Introduction to Cost Accounting (Cost Concepts and Classifications)

Introduction to Cost Accounting(Cost Concepts and Classifications)

Cost Accounting DefinedThis is an expanded phase of financial and management accounting which informs management promptly with the cost of rendering a particular service, buying, selling and producing a product.

It is the field of accounting that measures, records and reports information about costs.

Financial AccountingThe objective of financial accounting is primarily to provide information to external users through the preparation of financial statements.

This requires compliance with generally accepted accounting principles (GAAP).

Management AccountingProvides information primarily for the benefit of the internal users of an entity for decision-making.

Reports generated is not govern by rigid rules and may contain both financial and non-financial information.

Financial Accounting versus Management Accounting

Cost Accounting in relation to...Financial AccountingRecording of costs of a product or a serviceUse of cost for valuation of inventory and cost of goods sold for external reportingWhen costs are used by external users of information in evaluating the performance of an entity and make decisions about the organization

Cost Accounting in relation to...Management AccountingThe use of cost data in choosing between two or more alternatives (Differential Cost Analysis)When costs are used inside the organization to evaluate the performance of the operations or personnel or as a basis for decision making and as an aid during the management process

Management ProcessPlanning

Organizing

Controlling

PlanningThe construction of a detailed operating programThe process of sensing external opportunities and threats, determining desirable objectives and employing resources to achieve these objectives

OrganizingThe establishment of the framework within which activities are to be performedBringing the many functional units of an enterprise into a coordinated structure and assigning authority and responsibility to individuals

ControllingThe process of monitoring the companys operations and determining whether the objectives identified in the planning process are being accomplishedActual results of each activity are compared with plans, and if significant differences are noted, remedial actions may be takenA periodic step rather than continuous

What is Cost?An exchange price, a forgoing or a sacrifice made to secure benefit

Cash or cash equivalent value sacrificed for goods and services that are expected to bring a current or a future benefit to the organization.

Costs ClassificationsThe commonly used classifications of costs are based on the relationship of costs to the following:Association with Cost ObjectLevel of ActivityManufacturing departments, processes, cost centers or other subdivisionsNatureAccounting PeriodA decision, action or evaluationProduct (a single lot, batch or unit of a good or service)

Cost in relation to Association with Cost ObjectCost ObjectAny item or activity for which costs are accumulated and measuredProvides the answer to the most fundamental question about cost- The cost of what?

Common Cost ObjectsProductBatch of like unitsCustomer orderContractProduct LineProcessDepartmentDivisionProjectStrategic Plant

Cost in relation to Association with Cost ObjectDirect CostsCosts that are conveniently and economically traceable to the cost object

Indirect CostsCosts that cannot be economically traced to the cost object but instead are allocated to the cost object

Cost in relation to Level of ActivityThis classification involves the way a cost changes in relation to changes in activity of the organization.Activity refers to a measure of the organizations output of products or services

Cost in relation to Level of ActivityFixed CostsCosts that are constant in total amount within a relevant range of activityIn per unit basis, costs decreases as activity increases and vice versa (inversely proportional movement)

Examples of Fixed CostsDepreciationRentProperty TaxPatent AmortizationSupervisory Salaries

Fixed Costs

Total Fixed CostTotal Fixed Cost remains constant in any level of activity

Fixed Costs

As the level of activity increases, fixed cost per unit decreases.

Cost in relation to Level of ActivityVariable CostsCosts that increases or decreases in total as the activity changes (directly proportional movement)In per unit basis, costs remain constant within a relevant range

Examples of Variable CostsSuppliesMaterial CostsCommissionsRoyaltiesMaterials HandlingOvertime Premium

Variable Costs

Total Variable Cost increases as the level of activity increasesTotal VariableCost

Variable Costs

Variable cost per unit remain constant at any level of activity

Cost in relation to Level of ActivityMixed CostsCosts that contain both fixed and variable componentsMost of the time, the fixed and variable components of these costs must be separated for analytical purposes

Examples of Mixed CostsPayroll TaxesElectricityHealth and accident insuranceUtilities

Costs in relation to Manufacturing DepartmentsCategories of Manufacturing DepartmentsProducing DepartmentOperations done on this department like forming and assembling are performed directly on the product or its partsService DepartmentActivities done on this departments are for the benefit of other departmentsExamples of this kind of department include maintenance, payroll, accounting, data processing etc.

