Chapter 2

Cost terms, classification and concepts

 Overview – Cost Concepts, terms and
classification
Contents Learning Objectives
• General classifications • Identify and give examples of each of the three
• Product costs versus period costs manufacturing cost categories
• Distinguish between product costs and period costs
• Cost classifications on financial statements and give example of each
• Product costs – a closer look • Prepare an income statement including calculation of
the cost of goods sold
• Cost classifications for predicting cost behavior
• Prepare a schedule of cost of goods manufactured
• Cost classification for assigning costs to cost objects • Understand the difference Variable cost, fixed cost.
• Cost classification for decision making Direct & Indirect Cost
• Define and give examples of cost classifications used in
making decisions: differential costs, opportunity costs,
and sunk costs
• Identify the four types of quality costs and explain how
they interact
• Prepare and interpret a quality control report
 Section A –
Types of Businesses
Types of Business & Its inventory
Manufacturing Merchandising Services
Organization which Purchased finished Service business provides
purchase raw material goods and sell to next services to organization.
from suppliers and chain or consumers.
convert the raw material
into any finished products For example Insurance
through the use of labor companies,
Examples:
and production units. advertisement agencies,
Distributor, Wholesaler, hospitals etc.
Retailer.
Example: Toyota, Engro
Food, P&G etc. There is no inventory in
Inventory includes Service sectors.
Inventory includes – Raw Finished Goods only. However, unfinished
Material, Work in process, projects may be termed
Finished goods as Work in process.
Section B –
Cost Terms
Cost & Reason to Understand Cost
The simplest definition is COST IS AN EXPENDITURE.

Reason for Understanding Cost:

- Strategic decision making including pricing.
- Controlling tool the Departmental Performance.
- Short and long term planning.
Cost Unit
Cost Unit as ‘a unit of product or service in relation to which cost are
as ascertain.

Cost Unit can be for any type of organization. However, Cost units
should neither be too small or large which affect its usability.
Example:
Sector Cost Units
Biscuits, Cakes Per kg, per carton
Lawyers, consultants Per Hour
Education Enrolled Student
Transport Per Vehicle
Quick Check
What should be the Cost Unit for below types of business?

Sector Cost Units

Airlines
Hospitals
Eggs Suppliers
Refineries
Quick Check
What should be the Cost Unit for below types of business?

Sector Cost Units

Airlines Per Passenger, Per Trip
Hospitals Per Patients
Egg Suppliers Per Crate
Refineries Per Barrel (159 liters or 42 US
Gallon)
Cost Centres
Cost Centres is a production or service location, function or activity.

Cost Centres is a ‘Responsibility Centres’. It is a collecting place of all

cost.
Example:
Sector Cost Units
Manufacturing Companies Operational & Support
Departments
Banks Branches
Hotels Different restaurants within
hotels
Cost Objects
Cost Objects are anything for which costs can be
ascertained.

Therefore, all cost units are ‘Cost Objects’.

 Section C –
Cost Classification
Cost Classification
Cost based on Elements Assigning Cost to
(Manufacturing & Cost Objects
Non Manufacturing) (Direct & Indirect Cost)

Cost
Classification

Cost based on behavior Cost based on Financial

(Variable, Fixed, Semi Statement
Variable or Mixed Cost) (Product Cost, Period Cost)

Cost for Decision Making

(Differential Cost, Opportunity
Cost, Sunk Cost)
Cost Based on Elements
Material

Manufacturing Labour

Other Expenses
(Manufacturing)

Selling Expenses

Non Manufacturing
General &
Administrative
Expense
Material
• It is related to Manufacturing process. It is a component used for
production of finished goods.

• However, it is pertinent to mention here that finished goods for

one business can be raw material for another industry. For
instance, sugar cane will be converted to Sugar by Sugar
mills. This refined sugar will then be used as ‘raw material’ by
confectionary and food companies.
Material
Industry Raw Material
Furniture maker Woods
Cooking Oil Palm, coconuts, olives
Cake Manufacturer Sugar, Flour, Eggs
Refineries Oil extracted from oil well
Tea manufacturers Tea leaves
Direct & Indirect Material
• Raw materials may include both direct and indirect materials.

• Direct materials are those materials that become an integral part

of the finished product and whose costs can be conveniently traced
to the finished product. All above examples in previous slide is
for ‘Direct Material’.

