CHAPTER 2

COST CLASSIFICATIONS

MA. Le Hoang Oanh

LOGO
 LEARNING OBJECTIVES

Understanding the cost classification in different ways

for different purposes
Identify the types of costs in each classification
Understand the analysis of mixed cost
Prepare income statement in two ways: absorption
costing income statement and variable costing income
statement
CONTENTS

Cost concepts
Cost classifications
Income statement
COST CONCEPTS

LOGO
COST

is defined as
a resource sacrificed or forgone to
Cost
achieve a specific objective in
production and business activities
of enterprises.

Cost is classified differently according to the immediate

needs of management
COST UNITS

a unit of product or service which

Cost unit
has costs attached to it

the basic control unit for costing purposes

A Single item
Room (in a hotel)
A composite item
Patient night, a passenger mile
A batch of 1,000
Batch of 1,000 shoes
COST CLASSIFICATIONS

LOGO
 COST CLASSIFICATIONS
Element Nature Function Relationship with Behaviour
accounting
period
Material Direct Production cost Product cost Fixed cost
cost
Labour Indirect Selling & Period cost Variable
cost Distribution cost
cost
Expenses R & D cost Step-cost
Financing cost Semi-
variable
cost
Administration
cost 8
CLASSIFICATION BY ELEMENT

Types of costs

Materials Labour Expenses

9
COST CLASSIFICATION BY NATURE (FOR
ASSIGNING COSTS TO A COST UNIT)

Types of costs

Direct costs Indirect costs

 COST CLASSIFICATION BY NATURE

- Directly involve to a cost unit

(product or service)
à Easily and conveniently traced
to the particular cost unit

Prime
cost
Direct costs

Direct materials Direct labour Direct expenses

All materials which All wages paid for labour Any exp incurred on
form part of the product (either as basic hour or as a specific product
(unless used in negligible overtime ) which involved other than direct
amounts &/or having directly in making the material cost & direct
negligible cost àindirect product wages
materials)
 COST CLASSIFICATION BY NATURE

Direct costs

Direct materials Direct labour Direct expenses

- Raw materials - Workers altering condition - Cost of Special
- Component parts & composition of product designs , drawing &
- Part-finished work - Inspectors, analysts & layouts
- Primary packing testers: specifically required - Hire of tools or
materials - Foremen & shop clerks: equipment for a
wages are specifically particular job
identified
 COST CLASSIFICATION BY NATURE

-Not included in Non-mfg overhead incurred in the

production Cost course of making a
of goods or for product or providing
Inventory a service, but which
Indirect costs cannot be traced
valuation purpose
directly and in full to
- A, S & D the product or
overhead service.
Manufacturing overhead

Indirect materials Indirect labour Indirect expenses

are used for the benefit wages of all employees all manufacturing costs
of all products rather who do not work on the other than direct &
product itself but who indirect labour, direct &
than for any one specific
assist in the indirect materials and
product.
manufacturing operation direct expense.
 COST CLASSIFICATION BY NATURE

Manufacturing overhead

Indirect materials Indirect labour Indirect expenses

as lubricants for as supervisors and as heating and

machinery, maintenance workers lighting for the
grease, nuts, factory
screws
COST CLASSIFICATION BY NATURE

Materials = Direct Materials + Indirect Materials

+ + +

Labour = Direct Labour + Indirect Labour

+ + +

Expenses = Direct Expenses + Indirect Expenses

Total cost = Direct Cost + Indirect Cost

COST CLASSIFICATION BY FUNCTION

Production costs

Costs incurred to make things & get them ready to sale

Direct Direct
Materials Direct Production
Labor
expense Overhead
COST CLASSIFICATION BY FUNCTION
Non-production costs

The indirect costs of an organization that are not classified as

manufacturing overhead.
COST CLASSIFICATION BY FUNCTION
Costs incurred to get the
finished items to the point
where people can buy and
persuade people to buy
them.
Non-production
Distribution
& Selling costs
Financing
costs
Costs incurred when a business
has to borrow to purchase non-
current assets or to operate on a
day to day basis
R: costs of searching for new
/improved products.
R&D D: are costs incurred between
the decision to produce a new or
improved product and the
commencement of full
manufacture of the product
cost
Administration
costs
Costs incurred in co-
ordinating activities of the
production function and the
distribution and selling
function.
COST CLASSIFICATION BY FUNCTION

