Classifying Costs (a)
 By Element
 Material
 Labour
 Expense
 By Traceability
 Direct
 Indirect
Classification by element
Material
Labour
The
Product
Expense
Classification of Costs
by Traceability
Direct Costs
Indirect Costs
 Costs that can
 Costs cannot
be easily and
conveniently traced
to a unit of product or
other cost object.
 Examples:
 Direct material
 Direct labor
be easily and
conveniently traced
to a unit of product or
other cost object.
 Example:
 Manufacturing
overhead
Direct and Indirect Costs
Direct costs
Indirect costs
 Costs that can be
 Costs that must be
easily and
conveniently traced to
a product or
department.
 Example: cost of
paint in the paint
department of an
automobile assembly
plant.
allocated in order to
be assigned to a
product or
department.
 Example: cost of
national advertising
for an airline is
indirect to a particular
flight.
Classification by element or
traceability
Materials
Labour
Current
Direct
Indirect
Expenses
Direct
Indirect
Product costs =
Materials+Labour+Expenses
Direct
Indirect
Or
Direct costs + Indirect costs
Classifications of Costs in
Manufacturing Companies
Manufacturing costs are often
combined as follows:
Direct
Material
Direct Labour &
Direct Expenses
Prime
Cost
Manufacturing
Overhead
Conversion
Cost
Classifying Costs (b)
 By Function
Product
Period
Manufacturing Cost Flows
Costs
Balance Sheet
Inventories
Material Purchases
Raw Material
Direct Labor
Work in
Process
Manufacturing
Overhead
Selling and
Administrative
Finished
Goods
Period Expenses
Income
Statement
Expenses
Cost of
Goods
Sold
Selling and
Administrative
Cost Classification by Function
Product costs
Include expenditures
that are
necessary and integral
to finished products.
Capitalized on the
balance sheet until sold.
Cost of Good Sold
Inventory
Period costs
Include expenditures
identified more with a
time period than with
finished products.
Expensed on the
income statement.
Expense
Sale
Balance
Sheet
Income
Statement
Income
Statement
Classification of Costs by Function
Product Costs
Period Costs
 Direct materials
 Selling
 Direct labor
 General and
 Overhead
administrative
expenses
Classifying Costs (c)
 By Behaviour
 Fixed
 Variable
 Semi-fixed
 Semi-variable
Cost Classifications
by Behaviour
Cost Behaviour
How a cost will react to
changes in the level of business activity.
 Total variable costs change
when the level of activity changes.
 Total fixed costs remain unchanged
when the level of activity changes.
Total Variable Cost
Total Long Distance
Telephone Bill
A variable cost is one that changes in total
in proportion to changes in the volume of activity.
Your total long distance telephone bill
is based on how many minutes you talk.
Minutes Talked
Variable Cost Per Unit
On a per unit basis, a variable cost
remains constant over a wide range of activity.
Per Minute
Telephone Charge
The cost per long distance minute talked is constant.
For example, 10 cents per minute.
Minutes Talked
Cost Behaviour
Merchandisers
Service Organizations
Cost of Goods Sold
Supplies and travel
Examples of variable costs
Manufacturers
Direct Material, Direct
Labor, and Variable
Manufacturing Overhead
Merchandisers and
Manufacturers
Sales commissions and
shipping costs
Total Fixed Cost
A fixed cost is one that remains constant in total
even when the volume of activity changes.
Monthly Basic
Telephone Bill
Your monthly basic telephone bill probably does not
change when you make more local calls.
Number of Local Calls
Fixed Cost Per Unit
On a per unit basis, a fixed cost changes
as the volume of activity changes.
Monthly Basic
Telephone Bill per
Local Call
The average cost per local call decreases
as more local calls are made.
Number of Local
Calls
Cost Behaviour
Examples of fixed costs
Merchandisers, manufacturers, and
service organizations
Real estate taxes
Insurance
Sales salaries
Depreciation
Advertising
Cost Classifications for
Predicting Cost Behavior
Summary of Variable and Fixed Cost Behavior
Cost
In Total
Per Unit
Variable
Total variable cost is
proportional to the activity
level within the relevant range.
