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COST CONCEPTS, USES AND CLASSIFICATIION
General Theme. Costs can be classified in a number of ways—depending on
the purpose of the classification. For example, classification of costs for purposes
of determining inventory valuations and cost of goods sold for external reports
differs from the classification of costs that would be carried out to aid decision-
making. That is, a particular cost may be classified in many different ways—
depending on the purpose of the classification.
Manufacturing cost. These costs are incurred to make a product.
Manufacturing costs are usually grouped into three main categories: direct
materials, direct labor, and manufacturing overhead.
a. Direct materials
b. Direct Labor.
c. Manufacturing Overhead.
d. Prime versus Conversion Costs
Non-manufacturing costs. A manufacturing company incurs many other costs
in addition to manufacturing costs. For financial reporting purposes most of these
other costs are typically classified as selling (marketing) costs and administrative
costs. Marketing and administrative costs are incurred in both manufacturing and
a. Marketing Costs. These costs include the costs of making sales, taking
customer orders, and delivering the product to customers. These costs are also
referred to as order getting and order-filling costs.
b. Administrative Costs. These costs include all executive, organizational, and
clerical costs that are not classified as production or marketing costs.
Period vs. product costs. Costs can also be classified as period or product
Period Costs. Period costs are expensed in the time period in which they are
incurred. All selling and administrative costs are typically considered to be period
Product Costs Productcostsare added to units of product(i.e., “inventoried”) as
they are incurred and are not treated as expenses until the units are sold.
VARIABLE COSTS, FIXED COSTS, AND SEMIVARIABLE COSTS
From a planning and control standpoint, perhaps the most important way to
classify costs is by how they behave in accordance with changes in volume or
some measure of activity. By behavior, costs can be classified into three basic
Variable costs are costs that vary in total in direct proportion to changes in
activity. Examples are direct materials and gasoline expense based on mileage
Variable Factory Overhead
Supplies Receiving costs
Fuel and power Overtime premium
Spoilage and defective work
Fixed costs are costs that remain constant in total regardless of changes in activity.
Examples are rent, insurance, and taxes.
Fixed Factory Overhead
Salaries of production supervisors Rent of warehouse and factory building
-Depreciation Salaries of indirect labor
Property taxes Property insurance
Semi variable (or mixed) costs are costs that vary with changes in volume but,
unlike variable costs, do not vary in direct proportion. In other words, these costs
contain both a variable component and a fixed component. Examples are the rental
of a delivery truck, for which a fixed rental fee plus a variable charge based on
mileage is made; and power costs, for which the expense consists of a fixed
amount plus a variable charge based on consumption.
The breakdown of costs into variable and fixed components is very important in
many areas of management accounting, such as flexible budgeting, break-even
analysis, and short-term decision making.
. Semi variable Factory Overhead
Supervision Maintenance and repairs
Inspection Compensation insurance
Service department costs Employer’s payroll taxes
Rental of delivery truck Utilities
The standard cost is a production or operating cost that is carefully predetermined.
It is a target cost that should be achieved. The standard cost is compared with the
actual cost in order to measure the performance of a given costing department.
Cost Classifications for Decision-Making. Every decision involves choosing
from among at least two alternatives. Only those costs and benefits that differ
between alternatives are relevant in making the selection. This concept is explored
in greater detail in the chapter on relevant costs.
1. Differential Costs. A differential cost is a cost that differs between alternatives.
The cost may exist in only one of the alternatives or the total amount of the cost
may differ between the alternatives. Differential costs are also called incremental
costs. Differential costs and opportunity costs should be the focus of decision
They are the only relevant costs and all others should be ignored.
2. Opportunity Costs. An opportunity cost is the potential benefit that is given up
by selecting one alternative over another. The concept of an opportunity cost is
rather difficult for students to understand because it is not an actual expenditure
and it is rarely (if ever) shown on the accounting books of an organization. It is,
however, a cost that must be considered in decisions.
3. Sunk Cost. A sunk cost is a cost that has already been incurred and that cannot
be changed by any decision made now or in the future. Since sunk costs cannot be
changed and therefore cannot be differential costs, they should be ignored in