PRODUCTION COST Income statement

Revenue
(-)
DM DL POH
COGS
sold
used (=)
Work in process inventory Gross
unused margin
End of period non-.
(-)
Pr.cost
SA&D
Direct Work in process Finished goods cost
Material inventory inventory Balance (=)
inventory sheet Net income
unfinished finished
 COST CLASSIFICATION BY ASSOCIATION WITH
THE PRODUCT

Types of costs

Product costs Period costs

Costs of making or buying the
stock item.
à Identified with the product &
included in inventory values
à Prior sales: deferred as
inventories; shown on the
balance sheet as assets
à At the time revenue is
realized: become part of the
period costs (inventory
account à COGS account)
No direct relations to the
production of goods or purchase
of goods
à Not identified with product or
job
à charged in the profit and loss
account for the period in which
they are incurred
à Not carried forward as a part of
value of inventory to the next
accounting period
COST CLASSIFICATION BY ASSOCIATION WITH
THE PRODUCT

PRODUCT COST Income statement

Revenue
(-)
DM DL POH
COGS
sold
used (=)
Work in process inventory Gross
unused margin
End of period Period
(-)
cost
SA&D
Direct Work in process Finished goods cost
Material inventory inventory Balance (=)
inventory sheet Net income
unfinished finished
COST CLASSIFICATION IN RELATIONSHIP WITH
ACCOUNTING PERIOD
COST CLASSIFICATION BY BEHAVIOR

Volume of output:
- Value of items sold - Number of items sold
- Number of invoices issued
- Number of units of electricity consumed

Cost behavior is the way that costs are changed

by changes in the level of activity

Knowledge of cost behavior is essential for budgeting,

decision making and control accounting
COST CLASSIFICATION BY BEHAVIOR

Mixed costs
(semi-variable/semi-fixed costs

Types of costs

Variable costs Stepped – fixed costs Fixed costs

VARIABLE COSTS

- Cost of raw materials

Variable costs
- Direct labour costs
- Sales commission

A cost that changes in total in

a linear relationship
direct proportion to changes between cost &
in the volume of output. activity assumed

- Purchase price per unit of

The variable cost per Implied
materials purchased
constant
unit is the same for - Cost per labour hour worked
each unit produced - Rate of material usage
- Labour productivity
VARIABLE COST

($’s)
Petrol costs
30

20

10

100 200 300 kms travelled

10/26
VARIABLE COST PER UNIT

($’s)
Petrol
costs/km

0.1

100 200 300

kms travelled

10/27
FIXED COSTS - Salary of managing director
(per month)
- Rent cost (per month)
- Straight line depreciation of
Fixed costs single machinery (per month)

A cost that remains constant in

total even when the volume of
output changes

Fixed cost per unit will decrease

as more units are produced.
FIXED COSTS

Fixed costs

Period charge

- Relate to span of time

- Time span
à Fixed cost
FIXED COSTS

($)
Vehicle
insurance
costs

Vehicle insurance costs

$1,200

20,000 30,000
10,000
kms travelled pa
FIXED COSTS

($)
Vehicle
insurance
costs/km

20,000 30,000
10,000
kms travelled pa
FIXED COSTS & VARIABLE COSTS

Costs are either variable or fixed, depending upon whether

they change when the volume of production changes

Costs are either direct or indirect, depending upon how

easily they can be traced to a specific unit of production

usually
Direct costs are variable

Variable costs is not just another name

for a direct cost
Quick Check ü

Fixed costs are usually characterized by:

a. Unit costs that remain constant.

b. Total costs that increase as activity
decreases.
c. Total costs that increase as activity
increases.
d. Total costs that remain constant.
Quick Check ü

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.
Quick Check ü

Which of the following costs would be variable with

respect to the number of cones sold at a Baskins &
Robbins shop? (There may be more than one
correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.
STEPPED-FIXED COSTS

