Unit 7:Understanding and

Classifying Costs

Presenter
Dr. Md. Serazul Islam
Professor (Accounting)
School of Business
Bangladesh Open University
Dr. Ser@z 1
 Discussion Topics

■ Meaning of Cost
■ Difference between Cost and Expense
■ Types of Cost
■ Explanation of Costs with Examples
■ Preparation of Cost Statement
 Meaning of Cost
Cost is the exchange value
of acquiring goods or
services.

Example: Suppose you have

purchased a mobile card for Tk. 300.
This Tk.300 is exchanged or
sacrificed to acquire the asset-
mobile card. So, the cost is Tk.300.
Difference between Cost and
Expense
Cost

Unexpired Expired
Asset Expense

Generate Benefit: Asset

Generate No Benefit: Loss
 Costs Expenses
■ Incurred when ■ Incurred when assets
assets are are consumed / used
acquired
■ Summation of ■ All costs other than
all expenses materials and labor are
called expenses
(expired costs)
■ Example: ■ Examples:
Prepaid - office & admin.
insurance expenses
- selling expenses etc.
 Areas of Classifying Cost

■ Functional Areas
■ Volume of Production/Cost
Behavior
■ Decision Making
Classification According to
Functional Areas
■ 1. Product (Manufacturing) Costs
■ 2. Period (Non-manufacturing) Costs

Product Costs: These costs are

incurred for manufacturing or
producing a product. So these
costs are also named as
production or factory costs.
 Product Costs

Direct Direct Manufacturing

Materials Labor Overhead

Prime Cost Conversion Cost

Period Costs

Selling Cost Administrative Cost

 Direct Materials
Those materials that
become an integral part of
the product and that can
be conveniently traced
directly to it.
Examples of Direct Materials
■ Wood for Making Furniture
■ Flour for Baking Bread
■ Steel for Making Automobiles
■ Hard drives, Processing Chips
for Computer, etc.
 Direct Labor
Those labor costs that can
be easily traced to
individual units of
product.
 Examples of Direct Labor
■ Carpenter of a furniture
manufacturing house
■ Bakers of a bakery
■ Bottlers of a soft drink etc.
 Manufacturing Overhead
All manufacturing costs other than
direct material and direct labor are
called manufacturing overhead.
Terms synonymous with
manufacturing overhead include
factory overhead, factory burden,
and overhead.
 Examples of Manufacturing Overhead

■ Indirect Materials, bolts, nuts, screws, thread,

nails, lubricants, etc.
■ Indirect Labor (wages paid to timekeepers)
■ Factory Rent, rates, taxes and insurance
■ Factory Repairs & Maintenance
■ Factory Utilities (Gas, Power, fuel, coal,,
lighting, heating, painting etc.)
■ Factory Depreciation, repairs& maintenance
■ Factory Insurance
Examples of Manufacturing Overhead (Cont…)
■ Works manager’s salary
■ Factory workers salary
■ Oiling and cleaning of machines.
■ Technical director’s fees or remuneration.
■ Experimental and research expenses.
■ Cost of training the new employees.
■ Laboratory expenses.
■ Supervision, inspection and testing fees.
■ Municipal taxes.
■ Cost of rectifying defective output.
■ Pay for holiday
■ Welfare expenses.
 Period Costs

Administrative
Selling Cost Cost

Costs necessary to get All executive,

the order and deliver organizational, and
the product. clerical costs.
Selling Cost Distribution Cost

■ Advertising ■ Packing Costs

■ Salaries &
Commission of ■ Carriage Outward
Salesman
■ Uncollectible Expense ■ Warehousing Costs
■ Showroom Expense ■ Upkeep and Running
Costs of Delivery
■ Sample Vans
■ Travel Expense ■ Depreciation of
Delivery Van
 Administrative Costs
Administration costs are those costs,
which are incurred in:
■ Formulating the policy
■ Directing the organization
■ Controlling the operations of an
organization.
Examples of Administrative Costs
■ Office Salaries
■ Office Rent, rates and insurance
■ Audit Fees
■ Legal Expenses
■ Director’s Remuneration etc.
■ Printing and stationery used in the office.
■ Office lighting, heating and cleaning.
■ Depreciation and repairs of office building.
■ Legal, bank, audit, postage and telephone
charges.
■ Trade subscription / trade magazines.
Product Costs Period Costs
■ Incurred for ■ Incurred for a time
production period
■ Do not affect profit ■ Deduct profit
until goods have immediately
been sold
■ Carried forward to ■ Written off in the
the next accounting period in which these
period are incurred
■ All product costs are ■ All period costs are
included in the not included in the
inventory value of inventory
Behavioral Cost Classifications

