Costs Terms, Concepts and Classifications

"Costs Terms, Concepts and Classifications"Manufacturing costs

Manufacturing cost is the sum of costs of all resources consumed in the process of making a product.

The manufacturing cost is classified into three categories:

1) Direct materials: Raw materials that become an integral part of the product and that can be conveniently traced directly to it.

Example: A radio installed in an automobile

2) Direct labor: Those labor costs that can be easily traced to individual units of product.

Example: Wages paid to automobile assembly workers.

3) Manufacturing overhead: Manufacturing costs that cannot be traced directly to specific units produced.

Examples: Indirect labor and indirect materials.

Indirect labor: Wages paid to employees who are not directly involved in production work.

Examples: maintenance workers, janitors and security guards.

Indirect materials: Materials used to support the production process.

Examples: lubricants and cleaning supplies used in the automobile assembly plant.

Non-manufacturing Costs

It includes marketing or selling cost and administrative cost.

Marketing Cost: Costs necessary to get the order and deliver the product.

Administrative Cost: All executive, organizational, and clerical costs.

Product Costs Vs Period Costs

Product costs: Product costs include direct materials, direct labor, and manufacturing overhead.

Period costs: Period costs include all marketing or selling costs and administrative costs.

Comparing Merchandising and Manufacturing Activities


  • Buy finished goods.
  • Sell finished goods.


  • Buy raw materials.
  • Produce and sell finished goods.

Schedule of Cost of Goods Manufactured

  • Calculates the cost of raw material, direct labor and manufacturing overhead used in production.
  • Calculates the manufacturing costs associated with goods that were finished during the period.

Cost Classifications for Predicting Cost Behavior

"Cost Classifications for Predicting Cost Behavior"

Assigning Costs to Cost Objects

Direct costs:

Costs that can be easily and conveniently traced to a unit of product or other cost object.

Examples: direct material and direct labor

Indirect costs:

Costs that cannot be easily and conveniently traced to a unit of product or other cost object.

Example: manufacturing overhead

Cost Classifications for Decision Making

Every decision involves a choice between at least two alternatives.

Only those costs and benefits that differ between alternatives are relevant in a decision. All other costs and benefits can and should be ignored.

Differential Costs and Revenues

Costs and revenues that differ among alternatives.

Example: You have a job paying $1,500 per month in your hometown. You have a job offer in a neighboring city that pays $2,000 per month. The commuting cost to the city is $300 per month.

Differential revenue is: $2,000 – $1,500 = $500

Differential cost is: $300

Opportunity Costs

The potential benefit that is given up when one alternative is selected over another.

Example: If you were not attending college, you could be earning $15,000 per year. Your opportunity cost of attending college for one year is $15,000.

Sunk Costs

Sunk costs have already been incurred and cannot be changed now or in the future. They should be ignored when making decisions.

Example: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost.

Idle Time

The labor costs incurred during idle time are ordinarily treated as manufacturing overhead.


The overtime premiums for all factory workers are usually considered to be part of manufacturing overhead.

Labor Fringe Benefits

Fringe benefits include employer paid costs for insurance programs, retirement plans, supplemental unemployment programs, Social Security, Medicare, workers’ compensation and unemployment taxes.

Some companies include all of these costs in manufacturing overhead.

Other companies treat fringe benefit expenses of direct laborers as additional direct labor costs

Quality of Conformance

When the overwhelming majority of products produced conform to design specifications and are free from defects.

Prevention and Appraisal Costs

Prevention Costs: Support activities whose purpose is to reduce the number of defects.

Example: Quality training, Quality circles, Statistical process, control activities.

Appraisal Costs: Incurred to identify defective products before the products are shipped.

Examples: Testing & inspecting incoming materials, Final product testing, Depreciation of testing equipment.

Internal and External Failure Costs

Internal Failure Costs: Incurred as a result of identifying defects before they are shipped.

Examples: Scrap, Spoilage, Rework.

External Failure Costs: Incurred as a result of defective products being delivered to customers.

Examples: Cost of field servicing & handling complaints, Warranty repairs, Lost sales.

Distribution of Quality Costs

When quality of conformance is low, total quality cost is high and consists mostly of internal and external failure.

Companies can reduce their total quality cost by focusing on prevention and appraisal. The cost savings from reduced defects usually swamps the costs of the additional prevention and appraisal efforts.

Uses of Quality Cost Information

  • Help managers see the financial significance of defects.
  • Help managers identify the relative importance of the quality problems.
  • Help managers see whether their quality costs are poorly distributed.

Limitations of Quality Cost Information

  • Simply measuring quality cost problems does not solve quality problems.
  • Results usually lag behind quality improvement programs.
  • The most important quality cost, lost sales, is often omitted from quality cost reports.

ISO 9000 Standards

ISO 9000 standards have become an international measure of quality. To become ISO 9000 certified, a company must demonstrate:

  • A quality control system is in use, and the system clearly defines an expected level of quality.
  • The system is fully operational and is backed up with detailed documentation of quality control procedures.
  • The intended level of quality is being achieved on a sustained basis.
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