Cost Concepts and Terminology

Definitions
1. Cost is an asset. It goes in the balance sheet. It has a future economic benefit. E.g. amount
spent to purchase a car, building, prepaid rent, inventory. Expenses go in the income
statement and are uses of resources e.g. depreciation expense, rent expense, cost of goods
sold.
2. Cost driver – can change the total cost. E.g. cost driver for gas is litres of gas pumped, KwHr
for electricity, hours worked for wages, cubic feet of gas used for heating.
3. Cost object – an item for which you desire cost. E.g. cost of offering a course, running a
department or faculty. A cost object can be a unit of production, a department, a segment, an
entire institution.

Assumptions
1. Production is within the relevant range – the range where the cost behaviour holds true
2. The cost object is one unit of production

Cost has 3 major Classifications

1. Classification by behavior: variable vs. fixed vs. mixed e.g. gas vs. rent
Gas is an example of a variable cost:
Assume gas is $1 per litre
Then what is the unit variable cost if I pump:
7L: $1
8L: $1
That means, that unit variable cost (UVC) is actually fixed since it is $1 irrespective of how
much gas was pumped.
What is the total variable cost if I pump:
7L: $7
8L: $8
Therefore, Total Variable cost (TVC) is indeed variable.
So, variable costs are defined in totality, not per unit.

We said rent is fixed:

So, if the rent for the room is $500, then what is the unit fixed cost (UFC) if:
1 student comes: $500
2 students: $250
4 students: $125
So, unit fixed cost is actually variable since it changed based on number of students that attend.
However, total fixed cost (TFC) is fixed whether 1 student comes or 4 students come. Total
Fixed Cost is $500. So again, fixed costs are defined in totality, not per unit.

UVC in isolation has some meaning or value. If UVC is $1 per litre of gas, then that can tell us
that if we pump 20L, we will owe $20. Alternatively, it tells us that if we have $20, we can
afford to pump 20L of gas.

UFC given in isolation has no meaning. For example, if I say the cost of living in my student
house (not room), is $200 per student fixed, this does not mean that the cost will be $200 for one
student and $400 for 2 students and so on, otherwise it is not a fixed cost but rather a variable
cost. The rate $200 per student fixed is known at the UFC. And, a UFC is useless without a
denominator level or base. If I say, the rent is $200 per student fixed when 5 students live in this
house, then we can say that 5 students is the denominator level or base. And the TFC (Total
Fixed Cost) is $1,000 for the house (which is $200 x 5 students) whether 10 people share 5
rooms or 3 people stay only, or 1 person stays. From the TFC, we can now find the new UFC
depending on how many students actually live in the house. If it is 5 students, it is $1,000 / 5 =
$200 per student. If it is only 2 students, then UFC is $500 per student. The UFC will keep
changing. The TFC will remain constant (fixed) within the relevant range.

So, a UFC is meaningless without a denominator level. As soon as you see a UFC, you must
start looking for a reference point or denominator level.

Another definition is Average Cost. Average Cost is the Unit Mixed Cost or Unit Cost and is:

Total Cost / Total Units = [TFC + TVC] / Total Units = UVC + UFC

Total Mixed Cost = TVC + TFC

Summary:
UFC decreases proportionately as level of activity increases. UFC requires a denominator level
to give it meaning.
TFC is constant as level of activity increases.
UVC is constant as level of activity increases.
TVC increases proportionately as level of activity increases.
Unit Cost (called average cost or unit mixed cost) decreases non-linearly as level of activity
increases.
Total Cost (called total mixed cost) increases non-linearly as level of activity increases.

2. Classifying cost by Traceability: Direct vs. Indirect

Direct: is a cost that is accurately and economically traceable to the cost object.

Indirect cost: cannot be accurately or economically traceable to the cost object. Thus, they need
to be assigned or allocated or charged or applied to the cost object using some cost allocation
base or cost driver.

A cost item is direct or indirect depending on the cost object.

As an example, the cost of electricity bill of McMaster is indirect for the Faculty of Engineering.
But the same electricity bill is direct if we ask “What is the cost of electricity for McMaster”.
Thus, if McMaster is the cost object, then electricity is direct. If Engineering is the cost object,
then electricity is indirect. If we want to find the usage of electricity by Engineering, we need to
allocate the electricity to Engineering using some cost allocation base such as square feet
occupied by the building or number of students or number of class hours or something else.
Some direct costs, such as glue, paint, and nails in a product are direct but are intentionally
classified as indirect because tracing them to the cost object is not economical. This is when the
cost is immaterial in line with the materiality principle. Therefore, glue, paint and nails used in
production can either be direct material or indirect material.

