Costs are associated with all types of organizations - business, non-business, service, retail, and

manufacturing. Generally, the kinds of costs that are incurred and the way in which these costs are
classified will depend on the type of organization involved.

Our initial focus will be on a manufacturing, but in our discussion we should be aware that, in a
conceptual sense, manufacturing encompasses much more than just firms in the industrial sector of our
economy. It also encompasses many organizations that are typically viewed as being service in nature,
such as movie studios and fast-food outlets. Organizations such as these are involved in manufacturing in
the sense that they create a distinct product for customers or patrons. As we proceed with our
discussion, therefore, we should keep in mind that manufacturing is a broad term, and that the costs
included under the manufacturing heading have application to a wide range of organizations - many of
which may be involved in service-type activities. An understanding of the cost structure of a
manufacturing company therefore provides a broad, general understanding of costing that can be very
helpful in understanding the cost structures of other types of organizations.

Before cost terminology can be discussed the term cost itself must be defined. Cost is the cash or cash
equivalent value sacrificed for goods and services that are expected to bring a current or future benefit
to the organization. We say cash equivalent because non-cash assets can be exchanged for the desired
goods or services. For example, it may be possible to exchange land for some needed equipment.

Costs are incurred to produce future benefits in a profit making firm, future benefits usually mean
revenue. As costs are used up in the production of revenues, they are said to expire. Expired costs are
called expenses. In each period, expenses are deducted from revenues in the income statement to
determine the period's profit. A loss is a cost that expires without producing any revenue benefit. The
focus of cost accounting is on costs, not expenses.

CLASSIFICATION OF COSTS

1. Costs classified as to relation to a product

A. Manufacturing costs/product costs

1. Direct materials

2. Direct labor
3. Factory overhead

B. Non-manufacturing costs/period costs

1. Marketing or selling expense

2. General or administrative expense

II. Costs classified as to variability

A. Variable costs

B. Fixed costs

C. Mixed costs

III. Costs classified as to relation to manufacturing departments

A. Direct departmental charges

B. Indirect departmental charges

IV. Costs classified to their nature as common or joint

A. Common costs

B. Joint cost
V. Costs classified as to relation to an accounting period

A. Capital expenditures

B. Revenue expenditures

VI. Costs for planning, control, and analytical processes

A. Standard costs

B. Opportunity costs

C. Differential cost

D. Relevant cost

E. Out-of-pocket cost

F. Sunk cost

G. Controllable cost

MANUFACTURING COSTS/PRODUCT COSTS/INVENTORIABLE COSTS

Direct materials

Direct materials are the basic ingredients that are transformed into finished products through the use of
labor and factory overhead in the production process. Direct materials are those that can be traced to
the finished product can they form part of the product.
All manufactured products are made from basic direct materials. The basic material may be iron ore for
steel, sheet steel for automobiles, flour for bread wood tables and chairs.. Theses examples show the
link between a basic raw material and a final product.

The way a company buys, stores, and uses materials is important. Timely purchasing is important
because if the company runs out of materials, the manufacturing process will be forced to shut down.
Shutting down production results in no products. unhappy customers, and loss of sales and profits.
Buying too many direct materials, on the other hand, can lead to high storage costs

Proper storage of materials will avoid waste and spoilage. Large enough storage space and orderly
storage procedures are essential. Materials must be handled and stored properly to guarantee their
satisfactory use in production. Proper records, the materials stockcars, make it possible to find goods
easily. Such records reduce problems caused by lost or misplaced items.

Direct materials are materials that become part of a finished product and can be conveniently and
economically traced to specific product units. The costs of these

materials are direct costs. In some cases, however, even though a material becomes part of a finished
product, the expense of actually tracing the cost of a specific material is too great. Some examples of this
include nails in furniture, balts in automobiles, and rivets in airplanes. These minor materials and other
production supplies that cannot be conveniently or economically traced to specific products are
accounted for as indirect materials. Indirect materials costs are part of factory overhead costs.

Direct labor

Direct labor represent the amount paid as wages to those working directly on the product. Labor
services are, in essence, purchased from employees working in the factory. In addition, other types of
labor are purchased from people and organizations outside the company. The labor costs usually
associated with manufacturing include machine operators; maintenance workers; managers and
supervisors, support personnel; and people who handle, inspect, and store materials. Because these
people are all connected in some way with the production process, their wages and salaries must be
accounted for as production costs and, finally, as costs of products. However, tracing many of these costs
directly to individual products is difficult.
To help overcome this problem, the wages of machine operators and other workers involved in actually
shaping the product are classified as direct labor costs. Direct labor costs include all labor costs for
specific work performed on products that can be conveniently and economically traced to end products.
Labor costs for production related activities that cannot be conveniently and economically traced to end
products are called indirect labor costs. These costs include the wages and salaries of such workers as
machine helpers, supervisors, and other support personnel. Like indirect materials costs, indirect labor
costs are accounted for as factory overhead costs. Payroll related costs, such as payroll taxes, group
insurance, sick pay, vacation and holiday pay, and other fringe benefits can be considered as part of
direct labor costs, but are usually included as factory overhead.

