Cost Concepts and Cost Behaviour

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 Learning Objective
 Understand cost classifications used for assigning
costs to cost objects: direct and indirect costs.
 Identify three basic manufacturing cost categories.
 Understand cost classifications: product costs and
period costs.
 Understand the calculation of the cost of goods sold.
 Understand cost classifications used to predict cost
behavior: variable costs and fixed costs.
 Understand cost classifications used in making
decisions: differential costs, opportunity costs, and
sunk costs.

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 Assigning Costs to Cost Objects
Direct costs Indirect costs
 Costs that can be  Costs that cannot be
easily and conveniently easily and conveniently
traced to a unit of traced to a unit of
product or other cost product or other cost
object. object.
 Examples: direct  Example:
material and direct manufacturing
labor overhead

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 Manufacturing Costs

Direct Direct Manufacturing

Materials Labor Overhead

The Product

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 Direct Materials

Raw materials that become an integral part

of the product and that can be
conveniently traced directly to it.

Example: A radio installed in an automobile

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 Direct Labor

Those labor costs that can be easily traced to

individual units of product.

Example: Wages paid to automobile assembly workers

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 Manufacturing Overhead
Manufacturing costs that cannot be traced
directly to specific units produced.

Examples: Indirect materials and indirect labor

Materials used to support Wages paid to employees

the production process. who are not directly involved
in production work.
Examples: lubricants and Examples: maintenance
cleaning supplies used in the workers, janitors and security
automobile assembly plant. guards.

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 Nonmanufacturing Costs

Selling Administrative
Costs Costs

Costs necessary to All executive,

secure the order and organizational, and
deliver the product. clerical costs.

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 Product Costs Versus Period Costs

Product costs include Period costs include all

direct materials, direct selling costs and
labor, and manufacturing administrative costs.
overhead.

Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement
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 Classifications of Costs

Manufacturing costs are often

classified as follows:
Direct Direct Manufacturing
Material Labor Overhead

Prime Conversion
Cost Cost

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 Comparing Merchandising and
Manufacturing Companies
Merchandisers . . . Manufacturers . . .
 Buy finished goods.  Buy raw materials.
 Sell finished goods.  Produce and sell
finished goods.

MegaLoMart

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11
 Statement of Financial Position

Merchandiser Manufacturer
Current assets Current Assets
 Cash  Cash
 Receivables  Receivables
 Merchandise Inventory  Inventories
 Raw Materials
 Work in Process
 Finished Goods

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 Statement of Financial Position

Merchandiser Manufacturer
Current assets Current Assets
 Cash  Cash
Materials waiting to
 Receivables  Receivables
be processed.
 Merchandise Inventory  Inventories
Partially complete
products—some  Raw Materials
material, labor, or  Work in Process
overhead has been  Finished Goods
added.
Completed products
awaiting sale.

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 The Income Statement
Cost of goods sold for manufacturers differs only slightly
from cost of goods sold for merchandisers.

Merchandising Company Manufacturing Company

Cost of goods sold: Cost of goods sold:
Beg. merchandise Beg. finished
inventory $ 14,200 goods inv. $ 14,200
+ Purchases 234,150 + Cost of goods
Goods available manufactured 234,150
for sale $ 248,350 Goods available
- Ending for sale $ 248,350
merchandise - Ending
inventory (12,100) finished goods
= Cost of goods inventory (12,100)
sold $ 236,250 = Cost of goods
sold $ 236,250

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 Manufacturing Cost Flows
Balance Sheet Income
Costs Inventories Statement
Expenses
Material Purchases Raw Materials

Direct Labor Work in

Process
Manufacturing
Overhead Cost of
Finished
Goods
Goods
Sold

Selling and Period Costs Selling and

Administrative Administrative
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 Cost Classifications for Predicting Cost
Behavior

How a cost will react to

changes in the level of
activity within the
relevant range.
 Total variable costs change
when activity changes.
 Total fixed costs remain
unchanged when activity
changes.

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 Examples of Variable Costs

1. Merchandising companies – cost of goods sold.

2. Manufacturing companies – direct materials,
direct labor, and variable overhead.
3. Merchandising and manufacturing companies –
commissions, shipping costs, and clerical costs
such as invoicing.
4. Service companies – supplies, travel, and
clerical.

