associated with marketing, shipping, warehousing, billing activities. d. — the sum of direct labor costs and all factory overhead costs. (CMA, adapted) For external reporting a. _ costs are classified as either inventoriable or period costs. b. costs reflect current values. c. there are no prescribed rules since no one is exactly sure how . investors and creditors will use these numbers. d. costs include amounts that reflect both current ‘and future benefits. Ryan Soh is paid P10 an hour for straight-time and P15 an hour for overtime. One week he worked 45 hours, which included 5 hours of overtime, and 3 hours of idle time caused by material shortages. Compensation would be reported as a. P370 of direct labor and P105 of manufacturing overhead. P420 of direct labor and P55 of manufacturing overhead. P450 of direct labor and P25 of manufacturing overhead. ‘ b. . d. P445 of direct labor and P30 of manufacturing overhead.: Cost Terms, Concepts and Classifications 51 IV. Problems Problem 1 eee ae has been working a part-time job that pays P1,100 a month. i eae ane offered to convert the job into a full-time position at P1,500 se a me nome pay is 70 percent of these amounts. In view of this offer, npted not to return to school for the coming year. His friend Josie ry ‘ing to convince him to return to school. Francis remarks, “I’ve been talking to other friends and no matter how you figure it, school is extremely expensive. Tuition is about P2,200 per year. Books and supplies are another P300. Room and board will cost P3,700 a year even if] share a room. It costs P2,400 a year to keep up my car and clothing, and other incidentals amount to about P3,000 per year. I figure school will cost me the total of all these costs. which is P11,600 plus my lost salary of P18,000 per year. At P29,600 a year, who can justify higher education?” , If you were Josie, how would you respond to Francis’ remarks? Problem 2 Pat Cruz, an independent engineer, has been invited to bid on a contract engineering project. Pat is not the only bidder on the project. Pat wants the bid only if it will return an. adequate profit for the time and effort involved. The contract calls for 250 hours of Pat’s time. The following cost data have been extracted from Pat’s records and are not expected to change for the contract period. Per Hour Normal consulting rate P100 Office costs, secretary, etc. (G8) Travel, other variable costs _(Q2) Normal “profit” per hour P40 Billable hours (typical week) 30 The hourly rate for the office costs, secretary, etc. is based on a fixed cost of P1,140 per week divided by the 30 billable hours per typical week. However, these costs are fixed regardless of the number of hours Pat works per week. Under the contract, the travel and other expenses will be the same as for normal consulting.52_ Chapter 2 Required: What is the relevant “cost” for Pat’s bid under each o \ evan f the follow independent situations? Support your chosen cost ba: enwing sis. a. Pat will work on the co: : ntract during hours that woul i billable to other clients, Suid otherwise not be b. Pat will give up work for other clients to meet the time requirements under the contract. No ill will would be i 7 generated as a result of eau accepting the Problem 3 Tsokolate Corp. is a cookie company in Batangas City that produces and sells chocolate chip cookies with extremely high quality and service. The owner would like to identify the various costs incurred during each year in order to Plan and control the costs in the business. Tsokolate’s costs are the following (in thousands of pesos): Utilities for the bakery 2,100 Paper used in packaging product 90 Salaries and wages in the bakery 19,500 - Cookie ingredients 35,000 Bakery labor and fringe benefits 1,300 Administrative costs 1,000 Bakery equipment maintenance 800 Depreciation of bakery plant and equipment 2,000 Uniforms 400 Insurance for the bakery 900 Rent for administration offices 17,200 Advertising 1,900 Boxes, bags, and cups used in the bakery 1,100 Manager’s salary « Ei py Overtime premiums , 500 Idle timecations 53 Cost Terms, Concepts and Classi Required: What is the total amount of product costs? Problem 4 Use the same information as presented in Problem 3. Required: What is the total amount of period costs? Problem 5 Daisy Palisoc is a Partner in the consulting firm of Reyes, Santos and Dy. One of the current clients is planning a major expansion of its production facilities and has asked Daisy to prepare projected financial and cost data to be used by her client in requesting a long-term loan to finance the expansion. Daisy's client has suggested that she omit all “sunk” costs in her reports and use only differential cost data. a. List any “sunk” costs you can think of that would be omitted from Daisy’s differential cost reports. b. Why do you think the client suggested a differential cost basis for the reports? If you were the financing agency manager, why might you want to see the “sunk” costs that are omitted? Problem 6 The following information has been taken from the accounting records of EH Corporation for last year: Selling expenses P. 70,000 Raw materials inventory, January 1 45,000 Raw materials inventory, December 31 30,000 Work in process inventory, January | 90,000 Work in process inventory, December 31 50,000 Finished goods inventory, January 1 130,000 Finished goods inventory, December 31 105,000 Utilities factory 18,000 Direct labor cost 75,000 81,000 Depreciation, factory54 Chapter 2 Purchases of raw materials 375,000 Sales 1,250,000 Insurance, factory 20,000 Supplies, factory 7,500 Administrative expenses 135,000 Indirect labor . 150,000 Maintenance, factory 43,500 Management wants these data organized in a better format so that financial statements can be prepared for the year. Required: 1. Prepare a schedule of cost of goods manufactured. 