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Classification of Costs

The document outlines various classifications of costs incurred by a company, including fixed, variable, and mixed costs, as well as product and period costs. It details how these costs are calculated and their relevance in decision-making processes. Additionally, it introduces other cost classifications such as opportunity costs, sunk costs, and discretionary costs, providing a comprehensive overview of cost management in business operations.

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6 views

Classification of Costs

The document outlines various classifications of costs incurred by a company, including fixed, variable, and mixed costs, as well as product and period costs. It details how these costs are calculated and their relevance in decision-making processes. Additionally, it introduces other cost classifications such as opportunity costs, sunk costs, and discretionary costs, providing a comprehensive overview of cost management in business operations.

Uploaded by

moatasem
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Classification of Costs
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Classifications of Costs

 The various costs that a company incurs can be classified in


different ways. These different terms and classifications are
important because they will be the basis for a number of
other topics that will be discussed later.

 These terms may be tested directly (simple definition or


classification) or indirectly (as part of a larger question).
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Costs Based on the Level of Production

 Fixed Costs – do not change as the level of production changes (example, rent) as long
as the production level remains within the relevant range.
 Total fixed costs do not change, but the fixed cost per unit decreases as production increases.

 Variable Costs – change in total as the level of production changes (example, labor)
 Total variable costs will change, but the variable cost per unit will not change as production
increases, as long as the production level remains within the relevant range.

 Mixed Costs – have a component that is fixed and a component that is variable. May be
semi-fixed or semi-variable.
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Variable Costs

 Variable costs are costs that are incurred only when the
company produces something. If the company produces no
units, no variable costs will be incurred.
 Direct material and direct labor are usually variable costs.

 As the production level increases, the total amount of


variable costs will increase, but the cost per unit will remain
the same.
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Fixed Costs

 A fixed cost is a cost that does not change as the production level changes,
over the relevant range.
 The relevant range is the level of production in which fixed costs do not change.
 For example, factory rent is a fixed cost as long as the production level is within
the capacity of the factory. Once production exceeds the capacity of the factory,
a bigger factory will be needed. The rent cost will increase in order to cover the
increased factory space.
 As we will cover, in most situations, fixed costs are not relevant in the
decision making process, because they do not differ between
alternatives.
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Mixed Costs

 Mixed costs may be semi-variable costs or semi-fixed costs.


 A semi-variable cost has a fixed component and a variable component. It has a
basic fixed amount that must be paid regardless of activity, even if there is no
activity. Added to that fixed amount is an amount which varies with activity.
Example: utilities.
 A semi-fixed cost is fixed over a given, small range of activity, and above that
level of activity, the cost suddenly jumps. A semi-fixed cost moves upward in a
step fashion, staying at a certain level over a small range and then moving to the
next level quickly. The range over which it is fixed is smaller than that for a fixed
cost.
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Product (or Inventoriable) Costs

 Product costs are the costs of producing the product.

 The costs treated as product costs are inventoried and carried on the
balance sheet until sold. They are called inventoriable costs.

 Product costs include (with examples):


 Direct labor (assembly line labor)
 Direct materials (components of the product)
 Manufacturing overhead
 Indirect labor (maintenance costs)
 Indirect materials (glues, nails)
 Overhead costs (rent, electricity, utilities)
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Classifications of Product Costs

 The main types of product costs in the previous slide can be


further combined to create different cost classifications. The
three classifications that you need to be aware of are listed
below:
 Prime costs include direct materials and direct labor.
 Manufacturing costs include prime costs and manufacturing
costs applied.
 Conversion costs are manufacturing overhead and direct labor.
Conversion costs are the costs that are required to convert the
materials into the finished product.
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Period Costs

 Period costs are costs that are not involved in the production of
the product.

 Period costs are expensed as they are incurred.


 Examples include: general and administrative,
legal fees, marketing, accounting department…
 It is also possible that a company may choose to allocate period
costs to the production depts.
 Period costs must be reported as period costs for external reporting.
However, for internal reporting, companies may choose to allocate
them to units produced.
 This is covered later in the topic “Service Cost Allocation.”
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Other Costs and Cost
Classifications
 Opportunity costs are the contribution to income that is lost
because a different option was selected.

 Carrying costs are the costs of carrying a unit of inventory.

 Sunk costs are costs that have already been spent. Because
they have already been spent, they are not relevant to the
decision making process.

 Committed costs are costs that have not yet been spent, but
have been promised to be spent (example, future lease
payments that are owed under an existing lease contract).

 Marginal costs are the costs necessary to produce one more


unit.
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Other Costs and Cost
Classifications cont´d
 Discretionary costs are costs that do not need to be spent in
the short-term and there will be no negative impact on the
company. If they are not spent in the long-term, however, the
company may face detrimental results. Training and advertising
are often classified as discretionary costs.

 Engineered costs are costs that have a direct relationship


between the activity base and the incurring of costs.

 Imputed costs are costs that are not actually paid but are
necessary for decision making (interest is often imputed in
decision making, even when it is not actually paid).
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Cost of Goods Sold (COGS)

 The costs that were paid in order to produce (or purchase) the goods
that were sold during the period.

 It is calculated as:

Beginning finished goods inventory

+ Purchases (for a reseller) or

+ Cost of goods manufactured (for a manufacturer)

− Ending finished goods inventory

= Cost of goods sold

 This ignores goods that are lost or stolen, but is sufficient for our
purposes here.
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Cost of Goods Manufactured
(COGM)
 This is the cost to manufacture the goods completed during the
period and transferred to finished goods.
 For a manufacturing company, this is part of the COGS formula.
 The formula is:
Direct materials used*
+ Direct labor used
+ Manufacturing overhead applied
= Manufacturing Costs Incurred During the Period
+ Beginning work-in-process inventory
− Ending work-in-process inventory
= Cost of goods manufactured
* Calculation on next slide
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Direct Materials Used

 Direct materials used is calculated as:

Beginning direct materials inventory

+ Purchases

+ Transportation-in

− Returns

− Ending direct materials inventory

Direct materials used

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