Chapter 2

Cost 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 categories
1. Direct Materials
2. Direct Labor
3. 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 material
2. Indirect labor
3. Maintenance and repairs on production equipment
4. Heat and light
5. Taxes on property
6. 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 product
2. 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. Pricing
2. Profitability studies
3. 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 managers salary is called
a common cost of producing the various products of the factory.

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