Management Accounting-9

COST CONCEPTS, ELEMENTS,

CLASSIFICATIONS AND ESTIMATION
 Learning outcomes
After studying this chapter, you should be able to:

 Explain what is meant by cost

 Define and illustrate a cost object and cost
center
 Apply different cost classification methods
 Explain the importance of a cost data base
and
 Explain cost estimation methods.
Reasons for costing

◼ Planning
◼ Valuing inventory
◼ Making decisions
◼ Measuring performance
◼ Controlling
Cost concepts

a) Cost
◼ Value of resources sacrificed to achieve a
specific objective
◼ Measured in monetary terms

b) Cost object
◼ Anything for which a separate
measurement of cost is required
◼ Depends according to the requirement
of the user
 Basic Cost Terminology
Cost Resource sacrificed or forgone
to achieve a specific objective.

Actual Cost incurred (a historical cost)

cost
Budgeted A predicted cost
cost

Cost Anything for which a separate

object measurement of costs is desired.

4
Cost Object Examples at BMW

Cost Object Illustration

Product BMW X 5 sports activity vehicle

Service Dealer-support telephone hotline
R&D project on DVD system
Project
enhancement
Herb Chambers Motors, a dealer that
Customer purchases a broad range of BMW
vehicles
Activity Setting up production machines
Department Environmental, Health & Safety

5
Activity 2.1

Write some examples for cost objects of a

manufacturing and service organization.

Industry / Business Cost objects

Manufacturing:
Garment
Bakery
Service:
University
Cab service
Cost concepts

c) Cost center
◼ A cost center could be a location,
person, or item of equipment, activity,
process (or group of these) for which
costs are ascertained until those costs
are allocated to cost objects.
d) Cost driver
◼ Factor that has a direct cause-effect
relationship to a cost.
 How to account for costs?

Stage
Cost
(1) Cost Object 1
Accumulation
Cost
Object 2
Cost
Assignment Cost
(2) Object 3
Through Tracing
& Allocating
Classification of costs

Cost can be classified differently

according to the purposes
Classification of costs contd.

Cost

Other
Inventory Short-term
managerial
valuation decision making
decisions

make or buy
Measure the
decision,
Measuring performance
reduce prices
profit or loss of divisions or
to boost
for the period units of the
short-term
organization
sales
Classification of Costs contd.

Direct and indirect costs

Classified based on the identification and

traceability of costs with a cost object
 Direct and Indirect Costs
Direct Costs – can be conveniently and
economically traced (tracked) to a cost object
Examples
Parts
Assembly line wages

Indirect Costs – cannot be conveniently or

economically traced (tracked) to a cost object.
Examples
Electricity
Rent
Property taxes
Cost Assignment

Direct Costs Cost tracing COST

OBJECT
Example: Paper on which
Sports Illustrated magazine
is printed Example:
Cost Allocation Sports
Indirect Costs Illustrated
magazine
Example: Lease cost for the
building housing the senior
editors of Sports illustrated
and other magazines.

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Direct and indirect classification of costs

Cost

Direct Cost Indirect Cost

Non-
Direct Direct Direct Manufacturing Manufacturing
Material Labour Other Cost Cost

Selling & Finance Other

Administrative
Distribution
 Activity 2.2
The following cost information is given for a furniture
manufacturing company which produces different types of
wooden furniture items.
Wood cost
Carpenters’ salaries
Royalties paid for designers
Machine maintenance at the manufacturing division
Machine maintenance at the painting division
Nails
Paints
Commissions to sales persons
Electricity for the entire organization including for administration
Supervisors' salary - Manufacturing
Supervisors' salary - Painting
Sand papers
Distribution cost
Salaries for painters
Activity 2.2 Cont.

1. Identify direct and indirect costs of a

furniture manufacturing company
assuming that the cost object is a chair.
2. Classify identified direct costs into
material, labour and other.
3. If the cost object is painting division,
how would the answer given in the part
1 change?
Activity 2.3
Classify the indirect costs identified in
the part 1 of the activity 2.2 into
manufacturing and non-manufacturing
overheads.
Total manufacturing costs

Direct material cost xx

Direct labour cost xx
Direct other manufacturing cost xx
Total direct cost xx
Manufacturing overheads xx
Total manufacturing cost xx
Classification of costs for the purpose
of short-term decision making

Based on the cost behavior, following

categories of cost can be identified:

 Variable cost
 Fixed cost
 Semi-variable cost
 Step fixed cost
Variable cost (VC)

VC vary in proportion to the volume of

activity

Total and unit variable cost

Total variable cost (Rs.) Unit variable cost (Rs.)
5000

4000

3000

2000

1000

0 0 Units
Units
100 300
Example: Variable Cost
X Company buys a handlebar at $52 for each of its
bicycles.

