Classifications of Costs
Strategic Cost Analysis

Learning Objective
• Differentiate between
• Cost vs. expense
• Manufacturing vs. non-manufacturing costs
• Product costs, period costs and expenses
• Direct and indirect costs
• Fixed and variable costs
• Relevant costs, opportunity costs, sunk costs
• Controllable and non-controllable costs

Cost versus. Expense
• A cost is the sacrifice made to achieve a particular purpose.
• An (accounting) expense is defined as the cost incurred when
an asset is used up or sold for the purpose of generating
revenue.

Cost versus Expense2
Cost
Outlay Cost
Past, present,
or future cash
outflow
Opportunity Costs
Forgone benefit from
the best alternative
course of action
Expense
Cost charged against
revenue in an
accounting period

Costs on the income statement
Auto Manufacturing Co $
Total Sales (400 cars) 8,000,000
Less: Cost of goods sold 6,400,000
Gross profit 1,600,000
Less: Operating Expenses 1,280,000
Operating Income 320,000
Manufacturing expenses
Non-manufacturing expenses

Manufacturing Costs Non-manufacturing
Costs
The Product
Direct
Materials
Direct
Labor
Manufacturing
Overhead (MOH)
Selling
Costs
Administrative
Costs

By timing of expensing
Product Costs
• Costs that are recorded
as an asset in inventory
when incurred and
expensed when sold
Period Costs
• Costs recognized for
financial reporting when
incurred

Product versus Period Costs
The Product
Direct
Materials
Direct
Labor
Manufacturing
Overhead (MOH)
Selling
Costs
Administrative
Costs
Product costs
Period costs
Product costs
Product costs
Period costs

By traceability to cost object
Direct Costs
• Costs that, for a
reasonable cost, can be
directly traced to the
product.
Indirect Costs
• Costs that cannot
reasonably be directly
traced to the product.

Direct versus Indirect Costs
The Product
Direct
Materials
Direct
Labor
Manufacturing
Overhead (MOH)
Selling
Costs
Administrative
Costs
Direct costs
Direct costs
Indirect costs
Mostly
Indirect costs
Mostly
Indirect costs

By Cost Behavior
Fixed Costs
• Costs that are constant in
total and unrelated to the
level of activity.
Variable Costs
• Costs that increase as the
level of activity increases
Activity
# of cars
Cost
X
Y
Activity
# of cars
Cost
X
Y

Fixed versus Variable Costs
The Product
Direct
Materials
Direct
Labor
Manufacturing
Overhead (MOH)
Selling
Costs
Administrative
Costs
Variable costs
Variable costs
Fixed and
Variable costs
Fixed and
Variable costs
Fixed and
Variable costs

Recap
Costs Product/Period Direct/Indirect Fixed/Variable
Manufacturing Direct Material Product Direct Variable
Manufacturing Direct Labor Product
Direct
Variable
Manufacturing
Manufacturing
Overhead
Product Indirect Fixed and Variable
Non-manufacturing
Selling, general,
administration
Period
Direct and Indirect
(Mostly Indirect)
Fixed and Variable
(Largely Fixed)

By use in decision-making
Opportunity Costs
• Benefits forgone by
choosing one alternative
from the opportunity set
rather than the best non-
selected alternative.
• Opportunity costs are
relevant.
Sunk Costs
• Costs which were incurred
in the past and cannot be
changed no matter what
future action is taken. Sunk
costs are totally irrelevant
for decision making. They
might be useful for control
purposes.
• Sunk costs are not relevant

Opportunity Costs and Sunk Costs
Opportunity Costs
Example: The auto
manufacturer is using the plant
space to make batteries. Can it
free up that space and make
more cars and buy batteries
from outside?
Sunk Costs
Example: The auto manufacturing company spent $25,000 on a
machine two years ago. The $25,000 cost is sunk because whether
they use it, keep it idle, trade it, or sell it, they cannot change the
$25,000 cost.

By Controllability
Controllable costs
• are costs affected by the
manager’s decisions
Uncontrollable costs
• are those not affected by
the manager

Controllable and Non-controllable Costs
Controllable Costs
Example: The plant
supervisor may be able
to decide which
supplier to use for steel.
Non-controllable Costs
Example – The plant is damaged due to floods.

Different costs for different purposes
• Alternate cost classifications
• Product costs, period costs and expenses
• by timing of expensing on income statement
• Direct and indirect costs
• by cost object
• Fixed and variable costs
• by cost behavior
• Relevant costs, opportunity costs, sunk costs
• by decision making
• Controllable and non-controllable costs
• by controllability

Takeaway
• Functional classification of costs as manufacturing costs and
selling, general and administration expenses is not sufficient
when it comes to use of costs in decision-making and control
systems.
• Different costs for different purposes is often used to convey the
notion that different characteristics of costs can be important to
understand in a variety of managerial situations.

Managerial accounting is useful for
• Manufacturing
• Merchandising
• Service companies
• Profit
• Non-profit