Now, direct costs are traced to the cost object. Whereas indirect costs are allocated, assigned,
applied or charged to the cost object using a cost driver or cost allocation base. E.g. electricity
at McMaster is allocated or assigned to Engineering based on the number of students or class
hours or square feet or number of departments etc.

3. Classifying costs by function: Product Cost or Period Cost:

Product Costs: are costs of production function. They are assets. Since if you spend money on
producing units and do not sell these units, all the costs become “inventory of finished goods”
and sit on the balance sheet as a current asset. Therefore, all production costs are assets in the
balance sheet.

Period costs: are expenses in the income statement. They will go in the income statement as
operating expenses. They are period relevant e.g. selling and admin expenses. Usually period
costs are related to the selling function. E.g. sales commissions, sales salaries, advertising, HR
salaries.

Now if the production function and selling function occur within the same premises, then the
cost must be split using some cost driver between product cost and period cost e.g. splitting of
rent or property taxes.

Example 1
How would you treat the following items?
Rent $500
Sales Supervisor Salaries $300
Production Supervisor Salaries $200

The production supervisor salaries are product costs go in the balance sheet as an asset.
The sales supervisor salaries are period costs and go in the income statement
as an expense.
The rent must be split between product cost and period cost either depending on the square feet
occupied by the production function vs. the selling function or by number of employees in the
production function vs. selling function or the units sold vs units unsold.

MCQ Questions
1. Which one of the following statements is true as the level of activity (number units produced
or level of production) increases?
a. UVC is constant
b. TVC decreases
c. TFC is constant
d. UFC increases
e. Both a and c above
2. When the level of activity is increasing, which one of the following is true:
a. Average cost is increasing
b. Average cost is decreasing linearly
c. Average cost is constant
d. Cannot be determined from the information given
e. Average cost is decreasing but not linearly

Proof for MCQ 2:

A cost of producing a product is $1 per unit in variable cost and $500 in total fixed costs.
# units UVC UFC AVG COST (UVC + UFC)
5 1 100 101
10 1 50 51
15 1 33.33 34.33

Answers for MCQ:

1. E
2. E

Six Cost Categories (remember that cost object is a unit of production)

1. Direct materials (DM): These are materials that end up in the final product. E.g. wood,
glass, iron, plastic.
2. Direct labour (DL): also known as touch labour…the labour that produces the product.
Usually paid per hour or per unit produced. Usually, assembly line workers.
3. Variable Manufacturing Overhead (VMOH): these are indirect costs that are not part of
the final product or cannot be economically traced to it e.g. electricity, utilities, indirect
labour (see overtime and idle time discussion later), indirect material (e.g. glue, paint, nails,
lubrication for machine, cleaning supplies)
4. Fixed Manufacturing Overhead (FMOH): these are fixed and do not vary based on level
of activity e.g. rent, property taxes, insurance, manufacturing or production supervisor
salaries; depreciation on production equipment, etc.
5. Variable Selling and Admin costs (VS&A): e.g. sales commissions, packaging, delivery
6. Fixed Selling and Admin costs (FS&A): e.g. advertising, sales supervisor salaries, and rent
insurance and property taxes for the selling function or their portion.

How do we relate these 6 categories to the 3 classifications of cost? Well, if the cost object is a
unit of production, then, the following is True:
1. Behaviour
a. Variable: DM, DL, VMOH, VS&A
b. Fixed: FS&A, FMOH
2. Traceability
a. Direct: DM, DL
b. Indirect: VMOH, FMOH, VS&A, FS&A
3. Function
a. Product: DM, DL, VMOH, FMOH
b. Period: VS&A, FS&A
Some definitions:
Prime Costs or Direct Costs and made up of:
Prime Cost = DM used + DL

Conversion Costs = DL + VMOH + FMOH = DL + MOH (manufacturing overhead)

Total Manufacturing Costs (TMC) = DM Used + DL + MOH

True/False Questions
All direct costs are always product costs? True since made up of DM and DL which are the only
direct costs but also product costs.

Glue, paint, and nails used in operation could be period costs? False because these items can
either be direct materials if you bother to trace them and therefore product cost or it could be
indirect materials if you do not bother to trace them in which case they would fall under VMOH
which is also a product cost. Therefore, it can never be a period cost. Just as a reminder, period
costs are selling costs.
How do we “Account” for the 3 cost classifications and 6 cost categories? How do we keep track
of costs and their flows within the organization?

