Cost concepts and

Classifications of Costs
 Classifications of Costs
o Why cost classifications?
Identify costs of products and services.
Pricing of these products and services.
Identify costs relevant for decision
making.
o There are different cost classifications for
different purposes..
 Classifications of Costs
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 goods. – Buy raw materials.
– Sell finished goods. – Produce finished
goods.
– Sell 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 classified 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
Examples: janitors workers cleaning supplies used in
and security guards. the automobile assembly
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.
 Non-manufacturing Costs
• All Non-manufacturing Costs are recorded as
expenses in the P & L a/c…
 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
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
easily and conveniently and conveniently traced
traced to a unit of to a unit of product or
product or other cost other cost object.
object. • Example: manufacturing
• Examples: direct overhead
material and direct labor
 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
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 costs cannot be changed by any
decision. They are not differential costs and
should be ignored when making decisions.
Example: You bought an automobile that cost
$10,000 two years ago. The $10,000 cost is sunk
because whether you drive it or park it, you
cannot change the $10,000 cost.
Exercises