Difficulty: Introductory | Prerequisites: None, though a basic understanding of financial statements helps.
Big Picture
This is the foundation of management accounting. Before you can do anything useful in this course, from budgeting to pricing to performance evaluation, you need to know how costs are named, sorted and reported. Chapter 1 sets up the vocabulary: which costs attach to products, which ones hit the income statement immediately, and how the same data can be arranged in two completely different income statement formats. If you are coming in cold, start here. Everything that follows in the course builds on these classifications.
TL;DR
Costs are classified by their traceability (direct vs indirect), their function (manufacturing vs non-manufacturing), their behaviour (variable vs fixed), and their timing on the income statement (product vs period). The same set of numbers produces two different income statements, traditional and contribution format, depending on whether you organise costs by function or by behaviour.
Direct cost
A cost that can be easily and conveniently traced to a specific cost object (a product, department or activity). In simple terms, if you can point at a product and say "that cost belongs to that unit," it is direct.
Indirect cost
A cost that cannot be easily traced to a single cost object and must be allocated using some reasonable method. Think of it as a shared cost: factory rent benefits every product on the line, so you cannot pin it to just one.
Direct materials
Raw materials that become an integral part of the finished product and can be conveniently traced to it. In simple terms, these are the physical ingredients you can see in the finished good.
Direct labour
Labour costs of workers who physically touch or transform the product during manufacturing. Think of it as the wages you pay the people whose hands are on the product.
Manufacturing overhead (MOH)
All manufacturing costs that are not direct materials or direct labour. Includes indirect materials, indirect labour, factory utilities, depreciation on factory equipment, and similar items. In simple terms, it is every factory cost that is not a raw material or a production worker's wage.
Selling costs
Costs incurred to obtain customer orders and deliver the finished product. Examples: advertising, sales commissions, shipping costs. Think of it as anything spent to find a buyer and get the product to them.
Administrative costs
Costs associated with the general management of the organisation rather than with manufacturing or selling. Examples: executive salaries, accounting department costs, legal fees. In simple terms, the cost of running the office, not the factory floor.
Product cost (inventoriable cost)
A cost that is treated as an asset (inventory) on the balance sheet until the product is sold, at which point it becomes cost of goods sold on the income statement. In manufacturing: direct materials + direct labour + manufacturing overhead. Think of it as a cost that "travels with" the product until it leaves the warehouse.
Period cost
A cost that is expensed on the income statement in the period it is incurred, regardless of when the related product is sold. Selling and administrative costs are period costs. In simple terms, it hits the income statement straight away, no waiting for a sale.
Variable cost
A cost that changes in total in direct proportion to changes in activity level, but remains constant per unit. Think of it as a cost that goes up whenever you make or sell more.
Fixed cost
A cost that remains constant in total regardless of changes in activity level within the relevant range, but changes per unit as volume changes. In simple terms, you pay it whether you make one unit or ten thousand.
Sunk cost
A cost that has already been incurred and cannot be recovered, regardless of any future decision. Think of it as money already spent: it is gone and should not influence what you do next.
Differential cost (relevant cost)
A cost that differs between two alternatives. Only differential costs matter when choosing between options. In simple terms, if the cost stays the same no matter which option you pick, ignore it for that decision.
Opportunity cost
The potential benefit that is given up when one alternative is selected over another. Think of it as the value of the door you did not walk through.
Contribution margin
Sales revenue minus all variable expenses. It represents the amount available to cover fixed expenses and then contribute to profit. In simple terms, it is what is left from each sale after covering the costs that vary with volume.
Gross margin (gross profit)
Sales revenue minus cost of goods sold. It measures the markup over manufacturing cost, regardless of cost behaviour. Think of it as the manufacturing profit before any selling or admin costs are subtracted.
The distinction depends entirely on the cost object you choose. A cost is direct if it can be traced to the cost object easily and economically. The same cost can be direct to one cost object and indirect to another.
Factory floor worker's wages: direct to the product they assemble, but indirect to a particular unit if multiple products share the same worker.
