TYPES OF COSTS

• MANUFACTURING COSTS – these include all costs used in the manufacture of the products.

We have three manufacturing cost elements.

• Direct Materials – cost of materials that can be traced directly to the products.
• Direct Labor – cost of labor paid to factory workers directly involved in the manufacturing process.
• Manufacturing overhead – includes indirect materials (not directly traceable to the finished units), indirect labor (like factory maintenance personnel), and others incurred in the factory (rent of factory building, depreciation of factory equipment, utility bills in the factory, etc.)

• PRODUCT COSTS – costs that are incurred to manufacture your products. It includes Direct Materials, Direct Labor, and Manufacturing Overhead.
• It is classified into two, depending on whether the products are sold or not. When products are sold, the corresponding costs are presented as Cost of Goods Sold. When products are not sold, they are presented as Finished Goods Inventory.

• PERIOD COSTS – costs that do not form part as cost of the products. These include rent of office space, advertising, sales commission, utilities and supplies in the office. Practically includes administrative and selling expenses.

• With regards to losses, normal loss forms part of the product costs while abnormal loss forms part of period costs. (More of this on the topic Process Costing.)

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• NON-MANUFACTURING COSTS – from the term itself, costs that are not attributable to the manufacture of products.
• Examples:
• Research and Development costs
• Marketing or Advertising
• Selling and Distribution costs
• Customer service
• General and administrative costs

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• PRODUCTS COSTS and MANUFACTURING COSTS are technically the same. These are so-called “inventoriable” costs, as they go first into inventory (of finished goods) before being sold.
• PERIOD COSTS and NON-MANUFACTURING COSTS are technically the same. These are expensed outright.

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• DIRECT COSTS – refer to costs that are directly traceable to a cost object.
• Cost Object – examples include products, product line, or a department.

• INDIRECT COSTS – refer to costs that are not directly traceable to a cost object. Examples are repairs and maintenance costs that are applied to various departments and in the production, too.
• Direct costs do include direct materials and direct labor. But that is not how this is defined. Say maintenance costs are direct costs of the maintenance department. (Duh!) Kinda nonsense, if you ask me. But there you go. It’s not necessarily direct costs related to the products, it could be direct costs related to a product line, or a department.

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• RELEVANT COSTS (DIFFERENTIAL COSTS) – future costs that differ under alternative courses of action.
• OPPORTUNITY COSTS – benefit given up when one alternative is chosen over the others.
• SUNK COSTS (HISTORICAL COSTS) – already incurred and cannot be changed. As such, it is usually treated as an irrelevant cost.
• Historical costs are usually called irrelevant costs, too. Given that they are already incurred and the management cannot reverse the expense, it becomes irrelevant to future decision making.

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Two classifications of DIFFERENTIAL COSTS:

• INCREMENTAL COST (aka increment) – an increase in costs from one alternative to another.
• DECREMENTAL COST (aka decrement) – a decrease in costs from one alternative to another.
• The deal here is how you present the information. You have alternatives A and B. A is higher than B. If you present it as A to B, the differential cost is a decrement. If you present it as B to A, the differential cost is an increment. Again, A is higher than B. Or B is lower than A. I hope this didn’t confuse you. You’re good if you are able to follow. :)

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• VARIABLE COSTS – costs that vary directly to the volume of production. When production increases, the total variable costs also increases. The per unit variable cost is a constant amount.
• FIXED COSTS – costs that remain the same regardless of the production volume. The total fixed costs is constant. The per unit amount varies inversely to production. If production increases, the total fixed costs remains the same, but the per unit fixed cost decreases.

• There are two classifications of FIXED COSTS:
• COMMITTED FIXED COSTS – long-term in nature, usually bound by a contact (like leases). As such, it cannot be eliminated easily by the management.
• DISCRETIONARY FIXED COSTS – usually short-term, resulting from annual decisions of the management and can be changed by the management (like advertising, when they want to switch media, or channel).
• MIXED COSTS – costs that include variable and fixed costs. Good example is our Manufacturing overhead. The overhead includes rent (fixed), depreciation (fixed), wages of factory maintenance personnel (fixed), utilities (variable), indirect materials (variable).
• Alright, we concede the point that utilities are sometimes mixed, too, as well as the indirect materials. They have a portion that is fixed, and beyond that is variable.

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• STEP COSTS – when activity changes (level of production), this cost changes by a certain level or step. The change may be an increase or a decrease.
• STEP VARIABLE COSTS – have small differences between levels
• STEP FIXED COSTS – have large differences between levels

Best example of this is utility bills. The rates are different for residential, commercial, or industrial usage. This applies to water and electricity, usually. Rates of rent, also differ. Leases, which depends on the space you occupy. Sometimes, you get a lower rate for additional square feet. Only on the additional. Say the first 100 square feet is rented at P200/ft a month. You add another 100 square feet and they give it to you for P180/ft a month. Things like that.

Too much? Go and have a break before continuing with the next section. :)