Cost & Management Accounting-I

Chapter II: Introduction to Cost Terms & Cost Classifications

2.1 Introduction

Cost and revenue are the concern of any organization from the smallest stone corner to the
largest multinational companies. There are many different types of costs, and at different times
organizations put more or less emphasis on them. When times are good companies often focus
on selling as much as they can, with costs taking a backseat. But when times get tough, the
emphasis usually shifts to costs and cutting them. Hence, managers must understand cost terms,
concepts and classifications to effectively use the information provided. This chapter discusses
cost terms concepts and classifications that are the basis of accounting information used for
internal and external reporting.

2.2 Cost and cost terminology

Accountant usually defines cost as a resource sacrificed or forgone to achieve a specific
objective. Sacrificed refers to a resource that is consumed up. Forgone refers to giving up
opportunity to use a resource for another use. For instance, if a company paying $4000 to
purchase land, the $4000 amount is consumed or scarified to purchase the land. Hence, this
amount of money could not be used for another purpose.

A cost (such as direct materials or advertising) is usually considered as being measured in the
conventional accounting way, as monetary unit (for example birr) that must be paid to acquire
goods and services. An actual cost is the cost incurred (a historical or past cost), as distinguished
from a budgeted cost, which is a predicted or forecasted cost (a future cost).
Cost pool: is a grouping of individual cost items. Cost pools are often organized in conjunction
with cost-allocation bases (cost drivers).

2.3 Cost object and cost driver

To guide decisions, managers want data pertaining to a verity of purpose. They want the cost of
something. We call this something a cost object and define it as any activity or item for which a
separate measurement of costs is desired. A synonym is cost objective. Managers use their
knowledge of these costs to guide decisions about, for example, product innovation, quality, and
customer service. Managers want to know about both actual and budgeted costs of a cost object

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when making decisions. For example, comparing budgeted costs to actual costs helps managers
evaluate how well they did and learn about how they can do better in the future.

The cost object is a key feature of management accounting. It may be an activity or operation in
which resources are consumed or received (repairing automobiles, responding in inquires for
information, reconciling bank statement). The cost object may be a product or service e.g.
(Renting room, flying passenger from Addis Ababa to Gondr). The cost object may be project
e.g. constructing a house.

The cost objects maybe a department e.g. (producing department, procurement department. The
cost object may be a program e.g. (HIV/AIDS control program, athletic program). To summarize
the following are example of cost object.

Cost-Object

Activity or Product or Project Departments Program

operation services

By itself, the term cost is meaningless. Cost measurement must be tied to at least one cost object.
The same cost may pertain to many cost objects simultaneously. For instance, the cost of
materials may become part of the cost of a product and part of the cost of running the
department.

Cost driver: A cost driver: is a variable, such as the level of activity or volume that causally
affects costs over a given time span. A cost driver is any factor whose change causes a change in
the total cost of a related cost object. Drivers are casual factors whose effects are increases in
total costs. There are many possible cost drivers. Ex., In factory setting, the total cost of material
used may be driven not only by the production volume but also by the quality of the material, the
skills of the worker, and the number of parts in a finished product, and the condition of the
applicable machines.

Cost drive is an intuitively appealing term. It encompasses any underling factor that causes, or
drives, costs. It facilitates the subsequent explanation that factors in addition to production
volume.

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Example of cost drivers

Total Costs of Activity Cost Drive

Product design Number of products, number of parts
Distribution Type of transportation, miles driven
Weight number of stops, speed
Manufacturing Production volume, in unit of
Products, number of setups, number
of parts

The cost driver of a variable cost is the level of activity or volume whose change causes
proportionate changes in the variable cost. Costs that are fixed in the short run have no cost
driver in the short run but may have a cost driver in the long run. Therefore, cost driver and cost
pool has a cause and effect relationship.

For instance, Assume MOHA Soft Drink Company uses its different products (Pepsi-Cola,
Mirinda, 7 Up, Mirinda Apple, etc.) as its cost objects. Or the company is intended to know
(measure) the costs of its products. Some of the costs incurred by MOHA are costs of bottles,
distribution costs and design costs. The above cost groupings are termed as cost pools. There are
cost drivers for each cost pool.

