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Learning Objectives:
As discussed in the previous module, cost is is a resource given up in exchange of goods and services. Cost is usually
measured in monetary amount equivalent to that of the resource. Cost object is anything for which a separate
measurement of cost is desired, it can be any product, machine, service or process for which cost information is
accumulated. Cost object’s cost resulted from an activity which generates cost, this is what we refer to as the cost driver.
Some examples of cost driver are machine-hours worked, kilometers driven, machine set-ups, and direct labor hours. Cost
accumulation is the collection of cost data in some organized way by means of an accounting system.
ELEMENTS OF COST
The basic elements of cost include material, labor, and overhead costs. It can be illustrated as follows:
*source:https://www.tutorialspoint.com/accounting_basics
INDIRECT COSTS—are costs that cannot be easily and conveniently traced to a specified cost object. For example,
the salary of production supervisor of a furniture manufacturing is indirect cost to the furniture because the salary
is not incurred to produce a specific furniture hence you cannot trace the cost easily. Cost allocation is used to
describe the assignment of indirect costs to a particular cost object
Classification of a cost as direct or indirect depends on the cost object specification. For example, the depreciation
of machinery is indirect cost if the cost object is a product, but if the cost object is the production department the
depreciation is a direct cost.
DIRECT
COST
COST
OBJECT
INDIRECT
COST
As the activity level rises and falls, a particular cost may rise and fall as well—or it may remain constant.
Costs are found in the financial statement. The balance sheet contains the unexpired costs (assets) while the
income statement contains the expired costs (expenses and losses).
PRODUCT COSTS—costs that are related to making or acquiring the products or providing the services that directly
generate the revenues of an entity. Product costs are also called inventoriable costs and include the cost of direct
material, direct labor, and overhead.
▪ Direct Material is any readily identifiable part of a product. Includes raw materials, purchased
components from contract manufacturers, and manufactured subassemblies.
▪ Direct labor refers to the time spent by individuals who work specifically on manufacturing a product
or performing a service.
▪ Overhead is any factory or production cost that is indirect to the product or service and, accordingly,
does not include direct material and direct labor.
PERIOD COSTS—are related to business functions other than production, such as selling and administration.
Period costs are generally more closely associated with a particular time period than with making or acquiring a
product or performing a service. One important type of period cost is distribution—any cost incurred to
warehouse, transport, or deliver a product or service. Although distribution costs are expensed as incurred,
managers should remember that these costs relate directly to products and services. It must be planned for in
relationship to product/service volume, and these costs must be controlled for profitability to result from sales.
VARIABLE COSTS
Variable cost varies in direct proportion to changes in activity level. A cost to be variable must be variable with
respect to something or what we call an activity base—which is a measure of whatever causes the incurrence of
a variable cost. An activity base is sometimes referred to as a cost driver. Some of the most common activity bases
are direct labor-hours, machine-hours, units produced, and units sold.
For example, a small inn provides breakfast to its guests. The cost of one breakfast is P120. The behavior of the
cost is shown below:
As you can see the cost varies directly with the number of deliveries ON A TOTAL basis, it is to be noted that
variable cost remains constant on a PER UNIT basis.
FIXED COSTS
A fixed cost is a cost that remains constant, in total, regardless of changes in the level of activity. Unlike variable
costs, fixed costs are not affected by changes in activity. For example, assumes the inn rents its building. Monthly
rental is P10,000. Regardless of the number of deliveries, the monthly rent will still remain at P10,000 pesos. Take
note that fixed costs remain constant in total, but is indirectly proportional on a per unit basis.
Total Total
Cost Cost
Variable Cost
Fixed Cost
Relevant Range
Management accountants ordinarily assume that costs are strictly linear; that is, the relation between cost on the
one hand and activity on the other can be represented by a straight line. Economists point out that many costs
are actually curvilinear; that is, the relation between cost and activity is a curve. Nevertheless, even if a cost is not
strictly linear, it can be approximated within a narrow band of activity known as the relevant range by a straight
line.
Relevant range is the range of activity within which the assumption that cost behavior is strictly linear is reasonably
valid. Outside of the relevant range, a fixed cost may no longer be strictly fixed or a variable cost may not be
strictly variable. It is important to remember that assumptions on cost behavior may be invalid outside the
relevant range.
Other costs exist that are not strictly variable or fixed. A mixed cost has both a variable and a fixed component.
MIXED COSTS
A mixed cost is a cost which contains both variable and fixed cost elements. Mixed costs are also known as
semivariable costs.
