COST CONCEPTS

and
CLASSIFICATIONS

Ricardo R. Palo
What is Cost?

The sacrifice made,

usually measured by the How much each individual
resources given up, to product and service costs
achieve a particular to produce and to sell.
purpose.
Why is COST important?

1. Basis of determining selling price: Selling

Price = COST + MARK-UP
2. Used for planning purposes
(e.g. basis of budgets; determine cost of a
proposed project or improvement )
3. Used for control purposes
(e.g. determine which segment/activities
are more costly and, if possible, to reduce
cost)
4. Used as basis for balance sheet and income
statement valuation.
Why do we need to
understand COST?

TO MANAGE IT through:
1. Cost minimization (reduction of cost)
2. Cost benefit (OUTCOME>COST)

COST LEADERSHIP through cost visibility,

reduction, and productivity insights for
both finance and business operations
How do we manage cost?

1. Determine what drives it and how

is it driven; control cost by
managing its driver/s.
2. Understand the nature of cost.
What are Cost Drivers?

Number of projects/patients
treated in a day
A “cost driver” is an
activity or event that
causes costs to be
incurred. Length of
time to conduct/treat
each activity/patient
 Cost Classifications

Purpose of Cost Cost Classification

Classification
Cost per function (per  Product costs (inventoriable)
financial statement)  Direct materials
 Direct labor
 Manufacturing overhead
 Period costs (expensed)
 Marketing or selling costs
 Administrative costs
Income Statement for a
Manufacturer

Good Profit Company

Income Statement
For the Year Ended December 31, 20X7
Sales revenue $ 4,500,000
Less: Cost of goods sold 2,810,000
Gross margin $ 1,690,000
Less: Selling expenses 1,000,000
Administrative expenses 440,000
Operating profit before taxes $ 690,000
 Cost Classifications

Purpose of Cost Cost Classifications

Classification
Assigning costs to output  Product cost (direct materials,
(inventories) or to period direct labor and manufacturing
of incurrence (expense) overhead)
 Period cost (selling, general and
administrative expenses)
Production Costs in the
Service Industry

 A service provider cannot “inventory”

services.
 The costs of providing the service
can be identified and accounted for
just as in a manufacturing
environment.
 Cost Classifications

Purpose of Cost Cost Classifications

Classification
Predicting cost behavior in  Variable cost (proportional to
response to changes in activity)
activity  Fixed cost (constant in total)
VARIABLE COSTS

Variable Cost Behavior

In Total Per Unit

Total variable cost Variable cost per

increases unit is constant.
and decreases in
proportion
to changes in activity.
VARIABLE COSTS

EXAMPLE: A district distributes drugs to clients. Each drug

costs $30. The per unit and total cost of the drug at various
levels of activity (i.e., number of clients served) would be:

Cost per Number of Total Variable

drug clients Cost

$30 1 $    30
30 10 300
30 100 3,000
30 200 6,000
 Examples of Variable Costs

Costs Manufacturing Company Merchandising Company Service Company

VARIABLE Direct materials Merchandise to sell Equipment leasing
Direct labor (hourly) Sales commissions (based on usage)
Indirect labor (hourly) Shelf stockers (hourly) Contractual hires
Operating supplies (hourly)
Small tools Operating supplies
FIXED COSTS

Fixed Cost Behavior

In Total Per Unit

Total fixed cost is not Fixed cost per unit

affected by changes in decreases as the
activity (i.e., total fixed activity level rises and
cost remains constant increases as the
even if activity activity level falls.
changes).
FIXED COSTS
EXAMPLE: Assume again that a district will rent a facility. The
company pays $4,000 per month to rent for the building. The total
and per unit cost of rent at various levels of activity would be:

Rent cost Number of Rent Cost

per Month occupants per occupant

$4,000 1 $4,000
4,000 10 400
4,000 100 40
4,000 200 20
RELEVANT RANGE
Committed and
Discretionary Costs

Committed Discretionary
Long-term, cannot be May be altered in the
reduced in the short short term by current
term. managerial decisions.

