Cost classifications according to purpose

1. Lesson 2
Cost Classifications
According to Purpose
Module 1
Prepared by:
Prof. Rowena R. De Leon
ENT 106: Pricing & Costing

2. Purposes of Cost Classifications
• Preparing external financial statements
• Predicting cost behaviour in response to changes in activity
• Assigning costs to cost objects such as departments or products
• Making decisions
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3. Cost Classificationfor PreparingExternal
FinancialStatements
Manufacturing / Inventoriable /
Product Costs (B/S)
• Direct Materials (DM)
• Direct Labour (DL)
• Manufacturing Overhead
(MOH)
• Indirect materials
• Indirect labour
• Other manufacturing costs
(e.g., depreciation of
manufacturing plant and
equipment)
Non-manufacturing / Non-
inventoriable / Period Costs (I/S)
• Selling
• Sales personnel
• Advertising
• General and administrative
• Head office (e.g., CEO
compensation, depreciation of
head office equipment)
• R&D
• Non-operating costs
• Interest
• Income taxes
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4. The Product
Manufacturing Costs
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Manufacturing
Overhead
Direct
Materials
Direct
Labour

5. Direct Materials
Raw materials that become an integral part of the product and
that can be conveniently traced directly to it.
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Example: Tires on an automobile

6. Direct Labour
Those labour costs that can be easily traced to individual units of product.
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Example: Wages paid to automobile assembly workers

7. Manufacturing Overhead
Manufacturing costs that cannot be traced directly to specific units
produced.
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Examples: Indirect labour and indirect materials
Wages paid to employees
who are not directly
involved in production
work.
Examples: maintenance
workers, janitors and
security guards.
Materials used to
support the
production process.
Examples: lubricants
and cleaning supplies
used in the automobile
assembly plant.

8. Classifications of Manufacturing
Costs – Prime vs. Conversion Costs
Manufacturing costs are often
classified as follows:
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Direct
Material
Direct
Labour
Manufacturing
Overhead
Prime
Cost
Conversion
Cost

9. Non-manufacturing Costs
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Selling
Costs
Costs necessary to get
the order and deliver the
product.
Administrative
Costs
All executive,
organizational, and
clerical costs.

10. Product costs
• Recognized as an asset until goods sold
• Raw materials inventory
• Work-in-process inventory and
• Finished-goods inventory OR
• Merchandise inventory
• Recognized as an expense when goods are sold: Cost of goods
sold
• Can be referred to as Manufacturing cost or Inventoriable
cost
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11. Period Costs
• Assigned to the period of time in which incurred; Expenses of
that period.
• Profit is overstated if period costs are improperly recorded as
product costs and the goods remain in inventory.
• Can be referred to as Non-manufacturing cost or non-
inventoriable cost
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12. 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.
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13. Cost Classification Exercise
Part 1 – Product vs. Period Costs
You have been given a summer job at a company that
manufactures the i-slab (like an iphone or ipad). As part of your
job you are required to analyze cost information for the company.
The first task is to classify a list of cost items into product and
period costs for the purpose of external financial statements.
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14. The Income Statement
Cost of goods sold for manufacturers differs only slightly from
cost of goods sold for merchandisers.
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Manufacturing Company
Cost of goods sold:
Beg. finished
goods inv. 14,200
$
+ Cost of goods
manufactured 234,150
Goods available
for sale 248,350
$
- Ending
finished goods
inventory (12,100)
= Cost of goods
sold 236,250
$
Merchandising Company
Cost of goods sold:
Beg. merchandise
inventory 14,200
$
+ Purchases 234,150
Goods available
for sale 248,350
$
- Ending
merchandise
inventory (12,100)
= Cost of goods
sold 236,250
$

15. Manufacturing Manufacturing
Raw Materials Overhead Costs
Beginning raw Indirect materials Direct materials
materials inventory
+ Raw materials
purchased
= Raw materials
available for use
in production
– Ending raw materials
inventory
= Raw materials used
in production
As items are removed from raw materials inventory
and placed into the production process, they are
either called direct materials or indirect materials.
Product Cost Flows
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16. Quick Check
16
Beginning raw materials inventory was $32,000.
During the month, $276,000 of raw materials
was purchased. A count at the end of the month
revealed that $28,000 of raw materials was still
present. What is the cost of raw materials used?
A. $276,000
B. $272,000
C. $280,000
D. $2,000

17. Manufacturing Manufacturing
Raw Materials Overhead Costs
Beginning raw Indirect materials Direct materials
materials inventory + Factory Utilities + Direct labour
+ Raw materials + Factory equipment depr + MOH
purchased + Factory Insurance Total manufacturing
= Raw materials + Factory Telephone costs
available for use + Idle time
in production + Factory security
– Ending raw materials + Other MOH
inventory + Other MOH
= Raw materials used + Other MOH
in production Total MOH
Product Cost Flows
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18. Manufacturing Work
Costs In Process
Direct materials Beginning work in
+ Direct labour process inventory
+ Mfg. overhead + Total manufacturing
= Total manufacturing costs
costs = Total work in
process for the
period
Product Cost Flows
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All manufacturing
costs incurred
during the period
are added to the
beginning balance
of work in
process.

