Cost Types and Behaviour

Learning objectives

By the end of this chapter, you should be able to:

• Explain the difference betweenproduction (product)costs andperiod (non-manufacturing)costs, and how the classification affects inventory and reported profit.
• Distinguish between direct and indirect costs, and use these classifications to calculate prime cost and conversion cost.
• Describe how costs respond to changes in activity within a normal operating band (relevant range), including fixed, variable, mixed and step patterns.
• Use the high–low method to split a mixed cost into fixed and variable components, and explain why the estimate may be unreliable.
• Identify which costs matter for short-term decisions, including avoidable, sunk and opportunity costs.
• Select sensible cost drivers for allocating overheads and explain how driver choice can change reported product costs and margins.

Overview & key concepts

In a manufacturing environment, cost information is used for three main purposes:

1. Valuing inventoryfor financial reporting (what is carried forward as an asset and what is recognised as cost of sales).
2. Measuring performance(how costs affect profit for the period).
3. Supporting decisions and budgets(how costs behave and which costs change if a decision is taken).

Two classifications drive inventory valuation and profit timing:

• Production (product) costs: costs incurred to make goods. These are attached to units produced and carried in inventory until the units are sold.
• Period (non-manufacturing) costs: costs of running and selling the business that are not part of making the goods. These are charged to profit in the period incurred.

A second classification supports costing and control:

• Direct costsare traceable to a product or job in a practical, economical way.
• Indirect costssupport production or operations but cannot be traced to one unit/job without using an allocation method.

Finally, understanding cost behaviour (fixed, variable, mixed and step patterns) improves forecasting, break-even analysis and decision-making.

Manufacturing vs period costs

Production (manufacturing/product) costs

Production costs are incurred to manufacture goods. In a typical factory, these are grouped as:

• Direct materials: materials that become a physical part of the finished product.
• Direct labour: labour used to make the product (hands-on production time).
• Manufacturing overhead: all other production-related costs (for example factory rent, factory supervision, production equipment depreciation, indirect materials, factory utilities).

For inventory valuation, these production costs are accumulated and assigned to units produced (often described as an absorption approach for inventory valuation). Unsold units are shown as inventory. When units are sold, the assigned costs are released to profit as cost of sales.

Exam cue: If the cost is needed to produce the unit in the factory (materials, production labour, and factory support costs), it is usually a production cost.

Period (non-manufacturing) costs

Period costs are not included in the cost of making the goods. They are recognised as expenses in the period they are incurred, regardless of how many units are produced. Typical period costs include:

• Selling and distribution costs (sales staff, advertising, delivery, showroom costs).
• Administrative costs (head office salaries, accounting, legal, general office costs).

Exam cue: If the cost relates to selling the product or running the organisation rather than manufacturing it, it is usually a period cost.

Why the distinction matters (profit timing)

If a period cost is mistakenly treated as a production cost, the expense is pushed into inventory and delayed until the goods are sold—so current profit can appear higher when inventory levels rise. The opposite error pulls a production cost into the current period immediately, which reduces current profit. These are often timing differences that unwind when the inventory is eventually sold, unless inventory levels keep changing from period to period.

Direct vs indirect costs

Direct costs

A cost is direct if it can be traced to a specific product, job or batch without using broad assumptions. Examples include:

• Timber used in a furniture item.
• Wages for workers assembling that item.

Indirect costs

Indirect costs support production but are shared across products or jobs. These become part of manufacturing overhead and require allocation. Examples include:

• Factory rent.
• Factory utilities.
• Depreciation of production equipment.
• Salary of the factory manager.

Prime cost and conversion cost

Two useful groupings are:

• Prime cost= Direct materials + Direct labour
• (the most traceable manufacturing inputs)
• Conversion cost= Direct labour + Manufacturing overhead
• (the cost of converting materials into finished goods)

Cost behaviour within the relevant range

Cost behaviour describes how total cost changes as activity changes, assuming operations stay within a normal capacity band (the relevant range). Outside that band, relationships can change (for example, extra shifts, extra space or new equipment may be needed).

Variable costs

• Total variable costrises and falls in proportion to activity.
• Variable cost per unitis usually stable within the relevant range.

Examples: direct materials, piece-rate labour, packaging, and some power usage linked to machine time.

Fixed costs

• Total fixed coststays the same within the relevant range.
• Fixed cost per unitfalls as activity increases (because the same total cost is spread over more units).

Examples: factory rent, straight-line depreciation of factory building, salaried factory supervision (within capacity).

