Key Takeaways
- Variable costs change proportionally with activity levels; fixed costs remain constant within a relevant range.
- Direct costs are traceable to a specific cost object; indirect costs must be allocated using cost drivers.
- Product costs (DM, DL, MOH) attach to inventory; period costs (SG&A) expense immediately.
- Mixed costs contain both fixed and variable components and require separation for analysis.
- Understanding cost behavior is foundational for budgeting, pricing, and decision-making.
Cost Concepts and Classifications
Quick Answer: Costs are classified by behavior (variable, fixed, mixed), traceability (direct, indirect), and function (product, period). Variable costs change with activity; fixed costs remain constant. Direct costs trace to cost objects; indirect costs require allocation. Product costs attach to inventory; period costs expense when incurred.
Understanding cost classifications is fundamental to management accounting. Every budgeting decision, pricing strategy, and performance analysis depends on correctly identifying and categorizing costs.
Cost Behavior Classifications
Variable Costs
Variable costs change in total proportionally with changes in activity level, but remain constant per unit.
| Activity Level | Total Variable Cost | Cost Per Unit |
|---|---|---|
| 1,000 units | $10,000 | $10 |
| 2,000 units | $20,000 | $10 |
| 3,000 units | $30,000 | $10 |
Examples of Variable Costs:
- Direct materials (raw materials used in production)
- Direct labor (production wages)
- Sales commissions (percentage of sales)
- Shipping costs (based on units shipped)
Formula:
Total Variable Cost = Variable Cost per Unit × Number of Units
Fixed Costs
Fixed costs remain constant in total within a relevant range, regardless of activity level, but vary per unit.
| Activity Level | Total Fixed Cost | Cost Per Unit |
|---|---|---|
| 1,000 units | $50,000 | $50.00 |
| 2,000 units | $50,000 | $25.00 |
| 5,000 units | $50,000 | $10.00 |
Examples of Fixed Costs:
- Rent and lease payments
- Depreciation (straight-line method)
- Insurance premiums
- Salaried employees
- Property taxes
Important: Fixed costs are only "fixed" within a relevant range. If production doubles, you may need additional factory space, increasing fixed costs in a step pattern.
Mixed Costs (Semi-Variable)
Mixed costs contain both fixed and variable components. They must be separated for analysis.
Formula:
Total Mixed Cost = Fixed Component + (Variable Rate × Activity Level)
Y = a + bX
Where:
- Y = Total cost
- a = Fixed cost component
- b = Variable cost per unit
- X = Activity level
Example: A utility bill might have a $500 fixed monthly charge plus $0.05 per kilowatt-hour used.
Methods to Separate Mixed Costs
| Method | Description | Accuracy |
|---|---|---|
| High-Low Method | Uses highest and lowest activity points | Low |
| Scatter Diagram | Visual plot of costs vs. activity | Moderate |
| Regression Analysis | Statistical least-squares method | High |
High-Low Method Example:
| Month | Units Produced | Total Cost |
|---|---|---|
| January (Low) | 1,000 | $15,000 |
| June (High) | 3,000 | $25,000 |
Step 1: Calculate variable cost per unit:
Variable Cost = (\$25,000 - \$15,000) ÷ (3,000 - 1,000) = \$10,000 ÷ 2,000 = \$5 per unit
Step 2: Calculate fixed cost:
Fixed Cost = Total Cost - Variable Cost
Fixed Cost = \$25,000 - (\$5 × 3,000) = \$25,000 - \$15,000 = \$10,000
Cost Function: Total Cost = $10,000 + $5X
Direct vs. Indirect Costs
Direct Costs
Direct costs can be easily and economically traced to a specific cost object (product, department, project).
| Cost Type | Examples |
|---|---|
| Direct Materials | Wood for furniture, flour for bread |
| Direct Labor | Assembly line workers, machine operators |
Indirect Costs (Overhead)
Indirect costs cannot be easily traced to a specific cost object and must be allocated using cost drivers.
| Cost Type | Examples |
|---|---|
| Indirect Materials | Glue, lubricants, cleaning supplies |
| Indirect Labor | Supervisors, janitors, security |
| Other Overhead | Factory rent, utilities, depreciation |
Key Concept: The same cost can be direct or indirect depending on the cost object. Factory rent is indirect to products but direct to the factory as a whole.
Product Costs vs. Period Costs
Product Costs (Inventoriable Costs)
Product costs attach to inventory and are expensed as Cost of Goods Sold when products are sold.
| Component | Description |
|---|---|
| Direct Materials (DM) | Raw materials that become part of the product |
| Direct Labor (DL) | Wages for workers directly making the product |
| Manufacturing Overhead (MOH) | All other factory costs (indirect) |
Formula:
Product Cost = DM + DL + MOH
Period Costs
Period costs are expensed immediately in the period incurred—they do not attach to inventory.
| Type | Examples |
|---|---|
| Selling Expenses | Advertising, sales commissions, shipping |
| Administrative Expenses | Office salaries, executive compensation |
| General Expenses | Legal fees, accounting fees |
Product vs. Period Cost Comparison
| Characteristic | Product Costs | Period Costs |
|---|---|---|
| Treatment | Capitalize to inventory | Expense immediately |
| Financial Statement | Balance Sheet (until sold) | Income Statement |
| Examples | DM, DL, MOH | SG&A expenses |
| Timing | Matched to revenue | Expensed in period incurred |
Other Cost Classifications
Prime Costs vs. Conversion Costs
| Classification | Formula | Components |
|---|---|---|
| Prime Costs | DM + DL | Direct costs of production |
| Conversion Costs | DL + MOH | Costs to convert materials to finished goods |
Controllable vs. Non-Controllable Costs
- Controllable costs: Can be influenced by a manager at their level
- Non-controllable costs: Cannot be influenced by the manager at their level
Relevant Range
The relevant range is the span of activity within which cost behavior assumptions hold true. Outside this range:
- Fixed costs may increase in steps
- Variable cost per unit may change
- New cost structures may apply
A company pays its sales staff a base salary of $2,000 per month plus 5% commission on all sales. This compensation structure is best classified as:
Using the high-low method, if the highest activity level is 5,000 units with total costs of $40,000 and the lowest activity level is 2,000 units with total costs of $25,000, what is the variable cost per unit?
Which of the following is classified as a period cost?
Prime costs consist of: