Cost Terms, Concepts and

Classifications
with Mixed Cost Analysis
Chapter 02

Md. Tapan Mahmud

Assistant Professor
Bangladesh University of Professionals
(BUP)
2-2

Learning Objectives

• Identify and give examples of each of the

Cost from the perception of Manufacturing

• Prime Cost and Conversion Cost

(another way to see the Manufacturing Costs)

• Distinguish between product costs and

period costs and give examples of each
2-3

Learning Objectives

• Understand the differences between

variable costs and fixed costs
• Understand the differences between
direct and indirect costs
• Define and give examples of cost
classifications used in making
decisions: differential costs,
opportunity costs, and sunk costs
• Relating Cost Classification with
Perception and Purpose
2-4

Learning Objective

Identify and give examples

of each of the Cost from
the perception of
Manufacturing
2-5

Manufacturing Cost Classification

Perception of Manufacturing
1. Manufacturing
Direct Materials
Direct Labor
Manufacturing Overhead
2. Non-Manufacturing
Selling Cost
Administrative Cost
2-6

Manufacturing Costs

Direct Direct Manufacturing

Materials Labor Overhead

The Product
2-7

Direct Materials

a) Raw materials that become an integral part of the

product
b) That offers core benefit of the product
b) That can be conveniently (Economically and
Efficiently) traced directly to the product

Example: A radio installed in an automobile

2-8

Direct Labor

a) Those labor costs that can be easily (Economically

and Efficiently) traced to individual units of
product
b) Contributes towards the core benefit of a product

Example: Wages paid to automobile assembly workers

 Manufacturing Overhead (Indirect Labor +
2-9

Indirect Material)

Manufacturing costs that cannot be traced directly

(Economically and Efficiently) to specific units
produced.
Examples: Indirect labor and indirect materials

Wages paid to employees Materials used to support

who are not directly the production process.
involved in production
work. Examples: lubricants and
Examples: maintenance cleaning supplies used in
workers, janitors and the automobile assembly
security guards. plant.
2-10

Non-manufacturing Costs

Selling Administrative
Costs Costs

Costs necessary to get All executive,

the order and deliver organizational, and
the product. clerical costs.
2-11

Learning Objective

Prime Cost
and
Conversion Cost
2-12

Classifications of Costs

Manufacturing costs are often

classified as follows:

Direct Direct Manufacturing

Material Labor Overhead

Prime Conversion
Cost Cost
2-13

Learning Objective

Distinguish between
product costs and
period costs and give
examples of each.
2-14

Product Costs Versus Period Costs

Product costs include Period costs include all

direct materials, direct selling costs and
labor, and administrative costs.
manufacturing
overhead.

Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement
2-15

Quick Check 

Which of the following costs would be considered a

period rather than a product cost in a manufacturing
company?

A. Manufacturing equipment depreciation.

B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production
facility.
E. Sales commissions.
2-16

Quick Check 

Which of the following costs would be considered a

period rather than a product cost in a manufacturing
company?

A. Manufacturing equipment depreciation.

B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production
facility.
E. Sales commissions.
2-17

Manufacturing Cost Flows

Balance Sheet Income

Costs Inventories Statement
Expenses
Material Raw Materials
Purchases

Direct Labor Work in

Process

Manufacturing
Overhead Cost of
Finished
Goods
Goods
Sold

Selling and Period Costs Selling and

Administrative Administrative
2-18

Learning Objective

Understand the
differences between
variable costs and fixed
costs.
2-19

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.
2-20

Variable Cost

Your total long distance telephone bill is

based on how many minutes you talk.
Total Long Distance
Telephone Bill

Minutes Talked
2-21

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
2-22

Extent of Variable Costs

The proportion of variable costs differs across

organizations. For example . . .
A public utility with
large investments in A manufacturing company
equipment will tend will often have many
to have fewer variable costs.
variable costs.

A merchandising company
A service company
usually will have a high
will normally have a high
proportion of variable costs,
proportion of variable costs.
like cost of sales.
2-23

Examples of Variable Costs

1. Merchandising companies – cost of goods sold.

2. Manufacturing companies – direct materials,
direct labor, and variable overhead.
3. Merchandising and manufacturing companies –
commissions, shipping costs, and clerical costs,
such as invoicing.
4. Service companies – supplies, travel, and
clerical.
2-24

True Variable Cost

Direct materials is a true or proportionately

variable cost because the amount used
during a period will vary in direct proportion
to the level of production activity.
Cost

Volume
2-25

Step-Variable Costs

A resource that is obtainable only in large chunks (such

as maintenance workers) and whose costs increase or
decrease only in response to fairly wide changes in
activity is known as a step-variable cost.
Cost

Volume
2-26

Step-Variable Costs

Small changes in the level of production are not

likely to have any effect on the number of
maintenance workers employed.
Cost

Volume
2-27

Step-Variable Costs

Only fairly wide changes in the activity level will

cause a change in the number of maintenance
workers employed
Cost

Volume
2-28

Fixed Cost

Your monthly basic telephone bill (Line

Rent) probably does not change when you
make more local calls.
Monthly Basic
Telephone Bill

Number of Local Calls

2-29

Fixed Cost Per Unit

The average fixed cost per local call (Line

Rent) decreases as more local calls are
made.

