Direct vs Indirect

Cost Classifications: Direct vs. Indirect Costs
Definitions

  • Direct Cost: A cost that can be easily and conveniently traced to a specified cost object (e.g., flour for pizza, assembly line wages).

  • Indirect Cost: A cost that cannot be easily or conveniently traced to a specified cost object (e.g., factory electricity, manager's salary, factory rent).

Key Classification Contexts

  • Vaccines: Direct cost at a medical clinic (core service); Indirect cost (Manufacturing Overhead) at a factory.

  • Delivery Fuel: Selling expense (Period Cost) for a retailer; Direct Cost for a logistics provider (e.g., UPS).

  • Onboarding and Training: Treated as Manufacturing Overhead for factory personnel unless central and minor, in which case materiality permits administrative period cost treatment.

Product Costs vs. Period Costs
Definitions

  • Product Costs (Manufacturing Costs): Comprised of Direct Materials (DM), Direct Labor (DL), and Manufacturing Overhead (MOH). Inventoriable under GAAP until sold, then expensed as Cost of Goods Sold (COGS).

  • Period Costs (Non-manufacturing Costs): Selling, General, and Administrative (SG&A) expenses, expensed in the period incurred.

Perimeter Rules

  • Inside Factory Perimeter: Product Cost (DM, DL, or MOH).

  • Outside Factory Perimeter: Period Cost (SG&A).

Cost Behavior and Estimation
Core Concepts

  • Variable Cost: Constant per unit, but changes in total in direct proportion to volume.

  • Fixed Cost: Constant in total within the relevant range, but changes per unit inversely with volume.

  • Step Cost: Fixed over a narrow range, jumping to a higher level once capacity thresholds are breached.

General Formula

Total Cost=Total Fixed Cost+(Variable Cost Per Unit×Volume)Total Cost=Total Fixed Cost+(Variable Cost Per Unit×Volume)

Income Statement Formats: Traditional vs. Contribution
Traditional Format (External / GAAP)

Organizes costs by function:

Sales Revenue−Cost of Goods Sold=Gross MarginSales Revenue−Cost of Goods Sold=Gross Margin

Gross Margin−Selling and Administrative Expenses=Net Operating IncomeGross Margin−Selling and Administrative Expenses=Net Operating Income

Contribution Format (Internal Management)

Organizes costs by behavior:

Sales Revenue−Total Variable Expenses=Contribution MarginSales Revenue−Total Variable Expenses=Contribution Margin

Contribution Margin−Total Fixed Expenses=Net Operating IncomeContribution Margin−Total Fixed Expenses=Net Operating Income

Decision Making: Differential, Opportunity, and Sunk Costs
Definitions

  • Differential Cost/Revenue: Future cost or revenue that differs between alternatives.

  • Opportunity Cost: Potential benefit foregone when selecting one alternative over another; never an out-of-pocket cash payment.

  • Sunk Cost: A past cost already incurred that cannot be changed by future decisions; must always be ignored in decision analysis.