We first split the “Accounting” of costs by function.

Under the production function, we have 3 Accounts: Raw Materials (RM) ; Work in Progress or
Work in Process (WIP) and finally Finished Goods (FG). The production function, as a
reminder, is a cost; i.e. it goes in the balance sheet as an asset. Therefore all these 3 accounts are
assets and they have debit balances.

Under the production Function: balance sheet

Account 1: Raw Materials (RM)
Beginning Balance + Purchase of RM – Ending Balance = RM Used
Keep in mind that RM is DM + IM which is direct materials + indirect materials

Account 2: Work in Progress (WIP)

Beginning Balance + DM used + DL + MOH – Ending Balance = Cost of Goods Manufactured
(COGM)
Keep in mind that DM Used comes from the RM. Also, IM used from the RM account is part of
the MOH in the WIP account. MOH stands for Manufacturing Overhead and is the summation of
VMOH and FMOH.

Account 3: Finished Goods (FG)

Beginning Balance + COGM – Ending Balance = Cost of Goods Sold (COGS)
Keep in mind that COGM from WIP comes into FG. Also Beginning Balance of Finished Goods
+ COGM is given the name: Cost of goods available for sale (COGAS).
Under the selling function: income statement
Sales – COGS = Gross Margin (GM)
GM – period expenses = Operating Income (OI)
Keep in mind that COGS from FG came into the income statement under the selling function.

Last complication in the production function:

Direct Labour is touch labour. It is direct because it is traceable to the unit of production.
Sometimes, the direct labour is not traceable to the cost object which is the unit of production.

Example:
1. When direct labour is idle
a. Fault of the company: strike, running out of material, machine maintenance, bottle necks in
previous process, etc. In this case, idle time is indirect labour and is therefore manufacturing
overhead and will need to be allocated to units rather than traced to units.
b. Fault of the client: since it is traceable to the job of the client, this idle time is actually direct
labour.

2. Direct Labour which incurs overtime

a. If overtime is the fault of the client, then the extra premium paid per hour is direct labour
since it can be traced to the client or the job.
b. If overtime is the fault of the company e.g. bad scheduling. In this case, the regular portion
of the rate is direct labour since production is being done, however the premium portion of
the rate is indirect labour or overhead since the extra amount is not due to production but
rather due to poor management and internal controls. That is, this extra portion is not
traceable to production but rather the cause of bad management.

If idle time and overtime exist simultaneously, then idle time should first be blamed for overtime
and therefore charged at the overtime rate. Since, if the workers were not sitting idle and were
working instead, there would be less total hours and therefore less overtime.

Example
Rodney Worsham is paid $20 an hour for straight-time and $40 an hour for overtime. One week
he worked 50 hours, which included 40 hours of regular time and 10 hours of overtime. The 10
hours of overtime include: 4 hours of idle time caused by material shortages; 4 hours of overtime
due to bad scheduling; and 2 hours caused by a special request from a customer who made a late
order. How much is charged as direct labour and indirect labour?

Direct Labour
Regular 40 hours of work = $20 x 40 hrs
Regular wage during bad scheduling = $20 x 4 hrs
Overtime traceable to customer = $40 x 2 hrs

Total = 800 + 80 + 80 = $960

Indirect Labour or Manufacturing Overhead
Idle time causing overtime = $40 x 4 hrs
Overtime premium during bad scheduling = $20 x 4 hrs

Total = 160 + 80 = $240

Summary
Idle time is always indirect labour if due to reasons of the company and direct labour if traceable
to the customer. It is usually fully charged at overtime rate, if overtime exists.

Overtime due to bad scheduling is split into direct labour at regular rate and indirect labour
at difference between regular rate and overtime rate (the overtime premium)

Overtime traceable to customer is direct labour

True or False?
1. Unit Variable Cost will not change when level of activity increases.
2. Unit Cost will decrease non-linearly as level of activity increases.
3. Unit Fixed Cost will decrease as level of activity increases.
4. Total Mixed Cost will increase disproportionately as level of activity increases.
5. When the level of activity doubled, the unit cost did not change. Then, we can say that
this is a variable cost.
6. Glue, paint, and nails used in production are always direct costs?
7. Glue, paint, and nails used in production could be period costs depending on whether
you trace it to cost object or not?
8. Variable indirect manufacturing costs are always product costs.

Answers:
1. True
2. True
3. True
4. True
5. True
6. False
7. False
8. True