Costs Terms, Concepts and Classifications

Chapter Two

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Learning Objective

Identify and give examples of each of the three basic manufacturing cost categories.

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Classification of COST

Manufacturing Cost

1. Direct Labor 2. Direct Material 3. Mfg. OH

Non Manufacturing Cost

Selling Administrative

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Cost Classification according to Purpose

Financial Statement
Product Cost Period Cost Variable Cost Fixed Cost Direct Cost Indirect Cost Differential Cost Sunk Cost Opportunity Cost

Predicting Cost Behavior

Assigning Cost to cost object

Making Decision

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Manufacturing Costs

Direct Materials

Direct Labor

Manufacturing Overhead

The Product

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Direct Materials
Raw materials that become an integral part of the product and that can be conveniently traced directly to it.

Example: Engine installed in an automobile

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Direct Labor
Those labor costs that can be easily traced to individual units of product.

Example: Wages paid to automobile assembly workers

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Manufacturing Overhead
Manufacturing costs that cannot be traced directly to specific units produced.
Examples: Indirect labor and indirect materials

Wages paid to employees who are not directly involved in production work.
Examples: maintenance workers, janitors and security guards.

Materials used to support the production process.

Examples: lubricants and cleaning supplies used in the automobile assembly plant.

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Classifications of Costs

Manufacturing costs are often classified as follows:

Direct Material Direct Labor Manufacturing Overhead

Prime Cost

Conversion Cost

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Comparing Merchandising and Manufacturing Activities

Manufacturers . . .
Buy raw materials. Produce and sell finished goods. Buy finished goods. Sell finished goods.

Merchandisers . . .

MegaLoMart

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Balance Sheet Merchandiser

Current assets
Cash Receivables Prepaid Expenses Merchandise

Manufacturer
Current Assets
Cash
Receivables Prepaid Expenses Inventories Raw Materials Work in Process Finished Goods

Inventory

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Balance Sheet Merchandiser

Current assets
Cash Receivables Prepaid Expenses

Manufacturer
Current Assets
Cash
Receivables Materials waiting to be processed. Prepaid Expenses Inventories Raw Materials Work in Process Finished Goods

Partially complete Merchandise products Inventory some material, labor, or overhead has been added.

Completed products awaiting sale.

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Non-manufacturing Costs

Selling Costs

Administrative Costs

Costs necessary to get the order and deliver the product.

All executive, organizational, and clerical costs.

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Learning Objective

Distinguish between product costs and period costs and give examples of each.

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Product Costs Versus Period Costs

Product costs include direct materials, direct labor, and manufacturing overhead.
Inventory Sale
Cost of Good Sold

Period costs include all selling costs and administrative costs.

Expense

Balance Sheet

Income Statement

Income Statement

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Quick Check

Which of the following costs would be considered a period rather than a product cost in a manufacturing company? A. Manufacturing equipment depreciation. B. Property taxes on corporate headquarters. C. Direct materials costs. D. Electrical costs to light the production facility. E. Sales commissions.

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Quick Check

Which of the following costs would be considered a period rather than a product cost in a manufacturing company? A. Manufacturing equipment depreciation. B. Property taxes on corporate headquarters. C. Direct materials costs. D. Electrical costs to light the production facility. E. Sales commissions.

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Learning Objective

Understand the differences between variable costs and fixed costs.

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Cost Classifications for Predicting Cost Behavior

How a cost will react to changes in the level of activity within the relevant range.
Total variable costs change when activity changes. Total fixed costs remain unchanged when activity changes.

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Variable Cost
Your total long distance telephone bill is based on how many minutes you talk.
Total Long Distance Telephone Bill Minutes Talked

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Variable Cost Per Unit

The cost per long distance minute talked is constant. For example, 10 cents per minute.
Per Minute Telephone Charge Minutes Talked

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Fixed Cost
Your monthly basic telephone bill probably does not change when you make more local calls.
Monthly Basic Telephone Bill Number of Local Calls

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Fixed Cost Per Unit

The average fixed cost per local call decreases as more local calls are made.
Monthly Basic Telephone Bill per Local Call
Number of Local Calls

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Cost Classifications for Predicting Cost Behavior

Behavior of Cost (within the relevant range)

Cost Variable In Total Total variable cost changes as activity level changes. Total fixed cost remains the same even when the activity level changes. Per Unit Variable cost per unit remains the same over wide ranges of activity. Average fixed cost per unit goes down as activity level goes up.

Fixed

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Learning Objective

Understand the differences between direct and indirect costs.

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Assigning Costs to Cost Objects

Direct costs
Costs that can be easily and conveniently traced to a unit of product or other cost object. Examples: direct material and direct labor

Indirect costs
Costs that cannot be easily and conveniently traced to a unit of product or other cost object. Example: manufacturing overhead

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Learning Objective

Define and give examples of cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs.

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Differential Cost and Revenue

Costs and revenues that differ among alternatives.

Example: You have a job paying $1,500 per month in your hometown. You have a job offer in a neighboring city that pays $2,000 per month. The commuting cost to the city is $300 per month.

Differential revenue is: $2,000 $1,500 = $500 Differential cost is: $300

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Opportunity Cost
The potential benefit that is given up when one alternative is selected over another.
Example: If you were not attending college, you could be earning $15,000 per year. Your opportunity cost of attending college for one year is $15,000.

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Sunk Costs
Sunk costs have already been incurred and cannot be changed now or in the future. They should be ignored when making decisions.
Example: i) Cost of getting license of a business. iii) Suppose you bought a technology by $ 20,000 which is obsolete now.

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Quick Check

Suppose you are trying to decide whether to drive or take the train to Portland to attend a concert. You have ample cash to do either, but you dont want to waste money needlessly. Is the cost of the train ticket relevant in this decision? In other words, should the cost of the train ticket affect the decision of whether you drive or take the train to Portland? A. Yes, the cost of the train ticket is relevant. B. No, the cost of the train ticket is not relevant.

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Quick Check

Suppose you are trying to decide whether to drive or take the train to Portland to attend a concert. You have ample cash to do either, but you dont want to waste money needlessly. Is the cost of the train ticket relevant in this decision? In other words, should the cost of the train ticket affect the decision of whether you drive or take the train to Portland? A. Yes, the cost of the train ticket is relevant. B. No, the cost of the train ticket is not relevant.

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Quick Check

Suppose you are trying to decide whether to drive or take the train to Portland to attend a concert. You have ample cash to do either, but you dont want to waste money needlessly. Is the annual cost of licensing your car relevant in this decision? A. Yes, the licensing cost is relevant. B. No, the licensing cost is not relevant.

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Quick Check

Suppose you are trying to decide whether to drive or take the train to Portland to attend a concert. You have ample cash to do either, but you dont want to waste money needlessly. Is the annual cost of licensing your car relevant in this decision? A. Yes, the licensing cost is relevant. B. No, the licensing cost is not relevant.

Further Classification of Labor Costs

Appendix 2A

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Learning Objective

(Appendix 2A)
Properly account for labor costs associated with idle time, overtime, and fringe benefits.

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Idle Time
Machine Breakdowns Power Failures Material Shortages

The labor costs incurred during idle time are ordinarily treated as manufacturing overhead.

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Overtime

The overtime premiums for all factory workers are usually considered to be part of manufacturing overhead.

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Labor Fringe Benefits Fringe benefits include employer paid costs for insurance programs, retirement plans, supplemental unemployment programs, Social Security, Medicare, workers compensation and unemployment taxes.
Some companies include all of these costs in manufacturing overhead. Other companies treat fringe benefit expenses of direct laborers as additional direct labor costs.

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