Cost driver (causes) Cost pool (effect)

Number of bottles cost of bottles

Number of Kms driven distribution costs

Number of parts of a product designing cost

2.4 Cost Accumulation and Allocation

A cost system typically accounts for costs in two broad stages: (1) it accumulates costs by some
“natural” classification such as raw materials used, fuel consumed, or advertising placed, and
then (2) it allocate (trace) these costs to cost object. Cost accumulation is the collection of cost
data in same organized way through an accounting system. For example, a furniture production

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company that purchase woods for producing furniture collect or accumulate the costs of
individual woods to determine the costs of woods used in any one month to obtain the total
monthly cost of woods.
Cost assignment is a general term for assigning/transferring costs, whether direct or indirect, to
a cost object. For instance, dividing the total accumulated cost of wood for a month to different
furniture produced during that particular month can enable managers to get cost of different
furniture (table, chair, etc.)

Cost tracing is a specific term for assigning direct costs to a particular cost object.

Cost allocation refers to assigning indirect costs to a particular cost object. Cost allocation is a
general term that refers to identifying accumulated cost with or tracing accumulated cost-to-cost
object such as department, activities, or products.

Cost object are chosen not for their own sake but to help decision-making. The most
economically feasible approach to the design of a cost system is typically to assume some
common classes of decision e.g. (inventory control, labor control) and to choose cost object (for
example, product and departments) that relate to those decisions. Nearly all systems at least
accumulate actual cost, which are amounts determined on the basis of costs incurred as
distinguished from predicated or forecasted costs.

For example: for a furniture production company, the cost object is Table. And the direct cost is
cost of woods and indirect cost of producing different tables is the cost of renting the
building/plant in which the production is undertaken.

Cost Accumulation Cost object

Product 1
Actual Raw Production
Department Product 2
material Cost
Product 3
Purpose – to compute Purpose – To computer costs
costs for evaluating of various products for
departmental efficiency decisions such as product
and managerial pricing and product emphasis
performance

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You should avoid widely held belief that cost accounting’s sole purpose is to measure income
and inventories. The best system collects data in a form suitable for a variety of purposes. These
systems provide a reliable basis for predicting the economic consequence of various decisions
such as the following.
 Which product should continue to make
 Should manufacture a product component or should acquire it from another company.
 What price should we charge?
 Should buy the proposed equipment?
 Should change the manufacturing method?
 Should we expand a particular department?

Accuracy in determining costs

Before proceeding, ponder how the direct and indirect costs generally relate to various cost
objects. The cost object may be a broadly defined activity (total operation of an airplane repair
facility) or a narrowly defined activity (the painting operation of an airplane repair facility). It
may be a broadly defined project (designing a new automobile) or narrowly defined project
(designing a knob for radio in a new automobile).
A useful rule of thumb is that the broader the definition of the cost object, the higher the
proportion of its total cost are its direct cost and more confidence management has in the
accuracy of the resulting cost amounts. The narrower the definitions of the cost object, the lower
the proportion of its total cost are its direct costs the less confidence management has in the
accuracy of resulting cost amount.

2.5 Classification of Costs

All types of organizations incur costs. Generally, the kind of costs that are incurred and the way
in which these costs are classified depends on the type of organization involved (for instance,
manufacturing, merchandizing and service organizations). Measuring costs requires judgment.
That’s because there are alternative ways in which costs can be defined and classified. Different
companies or sometimes even different subunits within the same company may define and
classify costs differently. Be careful to define and understand the ways costs are measured in a
company or situation. Under the following part five major criteria for cost classification are
discussed.

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2.5.1 Direct Cost and Indirect Costs

Based on the traceability of costs to cost objects cost can be classified as direct and indirect. A

major question concerning costs in both manufacturing and non-manufacturing functions is

whether the cost has a direct or an indirect relationship to particular cost object.

 Direct costs – Costs that can be identified specifically with or traced to a given cost
object in an economically feasible way.
 Indirect cost – Costs that cannot be identified specifically with or traced to a given cost
object in an economically feasible way.

“Economically feasible” means “Cost effective”. Managers do not want cost accounting to be too
expensive in relation to expected benefits. The cost of tracing relatively in expensive items may
exceed the benefit of having the resulting information. For example, it may be economically
feasible to trace specifically the exact cost of steel and fabric (direct cost) to a specific lot of desk
chairs, but it may be economically not feasible to trace specific the exact cost of rivets or thread
(indirect costs) to the chars.

