Cost Accounting

Basic concepts
Learning Objectives
• Explain cost terms and classifications for financial
reporting: period vs. product cost
• Describe the components of product cost
• Calculate ‘cost of goods manufactured’ and ‘cost of
goods sold’ for a manufacturing entity
• Explain cost terms and classifications for decision
making: direct/indirect; variable/fixed;
controllable/non-controllable; opportunity,
differential, sunk, and quality
• Understand quality costs
Cost Classifications
• Cost classifications that are used depend on
the reason for cost data accumulation.
• There are two main reasons for cost
accumulation:
▫ financial reporting (asset and income
measurements, i.e., cost accounting)
▫ decision making (e.g., resource allocation,
motivation, pricing)
Cost Classification for Financial Reporting

• For financial reporting, costs are classified

into:
▫ Period costs
▫ Product costs
• This classification simply refers to whether a
cost (an expenditure) is related to a period or a
product, and thus the time in which the
expenditure is recognized as expense.
Period Costs
• Also known as selling, general and
administrative expenses, period costs are
related to time periods, i.e., they are
incurred every period.
▫ Examples are salaries of sales and
administrative personnel.
• Period costs are therefore expensed in the
period incurred (not paid).
Product Costs
• Also known as factory or manufacturing costs,
product costs are related to products (or
production activities).
▫ Examples are salaries of factory personnel and
factory utility costs.
• Product costs are therefore treated as assets
(inventories) until the products are sold at
which time they are expensed as cost of goods
sold.
Classification of Product Costs
Prime Conversion

Direct Direct (Manufacturing)

Materials Labor Overhead

The Product
Direct Materials
• Materials that can be easily and physically
identified as part of the product
▫ e.g., chips in a computer
• Small items such as glue and screws, and
items that do not become part of the product,
are considered indirect materials and their
cost is part of overhead cost.
Direct Labor
• Salaries/wages paid to employees who
convert direct materials into finished
products.
• Direct labor costs can be easily and
physically traced to specific units of
products.
▫ e.g., wages paid to computer assembly workers
• The salaries/wages of other personnel in the
factory (supervisors, janitors, custodians,
security guards) are considered indirect
labor cost and are part of overhead.
Overhead
• All factory or manufacturing costs except
direct materials and direct labor.
▫ e.g., indirect materials, indirect labor, utilities,
repair and maintenance, insurance, property taxes,
rent, depreciation
▫ Idle time and overtime premiums are part of
overhead costs.
• Fringe benefits is considered overhead in its
entirety by some companies; others only
consider fringe benefits for indirect labor as
overhead and the rest as direct labor.
Other Cost Classifications
• In process industries such as steel, chemical
and paper, direct labor cost is not normally
accumulated separately; direct labor and
overhead are combined and called conversion
or processing cost.
• In today’s manufacturing environment, direct
labor cost (<10% of total cost) is not normally
separately accumulated; the machining cost
(the rent or depreciation, utilities,
maintenance, engineering, and other machine
related costs) is.
Flow of Manufacturing Costs
• Traditionally, costs follow the physical flow of
goods, i.e., they move as goods move through the
manufacturing process and sale.
▫ e.g., cost of materials are transferred to work-in-
process as materials are released to production
floor.
Flow of Manufacturing Costs
Direct materials Work-in-process Finished goods
BI BI BI
Purchases DM used DM used COGM COGM COGS
EI DL EI
OH applied*
EI

Cost of goods sold

COGS
Application of Overhead
• OH is normally applied (allocated) on the basis
of a plant-wide rate, departmental rates, or
activity rates.
• There is an overhead account that is debited for
overhead cost incurred and credited for
overhead applied.
Selling and Administrative Costs
• Selling costs are costs necessary to secure the
order and deliver the product.
• Administrative costs are executive,
organizational, and clerical costs.
Cost Classifications for Decision Making
For decision making, costs are classified in
several ways:
• Direct vs. Indirect
• Variable vs. Fixed
• Controllable vs. Non-controllable
• Other
Direct Costs vs. Indirect Costs
• This classification is mainly used in evaluating
the performance of a segment
▫ e.g., product, product line, department, division
Direct Costs vs. Indirect Costs
• Direct costs of a • Indirect costs are costs
segment (cost object) incurred for the
are costs incurred for common benefit of two
the sole benefit of the or more segments.
segment. ▫ e.g., salary of general
▫ e.g., salary of segment manager
manager • They will not be
• They will be eliminated eliminated if one of the
if the segment is segments is eliminated.
eliminated.

