COST MANAGEMENT

(INTRODUCTION)

Samit Paul
IIM, Calcutta
Learning goals
 Need for Cost Management
 Overview of Cost Management
 Cost Accounting vs Financial Accounting
 Basic Terms: cost, cost object, cost unit, cost driver
 Classification of cost
 Degree of traceability to a cost object i.e. product or job.
 Management function
 Timing of charges against sales revenue
 Cost Behavior in relation to changes in output, activity.
 Relationship with accounting period
 Decision making and planning

 Cost of Goods Manufactured (COGM) and Cost of

Goods Sold (COGS)

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Value Creation
 Yash needs to decide whether to buy a tool from outsider or
make it in‐house.
 Nehal opens a boutique. She needs to know how to price her
products.
 Mr Raheja, the sales manager of Godrej needs to decide
whether they should drop a product line (say sofa‐cum‐bed)
which is reporting losses.
 Niraj needs to decide for Jindal Stainless Ltd whether they
should expand their manufacturing unit to China.
 Swetha Ltd has received a big, new project. It needs to identify
the most efficient division for taking up the project.

Decisions that improves products/services, improves allocation of

resources within a company, reduces and controls costs, supports
strategies adopted

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7 Overview of Cost Management
 Cost Accounting- Cost accumulation for
Inventory valuation and income determination.
 Management Accounting – Emphasis on the
use of cost data for planning, control and
decision making purposes.
 It helps the management in planning and
controlling costs relating to both production and
distribution activities.

 Both cost and management accounting are

interlinked with each other.
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Financial Accounting (FA)
Limitations of FA:
1. FA does not provide detailed cost information
for different departments, process, products,
jobs in the production divisions.
2. FA does not set up a proper system of
controlling materials and supplies.
3. The recording and accounting for wages and
labor is not done for different jobs, processes,
products, and departments.
4. Difficult to know the behavior of different costs
in FA

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 Difference between FA and CA

Accounting

Financial Management
(Focus: Past) (Focus: Future)

Interested parties or
External reporting Internal reporting Interested parties
Users

Planning Management
Income statement Shareholders
Decision making -Top
Balance sheet Investors
Performance -Middle
Cash flow statement Creditors
Evaluation -Lower
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10
Cost Concepts

1. Cost is the amount of expenditure actual (incurred)

or notional (attributable) relating to cost object.
2. When cost is incurred, it can be in the form of
deferred cost (asset) or expired cost (expense).
3. Deferred costs are capitalized costs and known as
assets. Example- plant, equipment, building,
inventory, prepaid rent and insurance.
4. When these deferred cost are used up or give up
their usefulness, they are written off or expensed
and to that extent they become expense.

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Accountants View

Accountants define cost as a resource sacrificed or

foregone to achieve a specified objective. An
actual cost is the cost incurred (historical or past)
as distinguished from a budgeted cost, which is
predicted or forecasted cost (future cost).

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12 Cost Object
 Cost object is anything for which a separate
measurement of cost is desired. Cost object may
be:
1. A product-
2. A process-
3. A service-
4. A department-
5. A program-
6. A project-

Note: cost object chosen should be appropriate to the

purpose for which costs will be collected and analyzed.

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Example: BMW’s Chennai Plant
Makes several types of cars and sports activity vehicles at this plant.
What are the Cost Objects?
Cost Object Illustration
1.Product A BMW X5 sports activity vehicle
2. Service Telephone hotline providing information and
assistance to BMW dealers
3. Project R&D project on enhancing the DVD system in BMW
cars
4. Customer Herb Chamber motors, the BMW dealer that
purchases a broad range of BMW vehicles
5. Activity Setting up machines for production or maintaining
production equipment

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Implications
 Manager wants to know the budgeted and
actual cost.

 How does a cost system determine the costs of

various cost object-

(a) Cost accumulation, followed by (b) Assignment

(Collection of cost data in some organized way
by means of an accounting system)
Example: collection of costs for materials, labor
and supervision
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15 Cost Centre
 It is a specific type of cost object.
 Cost centre is a location, function or items of
equipment in respect of which costs may be
ascertained and related to cost units for control
purposes.
 Example: Cost centre:
 Machine shop
 Works office
 Quality assurance department

Note: Cost centres are smallest segment of activity or area of

responsibility for which costs are gathered.

