CHAPTER -ONE

OVERVIEW OF COST ACCOUNTING

 Accounting-as defined by American Accounting Association(AAA), is the process of identifying, measuring and
communicating economic information to permit informed judgments and decisions by users of the information
 Accounting as a language of business can be viewed as an information system that provides essential information about
economic activities of an entity to various individuals and groups.
 Accounting as information system plays an important role in our economic and social system. The decisions made by
individuals, governments, and other entities determine the use of the nations scarce resources.
 The goal (objective) of accounting is to: identify, record, analyze, report, and interpret (communicate) economic data for use
by decision makers.

Identification of users Investors, Bankers, suppliers,

Governmental agencies,
Labor union, employees, management
User’s
information
nnnnUser’s
Economic data information Reports User’s decisions
Accounting
(Input) needs (Outputs)
System

-Financial reports -Investing

-Special reports -Approving loans
-Tax returns -Assessing taxes
-Regulatory reports -Negotiating labor
-Management reports contracts
-Establishing budgets
- Other decisions
The major purpose of accounting systems include:-
i) Routine internal reporting
ii) Non-routine internal reporting

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 iii) External reporting to users outside the organization.

Management Accounting, Financial Accounting and Cost Accounting

Accounting system

(One part of the organizations Management information system)

-Accumulate data for use in both financial and managerial
accounting.
Cost Accounting system

(One part of the organizations overall accounting system)

-Accumulates cost information i.e. measuring and reporting financial
and non-financial information that relates to the cost of acquiring and
consuming resources by organizations.
-It records and explains cost data, both actual and prospective that is
used by managers for planning and Controlling, as well as costing
products, services, and customers.
-It provides information for both management accounting and financial
accounting i.e. it includes those parts of both management accounting
and financial accounting where cost information is collected and
analyzed.

Financial
Management Accounting
Accounting
Type of report
-Preparation of information -Preparation of published
for decision making, planning, financial statements and
directing, and controlling an organizations’ other financial reports.
operations (management reports)

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-Measures and reports financial
and nonfinancial information that
help managers make decisions to
fulfill the goal of an organization.
-It emphasizes the segment of an
organization.
-Measure and records business
transactions and report financial
information in a statement that
are prepared according to GAAP
-It emphasizes the organization
as a whole.

Users of information
-External users such as
- Internal users of information i.e. stockholders, financial
managers at all levels in the analysts, lenders, labor
organizations. unions, consumer groups,
governmental agencies,gener
al public and others.

Regulation and requirement

-Not required to follow GAAP and -Required and must conform to GAAP
not regulated by FASB, SEC, and and regulated by FASB, SEC, and
other authoritative bodies. Its report others and it is mandatory
is based on usefulness to management.
and it is not mandatory
Source of data

-The source of data is the organizations -The source of data is almost exclusi-
basic accounting system, plus various vely the organizations basic accou-
other sources, such as rate of defective nting system, which accumulates
products manufactured, physical quantities financial information.
material and labor used in production
and others.
Nature of reports and procedures
-Reports often focus on sub-units -Reports focus on the enterprises
within the departments, divisions, in its entirety.

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geographical regions or products lines. -Based exclusively on historical
-Based on a combination of historical transactions data.
data, estimates and projection of
future events.

Characteristic of information
-Futuristic, subjective -Historical, objective
proactive, dynamic passive and static

Although many differences exist between financial and managerial accounting as mentioned above, they are similar at least in the
following ways:

First, both rely on the accounting information system. It would be a total waste of resource to have two different data-collecting
systems existing side by side.
For this reason, managerial accounting makes extensive use of routinely generated financial accounting data, although it expands on
and adds to these data, as discussed earlier
Thus, managerial accounting and financial accounting overlap to the extent that managers use the financial statements in directing
current operations and planning future operations of their businesses

Second, both financial and managerial accounting relies heavily on the concept of responsibility, or stewardship. Financial accounting
is concerned with stewardship over the company as a whole while managerial accounting is concerned with stewardship over its parts,
and this concern extends to the last person in the organization who has any responsibility over cost.

