Classification of Costs

Lecture No. 1
Chapter 8
Contemporary Engineering Economics
Copyright © 2015
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What Does It Cost to Make a Pencil
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General Cost Terms in Manufacturing Setting
 Manufacturing (Product) Costs
 Direct Raw Materials Factory overhead

 Direct Labor
 Manufacturing Overhead Mfg. Indirect Mfg.
Overhead costs

 Nonmanufacturing (Period) Costs Burden

 Overhead
 Marketing
 Administrative Functions
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 Period Costs – Outside Factory

Selling Administrative General

Product = Inside Factory

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Components of Manufacturing Cost

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 Classifying Costs for the Financial
Statements
• Matching Concept: The costs incurred to generate
particular revenue should be recognized as
expenses in the same period that the revenue is
recognized.

• Period Costs: Those costs that are matched

against revenues on a time period basis.

• Product Costs: Those costs that are matched

against revenues on a product basis.

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 Example- Period and Product Costs
ABC Company, Inc.
Income Statement
• Product Costs: (Factory)
Sales $5,000,000
• Direct material costs
• Direct labor costs Less: Cost of Goods Sold – (COGS) 3,250,000
• Manufacturing overhead Gross Profit (margin) 1,750,000
Less: Selling, General and 1,000,000
• Period Costs: Administration Expenses
• General & admin expenses Operating Profit (margin) 750,000
• Marketing expenses Less: Interest 250,000
• Insurance premiums
Net Income Before Taxes (NIBT) 500,000
• Income taxes
• Nonmanufacturing costs Less: Taxes 175,000
Net Income (margin) $325,000
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How the Period Costs and Product Costs Flow
Through the Financial Statements

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Cost Flows and Classifications
Manufacturing Company

Cost of Goods Sold

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 Example 8.1 Classifying Costs for a Wooden
chair manufacturer
Total
Item
• Given: Breakdown of Unit Cost
Wood $1250
Cost items
Maintenance of Machinery $47

Nails $750
• Find: Classify the cost items Wages $390
to product costs and period
Sales Tax $320
costs.
Property Tax $275

Utilities $112

Inspection costs for finished goods $42

Other Expenses (Advertising, $10

Miscellaneous etc.)
Total $3195

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Cost Classification for Predicting Cost
Behaviors
❑Volume index
❑Cost behaviors
o Fixed costs
o Variable costs
o Mixed costs
❑Average unit costs

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 Volume Index- Activity Based Costing

• Definition: The unit

measure used to Units KWH
define “volume” produced Produced
• Examples:
• Automobile – A measure of what
miles driven causes the
incurrence of a
• Generating plant variable cost
– kWh produced
• Stamping Miles Parts
machine – “parts” driven Assembled
stamped
• Assembly plant –
units assembled
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 The more you
Fixed Costs produce, it
doesn’t cost any
more

• Definition: The costs

of providing a
company’s basic
operating capacity
• Cost behavior:
Remains constant over
the relevant range

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 Make 1 more
Variable Costs Unit, costs
same amount
($0.10 more)

• Definition: Costs that

vary depending on
the level of
production or sales
• Cost behavior:
Increases or
decreases
proportionally
according to the level
of volume

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 Fixed Cost for a
Mixed Costs while, then
Variable

• Definition: Costs are Mixed cost behavior

fixed for a set level of
production or 6000
consumption, becoming

Depreciation Expenses ($)

5000
variable after the level is
exceeded. 4000

• Cost behavior: Increases 3000

or decreases after 2000
maintaining a fixed level
of expense 1000
0
5 15 25
Miles Driven (Unit: 1,000)

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 Example 8.2 Average Driving Cost per Mile

• Given: Owing and

Operating a 4WD
Sport-Utility vehicle

• Find: Average driving

cost per mile as a
function of mileage

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Future Costs for Business Decisions

•Differential (Incremental) cost

•Opportunity cost
•Sunk cost
•Marginal cost

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 Differential (Incremental) Costs
• Definition: Costs that
represent the difference in
total costs, which results
from selecting one
alternative instead of
another

• Cost behavior: Increases or

decreases with the overall
change that a company
experiences by producing
one additional unit of goods

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 Opportunity Costs

•Definition: Potential benefit

that is given up as you seek an
alternative course of action
•Example 1 : When you decide to pursue a college
degree, your opportunity cost would include
four-years’ potential earnings given up.
•Example 2: You have money in an account
earning 5% and you take it out to invest in
something, you are giving up the earnings.
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 Sunk Costs
• Definition: Cost that has already been incurred and cannot
be recovered. Such costs are independent of any event
that could take place in the future.

• Economic implications: Not relevant to future decisions

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Walmart Checkout Sunk Cost Example
Walmart has paid for all these
Checkout lines, computers, etc.

This is a SUNK COST

They can’t do
anything
About this past
money but since it
costs money to staff
them, they can justify
putting in Self
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 Sunk Cost Example
• Kellogg Corporate had spent $$Millions producing
and selling products in Venezuela, but decided to
close operations rather than continuing to lose
money.

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 Marginal Costs
• Definition: Added costs that
result from increasing rates
of output, usually by a single
unit
• Example: Cost of
electricity—decreasing
marginal rate

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