Costs Terms, Concepts and Classifications

Manufacturing Costs
Direct Materials

Direct Labor

Manufacturing Overhead

Direct Materials
Raw materials that become an integral part of the product and that can be conveniently traced directly to it.

Example: A radio installed in an automobile

Direct Labor
Those labor costs that can be easily traced to individual units of product.

Example: Wages paid to automobile assembly workers

Manufacturing Overhead
Manufacturing costs that cannot be traced directly to specific units produced.
Examples: Indirect labor and indirect materials
Wages paid to employees who are not directly involved in production work.
Examples: maintenance workers, janitors and security guards.

Materials used to support the production process.

Examples: lubricants and cleaning supplies used in the automobile assembly plant.

Non-manufacturing Costs
Selling Costs Administrative Costs

Costs necessary to get the order and deliver the product.

All executive, organizational, and clerical costs.

Product Costs Versus Period Costs

Product costs include direct materials, direct labor, and manufacturing overhead. Period costs include all selling costs and administrative costs. Period costs include all selling costs and administrative costs.

Classifications of Costs
Manufacturing costs are often classified as follows:
Direct Material Direct Labor Manufacturing Overhead

Prime Cost

Conversion Cost

Comparing Merchandising and Manufacturing Activities

Merchandisers . . .
Buy finished goods. Sell finished goods.

Manufacturers . . .
Buy raw materials. Produce and sell finished goods.

Balance Sheet
Merchandiser Current assets
Cash Receivables

Manufacturer
Current Assets
u Cash u Receivables u Prepaid Expenses u Inventories Raw Materials Work in Process Finished Goods

Prepaid Expenses
Merchandise Inventory

Balance Sheet
Merchandiser Current assets
Cash Receivables

Manufacturer
Current Assets
u Cash
u Receivables u Prepaid Expenses

Prepaid Expenses
Merchandise Inventory Partially complete products some material, labor, or overhead has been added.

Materials waiting to u Inventories be processed. Raw Materials Work in Process Finished Goods

Completed products awaiting sale.

The Income Statement

Cost of goods sold for manufacturers differs only slightly from cost of goods sold for merchandisers.
Merchandising Company
Cost of goods sold: Beg. merchandise inventory $ 14,200 + Purchases 234,150 Goods available for sale $ 248,350 - Ending merchandise inventory (12,100) = Cost of goods sold $ 236,250

Manufacturing Company
Cost of goods sold: Beg. finished goods inv. + Cost of goods manufactured Goods available for sale - Ending finished goods inventory = Cost of goods sold

$ 14,200 234,150 $248,350

(12,100) $236,250

Manufacturing Cost Flows

Costs
Material Purchases Direct Labor Manufacturing Overhead

Balance Sheet Inventories

Raw Materials Work in Process

Income Statement Expenses

Finished Goods

Cost of Goods Sold

Selling and Administrative

Selling and Administrative

Period Costs

Cost Classifications for Predicting Cost Behavior

How a cost will react to changes in the level of activity within the relevant range.
Total variable costs change when activity changes.
Total fixed costs remain unchanged when activity 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.
Per Minute Telephone Charge Minutes Talked

Fixed Cost
Your monthly basic telephone bill probably does not change when you make more local calls.
Monthly Basic Telephone Bill 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

Mixed Costs
A mixed cost has both fixed and variable components. Consider the example of utility cost.
Total Utility Cost

Y
Variable Cost per KW

Activity (Kilowatt Hours)

Fixed Monthly Utility Charge

Cost Classifications for Predicting Cost Behavior

Behavior of Cost (within the relevant range)

Cost Variable In Total Total variable cost changes as activity level changes. Total fixed cost remains the same even when the activity level changes. Per Unit Variable cost per unit remains the same over wide ranges of activity. Average fixed cost per unit goes down as activity level goes up.

Fixed

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.

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 $15,000 per year. Your opportunity cost of attending college for one year is $15,000.

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.

Absorption and marginal costing

Introduction
Before we allocate all manufacturing costs to products regardless of whether they are fixed or variable. This approach is known as absorption costing/full costing However, only variable costs are relevant to decision-making. This is known as marginal costing/variable costing

Absorption costing

It is costing system which treats all manufacturing costs including both the fixed and variable costs as product costs

Marginal costing It is a costing system which treats only the variable manufacturing costs as product costs. The fixed manufacturing overheads are regarded as period cost

J Company produces a single product with the following information available:

Unit product cost is determined as follows:

Selling and administrative expenses are always treated as period expenses and deducted from revenue as incurred.

Income Comparison of Absorption and Variable Costing

Lets assume the following additional information for J Company.
20,000 units were sold during the year at a price of $30 each. There were no units in beginning inventory.

Now, lets compute net operating income using both absorption and variable costing.

Absorption Costing

Variable Costing
Variable Costing
Sales (20,000 $30) Less variable expenses: Beginning inventory $ Add COGM (25,000 $10) 250,000 Goods available for sale 250,000 Less ending inventory (5,000 $10) 50,000 Variable cost of goods sold 200,000 Variable selling & administrative expenses (20,000 $3) 60,000 Contribution margin Less fixed expenses: Manufacturing overhead $ 150,000 Selling & administrative expenses 100,000 Net operating income $ 600,000

260,000 340,000

250,000 $ 90,000