COLLEGE OF BUSINESS AND ACCOUNTANCY

COURSE DESCRIPTION:
ü MAC 2A – Management Science

TOPIC:
ü Understanding and Classifying Costs

MODULE CODE:
ü MS 00

LEARNING OUTCOMES:
At the end of this module, the student should be able to:
ü Understand the importance of controlling costs.
ü Describe the different perspective of classifying costs.
ü Discuss the classification of costs according to accountant's perspective
ü Discuss the classification of costs according to manager's perspective.
ü Discuss the classification of costs according to economist's perspective.
ü Explain the relationship of economic costs to level of production and sales.

BIBLICAL VALUES INTEGRATION:

“9The LORD also will be a refuge for the oppressed, a refuge in times of trouble. 10 And they that know your name will put
their trust in you: for you, LORD, have not forsaken them that seek you.”
-Psalm 9:9-10
INTRODUCTION:
Costs Control: The Focus of Management Accounting in its Pioneering Years
Traditional management accounting deals with the accounting for normal operating activities. It relates to the processes
of production, sales, and profitability.

Operating results are summarized in the Statement of Profit or Loss. The ultimate objective of the operations is to
generate the best profit performance out of the resources used.
Statement of Profit or Loss To increase profit:
Sales xx ­
Less: Expenses (xx) ¯
Profit/(Loss) xx

Traditional management accounting is operations accounting.

Traditional management accounting provides intelligent information to managers in order to reduce expenses and
increased profit. Reducing expenses requires thoroughly understanding it first to be controlled and managed. This orientation
had led to the development of stand, albeit, management costing systems, cost-volume-profit analysis, flexible budgeting,
segment reporting and variance analysis, and responsibility accounting.

BODY:
Costs concepts
Managing costs means knowing their nature, behavior, and other characteristics. Costs may mean differently to
different people. In the perspectives of accountants, managers, and economists, costs may be classified as follows:

ACCOUNTANT'S PERSPECTIVE
Capital expenditures v. Operating expenditures
Capital expenditures are outlays normally requiring large amount of money and resources having a long-term impact
to business profitability but are initially relating to the investing activities of the organization.

Operating expenditures are outlays or consumption used to directly support the normal operating activities of the
business.

Cost v. Expenses v. Loss

Traditionally, we look at costs according to their functional classifications, that is according to the place and purpose of
their use.

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 Costs of goods manufactured are those incurred in producing goods and resources.

Expenses are those incurred in distributing goods and managing a business.

Losses do not give any benefit to the business.

Product cost v. Period cost (manufacturing vs Nonmanufacturing)

Product costs are those incurred to produce the product. They are inventoriable and deferred as assets while the
related units are unsold.
• Direct Materials. The materials that go into the final product are called raw materials.
• Direct labor consists of labor costs that can be easily (i.e., physically, and conveniently) traced to individual units
of product.
• Manufacturing overhead, the third element of manufacturing cost, includes all manufacturing costs except direct
materials and direct labor.

Direct materials and direct labor are called prime costs. Direct labor and factory overhead are called conversion costs.
Direct materials, direct labor, and variable factory overhead are called variable production costs.

Balance Sheet vs Income statement

The financial statements prepared by a manufacturing company are more complex than the statements prepared by a
merchandising company because a manufacturing company must produce its goods as well as market them. The production
process involves many costs that do not exist in a merchandising company, and these costs must be properly accounted for on
the manufacturing company’s financial statements. We begin by explaining how these costs are shown on the balance sheet.

The balance sheet, or statement of financial position, of a manufacturing company is similar to that of a
merchandising company. However, their inventory accounts differ. A merchandising company has only one class of inventory—
goods purchased from suppliers for resale to customers. In contrast, manufacturing companies have three classes of
inventories—raw materials, work in process, and finished goods.

At first glance, the income statements of merchandising and manufacturing companies are very similar. The only
apparent difference is in the labels of some of the entries in the computation of the cost of goods sold.

Schedule of Cost of Goods Manufactured

The subtle distinction between the total manufacturing cost and the cost of goods manufactured is very easy to miss.
Some of the materials, direct labor, and manufacturing overhead costs incurred during the period relate to goods that are not
yet completed. As stated above, the cost of goods manufactured consists of the manufacturing costs associated with the goods
that were finished during the period. Consequently, adjustments need to be made to the total manufacturing cost of the period
for the partially completed goods that were in process at the beginning and at the end of the period. The costs that relate to
goods that are not yet completed are shown in the work in process inventory figures at the bottom of the schedule. Note that
the beginning work in process inventory must be added to the manufacturing costs of the period, and the ending work in process
inventory must be deducted, to arrive at the cost of goods manufactured.

MANAGER'S PERSPECTIVE
Relevant cost v. Irrelevant cost
Costs that are useful in making decisions are relevant costs. Those that are not useful are irrelevant. Relevant costs
have two characteristics. They differ from one alternative to another (i.e., differential costs) and they deal about the future (i.e.,
future costs) .

Relevant costs are not only differential costs. They are future costs. Those costs that are not incurred in the future are
irrelevant. Past costs, sunk costs, historical costs are irrelevant costs in making a decision because they can no longer be changed.
Remember, management deals about the future not the past. The future could be influenced or directed, while the past cannot.

Direct segment cost v. Indirect segment cost

Direct departmental costs are those that are directly identified with the department, process, segment, or activity.
They may be variable or fixed costs. Direct costs may be direct product or direct costs segment costs.