19. Manufacturing Work
Costs In Process
Direct materials Beginning work in
+ Direct labour process inventory
+ Mfg. overhead + Total manufacturing
= Total manufacturing costs
costs = Total work in
process for the
period
– Ending work in
process inventory
= Cost of goods
manufactured
Product Cost Flows
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Costs associated with the goods that
are completed during the period are
transferred to finished goods
inventory.

20. Work
In Process Finished Goods
Beginning work in Beginning finished
process inventory goods inventory
+ Manufacturing costs + Cost of goods
for the period manufactured
= Total work in process = Cost of goods
for the period available for sale
– Ending work in - Ending finished
process inventory goods inventory
= Cost of goods Cost of goods
manufactured sold
Product Cost Flows
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21. Schedule of COGM
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Schedule of Cost of Goods Manufactured (COGM)
Beginning raw materials inventory XXXXX
Add: Purchases of raw materials XXXXX
Less: Ending raw materials inventory XXXXX
Raw materials used XXXXX
Less: Indirect materials XXXXX
Direct materials XXXXX
Direct materials XXXXX
Direct labor XXXXX
Manufacturing overhead XXXXX
Total manufacturing costs XXXXX
Beginning work in process inventory XXXXX
Add: Total manufacturing costs XXXXX
Less: Ending work in process inventory XXXXX
Cost of goods manufactured (COGM) XXXXX
COGS in I/S
Beginning
finished goods
inventory XXXXX
Add: COGM XXXXX
Less: Ending
finished goods
inventory XXXXX
Cost of Goods
Sold (COGS) XXXXX

22. Schedule of COGM (Con’t)
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What if we only have data on inventory changes rather than the
beginning and ending inventory?
Increase (Decrease) in inventory = Ending inventory – Beginning inventory.
Taking raw materials as an example:
RM used
= Beginning RM inventory + Purchases of RM – Ending RM inventory
= Purchases of RM – (Ending RM inventory – Beginning RM inventory)
= Purchases of RM – Increase in RM inventory
OR
Purchases of RM + Decrease in RM inventory
We can handle work in process and finished goods inventory in the same way.

23. Schedule of COGM (Con’t)
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Schedule of COGM (Alternative format)
Purchases of raw materials XXXXX
Less (Add): Increase (Decrease) in RM inventory XXXXX
Raw materials used XXXXX
Less: Indirect materials XXXXX
Direct materials XXXXX
Direct materials XXXXX
Direct labor XXXXX
Manufacturing overhead XXXXX
Total manufacturing costs XXXXX
Total manufacturing costs XXXXX
Less (Add): Increase (Decrease) in WIP inventory XXXXX
Cost of goods manufactured (COGM) XXXXX
COGS in I/S
COGM XXXXX
Less (Add):
Increase
(Decrease) in
finished goods
inventory XXXXX
Cost of Goods
Sold (COGS) XXXXX

24. RM
Inventory
Balance Sheet . Income Stmt .
WIP
Inventory
DM
MOH
FG
Inventory
COGM
Assigned
MOH
Cost of
Goods Sold
Cost of
Production
Workers
DL
Prime Costs = DM + DL
Conversion Costs = DL + MOH
Period
Costs
SG&A
Expenses
FlowofProductandPeriodCosts
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Indirect
Material
Indirect
Labour

25. Cost Classification for Assigning
Costs to Cost Objects
• A direct cost is one that is clearly and easily traceable to, and
a monetarily important part of, a specified cost object.
• An indirect cost is one that is not clearly and easily traceable,
or is not a monetarily important part of, a specified cost
object.
• Cannot be assigned directly
• No causal relationship exists
• Must assume a linkage
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26. Cost Classification Exercise
Part 2 – Direct vs. Indirect Costs
The second task is to classify the list of cost items into direct and
indirect costs, for the purpose of assigning costs to cost objects.
The company manufactures multiple products in its factory and
uses product lines as the cost object.
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27. Cost Classification for Predicting
Cost Behaviour
• 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.
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28. Variable Cost
Your total long distance cell phone bill is based on how many minutes
you talk.
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Minutes Talked
Total
Long
Distance
Cell
phone
Bill
Minutes Talked
Long
Distance
Cell
Phone
Bill
Per
Minute

29. Fixed Cost
Your monthly basic telephone bill probably does not change when you
make more local calls.
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Number of Local Calls
Total
Basic
Telephone
Bill
Number of Local Calls
Basic
Telephone
Bill
Per
Local
Call

30. Variable vs. Fixed Cost
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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.

31. Quick Check
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Which of the following costs would be variable with
respect to the number of ice cream 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.

32. Mixed Cost Behaviour
Combination of fixed and variable costs.
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Mixed-Cost Behaviour
$
Units Produced

33. Cost Classification 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.
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34. 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?
• Differential cost is?
• Net differential amount?
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35. Quick Check
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Suppose you are trying to decide whether to drive or
take the coach to Calgary to attend a conference. You
have ample cash to do either, but you don’t want to
waste money needlessly. Is the cost of the coach ticket
relevant in this decision? In other words, should the
cost of the coach ticket affect the decision of whether
you drive or take the coach to Calgary?
A. Yes, the cost of the coach ticket is relevant.
B. No, the cost of the coach ticket is not relevant.

36. Quick Check
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Suppose you are trying to decide whether to drive
or take the coach to Calgary to attend a
conference. 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.

37. 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.
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38. 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.
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