Chapter 20

Notes to teachers
1 2 3 4

Cost Classifications, Concepts and Terminology

Teachers should follow the sequence of chapters in the textbook. You will find each chapter is built upon an understanding of the previous chapter. Start with the Learn More section on p. 7, reviewing the features of financial accounting and introducing the features of management accounting. The examples in Fig. 20.1 and Fig. 20.2 give students a more concrete picture of the functions of cost accounting. There are many fundamental cost concepts in this chapter, such as cost objects, cost units, direct costs, indirect costs, fixed costs, variable costs, product costs and period costs. They may sound rather abstract to beginners, so teachers should use as many real-life examples as possible in their explanations. When classifying costs into direct and indirect costs, it is essential to define the cost object clearly. This is usually a particular product, even though it can be other things such as a process or a department. Likewise, when classifying costs into fixed and variable costs, it is essential to define the activity clearly, which is usually the production volume or sales volume. There is another way of classifying costs into fixed costs, variable costs and mixed costs. (i) When the cost total remains the same with changes in the activity level, that cost tends to be a fixed cost. (ii) When the cost total changes but the cost per unit remains the same with changes in the activity level, that cost tends to be a variable cost. (iii) When both the cost total and cost per unit change with the activity level, that cost tends to be a mixed cost. This method appears in some of the assessment questions. Make sure that students have mastered all the fundamental cost concepts. Such concepts are necessary for an understanding of the subsequent chapters.

5 6 7 8

Q1 Q2

Cost accounting refers to the process of recording, tracking and analysing the costs associated with an object. A cost object is anything which requires a separate measurement of costs. It can be a product, a process, a department or even the whole business. The unit of measurement of the cost object is known as a cost unit, which is usually a physical unit, such as the quantity or weight of a product. 1

Q3 Q4 Q5

A budget is a plan that states an organisations objectives in quantitative terms, such as monetary amounts, for a defined future period. Cost accounting provides costing information for both management and accountants in financial reporting, planning and controlling, and business decision-making. The wages of manufacturing workers are related to particular cost objects, which can be products or production departments. Each manufacturing worker has a labour time card (see p. 34 of Frank Woods Cost Accounting) to record the jobs he has worked on. Therefore, the wages of manufacturing workers can be easily traced to cost objects and are usually classified as a direct manufacturing cost. Carriage inwards on direct materials, royalties (Any one of the above or other reasonable answer) It is an indirect cost. This is because it is related to the manufacturing of a product but it is difficult to trace to a particular cost object. It is a fixed cost. This is because it normally remains unchanged within a certain range of production volume. Fixed cost: Factory rent, factory supervisors salaries Variable cost: Cost of raw materials, wages of manufacturing workers (on an hourly basis or a piece basis) (Any one of the above or other reasonable answer)

Q6 Q7 Q8 Q9

Q10 (a) Average factory rental ($)

0.8 0.4

25,000

50,000

Units of output/month

(b) Average direct material costs ($)

0.4

Units of output/month

Diagram in (a) shows a downward sloping straight line, which illustrates the inverse relationship between average fixed costs and output level. This diagram is different from that shown in Fig. 20.8, which illustrates that total fixed costs are unaffected by the level of output. Diagram in (b) shows a horizontal line, which illustrates that average variable costs are unaffected by the level of output. This is different from that shown in Fig. 20.10, which illustrates that total variable costs vary with changes in output.

Q11 Manufacturing overheads (also called factory overheads or production overheads) are the costs that are
associated with the manufacturing of a particular product but which cannot be easily traced to it.

Non-manufacturing overheads are the costs that are not associated with manufacturing but which are necessary for the operation of a manufacturing business. They can be classified by function into: administrative overheads, selling and distribution overheads, research and development overheads, and finance costs. and loss account only when the goods are sold. If the goods remain unsold at the end of an accounting period, their product costs will be carried forward as inventories. Therefore, product costs are also known as inventoriable costs. Examples: Direct materials, direct labour, manufacturing overheads (Any one of the above or other reasonable answer) Period costs are the costs that are not associated with the making of a product. They must be written off to the profit and loss account in the period in which they are incurred. Examples: Salespersons commissions, office rent (Any one of the above or other reasonable answer)

Q12 Product costs are the costs that are involved in the making of a product. They are written off to the profit