Variable cost per unit remains
the same over wide ranges
of activity.
Fixed
Total fixed cost remains the
same even when the activity
level changes within the
relevant range.
Fixed cost per unit goes
down as activity level goes up.
Fixed Costs and Relevant Range
Rent Cost in
Thousands of Dollars
The company’s
normal operating range
90
60
30
00
Relevant
Range
Total cost doesn’t
change for a wide
range of activity.
It then jumps to a
new higher cost
for the next higher
range of activity.
1,000
2,000
3,000
Rented Area (Square Feet)
Fixed Costs and Semi-fixed (or
Step-Wise or Step-Variable) Costs
How does this type of
fixed cost differ from a
step-variable (or stepwise) cost?
Step-variable
(or step-wise) costs
can be adjusted
more quickly and . . .
The width of the
activity steps is
much wider for the
fixed cost.
Semi-fixed Costs
(or Step-Variable or Step-Wise)
Cost
Total cost increases
to a new higher cost
for the next higher range
of activity.
Total cost
remains constant
within a narrow
range of activity.
Activity
Semivariable Cost
Total Utility Cost
Slope is
variable cost
per unit
of activity.
Variable
Utility Charge
Fixed Monthly
Utility Charge
Activity (Kilowatt Hours)
Curvilinear Cost
Total Cost
Curvilinear
Cost Function
Relevant Range
Activity
A straight-Line
(constant unit
variable cost) closely
approximates a
curvilinear line within
the relevant range.
Relevant Information
Information is relevant to a decision
problem when . . .
It has a bearing on the future,
It differs among competing alternatives.
Identifying Relevant
Costs and Benefits
Sunk costs
Costs that have already been incurred.
They do not affect any future cost and
cannot be changed by any current or
future action.
Sunk costs are irrelevant to decisions.
Relevant Costs
 Relevant costs are those costs and/or
benefits that differ between alternatives.
 Costs that can be eliminated (in whole or in
part) by choosing one alternative over
another are avoidable costs.
 Avoidable costs are relevant costs.
 Unavoidable costs include:
Sunk costs.
Future costs that do not differ between the
alternatives.
 Unavoidable costs are never relevant.
Incremental
Costs
Add or Drop a Product
S ales
K eep
D r op
W atch
W atch
$ 500,000
Less var iable expenses:
Mfg. expenses
Fr eight out
C om m issions
Total var iable expenses
C ontr ibution m ar gin
Less fixed expenses:
G ener al factor y over head
S alar y of line m anager
D epr eciation
Adver tising - dir ect
R ent - factor y space
G ener al adm in. expenses
Total fixed expenses
N et loss
$
-
D iffer ence
$ (500,000)
120,000
5,000
75,000
200,000
300,000
60,000
90,000
50,000
100,000
70,000
30,000
400,000
$ (100,000)
60,000
50,000
30,000
140,000
$ (140,000)
120,000
5,000
75,000
200,000
(300,000)
90,000
100,000
70,000
260,000
$ (40,000)
Summary
S u m m ar y
C o n tr ib u tio n m ar g in lo st if d ig ital
w atch es ar e d r o p p ed
$ (300,000)
L ess fixed co sts th at can b e avo id ed
S alar y o f th e lin e m an ag er
$ 90,000
Ad ver tisin g - d ir ect
100,000
R en t - facto r y sp ace
N et d isad van tag e
70,000
260,000
$ (40,000)
DECISION RULE
Swick should drop the digital watch segment
only if its fixed cost savings exceed lost
contribution margin.
Marginal Costs and Average Costs
The extra cost
incurred to produce
one additional unit.
The total cost to
produce a quantity
divided by the
quantity produced.
Marginal and average costs are
largely a function of cost behavior
-- variable and fixed costs.
Costs and Benefits of Information
Costs
Benefits
More information does not mean more
benefits if information overload results.