Classifying Costs (a) By Element

Material Labour Expense

By Traceability Direct Indirect

Classification by element

TheProduct

Material Labour Expense

Classification of Costsby Traceability

Direct CostsCosts that can

be easily and conveniently tracedto a unit of product or other cost object.

Examples: Direct material Direct labor

Indirect CostsCosts cannot

be easily and conveniently tracedto a unit of product or other cost object.

Example: Manufacturing

overhead

Direct and Indirect Costs

Direct costsCosts that can be

easily and conveniently traced to a product or department.

Example: cost of paint in the paint department of an automobile assembly plant.

Indirect costsCosts that must be

allocated in order to be assigned to a product or department.

Example: cost of national advertising for an airline is indirect to a particular flight.

Classification by element or traceability

Materials

Direct Indirect

Labour

Direct Indirect

Expenses

Direct Indirect

Current

Product costs =Materials+Labour+Expenses

Or

Direct costs + Indirect costs

Classifications of Costs in Manufacturing Companies

PrimeCost

ConversionCost

Manufacturing costs are oftencombined as follows:

DirectMaterial

Direct Labour &

Direct Expenses

ManufacturingOverhead

Classifying Costs (b)By Function

Product Period

Manufacturing Cost Flows

ManufacturingOverhead

Material Purchases

Direct Labor

Balance Sheet Costs Inventories

FinishedGoods

Cost of GoodsSold

Income StatementExpenses

Selling andAdministrative

Selling andAdministrative

Period Expenses

Work in Process

Raw Material

Cost Classification by Function Product costsInclude expenditures

that arenecessary and integralto finished products.Capitalized on the

balance sheet until sold.

Period costsInclude expendituresidentified more with atime period than with

finished products. Expensed on the

income statement.

Inventory Cost of Good Sold

BalanceSheet

IncomeStatement

Sale

Expense

IncomeStatement

Classification of Costs by Function

Product CostsDirect materialsDirect laborOverhead

Period CostsSellingGeneral and

administrative expenses

Classifying Costs (c) By Behaviour

Fixed Variable Semi-fixed Semi-variable

Cost Classificationsby Behaviour

Cost BehaviourHow a cost will react to

changes in the level of business activity.

Total variable costs change when the level of activity changes.

Total fixed costs remain unchanged when the level of activity changes.

Total Variable Cost

Your total long distance telephone billis based on how many minutes you talk.

Minutes Talked

Tota

l Lon

g D

ista

nce

Tele

phon

e B

illA variable cost is one that changes in total

in proportion to changes in the volume of activity.

Variable Cost Per Unit

Minutes Talked

Per

Min

ute

Tele

phon

e C

harg

e

The cost per long distance minute talked is constant.For example, 10 cents per minute.

On a per unit basis, a variable cost remains constant over a wide range of activity.

Cost BehaviourMerchandisers

Cost of Goods Sold

ManufacturersDirect Material, Direct Labor, and Variable

Manufacturing Overhead

Merchandisers and Manufacturers

Sales commissions and shipping costs

Service Organizations

Supplies and travel

Examples of variable costs

Total Fixed Cost

Your monthly basic telephone bill probably does not change when you make more local calls.

Number of Local Calls

Mon

thly

Bas

ic

Tele

phon

e B

illA fixed cost is one that remains constant in total

even when the volume of activity changes.

Fixed Cost Per Unit

Number of Local Calls

Mon

thly

Bas

ic

Tele

phon

e B

ill p

er

Loca

l Cal

l

The average cost per local call decreases as more local calls are made.

On a per unit basis, a fixed cost changesas the volume of activity changes.

Examples of fixed costs

Merchandisers, manufacturers, and service organizations

Real estate taxesInsurance

Sales salariesDepreciationAdvertising

Cost Behaviour

Cost Classifications for Predicting Cost Behavior

Summary of Variable and Fixed Cost BehaviorCost In Total Per Unit

Variable Total variable cost is Variable cost per unit remainsproportional to the activity the same over wide ranges

level within the relevant range. of activity.

Fixed Total fixed cost remains the Fixed cost per unit goessame even when the activity down as activity level goes up.

level changes within therelevant range.

Ren

t Cos

t in

Thou

sand

s of

Dol

lars

0 1,000 2,000 3,000 Rented Area (Square Feet)

0

30

60

Fixed Costs and Relevant Range

90

Relevant Range

Total cost doesn’t change for a wide range of activity.It then jumps to a new higher cost

for the next higher range of activity.

The company’s normal operating range

How does this type of fixed cost differ from a step-variable (or step-

wise) cost?

Step-variable (or step-wise) costs

can be adjusted more quickly and . . .

The width of the activity steps is

much wider for the fixed cost.

Fixed Costs and Semi-fixed (or Step-Wise or Step-Variable) Costs

Semi-fixed Costs(or Step-Variable or Step-Wise)

Activity

Cos

t

Total costremains constant within a narrow range of activity.

Total cost increasesto a new higher cost

for the next higher range of activity.

Fixed MonthlyUtility Charge

Variable Utility Charge

Activity (Kilowatt Hours)

Tota

l Util

ity C

ost

Total semivariable cost

Semivariable Cost Slope is

variable costper unit

of activity.

Curvilinear CostCurvilinear

Cost Function

Relevant Range

Activity

Tota

l Cos

tCurvilinear

Cost Function

A straight-Line(constant unit

variable cost) closely approximates a

curvilinear line withinthe relevant range.

Relevant Information

Information is relevant to a decision problem when . . .

It has a bearing on the future, It differs among competing alternatives.

Identifying RelevantCosts and Benefits

Sunk costsCosts that have already been incurred. They do not affect any future cost and cannot be changed by any current or

future action.

Sunk costs are irrelevant to decisions.Sunk costs are irrelevant to decisions.

Relevant Costs

Relevant costs are those costs and/or benefits that differ between alternatives.

Costs that can be eliminated (in whole or in part) by choosing one alternative over another are avoidable costs.

Avoidable costs are relevant costs. Unavoidable costs include:

Sunk costs.Future costs that do not differ between the

alternatives. Unavoidable costs are never relevant.

Add or Drop a Product Incremental Incremental CostsCosts

Summary

DECISION RULEDECISION RULESwick should drop the digital watch segment Swick should drop the digital watch segment

only if its fixed cost savings exceed lost only if its fixed cost savings exceed lost contribution margin.contribution margin.

Marginal Costs and Average Costs

The extra costincurred to produceone additional unit.

The total cost toproduce a quantity

divided by thequantity produced.

Marginal and average costs arelargely a function of cost behavior

-- variable and fixed costs.

Costs and Benefits of Information

Costs Benefits

More information does not mean more benefits if information overload results.