Indirect departmental costs are those that are not directly identified with a department. They are sometimes referred
to as "allocated costs", "common costs", or plainly "unavoidable costs ". The litmus test on whether a cost is direct or indirect to
a department is when the department ceases its operations, direct department costs are eliminated, while indirect departmental
costs are continuously incurred.
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Avoidable cost v. Unavoidable cost
Avoidable costs are those not incurred once an activity is not performed. They normally become savings on the part `
the business. These savings are considered an inflow in the economic sense and are referred to as imputed costs.

Unavoidable costs are those that would remain to be incurred regardless of option a manager chooses. They remain
constant, they do not change, and are irrelevant in short-term decisions.

Controllable cost v. Uncontrollable cost

Another way of classifying costs relates to the degree of authority given to a manager. Controllable costs are those which
incurrence or non-incurrence, can be influenced or decided upon by a manager. The influence or decision-making power of a
manager depends on the scope, nature, and extent of authority granted to him by the organization. The concept of controllability
is related to the organizational structure of an organization. The organizational structure reflects the manner on how the
business strategy is to be undertaken. Structures varies from organization to another.

Planned cost v. Actual cost

Planned costs are those that relate to future occurrences and are referred to in multifarious names such as projected
costs, estimated costs, budgeted costs, applied costs, and standard future costs. Projected costs are future values derived from
using forecasting models such as probability, regression, and causal models. Estimated costs are those future values derived
out of normal observations without the aid of standards or any reliable bases. Budgeted costs are future values derived using
standard costs. Applied costs are those future values derived using the normal costing system. Standard costs are reliable
values accepted by men in the organizations derived from empirical, scientific, and controlled studies.

Actual costs or explicit costs are those expenditures already incurred and recorded in the accounting books. The
difference between the planned cost and actual cost is called a planning gap or planning variance.

Budgeted cost v. Standard cost

Budgeted costs are those expected to be incurred at the level of activity used in preparing the master budget. Standard
costs are those expected to be incurred at "any level of activity" aside from that being used in the master budget. The level of
activity used in computing the standard cost may be actual or estimated.

Budgeted costs and standard costs use predetermined standard rates. The difference between the budgeted cost and
standard cost is called a capacity variance.

Out-of-pocket cost v. Non-cash costs

Out-of-pocket costs (OPs) are those that are incurred and are paid in cash. OPCs require cash payments. All costs that
are paid in cash are out-of-pocket costs. Those that are not paid in cash are non-cash costs.

Sunk cost v. Future cost

Sunk costs are those that have been incurred in the past and can no longer be changed. Sunk costs are not manageable.
They represent commitments made by the business in the past and are to be continually incurred in the future. They are constant
and not differential. They are historical and irrelevant in short-term decisions.

Future costs are to be incurred in the coming periods. They are relevant and are of value in making decisions. They
affect the future where the manager should plan, organize, direct and control. They are sometimes called planned costs,
budgeted costs, or estimated costs.

ECONOMIST'S PERSPECTIVE
Explicit cost v. Implicit cost
Explicit costs are actual costs. They are incurred and recorded in the accounting books. Implicit costs are theoretical
costs. They are assumed and are not recognized in the accounting books. Two good examples of implicit costs are opportunity
costs and imputed costs.

Opportunity cost v. Imputed cost

The benefits given up in favor of another choice are opportunity costs. In every decision, there is always an alternative
(or choice) not followed but could had been followed by the organization.

Imputed costs are those costs not incurred but are implied in a given decision. Say, a business uses its own cash in
buying an equipment. If the business borrows from a bank to buy the equipment, it should pay an interest rate of 15% per
annum. The imputed rate of using its own money instead of borrowing is, clearly, equivalent to the amount of the 15% interest
rate that should have been paid had the money been borrowed.
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Incremental cost v. Marginal cost
Incremental costs represent a total increase in costs. Marginal cost is an increase in cost per unit. Decremental costs
are decreases in costs.

Variable cost v. Fixed cost

The classification of costs as to fixed or variable refers to their behavior as they relate to the changes in the activity level
of production and sales. In our discussion, we assume that production and sales are equal.

Fixed costs are those that remain constant regardless of the change in the level of production and sales, but changes on
a per unit basis. Variable costs change in total in direct proportion to changes in the level of production and sales but is constant
on a per unit basis.

SUMMARY/CONCLUSION:
Historical, replacement, and budgeted costs are typically associated with time. Historical costs are used for external
financial statements; replacement and budgeted costs are more often used by managers in conducting their planning, con-
trolling, and decision-making functions.

For financial statements, costs are either considered unexpired and reported on the balance sheet as assets or expired
and reported on the income statement as expenses or losses. Costs may also be viewed as product or period costs. Product costs
are inventoried and include direct material, direct labor, and manufacturing overhead. When the products are sold, these costs
expire and become cost of goods sold expense. Period costs are incurred outside the production area and are usually associated
with the functions of selling, administrating, and financing. Costs are also said to be direct or indirect relative to a cost object.
The material and labor costs of production that are physically and conveniently traceable to products are direct costs. All other
costs incurred in the production area are indirect and are referred to as manufacturing overhead.

REFERENCES:
Roque, R. (2020). Management Advisory Services (Latest Edition). Roque Press, Inc.

Cabrera, M. E., Cabrera, G. A., & Cabrera, B. A. (2021). Strategic Cost Management (2021 ed.). GIC Enterprises & Co. Inc.

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