Chapter 2Cost terms, concepts and classification

To start the discussion of cost concepts our initial focus is on manufacturing companies, because they are involved in most of the activities found in other type of organization. Manufacturing companies like Coca-cola, Square Pharmaceuticals, Nestle are involved in acquiring raw materials, producing finished goods, marketing, distributing, billing and almost every other business activities. With slight modification these cost terms also apply to merchandising company.

Manufacturing cost: Manufacturing cost also called product costs or inventorial cost costs. These are costs required to manufacture product or make a product.

We can separate cost into three broad categories1. Direct Materials2. Direct Labor3. Manufacturing Overhead

Direct Materials: Materials that are used in the finished product are called raw materials. Raw materials may include both direct and indirect material. Direct materials are those that have become an integral part of the finished product and whose costs can be convenienty traced to the finished products.

Indirect materials are additional or support materials which cannot be traced directly as a part of the product.

Direct Labor: Direct labor consist of labor costs that can be easily (conveniently and physically) traced to individual units of product. Direct labor is sometimes called touch labor because direct labor workers typically touch the product while it is being made.

Labor cost that cannot be physically traced to particular product is called indirect labor. For example guards, janitors, supervisors etc.

Manufacturing overhead: Manufacturing overhead includes all manufacturing cost except direct materials and direct labor.

It includes 1. Indirect material2. Indirect labor3. Maintenance and repairs on production equipment4. Heat and light5. Taxes on property6. Depreciation and insurance on manufacturing facilities

These are cost associated with operating the factory. It is also called indirect manufacturing cost, factory overhead and factory burden.

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Non manufacturing cost: Non manufacturing cost are often divided into two category 1) Selling cost: All cost necessary to secure customer orders and get finished product or

service to the customers ( such as sales commission, advertising, and depreciation of delivery equipment and finished goods warehouses)

2) Administrative costs: All cost associated with the general management of the company as a hole

Product cost: Product costs include all the costs that are involved in acquiring or making a product. In the case of manufactured goods, these costs consist of direct materials, direct labor, and manufacturing overhead. Product costs are viewed as “attaching” to units of product as the goods are manufactured and they remain attached as the goods go into inventory awaiting sale.

Product costs are not necessarily treated as an expense in the period they are incurred but are treated as expense when the products are sold.

Period cost: Period costs are costs that are not product costs. For example sales commission, rental costs of administrative offices are period costs. They are treated as expense when the products are sold.

Prime cost and conversion cost Prime cost is the sum of direct labor and direct materials costs. Conversion cost is the sum of direct labor and manufacturing overhead cost. Theses are called conversion cost as they are required to convert materials into finished good.

Cost classifications on Financial Statements:The financial statements prepared by a manufacturing company are more complex than the statements prepared by a merchandising company because a manufacturing company must produce its goods as well as market them.

The balance sheet: the balance sheet of a manufacturing company is similar to that of a merchandising company but their inventory account differs. Manufacturing companies have three classes of inventories:

1. Raw materials are the materials that are used to make a product2. Work in process consists of units of product that are only partially complete and will

require further wok before they are ready for sale to customers. 3. Finished goods consist of completed units of product that have not yet been sold to

customers.

The Income Statement: the cost of goods sold is determined as follows in a manufacturing company

Cost of goods sold= Beginning Finished + Cost of Goods Manufactured – Ending Finished Goods Inventory Goods Inventory

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The cost of goods manufactured consists of the manufacturing costs associated with goods that were finished during the period.

In order to determine cost of goods manufactured we need to make schedule of cost of goods manufactured. It contains three elements of product costs that we have discussed earlier.

Cost classification for predicting cost behavior:

Cost behavior refers to how a cost reacts to changes in the level of activity. As the level of activity rises and falls, a particular cost may rise and fall as well--or it may remain constant.

1. Variable cost: Variable cost is the cost that varies, in total, in direct proportion to changes in the level of activity. But the variable cost per unit remains unchanged.

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2. Fixed cost: A fixed cost is a cost that remains constant in total regardless of change in the level of activity.

When we say a cost is fixed, we mean it is fixed within a relevant range (It is the range of activity within which assumption about variable and fixed cost are valid.

Cost classifications for assigning cost to cost objects

Cost are assigned to cost object for variety of purposes

1. Pricing2. Profitability studies3. Controlling spending

A cost object is anything for which cost data are desired. It can be products, customers or any organizational unit. For purposes of assigning costs to cost object, costs are classified as either direct or indirect.

A direct cost is a cost that can be easily traced to them individually. On the other hand indirect cost is a cost that cannot be easily and conveniently traced to a specific cost object.

Another type of cost is common cost. It is a cost that is incurred to support a number of cost objects but cannot be traced to them individually. For example factory manager’s salary is called a common cost of producing the various products of the factory.

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