Cost management-The term cost management is widely used in today’s business environments. It describes the activities of managers
in short-run and long-run planning and control of costs. It is important to organizations, because it is more than measuring and
reporting product and service costs. It is a philosophy, an attitude, and a set of techniques to create more value at lower cost.
Philosophy-cost management is a philosophy of improvement, because it promotes the idea of continually finding ways to help
organizations make the right decisions to create more customer value at lower cost. According to this philosophy, to be efficient,
companies should able to provide products and services that customers want by using the minimum of the organization’s scarce
resources, while continually seeking to improve value and costs.
Attitude- cost management represents a proactive attitude that all the costs of products or services result from management decisions.
In other words, costs don’t just happen. Therefore, cost managers do not simply document decisions and record costs. Instead, they are
active partners in management decisions to develop and improve products and services and reduce costs.

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Techniques-cost management is a set of reliable techniques that may be used individually to support a specific decision or together to
support the overall management of the organization. A set of cost-management techniques that function together to support the
organization’s goals and activities are called a cost-management system.

Classification, and analysis of costs and related cost concepts and terminologies
Different cost concepts and terms are often used in accounting reports. Managers who understand these concepts and terms are able to:
(a) Best use the information provided, and
(b) Avoid misuse of that information.
Communication among managers is greatly facilitated by there being common understanding on the meaning of
cost concepts and terms. This chapter discusses cost concepts and terms found in both internal and external uses of
accounting information.

Cost and Cost object

Cost-Accountants define cost as a resource scarified or forgone to achieve a specific objective. It is usually measured as the monetary amount that
must be paid to acquire goods and services. An actual cost is the cost incurred (a historical cost) as distinguished from budgeted or forecasted costs.

Cost Object-is any thing for which a separate measurement of costs is desired. To guide their decisions, managers want to know how much a
particular thing (such as a product, machine, service, or process) costs.
E.g. Product, service, project, customer, brand category, activity department etc
A costing system typically accounts for costs in two basic stages- accumulation and then assignment.
Cost accumulation- is the collection of cost data in some organized way by means of an accounting system.
E.g. organizations that manufacture consumer commodities accumulate the costs incurred in producing the commodities.
Cost assignment- is a general term that encompasses both (1) tracing accumulated costs to a cost object, and (2) allocating accumulated costs to a
cost object.

Eg. -Cost may be assigned to a department to facilitate decisions about departmental efficiency.
-Cost may be assigned to a product or a customer to facilitate product-profitability analysis

Direct costs and Indirect costs

Direct costs of a cost object- are related to the particular cost object and can be traced to it in an economically feasible (cost-effective) way.

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 E.g. -The salary of a manager of production department is a direct cost of that department.
-The cost of office supplies used in the loan department is a direct cost of that department.
The term cost- tracing is, therefore, used to describe the assignment of direct costs to the particular cost object.
Indirect costs of cost objects-are related to the particular cost object but, can not be traced to it in an economically feasible (cost-effective) way.
E.g. - Cost of quality-control personnel who conduct taste and content tests on multiple soft drink products bottled at a Pepsi plant is an
indirect cost of Pepsi soft drink.
-The cost of general advertising by the bank, which is allocated to the loan department.
The term cost allocation is, therefore, used to describe the assignment of indirect costs to the particular cost object.
Cost driver-is a characteristic of an event or activity that causes costs to be incurred by that event or activity
-It is a factor, such as the level of activity or volume, that causally affects costs (over a given time span).That
is, a cause-and –effect relationship exists between a change in the level of activity of volume and a change in the level of the
total costs of that cost object i.e. the higher the correlation between the cost and the cost driver, the more accurate will be the resulting
understanding of cost behavior.
Eg.-The cost driver of variable cost is the level of activity or volume whose change causes the (variable) costs to change proportionately.
-The number of vehicles assembled is a cost driver of the cost of steering wheels.
- In manufacturing companies, the cost of assembly labor would be driven by the quantity of products manufactured
as well as the number of parts in each product.