Managers prefer to classify costs as direct rather than indirect. Why? Because they have greater
confidence in the accuracy of the reported cost of products and services.

2.5.2 Variable cost and Fixed Costs

Let us now consider two basic types of costs variable costs and fixed costs. Based on the
behavior/reaction of costs for the change in the level of total activity or volume, costs can be
classified in to variable and fixed. We may define each in terms of whether its total cost changes
in response to change in a related cost driver. A variable cost is a cost that does change in total
in direct proportion to changes of a cost driver.
A fixed cost is a cost that does not change in total despite changes of a cost driver. Conceder the
following:
Examples:
1. If ABC plc. buys one type of special clamp at 1 Birr for each of its cars, then the total cost
of clamps should be 1 times the number of cars produced. This is an example of a variable

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cost a cost that is unchanged per unit of cost driver but change in total in direct proportion
to changes in the cost driver.
2. ABC plc. may incur 100,000 Birr in a given year for a factory taxes, executive salaries,
rent, and insurances. These are examples of fixed costs, costs that are unchanged in total
over a wide range of the cost deriver during a given time span but became progressively
smaller on a per unit basis as the cost driver increases.

Major Assumptions
The definitions of variable costs and fixed costs have important underlying assumptions.
1. The cost object must be specified. Examples are activities, products, services, projects,
departments etc.
2. The time span must be specified. Examples are months, quarters, years and product life
cycles.
3. Costs are linear: That is, when plotted on ordinary graph paper, a total cost in relation to
the cost drive will appear as an unbroken straight line.
4. For the time being, all costs are either variable or fixed. In practices, of course,
classification is difficult and nearly always necessitates some simplifying assumptions.
5. There is only one cost drive. The influences of other possible cost drivers on the total cost
are held constant or deemed to be insignificant. Volume, often expressed in measures of
units produced or sold.
6. The relevant range of fluctuations in the cost driver must be specified.

Relevant Range
A relevant range is the band of the cost driver in which a specific relationship between cost
(revenue) and cost (revenue) driver is valid. A fixed cost is fixed only in relation to a given
relevant volume range (usually large) and a given time (usually a particular budget period). For
example the following diagram shows that a fixed cost level of $600,00 applies to a relevant
range of 30,000 to 95,000 machine hours – the cost drive per year. The diagram also shows that
operations on either side of the relevant range would result in different fixed costs. With out put
the range from zero hours to 30,000 machines – hours, service and executive personal would
likely to be laid off. An increase in volume above 95,000-machine hours would increase fixed
costs. The business might hire additional personnel to help the increased operation. Fixed costs

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may differ from one year to the next wholly because of changes in items other than the volume
cost driver, such as rent terms, salary level, and property tax rates.

Total analysis fixed costs – Conceptual analysis

300,000

600,000

300,000

0
Relevant range

Volume in Thousands of machine hours

20 40 60 80 90 100
2.5.3 Manufacturing and Non-manufacturing cost
Some types of cost accounting applies to any entity, including manufacturing companies,
airlines, retail stores etc. regardless of whether they operate for a profit goal.

Manufacturing is the transformation of materials into other goods through the use of labor and
factory facilities. Merchandising is the marketing of goods without changing their basic form.
For example, assume Bershaco cosmetic manufacturing company wants to make shampoo and
sell it directly to retailers. The company may purchase a factory and equipment, buy certain oils
and containers, hire some workers, and manufacture thousands of units of finished product. This
is the company manufacturing function. But to persuade retails to buy the product, the company
will have to convince the ultimate consumer that this product is desirable. This means
advertising, including the development of a sales appeal, the selection of a brand name, the
choice of media and so forth. To maximize the success, the company must effectively manage
both manufacturing and merchandising function.

Instead of handling the merchandising, the Bershaco cosmetic manufacturing company may sell
its product through retailers that will resell the product to the final consumer. The difference
between manufacturer and merchandiser shows up in the income statement. The manufacture

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income statement includes the cost arising as the result of production (cost of goods
manufactured) but the merchandising business income statement do not show the cost of
production since it does not produce the product itself

Manufacturing companies involve in acquiring raw materials, producing finished goods,

marketing, distributing, billing and almost every other business activities. Therefore, the cost
concepts for manufacturing companies may be applied to other types of companies with some
slight modifications. In general sense costs for manufacturing organizations can be classified in
to two these are: manufacturing costs and non-manufacturing costs.

