Classification of Costs
Lecture No. 27
Chapter 8
Contemporary Engineering Economics
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Chapter Opening Story: What Does It Cost
to Make an iPhone?
Apple’s 16GB iPhone 6 is priced
at $649. Do you know the profit
margin for Apple from selling
an iPhone 6?
At Issue: The 16GB iPhone 6
costs Apple about $200 to
build. How does Apple come up
with such an estimate of
various component costs before
pricing their product?
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General Cost Terms in Manufacturing Setting
 Manufacturing Costs
 Direct Raw Materials
 Direct Labor
 Manufacturing Overhead
 Nonmanufacturing Costs
 Overhead
 Marketing
 Administrative Functions
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Factory overhead
Mfg.
Overhead
Indirect Mfg.
costs
Burden
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Components of Manufacturing Cost
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Classifying Costs for the Financial
Statements
• Matching concept: The costs incurred to generate
particular revenue should be recognized as
expenses in the same period that the revenue is
recognized
• Period costs: Those costs that are matched
against revenues on a time period basis
• Product costs: Those costs that are matched
against revenues on a product basis
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Example
• Period costs
• General and administrative
expenses
• Marketing expenses
• Insurance premiums
• Income taxes
• Nonmanufacturing costs
• Product costs
• Direct material costs
• Direct labor costs
• Manufacturing overhead
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How the Period Costs and Product Costs Flow
Through the Financial Statements
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Cost Flows and Classifications of a
Manufacturing Company
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Example 8.1: Classifying Costs for Uptown
Ice Cream Shop
• Given: Breakdown of unit
cost items
• Find: Classify the cost items
to product costs and period
costs.
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Solution
• Breakdown of unit cost items
• Product costs
• Period costs
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Cost Classification for Predicting Cost
Behaviors
Volume index
Cost behaviors
o Fixed costs
o Variable costs
o Mixed costs
Average unit costs
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Volume Index
• Definition: The unit measure
used to define “volume”
• Examples
• Automobile
• Miles driven
• Generating plant
Volume Index
miles kWh parts
• kWh produced
• Stamping machine
• “Parts” stamped
• Assembly plant
• Units assembled
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Fixed Costs
• Definition: The costs
of providing a
company’s basic
operating capacity
• Cost behavior:
Remains constant over
the relevant range
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Variable Costs
• Definition: Costs that
vary depending on
the level of
production or sales
• Cost behavior:
Increases or
decreases
proportionally
according to the level
of volume
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Mixed Costs
Mixed cost behavior
6000
Depreciation Expenses ($)
• Definition: Costs are
fixed for a set level of
production or
consumption, becoming
variable after the level is
exceeded.
• Cost behavior: Increases
or decreases after
maintaining a fixed level
of expense
5000
4000
3000
2000
1000
0
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5
15
25
Miles Driven (Unit: 1,000)
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Average Unit Cost
•Definition: activity cost per unit basis
•Cost behaviors:
• Fixed cost per unit varies with changes in
volume.
• Variable cost per unit of volume is a
constant.
• Mixed cost per unit of volume contains
both the constant and variable elements.
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Example 8.2: Average Driving Cost per Mile
• Given: Owning and
Operating a 4WD SportUtility vehicle
• Find: Average driving
cost per mile as a
function of mileage
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Solution
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Cost-Volume Chart
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Average Cost Per Mile
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Future Costs for Business Decisions
•Differential (incremental) cost
•Opportunity cost
•Sunk cost
•Marginal cost
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Differential (Incremental) Costs
• Definition: Costs that represent the
difference in total costs, which results from
selecting one alternative instead of another
• Cost behavior: Increases or decreases with
the overall change that a company
experiences by producing one additional
unit of goods
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Opportunity Costs
•Definition: The potential benefit that
is given up as you seek an alternative
course of action
•Example: When you decide to pursue
a college degree, your opportunity
cost would include four-years’
potential earnings given up.
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Sunk Costs
• Definition: Cost that has already been
incurred by past actions
• Economic implications: Not relevant to
future decisions
• Example: $500 spent to replace brakes
last year—not relevant to making a sales
decision in the future
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Marginal Costs
• Definition: Added costs that
result from increasing rates
of output, usually by a single
unit
• Example: Cost of
electricity—decreasing
marginal rate
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