-The cost of material handling labor would be driven by materials related factors such as the quantity and cost of raw material used,
the number of parts in various products, and the number of raw-material shipments received
Variable costs, fixed costs and mixed cost behaviors
From a planning and control standpoint, perhaps the most useful way to classify costs is by behavior. Cost behavior means how a cost will react or
respond to changes in the level of business activity. As the activity level rises and falls, a particular cost may rise and fall or may remain constant.
For planning purposes, the manager must be able to anticipate which of these will happen, and if a cost can be expected to change, he or she must
know by how much. To provide this information, costs are classified into two categories-variable and fixed.
Variable costs-are costs that vary in total, in direct proportion to changes in the level of activity or cost driver i.e. if activity increase by n%, total
variable cost also increase by n%, but the per unit cost remains constant.
‘‘Activity’ can be expressed in many ways, such as units produced, units sold or purchased, miles driven, hours worked, and so forth.
E.g. Direct material cost, direct labor cost, commission paid to sales personnel (at $30 per commodity sold), cost of natural gas to heat
factory, wages paid to employees who assemble the goods in the assembly department.
Exhibit 2-1 displays a graph of a variable cost. As this graph shows, total variable cost increases proportionately with activity. When activity
doubles, from 10 to 20 units, total variable cost doubles, from $1,000 to & 2,000. However, cost associated with each unit of activity is & 100,

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whether it is the first unit, the fourth, or the eighteenth. To summarize, as activity changes, total variable cost increases or decreases proportionately
with the activity change, but unit variable cost remains the same.

Exhibit 2-1: variable cost

Total variable cost

$3,000

$2,000

&1,000

Activity (or cost driver)

10 20 30

Tabulation of variable cost

Activity
(Cost driver) variable cost per unit Total variable cost

1-----------------------$100----------------------------------------$100
4-----------------------100-------------------------------------------400
18----------------------100-----------------------------------------1800
30----------------------100-----------------------------------------3000

Fixed costs-are costs that remain unchanged in total regardless of variation in the level of activity (or cost driver), for a given relevant range. If
activity increases or decreases by n% within the given relevant range, total fixed cost remains the same; but the per unit fixed cost changes.
E.g. Salary of plant manager, monthly rental cost of equipment and /or house, depreciation of machines used to produce
furniture’s at $10,000 per year and the like.

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 Exhibit 2-2: Fixed cost

Total fixed cost

$1,500

10 20 30 Activity (or cost driver)

Tabulation of fixed cost

Activity Fixed cost per unit Total fixed cost

(Or cost driver)

1----------------------------$1,500.00---------------------------$1,500
2-------------------------------750.00-----------------------------1,500
5-------------------------------300.00-----------------------------1,500
10-----------------------------150.00------------------------------1,500
11-----------------------------136.36------------------------------1,500
20-------------------------------75.00------------------------------1,500
21-------------------------------71.43------------------------------1,500
30-------------------------------50.00------------------------------1,500

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mixed costs some costs have both variable and fixed characteristics. These costs are often called mixed costs or semi-variable or semi-fixed costs.
Mixed costs occur because the total cost relationship with the activity base termed a cost function has an element that is constant (or fixed) to activity
volume change, and an element that is variable to activity volume changes. For example, the rental charge for a mobile telephone might be birr
50 per month plus some other variable costs.

Controllable and Uncontrollable costs

Another cost classification that can be helpful in cost control involves the controllability of a cost item by a particular manager. If a manager can
control or heavily influence the level of a cost, then that cost is classified as a controllable cost of that manager. Costs that a manager cannot
influence significantly are classified as uncontrollable costs of that manager.
The important question here is not, who control the costs but, who is in the best position to influence the level of a cost item? Some costs may be
controllable in the long run, but not in the short run.

Manufacturing organization cost terms

To assist managers in planning and control, managerial accountants classify costs by the functional area of the organization to which costs relate.
Some examples of functional area are manufacturing, service production, merchandise, marketing, administration, and research and development.