Costs in relation to Manufacturing DepartmentsDirect Departmental CostCosts that are traceable to the department which it originates and which directly benefited from its incurrenceIndirect Departmental CostCosts that are shared by several departments which should be allocated across these departments that indirectly benefited from its incurrence

Costs in relation to its NatureCommon CostsCosts of facilities or services employed in two or more operationsAn indirect costs that is subject for allocationJoint CostsCosts incurred in the production of a main product which consequently produced as well another product/s (by products)Cost that is also subject for allocation

30

Costs in Relation to Accounting PeriodCapital ExpendituresCosts incurred and intended for the benefit of future periods and reported as an assetRevenue ExpendituresCosts incurred that benefits only the current period and reported as an expense

Costs in Relation to a decision, action or evaluationDifferential/Incremental/Marginal CostDifference in total costs that results from selecting one choice over the otherOut-of Pocket CostCost that will be incurred only when a particular alternative is followedOpportunity CostProfit or benefit forgone by selecting one choice instead of another alternativeNot recorded in accounting records but usually relevant in making a decision

Costs in Relation to a decision, action or evaluationSunk CostCost that cannot be avoided because it has already been incurredHistorical cost that cannot be changed by any decision thus usually irrelevantUnavoidable CostCosts that will be incurred regardless of the chosen alternativeAvoidable CostCosts that may be saved by not adopting an alternative

Costs in Relation to a ProductManufacturing/Product/Inventoriable CostsCosts that are related in making or acquiring the products or providing the services that directly generate the revenues of an entityNon-manufacturing/Period CostsCosts that are associated with a particular time period rather than with making or acquiring a product or performing a servicePeriod costs that have future benefit are classified as assets while those having no future benefit are expenses

Components of Product CostDirect MaterialAny material that can be easily and economically traced to a productMaterials that form an integral part of the finished product and that are included explicitly in calculating the cost of the productExamples are lumbers for furniture & crude oil for gasoline

Components of Product CostDirect LaborCost of the time and effort spent by the individuals who work specifically on manufacturing a product or performing a serviceLabor that converts the direct materials into finished product and can be assigned feasibly to a specific productAn example is the assembly line workers salaries

Components of Product CostOverheadAny production cost that is indirect to the product or serviceExamples are the depreciation of the factory building, plant supervisors salary, traceable material to a product however bears insignificant costs

Categories of Period CostsMarketing Expenses/Distribution CostsInclude costs necessary to secure customer orders and get the finished product or service into the hands of customersOrder-getting and order-filling costsIncludes advertising, shipping costs, sales commissions and salaries etc.

Categories of Period CostsGeneral/Administrative ExpensesIncludes all executive, organizational and clerical expenses that cannot be logically included as product cost or marketing expenseExamples are the executive compensation, general accounting, secretarial, etc.

Classification of Entities using Costs DataService Companies

Merchandising Companies

Manufacturing Firms

Service CompaniesFirms that uses significant amount of labor and minimal material and convert these to a service to earn revenues

Examples are law firms, auditing firms or any undertaking which focuses on providing a service

Merchandising CompaniesEntities which purchase goods in finished or almost finished condition so that little conversion is needed before the goods are sold to customersOnly have one inventory account -Merchandise Inventory

Manufacturing FirmsCompanies that engage in activities that involve in the physical transformation of inputs (materials, labor and overhead) into finished productNormally has three types of inventory accounts namely:Raw Materials Inventory (includes direct and indirect materialsWork in Process Inventory (partially converted goods)Finished Goods Inventory

Types of Costing SystemActual CostingSystem which allocates product costs by accumulating actual costs of materials, labor and overhead directly to work in processImpractical because all production overhead information must be available before any cost allocation can be made to products or services

Types of Costing SystemNormal CostingSystem which uses a predetermined overhead rate to determine the overhead costs to be included as product cost together with the actual cost for materials and laborUses the Factory Overhead-Applied account