Monthly Basic Telephone

Bill per Local Call

Number of Local Calls

2-30

Types of Fixed Costs

Committed Discretionary
Long-term, cannot be May be altered in the
significantly reduced in short-term by current
the short term. managerial decisions

Examples Examples
Depreciation on Advertising and
Equipment and Research and
Real Estate Taxes Development
2-31

The Trend Toward Fixed Costs

The trend in many industries is toward

greater fixed costs relative to variable costs.
As machines take over Knowledge workers
many mundane tasks tend to be salaried,
previously performed highly-trained and
by humans, difficult to replace. The
“knowledge workers” cost to compensate
are demanded for these valued employees
their minds rather is relatively fixed
than their muscles. rather than variable.
2-32

Is Labor a Variable or a Fixed Cost?

The behavior of wage and salary costs can

differ across countries, depending on labor
regulations, labor contracts, and custom.

In France, Germany, China, and Japan, management has

little flexibility in adjusting the size of the labor force.
Labor costs are more fixed in nature.

In the United States and the United Kingdom, management

has greater latitude. Labor costs are more variable in nature.
2-33

Fixed Costs and Relevant Range

90
Rent Cost in Thousands

Total cost doesn’t

Relevant change for a wide
of Dollars

60 range of activity, and

Range then jumps to a new
higher cost for the
next higher range of
30 activity.

0
0 1,000 2,000 3,000
Rented Area (Square Feet)
2-34

Fixed Costs and Relevant Range

The relevant range of activity for a fixed cost

is the range of activity over which the graph
of the cost is flat.
Example: Office space is
available at a rental rate
of $30,000 per year in
increments of 1,000
square feet. As the
business grows, more
space is rented,
increasing the total cost.
2-35

Fixed Costs and Relevant Range

Step-variable costs
can be adjusted more
How does this type quickly and . . .
of fixed cost differ The width of the
from a step-variable activity steps is much
wider for the fixed
cost? cost.
2-36

Quick Check 

Which of the following statements about cost

behavior are true?
1. Fixed costs per unit vary with the level of
activity.
2. Variable costs per unit are constant within the
relevant range.
3. Total fixed costs are constant within the
relevant range.
4. Total variable costs are constant within the
relevant range.
2-37

Quick Check 

Which of the following statements about cost

behavior are true?
1. Fixed costs per unit vary with the level of
activity.
2. Variable costs per unit are constant within the
relevant range.
3. Total fixed costs are constant within the
relevant range.
4. Total variable costs are constant within the
relevant range.
2-38

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.
2-39

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.
2-40

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.
2-41

Learning Objective

Understand the
differences between
direct and indirect
costs.
2-42

Assigning Costs to Cost Objects

A cost object is any item for which costs are being separately
measured…
Direct costs Indirect costs
• Costs that can be • Costs that cannot be
easily and conveniently easily and conveniently
traced to a unit of traced to a unit of
product or other cost
product or other cost
object.
object.
• Example: manufacturing
• Examples: direct overhead
material and direct labor
2-43

Learning Objective

Define and give

examples of cost
classifications used in
making decisions:
differential costs,
opportunity costs, and
sunk costs.
2-44

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.
2-45

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
2-46

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.
2-47

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.
2-48

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.
2-49

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.
2-50

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 annual cost of licensing your car relevant
in this decision?

A. Yes, the licensing cost is relevant.

B. No, the licensing cost is not relevant.
2-51

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 annual cost of licensing your car relevant
in this decision?

A. Yes, the licensing cost is relevant.

B. No, the licensing cost is not relevant.
2-52

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.
2-53

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.
2-54

Relating Cost
Classification with
Perception and
Purpose
2-55

Summary of the Types of Cost

Classifications

• Financial reporting (Income Statement and

Balance Sheet)
 Manufacturing
 Direct Material, Direct Labor and Overhead
 Non-Manufacturing,
 Selling and Administrative
 Product and Period

• Predicting cost behavior

 Variable Cost
 Fixed Cost
2-56

Summary of the Types of Cost

Classifications

• Finding out total cost of a Cost Object

 Direct Cost
 Indirect Cost

• Decision making
 Differential Cost
 Opportunity Cost
 Sunk Cost
2-57

Breaking Up Mixed
Cost into Fixed and
Variable Costs
2-58

Mixed Costs

A mixed cost has both fixed and variable

components. Consider the example of utility cost.

