NATURE CLASSIFICATION AND PURPOSE OF COST

Cost Classifications for Preparing External Financial Statements. This section of the chapter focuses
on the problem of valuing inventories and determining cost of goods sold for external financial reports.
Before beginning this discussion, you may want to explain the difference between a manufacturing and a
merchandising company. Manufacturing companies convert raw materials into a product. The company
then sells that product either to other companies or, less commonly, directly to individuals.
Manufacturing includes restaurants, movie studios, and other service-type companies as well as the
more obvious examples of manufacturing such as automobile and clothing production. Merchandising
companies, by contrast, buy finished products and resell the products to customers. Valuing inventories
and determining cost of goods sold is simple in a merchandising company, but is difficult in a
manufacturing company. For that reason, we concentrate on manufacturing in this section of the chapter.

1. Manufacturing costs. These costs are incurred to make a product. Manufacturing costs are usually
grouped into three main categories: direct materials, direct labor, and manufacturing overhead.
a. Direct materials. Direct materials consist of those raw material inputs that become an integral
part of a finished product and can be easily traced into it. Examples include the aircraft engines
on a Boeing 777, the Intel processing chip in a personal computer, and the blank video cassette in
a pre-recorded video.
b. Direct Labor. Direct labor consists of that portion of labor cost that can be easily traced to a
product. Direct labor is sometimes referred to as touch labor since it consists of the costs of
workers who touch the product as it is being made.
c. Manufacturing Overhead. Manufacturing overhead consists of all manufacturing costs other
than direct materials and direct labor. These costs cannot be easily and conveniently traced to
products. Examples include miscellaneous supplies such as rivets in a Boeing 777, supervisors,
janitors, factory facility charges, etc.
d. Prime versus Conversion Costs. Prime cost consists of direct materials plus direct labor.
Conversion cost consists of direct labor plus manufacturing overhead.

2. Non-manufacturing costs. A manufacturing company incurs many other costs in addition to
manufacturing costs. For financial reporting purposes most of these other costs are typically classified as
selling (marketing) costs and administrative costs. Marketing and administrative costs are incurred in both
manufacturing and merchandising firms.
a. Marketing Costs. These costs include the costs of making sales, taking customer orders, and
delivering the product to customers. These costs are also referred to as order-getting and order-
filling costs.
b. Administrative Costs. These costs include all executive, organizational, and clerical costs that
are not classified as production or marketing costs.

3. Period vs. product costs. Costs can also be classified as period or product costs.
a. Period Costs. Period costs are expensed in the time period in which they are incurred. All
selling and administrative costs are typically considered to be period costs. You should be careful
to point out that the usual rules of accrual accounting apply. For example, administrative salary
costs are incurred when they are earned and not necessarily when they are paid to employees.
b. Product Costs. Product costs are added to units of product (i.e., inventoried) as they are
incurred and are not treated as expenses until the units are sold. This can result in a delay of one
or more periods between the time in which the cost is incurred and when it appears as an expense
on the income statement. Product costs are also known as inventoriable costs. The discussion in
the chapter follows the usual interpretation of GAAP in which all manufacturing costs are treated
as product costs.

4. Inventory valuations and Cost of Goods Sold. In a manufacturing company, raw materials purchases
are recorded in a raw materials inventory account. These costs are transferred to a work in process
inventory account when the materials are released to the production departments. Other manufacturing
costsdirect labor and manufacturing overheadare charged to the work in process inventory account as
incurred. As work in process is completed, its costs are transferred to the finished goods inventory
account. These costs become expenses only when the finished goods are sold. Period expenses are taken
directly to the income statement as expenses of the period.

5. Schedule of Cost of Goods Manufactured. Because of inventories, the cost of goods sold for a period
is not simply the manufacturing costs incurred during the period. Some of the cost of goods sold may be
for units completed in a previous period. And some of the units completed in the current period may not
have been sold and will still be on the balance sheet as assets. The cost of goods sold is computed with
the aid of a schedule of costs of goods manufactured, which takes into account changes in inventories.
The schedule of cost of goods manufactured is not ordinarily included in external financial reports, but
must be compiled by accountants within the company in order to arrive at the cost of goods sold. You
should take some time to explain the cost of goods manufactured schedule since it is often difficult for
students to understand.

Cost Classifications to Describe Cost Behavior. Managers often need to be able to predict how costs
will change in response to changes in activity. The activity might be the output of goods or services or it
might be some measure of activity internal to the company such as the number of purchase orders
processed during a period. In this chapter, nearly all of the illustrations assume that the activity is the
output of goods or services. In later chapters, other measures of activity will be introduced.
While there are other ways to classify costs according to how they react to changes in activity, in this
chapter we introduce the simple variable and fixed classifications. A variable cost is constant per unit of
activity but changes in total as the activity level rises and falls. A fixed cost is constant in total for
changes in activity within the relevant range. (Just about any cost will change if there is a big enough
change in activity. Fixed costs do not change for changes in activity that fall within the relevant range.)
When expressed on a per unit basis, a fixed cost is inversely related to activitythe per unit cost
decreases when activity rises and increases when activity falls.
There is some controversy concerning the proper definition of the relevant range. Some refer to the
relevant range as the range of activity within which the company usually operates. We refer to the
relevant range as the range of activity within which the assumptions about variable and fixed costs are
valid. Either definition could be usedour choice was dictated by our desire to highlight the notion that
fixed costs can change if the level of activity changes enough.

