Cost Behaviors and

Classification
Cost Concept
 Cost is the amount measured by the
current monetary value of economic
resources given up or to be given up in
obtaining goods and services.

 Cost accounting may be regarded as ``a

specialized branch of accounting which
involves classification, accumulation,
assignment and control of costs.

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Cost Concept (Conti..)
 First, the most basic notion is that cost
measures the use of resources.
 Second, cost measurement is expressed in
monetary terms. Money provides a common
denominator that permits the amount of
resources, each measured according to its own
scale (kilograms of materials, hours of labour) to
be aggregated so that the total amount of
resources used can be determined.
 Third, cost measurement is always related to a
purpose, that is, to a cost object. A cost object is
an activity or resource for which a separate
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Cost Object
 A Cost Object is anything for which a cost
is to be calculated or that makes you incur
a cost. It could be anything for which a
company plans to calculate costs
separately.

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COST OBJECT EXAMPLES AT
BMW
Cost Object Illustration
Product A BMW X6 sports activity vehicle
Telephone hotline providing information and assistance
Service
to BMW dealers
R&D project on DVD system enhancement in BMW cars
Project

Herb Chambers Motors, a dealer that purchases a broad

Customer
range of BMW vehicles
Setting up machines for production or maintaining
Activity
production equipment
Department Environmental, Health and Safety department
Basic Cost Terminology
Cost Accumulation – the collection of cost data
in an organized way by means of an accounting
system
Cost Assignment – a general term that
encompasses the gathering of accumulated costs
to a cost object in two ways:
Tracing costs with a direct relationship to the
cost object, and
Allocating accumulated costs with an indirect
relationship to a cost object.
Cost Assignment to a Cost Object
(BMW Example)

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Classification according to traceability
to the product

Cost

Direct Indirect
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Direct and Indirect Costs
 Direct costs can be conveniently and
economically traced (tracked) to a cost object.

 Indirect costs cannot be conveniently or

economically traced (tracked) to a cost object.
Instead of being traced, these costs are allocated
to a cost object in a rational and systematic
manner.
Cost Allocation Challenges
Direct Costs
Material (steel or tires for a car, as an
example)
Labor (Assembly line wages)
Indirect Costs
Rent
Property taxes
Plant administration expenses
Factors Affecting Direct/Indirect
Cost Classifications.
 The materiality of the cost in question.
 The available information-gathering technology.
 Design of operations.
NOTE: a specific cost may be both a direct cost of
one cost object and an indirect cost of another cost
object.
The direct/indirect classification depends on the
choice of the cost object.
Cost Behavior Patterns: Variable
Costs And Fixed Costs – (1 of 2)
 Variable costs change, in total, in proportion to
changes in the related level of activity or volume
of output produced.
 Fixed costs remain unchanged, in total, for a
given time period, despite changes in the related
level of activity or volume of output produced.
 Costs are fixed or variable for a specific activity
and/or for a given time period.
Cost Behavior Patterns: Variable
Costs and Fixed Costs – (2 of 2)
 Variable costs are constant on a per-unit basis.
If a product takes 5 pounds of material each, it
stays the same per unit regardless if one, ten or
a thousand units are produced.

 Fixed costs per unit change inversely with the

level of production. As more units are produced,
the same fixed cost is spread over more and
more units, reducing the cost per unit.
Cost Behavior Summarized
- TOTAL DOLLARS COST PER UNIT

VARIABLE COSTS Change in Unchanged in

proportion with relation to output
output
(more output =
more cost)
FIXED COSTS Unchanged in Change inversely
relation to output with output
(within the relevant (more output =
range) lower cost per unit)
Graphs of variable and fixed costs
PANEL A: Variable Costs of Steering PANEL B: Supervision Costs for the
Wheels at $60 per BMW X6 BMW X6 Assembly Line (in Millions)
Assembled
Other Cost Concepts
 Mixed costs have both fixed and variable
elements
 Cost driver – a variable, such as the level of
activity or volume, that causally affects costs
over a given time span.
 Relevant range – the band or range of normal
activity level (or volume) in which there is a
specific relationship between the level of activity
(or volume) and the cost in question.
 Fixed costs are considered fixed only within the
relevant range.
Multiple Classifications of Costs
 Costs may be classified as:
◼ Direct/Indirect, and
◼ Variable/Fixed
 These multiple classifications give rise to
important cost combinations:
◼ Direct and variable
◼ Direct and fixed
◼ Indirect and variable
◼ Indirect and fixed
Examples of the Multiple
Classifications Of Costs

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Functional Classification of Cost

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Production or Manufacturing Costs
 All the costs relating to the production of
goods or services, whether direct or
indirect, variable or fixed, are included in
the production cost.