For example, a company incurs a mixed cost called fees paid to the state. It includes a license fee of $25,000 per
year plus $3 per rafting party paid to the state’s Department of Natural Resources. If the company runs 1,000
rafting parties this year, then the total fees paid to the state would be $28,000, made up of $25,000 in fixed cost
plus $3,000 in variable cost. Exhibit 2–5 depicts the behavior of this mixed cost. Even if Nooksack fails to attract
any customers, the company will still have to pay the license fee of $25,000. This is why the cost line in Exhibit 2–
5 intersects the vertical cost axis at the $25,000 point. For each rafting party the company organizes, the total cost
of the state fees will increase by $3. Therefore, the total cost line slopes upward as the variable cost of $3 per
party is added to the fixed cost of $25,000 per year. (Adapted Managerial Accounting Garrison, Noreen, Brewer)
The total cost hence can be expressed using the equation:
Y= a +bX
Y represents total cost
a represents total fixed cost
b represents variable cost per unit
X represent the level of activity
Applying the equation, supposed that the company organize 800 rafting parties, the total cost can be calculated
as:
Y= 25,000 + (3 x 800)
=27, 4000
Illustration:
A company produces a product, the following costs were incurred during the first half of the year:
Units produced Total Cost
January 500 12,000
February 800 15,000
March 1000 19, 500
April 1250 23,000
May 900 18,000
June 600 13,500
Let us separate the mixed cost using:
HIGH-LOW method
The high-low method uses the highest and lowest activity levels and their related costs to estimate the variable
cost per unit and the fixed cost.
First Step: Identify the highest point of activity and lowest point activity.
Looking at the table, the highest activity level is 1,250 units and the lowest is 500 units
Second step: Calculate the variable cost. Variable cost will be calculated using the formula:
Cost at high activity level – cost at low activity level
Variable Cost= High activity level – Low activity level
Third step: After calculating the variable cost, determine the fixed cost. This is done by taking the total cost at
either the high or the low activity level and deducting the variable cost element.
Let us take the high level total cost of 23, 000 at 1, 250 units.
Fourth step: Since the fixed and variable elements are now separated we can now formulate our cost formula
that can be used to calculate costs at different activity levels.
Total Cost= 4, 6662.5 + 14.67X
The least-squares regression method, unlike the high-low method, uses all of the data to separate a mixed cost
into its fixed and variable components. This is the edge of least-squares over high-low, since it uses all data it
provides a more accurate information. A regression line of the form Y= a + bX is fitted to the data, where a
represents the total fixed cost and b represents the variable cost per unit of activity.
First Step: Find the value of a and b. The formula to calculate the values is presented below.
Second Step: Calculate the figures needed for the formula. To do this, identification of variables should be made.
Using the illustration, the independent variable will be the number of units produced and dependent
variable is the total cost.
x y xy x2
January 500 12,000 6,000,000 250,000
February 800 15,000 12,000,000 640,000
March 1000 19, 500 19,500,000 1,000,000
April 1250 23,000 28,750,000 1,562,500
May 900 18,000 16,200,000 810,000
June 600 13,500 8,100,000 360,000
Total 5,050 101,000 90,550,000 4,622,500
Mean 841.67 16,833.33
Third step: Substitute the figures to the formula to find a and b. Thus,
Y= a +bX
Y= 4, 300. 86 + 14. 89X
All business has different departments or divisions, and each of these departments have their own function and
contribution to the business. Identification of departments is essential for multiple reasons including cost allocation and
budgeting, staff management, profitability and efficiency analysis etc.
Cost center is a unit of a business that is responsible for incurring of costs. A cost center is generally that part of a business
that does not directly generate revenue but supports the functioning of key revenue generating departments of a
business. It thus incurs costs during its operation. A cost center is termed as such as costs are incurred by it to keep it
running. Example of cost center includes administration department, accounts and finance departments and human
resources departments.
Profit center is a unit of a business that is responsible for generating revenue for the business. A profit center utilizes
business resources to generate revenue and thus has both identifiable revenues and identifiable costs. Profit centers
include different product lines in a manufacturing concern, different sales departments in a retail store, and IT hardware
sale and IT software services in an information technology company.
Retail companies purchase goods in finished or almost finished condition, which typically need little, if any,
conversion before being sold to customers. While manufacturing or service companies have activities that involves
conversion of inputs into finished goods or service. The materials or supplies and conversion costs of
manufacturers and service companies must be assigned to output to determine the cost of both inventory
produced and goods sold or services rendered.
Thus, manufacturers normally use three inventory accounts to accumulate costs as goods flow through the
manufacturing process:
▪ Raw Material Inventory,
▪ Work in Process Inventory (for partially converted goods), and
▪ Finished Goods Inventory.
As you can see in the illustration above, the main difference between retailer and manufacturing and service company is
the presence of the “production center”. This is the phase where inputs (materials, labor, overhead) are processed or
transformed into finished products. The finished products are then stored and transferred into finished goods inventory
account until it is sold. When a product is sold, its cost will flow from inventory to cost of goods sold that will be reflected
in the income statement.
