Cost and Cost Classifications

Cost is a sacrifice of resources to obtain a benefit or any other resource. For example in
production of a car, we sacrifice material, electricity, the value of machine's life (depreciation),
and labor wages etc. Thus these are our costs.
Product costs are costs assigned to the manufacture of products and recognized for financial
reporting when sold. They include direct materials, direct labor, factory wages, factory
depreciation, etc.
Period costs are on the other hand are all costs other than product costs. They include marketing
costs and administrative costs, etc.
The product costs are further classified into:

Direct materials: Represents the cost of the materials that can be identified directly with
the product at reasonable cost. For example, cost of paper in newspaper printing, cost of

Direct labor: Represents the cost of the labor time spent on that product, for example
cost of the time spent by a petroleum engineer on an oil rig, etc.

Manufacturing overhead: Represents all production costs except those for direct labor
and direct materials, for example the cost of an accountant's time in an organization,
depreciation on equipment, electricity, fuel, etc.

The product costs that can be specifically identified with each unit of a product are called direct
product costs. Whereas those which cannot be traced to a specific unit are indirect product costs.
Thus direct material cost and direct labor cost are direct product costs whereas manufacturing
overhead cost is indirect product cost.
Prime costs are the sum of all direct costs such as direct materials, direct labor and any other
direct costs.
Conversion costs are all costs incurred to convert the raw materials to finished products and they
equal the sum of direct labor, other direct costs (other than materials) and manufacturing
overheads.
Fixed costs are costs which remain constant within a certain level of output or sales. This certain
limit where fixed costs remain constant regardless of the level of activity is called relevant range.
For example, depreciation on fixed assets, etc.
Variable costs are costs which change with a change in the level of activity. Examples include
direct materials, direct labor, etc.

Sunk Costs Vs. Opportunity Costs

The costs discussed so far are historical costs which means they have been incurred in past and
cannot be avoided by our current decisions. Relevant in this regard is another cost classification,
called sunk costs. Sunk costs are those costs that have been irreversibly incurred or committed;
they may also be termed unrecoverable costs.
In contrast to sunk costs are opportunity costs which are costs of a potential benefit foregone. For
example the opportunity cost of going on a picnic is the money that you would have earned in
that time.