M.A.
Chapter 2 Cost Classification and Cost Behavior Analysis
what is cost accounting?
Cost Accounting is a branch of accounting that focuses on recording, analyzing, and
controlling the costs of producing goods or services.
Simple Definition
Cost accounting means finding out how much it costs to make a product or provide a
service, so a business can control expenses and increase profit.
Key Points
• It tracks material cost, labor cost, and overhead cost
• Helps in cost control and cost reduction
• Assists management in decision-making
• Used for budgeting and planning
• Control unnecessary expenses
cost vs expenses
• Cost = Amount spent to produce or acquire something
• Expenses = Cost that is used up to earn revenue
Difference Table
Basis Cost Expenses
Meaning Total amount spent on production or purchase Part of cost that is consumed
Nature Can be asset or expense Always expense
Purpose Helps determine product value Helps earn revenue
Time May benefit future (e.g., machine) Relates to current period
Example Buying a machine, raw materials Salary, rent, electricity
Easy Example
• You buy raw materials for 10,000 Tk → Cost
• You use part of it in production → becomes Expense
So,
All expenses are costs, but not all costs are expenses.
Cost Classification (for assigning costs to cost objects)
What is a Cost Object?
A cost object is anything you want to find cost for.
Example: product, customer, department
1. Direct Cost (easy to trace)
A direct cost is a cost that can be easily and clearly traced to a specific product, job, or
service.
Example:
• Cloth used to make a shirt
• Wages of workers making that shirt
You can clearly say: “This cost is for this product.”
2. Indirect Cost (not easy to trace)
An indirect cost is a cost that cannot be easily traced to a specific product, job, or service.
Example:
• Factory rent
• Electricity
• Supervisor’s salary
These costs are shared among many products.
Common Cost
A common cost is a cost that is shared by many cost objects (products or
departments), so it cannot be easily traced to just one.
Example:
• Factory manager’s salary
• Factory rent
Real life Example: A factory produces shirts, pants, and jackets.
• The factory manager supervises all products
• His salary = 50,000 Tk per month
Now, can you say:
• 20,000 Tk for shirts
• 15,000 Tk for pants
• 15,000 Tk for jackets
No—because he works for everything together, not one specific product.
How the cost is shared: The company may divide the salary artificially, for example:
• Based on number of units produced
• Based on machine hours
• Based on labor hours
Accounting for Costs in Manufacturing
Companies
There are 2 main types of costs:
1. Manufacturing Costs (Product Costs)
These are costs used to make the product (door, shirt, etc.)
a) Direct Materials
Meaning:
Raw materials that are directly used in making the product
Examples:
• Wood for doors
• Cloth for shirts
You can easily see these in the product
b) Direct Labor
Meaning:
Wages of workers who directly make the product
Examples:
• Carpenter making doors
• Tailor sewing shirts
They physically work on the product
c) Manufacturing Overhead
Meaning:
All other factory costs that are needed for production but not direct
Examples:
• Factory rent
• Electricity
• Supervisor salary
• Machine maintenance
These are indirect costs
• Indirect Materials
Indirect materials are small materials used in production (like glue for chairs) whose cost cannot
be easily traced to one specific product.
• Indirect Labor
Indirect labor includes workers like janitors, supervisors, maintenance staff, and security guards
who help run the factory, but their wages cannot be linked to a single product. Their works are
used to support production process.
Since both indirect materials and indirect labor cannot be directly traced to products, their
costs are included in Manufacturing Overhead.
2. Non-Manufacturing Costs (Period Costs)
These are costs not related to making the product, but help in selling and managing the
business.
a) Selling Costs
Selling costs are expenses used to sell the product and deliver it to customers.
Costs necessary to get the order and deliver it.
Examples:
• Advertising
• Sales salary
• Sales commission
• Delivery/shipping cost
• Sales travel
• Finished goods warehouse
These are also called:
• Order-getting costs (getting customers)
• Order-filling costs (delivering products)
Important point:
Selling costs can be either direct or indirect costs. For example, the cost of an advertising
campaign for one specific product is a direct cost of that product, whereas the salary of a
marketing manager who oversees numerous products is an indirect cost with respect to
individual products.
• If cost is for one product only → Direct selling cost
• If cost is for many products → Indirect selling cost
Example:
• One product advertisement → Direct cost
• Marketing manager salary → Indirect cost
b) Administrative Costs
Meaning:
Costs for managing and running the office/business. These costs are for overall control and
decision-making of the business.
Examples:
• Office rent
• Manager salary
• Office electricity
• Executive salaries
• Accounting department costs
• Secretarial work
• Public relations
• Office management costs
Helps in running the business
Direct or Indirect?
