Classification of Costs

COSTS

Direct Material

Direct Labor

Manufacturing Overhead

Selling Expenses

General & AdministrativeExpenses

Manufacturing Costs

Include the acquisition costs of all

materials that are physically

identified as a part of the

manufactured goods and that may

be traced to the manufactured goods

in an economically feasible way.

1. Direct Material Costs1. Direct Material Costs

Manufacturing Costs

Include the wages of all labor

that can be traced specifically

and exclusively to the

manufactured goods in an

economically feasible way.

2. Direct Labor Cost -2. Direct Labor Cost -

Manufacturing Costs

Or “Indirect manufacturing cost” or

“factory overhead”

Include all costs associated with the

manufacturing process that cannot

be traced to the manufactured

goods in an economically feasible

way.

Can be further classified as:

3. Manufacturing Overhead 3. Manufacturing Overhead

Production Cost

Production CostLabor

Material

Manufacturing Overhead

Prime Costs and Conversion Costs

All indirect costs are commonly combined into a single cost pool call factory overhead

Prime cost refers to direct materials and direct labor that are sometimes considered together

Conversion cost refers to direct labor and factory overhead combined into a single amount

Manufacturing costs are often combined as follows:Direct

MaterialsDirect

MaterialsDirectLabor

DirectLabor Factory

OverheadFactory

Overhead

Fixed Costs or capacity cost

Definition: The costs of providing a company’s basic operating capacity

Cost behavior: Remain constant over the time though volume may change.

Some examples; Annual insurance premium, property tax, and license fee, building rents, depreciation of buildings, salaries of administrative and production personnel.

Variable Costs Definition: Costs that vary depending on the

level of production or sales

Cost behavior: Increase or decrease according to the level of volume change.

Example: Ice cream cone company, wages, payroll taxes, sales tax, and supplies. Fuel consumption is directly related to miles driven.

Cost Concepts relevant to the decision making.

Costs are an important feature of many business decisions. In order to make such decisions following cost needed to be well understood… Differential costs Opportunity costs Sunk costs Marginal costs

Differential (Incremental) Costs Revenues

Decision involve selection among alternatives. Each alternative have certain costs / benefits that

are needed to be compared to the costs / benefits of the other alternatives

Increase or decrease in total cost resulting from an alternative course of action

Differential (Incremental) Costs and Revenues

Definition: Difference in costs between any two alternatives known as Differential cost.

Difference in revenues between any two alternatives is known as differential revenue.

Example 3.3: Differential Cost Associated with Adopting a New Production Method

Variable costs: Materials $150,000 $170,000 $20,000 Machining labor 85,000 64,000 -21,000 Electricity 73,000 66,000 -7,000Fixed costs: Supervision 25,000 25,000 0 Taxes 16,000 16,000 0 Depreciation 40,000 43,000 3,000

Total $392,000 $387,000 -$5,000

Current Dies Better Dies Differential Cost

Opportunity Costs

Definition: 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 the 4-year’s potential earnings foregone.

Sunk Costs

Definition:Cost that has already been incurred by past actions

Economic Implications: Not relevant to future decisions

Example: Rs. 500 spent to replace tires last year—not relevant in making selling decision in the future

Marginal Costs

Definition: Added costs that result from increasing rates of outputs, usually by single unit

Unit Marginal Contribution (MC) Definition: Difference between the

unit sales price and the unit variable cost, also known as marginal income or producer’s marginal contribution (MC). This means each unit sold contributes toward absorbing the company’s fixed cost.

MC = Sales price – Variable cost Application: Break-even volume

analysis:

Break - even volume =Fixed costs

MC

Income Statement For External ReportingSales Revenue $400,000

Less Cost of Goods Sold 210,000

Gross Margin $190,000

Less Mktg. & Admin Exp. 80,000

Net Income Before Taxes $110,000

Contribution Margin Format Income Statement

Sales Revenue $400,000

Less Variable Costs:

Variable Cost of Sales $160,000

Variable Mktg & Admin 8,000 168,000

Contribution Margin $232,000

Less Fixed Costs:

Fixed Cost of Sales $50,000

Fixed Mktg & Admin 72,000 122,000

Net Income Before Taxes $110,000

Marginal Costing-short term decision making Selling price decision Exploring new markets Make or buy decisions Sales mix decision Selecting a suitable method of production Plant shut down decision

EXAMPLES OF OPERATING EXAMPLES OF OPERATING DECISIONSDECISIONS

PRICE OF SALESPRICE OF SALES IN HOUSE PRODUCTION (MAKE) IN HOUSE PRODUCTION (MAKE) OR OUTSOURCING (BUY)OR OUTSOURCING (BUY) END OF PRODUCTION LINES END OF PRODUCTION LINES RESOURCES REPLACEMENTRESOURCES REPLACEMENT SPECIAL ORDERSSPECIAL ORDERS PRODUCTS MIXPRODUCTS MIX ETC.ETC.

IF ALL THE PRODUCTS ARE IF ALL THE PRODUCTS ARE INDEPENDENT, WE DON’T HAVE TO INDEPENDENT, WE DON’T HAVE TO

CHOOSE ONE TO PUSH MORECHOOSE ONE TO PUSH MORE

(we’ll try to maximize the sales of all products)(we’ll try to maximize the sales of all products)

ANSWERING THE QUESTION USING ANSWERING THE QUESTION USING

““CONTRIBUTION MARGIN”CONTRIBUTION MARGIN”

PROPORTIONED TO PROPORTIONED TO

THE SCARCE RESOURCETHE SCARCE RESOURCE

(ratio)(ratio)