Chapter 2

An Introduction to cost terms,

concepts and classifications
Text Book: Chapter 2 (P. 54-62); Chapter 4 (P. 142; 144; 149-152);
Chapter 6 (P.245-247)
TABLE OF CONTENTS
CHAPTER 2

PART I – An Introdution to Management Accounting

Chapter 2. An Introduction to Cost Behavior

1. General Cost Classifications

2. Cost Classifications on Financial Statements
3. Costing in Service Organizations
4. Cost Classifications for Predicting Cost Behaviour
5. Cost Classifications for Assigning Costs to Cost Objects
6. Cost Classifications for Decision Making
7. Short Quiz

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1. GENERAL COST CLASSIFICATIONS
OVERVIEW

▪ The classifications
of costs are not
mutually exclusive

▪ A particular cost
may be classified
in many different
ways depending
upon the purpose
of the
classification.

‫ ﺧطوط اﻹﻧﺗﺎج أو اﻟﻣﻧﺎطﻖ اﻟﺟﻐراﻓﯾﺔ أو اﻟﻌﻣﻼء أو اﻹدارات أو أي ﺷﻲء آﺧر ﺗرﻏب اﻹدارة‬:‫ اﻷﻣﺛﻠﺔ اﻟﺷﺎﺋﻌﺔ ﻋﻠﻰ ﻛﺎﺋﻧﺎت اﻟﺗﻛﻠﻔﺔ ھﻲ‬.‫ اﻟﺗﻛﺎﻟﯾف ﻟوﺻف ﺷﻲء ﯾﺗم ﺗﻌﯾﯾن اﻟﺗﻛﺎﻟﯾف ﻋﻠﯾﮫ‬:‫ﻛﺎﺋن اﻟﺗﻛﻠﻔﺔ‬
‫ﻓﻲ ﺗﺣدﯾد اﻟﺗﻛﻠﻔﺔ ﻣن أﺟل‬ Managerial Accounting
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1. GENERAL COST CLASSIFICATIONS
COST VERSUS PRICE

Don’t confuse prices with costs. Price (or sales price)

is the amount the company charges the customer for
the goods or services provided. Cost is the amount
the company incurs to acquire the goods or services.
If a company purchases an item for €4 and sells it
for €10, the cost is €4 and the price is €10.

A cost is a sacrifice or giving up of

resources for a particular purpose.

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1. GENERAL COST CLASSIFICATIONS
TYPE OF BUSINESS

Merchandising Manufacturing
Service Company Company
Company

A company that sells A company that resells A company that uses

services – time, skills, products previously labor, equipment, supplies,
and knowledge – bought from suppliers and facilities to convert
instead of products raw materials into other
goods

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1. GENERAL COST CLASSIFICATIONS
MANUFACTURING COSTS

1. Direct Materials (DM)

2. Direct Labor (DL)

3. Manufacturing Overhead

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1. GENERAL COST CLASSIFICATIONS
Raw materials may include
MANUFACTURING COSTS both direct and indirect
materials (= manufacturing
overhead)

1. Direct Materials (DM)

▪ are the costs of raw materials that are converted into the finished product and
are easily traced to the product and are easily traced to the product

▪ raw materials refer to any materials that are used in the final product (the
finished product of one company can become the raw materials of another
company)

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1. GENERAL COST CLASSIFICATIONS
MANUFACTURING COSTS
Indirect Labor

2. Direct Labor (DL)

▪ is the cost of wages and salaries of employees who convert the raw materials into the
finished product. Direct labor is a direct cost that can be easily traced to the finished
product.

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1. GENERAL COST CLASSIFICATIONS
MANUFACTURING COSTS

3. Manufacturing Overhead (factory overhead or indirect manufacturing costs)

▪ refers to indirect manufacturing costs that cannot be easily be traced to specific products

▪ It includes all manufacturing costs other than direct materials and direct labor that are
associated with operating the factory. These costs are created by all of the supporting
production activities, including storing materials, cleaning work areas, maintenance costs,
manufacturing building, equipment, heat and light, indirect materials and indirect labor.

