CHAPTER 2 COSTS – CONCEPTS AND CLASSIFICATIONS

Direct Materials- Raw materials that become an integral part of the product and that can be conveniently traced
directly to it. Direct materials are the traceable matter used in manufacturing a product. The direct materials for
a manufacturer of dessert products will include flour, sugar, eggs, milk, vegetable oil, spices, and other
ingredients in the recipes.
Direct Labor- Those labor costs that can be easily traced to individual units of product.
Manufacturing Overhead- Manufacturing costs that cannot be traced directly to specific units produced.
Ex. Indirect materials and indirect labor

Marketing or Selling Cost- Costs necessary to get the order and deliver the product.
Administrative cost- All executive, organizational, and clerical costs.
Product costs- include direct materials, direct labor, and manufacturing overhead.
Period costs- include all marketing or selling costs and administrative costs.

Merchandisers . . . Manufacturer
Buy finished goods. Buy raw materials
Sell finished goods Produce and sell finished goods.
PRODUCT COST FLOW

COST CLASSIFICATION AND 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.

Behavior of Cost (within the relevant range)

Cost In Total Per Unit

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

Direct costs
• Costs that can be
easily and conveniently traced to a unit of product or other cost object.
• Examples: direct material and direct labor
Indirect costs
• Costs that cannot be easily and conveniently traced to a unit of product or other cost object.
• Example: manufacturing overhead
Cost classification 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.
Differential cost and revenues- Costs and revenues that differ among alternatives.
Opportunity Cost- The potential benefit that is given up when one alternative is selected over another.
Sunk Cost- Sunk costs have already been incurred and cannot be changed now or in the future. They should
be ignored when making decisions.
Idle time- is the time associated with employees waiting, or when a piece of machinery cannot be used. Idle
time could also be associated with computing, and in that case, refers to processing time. Idle time can be
classified either as normal or abnormal. The labor costs incurred during idle time are ordinarily treated as
manufacturing overhead.
Abnormal idle time arises due to power failure, breakdown of machinery, non supply of raw material in time,
delay in previous process, strikes and accidents etc.
Overtime- The overtime premiums for all factory workers are usually considered to be part of manufacturing
overhead.
Fringe benefits- include employer paid costs for insurance programs, retirement plans, supplemental
unemployment programs, Social Security, Medicare, workers’ compensation and unemployment taxes. Some
companies include all of these costs in manufacturing overhead. Other companies treat fringe benefit
expenses of direct laborers as additional direct labor costs.
Employee benefits and benefits in kind include various types of non-wage compensation provided to
employees in addition to their normal wages or salaries. Instances where an employee exchanges wages for
some other form of benefit is generally referred to as a "salary packaging" or "salary exchange" arrangement. 
Quality of Conformance- When the overwhelming majority of products produced conform to design
specifications and are free from defects.
Prevention Cost- Support activities whose purpose is to reduce the number of defects.
Appraisal Cost- Incurred to identify defective products before the products are shipped.
Internal Failure Costs- Incurred as a result of identifying defects before they are shipped
External Failure Costs- Incurred as a result of defective products being delivered to customers

Prevention Costs Appraisal Costs

• Quality training • Testing & inspecting
• Quality circles incoming materials
• Statistical process • Final product testing
control activities • Depreciation of testing
equipment

Internal Failure Costs External Failure Costs

• Scrap • Cost of field servicing &
• Spoilage handling complaints
• Rework • Warranty repairs
• Lost sales

Distribution of Quality Cost

• When quality of conformance is low, total quality cost is high and consists mostly of internal and
external failure.
• Companies can reduce their total quality cost by focusing on prevention and appraisal. The cost
savings from reduced defects usually swamps the costs of the additional prevention and appraisal
efforts.
• Quality cost reports provide an estimate of the financial consequences of the company’s current defect
rate.
Use of Quality Information
• Help managers see the financial significance of defects.
• Help managers identify the relative importance of the quality problems.
• Help managers see whether their quality costs are poorly distributed.

Limitation of Quality Cost Information

 • Simply measuring quality cost problems does not solve quality problems.
• Results usually lag behind quality improvement programs.
• The most important quality cost, lost sales, is often omitted from quality cost reports.

ISO 9000 standards have become an international measure of quality. To become ISO 9000 certified, a
company must demonstrate:
1. A quality control system is in use, and the system clearly defines an expected level of quality.
2. The system is fully operational and is backed up with detailed documentation of quality control
procedures.
3. The intended level of quality is being achieved on a sustained basis.