Classification of Costs
Lecture No. 29
Chapter 8
Contemporary Engineering Economics
Copyright © 2006
Contemporary Engineering Economics, 4th
edition, © 2007
Chapter Opening Story – High Hopes
for Plastic Beer Bottles

What is the least
expensive way to make
a 0.5L PET barrier beer
bottle?
Types of Production
Method
Capital investment
(20,000 bottles/hr)
Direct Mfg Cost (per
1,000 units)
Comments
5-layer
3-layer
Internal
coating
External
coating
$10.8M
$9.9M
$9.2M
$7.5M
$59.35
$66.57
$46.90
$55.34
Need a bottle that provides shelf life of over 120 days with less than
15% loss of CO2 and admittance of no more than 1 ppm of oxygen
Contemporary Engineering Economics, 4th
edition, © 2007
General Cost Terms
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Manufacturing Costs
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Direct Raw Materials
Direct Labor
Manufacturing Overhead
Nonmanufacturing
Costs
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Overhead
Marketing
Administrative Functions
Contemporary Engineering Economics, 4th
edition, © 2007
Various Types of Manufacturing Costs
Contemporary Engineering Economics, 4th
edition, © 2007
Classifying Costs for Financial
Statements
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Matching Concept: The costs
incurred to generate particular
revenue should be recognized
as expenses in the same period
that the revenue is recognized.
Period Costs: Those costs that
are matched against revenues
on a time period basis
Product Costs: Those costs that
are matched against revenues
on a product basis.
Contemporary Engineering Economics, 4th
edition, © 2007
Example
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Period Costs:
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General and
administrative expenses
Marketing expenses
Insurance premiums
Income taxes
Nonmanufacturing costs
Product Costs:
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Direct material costs
Direct labor costs
Manufacturing overhead
Contemporary Engineering Economics, 4th
edition, © 2007
How the Period Costs and Product Costs
Flow Through Financial Statement
Contemporary Engineering Economics, 4th
edition, © 2007
Cost Flows and Classifications in a
Manufacturing Company
Contemporary Engineering Economics, 4th
edition, © 2007
Example 8.1 Classifying Costs for
Uptown Ice Cream Shop
Product
Cost
Period
Cost
Unit Price of an Ice Cream
Ice cream (cream, sugar, milk, and milk solids) $0.65
Cone
0.05
Rent
0.61
Wages
0.25
Payroll taxes
0.25
Sales taxes
0.23
Business taxes
0.08
Debt service
0.23
Supplies
0.09
Utilities
0.08
Other (insurance, advertising,professional fees) 0.05
Profit
0.13
$2.50
Contemporary Engineering Economics, 4th
edition, © 2007
Cost Classification for Predicting Cost
Behavior
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Volume index
Cost Behaviors
Fixed costs
Variable costs
Mixed costs
Average unit costs
Contemporary Engineering Economics, 4th
edition, © 2007
Volume Index
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Def: The unit measure
used to define “volume”
Examples:
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Automobile – “miles”
driven
Generating plant – “kWh”
produced
Stamping machine –
“parts” stamped
Contemporary Engineering Economics, 4th
edition, © 2007
Fixed Costs

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Def: The costs of
providing a company’s
basic operating
capacity
Cost behavior: Remain
constant over the
relevant range
Contemporary Engineering Economics, 4th
edition, © 2007
Variable Costs

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Def: Costs that vary
depending on the level
of production or sales
Cost behavior: Increase
or decrease
proportionally
according to the level of
volume
Contemporary Engineering Economics, 4th
edition, © 2007
Mixed Costs

Def: Costs are fixed
for a set level of
production or
consumption,
becoming variable
after the level
exceeded.
Cost behavior:
Increase or
decrease after
maintaining a fixed
level of expense
Mixed cost behavior
Depreciation Expenses ($)

6000
5000
4000
3000
2000
1000
0
5
15
25
Miles Driven (Unit: 1,000)
Contemporary Engineering Economics, 4th
edition, © 2007
Average Unit Cost
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Def: activity cost per
unit basis
Cost Behaviors:
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Fixed cost per unit varies
with changes in volume.
Variable cost per unit of
volume is a constant.
Mixed cost per unit of
volume contains both the
constant and variable
elements
Contemporary Engineering Economics, 4th
edition, © 2007
Practice Problem
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You have 3000 units to produce.
Total labor cost = $20,000
Total material cost = $25,000
Total overhead cost = $15,000
Total fixed cost = $40,000
What is the average cost per unit?
Average cost = ($100,000)/3,000 = $33.33/unit
Contemporary Engineering Economics, 4th
edition, © 2007
Future Costs for Business Decisions
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Differential
(Incremental) cost
Opportunity cost
Sunk cost
Marginal cost
Contemporary Engineering Economics, 4th
edition, © 2007
Differential (Incremental) Costs
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Def: Costs that represent
the differences in total
costs, which results from
selecting one alternative
instead of other
Cost behavior: Increase or
decrease with the overall
change that a company
experiences by producing
one additional unit of good
Contemporary Engineering Economics, 4th
edition, © 2007
Opportunity Costs
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Def: The potential benefit
that is given up as you seek
an alternative course of
action
Example: When you decide
to pursue a college degree,
your opportunity cost would
include a 4-year’s potential
earnings foregone.
Contemporary Engineering Economics, 4th
edition, © 2007
Sunk Costs
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Def:Cost that has already
been incurred by past
actions
Economic Implications: Not
relevant to future decisions
Example: $500 spent to
replace brakes last year—
not relevant in making a
selling decision in the future
Contemporary Engineering Economics, 4th
edition, © 2007
Marginal Costs
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Def: Added costs that result
from increasing rates of
outputs, usually by single unit
Example: Cost of electricity—
decreasing marginal rate
Contemporary Engineering Economics, 4th
edition, © 2007