A. Manufacturing Costs
Many companies recognize three major categories of the cost of manufactured product:
1. Direct materials cost: - The acquisition costs of all materials that are identified as part of
the cost object and that may be traced to the cost object in an economically feasible way.
Acquisition costs of direct materials include in ward delivery charges, sales tax, and custom
duties. Direct material often does not include minor items such as glue or tacks. Why
because the cost of tracing insignificant items do not seem worth the possible benefits of
having more accurate product costs. Such items are called supplies or indirect materials and
are classified as part of the indirect manufacturing costs.
2. Direct labor: - The compensation of all labor that can be identified in an economically
feasible way with a cost object. Examples in manufacturing are the labor of machine
operators and assembler. Indirect labor costs are all factory labor compensation other than
direct labor compensation. These are labor costs that are impassible or impractical to trace
to a specific product. They are classified as part of the indirect manufacturing cost ex.
Wages of janitors and plant guards.
3. Indirect manufacturing costs (manufacturing overhead): - all manufacturing costs that
cannot be identified specifically with or traced to the cost object in an economically
feasible way. Other terms used are factory overhead, factory burden, manufacturing
overhead and manufacturing expenses. The term indirect manufacturing costs is a clear
descriptor than factory overhead, but the latter will be used through this text because it is
briefer. Examples of factory overhead when products are cost object include power,
supplies, indirect labor, factory rant, insurance, property taxes, and depreciation.

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Prime Costs and Conversion Costs

Two of the three major categories of the cost of a manufactured product are sometimes combined
in cost terminology as follow: - Prime costs are all direct manufacturing costs. Conversion costs
are all manufacturing costs other than direct materials costs.
Some companies have stopped considering direct labor as a separate cost categories. Direct labor
costs have become less and less important in relation to total manufacturing costs. An important
point emerges. The direct indirect distinction between costs depends heavily on the underlying
manufacturing processes. Many cost accounting systems have retained the classic three fold cost
categories, but other systems uses two-fold categories.

Three fold Categories Two fold Categories

Direct material direct materials
Direct labor Conversion Costs
Factory overhead

B. Non-manufacturing costs
Non- manufacturing costs are also called selling, general, and administrative costs (SG&A).
Non-manufacturing costs are sub classified in to two categories:

Marketing or selling costs: includes all costs necessary to secure customer orders and get the
finished product in to the hands of the customer. They are often called order getting and order
filling costs. For example: advertising, shipping, sales travel, sales commissions, sales salaries,
customer service and cost of finished goods warehouses.

General and administrative costs: include all executive, organizational and clerical costs
associated with the general management of an organization rather than with manufacturing,
marketing or selling. For example, executive compensation, general accounting, secretarial,
public relations, R&D, design etc.

2.5.4 Product (inventoriable) costs and Period (non-inventoriable) costs

For the financial reporting purpose costs can be classified as product or inventoriable and
period or non-inventoriable. The rules of financial accounting have major influence on
accounting for manufacturing costs. For example, under generally accepted accounting

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principles, the manufacturing costs of a product are initially regarded as measure of assets. They
are inventor able costs, which are all cost of a product that are regarded as an asset for financial
reporting under generally accepted accounting principles. Such cost become expenses (in the
form of cost of good sold) only when the units in inventory are sold.

Other costs, often called period cost, are regarded as immediate expenses. These costs are always
expensed in the same period in which they are incurred; they are not considered inventeriable
costs. Example: research, marketing, and administrative costs.

2.5.5 Sunk costs and Out-of-pocket costs

A cost can be classified by relevance by identifying it as either a sunk cost or an out-of-pocket
cost.
A sunk cost has already been incurred and cannot be avoided or changed. It is irrelevant to
future decisions. One example is the cost of a company’s office equipment previously purchased.
An out-of-pocket cost requires a future outlay of cash and is relevant for decision making.
Future purchases of equipment involve out-of-pocket costs. A discussion of relevant costs must
also consider opportunity costs.
An opportunity cost is the potential benefit lost by choosing a specific action from two or more
alternatives. One example is a student giving up wages from a job to attend evening classes.

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