Mixed costs

Mixed costs contain a fixed element plus a variable element. Example: a factory utility bill that includes a standing charge plus usage-based charges.

To plan and budget, mixed costs are often estimated using methods such as high–low, although judgement and better data usually improve accuracy.

Step costs

Step costs stay flat over a band of activity and then “jump” when capacity is increased in blocks.

• Step-fixed: fixed over a band, then rises at a threshold (for example, an extra supervisor required once output exceeds a certain level). This is the most common step pattern tested in exams.
• Step-variable: can increase in chunks, but many “bulk purchase” situations are better explained byprice breaks/discountsthan by true step behaviour in cost.

High–low method

The high–low method estimates the variable rate and fixed element of a mixed cost using two observations:

• the period with thehighestactivity level
• the period with thelowestactivity level

Steps:

1. Compute the change in cost between high and low activity periods.
2. Compute the change in activity between those periods.
3. Variable rate per unit = (Change in cost) ÷ (Change in activity).
4. Fixed cost = Total cost at either point − (Variable rate × Activity at that point).

Exam cue: Use an activity measure that plausibly drives the cost (for example machine hours for machine-related costs). If the activity measure is weakly related to the cost, the estimate will also be weak.

Limitations:

• Uses only two data points and ignores the rest.
• High and low points may be unusual (outliers).
• Assumes a straight-line relationship within the relevant range.

Contribution margin

Contribution margin is a short-term analysis tool used in marginal (contribution) analysis. It separates variable costs from fixed costs.

• Contribution margin= Sales revenue − Variable costs
• Contribution margin ratio= Contribution margin ÷ Sales revenue

Contribution margin indicates how much is available to cover fixed costs and then generate profit.

Important scope note (exam focus): In decision-making questions, variable costs include any costs that change with the decision, which may include variable selling/distribution costs (for example sales commission, delivery per unit, special packaging). If selling/distribution costs do not change with the decision, they are not relevant to contribution for that decision.

Relevant costing for decisions

For many short-term decisions (special orders, make-or-buy, discontinuing a product line), the costs that matter are those that change as a result of the decision.

Relevant costs (incremental focus)

A relevant cost is a future cash flow (or cash-equivalent sacrifice) that differs between options. Common categories include:

• Avoidable costs: costs that will be saved if an option is chosen.
• Opportunity cost: the benefit sacrificed by choosing one option instead of the best alternative.
• Incremental specific costs: extra costs triggered by the decision, such as set-up time, inspection, special materials, packaging, delivery, overtime premiums, or subcontracting.

Irrelevant costs

• Sunk costs: past costs that cannot be changed by any current decision.

Decision checklist (short-term):
Include (i) incremental variable production costs, (ii) any extra specific costs caused by the order (set-ups, inspection, packaging, delivery), and (iii) opportunity cost if capacity is constrained.

Cost drivers and overhead allocation

A cost driver is an activity measure that helps explain why an overhead cost is incurred and provides a basis for assigning overhead to products or jobs.

Examples of drivers include:

• Machine hours (often suitable when production is machine-intensive).
• Labour hours (often suitable when labour time drives support effort).
• Number of setups, inspections or material moves (often suitable in more complex environments).

Why driver choice matters: If the driver does not reflect how resources are consumed, overhead may be assigned in a distorted way, leading to misleading product margins and poor decisions (pricing, product mix, discontinuation decisions).

Core theory and frameworks

1) Product costing and inventory valuation (production costs)

• Production costs are collected and assigned to units produced.
• Unsold units carry production costs as inventory.
• When units are sold, assigned production costs become cost of sales.

This approach links the cost of manufacturing the units to the period in which the related sales revenue is recognised.

2) Period costing (non-production costs)

Selling and administrative costs are expensed because they relate to running the period’s operations rather than making the units. They sit outside the factory boundary: they support selling the product and managing the organisation rather than transforming materials and labour into finished goods. For inventory valuation, costs are attached to inventory only when they are incurred to manufacture the units; selling and administrative costs are recognised against the period’s activity.

3) Behavioural costing (planning and control)

• Variable, fixed, mixed and step patterns support forecasting and break-even analysis.
• Estimating mixed costs (for example using high–low) is useful for quick planning but should be treated as an approximation.

4) Decision costing (relevance)

• Focus on incremental revenues and incremental costs.
• Include opportunity costs where resources are limited.
• Exclude sunk costs and costs that will be unchanged.

Worked example

Narrative scenario

ABC Manufacturing produces custom furniture.

