Classification of Costs

Lecture No. 29
Chapter 8
Contemporary Engineering Economics
Copyright 2006
Contemporary Engineering
Economics, 4th edition, 2007

Chapter Opening Story

High Hopes for Plastic Beer

Bottles
What is the least
expensive way to make
a 0.5L PET barrier beer
bottle?
Types of Production
Method
Capital investment
(20,000 bottles/hr)
Direct Mfg Cost (per
1,000 units)
Comments

5-layer

3-layer

Internal
coating

External
coating

$10.8M

$9.9M

$9.2M

$7.5M

$59.35

$66.57

$46.90

$55.34

Need a bottle that provides shelf life of over 120 days with less than
15% loss of CO2 and admittance of no more than 1 ppm of oxygen

Contemporary
Engineering Economics,

General Cost Terms

Manufacturing Costs

Direct Raw Materials

Direct Labor
Manufacturing Overhead

Nonmanufacturing
Costs

Overhead
Marketing
Administrative Functions

Contemporary
Engineering Economics,

Various Types of
Manufacturing Costs

Contemporary
Engineering Economics,

Classifying Costs for

Financial Statements

Matching Concept: The costs

incurred to generate particular
revenue should be recognized
as expenses in the same period
that the revenue is recognized.
Period Costs: Those costs that
are matched against revenues
on a time period basis
Product Costs: Those costs that
are matched against revenues
on a product basis.
Contemporary
Engineering Economics,

Example

Period Costs:

General and
administrative expenses
Marketing expenses
Insurance premiums
Income taxes
Nonmanufacturing costs

Product Costs:

Direct material costs

Direct labor costs
Manufacturing overhead
Contemporary
Engineering Economics,

How the Period Costs and

Product Costs Flow Through
Financial Statement

Contemporary
Engineering Economics,

Cost Flows and Classifications

in a Manufacturing Company

Contemporary
Engineering Economics,

Example 8.1 Classifying

Costs for Uptown Ice Cream
Unit Price of an Ice Cream
Shop
Ice cream (cream, sugar, milk, and milk solids) $0.65
Product
Cost

Period
Cost

Cone
0.05
Rent
0.61
Wages
0.25
Payroll taxes
0.25
Sales taxes
0.23
Business taxes
0.08
Debt service
0.23
Supplies
0.09
Utilities
0.08
Other (insurance, advertising,professional fees) 0.05
Profit
0.13
$2.50
Contemporary
Engineering Economics,

Cost Classification for

Predicting Cost Behavior

Volume index
Cost Behaviors
Fixed costs
Variable costs
Mixed costs
Average unit costs

Contemporary
Engineering Economics,

Volume Index

Def: The unit measure

used to define volume
Examples:

Automobile miles
driven
Generating plant kWh
produced
Stamping machine
parts stamped

Contemporary
Engineering Economics,

Fixed Costs

Def: The costs of

providing a companys
basic operating
capacity
Cost behavior: Remain
constant over the
relevant range

Contemporary
Engineering Economics,

Variable Costs

Def: Costs that vary

depending on the level
of production or sales
Cost behavior: Increase
or decrease
proportionally
according to the level of
volume

Contemporary
Engineering Economics,

Mixed Costs

Def: Costs are fixed

for a set level of
production or
consumption,
becoming variable
after the level
exceeded.
Cost behavior:
Increase or
decrease after
maintaining a fixed
level of expense

Mixed cost behavior

Depreciation Expenses ($)

6000
5000
4000
3000
2000
1000
0

5
15
25
Miles Driven (Unit: 1,000)

Contemporary
Engineering Economics,

Average Unit Cost

Def: activity cost per

unit basis
Cost Behaviors:

Fixed cost per unit varies

with changes in volume.
Variable cost per unit of
volume is a constant.
Mixed cost per unit of
volume contains both the
constant and variable
elements
Contemporary
Engineering Economics,

Practice Problem

You have 3000 units to produce.

Total labor cost = $20,000
Total material cost = $25,000
Total overhead cost = $15,000
Total fixed cost = $40,000
What is the average cost per unit?
Average cost = ($100,000)/3,000 = $33.33/unit

Contemporary
Engineering Economics,

Future Costs for Business

Decisions

Differential
(Incremental) cost
Opportunity cost
Sunk cost
Marginal cost

Contemporary
Engineering Economics,

Differential (Incremental)
Costs

Def: Costs that represent

the differences in total
costs, which results from
selecting one alternative
instead of other
Cost behavior: Increase or
decrease with the overall
change that a company
experiences by producing
one additional unit of good

Contemporary
Engineering Economics,

Opportunity Costs

Def: The potential benefit

that is given up as you seek
an alternative course of
action
Example: When you decide
to pursue a college degree,
your opportunity cost would
include a 4-years potential
earnings foregone.

Contemporary
Engineering Economics,

Sunk Costs

Def:Cost that has already

been incurred by past
actions
Economic Implications: Not
relevant to future decisions
Example: $500 spent to
replace brakes last year
not relevant in making a
selling decision in the future

Contemporary
Engineering Economics,

Marginal Costs

Def: Added costs that result

from increasing rates of
outputs, usually by single unit
Example: Cost of electricity
decreasing marginal rate

Contemporary
Engineering Economics,