A1 A2 A3 A4 A5 A6

Cost object: Oil refined Cost unit: Barrels of oil refined (Any other reasonable answer) Cost accounting can provide management with data on the relevant costs of retaining and replacing an existing machine. It can then compare the costs and choose the less costly alternative. Indirect materials usually involve the manufacturing of several products at the same time. It would be technically infeasible or uneconomical to trace their costs to a particular product. Examples are lubricants and coolants for machines. (Any other reasonable answer) Indirect labour usually involves the manufacturing of several products at the same time. It would be technically infeasible or uneconomical to trace its costs to a particular product. Examples are the salaries of factory security guards and janitors. (Any other reasonable answer) Direct costs: Cost of leather, wages of shoe workers Indirect costs: Electricity consumed by machines, salaries of factory supervisors (Any other reasonable answer) Direct costs: Salaries of shoe departments salespersons, cost of shoe display shelves Indirect costs: Salaries of store managers, the department stores utility bills (Any other reasonable answer)

A7 A8 A9

The rental of the shop premises would remain unchanged regardless of the level of sales revenueNote while the salesmens commissions would rise with increases in sales revenue. Note:  The rental would change if the retail shop is charged a base rent plus a percentage of sales revenue. This method is used by many shopping malls in Hong Kong. Activity: Number of students enrolled Fixed costs: Salaries of the principal and teaching staff, fire insurance for the school Variable costs: Cost of paper consumed, printing cost (Any other reasonable answer) No. An indirect cost can be a variable cost, such as factory electricity, which varies with the output produced. By the same logic, a direct cost can be a fixed cost, such as the salaries of manufacturing workers paid on a monthly basis. Direct and fixed: Salaries of manufacturing workers paid on a monthly basis Direct and variable: Cost of raw materials consumed Indirect and fixed: Factory rent Indirect and variable: Cost of indirect materials such as machine lubricants (Any other reasonable answer) costs refer to the costs that vary with changes in the level of activity.

A10

A11 Marginal costs refer to the change in total costs when the level of activity increases by one unit. Variable
In a sense, marginal costs are the same as variable costs because both are concerned with changes in the level of activity and only variable costs should be measured in marginal terms. It is meaningless to measure the marginal costs of fixed costs, which must be zero. Thus, many people would treat the costing approaches of marginal costing and variable costing (to be introduced in Chapter 22) as the same. are produced or a lump sum charge of $100,000 when 10,000 or more units are produced. (Any other reasonable answer) could not be traced to a particular product.

A12 An operating lease for a machine with a charge of $10 per unit of output when fewer than 10,000 units

A13 Agree. Non-manufacturing overheads are not associated with manufacturing and therefore these costs A14 Product costs are written off to the profit and loss accounts only when the goods are sold (i.e., when sales
revenue is recognised). If the goods remain unsold at the end of an accounting period, their product costs will be carried forward as inventories.

Period costs are not associated with the manufacturing of a product. It is difficult to ascertain whether and when revenue will be generated from the amounts spent on these costs. Therefore, they are written off in the period in which they are incurred. (a) Postage (b) Sales tax (c) Laboratory rental (d) Penalty on overdue loans (Any other reasonable answer)

A15

ASSESSMENT

Short Questions
20.1
A cost object is anything which requires a separate measurement of costs. It can be a product, a process, a department or even the whole business. Examples: milk produced by a dairy farmer, audit department of a CPA firm. (Any other reasonable answer)

20.2X
Direct cost: Cost of paper Indirect cost: Salary of the chief editor in charge of a number of magazines (Any other reasonable answer)

20.3
(a) (b) (c) (d) (e) Cost per customer Cost per tonne of coal mined Cost per patient Cost per passenger Cost per employee of the company

20.4X
(a) (b) (c) (d) (e) Cost per toy produced Cost per student Cost per chargeable hour Cost per housing unit completed or cost per site developed Cost per bottle of beer

20.5X
Direct costs are the costs that are related to a particular cost object and can be easily traced to it. Indirect costs are the costs that are related to a particular cost object but cannot be easily traced to it. The classification of a cost as direct or indirect depends on the choice of the cost object. A particular cost can be both a direct cost and an indirect cost. For example, the salary of a supervisor in the assembly department would be considered a direct cost of the assembly department but an indirect cost of one of many products made by the assembly department.