Depreciation on Campaign costs

Buildings and
Equipment
 Examples of Fixed Costs

Costs Manufacturing Company Merchandising Company Service Company

FIXED Depreciation, machinery Depreciation, building Depreciation, furniture
and building Insurance premiums and fixtures
Insurance premiums Buyers (salaried) Insurance premiums
Labor (salaried) Supervisory salaries Administrative salaries
Supervisory salaries Property taxes (on Rental of facilities
Property taxes equipment and building) (assuming fixed per
month)
 Cost Classifications

Purpose of Cost Cost Classifications

Classification
Assigning costs to cost objects  Direct cost (can be easily traced)
such as clients, activities,  Indirect cost (cannot be easily
departments, products or traced; must be allocated)
segments
 Cost Classifications

Purpose of Cost Cost Classifications

Classification
Making decisions  Differential cost (differs between
alternatives)
 Sunk cost (past cost not affected
by a decision)
 Opportunity cost (forgone benefit)
 Out-of-pocket cost (actual cash
outlay)
 Cost Classifications

Purpose of Cost Cost Classifications

Classification
Frequency of Cost Usage  Recurrent costs – those that used
up in a year’s time (usually
operating expenses, OPEX)
 Non-recurrent costs – those that
are used longer than one year
(usually those costs classified as
capital expenditures, CAPEX)
 Cost Classifications

Purpose of Cost Cost Classifications

Classification

Value-adding attributes  Value-adding costs

• Nonvalue-adding costs
Value-adding Cost Qualities

Value-adding Costs: Costs incurred in

conducting value-adding activities (e.g.
conducting the actual activity, cost of
inspecting stocks for defects or
expirations).

Objective: Cost-effectiveness
Value-adding Cost Qualities

Non-value-adding Costs: Costs incurred in

conducting non-value-adding activities
(e.g. moving stocks into and out of
storage areas).

Objective: Eliminate these costs

 Cost Classifications

Purpose of Cost Cost Classification

Classification

Cost of quality  Prevention costs

 Appraisal costs
 Internal failure costs
 External failure costs
Quality Costs

Support activities whose

Prevention
purpose is to reduce the
Costs number of defects

Incurred to identify
Appraisal Costs defective products before
the products are shipped
Quality Costs

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

Incurred as a result of
External Failure
defective products being
Costs delivered to customers
Examples of Quality Costs
 Good Profit Company
Quality Cost Report
For Years 1 and 2
Year 2 Year 1
Amount Percent* Amount Percent*
Prevention costs:
Systems development $ 400,000 0.80% $ 270,000 0.54%
Quality training 210,000 0.42% 130,000 0.26%
Supervision of prevention activities 70,000 0.14% 40,000 0.08%
Quality improvement 320,000 0.64% 210,000 0.42%
Total prevention cost 1,000,000 2.00% 650,000 1.30%
Quality cost
Appraisal costs:
Inspection 600,000 1.20% 560,000 1.12% reports provide
Reliability testing 580,000 1.16% 420,000 0.84%
Supervision of testing and inspection 120,000 0.24% 80,000 0.16% an estimate of
Depreciation of test equipment 200,000 0.40% 140,000 0.28%
Total appraisal cost 1,500,000 3.00% 1,200,000 2.40% the financial
Internal failure costs:
Net cost of scrap 900,000 1.80% 750,000 1.50%
consequences
Rework labor and overhead
Downtime due to defects in quality
1,430,000
170,000
2.86%
0.34%
810,000
100,000
1.62%
0.20%
of the
Disposal of defective products
Total internal failure cost
500,000
3,000,000
1.00%
6.00%
340,000
2,000,000
0.68%
4.00%
company’s
External failure costs:
current defect
Warranty repairs
Warranty replacements
400,000
870,000
0.80%
1.74%
900,000
2,300,000
1.80%
4.60%
rate.
Allowances 130,000 0.26% 630,000 1.26%
Cost of field servicing 600,000 1.20% 1,320,000 2.64%
Total external failure cost 2,000,000 4.00% 5,150,000 10.30%
Total quality cost $ 7,500,000 15.00% $ 9,000,000 18.00%

* As a percentage of total sales. In each year sales totaled $50,000,000.

Thank You