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16 Example:
 Personal- CEO office
 Process- Finishing
 Service cost centre- accounts, storage and
material handling, maintenance and tool room,
canteen.
 Number of cost centres depends on organization
structure, production process, number of
products and services etc.

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17 Cost Unit
 Cost unit as a unit of quantity of product,
service or time (or a combination of those) in
relation to which costs may be ascertained or
expressed.

 Choice of cost unit depends on the nature of the

product manufactured, methods of production
and trade practices.

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 Example
Sl.No. Industry /product Cost Unit
1 Automobile Numbers
2 Steel Ton
3 Sugar Ton
4 Cement Kg, Bag
5 Chemical Litre, Kg, Ton
6 Brick works 1000 Bricks
7 Cosmetics Grams, jars or tubes
8 Mineral water Cases or 24 bottles
9 Shoes Pairs
10 Timber Cubic ft, tons
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Cost Driver
 Activities that require the use of resources and
thereby cause costs are known as cost driver

 Example: Machine depreciation cost is driven

by machine hours; Purchasing, storage and
material handling cost is driven by raw
material cost

 The limit of cost driver level within which a

specific relationship between costs and the cost
driver is valid, is known as relevant range

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Linear Approximation and Relevant
Range

Total
Cost

3,500 3,600
Units of the Cost Driver
General Cost Classification
Basis for cost classification
1. Degree of traceability to a cost object i.e.
product or job
2. Management function
3. Timing of charges against sales revenue
4. Cost Behavior in relation to changes in output,
activity.
5. Relationship with accounting period
6. Decision making and planning

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22
1. Degree of traceability
Some costs such as costs of materials are
easier to assign to a cost object than others
such as costs of supervision.
a. Direct cost of a cost object: can be traced to
the cost object in an economically feasible
(cost-effective way). Example: cost of steel and
tires.
b. Indirect cost of a cost object: Related to cost
object but tracing is not easy. Example: salaries
of plant administrators.
Note: the cost tracing is the basis.

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23 Direct Material
 Cost of the materials which becomes a major
part of the finished product.
 Raw materials that are integral part of the
finished product and are conveniently and
economically traceable to specific units of
product.

Examples: Crude oil to produce petrol or diesel,

raw cotton in textile, Steel in automobile making.

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24 Direct Material
 Materials specifically purchased for a particular
job, order, process or product.
 Materials passing from one process to another
process
 Primary packing materials, wrapping, and
cardboard boxes.

Note: Import duties, dock charges, transport cost of

materials, storing of material cost, and cost of purchasing
and receiving materials are added to their invoiced price.

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25 Direct Labor
 Labor of those workers who are engaged in the
production process. Can be easily (i.e.
physically and conveniently) traced to individual
units of product.
 Some times called as touch labor.
 Example: labor cost of assembly line workers,
carpenters, bricklayers, and machine operators.

Note: Direct labors are expended directly upon the

materials comprised finished product.

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26 Direct Expenses
 Expenses which can be allocated conveniently to
a unit of cost other than direct material and
direct labor.

 Carriage on materials, royalty paid on the basis

of quantity of goods produced.

 Special necessary expenses can be identified

with cost units and are charged directly to the
product as part of the prime cost. Also called as
chargeable expenses.

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Examples of Direct Expenses
 Cost of hiring special machinery or plant.
 Cost of special moulds, designs and patterns
 Experimental costs and expenditure on model
and pilot schemes
 Fees paid to architects, surveyors and other
consultants
 License fees
 Cost of patents and royalties

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28 Indirect Cost
 Indirect cost: Those costs which cannot be
identifiable with or traced to a single product
because they are common to several products.

Example: Indirect material (lubricants), salary of

factory supervisors (indirect labor), rent.

Note: The term cost allocation is used to describe the

assignment of indirect costs to a particular cost object.

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29 Indirect Material
 Materials which are used for maintenance and
repair of machinery, running of service
department, spare and components, packing
materials.

 They don’t normally form a part of the finished

product.

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30 Indirect Labor
 Wages which can not be allocated to different
jobs or products. Indirect wages are part of
factory expenses.

