Module No.

1 – Basic Concepts, Cost Terminologies and Cost Behaviors

Learning Outcome/s:
 Define and differentiate cost accounting versus any other branches of accounting
 Understand the scope of cost accounting
 Properly classify manufacturing costs
 Classify the inventories of a manufacturing entity
 Differentiate the different systems of cost accumulation

Core Values/Biblical Principles:

Competency is defined as the quality or state of having sufficient knowledge, skill or strength. A lack of
competency can cause problems within the work environment and can lead to poor quality work. This
could lead to fatalities or rework which may cost the company money and possibly their reputation.

Introduction:
Cost accounting is a system that records, summarizes, analyzes, and interprets the details of the costs of
materials, labor, and overhead necessary to produce and sell an article.

Body:
Financial Accounting vs Management Accounting

Purposes of Cost Accounting

1. Estimating and bidding
2. Planning, budgets, and control

Terminologies:
Cost – a measurement, in monetary terms, of the amount of resources used for some purpose. When
notified by a term that defines the purpose, cost becomes operational, e.g., selling cost, acquisition cost,
variable cost, etc.

Cost pool – an account in which a variety of similar costs are accumulated prior to allocation to cost
objects. It is a group of costs associated with an activity, e.g., overhead account.
Cost object – the intermediate and final disposition of cost pools, e.g., product, job, process.

Cost driver – a factor that causes a change in the cost pool for a particular activity. It is used as a basis
for cost allocation; any factor or activity that has a direct cause-effect relationship.

Activity – any event, action, transaction or work sequence that incurs costs when producing a product or
providing a service.
 Value-Adding activities - Activities that are necessary to produce the products
 Non-Value-Adding activities - Activities that do not make the product or service more valuable to
the customer

Manufacturing is the process of converting materials into finished goods by using labor and incurring
other costs, generally called manufacturing overhead.

Kinds of Cost
Cost as to type:
 Product cost - Costs incurred to manufacture the product
 Period cost - Cost that are expensed in the period of incurrence and do not become part of the
cost of inventory

Cost as to function:
 Manufacturing Cost - Costs incurred in the factory to convert raw materials into finished goods
 Direct Manufacturing Costs
 Direct Materials
 Direct Labor

 Indirect Manufacturing Cost

 Manufacturing Overhead

 Non-Manufacturing Cost - All costs which are not incurred in transforming materials into
finished goods

Cost as to traceability/assignment to cost objects:

 Direct Cost - Costs that are related to a particular cost object and can economically and
effectively be traced to that cost object
 Indirect Cost - Costs that are related to a cost object, but cannot practically, economically and
effectively be traced to that cost object

Cost as to behavior:
 Variable Cost - Within the relevant range and time period under consideration, the total amount
varies directly to change in activity level or cost driver
 Fixed Cost - Within the relevant range and time period under consideration, the total amount
remains unchanged

Within a relevant range:

Total Amount Per Cost Driver

Varies directly with

Variable Cost Constant
cost driver

Varies inversely with cost

Fixed Cost Constant
driver
  Mixed Cost - Cost that has both variable and fixed component
TC = FC + VC
Where variable cost can be computed as cost driver multiply to cost per cost driver

Method to separate fixed and variable components:

» High-Low Method
» Scattergraph Method
» Least Squares Regression Method

Other Costs:
 Relevant Cost - Future costs that will differ under alternative courses of actor
 Differential Cost - Difference in costs between any two alternative courses of action
 Opportunity Cost - Income or benefit given up when one alternative is selected over another
 Sunk Cost - Already incurred and cannot be changed by any decision made now or to be made in
the future

Three Manufacturing Cost Classifications

1. Direct materials – also called raw materials; these are used in the manufacturing process that
become a significant part of the finished goods.

2. Direct labor – this account is represented by employees who work directly with the raw
materials in converting them to finished goods.

3. Manufacturing overhead – also called factory overhead, manufacturing expenses, or factory

burden; these are costs incurred in the factory that cannot be considered direct materials or
direct labor.

a. Indirect materials – materials that are used in small amounts in the manufacturing process
or that cannot easily be traced to specific products.

Factory supplies or operating supplies – another type of indirect material which consist of
items that are used in the manufacturing process but do not become a part of the finished
goods.

b. Indirect labor – salaries and wages of factory personnel who do not work directly on raw
materials.

c. Other manufacturing overhead – includes costs such as payroll taxes on factory wages;
rent, depreciation, taxes, and insurance on factory buildings and machinery; heat, light and
power; repairs and maintenance of machinery and equipment.

Prime and Conversion Costs

Prime cost – is the sum of direct materials and direct labor. It reflects the primary sources of costs for
units in production.

Conversion cost – is the total of direct labor and manufacturing overhead. It indicates the costs required
to convert the raw materials into finished products.

Inventory Accounts for a Manufacturing Company

1. Raw materials inventory – this account reflects the cost of raw materials and factory supplies
that will be used in the manufacturing process.
 2. Work in process inventory – this account reflects the cost of raw materials, direct labor, and
manufacturing overhead of goods on which manufacturing has begun but has not been
completed at the end of the fiscal period.

3. Finished goods inventory – this account reflects the costs of goods that have been completed
and are ready for sale.

System of Cost Accumulation

1. Actual cost system (Historical) – direct materials, direct labor and factory overhead costs are
determined as they occur simultaneously with the manufacturing operation but the total of
these costs is known only after the operation has been completed.

2. Standard cost system (Predetermined) – costs are determined in advance from analysis and
forecasts made before the actual production begins.

3. Normal cost system – it is a combination of the actual cost system and standard cost system.
This system accumulates only the actual amounts of direct materials and direct labor costs.
Factory overhead costs are accumulated on the basis of a predetermined rate.

Comparison of the product costing system:

Product Costs Actual Costing Standard Costing Normal Costing

Direct Materials Actual Standard Actual

Direct Labor Actual Standard Actual

Factory
Actual Standard Predetermined
Overhead

Types of Cost System

1. Job Order Cost System - Accumulates cost applicable costs applicable to each specified job
order or lot of similar goods
2. Process Cost System - Costs without attempting to allocate them during the accounting period
to specific units of goods being manufactured
3. Dual Systems - System used when a company makes standard parts or subassemblies
continuously and then incorporates them into finished goods built to customer satisfaction

Summary:
Cost accounting is used in the determination or accumulation of a product’s cost for inventory valuation
and consequently income determination, hence, it is important to understand the cost of a product and
to have proper classification of these costs.

References:
Cost Accounting Principles and Procedural Applications by Pedro P. Guerrero, 2014-2015 edition