▪ Manufacturing overhead can be categorized in 3 groups:

✓ Indirect materials: are the cost of raw materials that are difficult to trace directly to
the product or materials used to support the production. It may be the glue used in
assembling the product or cleaning supplies in the assembly plant

✓ Indirect labor: includes the cost of wages and salaries in the factory for persons not
directly producing the product. Examples include production supervisors, workers who
repair factory equipment, cleaners

✓ Other indirect manufacturing costs

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1. GENERAL COST CLASSIFICATIONS
NON-MANUFACTURING COSTS

▪ Non-manufacturing costs are often divided into two categories:

1. Selling costs - include all costs that are incurred to secure customer orders
and get the finished product to the customer
Examples: advertising, shipping, sales travel, sales commissions, sales
salaries, and costs of finished goods warehouses

2. Administrative costs - include all costs associated with the general

management of an organization rather than with manufacturing or selling
Examples: executive compensation, general accounting, secretarial, public
relations, and similar costs involved in the overall, general administration of
the organization as a whole.

▪ Nonmanufacturing costs are also often called selling, general, and

administrative (SG&A) costs or just selling and administrative costs.

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1. GENERAL COST CLASSIFICATIONS
PRIME VERSUS CONVERSION COSTS

▪ Prime costs combine the direct costs of direct materials and direct labor

▪ Conversion costs combine direct labor with manufacturing overhead

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1. GENERAL COST CLASSIFICATIONS
PRODUCT COSTS VERSUS PERIOD COSTS

▪ Another way costs can be classified is as product or period costs

▪ To understand this difference, we should refresh the accruals basis and the matching principle:

▪ Cost are recognized as expenses on the income statement in the period

that benefits from the cost (accrual basis)
▪ Example: Rent for January can only be recorded as an expense in January even if the
payment has occurred already in December. In December the prepaid rent will be shown
as an asset on the balance sheet

▪ The matching principle is based on the accrual concept that costs incurred to
generate a particular revenue should be recognized as expenses in the
same period that the revenue is recognized
▪ Example: a cost incurred to acquire or make something that will eventually be sold,
should be recognized as an expense only when the sale takes place—that is, when the
benefit occurs;

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1. GENERAL COST CLASSIFICATIONS
PRODUCT COSTS VERSUS PERIOD COSTS

▪ Product costs are costs identified with goods produced or purchased for
resale.

▪ In the case of manufactured goods, product costs consist of direct

materials, direct labor, and manufacturing overhead.

▪ Product costs are initially assigned to an inventory account on the

balance sheet (‘inventoried’). When the goods are sold, the costs are
released from inventory as expenses (typically called cost of goods sold)
and matched against sales revenue. This can result in a delay of one or
more periods between the time in which the cost is incurred and when it
appears as an expense on the statement of profit or loss.

Inventory COGS

Sale

Balance Income Managerial Accounting

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1. GENERAL COST CLASSIFICATIONS
PRODUCT COSTS VERSUS PERIOD COSTS

▪ Period costs are costs that are expensed on the statement of profit or
loss during the current period without becoming part of the inventory.

▪ Period costs are not included as part of the cost of either purchased or
manufactured goods

▪ Keep in mind that the period in which a cost is incurred is not necessarily
the period in which cash changes hands.

Expense

Income
Statement
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1. GENERAL COST CLASSIFICATIONS
PRODUCT COSTS VERSUS PERIOD COSTS

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1. GENERAL COST CLASSIFICATIONS
SUMMARY OF COST TERMS

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2. COST CLASSIFICATIONS ON FINANCIAL STATEMENTS
INTRO

• Financial statements prepared by a manufacturing company are more complex than

the statements prepared by a merchandising company because a manufacturing
company must produce its goods as well as market them.

• The production process gives rise to many costs that do not exist in a merchandising
company, and these costs must be properly accounted for on the manufacturing
company’s financial statements.