Direct labor plus direct materials = prime costs, while direct labor plus factory overhead = conversion
costs. Prime costs and conversion costs may be diagrammed as shown on the next page

total manulacturing cos t =direct materials,+direct 1abor+factory overhcad

Factory Overhead

The third manufacturing cost element is a catchall for manufacturing costs that cannot be classified as
direct materials or direct labor costs. Factory overhead costs are a varied collection of production-related
costs that cannot be practically or conveniently traced directly to end products. This collection of costs is
also called manufacturing overhead, factory burden, and indirect manufacturing costs.

Examples of the major classifications of factory overhead costs are:

Indirect materials and supplies: nails, rivets, lubricants, and small tools.

Indirect labor costs: lift-truck driver's wages, maintenance and inspection labor, engineering labor,
machine helpers, and supervisors.

Other indirect factory costs: building maintenance, machinery and tool maintenance, property taxes,
property insurance, pension costs, depreciation on plant and equipment, rent expense, and utility
expense.

NON-MANUFACTURING COSTS/PERIOD COSTS

Marketing or selling expenses include all costs necessary to secure customer orders and get the finished
product or service into the hands of the customer. Since marketing expenses relate to contacting
customers and providing for their needs, these expenses are often referred to as order-getting and
order-filling costs. Examples of marketing expenses include advertising, shipping, sales travel; sales
commissions, sales salaries, and expenses associated with finished goods warehouses. All organizations
have marketing costs, regardless of whether the organizations are manufacturing, merchandising, or
service in nature.

Administrative or general expenses Administrative expenses include all executive, organizational, and
clerical expenses that cannot logically be included under either production or marketing. Examples of
such expenses include executive compensation, general accounting. secretarial, public relations, and
similar expenses having to do with the overall, general administration of the organization as a whole. As
with marketing expenses, all organizations have administrative expenses

COSTS CLASSIFIED AS TO VARIABILITY

Fixed, Variable, and mixed

One of the most important cost classifications involves the way a cost changes in relation to changes in
the activity of the organization. Activity refers to a measure of the organization's output of products or
services. In specifying cost behavior, the managerial accountant often limits the description to a specific
range of activity. This is called the relevant range.

Fixed cost

Items of cost which remain constant in total, irrespective of the volume of production. Fixed cost are not
related to activity within the relevant range. If activity increases or decreases by 20 percent, total fixed
cost remains the same. Cost per unit decreases as volume increases and increases as volume decreases.
Fixed costs are assignable to departments based on difference allocation methods. Examples are salaries
of production executives. depreciation of equipment computed on a straight-line basis, periodic rent
payments, and insurance.
Fixed costs may classified into two categories, depending on the ability of management to influence the
levels of these costs in the short-term.

1) Committed fixed costs costs that represent relatively long term commitments on the part of
management as a result of a past decision. Example-depreciation on equipment.

2) Managed fixed costs (also known as discretionary, programmed, or planned fixed costs) - costs that
are incurred on a short-term basis and can be more easily modified in response to changes in
management objectives. Examples-advertising, research and development and costs of training of
employees

Variable costs

These are the items of cost which vary directly, in total, in relation to volume of production. If activity
increases by 20 percent, total variable cost increases by 20 percent also. Cost per unit remains constant
as volume changes within a relevant range. Examples are: direct materials, direct labor, royalties, and
commission of salesmen. Shown on the next page is a graph of total variable cost. As this graph shows
total variable cost increases proportionately with activity. When activity doubles from 10 to 20 units.
total variable cost doubles, from P1, 000 to P2, 000. However, the variable cost per unit remains the
same as activity changes. The variable cost associated with each unit of activity is P100, whether it is the
first unit the fourth, or the tenth.

Mixed costs

Items of cost with fixed and variable components. Mixed costs vary with the level of production, though
not in direct relation to it, probably because part of the cost is fixed while the rest is variable. Two types
of mixed costs exist: semi-variable costs and step costs

Semi-variable cost. The fixed portion of a semi-variable cost usually represents a minimum fee for
making a particular item or service available. The variable portion is the cost charged for actually using
the service. The cost of electricity where there is a basic minimum charge plus a specified cost per
kilowatt hour above the
Common cost vs. Joint cost

Common cost

Costs of facilities or services employed in two or more accounting periods, operations, commodities, or
services. Just like indirect costs, these costs are subject to allocation. Example if two departments are
occupying the same building, the depreciation of the building id a common cost subject to allocation
based on floor area occupied.

Joint cost

Costs of materials, labor, and overhead incurred in the manufacture of two or more products at the
same time. A major difficulty inherent to joint costs is that they are indivisible and they are not
specifically identifiable with any of the products being simultaneously produced. These costs are also
subject to allocation. Example - direct materials, direct labor, and factory overhead cost incurred to
manufacture two or more products up to the point of split-off (or where they will go separate ways)

Capital expenditure vs. Revenue expenditure

Capital expenditure

Expenditure intended to benefit more than one accounting periods and is recorded as an asset. The
allocation of the cost to the different periods is depreciation for fixed tangible assets, amortization for
intangible assets and depletion for wasting assets.