COST SHEET
Raw Materials Inventory, beginning xxx
Add: Raw materials purchased xxx
Raw materials available for use xxx
Less: Raw Materials Inventory, ending (xxx)
Raw materials used xxx
Direct Labor xxx
Manufacturing Overhead xxx
Total Manufacturing Cost xxx
Add: Work-in process, beginning xxx
Cost of goods to be manufactured xxx
Less: Work in process, ending (xxx)
Cost of Goods Manufactured xxx
Add: Finished Goods inventory, beginning xxx
Goods available for sale xxx
Less: Finished Goods inventory, ending (xxx)
Cost of Goods Sold xxx
All data presented in the cost sheet is derived from the corresponding ledger accounts supported by source documents.
The illustration below gives you an overview on the flow of costs in manufacturing operations as well as its related
journal entries. These will be further discussed in the future modules or topics
Raw Materials Inventory
Cash/Accounts Payable
to record purchase of raw materials
Manufacturing Overhead
Raw materials inventory
to record indirect materials issued/used
Manufacturing Overhead
Salaries and Wages Payable
to record indirect labor
Manufacturing Overhead
Various Accounts
to record other indirect expenses
Work In Process
Manufacturing Overhead
to record applied overhead
Demonstration Problem on Cost Flows, Jornal Entries, and Cost Statement (Adapted, Raiborn)
▪ Journal Entries:
▪ Cost Statement
COST SHEET
Raw Materials Inventory, beginning 20,300
Add: Raw materials purchased 164,000
Raw materials available for use 184,300
Less: Raw Materials Inventory, ending (4,300)
Raw materials used 180,000
Less: Indirect materials (46,000)
Direct Materials 134,000
Direct Labor 62,000
Variable Manufacturing Overhead 51,400
Fixed Manufacturing Overhead 69, 600
Total Manufacturing Cost 317,000
Add: Work-in process, beginning 7,000
Cost of goods to be manufactured 324,000
Less: Work in process, ending (4,000)
Cost of Goods Manufactured 320,000
Add: Finished Goods inventory, beginning 18,000
Goods available for sale 338,000
Less: Finished Goods inventory, ending (8,000)
Cost of Goods Sold 330,000
References Used:
Exercise 1: True/False
_____1. Rent on a factory building used in the production process would be classified as a period cost.
_____2. Period costs are found only in manufacturing companies, not in merchandising companies.
_____3. Costing and cost accounting are the same.
_____4. The cost of goods manufactured is calculated by adding the amount of work in process at the end of the
year to the cost of raw materials used, direct labor worked, and manufacturing overhead incurred for the year
and then subtracting work in process at the beginning of the year.
_____5. A publisher that sells its books through agents who are paid a constant percentage commission on each
book sold would classify the commissions as a fixed cost
_____6. Variable costs per unit are affected by changes in activity.
_____7. Profit centers do not have costs.
_____8. The assumption that cost is strictly linear is always valid.
_____9. Retails, merchandising and manufacturing business have the same conversion process,
_____10. Product costs are called inventoriable costs.
Exercise 2:
Determine the classification of the following costs. Indicate whether each of the following items is a variable (V), fixed
(F), or mixed (M) cost and whether it is a product/ service (PT) or period (PD) cost. If some items have alternative
answers, indicate the alternatives and the reasons for them.
________1. Wages of factory maintenance workers
________2. Insurance premiums paid on the headquarters of a manufacturing company
________3. Cost of labels attached to shirts made by a company
________4. Property taxes on a manufacturing plant
________5. Paper towels used in factory restrooms
________6. Salaries of offi ce assistants in a law fi rm
________7. Freight costs of acquiring raw material from suppliers
________8. Computer paper used in an accounting fi rm
________9. Cost of wax to make candles
________10. Freight-in on a truckload of furniture purchased for resale
Exercise 3:
O&W Metal Company makes designer emblems for luxury vehicles. Each emblem is handcrafted out of titanium to the
customer’s design specifications. O&W’s artisans are paid an hourly wage and work between 30 and 60 hours a week.
O&W uses the straight-line method of depreciation. To ensure that each emblem conforms to the customer’s
specifications, O&W has each emblem inspected by an independent company. The inspection company charges a set
price per month, plus an additional amount for each item inspected. After inspection, each emblem is shipped in a
crush-resistant shipping container.
a. Which of O&W’s costs (titanium, artisan wages, equipment depreciation, inspection, shipping containers) is a mixed
cost?
b. Data on total mixed costs and total production for O&W’s five months of operations are as follows:
c. O&W estimates that it will produce 2,000 units during January. Using your answer to (b), estimate the (1) total
variable costs and (2) fixed cost per unit for January.
Exercise 4:
The following data (in thousands of dollars) have been taken from the accounting records of Karstone Corporation for
the just completed year.
Compute the:
1. The cost of the raw materials used in production during the year
2. The cost of goods manufactured
3. The cost of goods sold for the year
Evaluation