■ Variable Cost
■ Fixed Cost
■ Mixed Cost
 Variable Cost
■ Variable costs are those costs which
tend to vary in direct proportion to
the volume of production/level of
activity. In another words, when the
volume of production increases the
total variable cost also increases and
vice-versa. But the variable cost per
unit remains constant.
 Variable Cost
Cost (Tk.) Co
s t
le
b
aria
l V
ta
T o
Tk.3000
Tk.2000
Variable Cost Per Unit
Tk.2
1,500
1,000

Level of Activity
 Variable Cost
■ Illustration: You see the variable cost per unit is
Tk.2. Suppose; this is per minute mobile phone
call cost i;e. if you talk 1 minute, the variable cost
is Tk. 2 and it is fixed, no matter how many
minutes you talk. If you talk 1000 minutes, the
total cost will be Tk. 2,000; if you talk more 500
minutes I;e 1,500 minutes, the total cost will vary
from Tk.2,000 to Tk. 3,000. Hence, the total cost is
increasing with the increase of level of activity.
So the total variable cost is linear in the level of
activity.
 Examples of Variable Costs

■ Direct Materials
■ Direct Labor / Wage
■ Power
■ Fuel
■ Sales Commission, etc.
 Fixed Cost
■ Fixed costs are those costs, which
remain fixed in total amount and do
not increase or decrease when the
volume of production changes. But
the fixed cost per unit decreases
when the volume of production
increases and vice-versa.
 Fixed Cost
Cost (Tk.)

Total Fixed Cost

Tk.50,000

Tk.2.50 Fixed Cost Per Unit

Tk.2.00
25,000
20,000

Volume of
Production
 Fixed Cost
■ Illustration: You notice, the total fixed cost
is Tk.50, 000. Assume that this is factory
rent and it is fixed at all levels of
production. That is if you produce 1 unit,
20,000 units or 25,000 units or more, the
total costs will remain fixed at Tk.50, 000.
But if you produce 20,000 units, the fixed
cost per unit will be Tk.2.50 (Tk.50,
000÷20,000); if you produce more 5,000
units i,e. 25,000 units, the fixed cost per unit
will decline from Tk. 2.50 to Tk.2. So the
fixed cost decreases when the level of
activity or production increases.
 Examples of Fixed Costs

■ Factory Rent
■ Depreciation of Factory Building
■ Managerial Salaries
■ Building Insurance
■ Municipal Tax, etc.
 Mixed Cost

