Cost Terminology and

Classification

Overview

Cost Accounting System

Cost Management System
Cost Terminology
Classification of Cost

Cost Traceability & Assignment

Cost Behaviour & Estimation
Cost Function

Other Cost Terms

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Overview

Cost Accounting for Manufacturing

Company

Objectives
Double-Entry Bookkeeping System
Manufacturing Cost Accounting

Cost Accounting System

Part of the basic accounting system that

accumulates cost for use in both
managerial and financial accounting.

Cost Management System

A management planning and controlling

system that measures the costs of
significant activities, identifies nonvalue-added costs, and identifies
activities that will improve
organizational performance.

Objectives of
Cost Management Systems

To measure cost of resources

consumed in performing activities
To identify and eliminate non-value
added costs
To determine efficiency and
effectiveness of activities
To identify and evaluate the value of
new activities
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Cost Terminology

Cost - resources given up for a specific

objective
Cost Object - anything for which a
separate measurement of cost is
desired

Classification of Cost

Cost Traceability

Cost Behaviour

Cost Function

Cost Traceability

Direct Cost - traceable to the cost

object in an economically feasible
manner
Indirect Cost - not traceable but
allocated to the cost object using some
allocation bases
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Cost Assignment
Direct Costs
traced

Cost Object
allocated
on the basis of cost
Indirect Costs drivers/activity levels
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Assumptions per Cost

Behaviour
Costs are classified as variable or fixed:
With respect to a specific cost object.
For a specific time horizon.
Given a specific relevant range.
One cost driver for each cost.
Total costs are the sum of variable and
fixed costs.
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Cost Behaviour
Within the relevant range for a given period:
Variable Cost - total variable cost changes
proportionally with activity level or cost
driver
Fixed Cost - total fixed cost does not
change with activity level or cost driver
Mixed Cost - include both variable and
fixed cost components
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Variable Cost
Cost, $, y

Cost driver, x
13

Fixed Cost
Cost, $, y

Cost driver, x
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Mixed Cost
Cost, $, y

Cost driver, x
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Estimation of Cost Behaviour

High-Low Method

Linear Regression Analysis

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High-Low Method
Cost, $, y

H2

x
x
x

L1

x
x

x
x

H1

x
x

L2

Cost driver, x
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High-Low Method

Pros

Simple

Cons

Ignore other data points

Outliers
Fitness of model cannot
be determined

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Linear Regression Analysis

Ordinary Least Squares
Cost, $, y

Min (yi - i)2

yi
i

x
x
x

x
x

x
x

x
x

= b 0 + b1x

Cost driver, x
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Linear Regression Analysis

Assumptions:
Economic plausibility
Linearity
2
Normality of residuals, ~ N(0, )
Uniformity of residuals, i.e.,
independence of (yi i) from xi

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Linear Regression Analysis

Pros

Use all data points

Model of best-fit
Statistical inference

Significance of regression coefficient, b

Coefficient of determination, R2
Confidence interval
Prediction
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Cost Function
Research & Development
Product/Process Design
Production

Marketing
Distribution
Customer Service

Manufacturing
Product Costs /
Inventoriable Costs

Non-Manufacuring
Period Costs

Value Chain Analysis

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Cost Function

Nonmanufacturing costs (Period costs)

Manufacturing costs (Product costs)

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Nonmanufacturing Costs

costs not related to the

manufacturing activities of a company
include general, selling, and
administrative expenses (R&D, design
marketing, distribution, and customer
service expenses)
expensed in the income statement as
incurred
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Manufacturing Costs

Direct Materials, DM

Direct Labour, DL

Indirect Manufacturing Costs,

Manufacturing Overhead, or
Factory Overhead, OH
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Product (Inventoriable) Costs

Direct Costs,
DM & DL
traced

Cost Object
allocated
on the basis of cost
Indirect Costs, drivers/activity levels

OH

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Direct Materials, DM

costs of materials traceable to

the product in an economically
feasible manner

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Direct Labour, DL

costs of manufacturing labour

traceable to the product in an
economically feasible manner

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Indirect Manufacturing Costs, OH

other costs required in the manufacturing

of the product and cannot be traced to
the product in an economically feasible
manner

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Prime Costs
= Direct Materials + Direct Labour
Conversion Costs
= Direct Labour + Indirect Manufacturing
Costs

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Product Cost/
Inventoriable Cost (GAAP)

Product Cost
= Direct Materials +
Direct Labour +
Indirect Manufacturing Costs
Product Cost
= Direct Materials + Conversion Costs
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Different Definitions of Product Cost

Value Chain

GAAP

Pricing

R&D

Design

Production

Marketing

Distribution

Customer
Service

Taxation

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Other Cost Terms

Controllable and Non-Controllable costs

Opportunity costs
Out-of-pocket costs
Sunk costs
Differential costs
Marginal costs and Average costs

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Cost Accounting for

Manufacturing Company

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Objectives of
Manufacturing Cost Accounting

Financial reporting

Inventory (B/S); Cost of goods sold (I/S)

Decision making

Pricing
Outsourcing

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Double-Entry Bookkeeping System

B/S:

I/S:

Income

Revenue

Owners Equity

Liabilities

Assets

+
Expenses

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Cost Accounting for

Manufacturing Company

Merchandising Company

one inventory account:

Merchandise Inventory

Manufacturing Company

Three inventory accounts:

Stores Control;
Work in Process (WIP); and
Finished Goods (FG)
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Stores Control
- keeps track of IN and OUT of materials

Work in Process (WIP)

- keeps track of use of resources (DM, DL & OH)
in production of goods
- records costs of partially completed units

Finished Goods (FG)

- keeps track of IN and OUT of finished products
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Manufacturing Cost Accounting

Stores Control

Work in Process

Finished Goods

Beg Inv

Beg Inv
Mfg cost
incurred: Cost of
DM Used goods
DL
mfg
OH

Beg Inv

Purchase

End Inv

Used

End Inv

Cost of
goods
mfg

Cost of
goods
sold

End Inv

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