In January, the business incurred the following costs:

• Direct materials issued to production (wood): $50,000
• Assume all materials purchased in January were issued to production in January.
• Wages paid to production workers:$30,000
• Factory rent:$10,000
• Factory utilities:$5,000
• Selling expenses:$8,000
• Administrative expenses:$6,000

Production and sales for January:

• Units produced:500
• Units sold:400at$200each
• Units in closing inventory:100

Inventory is valued using a full production-cost approach (absorption for inventory valuation).

Assumptions for this example:
There is no opening inventory, all manufacturing costs relate to the 500 units produced, and there is no work in progress at month-end.

Required

1. Calculate the total production (manufacturing) cost for January.
2. Determine the cost of sales for January.
3. Calculate the closing inventory value.
4. Compute themanufacturing contributionand manufacturing contribution margin ratio.
5. Identify the relevant costs for a special order decision.

Solution

1) Total production (manufacturing) cost for January

Production costs include direct materials, direct labour and manufacturing overhead. Selling and administrative costs are period costs and are excluded.

• Direct materials (issued):$50,000
• Direct labour:$30,000
• Manufacturing overhead:
  • Factory rent:$10,000
  • Factory utilities:$5,000
  • Total overhead:$15,000

Total production cost
= 50,000 + 30,000 + 15,000
= $95,000

2) Cost of sales for January

First, calculate the production cost per unit:

Production cost per unit
= Total production cost ÷ Units produced
= 95,000 ÷ 500
= $190 per unit

Cost of sales (400 units sold)
= 400 × 190
= $76,000

3) Closing inventory value

Closing inventory (100 units)
= 100 × 190
= $19,000

4) Manufacturing contribution and manufacturing contribution margin ratio

This example computes manufacturing contribution based on variable production costs. In decision-making questions, include any variable selling/distribution costs if they change with the decision (for example delivery per unit or sales commission).

Assumptions for this calculation:

• Factory rent is treated asfixedfor the month.
• Direct materials and direct labour are treated asvariable with units produced.
• Factory utilities are treated asvariable with production(a simplifying assumption for illustration).

Step 1: Sales revenue

Sales revenue
= 400 units × $200
= $80,000

Step 2: Variable production costs per unit

Variable production costs assumed:

• Direct materials: 50,000
• Direct labour: 30,000
• Factory utilities: 5,000
• Total variable production cost =$85,000

Variable production cost per unit
= 85,000 ÷ 500
= $170 per unit

Variable production cost of units sold (400 units)
= 400 × 170
= $68,000

Manufacturing contribution margin

Manufacturing contribution
= Sales revenue − Variable production cost of units sold
= 80,000 − 68,000
= $12,000

Manufacturing contribution margin ratio
= 12,000 ÷ 80,000
= 15%

5) Relevant costs for a special order decision

Special order: 100 units at $150 each.

Relevant costs are the incremental costs caused by the order. If the business has spare capacity and fixed costs will not change, fixed costs (such as factory rent) are not relevant. If capacity is constrained, include any opportunity cost of using scarce resources.

Incremental variable production cost (using the estimate above):

Relevant variable production cost per unit = $170
Relevant cost for 100 units = 100 × 170 = $17,000

Incremental revenue:

Special order revenue
= 100 × 150
= $15,000

Incremental contribution from the special order
= 15,000 − 17,000
= −$2,000

Decision (based on these assumptions): the order reduces contribution by $2,000, so it would normally be rejected unless there are other benefits or the cost assumptions change.

Decision checklist reminder: Add any extra costs triggered by the order (set-ups, inspection, special packaging, delivery) and include opportunity cost if capacity is limited.

Interpretation of the results

January’s production cost was $95,000, giving a unit cost of $190 when all manufacturing costs are absorbed into units produced. Cost of sales for 400 units was $76,000, and the closing inventory (100 units) carried $19,000 of production cost into the next period.

Manufacturing contribution, based on variable production costs, was $12,000 (15% of sales). This highlights that full production costing assigns both variable and fixed manufacturing costs to units, while contribution analysis focuses on how sales cover costs that vary with volume.

For the special order, the incremental revenue did not cover the incremental variable production cost, resulting in a $2,000 shortfall under the stated assumptions.