 Example: wages paid to watch and ward staff,

repair gangs, supervisor, general helpers,
cleaners, employees engaged in maintenance
work.

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Indirect Expenses
 Rent, insurance-fire and liability
 Taxes
 Depreciation
 Maintenance and repair
 Power, light, steam and heat

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32 Implication
 Indirect costs are often referred as Overheads
 Costs may also indirect with respect to
particular company segments or divisions.

“The salary of the plant manager of plant A is a

direct cost of plant A. But if the multiple products
are produced in plant A the managers salary is
indirect to specific products.”

Note: What is a direct cost for one purpose may be an

indirect cost for another purpose.

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Factory Overheads
 Also called as manufacturing
overheads/expenses

 Cost of indirect materials, indirect labor, and

indirect expenses incurred at factory.

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Administrative Overheads
 Office salaries, rent, executive salaries
 Depreciation of equipment, Telephone,
 Travel
 Property taxes
 Auditing expenses
 Stationery, and printing, postage and other
administrative expenses.

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Selling and Distribution Overheads
 Advertising, sales promotion, samples
 Salesmen salaries, travel
 Depreciation of sales equipment
 Rent of sales branches/stores
 Telephone, telegraph, supplies at sales
department
 Stationery, printing, freight and carriage out
 Sales accounting.

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36 Challenges in cost allocation
Example: Lease cost (Plant Rent) at Chennai Plant

1. Managers want to allocate the costs (Rent) to

cost objects.
2. Managers are more confident of the accuracy of
the direct costs of the cost object.

Note: allocation of other indirect cost, i.e. plant

administration to X5 is more difficult.

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 Allocation of plant administration
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costs

1. Number of workers working on each car model

2. Number of cars produced of each model

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38 2. Management function
a. Manufacturing cost: Direct material costs,
Direct manufacturing labor cost, Direct
manufacturing other expenses, Indirect
manufacturing costs.
b. Non-manufacturing cost: Administrative costs,
Marketing, selling and distribution costs.

Note: Indirect manufacturing costs: all mfg costs that are

related to cost object but cannot be traced to the cost
object in an economical feasible way, i.e. plant
maintenance, plant rent, plant insurance, compensation
of plant manager. Also called as mfg overhead or factory
overhead costs.
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By Element and Function

Direct Material Administrative

Overhead
Prime
Direct Labor Cost

Direct Expense Conversion Selling and

Cost Distribution
Overhead
Manufacturing
Indirect Material
Overhead
Indirect Labor

Indirect Expense Non-Manufacturing

Manufacturing
Cost Cost

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Flow of Manufacturing Cost
Opening RM Direct Labor Opening WIP

Closing WIP
RM Purchases Other Direct
Expense
Cost of Goods
Closing RM Manufactured
Manufacturing
Overhead Opening FG
Direct Material
Consumed Closing FG
Manufacturing
Cost
Cost of Goods
Sold (COGS)

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41 Problem : 2-43

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42 Reporting Structure

INCOME STATEMENT
TOPLINE Sales Revenue $ xxx
Less: Cost of goods sold (xxx)

Gross margin xxx

Selling and administrative expenses (xxx)

Income before taxes xxx

Income tax expense (xxx)

BOTTOMLINE Net income XXX

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43 Problem : 2-45

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44 3. Timing of charges against sales revenue

a. Product cost
b. Period cost

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45 Product cost
 Product costs are those costs which are identified
with the product and included in stock valuation.
 Identified as part of inventory on hand.
 All manufacturing costs are product costs.
 In a manufacturing firm these include:
1. Direct material
2. Direct labor
3. Direct expenses
4. Manufacturing overhead
Note: Product cost is a full factory cost.

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46 Implication
 Prior to sale product costs are deferred as
inventories and until the goods are sold , are
shown in the balance sheet as assets. As
finished inventory goods are sold, product costs
are transferred from the inventory accounts to
the cost of goods sold account, thus becoming
part of the period costs at the time revenue is
realized.

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47 Period Cost
 Period costs are those which are not included in
stock valuation and treated as expenses during
the period in which they are incurred. Hence,
non-inventoriable costs.