Manufacturing-sector companies purchase materials and components and convert them into different finished goods. Examples are automotive
companies, food processing companies, textile companies, companies that produce different drinks and the like.
Manufacturing costs are further classified into the following three categories: direct material, direct labor, and manufacturing overhead costs.

Direct material costs- are the acquisition costs of all materials that eventually become part of the cost object (work in process and finished
goods),and that can be traced to the cost object in an economically feasible way. Acquisition cost of direct materials includes freight-in (inward
delivery) charges, sales taxes, custom duties and the like.
Direct manufacturing labor costs – includes the compensation of all manufacturing labor that can be traced to the cost object in an economically
feasible way. Such costs includes costs of salaries, wages, fringe benefits paid to personnel’s who work directly on the manufacturing of products.

Manufacturing overhead costs (Indirect manufacturing costs)- are all manufacturing cost that are considered part of the cost object, units
finished or in process, but that cannot be traced to that cost object in an economically feasible way. These costs include three types of costs: indirect
material, indirect labor, and other manufacturing costs (manufacturing overhead costs).
Indirect material-The costs of materials that are required for the production process but do not become an integral part of the finished product are
classified as indirect- material costs.

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Indirect labor-the costs of personnel who do not work directly on the product, but whose services are necessary for the manufacturing process, are
classified as indirect labor costs. Such personnel include production department supervisors, custodial employees, security guards and the like.
Other Manufacturing costs-all other manufacturing costs that are neither material nor labor costs, are classified as manufacturing overhead costs.
These costs include depreciation of plants and equipments, property taxes, insurance, and utilities such as electricity, supplies, as well as the cost of
operating service departments.

Product costs (inventoriable costs) vs period costs-An important issue in both managerial and financial accounting is the timing with which the
costs of acquiring assets or services are recognized as expenses. An expense is defined as the cost incurred when an asset is used up or sold for
the purpose of generating revenues. The terms product cost and period cost are used to describe the timing with which various expenses are
recognized.
Product or inventoriable costs-are all cost of a product that are regarded as an asset when they are incurred and then become cost of goods sold
when the product is sold. For manufacturing sector companies, all manufacturing costs are inventoriable.Costs incurred for direct material, direct
manufacturing labor, and indirect manufacturing costs create new assets, first work-in process, and then finished goods.

For merchandizing sector companies, inventoriable cost are the costs of purchasing the goods that are resold in their same form. These costs are
the costs of the goods themselves and any incoming freight costs for those goods. For service sector companies, since there is no inventory of
services, there are no inventoriable costs.

Period costs-are all costs in the income statement other than cost of goods sold. These costs are treated as expenses of the period in which they
are incurred because they are presumed not to benefit future periods (or because there is not sufficient evidence to conclude that such benefit
exists).These costs are identified with the period of time in which they are incurred. As such, period costs are not included as part of the cost of
either purchased or manufactured goods.
For manufacturing sector companies, period costs include all non manufacturing costs.
For merchandising companies, period costs include all costs not related to the cost of goods purchased for resale in their same form.
For service-sector companies, since there is no inventoreable cost, all their costs are period costs.

Some examples of period costs are- research and development costs, Selling /marketing/ and administrative expenses such as salary expense,
advertising expenses, sales commission expenses, depreciation expenses, supplies expense, interest expenses, and the like.

Exhibit 2-3: A summary of product and period costs

Types of Product costs (also called period cost (also called Treatments
Company inventoreable costs) noninventoriable costs)
These costs are placed in an

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Merchandising Costs associated with inventory account until the
Company purchased inventory goods are sold. When sale
from suppliers takes place, the costs are then
taken to expense as cost of
goods sold.

Manufacturing Direct materials These costs are placed in

Companies Direct labor inventory accounts until the
Manufacturing overhead associated goods are cople-
(consists of all costs of ted and sold. When sale
production other than takes place, the costs are
direct material and direct labor. then taken (released) to
expense as cost of goods
sold.
Merchandising, Selling expenses:
manufacturing, Sales personnel’s salaries These costs are
and service Depreciation on sales taken directly to
companies equipment, insurance onexpenses accounts.
sales equipments,etc. They are classified
Administration expenses: as operating
Secretarial salaries expenses and
Depreciation on office deducted from
Equipment, insurance on gross margin.
office equipment etc.