Administrative costs can be both direct and indirect:
Direct Administrative Cost
Example: Salary of accounting manager for East region → Direct cost of that region
Indirect Administrative Cost
Example: Chief Financial Officer (CFO) salary → works for whole company → Indirect cost of
that region
Preparing Financial Statements
In accounting, costs are divided into two types when preparing financial statements:
1. Product Costs (Inventoriable Costs)
These are costs that are included in inventory first and become expense only when the
product is sold.
Costs of making the product that stay in inventory until sale.
Examples:
• Direct materials (wood, cloth)
• Direct labor (workers’ wages)
• Manufacturing overhead (factory rent, electricity)
How it works:
• When products are not sold → shown as Inventory (asset-Balance Sheet)
• When sold → become Cost of Goods Sold (expense-Income Statement)
Product costs move step by step as production happens and goods are sold.
1. Raw Materials Stage
When materials are bought (like wood, cloth), they go into Raw Materials inventory.
2. Work in Process (WIP)
When materials are used in production:
• Raw materials are moved to Work in Process
• Add:
o Direct labor (workers’ wages)
o Manufacturing overhead (factory costs)
This stage means the product is being made but not finished yet
3. Finished Goods
When products are fully completed:
• Costs move from Work in Process → Finished Goods
Now products are ready for sale
4. Cost of Goods Sold (COGS)
When products are sold:
• Costs move from Finished Goods → Cost of Goods Sold
This becomes an expense in income statement
Easy Flow to Remember: Raw Materials → Work in Process → Finished Goods →
Cost of Goods Sold
2. Period Costs (Expensed Costs)
Period costs are all the costs that are not related to making products.
These are costs that are charged as expenses in the period they occur, not stored in
inventory.
Meaning:
Costs not related to production, but to running the business.
Examples:
• Selling costs (advertising, delivery)
• Administrative costs (office salary, rent)
How it works:
• Always recorded as expense in income statement immediately (in the same period
they occur).
• Product cost = goes to inventory first
• Period cost = becomes expense immediately
Cost Classifications for predicting cost behavior
Cost behavior means how costs change when business activity (like production or sales)
changes.
There are 3 main types:
Variable, Fixed, Mixed
1. Variable Cost
A variable cost changes in total when activity changes.
Meaning:
• More production → more cost
• Less production → less cost
• It changes proportionally
Examples:
• Raw materials
• Direct labor (piece-rate)
• Packaging cost
“More output = more cost”
More Examples:
1. For Merchandisers
(Companies that buy and sell goods, like shops)
Variable cost: Cost of Goods Sold (COGS)
If they sell more goods, cost increases.
2. For Manufacturers
(Companies that make products)
Variable costs:
• Direct materials (wood, cloth, etc.)
• Direct labor (workers’ wages)
• Variable manufacturing overhead (electricity used in production, etc.)
More production = more cost
3. For Service Organizations
(Companies that provide services)
Variable costs:
• Supplies (stationery, cleaning items, etc.)
• Travel expenses
More service activity = more cost
4. For Merchandisers & Manufacturers (Both)
Variable costs:
• Sales commissions
• Shipping costs
More sales = more commission and shipping cost
2. Fixed Cost
A fixed cost remains constant in total, no matter the activity level.
Meaning:
• Production increases or decreases → cost stays same (total)
Examples:
• Factory rent
• Manager salary
• Insurance
Easy idea:
“Cost stays fixed even if production changes”
Real estate taxes, Insurance, Sales salaries, Depreciation, Advertising
Types of Fixed Costs
Fixed costs are not all the same. They are divided into two types:
1. Committed Fixed Costs
These are long-term fixed costs that cannot be easily changed or reduced in the short term.
Meaning:
• Must be paid for a long time
• Hard to cancel quickly
• Linked to long-term assets or commitments
Examples:
• Depreciation on buildings
• Depreciation on machinery
• Long-term lease contracts
Even if production decreases, you still have to pay these.
2. Discretionary Fixed Costs
These are fixed costs that can be changed or reduced by management decisions in the short
term.
Meaning:
• Flexible
• Can increase or decrease based on decisions
• Not essential for daily survival of production
Examples:
• Advertising
• Research and Development (R&D)
• Training programs
• Employee welfare programs
Managers can increase or cut these depending on budget.
3. Mixed Cost
A mixed cost has both fixed and variable parts.
Meaning:
• Part of the cost is fixed
• Part changes with activity
Examples:
• Electricity bill (fixed charge + usage charge)
• Phone bill
• Utility costs
• Salesperson Salary
Has two parts:
Fixed: basic monthly salary
Variable: commission on sales
More sales → more total earnings
Easy Summary
• Variable = changes with activity
• Fixed = stays constant
• Mixed = combination of both
Labor / Wages: Variable, Fixed, or Mixed?