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Direct Manufacturing Cost
• Direct Raw Material
• Direct Labor
• Other Direct Expenses such as job work charges relating to a
particular product, etc.

Indirect Production Costs (also known as Production or

Manufacturing Overheads)
• Salaries of Supervisors, Production Heads,
• Quality control costs
• Other labor-related expenses
• Quality control
• Store expenses
• Depreciation of plant and machinery
• Repair and maintenance of factory building and plant & machinery
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• Security expenses for the unit

Administration Costs
 These costs are incurred in connection with the
general management of the business. These
usually are indirect costs and are also known as
administrative overheads. Examples of such costs
can be the following:
◼ Salaries of staff in general management
◼ Office-related expenses such as rent, rates, taxes,
telephone, stationery, etc.
◼ Charges levied by the bank.
◼ Audit and legal fees
◼ Office-related depreciation etc.

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Marketing or Selling Costs
 Selling costs include all kinds of expenses
incurred for achieving sales of the products and
services. These are also considered indirect
expenses are, known as selling overheads.
Examples of such costs are as follows:

◼ Salaries of selling staff

◼ Commission, conveyance, discount, etc
◼ Product market research

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Distribution Costs
 Distribution costs include all kinds of expenses
are incurred for distributing the products from
their point of production to their customers.
Examples of distribution costs are as follows:

◼ Transportation costs
◼ Warehouse rents
◼ Commission to Distribution channel etc

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Different Types of Firms
1. Manufacturing-sector companies purchase
materials and components and convert them
into various finished goods.
2. Merchandising-sector companies purchase and
then sell tangible products without changing
their basic form.
3. Service-sector companies provide services
(intangible products) like legal advice or audits.
Types of Inventory

• Direct materials – resources in-stock and

available for use
• Work-in-process (or progress) – goods partially
worked on but not yet completed, often
abbreviated as WIP
• Finished goods – goods completed but not yet
sold
• Note: Merchandising-sector companies hold only
one type of inventory: merchandise inventory
Commonly Used Classifications of
Manufacturing Costs
Also known as inventoriable costs:
Direct materials – acquisition costs of all
material that will become part of the cost
object.
Direct labor – compensation of all
manufacturing labor that can be traced to the
cost object.
Indirect manufacturing – all
manufacturing costs that are related to the
cost object but cannot be traced to that cost
object in an economically feasible way.
Product Cost (Inventoriable) VS.
Period Costs
 Inventoriable costs are all costs of a product that
are considered assets in a company’s balance
sheet when the costs are incurred and that are
expensed as cost of goods sold only when the
product is sold. For manufacturing companies,
all manufacturing costs are inventoriable costs.
 Period costs are all costs in the income statement
other than cost of goods sold. They are treated
as expenses of the accounting period in which
they are incurred.
Cost Flows
The Cost of Goods Manufactured and the cost of
goods sold section of the income statement are
accounting representations of the actual flow of
costs through a production system.
Note how inventoriable costs go through the
balance sheet accounts of direct materials, work-in-
process and finished goods inventory before
entering the cost of good sold in the income
statement.
Full Costing
 Full costing means that all of the manufacturing costs are
absorbed by the total units produced. In short, the cost of a
finished unit in inventory will include direct materials, direct
labour, and both variable and fixed overhead.
 As a result, absorption costing is also referred to as full
costing or the full absorption method.
 Absorption costing is often contrasted with variable costing
or direct costing. Under variable or direct costing, the fixed
manufacturing overhead costs are not allocated to the
products manufactured. Variable costing is often useful for
management’s decision-making. However, absorption
costing is required for external financial reporting and for
income tax reporting. It is also referred to as the full- cost
technique
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Elements of Full Cost

31
Elements of Product Cost
 Direct Material Cost “The quantities of material
that can be specifically identified with a cost
object in an economically feasible manner, priced
at the unit price of direct material,” are the direct
material cost of a cost object.

 Direct Labor Cost “The labor quantities that can

be specifically identified with a cost object in an
economically feasible manner, priced at a unit
price of direct labor,” are the direct labor cost of a
cost object

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Conti…
 Other Direct Costs: Conceptually, any
cost traced to a single product is a direct
cost of that product. Energy costs, for
example, are direct costs of
manufacturing energy-intensive products.