Revenue expenditure

Expenditure that will benefit current period only and is recorded as an expense.

Direct vs. Indirect departmental charges

Direct departmental charges

Indirect departmental charges

Costs that are originally charged to some other manufacturing department(s) or account(s) but are later
allocated or transferred to another department(s) that indirectly benefited from said costs.

Costs for Planning, control and analytical processes

Standard costs

Predetermined costs for direct materials, direct labor, and factory overhead. They are established by
using information accumulated from past experience and data secured from research studies. In
essence, a standard cost is a budget for the production of one unit of product or service. It is the cost
chosen by the managerial accountant to serve as the benchmark in the budgetary control system.

Opportunity cost

The benefit given up when one alternative is chosen over another. Opportunity costs are not usually
recorded in the accounting system. However, opportunity costs should be considered when evaluating
alternatives for decision-making. If an asset can be used to perform only one function and cannot be
sold or used in other ways, the opportunity cost of that asset is zero.

Example 1

Michelle has a part-time job that pays her P1, 000 per week. She would like to spend a week in Boracay
during summer vacation from school, but she has no vacation time available. If she takes the trip anyway,
the P1, 000 in lost wages will be an opportunity cost of doing so.

Example 2
Marco is employed with a company that pays him a salary of P20, 000 a month. He is thinking about
leaving the company and returning to school. Since returning to school would require that he give up his
P240, 000 salaries. the forgone salary would be an opportunity cost of seeking further education.

Differential cost

Cost that is present under one alternative but is absent in whole or in part under another alternative. An
increase in cost from one alternative to another is known as. incremental cost, while a decrease in cost is
known as decremental cost. Differential cost is a broader term, encompassing both cost increases
(incremental cost) and cost decreases (decremental costs) between alternatives.

The accountant's differential cost concept is basically the same as the economist's marginal cost concept.
In speaking of changes in cost and revenue, the economist employs the terms marginal cost and
marginal revenue. The revenue that can be obtained from selling one more unit of product is called
marginal revenue, and the cost involved in producing one more unit of product is called marginal cost.

Differential costs can be either fixed or variable. To illustrate, assume that Avon Corp. is thinking about
changing its marketing method from distribution through retailers to distribution by direct sale. Present
costs and revenues are compared to projected costs and revenues in the table on the next page.

Relevant cost

A future cost that changes across the alternatives. In the example above, the relevant costs are cost of
goods sold, advertising, commissions, and warehouse depreciation.

Out-of-pocket cost

Cost that requires the payment of money (or other assets) as a result of their incurrence.

Sunk cost
A cost for which an outlay has already been made and it cannot be changed by present or future
decision. Since sunk costs cannot be changed by any present or future decision, they are not differential
costs, and therefore they should be used in analyzing future courses of action.

To illustrate the notion of a sunk cost, assume that a firm has just paid P 250,000 for a special purpose
machine. Since the cost outlay has been made. the P250,000 investment in the machine is a sunk cost.
Even though the purchase may have been unwise, no amount of regret can relieve the company of its
decision, nor can any future decision cause the cost to be avoided.

Controllable and Non-controllable Costs

A cost is considered to be a controllable cost at a particular level of management if that level has power
to authorize the cost. For example, entertainment expense would be controllable by a sales manager if
he or she had power to authorize the amount and type of entertainment for customers. On the other
hand, depreciation of warehouse facilities would not be controllable by the sales manager, since he or
she would have no power to authorize warehouse construction.

In some situations, there is a time dimension to controllability. Costs that are controllable over the long
run may not be controllable over the short run. A good example is advertising. Once an advertising
program has been set and a contract signed, management has no power to change the amount of
spending. But the contract expires, advertising costs can be renegotiated, and thus management can
exercise control over the long run.

The essential purpose of any organization is to transform inputs into outputs. The activity for
merchandising, manufacturing, and service organizations are shown in the previous and current page.
These organizations have many similarities, all require labor and capital as inputs, and all transform them
into a product or service for the market. These organizations also differ from one another in many
respects. The differences between these organizations are reflected in their accounting systems.

A merchandising organization starts with a finished product and markets it. Because inventory is
acquired in finished form, its cost is easily ascertained.

The accounting system for a manufacturing organization is more complex because direct materials are
first acquired and then converted to finished products. A manufacturer's accounting system focuses on
work in process, which is the account that reflects the costs involved in transforming input materials into
finished goods.
Service organizations are different from manufacturing and merchandising because they have no
inventory of goods for sale. Costs are charged to responsibility centers for performance evaluation. In a
public accounting firm, for example, costs are charged to the audit department, the tax department, and
so forth. Costs are also charged to jobs. The assignment of costs facilitates performance evaluation. The
manager of each department is held responsible for the costs of the department, the manager of each
job is held responsible for the cost of that job of the three kinds of operations, manufacturers require
the most complex and comprehensive cost accounting system. All three uses cost information for
decision making and performance evaluation. But in addition, manufacturers need product costing for
inventory valuation and to measure cost of goods sold reported on external financial statements. Many
manufacturers also have service and merchandising activities, costs of which must be recorded.