Stepped-Fixed costs

Costs that are fixed in nature within

certain level of activity

Basic wages of employees is usually fixed, but as

output rises more employees are required.
Accommodation requirements increase when output
rise, therefore rent costs increase.
STEP COST
MIXED COSTS

Electricity bills =
Mixed costs Standing basic charge
+ A variable charge per
unit of consumption

Part fixed and part variable

Partly affected by changes in the

level of activity.
Mixed Costs

Y
Total Utility Cost

s t
c o
e d Variable
i x
l m
a Utility
T ot
Charge
Fixed Monthly
Utility Charge
X
Activity (Kilowatt
Hours)
Mixed Costs
§ y: the total mixed cost
§ bx: total variable cost
§ b: the variable cost per unit of activity
§ x: the level of activity
§ a: the total fixed cost
Y
bX
a+
Total Utility Cost

Y=
s t
c o
e d Variable
i x
m bX
t al Utility
T o
Charge
Fixed Monthly
a
X
Utility Charge
Activity (Kilowatt Hours)
MIXED COST

FC = road tax, insurance, VC = petrol, oil, repairs

(vary with miles travelled)
MIXED COST
§ y: the total mixed cost
§ bx: total variable cost
§ b: the variable cost per unit of activity
§ x: the level of activity
§ a: the total fixed cost

Total
cost y = a + bX

Variable costs

yF = a
Fixed costs
Lowest Highest level of activity
MIXED COSTS

($)
Cost per
unit

Level of activity
MIXED COST

To better control mixed costs à analyze mixed cost into

fixed component and variable component

The high-low method

THE HIGH-LOW METHOD

Estimate b:
Determining data points: A1 (x1, y1), … , An (xn, yn)
– y1 = a + bx1
– ……………………………………
– yn= a + bxn.
Identifying 2 periods with 2 levels of activity within the
relevant range
• Lowest level of activity Ai (xi, yi)
yi = a + bxi.
• Highest level of activity Aj (xj, yj)
yj = a + bxj.
Solving equations à b = yj – yi / xj – xi
Estimate a: a = y – bx.
THE HIGH-LOW METHOD

Plot the data points on a graph, connecting the lowest and

highest data point to have the straight line of mixed cost

Simple to apply
x
xx

x xx incorrect
THE HIGH-LOW METHOD

Month Direct Labor Total maintenance

Hours cost ($)
Example:
1 1,100 2,650
Determine variable
2 1,000 2,500
cost per labor
3 1,300 3,150
hour, total 4 1,150 2,700
fixed cost of 5 1,400 3,350
maintenance, 6 1,250 2,900

Cost equation for 7 1,100 2,650

maintenance at 8 1,200 2,900

Company M 9 1,350 3,250

in 20x8 10 1,450 3,400

11 1,150 2,700
12 1,500 3,500
THE HIGH-LOW METHOD

variable
cost per =
hour
Total
=
fixed cost
or =

Cost equation for maintenance

y=
THE HIGH-LOW METHOD

Total
cost ($)

Relevant range
3,500
High activity level

2,500
Low
activity level

500

1,000 1,500
Direct
labour
hours
 COST ASCERTAINMENT

Direct Direct Direct Prime

Materials + Labor + Expenses = Costs

2 - 50
 COST ASCERTAINMENT

Cost components need to change raw

materials to finished goods

Direct Manufacturing Conversion

Labor + DE + Overhead = Costs

Indirect Indirect
Materials Other
Labor 2 - 51
INCOME STATEMENT

LOGO
ABSORPTION AND VARIABLE COSTING INCOME
STATEMENT
Product costs (in inventory
or in cost of goods sold)
include variable & fixed
Absorption production costs Variable
Costing Costing
Direct Materials
Product
Product Direct Labor
Costs
Costs Variable POH

Fixed POH
Period
Period Variable Selling and Administrative Expenses
Costs
Costs Fixed Selling and Administrative Expenses

Product costs (in inven. or in

COGS only include variable
manufacturing costs)
ABSORPTION AND VARIABLE (MARGINAL) COSTING
INCOME STATEMENT

ABSORBTION COSTING I.S VARIABLE

VARIABLE
COSTING
I.S I.S

- Cost data is organized in - Cost data is organized in

a functional format in cost behavior format
ABSORPTION AND VARIABLE COSTING INCOME
STATEMENT

Fixed manufacturing
costs must be assigned
to products to properly Fixed manufacturing
match revenues and costs are capacity costs
costs. and will be incurred
even if nothing is
produced.