2. Compute the cost of goods sold. 3. Prepare an income statement. Problem 7 Listed below are costs found in various organizations. Depreciation, executive jet. Costs of shipping finished goods to customers. Wood used in manufacturing furniture. Sales manager’s salary. Electricity used in manufacturing furniture. Secretary to the company president. Aerosol attachment placed on a Spray can produced by the company. Billing costs. Packing supplies for shipping products overseas. 10. Sand used in manufacturing concrete. 1]. Supervisor’s salary, factory. 12. Executive life insurance. 13. Sales commissions. 14, Fringe benefits, assembly-line workers, 15. Advertising costs, 16. Property taxes on finished goods warehouses. 17, Lubricants for production equipment. CPA AM Rw Required: ; . Prepare an answer sheet with column headings as shown below. For each cost item, indicate whether it would be variable or fixed with respect to the number of units produced and sold; and then whether it would be a selling cost, an administrative cost, or a manufacturing cost. If it is a manufacturing cost,Cost Terms, Concepts and Classifications 55 indicate whether it would A typically be treated as a direct or indirect cost with respect to units of product, Three sample answers are provided for illustration, Manufacturing Variable | Selling | Administrative | (Product) Cost Cost Item or Fixed | Cost Cost Direct_| Indirect Direct labor ‘Vv x Executive salaries F x Factory rent F x Test Material 2-1 Problem A Ling has invented a new type of flyswatter. After giving the matter much thought, Ling has decided to quit her P400,000 per month job with a consulting firm and produce and sell the flyswatters full time. Ling will rent a garage that Will be used as a production plant. The rent will be P15,000 per month. Ling will rent production equipment at a cost of P50,000 per month The cost of materials for each flyswatter will be P30,00. Ling will hire workers to produce the flyswatters. They will be paid P50.00 for each completed unit. Ling will rent a room in a house next door for use as her sales office. The rent will be P7,500 per month. She has arranged for the telephone company to attach a recording device to her home phone to get off-hours messages from customers. The device will increase her monthly phone bill by P2,000. Ling has some money in savings that is earning interest of P100,000 per year. These savings will be withdrawn and used for about a year to get the business going. To sell her flyswatters, Ling will advertise heavily in the local area. Advertising costs will be P40,000 per month. In addition, Ling will pay a sales commission of P10.00 for each flyswatter sold, For the time being, Ling does not intend to draw any salary from the new company. Ling has already paid the legal and filing fees to incorporate her business. These fees amounted to P60,000.36 Chapter 2 Required: 1. Prey it ; Pare an answer sheet with the following column headings: Name Period ofthe Variable Fi: 5 : (Selling and Cost Cost, axed | Direct Direct Manufacturing Administrative) Opportunity Sunk Cost Materials Labor — Overhead Cost Cost Cost List the different costs associated with the new company down the extreme left column (under Name of Cost). Then place an X under each heading that helps to describe the type of cost involved. There may be X’s under several column headings for a single cost. (That is, a cost may be a fixed cost, a period cost, and a sunk cost; you would place an X under each of these column headings opposite the cost.) Under the variable cost column, list only those costs that would be variable with respect to the number of flyswatters that are produced and sold. 2. All the costs you have listed above, except one, would be differential costs between the alternatives of Ling producing flyswatters or staying with the consulting firm. Which cost is not differential? Explain? Use answer sheet on page 363. Problem B The top management of Star Electronics, Inc., is well known for “managing by the numbers.” With an eye on the company’s desired growth in overall net profit, the company’s CEO (chief executive officer) sets target profits at the beginning of the year for each of the company’s divisions. The CEO has stated her policy as follows: “I won’t interfere with operations in the divisions. | am available for advice, but the division vice presidents are free to do anything they want so long as they hit the target profits for the year.” i i i in charge of the Cellular vember, Kacey Rio, the vice president in charg ‘ Oe Technologies Division, saw that making the current year target ivisi i i ther actions, division was going to be very difficult. Among other actions, prof Atal discretionary expenditures be delayed until the beginning of she i house (0, she was angered to discover that a ware the ee aD arts earlier in December clerk had Telephone ordered P350,000 of cellular telephone pCost Terms, Concepts and Classifications _57 even though the parts weren’t really needed by the assembly department until January or February. Contrary to common accounting ‘practice, the Star Electronics, Inc., Accounting Policy Manual states that such parts are to be recorded as an expense when delivered. ‘To avoid recording the expense, Ms. Rio asked that the order be canceled, but the purchasing department reported that the parts had already been delivered and the supplier would not accept returns. Since the bill had not yet been paid, Ms. Rio asked the accounting department to correct the clerk’s mistake by delaying recognition of the delivery until the bill is paid in January. Required: 1. Are Ms. Rio’s actions ethical? Explain why they are or are not ethical. 2. Do the general management philosophy and accounting policies at Star Electronics encourage or discourage ethical behavior? Explain. Use answer sheet on page 364.