1. Variable Labor Cost
Labor cost changes with production/activity.
Meaning:
• More output → more wages
• Less output → less wages
Example:
• Piece-rate workers (paid per shirt, per door, etc.)
• Overtime paid based on production
2. Fixed Labor Cost
Labor cost stays the same every month, no matter output.
Meaning:
• Production increases or decreases → salary stays same
Example:
• Manager salary
• Supervisor fixed monthly pay
• Office staff salary
3. Mixed Labor Cost
Labor cost has both fixed and variable parts.
Meaning:
• Fixed base salary + extra pay based on work/output
Example:
• Salesperson: fixed salary + commission
• Worker: fixed wage + overtime pay
Cost Structure: Cost structure means the mix (proportion) of variable and fixed costs in a
company.
Simple explanation of variable cost per unit and fixed cost per unit
Variable Cost per Unit
Variable cost per unit stays the same, but total cost changes with output.
Meaning:
• Cost for each unit is constant
• But total cost increases when you produce more units
Example:
• Raw material cost = 10 Tk per shirt
If you make:
• 1 shirt → 10 Tk
• 10 shirts → 100 Tk
• 100 shirts → 1000 Tk
Per unit cost = same (10 Tk)
Fixed Cost per Unit
Fixed cost per unit changes depending on output, even though total fixed cost stays the same.
Meaning:
• Total fixed cost is constant
• But per unit cost decreases when output increases
Example:
• Factory rent = 10,000 Tk
If you make:
• 10 units → 1000 Tk per unit
• 100 units → 100 Tk per unit
• 1000 units → 10 Tk per unit
Per unit cost goes down as production increases
Cost Classification for Decision Making
These costs help managers choose between alternatives. It has several classifications:
relevant/irrelevant costs, sunk costs, opportunity costs, differential/incremental costs, and
avoidable costs.
1. Differential Cost (Relevant Cost)
A differential cost is the difference in total cost between two or more alternatives. It is the
extra cost or saving when choosing one option over another.
Differential Cost = Cost of Option A − Cost of Option B
Example:
• Make a product = 100 Tk
• Buy the product = 120 Tk
Difference (20 Tk) = Differential cost
Key idea: Compare costs that change between options.
Types of Differential Cost
1. Incremental Cost
If choosing an option increases total cost, it is called incremental cost.
Example:
• Option A cost = 100 Tk
• Option B cost = 130 Tk
Increase = 30 Tk → Incremental cost
2. Decremental Cost
If choosing an option decreases total cost, it is called decremental cost.
Example:
• Option A cost = 100 Tk
• Option B cost = 80 Tk
Decrease = 20 Tk → Decremental cost
Decision Rule (Very Important)
When making decisions:
• Compare incremental cost with incremental revenue
✔ Accept the change if:
Incremental Revenue > Incremental Cost → Profit increases
✖ Reject the change if:
Incremental Cost > Incremental Revenue → Loss
2. Sunk Cost
Sunk costs are past costs that have already been incurred and cannot be changed or recovered
by any future decision. Key Points
• Already spent
• Cannot be recovered
• Irrelevant for decision making
Example:
• Machine purchased for 50,000 Tk
This cost is already spent and cannot be changed.
Key idea: Ignore sunk costs in decision making.
Shutdown Costs
Shutdown costs are fixed costs that continue even when production is
temporarily stopped.
Key Points
• Occur during temporary closure (shutdown)
• Production = 0, but some costs still exist
• Usually fixed in nature
Examples
• Rent of factory
• Insurance
• Depreciation
• Maintenance cost
Example Explained
A factory stops production due to:
• shortage of raw materials
• lack of workers
Even though no goods are produced:
• Rent must be paid
• Machines still depreciate
• Maintenance is needed
These are shut down costs.
Relevant Cost
A relevant cost is a cost that changes because of a decision.
• differs between alternatives, and
• affects decision making (future cost)
Key Points
• It is future cost
• It changes depending on the decision
• It is considered in decision making
Examples
• Direct materials for a new order
• Extra labor cost for overtime
• Additional shipping cost
Irrelevant Cost
An irrelevant cost is a cost that does not change because of a decision.
• does not differ between alternatives, or
• does not affect the decision
Key Points
• It may be past cost (sunk cost) or unchanged future cost
• It remains same in all options
• It is ignored in decision making
Examples
• Sunk cost (already spent money)
• Fixed salary that does not change
• Depreciation (if same in all options)
3. Opportunity Cost
An opportunity cost is the benefit forgone by choosing one alternative over another.
Example:
• Use a shop for business → profit = 20,000 Tk
• Rent it out → income = 15,000 Tk
Lost rent (15,000 Tk) = Opportunity cost
Key idea: Value of the next best alternative given up.