MA Chapter (II)
I. General cost classifications
II. Product costs versus period costs
III. Cost classifications for predicting cost behavior
IV. The analysis of mixed costs
V. Traditional and contribution format income statement
VI. Cost classifications for assigning costs to cost objects
VII. Cost classifications for decision making
I. General Cost Classifications
⮚ There are many types of costs, and these costs are classified differently according to the immediate needs of
management.
⮚ Managers may want cost data to prepare external financial reports, to prepare planning budgets, or to make
decisions.
⮚ Manufacturing costs (three broad categories)
1. Direct materials
2. Direct labor (touch labor)
3. Manufacturing overhead
⮚ Nonmanufacturing costs
1. Selling costs
2. Administrative costs
II. Product Costs Versus Period Costs
➢ Product costs
- For financial accounting purposes, product costs include all costs involved in acquiring or making a product.
- In the case of manufactured goods, these costs consist of direct materials, direct labor, and manufacturing
overhead.
⮚ Period costs
- Period costs are all the costs that are not product costs. All selling and administrative expenses are treated
as period costs.
➢ Prime cost
- Prime cost is the sum of direct materials costs and direct labor cost.
⮚ Conversion cost
- Conversion cost is the sum of direct labor cost and manufacturing overhead cost. (to convert materials into
finished product)
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III. Cost Classifications for Predicting Cost Behavior
➢ Cost behavior refers to how a cost reacts to changes in the level of activity.
➢ As the activity level rises and falls, a particular cost may rise and fall as well – or it may remain constant.
➢ Costs are often categorized as
- Variable,
- Fixed,
- Or mixed.
➢ Variable cost
➢ A variable cost varies, in total, in direct proportion to changes in the level of activity.
➢ Fixed cost
➢ A fixed cost is a cost that remains constant, in total, regardless of changes in the level of activity.
➢ Committed fixed costs
➢ Committed fixed costs represent organizational investments with a multiyear planning horizon that
can’t be significantly reduced even for short periods of time without making fundamental changes.
➢ Discretionary fixed costs
➢ Discretionary fixed costs (often referred to as managerial fixed costs) usually arise from annual
decisions by management to spend on certain fixed cost items.
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⮚ Mixed costs
⮚ A mixed cost contains both variable and fixed cost elements. Mixed costs are also known as semi-
variable costs.
⮚ Y = a + bX
IV. The Analysis of Mixed Costs
Activity Level: Maintenance
Month
Patient-Days Cost incurred ($)
January 5,600 7,900
February 7,100 8,500
March 5,000 7,400
April 6,500 8,200
May 7,300 9,100
June 8,000 9,800
July 6,200 7,800
➢ The high-low method
Maintenance Cost
Patient Days
Incurred
High activity level (June) 8,000 $9,800
Low activity level (March) 5,000 7,400
Change 3,000 $2,400
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑐𝑜𝑠𝑡 $2,400
Variable cost = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 = 3,000 𝑃𝑎𝑡𝑖𝑒𝑛𝑡−𝑑𝑎𝑦𝑠 = $0.80 per patient-day
Fixed cost element = Total cost – Variable cost element
= $9,800 – ($0.80 per patient-day x 8,000 patient-days)
= $3,400
Y = $3,400 + 0.80 X
V. Traditional and Contribution Format Income Statement
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⮚ The contribution format income statement is used as an
- internal planning and
- decision making tool.
⮚ Its emphasis on cost behavior aids cost-volume-profit analysis, management performance appraisals, and
budgeting.
⮚ The contribution approach helps managers organize data pertinent to numerous decisions such as
product-line analysis, pricing, use of scare resources, and make or buy analysis.
VI. Cost Classifications for Assigning Costs to Cost Objects
⮚ Costs are assigned to cost objects for a variety of purposes including pricing, preparing profitability studies, and
controlling spending.
⮚ A cost object is anything for which cost data are desired – including products, customers, jobs, and organizational
subunits.
⮚ Direct cost
- A direct cost is a cost that can be easily and conveniently traced to a specified cost object.
- The concept of direct cost extends beyond just direct materials and direct labor.
⮚ Indirect cost
- An indirect cost is a cost that cannot be easily and conveniently traced to a specified object.
VII. Cost Classifications for Decision Making
⮚ Differential cost and revenue
- A difference in costs between any two alternatives is known as a differential cost.
- A difference in revenues between any two alternatives is known as differential revenue.
⮚ A differential cost is also known as an incremental cost, although technically an incremental cost should refer
only to an increase in cost from one alternative to another: decreases in cost should be referred to as decremental
costs.
⮚ Marginal cost and revenue
- The cost involved in producing one more unit of product is called marginal revenue.
- The revenue that can be obtained from selling one more unit of product is called marginal revenue.
⮚ Opportunity cost
- Opportunity cost is the potential benefit that is given up when one alternative is selected over another.
⮚ Sunk cost
- A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now
or in the future.
- It should be ignored in current decisions.
By Ko Thuya – MBA 24