CLASSIFICATIONS

OF COSTS
 Classifications of Costs
o What are the purposes of cost
classifications?
Preparing external financial statements

Predicting cost behaviour

Identifying costs relevant for decision

making.
 Classifications of Costs
o There are different cost classifications for
different purposes..

o Costs can be classified as:

1. Manufacturing and Non-Manufacturing
Costs (Functional classification)
2. Product Costs and Period Costs
3. Predicting Cost Behaviour
4. Assigning Costs to Cost Objects
5. Costs for Decision Making
 Comparing Merchandising and
Manufacturing Activities
Merchandisers . . . Manufacturers . . .
– Buy finished – Buy raw
goods. materials.
– Sell finished – Produce finished
goods. goods.
– Sell finished
goods

Here we will concentrate on the

manufacturing activities..
 Comparing Merchandising and
Manufacturing Activities
• A manufacturing • A merchandising
company usually has company may have a
three inventory single inventory
accounts: account—
 Raw Materials.  Merchandise
 Work in Process. Inventory.
 Finished Goods.
 Classifications of Costs

1. Functional Classification:

In manufacturing companies costs can

be classified as:
 Manufacturing costs

 Non-manufacturing costs
 Functional Classification
Manufacturing costs are usually categorized as
follows:

Direct Direct Manufacturing

Material Labor Overhead

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

Example: Tyres/seats installed in an

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

Example: Wages paid to automobile assembly workers

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

Wages paid to employees Materials used to support

who are not directly the production process.
involved in production
work. Examples: lubricants and
cleaning supplies used in
Examples: janitors workers the automobile assembly
and security guards. plant.
Flow of Manufacturing Costs
Direct Direct Manufacturing
Materials Labor Overhead

Work In
Process

Finished
Goods

Balance Sheet: Income Statement:

Ending Inventory Cost of Goods Sold
Non-manufacturing
Costs
Marketing and selling costs . . .
 Costs necessary to get the order and deliver
the product.
Administrative costs . . .
 All executive, organizational, and clerical
costs.
 All Non-manufacturing Costs are recorded
as expenses in the P & L a/c…
 Categories of Manufacturing and
Non-Manufacturing Costs

Traditional cost systems accumulate product

costs as follows:

Direct materials xxx

Direct labour xxx
Prime cost xxx
Manufacturing overhead xxx
Total manufacturing cost xxx
Non-manufacturing cost xxx
Total cost xxx
Product Costs Vs. Period Costs
o Product costs are those that are
attached to the products and included
in the stock (inventoriable costs).

o Period costs are not attached to the

product and not included in the
inventory valuation (non-inventoriable
costs).
 Product Costs Vs. Period Costs
Example:
Product costs = SDG 100,000
Period costs = SDG 80,000
50% of the output for the period is sold and there are
no opening inventories. What are the total costs
included in P & L a/c?
Production cost (product costs) 100,000
Less closing stock (50%) 50,000
Cost of goods sold (50%) 50,000
Period costs (100%) 80,000
Total costs recorded as an
expense for the period 130,000
Product Costs Vs. Period Costs
Product costs include
direct materials, direct
labor, and manufacturing
overhead.
Appeared as:
Inventory Cost of Good Sold
Sale
Period costs are not
included in product costs
(such as selling and
administrative costs) .
Appeared as:
Expense

Balance Income Income

Sheet Statement Statement
 Cost Classifications for
Predicting Cost Behavior
How a cost will react to
changes in the level of
business activity?
Variable costs vary in
direct proportion with
activity (e.g. cotton in
textile industry)
Fixed costs remain
constant over wide
ranges of activity (e.g.
rental cost)
Mixed costs include
both a fixed and a
variable component (e.g.
telephone charges)
 Cost Classifications for
Predicting Cost Behavior

Number of Total Variable Average Cost

Units Costs per Unit
Produced
250 $ 7500 $ 30
500 $ 15000 $ 30
750 $ 22500 $ 30
1000 $ 30000 $ 30
 Cost Classifications for
Predicting Cost Behavior

Number of Total Fixed Average Cost

Units Costs per Unit
Produced
250 $ 500 $ 2.00
500 $ 500 $ 1.00
750 $ 500 $ 0.67
1000 $ 500 $ 0.50
 Cost Classifications for
Predicting Cost Behavior
Assigning Costs to Cost Objects
What is a cost object?
• A cost object is anything for which cost data
are desired—including products, customers,
jobs, and organizational subunits.

• For purposes of assigning costs to cost

objects, costs are classified as either direct
or indirect.
Assigning Costs to Cost Objects
Direct costs Indirect costs
• Costs that can be • Costs cannot be
easily and easily and
conveniently traced to conveniently traced to
a unit of product or a unit of product or
other cost object. other cost object.
• Examples: direct • Example:
material and direct manufacturing
labor overhead
 Costs for Decision Making
o In making business decisions, it is
essential to differentiate between the
following concepts:
Differential costs and revenues
Opportunity cost
Sunk cost
 Differential costs and revenues

In business decisions, each alternative will

have costs and benefits that must be
compared to the costs and benefits of the
other available alternatives.
A difference in costs between any two
alternatives is known as a differential cost.
A difference in revenues between any two
alternatives is known as differential revenue.
 Differential Costs and Revenues
Retailer Sales Differential
Distribution Representatives Costs and
(present) (proposed) Revenues
Revenues (Variable) SDG 700,000 SDG 800,000 SDG 100,000
Cost of goods sold 350000 400000 50000
(Variable)
Advertising (Fixed) 80000 45000 (35000)
Commissions (Variable) 0 40000 40000
Warehouse depreciation 50000 80000 30000
(Fixed)
Other expenses (Fixed) 60000 60000 0
Total expenses 540000 625000 85000
Net operating income SDG 160000 SDG 175000 SDG 15000
 Opportunity Costs
Opportunity Costs is 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.
 Sunk Costs
 Sunk cost is a cost that has already been
incurred and that cannot be changed by any
decision made now or in the future.
 Sunk cost is not a differential cost and
should be ignored when making decisions.

Example: You bought an automobile that cost $10,000

several years ago. The car was used and is now
obsolete and is no longer being sold. Hence, the
original cost can not be recovered.
 Summary
Purpose of Cost Cost
Classification Classifications

 Preparing external financial • Product costs (inventoriable)

• Direct materials
statements
• Direct labor
• Manufacturing overhead
• Period costs (expensed)
• Nonmanufacturing costs
• Selling costs
• Administrative costs
 Summary
Purpose of Cost
Classification
 Predicting cost behavior in
response to changes in
activity
 Assigning costs to cost
objects (e.g., departments or
products)
 Making decisions
Cost
Classifications
• Variable cost (proportional to
activity)
• Fixed cost (constant in total)
• Mixed cost (has variable and fixed
elements)
• Direct cost (can be easily traced)
• Indirect cost (cannot be easily
traced)
• Differential cost (differs between
alternatives)
• Sunk cost (past cost not affected
by a decision)
• Opportunity cost (forgone benefit)
Exercises