Semi-Variable Semi-Fixed
Cost Cost
Step Cost

Supervision Cost
▪ Indirect labor
▪ Repairs & maintenance 800

▪ Telephone expenses 600

▪ Light & power etc. 400

200
10 20 30 40
No. of Workers
 Mixed Cost
■ Semi-Variable Costs: Semi-Variable costs are
those costs which are partly fixed and partly
variable.
■ Semi-fixed (step) Costs: Fixed costs are constant
over a range of volume. If the volume increases
beyond a given range, fixed costs would
increase. You see, the supervision cost for up to
10 workers is fixed at Tk.200. For more 10
workers i,e. for 20 workers the supervision cost is
Tk.400, for 30 workers Tk. 600 and so on. That is
this cost is increased step by step. So this cost is
also called step cost.
 Relevant Cost
Relevant costs are those costs
which are associated with a
particular decision. To be
relevant , a cost :
■ must be of future.
■ must change as a result of a
particular current decision.
■ must differ between alternatives.
 Irrelevant Cost
Irrelevant costs are those
costs which are incurred in
the past and are not
associated with decision.
These costs do not affect the
decisions. For example, the
investment in fixed asset.
 Sunk Cost
■ Sunk costs are those costs that have been
incurred in the past and can not be
changed by present or future decision.
■ Sunk costs are not differential costs and
should be ignored when making
decisions.
■ The book value of an asset is irrelevant
cost and it would not be considered in
decision making. If the book value of that
asset can not be realized, it would be sunk
cost.
 Opportunity Cost
■ Opportunity cost is the potential benefit that is
given up when one alternative is selected over
another. This concept is used in problems of
alternative choice. Opportunity cost is a pure
decision making cost and is not entered in the
book of accounts.
■ Illustration: Suppose your machine can
manufacture either product X or product Y at a
time. Product X can generate monthly revenue
of Tk.12, 000 and the product Y Tk.10, 000. If you
decide to manufacture product X, the
opportunity cost of producing product X ( i’e;
Tk.10,000) is the loss of revenue from product Y.
 Opportunity Cost
Machine

Producing X Producing Y
Revenue: Revenue:
Tk.12,000 Opportunity Tk.10,000
Cost
 Controllable & Non-controllable Cost
■ Controllable Costs: Controllable Costs are
those costs which may be directly
regulated at a given level of management
authority. Variable costs are generally
controllable by dept. heads.
■ Un/Non-controllable Costs:
Non-controllable costs are those costs
which can not be influenced by the action
of a specified member of an organization.
Fixed costs are generally non-controllable.
Controllable Costs
■ Stationery Expenses
■ Entertainment Expenses

Non-Controllable Costs
■ Factory Rent
■ Managerial Salaries
■ Building Insurance etc.
 Standard & Budgeted Costs
■ Standard Cost: A standard cost is
pre-determined cost under given operating
conditions. A manufacturing enterprise would
generally determine standard costs for:
- direct materials
- direct labor
- manufacturing overhead
■ A Standard cost is used as a basis for formulating
budgets.
■ Budgeted Costs: Budgeted costs are those costs
which are expected to be incurred for the planned
activities of an organization for a specific period
of time.
Committed & Discretionary Costs
■ Committed Costs: Committed costs are
the results of the company’s past
commitments in fixed costs and other
long-term activities.
■ Discretionary Costs: Discretionary costs
are the results of the management
discretion and policy. The amounts of
these costs are periodically decided by
■ management. These costs are also known as
managed or programmed costs.
Committed Costs
■ Depreciation
■ Plant Insurance
■ Building Rent, etc.

Discretionary Costs
■ Research & Development
■ Donations
■ Advertising
■ Training, etc.
 Shutdown Costs

Shut down costs are those costs

which continue to occur even if there
is temporary closure or shut down of
the production activities
Examples:
■ Gateman Wages
■ Cost of Machine of Plant & Machinery
 Out of Pocket Costs

Are those costs, which involve

cash outlay (cash payment) or
require the utilization of current
resources.
■ Direct Materials
■ Direct Labor
■ Manufacturing Overhead
 Imputed Costs

Imputed costs are those costs which do

not involve any cash outlay. They are not
included in cost accounts but are
important for making management
decisions.

■ Interest on Own Capital

■ Rent of Own Building
 Common Cost

A common cost is a cost that is

incurred to support a number of cost
objects but can not be traced to them
individually. It is a type of indirect
cost.
Example
▪Factory manager’s salary
▪Wages paid to the pilot of a 747 airliner
 Prevention/Quality Costs
■ Prevention costs are those costs that
support activities whose purpose is to
reduce the number of defects. Companies
employ many techniques to prevent
defects including statistical process
control, quality engineering, training,
systems development, etc.
 Joint Costs
When two or more products are produced
out of one and the raw material or process,
the cost of material purchased and the
processing are called joint costs. It is the
manufacturing cost incurred on a joint
production process which takes common
inputs but simultaneously produces
multiple products called joint-products e.g.
processing of crude oil simultaneously
yields gasoline, diesel, jet fuel, lubricants
and other products.
Thank You