Cost Classifications for Assigning Costs. Managers often want costs to be assigned to cost objects
such as products, customers, departments, etc. for pricing or other purposes. A direct cost is a cost that
can be conveniently and easily traced to a particular cost object. Indirect costs are everything else. A cost
would be considered indirect for one of two reasons: either it is impractical or it is impossible to trace the
cost to the cost object.
1.Common costs. For example, it is impossible to trace the factory managers salary in a multi-
product plant to any particular product made in the plant. Even if a product were dropped entirely, we
would ordinarily expect the factory managers salary to remain the same. This is an example of a
common cost and later in the text we emphasize that such costs should not be allocated for decision-
making or performance evaluation purposes.
2.Variable indirect costs. On the other hand, other costs are treated as indirect costs because it
would not be practical to treat them otherwise. For example, it would be possible to measure the precise
amount of solder used on each circuit board produced at a HP plant, but it wouldnt be worth the effort.
Instead, solder would typically be considered an indirect material and would be included in overhead.

Cost Classifications for Decision-Making. Every decision involves choosing from among at least two
alternatives. Only those costs and benefits that differ between alternatives are relevant in making the
selection. This concept is explored in greater detail in the chapter on relevant costs. However, decision-
making contexts crop up from time to time in the text before that chapter, so it is a good idea to
familiarize students with relevant cost concepts.
1. Differential Costs. A differential cost is a cost that differs between alternatives. The cost may
exist in only one of the alternatives or the total amount of the cost may differ between the alternatives. In
the latter case, the differential cost would be the difference between the cost under one alternative and the
cost under the other. Differential costs are also called incremental costs. Differential costs and opportunity
costs should be the focus of decision-making. They are the only relevant costs and all others should be
ignored.
2. Opportunity Costs. An opportunity cost is the potential benefit that is given up by selecting
one alternative over another. The concept of an opportunity cost is rather difficult for students to
understand because it is not an actual expenditure and it is rarely (if ever) shown on the accounting books
of an organization. It is, however, a cost that must be considered in decisions.
3. Sunk Cost. A sunk cost is a cost that has already been incurred and that cannot be changed by
any decision made now or in the future. Since sunk costs cannot be changed and therefore cannot be
differential costs, they should be ignored in decision making. While students usually accept the idea that
sunk costs should be ignored on an abstract level, like most people they often have difficulty putting this
idea into practice.

ELEMENTS OF COST
Direct materials consist of all of the materials that become an integral part of the finished product. Direct
materials should include the actual cost of the materials, as well as freight in, import duties, purchasing
costs, receiving costs, storage costs and other directly attributable costs of acquiring the materials. Direct
materials should be recorded net of any trade, quantity or cash discounts attributed to the materials.

Direct labor consists of all of the personnel costs required to manufacture the finished product. Direct
labor should include wages, payroll taxes, and benefits associated with personnel who are integral to
manufacturing the finished product.

Factory overhead consists of all of the other costs required to manufacture the finished product that do
not fit into the direct material or direct labor elements. They consist mainly of indirect material, indirect
labor, depreciation, utilities, rent, repairs and maintenance and insurance.

DISTINCTION BETWEEN TRADING AND MANUFACTURING BUSINESS
Operational features:
For manufacturing enterprise: They process or assemble the products they sell. The
procedure of purchasing and processing of raw material with labor force is its great
feature. For technical companies, they can be deemed as manufacturing enterprise if their
operation activities include the procedure of processing the raw materials. Otherwise,
they cant be defined as manufacturing enterprises.
For trading enterprise: Their chief feature is that they mainly carry on commodity or
service exchange using some kind of currency. Generally, its operation pattern is a
buying and selling.
For service enterprise: They provide certain invisible services, such as consultation,
technology, patent and so on. Generally there is no trading of physical commodities.




Main distinction between Cost Accounting and Management Accounting are as follows.
1. Cost accounting deals with ascertainment , allocation , apportionment accounting aspect of
costs.Management accounting deals with the effect and impact of costs on the business.

2. Cost accounting provides a base for management accounting whereas management accounting is
derived from cost accounting and financial accounting.

3. Cost accounting does not include financial accounting , tax planning and tax accounting.
Management accounting includes financial and cost accounting , tax accounting and tax planning.

4. Cost accounting is concerned with short term planning. Management accounting is concerned with
short range and long range planning.

5. Cost accounting merely assists the management with functioning.Management accounting assists
and evaluates the management performance.

6. Cost accounting can be installed with management accounting but management accounting can not
be installed without cost and financial accounting.

Cost Accounting vs Management Accounting
Management accounting is concerned with decision making, strategy formulation, planning and
budgetary control, while cost accounting is concerned with analysis and evaluation of costs incurred in
order to reduce inefficiencies and improve the firms overall productivity.

The output of management accounting is for decision making at the top level whereas many internal and
external to the organisation use the cost accounting information.

Cost accounting is backward looking and evaluates past data, whereas managerial accounting is forward
looking and involves planning and prediction for the future.
Both forms of accounting are essential for the smooth running of a business and essential components in
the decision making process.