 In a manufacturing firm these cost include:

Selling and administrative costs. They are
treated as expenses in the same period in which
the costs are incurred.

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48 Implication
 Product costs influence the value of inventory
as such costs by nature should be included in
the cost of product.

 The nature of the firm, to a great extent,

determines which costs should be included in
the product costs:
1. Manufacturing firm:
2. Service firm:
3. Merchandising firms:

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49
Implication
FIRMS
1. Manufacturing DM + DL + DE + Mfg OH = Full factory cost
firm

2. Service firm No such thing is called as product costs. All

expenses are classified as operating expenses
which expire during current accounting period, and
are deducted from revenues to determine the net
income.
3. Merchandising Example: Departmental stores, grocery, drug
firm stores etc. The cost incurred i.e. purchase price
paid by a merchandising firm in buying the
merchandise is the product cost. This product cost
(purchase price) appears on the balance sheet as
an asset (unexpired cost) till a sale is made.

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 Problem 2-40
Number Cost Item Product Cost
or Period Cost
1. Cost of grapes purchased by a winery
2. Depreciation on pizza ovens in a pizza restaurant
3. Cost of plant manager’s salary in a computer production
facility
4. Wages of security personnel in a department store
5. Cost of utilities in a manufacturing facility
6. Wages of aircraft mechanics employed by an airline
7. Wages of drill-press operators in a manufacturing plant
8. Cost of food in a microwavable dinner
9. Cost incurred by a department store chain to transport
merchandise to its stores

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 Solution 2-40
Number Cost Item Product Cost
or Period Cost
1. Cost of grapes purchased by a winery Product
2. Depreciation on pizza ovens in a pizza restaurant Period
3. Cost of plant manager’s salary in a computer production facility Product
4. Wages of security personnel in a department store Period
5. Cost of utilities in a manufacturing facility Product
6. Wages of aircraft mechanics employed by an airline Period
7. Wages of drill-press operators in a manufacturing plant Product
8. Cost of food in a microwavable dinner Product
9. Cost incurred by a department store chain to transport Product
merchandise to its stores

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 4. Cost Behavior in relation to changes
in output, activity
52

 Costing systems record the cost of resources

acquired, such as materials, labor, and equipment,
and track how these resources are used to
produce and sell products or services.
 Consider three basic types of cost behavior
patterns:

a. Fixed cost
b. Variable cost
c. Mixed cost (Semi variable and semi fixed cost)

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53 Fixed cost
 Does not change in total for a given time period
despite change in volume, output or activity.
 Depends mainly on effluxion of time and do not vary
directly with volume or rate of output.
 Examples: rent, property tax, supervising salary,
depreciation on office facilities, advertising,
insurance.
 By nature total fixed cost is constant and are
expressed in terms of time i.e. per day, per month,
per year and not per unit.
Note: when considering fixed costs, always focus on total costs.

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54 Implication
 Management policy decides the nature of the
cost as fixed or variable. Example: if
depreciation on machinery is charged with
reference to total number of hours for which the
machine is expected to function.

 Note: Costs are defined as variable or fixed with

respect to specific activity and for given time
period.

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55 Variable cost (VC)
 VC is one whose total amount changes in
proportion to the activity level. However,
variable cost per unit remain fixed.
 Tends to follow (in the short term) the level of
activity.
 Example: Direct material, direct labor paid on
piece rate basis, set up labor cost, sales
representative’s commission.

Note: When considering how variable costs behave

always focus on total cost.

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 Total Fixed Cost Fixed Cost Per Unit
Costs that remain constant in Costs that vary inversely with
total within the relevant range as activity. As volume increases,
the level of activity driver varies unit cost declines.

Total Variable Cost Variable Cost Per Unit

Costs that vary in total directly
Costs that remain the
and proportionately with same per unit at every
changes in the activity level. level of activity.

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Whether a cost is variable or fixed with respect
to a particular activity depends on the time span.

More costs are variable with longer time spans.

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 Example: BMW
 BMW buys a steering wheel at Rs 600 for each of
its BMW X5 vehicles. The total cost of steering
wheels should be Rs.600 times the number of
vehicles produced.