The basic idea is that any segment of the company should

at least cover its own direct costs.
Controllable vs. Non-controllable Costs
• This classification is mainly used in evaluating a
segment manager’s performance.
Controllable vs. Non-controllable Costs
• Controllable costs to a • Non-controllable costs are
particular manager are those those that an upper level
that he/she can authorize, or manager can authorize.
significantly influence. ▫ e.g., CEO decides how
▫ e.g., segment manager much to spend on
decides how much to spend marketing
on marketing

The basic idea is that responsibility should be commensurate

with authority, i.e., a manager can not be held responsible for
what he/she cannot control.
Variable Costs vs. Fixed Costs
• This classification is widely used in managerial
accounting, e.g., in CVP analysis, budgeting,
standard costing, segment reporting, and special
decisions.
Variable Costs vs. Fixed Costs
• Variable costs vary in total
in direct proportion to the
level of activity.
• They are fixed per unit of
activity.
DL cost
• Fixed costs stay the same in
total regardless of the level
of activity.
• They vary per unit of
activity.

Total
Rent

Per unit Per unit

Units produced Units produced
What is an Activity? Cost Driver?
• An activity is a transaction or event that involves
cost.
▫ e.g., production; purchase order; material handling
and cutting
• Every activity has one or more cost drivers.
▫ e.g., number of units produced; number of orders
processed; type of material, its weight, or volume.
Variable Costs vs. Fixed Costs
• Both variable and fixed cost definitions are true
within the relevant range (the range of normal
activity) and within a time frame.
▫ No cost is fixed over all activity levels or over a
very long period of time.
• Cost that vary in steps (such as supervisory
salaries) are called step-variable or step-fixed
costs.
Types of Variable Costs
• Variable costs can be:
▫ Engineered – causally related to level of activity
▫ Discretionary – decided on by management as
part of the budget
Types of Fixed Costs
• Fixed costs can be:
▫ Committed – related to possession of plant and
equipment and existence of the organization
▫ Discretionary (or managed)– decided on by
management as part of the budget
Mixed (Semi-Variable) Costs
• Mixed costs are costs that contain both variable
and fixed components, e.g., utilities.
▫ Costs aggregated in various ways are also mixed, e.g.,
overhead or machining.
• The fixed component represents the minimum
cost of having a service available for use; the
variable component represents the cost of
actual consumption.
• Graphically, a mixed cost is represented by a
straight line that intersects the vertical (Y) axis.
Other Cost Terms
• Opportunity cost is the potential benefit
that is given up when one alternative is
selected over another.
▫ e.g., by deciding to make a component for a
product, a company experiences an opportunity
cost because it gives up the profit that would be
realized by using the facilities to make another
product.
• This cost is not a cash outlay and is not
recorded in the books, but is relevant in any
managerial decision.
Other Cost Terms
• Incremental (differential) cost is the
change in cost as a result of taking a given course
of action.
• This concept is mainly used in making special
decisions.
▫ e.g., what would the increase in cost be as a result of
accepting a special order.
• Economists refer to incremental cost as increase
in cost as a result of a “one” unit increase in
activity.
Other Cost Terms
• Sunk cost is cost incurred in the past that
can not be recovered.
• Past costs are always irrelevant and should be
ignored in all managerial decisions. Decisions
should be based on present and future cash
flows.
• For example, in deciding to replace an asset, we
ignore its original cost (not the cash resale price
of the asset or the tax loss shield).