Absorption Variable
Costing Costing
§ ABSORPTION AND VARIABLE COSTING INCOME
STATEMENT

Treament on fixed production costs

VARIABLE I.S

ABSORBTION COSTING I.S VARIABLE COSTING I.S

All fixed production costs

Fixed production costs
absorbed to products: P&L

Sold: P&L

Unsold: BS
 VARIABLE I.S

ABSORBTION COSTING MARGINAL COSTING

P&L

Sold: P&L

Unsold: BS
§ ABSORPTION AND VARIABLE COSTING INCOME
STATEMENT
ABSORBTION COSTING INCOME STATEMENT
Total
Sales SA&D costs are
Less Cost of goods sold treated as period
Gross margin expenses and
Less operating expenses deducted from
Variable SA&D cost revenue as incurred.
Fixed SA&D cost
Net operating income

Fixed Production Total fixed production costs

=
costs per unit Number of units produced

Fixed production = Fixed production x Number of

costs for units sold costs per unit units sold
§ ABSORPTION AND VARIABLE COSTING INCOME
STATEMENT
VARIABLE COSTING INCOME STATEMENT

Total
Sales
Less variable costs
Contribution margin
Less fixed costs
FIxed production = all are incurred in the current period
costs
Fixed SA&D costs
Net operating income

Besides SA&D costs, Fixed production costs are also treated as

period expenses and deducted from revenue as incurred.
 § ABSORPTION AND VARIABLE COSTING INCOME
STATEMENT
Example 2
Company K has started the business since 20x6, unit selling
price of product X over 3 years of 20x6, 20x7 and 20x8 is
$80. Income statement over 3 years and each of these years?

Costs $
Direct material costs $30/unit 20x6 20x7 20x8
Direct labor costs $10/unit Beg.Inv 0 0 2,000
Variable POH $5/unit Number
of goods 6,000 8,000 4,000
produced
Variable selling costs $4/unit
Number
Fixed POH $90,000/yr of goods 6,000 6,000 6,000
Fixed administration $36,000/yr sold
costs
INCOME STATEMENT
§ ABSORPTION AND VARIABLE COSTING INCOME
STATEMENT
20x6 20x7 20x8 3 years
Absorption costing
Sales
Cost of goods sold
Gross profit
SA&D
Net operating income
Variable costing
Sales
Variable costs
Contribution margin
Fixed costs
Net operating income
§ ABSORPTION AND VARIABLE COSTING INCOME
STATEMENT
§ ABSORPTION AND VARIABLE COSTING INCOME
STATEMENT

RELATION BETWEEN ABSORBTION AND VARIABLE INCOME

units produced …… units sold Effects on inventory Absorbtion inc …. Variable inc

> Inventory >

< Inventory <

= No change =
§ ABSORPTION AND VARIABLE COSTING INCOME
STATEMENT
HW: E2.4,Problem 2.17 – high-low method; E6.12: Absorption vs variable costing I.S

#MC# Henry Company had the following information for the year 20x8: Correct
- Beginning inventory: 0
- Number of units produced: 1,000 units
- Number of units sold: 800 units
- Selling price per unit: $100/unit
- Variable cost per unit: $40/unit (included $30 of variable
production cost)
- Fixed cost for the year: $35,000 (included $20,000 of fixed
production overhead)
Which one of the following would be true?

Profit under absorption costing system is $18,000

Profit under contribution costing system is $14,000
Profit under absorption costing system is higher than profit under
marginal costing by $4,000
Profit under absorption costing system is higher than profit under
marginal costing by $7,000

Prepare the income statement under absorption costing and marginal costing methods
End of Chapter 2