Chapter Summary

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 behaviour, assigning costs to cost objects, or decision making-will dictate how the costs will be 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, following the usual accrual practices, 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 cost behaviour-how costs will react to changes in activity-managers commonly classify costs into two categories-variable and fixed. Variable costs, in total, are strictly proportional to activity. Thus, 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. Thus, 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 the 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 of vital importance. Differential cost and revenue are the cost and revenue items 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 cost and opportunity cost should be carefully considered in decisions. Sunk cost is 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. .

All organizations have basic objectives and a set of strategies for achieving those objectives. Both determining objectives and the setting of strategy, termed strategic planning, are key functions for managers and also set the framework for much of what managerial accounting needs to carry out.