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 Total Variable Cost
The total cost of batteries is based on the number of
autos produced in a month

Total cost of batteries

Number of autos
produced in a month

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 Variable Cost Per Unit
The cost of battery is constant per each auto produced

Cost of battery per auto

Number of autos
produced in a month
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 Step-Variable Costs
A step-variable cost is a resource that is obtainable only
in large chunks (such as maintenance workers) and
whose costs change only in response to fairly wide
changes in activity.
Cost

Volume
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 Step-Variable Costs

Small changes in the level of production are not

likely to have any effect on the number of
maintenance workers employed.
Cost

Volume
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 Step-Variable Costs

Only fairly wide changes

in the activity level will
cause a change in the
number of maintenance
workers employed.
Cost

Volume

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 Total Fixed Cost

The monthly rent for an auto factory is fixed regardless of

the number of autos produced
Monthly rent

Number of autos produced

in a month
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 Fixed Cost Per Unit
The average monthly rent per auto decreases as more
autos are produced

Unit cost of rent for each

auto produced

Number of autos
produced in a month
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 Fixed Costs and the Relevant Range

90
Rent Cost in Thousands

The relevant range

Relevant of activity for a fixed
60
of Dollars

cost is the range of

Range activity over which
the graph of the
cost is flat.
30

0
0 1,000 2,000 3,000
Rented Area (Square Feet)

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 Types of Fixed Costs

Committed Discretionary
Long-term, cannot be May be altered in the
significantly reduced in short-term by current
the short term. managerial decisions

Examples Examples
Depreciation on Buildings Advertising and
and Equipment and Real Research and
Estate Taxes Development

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 Fixed Costs and the Relevant Range
For example, assume office space is available at
a rental rate of $30,000 per year in increments of
1,000 square feet.

Fixed costs would increase

in a step fashion at a rate of
$30,000 for each additional
1,000 square feet.

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 Fixed Costs and the Relevant Range

Step-variable costs
can be adjusted more
How does this quickly as conditions
step-function change and . . .
pattern differ from a The width of the activity
step-variable cost? steps is much wider for
the fixed cost.

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 Cost Classifications for Predicting Cost
Behavior

Behavior of Cost (within the relevant range)

Cost In Total Per Unit

Variable Total variable cost changes
as activity level changes.
Fixed Total fixed cost remains
the same even when the
activity level changes.
Variable cost per unit remains
the same over wide ranges
of activity.
Average fixed cost per unit goes
down as activity level goes up.

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 Activity 1 and 2

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 Mixed Costs (also called semivariable costs)

A mixed cost contains both variable and fixed

elements. Consider the example of utility cost.
Y
Total Utility Cost

ost
d c
x e
al mi
To t
Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge

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 Mixed Costs
The total mixed cost line can be expressed
as an equation: Y = a + bX

Where: Y = The total mixed cost.

a = The total fixed cost (the
Y vertical intercept of the line).
b = The variable cost per unit of
Total Utility Cost

o st activity (the slope of the line).

d c X = The level of activity.
ix e
al m
Tot Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge

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 High and Low Method

Is a method to separate out fixed and variable costs

given a limited amount of data.

Four steps must be taken in the high-low method:

STEP 1
Find the high point and the low point for a given data set.
STEP 2
Using the high and low point, calculate the variable rate.

Variable rate = (High point cost - Low point cost) ÷ (High point output - Low point output)

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 High and Low Method

STEP 3
Calculate the fixed cost using the variable rate (from
Step 2) and either the high point or low point.

Fixed cost = Total cost at high point - (Variable rate x Output at high point)

STEP 4
Form the cost formula for materials handling based on
the high-low method.

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 Discussion:

Mini Case 1

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 Cost Classifications for Decision Making

 Every decision involves a choice

between at least two
alternatives.

 Only those costs and benefits

that differ between alternatives
are relevant in a decision. All
other costs and benefits can
and should be ignored.

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 Differential Cost and Revenue

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 neighboring
city that pays $2,000 per month. The commuting cost
to the city is $300 per month.

Differential revenue is: Differential cost is:

$2,000 – $1,500 = $500 $300

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 Opportunity Cost
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.

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 Sunk Costs

Sunk costs have already been incurred and

cannot be changed now or in the future. These
costs 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, park it, trade it, or sell
it, you cannot change the $10,000 cost.

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 Activity 3

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 Thank You!

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