Y
Total Utility Cost

Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours) Utility Charge
2-59

Mixed Costs

The total mixed cost line can be expressed

as an equation: Y = a + bX

Where: Y = the total mixed cost

a = the total fixed cost (the
Y vertical intercept of the line)
b = the variable cost per unit of
Total Utility Cost

activity (the slope of the line)

X = the level of activity

Variable
Cost per KW

X Fixed Monthly
Activity (Kilowatt Hours) Utility Charge
2-60

Mixed Costs Example

If your fixed monthly utility charge is $40, your

variable cost is $0.03 per kilowatt hour, and your
monthly activity level is 2,000 kilowatt hours,
what is the amount of your utility bill?

Y = a + bX
Y = $40 + ($0.03 × 2,000)
Y = $100
2-61

Analysis of Mixed Costs

Account Analysis and the Engineering Approach

Each account is classified as either

variable or fixed based on the analyst’s
knowledge of how the account behaves.

Cost estimates are based on an

evaluation of production methods, and
material, labor and overhead
requirements.
2-62

Learning Objective 2

Use a scattergraph plot to

diagnose cost behavior.
2-63

The Scattergraph Method

Plot the data points on a graph

(total cost vs. activity).
Y
20
Maintenance Cost

* ** *
1,000’s of Dollars

* *
**
10 * *

0 X
0 1 2 3 4
Patient-days in 1,000’s
2-64

The Scattergraph Method

Draw a line through the data points with about an

equal numbers of points above and below the line.
Y
20
Maintenance Cost

* ** *
1,000’s of Dollars

* *
**
10 * *

0 X
0 1 2 3 4
Patient-days in 1,000’s
2-65

The Scattergraph Method

Use one data point to estimate the total level of activity

and the total cost.
Y Total maintenance cost = $11,000
20
Maintenance Cost

* ** *
1,000’s of Dollars

* *
**
10 * *
Intercept = Fixed cost: $10,000

0 X
0 1 2 3 4
Patient-days in 1,000’s
Patient days = 800
2-66

The Scattergraph Method

Make a quick estimate of variable cost per unit and

determine the cost equation.

Total maintenance at 800 patients $ 11,000

Less: Fixed cost 10,000
Estimated total variable cost for 800 patients $ 1,000

$1,000
Variable cost per unit = = $1.25/patient-day
800

Y = $10,000 + $1.25X

Total maintenance cost Number of patient days

2-67

Learning Objective 3

Analyze a mixed cost

using the high-low
method.
2-68

The High-Low Method

Assume the following hours of maintenance work

and the total maintenance costs for six
months.
2-69

The High-Low Method

The variable cost

per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.

$2,400
= $8.00/hour
300
2-70

The High-Low Method

Total Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = $9,800 – ($8/hour × 800 hours)
Total Fixed Cost = $9,800 – $6,400
Total Fixed Cost = $3,400
2-71

The High-Low Method

The Cost Equation for Maintenance

Y = $3,400 + $8.00X
2-72

Problem (High-Low & Scattergraph)

2-73
2-74
2-75

Problem (High-Low & Scattergraph)

2-76
2-77
 High-Low Class Exercise
2-78

3. Find out total cost for 1750 Patient Days.

2-79
High-Low Class Exercise
2-80

Quick Check 

Sales salaries and commissions are $10,000

when 80,000 units are sold, and $14,000
when 120,000 units are sold. Using the high-
low method, what is the variable portion of
sales salaries and commission?
a. $0.08 per unit
b. $0.10 per unit
c. $0.12 per unit
d. $0.125 per unit
2-81

Quick Check 

Sales salaries and commissions are $10,000

when 80,000 units are sold, and $14,000
when 120,000 units are sold. Using the high-
low method, what is the variable portion of
sales salaries and commission?
Units Cost
a. $0.08 per unitHigh level 120,000 $ 14,000
b. $0.10 per unitLow level 80,000 10,000
c. $0.12 per unitChange 40,000 $ 4,000

d. $0.125 per unit $4,000 ÷ 40,000 units

= $0.10 per unit
2-82

Quick Check 

Sales salaries and commissions are $10,000

when 80,000 units are sold, and $14,000
when 120,000 units are sold. Using the high-
low method, what is the fixed portion of sales
salaries and commissions?
a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000
2-83

Quick Check 

Sales salaries and commissions are $10,000

when 80,000 units are sold, and $14,000
when 120,000 units are sold. Using the high-
low method, what is the fixed portion of sales
salaries and commissions?
Total cost = Total fixed cost +
a. $ 2,000 Total variable cost

b. $ 4,000 $14,000 = Total fixed cost +

($0.10 × 120,000 units)
c. $10,000
Total fixed cost = $14,000 - $12,000
d. $12,000
Total fixed cost = $2,000
2-84

End of Chapter 2