Factory rent: indirect to any single product, but direct to the factory as a whole.
The test is traceability, not size. A small cost that is easy to trace is still direct.
Every cost in a manufacturing firm falls into one of these buckets:
Direct materials: raw inputs physically incorporated into the product.
Example: steel in a car body, flour in a bakery.
Direct labour : wages of workers who convert materials into finished goods.
Example: assembly-line workers, machine operators who shape the product.
Manufacturing overhead (MOH) : all other factory costs.
Indirect materials (glue, nails, lubricants).
Indirect labour (factory supervisor, maintenance crew).
Factory utilities, depreciation on factory equipment, factory insurance.
Non-manufacturing costs sit outside the factory:
Selling costs : advertising, sales commissions, delivery/freight-out, sales salaries.
Administrative costs : executive pay, legal, accounting, office rent.
This classification determines when a cost reaches the income statement.
Product costs (direct materials + direct labour + MOH) are inventoried. They sit on the balance sheet as work-in-progress or finished goods until the unit sells. Then they become cost of goods sold.
Period costs (selling + administrative) are expensed in the period incurred, regardless of sales activity.
Quick rule: if the cost is incurred inside the factory to make the product, it is a product cost. If it is incurred outside the factory or after the product is complete, it is a period cost.
Variable costs change in total with activity but stay constant per unit. Example: if direct materials cost $7 per unit, making 20,000 units costs $140,000 in materials.
Fixed costs stay constant in total within the relevant range but fall per unit as volume rises. Example: a $50,000 per year advertising contract does not change if you sell 10,000 or 20,000 units.
Mixed costs contain both a fixed and a variable component. Example: a utility bill with a base charge plus a per-kilowatt rate.
Sunk costs : already incurred, irreversible. Never relevant to a future decision. Example: the purchase price of equipment you already own.
Differential (relevant) costs : costs that differ between alternatives. These are the only costs that matter when making a choice.
Opportunity costs : the benefit forgone by not choosing the next-best alternative. Not recorded in the accounting system but critical in decision-making.
The same data, two arrangements. The difference is how costs are grouped.
Organises costs by function: manufacturing costs go into COGS, non-manufacturing costs go into SG&A.
Sales
Less: Cost of Goods Sold (direct materials + direct labour + MOH, adjusted for inventory changes)
= Gross margin
Less: Selling and Administrative expenses
= Net operating income
Worked example from E1-6:
Sales: 20,000 units x $30 = $600,000
COGS: $24,000 + $180,000 - $44,000 = $160,000
Gross margin: $440,000
SG&A: $40,000 + $30,000 + $80,000 + $40,000 = $190,000
Net operating income: $250,000
Organises costs by behaviour: variable costs are separated from fixed costs, regardless of function.
Sales
Less: All variable expenses (manufacturing and non-manufacturing)
= Contribution margin
Less: All fixed expenses (manufacturing and non-manufacturing)
= Net operating income
Worked example from E1-6:
Sales: $600,000
Variable expenses: $80,000 + $40,000 + $180,000 + $24,000 - $44,000 = $280,000
Contribution margin: $320,000
Fixed expenses: $40,000 + $30,000 = $70,000
Net operating income: $250,000
The traditional format is required for external reporting (GAAP). The contribution format is used internally because it makes cost-volume-profit analysis possible: you can immediately see how much each additional unit sold contributes toward covering fixed costs.
Total manufacturing cost = Direct materials + Direct labour + Manufacturing overhead
Cost of goods sold = Beginning finished goods inventory + Cost of goods manufactured - Ending finished goods inventory
Gross margin = Sales - Cost of goods sold
Net operating income (traditional) = Gross margin - SG&A expenses
Contribution margin = Sales - Total variable expenses
Net operating income (contribution) = Contribution margin - Total fixed expenses
Contribution margin per unit = Selling price per unit - Variable cost per unit
Total variable cost = Variable cost per unit x Number of units
Total cost = Total variable cost + Total fixed cost
These classifications are not just exam material. A product manager deciding whether to drop a product line needs to separate fixed from variable costs, because fixed costs often remain even after the product is gone. A startup founder setting prices needs to know the contribution margin per unit to work out how many sales are required to break even. The contribution format income statement is the backbone of every break-even and target-profit calculation you will meet in later chapters.
