Cost Concepts, Classifications, and Analysis
COST - reflects the amount of resources sacrificed in order for the company to achieve
a certain objective such as creation of goods or rendering of services in order to earn
revenues.
Examples:
• A service provider needs to purchase supplies and materials, and pay salaries to
employees in order to render service and earn revenues.
• A merchandiser has to first purchase the goods that they need to sell in order to
earn revenues.
• A manufacturer spends for materials, labor payroll, and other factory burden to
transform raw materials to finished goods and eventually sells those goods to earn
revenue.
Cost Behavior - how a cost will respond according to changes in the production process
or level of activity.
Variable Costs - they are costs that change as the quantity of the goods produced
changes. Total amount of variable costs is dependent to the level of production.
Examples:
• Cost of materials
• Cost of direct labor computed per hour
Constant on a per-unit basis.
Varies when presented as a total.
Example problem:
Assume an entity's normal manufacturing process with a range of 5,000 to 7,000 units of
goods with s variable cost per unit of P20 and P15,000 fixed cost.
Fixed Costs - at whatever level of production within the relevant range, this cost does not
change. It is independent of the level of production.
Examples:
• Rent of facilities
• Depreciation of equipment.
Constant when presented in total.
Varies on a per unit basis.
Example problem:
Assume an entity's normal manufacturing process with a range of 5,000 to 7,000 units of
goods with s variable cost per unit of P20 and P15,000 fixed cost.
Total Cost
The sum of all costs incurred by a firm in producing a certain level of output. It is the sum
of fixed costs and variable costs.
Example:
• A firm has a fixed cost of P120 per unit and a variable cost of P20 per unit as the
increased their output, the total cost will be P140.
Example problem:
Cost Equation
y = a + bx a = total fixed cost
y = total cost b = variable cost per unit
x = volume of activity
How much is the total cost to manufacture products with a variable manufacturing cost
per unit of P25 and total manufacturing fixed cost of P40,000 at the following production
levels:
A. 2,000 units
B. 4,500 units
C. 7,250 units
Cost as to decision making
Opportunity Cost - these are the benefits forgone in choosing one alternative over the
other course of action.
Examples:
• Spending for a milk tea for P80 per day for the next ten years would have
accumulated to P182,500 worth of saving if chose to save.
• An entity has chosen to rent a facility. The payment for the rent could have been
spent on other aspects of the operations of the business.
Marginal Cost - extra cost incurred when one additional unit is produced. It determines
the quantity most efficient to produce.
• Marginal cost of production is an important concept, as it can help an
organization optimize their production.
• Fixed costs are constant regardless of production levels, so higher production
leads to a lower fixed cost per unit as the total is allocated over more units.
• Variable costs change based on production levels, so producing more units will
add more variable costs. (Investopedia)
Average Cost per unit - total cost to produce divided by the total number of units
manufactured.
Example:
Variable cost P40 per unit
Fixed cost P5,000
Sunk Cost - cost that has been already incurred that will not affect future costs since they
are already paid for or incurred and cannot be changed by future action.
Example:
• A company spends 100,000 training its employees to use a new ERP system. The
software turns out to be heavily confusing and unreliable. The senior management
team wants to discontinue the use of the new ERP system. The 100,000 spent to
train employees is a sunk cost and should not be considered in the decision of
discontinuing the new ERP system. (Corporate Finance Institute)
Break-even Point - the point wherein the entity does not enjoy a profit but does not incur
a loss, which is when total contribution margin equals total fixed costs. This is a
determinant on how much sales or how much units to be sold to be able to, at least,
cover all operational costs.