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 Merchandising
2. COST CLASSIFICATIONS ON FINANCIAL STATEMENTS Inventory:
Goods purchased
THE STATEMENT OF FINANCIAL POSITIONS (BALANCE SHEET) from suppliers that
are awaiting resale
to customers

Raw Material
Inventory:
Materials waiting to
be processed.

Work-in-Process
Inventory:
Partially complete
products – some
material, labour or
overhead has been
added.

Finished Goods
Inventory:
Completed
products awaiting
sale.
No inventory 1 type of inventory 3 types of inventory

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2. COST CLASSIFICATIONS ON FINANCIAL STATEMENTS
THE STATEMENT OF PROFIT AND LOSS (INCOME STATEMENT)

Only period costs period costs & period costs &

No product costs product costs product costs
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2. COST CLASSIFICATIONS ON FINANCIAL STATEMENTS
COST FLOW PRODUCT AND PERIOD COSTS IN A MERCHANDISING COMPANY

Goods sold

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2. COST CLASSIFICATIONS ON FINANCIAL STATEMENTS
COST FLOW PRODUCT AND PERIOD COSTS IN A MANUFACTURING COMPANY

Direct
materials
used

Goods
completed
(COGM)

Goods sold

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2. COST CLASSIFICATIONS ON FINANCIAL STATEMENTS
BASIC EQUATION FOR INVENTORY ACCOUNTS

Beginning
+ Additions = Available
balance
£££ £££££
££
_

Withdrawals
£££

=
Ending
balance
££

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2. COST CLASSIFICATIONS ON FINANCIAL STATEMENTS
COST OF GOODS SOLD IN A MERCHANDISING COMPANY

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2. COST CLASSIFICATIONS ON FINANCIAL STATEMENTS
COST OF GOODS SOLD IN A MANUFACTURING COMPANY

▪ COGS represents the cost of the Finished Goods Inventory that

has been sold.
▪ To determine the COGS in a manufacturing company, we need to
know the COGM and the beginning and ending balances in the
finished goods inventory account.

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2. COST CLASSIFICATIONS ON FINANCIAL STATEMENTS
COST OF GOODS SOLD IN A MANUFACTURING COMPANY

▪ The COGM contains the three elements of product costs: direct materials, direct labor
and manufacturing overhead

▪ However, the total of these three cost elements is not the COGM. The reason is that some
of the materials, labor and overhead costs incurred during the period relate to goods that
are not yet completed. The costs that relate to goods that are not yet completed are shown
in the work in progress inventory.

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2. COST CLASSIFICATIONS ON FINANCIAL STATEMENTS
COST OF GOODS SOLD IN A MANUFACTURING COMPANY

▪ Cost of Goods Manufactured is the manufacturing costs of the goods that finished the
production process in a given accounting period

▪ Four calculation steps:

1. Calculate the direct materials used

2. Calculate the total manufacturing costs incurred during the year
3. Calculate the cost of goods manufactured
4. Calculate the cost of goods sold
1
3 4
2

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 1 3 4
2. COST CLASSIFICATIONS ON FINANCIAL STATEMENTS 2
COST OF GOODS SOLD IN A MANUFACTURING COMPANY

1 2 4

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2. COST CLASSIFICATIONS ON FINANCIAL STATEMENTS
COSTS VERSUS EXPENSES

▪ Cost is a broad term that describes the

amount paid for an activity, product, or
service.

▪ Expenses specifically denote the costs

deducted from revenue on an income
statement in a given period.

▪ All costs eventually become expenses,

but they are not expenses until
accountants deduct them from revenue in
the income statement.

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3. COSTING IN SERVICE ORGANIZATIONS
CHARACTERISTICS SERVICE ORGANIZATIONS

Although many basic cost concepts and classifications can equally be applied to manufacturing
and service operations, there are some important general differences:

▪ Services cannot be stored as inventory – no interest in inventory valuation

▪ Service outputs often specially customized for a client, i.e. heterogeneous with many
intangible characteristics – hard to define output

▪ Services cannot be counted, measured, inspected, tested or verified in advance of sale, i.e.
simultaneity

➔ These differences have had an effect on costing practices in service organizations.

