ACTG 1P11 – MA CHAPTER 2
Four common ways in which costs are classified:
Cost classifications by
A. behaviour of the cost
B. traceability to a department, process or activity
C. relevance in decision making
D. function of the cost in the organization
a) Costs by Behaviour:
o Variable costs – increase or decrease as the level of activity
E.g. Direct labour is a variable cost that varies with the level of
labour hours, which can then be related to the number of units
If activity increases 10%, cost increases 10%
VC per unit remains the same as # of units increase or decrease
o Fixed costs – remain constant as the level of activity
E.g. Building rent is a fixed cost that doesn’t vary with the level of
Fixed cost per unit = total fixed costs ÷ total # of units
• FC per unit will decrease as # of units increases and vice-
o NB: Variable and Fixed distinction only applies over a given range of
activity levels. We call this the “relevant range”
b) Costs by Traceability to Cost Objects
o Direct costs – directly traceable to a cost object (e.g. Direct labour is
labour costs that can be directly traced to cost of each product)
o Indirect costs – cannot be directly traced to a product or are not worth
tracing (e.g. building insurance cannot be directly related to the cost of
each product) o Direct/Indirect is in relation to a cost object, which is anything for which
a measurement of cost is desired c) Costs by relevance
o Relevant costs are future cots that differ among the alternatives
o Sunk costs are irrelevant to the business decision – they cannot be
o Opportunity Costs are benefits given up when you select one
alternative versus another (expressed as a monetary value: e.g. the $
you could earn working v. going to school)
Always relevant to the business decision
d) Costs by Function
o Manufacturing or Product costs – those associated with the production
of goods; those assigned to goods produced.
Direct materials (DM): Materials directly and easily traceable to
the end product.
Direct labour (DL): The hands on labor in the production process.
Manufacturing overhead (MOH): All other manufacturing costs
other than direct materials and direct labor. Includes indirect
materials and indirect labour.
- These costs are inventoried until sold and then expensed through cost of
o Nonmanufacturing or period costs – all other costs, not associated with
the production of goods; assigned to an accounting period, not to a
good being produced.
Selling, general, and administrative costs.
E.g. Management salaries, office supplies, accounting & legal
Expensed as incurred.
- Product costs are treated as assets until they are sold.
- Prime Costs = DM + DL
- Conversion Costs = DL + MOH e) Controllable vs. Uncontrollable costs
o Controllable costs are those the manager can influence, i.e. increase or
o Uncontrollable costs are those the manager cannot influence or change
Types of Companies
a) Service companies do not sell tangible products, but rater services
a. Inventory is not an issue
b) Merchandising companies resell tangible products bought from suppliers
a. Retailers: sell to consumers
b. Wholesalers: sell to retailers
c. Balance sheet item: merchandise inventory
c) Manufacturing companies make and sell their own products
a. Three types of inventory on B/S:
i. Raw materials inventory
ii. Work-in-Process inventory
iii. Finished Goods inventory
Flow of product costs
a) Product costs flow into work in process inventory until the job is completed.
a. Direct materials: traced to products using materials requisition sheets
b. Direct labour: traced to products using time tickets/time sheets
c. Manufacturing overhead: allocated to products using an allocation basis
b) Product costs flow out of work in process inventory into finished goods inventory
when the job is completed.
a. Cost of goods manufactured
c) Product costs flow out of finished goods inventory into cost of goods sold when the
job is sold. Raw Materials Work In Process Finished Goods
Inventory Inventory Inventory Goods Sold
D.M. Cost of
D.L. Goods Cost of
Applied Manufactured Goods Sold
Labor Product costs – Calculation & Presentation.
a) Service Companies: No inventories, so all costs are period costs; charged through
the income statement as incurred
b) Merchandising Companies: Sales less Cost of Goods Sold