In this chapter, we have looked at some of the ways in which managers classify costs. How the costs will be used—for preparing external reports, predicting cost behavior, assigning costs to cost objects, or decision making—will dictate how the costs are classified.

For purposes of valuing inventories and determining expenses for the balance sheet and income statement, costs are classified as either product costs or period costs. Product costs are assigned to inventories and are considered assets until the products are sold. At the point of sale, product costs become cost of goods sold on the income statement. In contrast, period costs are taken directly to the income statement as expenses in the period in which they are incurred.

In a merchandising company, product cost is whatever the company paid for its merchandise. For external financial reports in a manufacturing company, product costs consist of all manufacturing costs. In both kinds of companies, selling and administrative costs are considered to be period costs and are expensed as incurred.

For purposes of predicting how costs will react to changes in activity, costs are classified into two categories—variable and fixed. Variable costs, in total, are strictly proportional to activity. The variable cost per unit is constant. Fixed costs, in total, remain at the same level for changes in activity that occur within the relevant range. The average fixed cost per unit decreases as the number of units increases.

For purposes of assigning costs to cost objects such as products or departments, costs are classified as direct or indirect. Direct costs can be conveniently traced to cost objects. Indirect costs cannot be conveniently traced to cost objects.

For purposes of making decisions, the concepts of differential cost and revenue, opportunity cost and sunk cost are vitally important. Differential costs and revenues are the costs and revenues that differ between alternatives. Opportunity cost is the benefit that is forgone when one alternative is selected over another. Sunk cost is a cost that occurred in the past and cannot be altered. Differential costs and opportunity costs should be carefully considered in decisions. Sunk costs are always irrelevant in decisions and should be ignored.

These various cost classifications are different ways of looking at costs. A particular cost, such as the cost of cheese in a taco served at Taco Bell, could be a manufacturing cost, a product cost, a variable cost, a direct cost, and a differential cost—all at the same time. Taco Bell is a manufacturer of fast food. The cost of the cheese in a taco is a manufacturing cost and, as such, it would be a product cost as well. In addition, the cost of cheese is variable with respect to the number of tacos served and it is a direct cost of serving tacos. Finally, the cost of the cheese in a taco is a differential cost of making and serving the taco.

Identify and give examples of each of the three basic manufacturing cost categories.

Distinguish between product costs and period costs and give examples of each.

Prepare an income statement including calculation of the cost of goods sold.

Prepare a schedule of cost of goods manufactured.

Understand the differences between variable costs and fixed costs.

Understand the differences between direct and indirect costs.

Define and give examples of cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs.

(Appendix 2A) Properly account for labor costs associated with idle time, overtime, and fringe benefits.

(Appendix 2B) Identify the four types of quality costs and explain how they interact.

(Appendix 2B) Prepare and interpret a quality cost report.