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Cost Classification: Predicting Behavior & Decision-Making

Cost Classification: Predicting Behavior & Decision-Making
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Lesson Transcript
Instructor: Deborah Schell

Deborah teaches college Accounting and has a master's degree in Educational Technology.

Companies incur costs to manufacture a product. Classifying these costs and understanding their behavior helps management understand their company's cost structure.

Cost Classification & Behaviors

Mr. Shute owns the Best Doors Company, which manufactures wooden doors. Currently, all of his doors are manufactured in house at his production facility. Mr. Shute plans to start selling a new type of door, but he is unsure whether it would be more profitable for him to manufacture the door or to buy it from one of his suppliers. To make this important decision, Mr. Shute needs to better understand his cost structure.

Costs can be classified as variable, fixed or mixed. Variable costs are those costs that vary with the amount of activity. For example, the amount of wood that Mr. Shute uses to manufacture his doors would vary depending on how many doors he manufactured in a particular month. Similarly, the Best Doors Company would incur more direct labor costs as more doors are produced. Knowing the variable cost per door allows Mr. Shute to estimate the costs he would incur at different volumes of production.

Fixed costs do not change with the amount of activity. An example of a fixed cost for Mr. Shute's business is the monthly rent he pays on his manufacturing facility. The amount he pays would be the same whether he manufactured ten doors or 10,000 doors.

Mixed costs contain elements of both variable and fixed costs. The utilities that Mr. Shute has to pay are one of his mixed costs. The utility bill will be higher if more hydro is used (variable cost), but it always contains a fixed amount for hydro delivery to Mr. Shute's business (fixed cost).

Understanding how costs behave helps management in many ways. For example, Mr. Shute can create a budget to predict costs and calculate profit and compare actual amounts spent to budgeted amounts to determine differences so he can take action to resolve them. Understanding the types of costs he incurs will also help him to determine the proper mix and volume of products to manufacture that will generate the greatest profit for his company. This is known as CVP, or cost-volume-profit analysis. Finally, information on cost behavior will assist Mr. Shute in calculating how many doors he must produce to break even and cover his costs.

Cost Classification & Decision-Making

It is useful to classify costs as direct or indirect when making decisions like whether to make or buy a particular product. Direct costs are those costs that can be directly attributed to the manufacture of a product, department or particular project. Knowing how costs behave is helpful when calculating an overall cost for a particular item or project at an estimated volume. Examples of direct costs for the Best Doors Company would be raw materials, or the cost of the wood used to manufacture the doors and direct labor. Most variable costs are examples of direct costs, and the concept of direct costs does not apply to non-manufacturing activities, like administrative activities.

Indirect costs are those costs that are incurred by a company but cannot be traced to the manufacture of an individual item. For example, the salary paid to a factory supervisor at Best Doors cannot be attributed to one manufactured door, but is a cost of manufacturing many doors. Indirect costs can be fixed or variable and are usually included in the calculation of overhead, where indirect costs are accumulated and allocated to each manufactured item.

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