Let's consider the cost classification I have listed first, direct versus indirect costs. Direct costs are costs that can be traced easily to an individual cost object. Indirect costs are those that cannot be traced easily to an individual cost object. For example, let's consider a company that makes T-shirts. Costs that can easily be traced to a T-shirt include the fabric used to make the T-shirt. We'll call that direct material. And the wages, salaries, and benefits of the worker that converts the fabric into a T-shirt. We'll call that direct labor. In addition, if sales representatives get paid a commission based on the number of T-shirts sold, then sales commission would be a cost that is easy to trace to an individual T-shirt. All of these costs that can be easily traced to a T-shirt are direct costs. We can trace them directly to the cost object. What other costs are associated with T-shirts? Well, they include things like electricity cost for lighting and running equipment to make the T-shirts. Cost of the equipment itself, wages that are paid for the maintenance staff, rent for the workshop, and things like that. But these costs are hard to trace to any one T-shirt, so they're considered indirect costs. Another example, if sales representatives are paid a fixed salary, then that salary would be considered an indirect cost, because, unlike the sales commission for each T-shirt sold, the sales rep's salary cannot be traced to any one T-shirt. Now, it's important for me to mention that another term used for indirect cost is overhead. You may hear me use the terms indirect cost and overhead interchangeably throughout the course. Determining whether cost is direct or indirect, is important. If a manager needs to know the total cost of a particular cost object like a T-shirt, he'll need to find a way to associate indirect costs with that cost object. And remember, those costs are not easily traceable to a cost object. Let's move to the second classification, product versus period costs. Product costs are costs associated with making a product. In a manufacturing company, they're also called manufacturing costs. They include direct material, direct labor, and manufacturing overhead or the indirect costs related to the manufacturing process. Period costs are costs not associated with making a product. They're also called non-manufacturing costs. For our T-shirt maker, product costs include fabric or the direct material, the direct labor and those indirect costs associated with manufacturing the T-shirts, such as the rent for the workshop, the electricity, the wages of the maintenance staff in the workshop. And period costs include salaries paid to sales representatives, sales commissions and general office and administrative costs. Determining whether cost of product or period cost is important because that determination has implications for an organization's financial statements. Product or manufacturing costs sit on the balance sheet as inventory. As those products are being made. They're removed from inventory and recorded as cost of goods sold expense on the income statement When the products are sold. Then period costs, on the other hand, are recorded as expenses on the income statement when they are incurred. Now what about merchandising and service firms? Merchandising companies purchase inventory to resell. A retailer is an example. And as such, the cost of the inventory purchased is treated like a product cost. In that once it's purchased, it sits on the balance sheet in inventory until it is sold. At which time it moves to the income statement as cost of goods sold expense. And other costs are treated like period costs. And recorded as expenses on the income statement as incurred. Service companies generally don't make products, and they don't purchase inventory for resell in general, so they don't have product cost and inventory. Their costs are typically treated like period cost, and all of those are expensed on the income statement as they're incurred. Okay, what about that third classifications gain variable in fixed costs? This is a way of classifying costs based on how they behave in response to changes in activity levels such as the number of T-shirts made. A variable cost changes in proportion to changes in activity levels, a fixed cost does not, it remains constant. An example of variable cost for the T-shirt maker would be the fabric from which the T-shirts are made, or the sales commission paid for each unit sold. An example of a fixed cost would be the salary paid to the sales representative. We'll learn a lot more about cost behavior shortly. Note that we can take any of the cost incurred by the T-shirt maker and classify them using each of these three classification schemes. Just a few examples, take the fabric, for example. It would be classified as a direct cost, a product or manufacturing cost, and a variable cost. Take the sales reps salary as another example. It would be classified as an indirect cost, a period cost, or non-manufacturing cost, and a fixed cost. And as a third example, if the sales rep is paid a commission for each T-shirt sold, that cost is a direct cost because it'seasily traced to the individual T-shirt. It's a period cost because it's not associated with manufacturing the T-shirt, and a variable cost because it increases proportionately with increases in the number of T-shirts sold. As we will see throughout the course, the classification scheme we use will depend on the management decision we're tasked with making. Remember, different costs for different purposes!