Common pitfalls and misunderstandings

• Including period costs in inventory:selling and administrative costs are not production costs. Treating them as production costs inflates inventory and can overstate profit when inventory levels rise.
• Excluding manufacturing overhead from unit cost when valuing inventory:production overheads form part of manufacturing cost and must be assigned to units for inventory valuation under a full production-cost approach.
• Mixing total costs with unit-based variable costs in contribution analysis:contribution must compare sales with the variable costs that change with the units sold (and, in decisions, any variable selling/distribution costs that change with the decision).
• Forgetting the relevant range:cost behaviour assumptions typically hold only within normal capacity; step changes can occur when thresholds are reached.
• Misusing high–low:unusual high/low points can distort estimates; treat results as a rough guide.
• Allowing sunk costs to influence decisions:past costs should not drive current choices.
• Ignoring opportunity costs:when a resource is scarce, using it for one option means giving up another benefit.
• Choosing weak cost drivers:if the driver does not reflect resource consumption, overhead allocation can distort product costs and margins.

Summary and further reading

Production (product) costs—direct materials, direct labour and manufacturing overhead—are assigned to units produced and carried in inventory until sale. Period (non-manufacturing) costs—selling and administrative—are expensed in the period incurred. Direct versus indirect classification supports cost assignment and overhead allocation, while cost behaviour (fixed, variable, mixed and step patterns) supports budgeting and planning.

The high–low method provides a quick estimate of mixed costs but can be inaccurate because it uses only two observations and assumes a straight-line relationship. Contribution (marginal) analysis focuses on variable costs and supports break-even and short-term decisions. Relevant costing improves decisions by focusing on incremental costs and benefits and excluding sunk costs.

FAQ

What is the difference between production costs and period costs?

Production costs are incurred to manufacture goods and are attached to units produced. Unsold units carry these costs as inventory; when units are sold, the costs are recognised as cost of sales. Period costs relate to selling the product and running the organisation and are expensed in the period incurred.

How do fixed, variable and mixed costs behave within a normal operating range?

Within a normal capacity band, variable costs change in total with activity, fixed costs remain constant in total, and mixed costs contain both elements. Outside that band, the pattern may change, including step increases when additional resources are needed.

What does the high–low method do, and why can it be unreliable?

High–low estimates a variable rate and a fixed amount for a mixed cost using only the highest and lowest activity observations. It can be unreliable if those points are unusual or if the chosen activity measure does not truly drive the cost.

Why is contribution margin useful?

Contribution margin shows how much revenue is available to cover fixed costs and then generate profit. In decision-making, variable costs should include any costs that change with the decision, including variable selling/distribution costs where relevant.

How do cost drivers affect overhead allocation?

Overheads are assigned using a driver. If the driver reflects how overhead resources are consumed, reported product costs are more meaningful. If the driver is poorly chosen, product margins can be distorted, leading to weak pricing or product mix decisions.

Summary (Recap)

This chapter explained how production (product) costs are accumulated and assigned to units for inventory valuation, while period (non-manufacturing) costs are treated as expenses of the period. It explored direct and indirect costs and how they feed into prime cost and conversion cost. It then covered cost behaviour within a relevant range, introduced the high–low method for estimating mixed costs, and used contribution (marginal) analysis to focus on variable costs. Finally, it applied relevant costing to short-term decisions and showed how overhead allocation depends on selecting appropriate cost drivers.

Glossary

Production (manufacturing/product) costs
Costs incurred to make goods, including direct materials, direct labour and manufacturing overhead. These costs are assigned to units produced and carried in inventory until sale.

Period (non-manufacturing) costs
Costs that relate to selling the product and running the organisation, such as selling, distribution and administration. These are expensed in the period incurred.

Direct costs
Costs that can be traced to a specific product, job or batch without broad assumptions.

Indirect costs
Shared costs that support production or operations and require allocation.

Manufacturing overhead
All production-related costs other than direct materials and direct labour.

Prime cost
Direct materials plus direct labour.

Conversion cost
Direct labour plus manufacturing overhead.

Fixed costs
Costs that remain constant in total within a normal operating band.

Variable costs
Costs that change in total in line with activity, with a relatively stable per-unit amount within the relevant range.

Mixed costs
Costs containing both fixed and variable elements.

Step costs
Costs that remain constant over a band of activity and then increase in blocks when capacity thresholds are crossed.

High–low method
A technique that estimates the variable rate and fixed element of a mixed cost using the highest and lowest activity observations.

Contribution margin
Sales revenue minus variable costs; the amount available to cover fixed costs and then generate profit.

Relevant costs
Future costs (and benefits) that differ between options and therefore influence decisions.

Sunk costs
Past costs that cannot be changed by current decisions.

Opportunity cost
The benefit sacrificed by choosing one option instead of the best alternative.

Cost driver
An activity measure used to assign overhead based on a cause-and-effect link.