Students often think "direct" and "variable" mean the same thing. They do not. Direct materials are variable, but a direct cost can also be fixed (a factory manager's salary is direct to the factory but fixed in behaviour).
Students assume all manufacturing overhead is fixed. It is not. Some overhead items (indirect materials, factory utilities tied to machine hours) vary with production volume.
Students confuse gross margin with contribution margin. Gross margin subtracts all manufacturing costs (variable and fixed) from sales. Contribution margin subtracts only variable costs (manufacturing and non-manufacturing) from sales. They answer different questions.
Students sometimes include sunk costs in decision analysis. Sunk costs are irrelevant to any future decision, regardless of their size. The money is already spent.
⚠️ Expect classification questions: given a list of costs, identify each as direct/indirect, product/period, or variable/fixed. These are high-frequency, low-difficulty marks.
⚠️ Be able to prepare both a traditional and a contribution format income statement from the same data set. Know which costs land where in each format.
⚠️ Know the difference between sunk, differential and opportunity costs. Decision-analysis questions will test whether you include only relevant costs.
⚠️ Whether a cost is direct or indirect depends on the cost object chosen. The same cost can switch classification if the cost object changes.
True or false: A sunk cost should be included when deciding between two alternatives.
False. Sunk costs are irrelevant to future decisions.
Fill in the blank: Sales minus all variable expenses equals the ________.
Contribution margin.
True or false: Manufacturing overhead is always an indirect cost.
True (relative to individual units of product).
Fill in the blank: Costs that are expensed in the period incurred, not inventoried, are called ________ costs.
Period costs.
True or false: The traditional and contribution format income statements will always produce the same net operating income.
True, provided the same data is used. They rearrange costs, they do not change the total.
Q: A company pays $80,000 per year in sales commissions that vary with units sold, and $30,000 per year in fixed factory supervisor salaries. Classify each cost by function (manufacturing vs selling) and by behaviour (variable vs fixed).
A: Sales commissions: selling cost, variable. Factory supervisor salary: manufacturing overhead, fixed.
Q: A firm had $24,000 in beginning finished goods inventory, $180,000 in cost of goods manufactured and $44,000 in ending finished goods inventory. What is cost of goods sold?
A: $24,000 + $180,000 - $44,000 = $160,000.
Q: Using the contribution format, a company has $600,000 in sales, $280,000 in total variable expenses and $70,000 in total fixed expenses. What is the contribution margin and net operating income?
A: Contribution margin = $600,000 - $280,000 = $320,000. Net operating income = $320,000 - $70,000 = $250,000.
Q: You bought a machine for $50,000 last year. It has no resale value. You are deciding whether to continue using it or replace it. Is the $50,000 purchase price relevant to this decision?
A: No. The $50,000 is a sunk cost. It has already been spent and cannot be recovered, so it is irrelevant.
Q: A cost is $7 per unit at all production levels. Is it variable or fixed? What happens to the total cost if production doubles from 10,000 to 20,000 units?
A: Variable. Total cost doubles from $70,000 to $140,000, while the per-unit cost stays at $7.
This connects to Chapter 2 (job-order costing) because the cost classifications here, particularly the three manufacturing cost categories and the concept of manufacturing overhead, are the inputs to a job-order costing system. You cannot allocate overhead to a job if you do not first know which costs count as overhead.
The contribution format income statement introduced here is the foundation for cost-volume-profit (CVP) analysis, which you will meet later in the course. CVP starts from the contribution margin line.
The distinction between relevant and irrelevant costs (sunk, differential, opportunity) reappears in every decision-analysis chapter: special orders, make-or-buy, keep-or-drop.
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