• Indirect Materials are those components of material which cannot

be traced back to specified cost objects.
Examples of Indirect Material
• Consumable Stores
• Lubricants and oil for cleaning
• Printing and Stationary for Production Floor
Labor
It is the costs of people working in the organization. As mentioned in
the previous slides cost of labor can also be distributed into direct and
indirect labor.

• DIRECT LABOR consists of labor costs that can be easily (i.e.,

physically and conveniently) traced to individual units of product.

• Labor costs that cannot be physically traced to particular products,

or that can be traced only at great cost and inconvenience, are
termed INDIRECT LABOR .
Examples of Indirect Labors
• Labor cost of Supervisors
• Janitorial Services on Production floor
• Material handlers
• Security guards for production floors
Direct Expenses
• These are expenses which can be directly allocated
to cost objects.

Example:
Drawing, tools for special products
Special tools or equipment for particular jobs
Manufacturing Overheads
• Manufacturing overhead , the third manufacturing
cost category, includes all manufacturing costs except
direct materials, direct labor and direct expenses.

• These expenses cannot be easily traceable to any

specific cost object.

• These cost also termed as ‘Factory Overheads’.

Examples of Manufacturing Overheads
• Indirect Material
• Indirect Labors
• Maintenance expense
• Electricity and gas charges of production floor
• Depreciation of production units
• Insurance expense of production units
Non Manufacturing Cost
• Non Manufacturing Overheads commonly divide
into two categories:

Selling Cost Administrative Cost

Selling Cost
• Selling costs include all costs that are incurred to
secure customer orders and get the finished product
to the customer.

• Examples includes advertisement, commission,

travel cost, sales staff salaries, finished goods
warehousing cost.
General Administrative Cost
• Administrative costs include all costs associated
with the general management of an organization
rather than with manufacturing or selling.

• Examples includes Salaries of general staff

including executive, insurance of general purpose
vehicles, depreciation of Corporate office.
Assigning Cost to Cost Objects
Direct Cost Indirect Cost

• A direct cost is a cost that can • An indirect cost is a cost that

be easily, economically and cannot be easily, economically
conveniently traced to a and conveniently traced to a
specified cost object. specified cost object.
Quick Check
AM & Co is an office cleaning business which employs a
team of part time cleaners who are paid an hourly wage.
The business provides cleaning services for a number of
clients ranging from small office to high street shops and
large offices.

In determining the cost of providing the cleaning services

to a particular clients, which of the following would be a
direct cost and indirect cost of cleaning that clients office?
Quick Check (Cont’d)
Particulars Direct Cost Indirect
Cost
The wages paid to the cleaner who is sent to client’s
premises
The cost of carpet shampoo used by the cleaner
The salaries of AM & Co accountant
Rent of the premises where AM & Co. stores its
cleaning material
Travelling expense paid to the cleaner to reach the
client’s premises
Advertising expenses paid to attract more customers.
Quick Check (Cont’d)
Particulars Direct Cost Indirect
Cost
The wages paid to the cleaner who is sent to client’s a
premises
The cost of carpet shampoo used by the cleaner a
The salaries of AM & Co accountant a
Rent of the premises where AM & Co. stores its a
cleaning material
Travelling expense paid to the cleaner to reach the a
client’s premises
Advertising expenses paid to attract more customers. a
Cost for preparing Financial
Statements
Product Cost Period Cost

• product costs include all costs • Period costs are all the costs
involved in acquiring or making that are not product costs. All
a product. In the case of selling and administrative
manufactured goods, these expenses are treated as period
costs consist of direct costs.
materials, direct labor, and
manufacturing overhead.
 Product & Period Cost - Treatment
Recorded as an asset (inventory) in
Manufacturing Product the balance sheet and becomes an
Cost Cost expense in the profit and loss
account when the product is sold.

Recorded as an expense in the

Non Manufacturing Period
profit and loss account in the
Cost Cost current accounting period.
Summary -
Manufacturing Cost

Prime Cost

Direct Direct Direct Manufacturing Product

Material Labor Expenses Overhead Cost

Conversion Cost
Direct
Direct Cost Indirect Cost
Cost

Non Manufacturing Cost

Period
Selling Cost General Administrative Cost Cost

Direct Cost Indirect Cost Indirect Cost

Cost of goods sold & Cost of goods manufactured
Cost of Goods Sold & Manufactured
Cost of Goods Sold & Manufactured
Cost Classifications for Predicting Cost Behavior

How
Howaacostcostwill
willreact
reactto
tochanges
changesin
in
the
thelevel
levelof
ofactivity
activitywithin
withinthe
the
relevant
relevantrange.
range.
•• Total
Totalvariable
variablecosts
costschange
change
when
whenactivity
activitychanges.
changes.
•• Total
Totalfixed
fixedcosts
costsremain
remain
unchanged
unchangedwhenwhenactivity
activity
changes.
changes.
Variable Cost
Your total long distance telephone bill is based on how
many minutes you talk.