 BMW incurs a total cost of Rs. 2 crore per year for

supervisors who work exclusively on the X5 line.
These costs are unchanged in total over a
designated range of the number of vehicles
produced during a given time span.

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 Mixed cost (Semi variable and semi
fixed cost)
59

 SVC is the one whose total amount varies with the

change in activity level but not in direct proportion.
 Example: salesmen are entitled for a fixed salary
plus a commission for every rupee sales.
Telephone costs-may have a fixed monthly
payment and a charge per phone-minute used.
 The amount of a fixed cost item remains constant
for a particular range of activity level and for a
specified period, which are known as relevant range
and relevant period respectively.

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Think it
 Annual registration and license costs for a fleet
of planes owned by an Airline company.
Registration and license costs would be
________costs with respect to number of plane
owned. But registration and license costs for a
particular plane is _______ costs with respect
to miles flown by that plane during a year.

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 5. Relationship with accounting
61
period
Two broad classes on the basis of the accounting
period to which they relate:

a. Capital expenditure
b. Revenue expenditure

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62
Capital Cost
 A capital expenditure provides benefit for future
periods and is classified as an asset.
 A revenue expenditure is assumed to benefit the
current period and is classified as an expense
and hence matched with revenue for the current
period.
 A capital expenditure will flow into the cost
stream as an expense when the asset is used up
or written off.

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63
6. Decision making and planning

a. Opportunity cost
b. Differential cost
c. Sunk cost
d. Relevant cost
e. Shutdown cost

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64 a. Opportunity Cost

 The potential benefit that is given up or sacrificed

when one alternative is selected over another.
 It is the income foregone by selecting another
alternative.
 It is the cost of opportunity lost.

 Example: It is assumed that the manufacturer can

sell a semi-finished product to a customer for Rs.
50,000. He decides however, to keep it and finish it.
The opportunity cost is Rs. 50,000.

Note: The general rule is that the opportunity cost should not
exceed the value of the option selected.
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b. Differential cost
 Costs and revenues that differ among
alternatives.
 Example: You have a job paying Rs.55000 per
month in your hometown. You have a job offer
in a neighboring city that pays Rs.70,000 per
month. The commuting cost to the city is
Rs.5000 per month.
Differential revenue is:
70,000 – 55,000 = 15000
Differential cost is:
Rs.5000
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66 c. Sunk Cost
 Sunk costs have already been incurred and
cannot be changed now or in the future. They
should be ignored when making decisions.
 It is a past or committed cost, cost gone
forever.
 Any historical cost is a sunk cost
 Example: You bought an automobile that cost
$10,000 two years ago. The $10,000 cost is
sunk because whether you drive it, park it,
trade it, or sell it, you cannot change the
$10,000 cost.

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67 Implication
1. Suppose that your car which have been
bought for $10,000, could be sold now for
$5,000. What is the sunk cost?
2. If a plant was purchased five years ago for Rs.
500,000. with the expected life of 10 years and
scrap value is nil. Then the WDV is Rs.2,50,000
(straight line method) will have to be written off
no matter what alternative future action is
chosen.
3. Note: sunk cost are not relevant for decision
making. A past cost has no meaning in
decisions to hold, use or sell. Only current and
future values have meaning.

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68 d. Relevant Cost
1. Relevant costs are those future costs which
differ between alternatives.
2. Costs which are affected and changed by a
decision. Irrelevant costs are those costs which
remain the same and not affected by the
decision, whatever alternative is chosen. Hence
irrelevant but not forgotten.
3. Relevant costs are future costs i.e. those costs
which are expected to be incurred in future.
4. Relevant costs are only incremental (additional)
or avoidable costs. Incremental costs refer to
an increase in cost between two alternatives.

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69 Case:
 A business firm purchased a plant for
Rs.1,00,000 and has now a book value of Rs.
10,000. The plant has become obsolete and
cannot be sold in its present condition.
However, the plant can be sold for Rs.15,000 if
some modification is done on it which will cost
Rs. 6000.

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70 Implication
 Rs. 6000 (modification cost) and Rs. 15000
(sales value) both are relevant. Generates
incremental cost, reflect future, and future
revenues. Incremental benefit, Rs.15000-
6000=Rs. 9000.
 Rs. 100,000 has already been incurred and
being a sunk cost is not relevant for decision i.e.
whether modification should be done or not.
Similarly the book value of Rs. 10,000 has to be
written off whatever future action is chosen is
also not relevant.