Prime costs and Conversion costs-These two terms are used in manufacturing companies. Prime costs are all direct manufacturing costs i.e. the
combination of direct material and direct manufacturing labor costs. Conversion costs are all manufacturing costs other than direct material
costs. It is the combination of manufacturing labor costs and manufacturing overhead costs. These costs are incurred to transform direct
materials into finished goods.

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Exhibit 2-4: Summary of manufacturing cost terms
Manufacturing costs
(Also called product costs)
Direct Materials Direct labor Manufacturing overhead
All costs of manufacturing
Materials that can be Labor cost that can be a produce other than direct
Physically and conveniently physically traced to the materials and direct labor,
traced into a product creation of a product factory utilities and depreciation
(such as wood in a table) in a`` hands on`` sense (such as of factory buildings and
assembly-line worker in a plant). Equipment) and the like.

Prime cost conversion cost

Nonmanufacturing costs
(also called period costs)

Marketing or selling cost Administrative costs

All costs necessary to secure customer All costs of general administration

orders and get the finished products or of the company as a whole (such as
services into the hands of the customer executive compensation, executive
(such as sales commissions, advertising, travel costs, secretarial salaries, and
and depreciation of delivery equipment depreciation of office buildings and
and finished goods warehouses). equipment).

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Inventory classification of manufacturing companies and their cost flows

Manufacturing –sector companies purchase materials and components and convert them in to different finished goods. They typically have one or
more of the following three types of inventories:

1. Direct material inventory-direct materials and in stock and awaiting use in the manufacturing process.

2. Work-in process inventory-Goods partially worked on but not yet fully completed. They are also called
work in progress.
3. Finished goods inventory- Goods fully completed but not yet sold.

Merchandising-sector companies purchases and then sell tangible products with out changing their basic form.
They hold only one type of inventory, which are the products in their original purchased form. Service-sector companies provide only services or
intangible products to their customers and hence do not hold inventories of tangible products for sale.
Exhibit 2-5: Summary of manufacturing costs flows and their classification
Balance sheet Income statements

Direct materials
Inventoreable costs
Costs or product Work in Revenues
Costs/direct material process
Inventory/ Direct labor costs
deduct
Manufacturing overhead Goods completed
costs (cost of goods manufactured)

When sales
Finished occur Cost of goods sold
goods (an expense)
Balance sheet inventory
Accounts ( Assets)
Equals

Gross margin

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 deduct

R&D costs,
marketing,
administrative, and
Period costs other expenses

Operating income

Some formulas to compute manufacturing costs

i) Cost of goods = Beginning finished + cost of goods - Ending finished

sold goods inventory manufactured goods inventory

ii) Cost of direct = Cost of beginning + Cost of purchase - Cost of ending direct
materials used direct materials direct materials materials inventory
inventory inventory

Exhibit 2-6: Summary of merchandising cost flows and their cost classification

Balance sheet Income statement

Revenues

deduct

Cost of goods Page 14 of 31

sold (an
expense
Inventoreable Merchandise Merchandise When sales occur
cost purchase inventory

Equals

Gross Margin

deduct

Design costs, Operating

costs such as purchasing
department costs,
Period costs marketing costs,
distribution costs,
customer service costs
and other period costs.