 Overhead Cost All indirect production

costs—all production costs other than
direct costs—are included in overhead
cost.
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Conti…
 Conversion Cost: The sum of direct labor cost and
Manufacturing overhead cost is conversion cost. It includes
all production costs needed to convert direct materials into
finished goods.
 Full Production Cost: The sum of direct material cost and
conversion cost is full production cost. In a manufacturing
firm, full production cost often is called inventory cost
because this is the cost at which completed goods are
carried as inventory and the amount that is reported as ost
of sales when the goods are sold.
 The cost at which goods are carried in inventory includes
neither distribution nor selling costs, nor those general and
administrative costs that are unrelated to production
operations.
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Conti…
 Nonproduction Costs: Nonproduction costs
(also called period costs) are all costs incurred in
an organization other than inventory costs. These
include selling costs, research and development
costs, general and administrative costs, and
interest costs.

 Full Cost: The full cost of a product is simply the

sum of all the cost elements described above.
Thus, full product cost includes both inventory
(full production) cost and nonproduction cost.
However, in practice, many accountants use the
term full cost to mean only full production cost 35
Multiple-Step Income Statement,
Part One
Income Statement and Schedule of Cost of Goods
Manufactured of a Manufacturing-Sector Company,
Cellular Products
Multiple –Step Income Statement, Part Two
Income Statement and Schedule of Cost of Goods
Manufactured of a Manufacturing-Sector Company,
Cellular Products
Basic Costing Terminology
Let’s review several key terms from prior chapters:
 Cost objects are anything for which a cost
measurement is desired
 Direct costs of a cost object are costs that can be
traced to that cost object in an economically
feasible way
 Indirect costs of a cost object are costs that
cannot be traced in an economically feasible way
Conti…
 Cost Pool – a grouping of individual indirect cost
items. Cost pools simplify the allocation of
indirect costs because the costing system does
not have to allocate each cost individually.
 Cost-allocation base – a systematic way to link an
indirect cost or group of indirect costs to cost
objects.
 The concepts represented by these five terms
constitute the building blocks we will use to
design the costing systems described in this
chapter.
Costing Systems
In a JOB COSTING SYSTEM, the cost object is a unit
or multiple units of a distinct product or service
which we call a job. Each job generally uses
different amounts of resources.
In a PROCESS COSTING SYSTEM, the cost object is
masses of identical or similar units of a product or
service. In this type of system, we divide the total
cost of producing an identical or similar product or
service by the total number of units produced to
obtain a per-unit cost.
Conti…

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Costing Systems Illustrated
Examples of Job Costing and Process Costing in the Service,
Merchandising, and Manufacturing Sectors.
Seven-step Job Costing (1 of 3)
1. Identify the job that is the chosen cost object.
2. Identify the direct costs of the job.
3. Select the cost-allocation base(s) to use for
allocating indirect costs to the job.
4. Identify the indirect costs associated with each
cost-allocation base. (Determine the appropriate
cost pools that are necessary.)
Seven-step Job Costing (2 of 3)
5. Compute the Rate per Unit of each cost-
allocation base used to allocate indirect costs to the
job (normal costing so use budgeted values)
Budgeted Manufacturing Overhead Rate =
Budgeted Manufacturing Overhead Costs / Budgeted
Total Quantity of Cost-Allocation Base

6. Compute the indirect costs allocated to the job:

Budgeted Allocation Rate x Actual Base Activity
For the Job
Seven-step Job Costing (3 of 3)
7. Compute total job costs by adding all direct and
indirect costs together.
Direct Manufacturing Costs
Direct Materials xxxx
Direct Labor xxxx xxxx
Manufacturing Overhead
Indirect Costs xxxx
Total Mfg Costs of Job XYZ xxxx
46
Costing Approaches
ACTUAL COSTING – allocates indirect costs
based on the actual indirect cost rates times
the actual quantities of the cost allocation
base.
NORMAL COSTING – allocates indirect costs
based on the budgeted indirect cost rates
times the actual quantities of the cost
allocation base.
Both methods allocate direct costs to a cost
object the same way – by using actual direct
cost rates times actual consumption.
Costing Approaches Summarized
Blank Actual Costing Normal
Costing
Direct Costs Actual direct-cost Actual direct-
rates x actual cost rates x
quantities of direct- actual quantities
cost inputs of direct-cost
inputs

Indirect Actual indirect-cost Budgeted

Costs rates x actual indirect-cost
quantities of cost- rates x actual
allocation bases quantities of
cost-allocation
bases