Total Long Distance

Telephone Bill

Minutes Talked
Variable Cost Per Unit
The cost per long distance minute talked is constant. For
example, 10 cents per minute.

Telephone Charge
Per Minute
Minutes Talked
Fixed Cost
Your monthly basic telephone bill probably does not change when you make
more local calls.

Telephone Bill
Monthly Basic

Number of Local Calls

Fixed Cost Per Unit
The average fixed cost per local call decreases as more local calls are made.

Monthly Basic Telephone

Bill per Local Call
Number of Local Calls
Cost Classifications for Predicting Cost
Behavior
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.
Quick Check 

Which of the following costs would be variable with

respect to the number of cones sold at a Baskins &
Robbins shop? (There may be more than one correct
answer.)

A. The cost of lighting the store.

B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.
Quick Check 

Which of the following costs would be variable with

respect to the number of cones sold at a Baskins &
Robbins shop? (There may be more than one correct
answer.)

A. The cost of lighting the store.

B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.
Learning Objective 7
Define and give
examples of cost
classifications used in
making decisions:
differential costs,
opportunity costs, and
sunk costs.
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.
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:

$2,000 – $1,500 = $500

Differential cost is:

$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
Rs15,000 per year.
Your opportunity cost of attending
college for one year is Rs15,000.
Sunk Costs
Sunk costs have already been incurred and cannot be changed now
or in the future. They 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.
Quick Check 

Suppose you are trying to decide whether to drive or

take the train to Portland to attend a concert. You
have ample cash to do either, but you don’t want to
waste money needlessly. Is the cost of the train
ticket relevant in this decision? In other words,
should the cost of the train ticket affect the decision
of whether you drive or take the train to Portland?

A. Yes, the cost of the train ticket is relevant.

B. No, the cost of the train ticket is not relevant.
Quick Check 

Suppose you are trying to decide whether to drive or

take the train to Portland to attend a concert. You
have ample cash to do either, but you don’t want to
waste money needlessly. Is the cost of the train
ticket relevant in this decision? In other words,
should the cost of the train ticket affect the decision
of whether you drive or take the train to Portland?

A. Yes, the cost of the train ticket is relevant.

B. No, the cost of the train ticket is not relevant.
Quick Check 

Suppose that your car could be sold now for $5,000. Is this a sunk cost?

A. Yes, it is a sunk cost.

B. No, it is not a sunk cost.
Quick Check 

Suppose that your car could be sold now for $5,000.

Is this a sunk cost?

A. Yes, it is a sunk cost.

B. No, it is not a sunk cost.
Quality Cost - TQM
• Total Quality Management

• Total means that everyone in the value chain is involved in the process
including employees, customers and suppliers

• Quality – product and services quality MUST be as per customer

requirement

• Management – Quality is actively managed instead of controlled so that

problems are prevented from occurring.
Basic Principles of TQM
• Get it right, first time – Cost of prevention are less than the
cost of correction. Zero Reject or defects

• Continuous improvement – Zero Defects may not be a

obtainable target. However, it will ensure that improvement
effort will raise the quality benchmark.

• Customer Focus – Customer needs and expectation is the

key for quality benchmarking.
Quality Related Cost

Prevention Cost Appraisal Cost

Cost to prevent defects and failure. Inspection and testing Cost

Quality Cost

Internal Failure Cost External Failure Cost

Cost arising from inadequate quality Cost arising from inadequate quality
where problems are discovered from discovered after the transfer of
supplier to purchaser ownership from suppliers to purchaser.
Quality Cost Report
Quality Cost Report - Interpretation
• In year number 2, Preventive and Appraisal cost has been increase
by the Company which consequently decrease the external failure
cost of the Company.

• Overall cost reduced by 3 percent.

• However, due to increase in quality checks, internal failure cost has

been increased in year 2. This cost will gradually decrease in longer
run.