Equals

Operating Income

Comparative Financial statements of manufacturing and merchandising companies

PANEL-A: COMPARATIVE INCOME STATEMENTS

ABC- Manufacturing Company
Income Statement
For the year ended December 31, 2001(in thousands)

Revenues---------------------------------------------------------------------------------------------$210,000
Cost of goods sold:

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 Beginning finished goods, January-1, 2001----------------- $22,000
Cost of goods manufactured (see exhibit 2-7) ---------------104,000
Cost of goods available for sale-------------------------------- 126,000
Less: Ending finished goods, December-31, 2001----------------- 18,000
Cost of goods sold during the year------------------------------------------------------ 108,000
Gross margin (or gross profit) ----------------------------------------------------------- 102,000
Less: Operating expenses-------------------------------------------------------------------------- 70,000
Operating income--------------------------------------------------------------------------- $32,000

XYZ-Merchandising Company
Income statement
For the year ended December 31, 2001, (in thousands)

Sales------------------------------------------------------------------------------------------------------$100,000
Cost of goods sold:
Beginning inventory-------------------------------------------------------$10,000
Net cost of purchase---------------------------------------------------------65,000
Cost of goods available for sale--------------------------------------------75,000
Ending inventory cost December 31, 2001-------------------------------15,000
Cost of goods sold during the year----------------------------------------------------------------------60,000
Gross margin-----------------------------------------------------------------------------------------------40,000
Less: Operating expenses:
Selling expenses----------------------------------------------------10,000
Administrative expenses------------------------------------------20,000
Total operating expenses---------------------------------------------------------------------30,000
Net Income-------------------------------------------------------------------------------------------------$10,000

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Exhibit 2-7
ABC- Manufacturing Company
Schedule of cost of Goods Manufactured
For the year ended December 31, 2001 (in thousands)

Direct materials:
Beginning inventory, January 1, 2001 $11,000
Purchases of direct materials 73,000
Cost of direct material available for use 84,000
Ending inventory, December 31, 2001 8,000

Cost of direct materials used during the year 2001 $76,000

Direct manufacturing labor 9,000
Indirect manufacturing (MOH) costs:
Indirect manufacturing labor 7,000
Supplies 2,000
Heat, light and power 5,000
Depreciation-plant building 2,000
Depreciation-plant equipment 3,000
Miscellaneous expenses 1,000
Total indirect manufacturing costs of the year 20,000
Total manufacturing costs incurred during the year 105,000
Add beginning work-in- process inventory, January 1, 2001 6,000
Total manufacturing costs up to date 111,000
Deduct ending work-in-process inventory, December 31, 2001 7,000
Cost of goods manufactured $104,000

PANEL-B: COPARATIVE PARTIAL BALACE SHEET (CURRENT ASSETS SECTION)

Merchandising Company
Current Asset:

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 Cash-----------------------------------------------------------$ 10,000
A single inventory Accounts receivable------------------------------------------60,000
Account considering Merchandise inventory-------------------------------------150,000
Of goods purchased prepaid expenses-----------------------------------------------5,000
From suppliers Total current Assets-----------------------------------------$225,000

Manufacturing Companies

Current Assets:
Cash-----------------------------------------------------$15,000
Accounts receivable-----------------------------------100,000
Inventories:
Three inventory accounts Raw materials-----------------$15,000
consisting of materials to be Work in process---------------60,000
used in production, goods Finished goods--------------175,000 250,000
partially manufactured,
and goods completely Prepaid expenses----------------------------------------10,000
manufactured. Total current assets---------------------------$375,000

Non manufacturing costs –many other functional cost classifications are used besides manufacturing
costs. Some of the most important ones are:
- Merchandise costs
- Marketing costs
-Administrative costs
-Research and development costs
- Others
Merchandise costs –are the costs incurred by retail and wholesale firms to acquire merchandise for resale. Merchandise costs include the
purchase cost of the goods plus transportation costs.

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Marketing costs- includes the costs of selling goods or services and the costs of distribution. Selling costs (or order –getting costs) include salaries,
commissions and travel costs of sales personnel, and the costs of advertising and promotion. Distribution costs (or order-filling costs) refer to the
costs of storing, handling, and shipping finished products.

Administrative costs- refer to all costs of running the organization as a whole. The salaries of top-management personnel and the costs of the
accounting, legal, and public relation activities are examples of administrative costs.

Research and development costs-include all costs of developing new products and services. Such costs becoming increasingly important as
international competition increases and as high-technology firms make up a growing segment of the economy. The costs of running laboratories,
building prototypes of new products and testing new products are all classified as research and development (or R & D) costs.