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71 e. Shutdown Cost
1. Shutdown costs are those costs which have to
be incurred under all situations in case of
stopping manufacture of a product or closing
down a department or division.
2. Shut down costs are always fixed costs. Why?
3. Shut down costs thus refer to minimum fixed
cots which are incurred in the event of closure
of a department, division etc.

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72 Implication
1. Shut down costs are always fixed costs,
because, if the manufacturing of a product is
stopped variable costs will not be incurred.

Example:
a. rent, watchman’s salary, property taxes.
Such fixed costs are unavoidable.
b. Some fixed costs can be avoidable:
Supervisor’s salary, Factory manager salary,
Lighting.

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73 Expenses Excluded from Cost:
 The total cost of a product should include only
those items of expenses which form part of cost
of production and which are charged against
profit. Items of expenses which are appropriation
or apportionment of profit should not form a
part of costs. Example:
 Income tax
 Dividend to shareholders
 Commission to partners and managing agents

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Some facts:
 Costs are expired or unexpired.
 Loss is lost cost i.e. cost which expires without
giving any revenue benefit.
 Cost incurrence and cost recognition are
different from each other. Cost incurrence refers
to the receipt of goods or services at a
bargained price in an exchange. Cost
recognition is the identification of the cost as
expired and showing it as an expenses or loss in
a given years income statement.
 Cost incurrence logically precedes cost
recognition.
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 Costs Sum of
Product Costs  direct materials
Balance Sheet  direct labor and
Materials
 Mftg overhd incurred
Purchases

Direct
Labor

Factory
Overhead Income Statement

Period Costs
Selling and
Administrative

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 Costs Sum of
Product Costs Balance Sheet  direct materials
 direct labor and
Materials Materials
 Mftg overhd incurred
Purchases Inventory

Direct
Labor

Factory
Overhead Income Statement

Period Costs
Selling and
Administrative

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 Costs Sum of
Product Costs Balance Sheet  direct materials
 direct labor and
Materials Materials
 Mftg overhd incurred
Purchases Inventory

Direct
Work in
Labor
Process
Inventory
Factory
Overhead Income Statement

Period Costs
Selling and
Administrative

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 Costs Sum of
Product Costs  direct materials
Balance Sheet
 direct labor and
Materials Materials
 Mftg overhd incurred
Purchases Inventory

Direct Cost of Goods

Labor Work in Manufactured
Process
Factory Inventory
Overhead Income Statement

Finished
Period Costs Goods
Inventory
Selling and
Administrative

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 Costs Sum of
Product Costs Balance Sheet  direct materials
 direct labor and
Materials Materials  Mftg overhd incurred
Purchases Inventory
Product costs flow
through the balance
Direct sheet to the income
Work in
Labor statement
Process
Inventory
Factory
Overhead Income Statement
Finished
Goods Cost of
Period Costs Inventory Goods Sold

Selling and
Administrative

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 Costs
Product Costs Balance Sheet

Materials Materials
Purchases Inventory
Period costs flow
Direct directly to the
Work in income statement
Labor
Process
Inventory
Factory
Overhead Income Statement
Finished
Goods Cost of
Period Costs Inventory Goods Sold

Selling and Selling and

Administrative Administrative

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 TATA NANO
Cost of Goods Manufactured Schedule
For the Year Ended December 31, 2009

Work in process, January 1 Rs 18,400

Direct materials
Raw materials inventory, January 1 Rs 16,700
Raw materials purchases 152,500
Total raw materials available for use 169,200
Less: Raw materials inventory, December 31 22,800
Direct materials used Rs 146,400
Direct labor 175,600
Manufacturing overhead

Put illustration 1-7 here

Indirect labor
Factory repairs
14,300
12,600
Factory utilities 10,100
Factory depreciation 9,440
Factory insurance 8,360
Total manufacturing overhead 54,800
Total manufacturing costs 376,800
Total cost of work in process 395,200
Less: Work in process, December 31 25,200
Cost of goods manufactured Rs 370,000

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