Chapter 1: Cost Classification

What is accounting
Accounting
measures,

is

an

information

processes,

and

system

that

communicates

financial information about a certain economic

entity.

What is cost accounting:

Cost accounting is an information system that provides information
for both management accounting and financial accounting. It
measures and reports financial information that relates to the cost
of consuming resources by an organization.
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General Cost Classifications:

Costs are associated with all kinds of organizations.

Generally, the way in which these costs are classified

depends on the kind of organization involved. There are
three main kinds of organization which are manufacturing,
merchandising, and service.
Costs can be classified according to the

following points:
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A- Manufacturing and Non-manufacturing Costs:

1-Manufacturing Costs:
Most manufacturing companies divide manufacturing costs
into three broad categories: direct materials, direct labor,
and manufacturing overhead.
Direct Materials: are those materials that become an
integral part of the finished product and that can be easily
traced to it. For example, wood is the direct material in a
piece of wooden furniture. Materials that are not
significant on a per-unit basis and cannot be easily traced
to the finished product are termed indirect materials. For
example, glue, nails, and screws.
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Direct Labor: the term direct labor is reserved for those

labor costs that can be easily traced to individual units of

product. Labor costs that are not significant on a per-unit
basis and cannot be easily traced to the finished product
are termed indirect labor. Indirect labor includes the
labor costs of supervisors, janitors, and night security
guards.

Manufacturing

Overhead:

the

third

elements of manufacturing cost, includes all

costs of manufacturing except direct material
and

direct

includes

labor.

items

Manufacturing

such

as

overhead

indirect material,

indirect labor, depreciation, heat and light,

maintenance

and

repairs

on

production

equipment, and insurance on manufacturing

facilities.
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Manufacturing Cost = direct material + direct labor + overhead

D.M

D. L

O.H

Prime Cost = D.M + D.L

Conversion Cost = D. L + O.H

Conversion costs are costs incurred to convert the

direct material into a finished product
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2-Non-manufacturing Costs:
Generally, non-manufacturing costs are sub-classified

into two categories:

Marketing or Selling Costs: included all costs

necessary to secure customer orders and get the

finished product into the hands of the customer.
Examples of marketing costs included advertising,
shipping, sales commissions, sales salaries, and cost of
finished goods warehouses.
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Administrative Costs: included all executive and

organizational

costs

associated

with

general

management of an organization rather than with

manufacturing, marketing, or selling. Examples of
administrative costs include executive compensation,
general accounting, secretarial, and public relations.

Example:
The following are some cost data for a manufacturing
company for the month of January:
Raw material used in production
Direct labor
Indirect material
Supervisor salaries
Insurance- factory
Machine rental
Sales salaries
Depreciation factory

380,000
120,000
5,000
100,000
10,000
20,000
50,000
15,000

Required: determine prime cost, conversion cost, and

total manufacturing cost

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B: Product costs and Period Costs

Product costs: include all the costs that are involved in
acquiring or making product. In the case of manufactured
goods, these costs consist of direct material, direct labor,
and manufacturing overhead. (manufacturing costs)
Period costs: are all the costs that are not included in product
costs (marketing or selling costs and administrative costs.
These costs are expensed on the income statement in the
period in which they are incurred, using the usual rules of
accrual accounting that we learn in financial accounting.
(nonmanufacturing costs)
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Cost behavior refers to how a cost will react or respond to

changes in the level of business activity. As the level of
activity rises and falls, a particular cost may rise and fall
C. Variable Cost and Fixed Cost (Cost Behavior):
as well--or it may remain constant.
For planning purposes, a manager must be able to anticipate
which of these will happen; and if a cost can be expected
to change, the manager must know by how much it will
change. To help make such distinctions, costs are often
characterized as variable or fixed.

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Variable Cost:
Are costs that changed in total in proportion to
changes in the related level of production. But
its remains constant (fixed) per unit.
suppose that in order to make one suit, required 5 meter of cloth
and the company purchase the meter in 2 pounds.
So, direct material for make one suit = 5 meter * 2 pounds = 10
pounds
Production volume
1
5
100

total variable cost

10
50
1000

variable cost per unit

10
10
10
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Fixed Cost:
Are costs that remains unchanged (constant) in total
regardless of changes in the related level of production.
But fixed cost per unit decreases with the increase in the
volume of production.
Example: factory rental
Suppose that the company pay 10,000 LE for factory rental.
Production level
2,000
4,000
10,000

total fixed cost

10,000
10,000
10,000

fixed cost per unit

5
2,5
1
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1
1

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Mixed Costs:
Is one that contains both variable cost and fixed cost such as
maintenance cost.
Mixed costs equation:
Y=a+bx
In this equation:
y = the total mixed cost
a = the total fixed cost
b = the variable cost per unit
x = the level of production

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Analyze a mixed cost using the high-low method:

The high-low method is an estimation technique which relies on
the relationship between the highest and lowest observed
values of cost.

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Example:
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solution
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