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4. COST CLASSIFICATIONS FOR PREDICTING COST BEHAVIOR
COST BEHAVIOR For example, an activity that requires resources and therefore causes costs for Boeing
is installing seats

▪ Cost behavior is how the activities of an organization affect its costs, how a cost will
react or respond to changes in the level of business activity

▪ Cost drivers (= Activity Base) are measures of activities that require the use of
resources and thereby cause costs (for example: miles driven, beds occupied, hours
worked, units produced)

Labor for
installing seats
Installing seats in
airplane
Seats

▪ One measure of activity: number

of seats → cost driver for the
cost of the seats

▪ A different measure of activity:

labor hours used in installing the
seats → cost driver for the
cost of labor

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4. COST CLASSIFICATIONS FOR PREDICTING COST BEHAVIOR
VARIABLE COSTS If you are the owner,
you will be most interested in the total cost because that shows how much finance you
will need in order to carry on production. You will only recover the cost of buying the
clay when you sell the finished goods to the customers
▪ A variable cost is a cost that varies, in total, in direct proportion to changes in the level of
activity (the cost-driver)

▪ The per-unit variable cost remains unchanged regardless of changes in the cost-driver.
l materials used to manufacture a unit of output or to provide
a type of service;
▪ Examples of variable costs: delivery charges, sales commissions
l labour costs of manufacturing a unit of output or providing a
type of service;
The total cost of batteries is The cost per battery is
based on the number of cars constant. For example, 24 £
produced in a month. per battery. l commission paid to a salesperson
l fuel used by a haulage company

Cost per battery

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4. COST CLASSIFICATIONS FOR PREDICTING COST BEHAVIOR
Suppose the cost driver is units of goods or services produced. A 10% increase in units produced would result in a
FIXED COSTS 10% increase in variable costs. However, the fixed costs would remain unchanged.
Notice that variable costs do not change per unit of the cost driver, but the total variable costs change in direct proportion to the
cost-driver activity.
▪ A fixed cost is a cost that remains constant, in total, regardless of changes in the level of
activity (the cost-driver)

▪ The fixed cost per unit is inversely related to changes in volume.

▪ Examples of variable costs: rent, salaries, insurance, property tax, advertising

The total rent cost of a machine
is constant, regardless of the
number of tests that may be
performed during the month
The average cost per test
decreases as more lab tests
are performed
Rent of buildings
l salary paid to a supervisor
l advertising in the trade journals
l business rates paid to the local authority
l depreciation of machinery calculated on the straight-line basis

Cost per lab test

Number of lab test

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4. COST CLASSIFICATIONS FOR PREDICTING COST BEHAVIOR
RELEVANT RANGE

▪ The relevant range is the range of activity within

which the assumptions about variable and fixed
costs are valid.

▪ Example for fixed costs: the assumption that

the rent for machines in £8,000 per month is valid
within the relevant range of 0 to 2,000 tests per
month.

▪ Example for variable costs: if a company

obtains volume discounts for purchasing large
quantities of input materials, the materials cost
would be lower, at higher levels of production

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4. COST CLASSIFICATIONS FOR PREDICTING COST BEHAVIOR
VARIABLE AND FIXED COSTS

• A particular cost may be variable or fixed, depending on the cost-driver

• Rent is:
• A variable cost if cost-driver is surface (measured as square meters)
• A fixed cost if cost-driver is output (measured as number of items produced)

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4. COST CLASSIFICATIONS FOR PREDICTING COST BEHAVIOR
SUMMARY VARIABLE AND FIXED COSTS

If activity level/cost-
driver increases

Fixed

Fixed

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 5. COST CLASSIFICATIONS FOR ASSIGNING COSTS TO COST OBJECTS
DIRECT AND INDIRECT COSTS

• Costs are assigned to objects for a variety of purposes including pricing, profitability studies and control
of spending.