Service organizations and their cost concepts

The use of direct materials is not common in service companies unlike the case of manufacturing companies. This is because, direct materials are
used to build products, but since service companies do not build products, direct materials are not usually a significant cost input. Exception would
be fuel for transportation and utility services.
Likewise, service concerns do not have direct labor in the normal sense of the term. This is not to say that service firms do not employ labor to serve
customers directly. A hospital employs nurses, a university employs professors, a hotel employs desk clerks, and an airline employs pilots and so on.
These people are not typically referred to as direct labor, even though they may provide direct service to the customer. Since direct materials and
direct labor are not found in service companies, that leaves mostly overhead resources. Thus the overhead used in services companies includes
most of the costs to perform the services for the customer.

The distinction between product and period costs are generally not repaired for the service companies. The reason is that there is no inventory in
the service companies. The period/product cost distinction was developed in order to value inventory for determining income. Since service
companies have no inventory, the cost of providing the service is entirely expensed in the period the service is provided. Therefore, the costs shown
on the income statement of service companies usually consists wholly of period costs.
Service companies may need to determine service costs in order to price various services. For example, a trucking company needs to know the cost
to move a shipment from one location to another in order to determine appropriate pricing.

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Economic characteristics of costs

In addition to accounting cost classifications, such as product costs and period costs, managerial accountants also employ economic concepts in
classifying costs. Such concepts are often useful in helping accountants decide what cost information is relevant to the decisions faced by the
organization’s managers. Some of the most important economic cost concepts are:

 Opportunity costs
 Out-of- pocket costs
 Sunk costs
 Differential costs
 Marginal costs and Average costs

Opportunity costs-An opportunity cost is defined as the benefit that is sacrificed when the choice of one action precludes taking an alternative
course of action. e.g. if beef and fish are the available choices for dinner, the opportunity cost of eating beef is the forgone pleasure associated with
eating fish.

Out-of pocket costs- are those that require the payment of cash or other assets as a result of their incurrence. The out of pocket costs associated
with office equipment order is consists of the manufacturing costs required to produce the equipments.

Sunk costs- are costs that have been incurred in the past. Consequently, they do not affect future costs and cannot be changed by any current or
future action. Examples of such costs include the acquisition cost of equipment previously purchased, the manufacturing cost of inventory on hand,
and the like.

Differential costs- A differential cost is the amount by which the cost differs under two alternative actions. It is also known as incremental costs.
Suppose for example that Alemaya University is considering two alternative means of providing accommodation for academic stuffs.
i) To provide a house and transport allowance and get the stuffs reside else where out side the University compound. Assume that the total
monthly cost to be incurred by the university under this alternative is Br 150,000
ii) To provide all stuff with accommodation within the university compound and pay no house and transport allowances. Let say that the total
monthly cost to be incurred by the university under this alternative is estimated to be Br 100,000.

The monthly differential cost of accommodating the stuff by the university would therefore be:

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 Cost of providing house and transport allowance Br 150,000
Cost of accommodating the stuff in the university compound 100,000
Monthly differential cost 50,000

Marginal costs and Average costs- marginal cost is the extra cost incurred when one additional unit produced. The additional cost incurred to
assemble one additional machinery by assembly department is the marginal cost of assembling the machinery. The average cost per unit is the
total cost for whatever quantity is manufactured, divided by the number of units manufactured.

NB Many deferent cost concepts have been explored in this chapter. An important task of the managerial accountant is to determine which
of these cost cosncepts is most appropriate in each situation. The accountant attempts to structure the organization’s accounting information
system to record data that will be useful for different purposes. The benefits of measuring and classifying costs in a particular way are
realized through the improvements in planning, control, decision making and other management activities that the information facilitates.
Another important task of the managerial accountant is to weigh the benefits of providing information against the costs of generating,
communicating, and using that information. Moreover the management accountants are expected to decide on amount of information to be
provided. This is because, to process more information may lead to information overload, the case where managers face a problem of properly
identifying important facts out of what is available.

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Chapter Exercises

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Required:

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as

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