Application Problems
20.6
(a) (b) (c) Direct manufacturing costs: (i), (ii), (v) Manufacturing overheads: (iii), (vii), (viii), (x) Non-manufacturing overheads: (iv), (vi), (ix), (xi), (xii)

20.7X
(i) (ii) (iii) (iv) Direct and variable cost Direct and fixed cost Indirect and variable cost Indirect and fixed cost

20.8
(a)
Royalty ($)

100,000

(b)

0 Royalty ($) 150,000 100,000 50,000

No. of copies sold

(c)

0 Royalty ($) 150,000 100,000 50,000

5,000

10,000

15,000

20,000

No. of copies sold

5,000

10,000

15,000

No. of copies sold

(d)

Royalty ($) 160,000 100,000

5,000

10,000

15,000

No. of copies sold

20.9X
(a) (b) (c) Fixed cost: Salaries of factory supervisors, factory insurance, salaries of clerical staff Variable cost: Direct materials, direct labour Mixed cost: Factory water and electricity, depreciation on factory and machinery, salaries of salesmen

20.10X
(a) (b) (i) Production overheads: (iv) and (vi) (ii) Administrative overheads: (vii), (viii) and (xi) (iii) Selling and distribution overheads: (iii) and (x) (iv) Research and development overheads: (ii) and (v) (v) Finance costs: (xii) Production overheads should be treated as product costs, which are written off to the profit and loss account only when the goods are sold. If the goods remain unsold at the end of an accounting period, their product costs will be carried forward as inventories. In contrast, all non-manufacturing overheads are treated as period costs, which are written off in the period in which they are incurred.

20.11
(a) Variable costs per unit = ($2,200,000 $1,600,000) (200,000 100,000) = $6 Total fixed costs = $1,600,000 (100,000 $6) = $1,000,000 Units produced 100,000 200,000 500,000 800,000 1,000,000 Unit costs $16 $11 $8 $7.25 $7

(b)

Total costs increase but at a decreasing rate with the increase in level of production. Unit costs decrease with the increase in level of production.

20.12
Cost Direct materials Direct labour Factory overheads Total 25,000 units/month $ 125,000 70,000 20,000 215,000

Workings: Variable direct labour cost = ($80,000 $40,000) (30,000 10,000) = $2 per unit Fixed direct labour cost at 30,000 units = $80,000 (30,000 $2) = $20,000 Direct labour at 25,000 units = $20,000 + (25,000 $2) = $70,000

20.13X
(a) Prime cost = $7,600,000 + $800,000 = $8,400,000 Factory overheads = $600,000 + ($80,000 80%) + ($120,000 70%) + $20,000 = $768,000 Non-manufacturing overheads = $140,000 + ($80,000 20%) + ($120,000 30%) + $10,000 + $8,000 = $210,000 (b) Prime cost and factory overheads are treated as product costs and written off in the period in which the goods are sold. If the goods remain unsold at the end of the period, their product costs will be carried forward as inventories. Non-manufacturing overheads are treated as period costs and written off in the period in which they are incurred.

Past Exam Questions

20.14
(a) Production overhead Selling overhead Total cost (2,500 units) $12,000 ($4.8 2,500) $3,500 ($1.4 2,500) Total cost (3,500 units) $13,300 ($3.8 3,500) $3,500 ($1 3,500)

Variable production overhead Change in cost = Change in activity $13,300 $12,000 = 3,500 2,500 = $1.3


(b)

Selling overhead = Fixed cost (as total costs remain unchanged) The unit costs of direct material and direct labour are constant at both activity levels and are therefore variable. Production overhead fixed cost element = Total cost ($12,000) Variable cost (2,500 $1.3) = $8,750 Total fixed cost = $8,750 + $3,500 = $12,250 Unit variable cost = $9.6 + $17 + $1.3 = $27.9 Alternative answer: Let y = Total cost x = Number of units a = Total fixed cost b = Unit variable cost As y = a + bx, we can derive the following two equations: 32.8 2,500 = a + (b 2,500) and 31.4 3,500 = a + (b 3,500) Solving the two equations, we have a = 12,250 and b = 27.9 Direct costs of a cost object are related to and can be easily traced to a given cost object. Indirect costs of a cost object are related to but cannot be easily traced to a given cost object. Prime costs include direct materials and direct labour. Conversion costs are all manufacturing costs other than direct materials. They include direct labour and indirect manufacturing costs.