12/31/2024

Session 2
Cost classifications

Learning Objectives
1. Define cost
2. Understand three types of manufacturing costs.
3. Distinguish between product costs and period costs
4. Apply cost estimation methods to separate mixed
costs into fixed and variable elements.

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What is cost?
• Cost is the amount of cash or cash equivalent
sacrificed for goods and/or services that are
expected to bring a current or future benefit to
the organization.

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

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
Examples: lubricants and work.
cleaning supplies used in the Examples: maintenance
automobile assembly plant. workers, janitors and
security guards.

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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Exercise 2-1

Product Costs Versus Period Costs

Product costs include direct Period costs include all selling

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

Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement

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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

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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The Linearity Assumption and the Relevant

Range
A straight line
Economist’s
Total Cost

closely
Curvilinear Cost approximates a
Function curvilinear variable
cost line within the
relevant range.
Relevant
Range
Accountant’s Straight-Line
Approximation (constant unit
variable cost)

Activity

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

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

activity (the slope of the line).

X = The level of activity.

Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge

The Scattergraph Method

Plot the data points on a graph
(Total Cost Y vs. Activity X).
Y
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Maintenance Cost

* ** *
1,000’s of Dollars

* *
**
10 * *

0 X
0 1 2 3 4
Patient-days in 1,000’s

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The Scattergraph Method

Draw a line through the data points with about an
equal numbers of points above and below the line.
Y
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Maintenance Cost

* ** *
1,000’s of Dollars

* *
**
10 * *

0 X
0 1 2 3 4
Patient-days in 1,000’s

The Scattergraph Method

Use one data point to estimate the total level of activity
and the total cost.
Y Total maintenance cost = $11,000
20
Maintenance Cost

* ** *
1,000’s of Dollars

* *
**
10 * *
Intercept = Fixed cost: $10,000

0 X
0 1 2 3 4
Patient-days in 1,000’s
Patient days = 800

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The Scattergraph Method

Make a quick estimate of variable cost per unit and
determine the cost equation.

Total maintenance at 800 patients $ 11,000

Less: Fixed cost 10,000
Estimated total variable cost for 800 patients $ 1,000

Variable cost per unit = $1,000 = $1.25/patient-day

800
Y = $10,000 + $1.25X

Total maintenance cost Number of patient days

The High-Low Method – An Example

Assume the following hours of maintenance work and the total maintenance costs for six months.

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The High-Low Method – An Example

The variable cost per

hour of maintenance
is equal to the change
in cost divided by the
change in hours.

$2,400
= $6.00/hour
400

The High-Low Method – An Example

Total Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = $9,800 – ($6/hour × 850 hours)
Total Fixed Cost = $9,800 – $5,100
Total Fixed Cost = $4,700

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The High-Low Method – An Example

The Cost Equation for Maintenance

Y = $4,700 + $6.00X

Least-Squares Regression Method

A method used to analyze mixed costs if a scattergraph
plot reveals an approximately linear relationship between
the X and Y variables.

This method uses all of the

data points to estimate
the fixed and variable
cost components of a
mixed cost.
The goal of this method is
to fit a straight line to the
data that minimizes the
sum of the squared errors.

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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

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

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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