• A cost object is anything for which cost data are desired – including products, product lines, customers,
jobs, departments, service and organizational subunits.

• For purposes of assigning costs to cost objects, costs are classified as either direct or indirect
• Direct costs are costs that can be easily and conveniently traced to a cost object
• Examples: direct material and direct labor

• Indirect costs are costs that cannot be easily and conveniently traced to a cost object
• Example: manufacturing overhead such as cleaning supplies and lubricant

To be traced to a cost object such as a particular product, the cost must be

caused by the cost object

• Unallocated costs are costs that are not assigned to a cost object because they lack an identifiable relationship to
a cost object

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 5. COST CLASSIFICATIONS FOR ASSIGNING COSTS TO COST OBJECTS
DIRECT AND INDIRECT COSTS

• A particular cost may be direct or indirect, depending on the cost object

• The soup factory manager’s salary is:

• An indirect cost of manufacturing carrot soup as cost object is carrot soup
• A direct cost of the manufacturing division as cost object is the entire manufacturing division

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5. COST CLASSIFICATIONS FOR ASSIGNING COSTS TO COST OBJECTS
DIRECT AND INDIRECT COSTS

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6. COST CLASSIFICATIONS FOR DECISION MAKING
DIFFERENTIAL/INCREMENTAL COSTS, OPPORTUNITY COST, SUNK COST

▪ Differential Costs and Revenues

▪ Costs and revenues that differ among alternatives.

▪ Example: you have a job paying £1,500 per month in your hometown. You have a job
offer in a neighbouring city that pays £2,000 per month. The commuting cost to the
city is £300 per month.

Differential revenue is:

£2,000 - £1,500 = £500

Differential cost is:

£300

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6. COST CLASSIFICATIONS FOR DECISION MAKING
DIFFERENTIAL/INCREMENTAL COSTS, OPPORTUNITY COST, SUNK COST

▪ Opportunity Cost

▪ The potential benefit that is given up when one alternative is selected over another.

▪ Example: If you were not attending university, you could be earning £15,000 per
year. Your opportunity cost of attending university for one year is £15,000.

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6. COST CLASSIFICATIONS FOR DECISION MAKING
DIFFERENTIAL/INCREMENTAL COSTS, OPPORTUNITY COST, SUNK COST

▪ Sunk Cost

▪ Sunk costs cannot be changed by any decision. They are not differential costs and
should be ignored when making decisions.

▪ Example: you bought a car that cost £10,000 two years ago. The £10,000 cost is sunk
because whether you drive it, park it, trade it or sell it, you cannot change the
£10,000 cost.

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7. SHORT QUIZ
QUESTION 1

Cost Drivers _____.

a. Can be volume based

b. Affect the total level of costs incurred by companies

c. All of these

d. Are activities that cause costs to be incurred

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7. SHORT QUIZ
QUESTION 2

Variable costs are usually characterized by:

a. Unit costs that decrease as activity increases

b. Total costs that increase as activity decreases

c. Total costs that increase as activity increases

d. Total costs that remain constant

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7. SHORT QUIZ
QUESTION 3

Beginning work in progress was €125,000. Manufacturing costs

incurred for the month were €835,000. There were €200,000 of
partially finished goods remaining in work in progress inventory at the
end of the month. What was the cost of goods manufactured during
the month?:
Beginning work in

a. €1,160,000 +
process inventory
Mfg. costs incurred
Begin ingworkin £ 125.000

for the period 835.000

b. €910,000 = Total work in progress
Beginning work in
during the period
proces inventory £125.0 0 £ 960.000
c. €760,000 – Ending work in process inventory
progress inventory + Mfg. cost incur ed £ 125.000 200.000
= Cost of goods+ Mfg. costs incurred
d. Cannot be determined. Beginning work in
manufactured for the period fo r th e p
process inventory £ 125.000
= Total work in progress
e ri o d 835.835.00 000
£ 760.000

+ Mfg. costs incurred

during=tThoetalperiwork oindprogres £ 960.000 Managerial Accounting
for the period 835.000
– Ending work in
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