Total Cost Unit Cost

What is the total handlebar What is the handlebar cost
cost when 1,000 bicycles per bicycle when 1,000
are assembled ? bicycles are assembled ?
1,000 units × $52 = $52,000
What is the total
What is the handlebar cost
handlebar cost when
per bicycle when 3,500
3,500 bicycles are
bicycles are assembled ?
assembled?
3,500 units × $52 = $182,000
Fixed cost (FC)

Within the relevant range, Total Fixed Costs (TFC) do not change with
the rate of output.

Total and Unit Fixed Cost

Total fixed cost (Rs.) Unit fixed cost (Rs.)

0 0 Units
Units
Example: Fixed Cost
X Company incurred $94,500 in a given year
for the leasing of its plant.

Total Cost Unit Cost

What is the total leasing What is the leasing cost
cost when 1,000 bicycles per bicycle when 1,000
are assembled? bicycles are assembled?
$94,500

What is the leasing (fixed) What is the leasing cost

cost 3,500 bicycles are bicycle when 3,500
assembled? bicycles are assembled?
$94,500
 Cost Behavior Summarized
Total Costs Cost Per Unit
Variable Change in proportion Unchanged in relation to output
costs with output
More output = More cost
Example
1,000 units =$52,000 1,000 units =$52
3,500 units=$182,000 3,500 units= $52
Fixed Unchanged in relation to Change inversely with output
Costs output
More output = lower cost per unit
Example Example
1,000 units =$94,500 1,000 units =$94.50
3,500 units =$94,500 3,500 units=$27.00
Semi-variable costs (Mixed costs)

Semi-variable costs include both fixed and variable costs. Example

of a semi-variable cost is telephone charge which includes fixed
rental plus the charges on the usage.

Cost (Rs.)

Units
Step fixed costs

Up to a certain
Step fixed cost (Rs.)
level of activity
the fixed cost
remain constant
and if that level of
activity exceeds,
additional fixed
cost would be
Units required
 Relationships of Types of Costs

Direct

Variable Fixed

Indirect
Example: Relationships of Types of Costs
Direct Costs
Cost Object: Ford Focus
Fixed cost Variable cost
Example
Tires used in assembly of
automobile
Cost Object: Ford Focus
Example
Salary of supervisor on Ford
Focus assembly line
Indirect Costs
Cost Object: Ford Focus
Example
Power costs at Detroit plant.
Power usage is metered only
to the plant, where multiple
products are assembled
Cost Object: Ford Focus
Example
Annual lease costs at Detroit
plant.
Lease is for the whole plant,
where multiple products are
assembled
 Total Costs
TC = TVC + TFC
Total
Dollars

Total Cost

Total Variable Cost

Total Fixed Cost

Output
Relevant Range
 Example: Total Costs and Unit Costs
What is the unit cost (leasing and handlebars)
when the company assembles 1,000 bicycles?
Total costs= FC + TVC Unit cost= TC ÷ Q
= $94,500 + $52,000 = $146,500 ÷ 1,000
= $146,500 = $146.50
TC
200000

150000

$94,500
$146,500

100000

50000

0 Volume
500 1000 1500
Classifications of costs contd.
Product Vs. period costs:
1. Product costs
 Costs identified with goods purchased or produced for
resale
 Often used for the external financial reporting purpose
 Manufacturing costs and cost of goods purchased are
regarded as product costs

2. Period costs
 Treated as expenses in the period in which they are
incurred
 Not included in the inventory valuation
 Administration, selling and distribution, finance, and
other expenses are examples for period costs
 Product Costs Vs. Period Cost

Product Costs
Product costs (assets)…
become cost of goods sold after a sale takes
place
Period Costs
Period costs are all costs in the income
statement other than cost of goods sold.
Period costs are recorded as expenses of the
accounting period in which they are incurred.

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Treatment for product and period costs

Manufacturing Product Recorded as an

Unsold asset (inventory)
Cost Cost
and becomes an
expense when the
product is sold
Sold

Recorded as an
expense in the
Non- current financial
Period
period
manufacturing Cost
Cost
Product Costs Versus Period Costs
Product costs Period costs
include direct include all
materials, direct selling costs and
labor, and administrative
manufacturing costs.
overhead.
Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement
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Cost and Expense

 Cost is the monetary value of goods

and services spent to obtain current
or future benefits

 Expenses are the costs of goods or

services that have expired.
 Product Costs Vs Period Costs
(Manufacturing Company)

BALANCE SHEET INCOME STATEMENT

Product Costs
Revenues xxx
Materials
Less:
Inventory
Cost of Goods Sold (xxx)
Gross Margin xxx
Work in Process Less:
Inventory
Operating Exp
(Period costs) (XXX)
Finished Goods Operating Income xxx
Inventory
When sales occur
 Product Costs Vs Period Costs
(Merchandising Company)

BALANCE SHEET INCOME STATEMENT

Product Costs
Revenues xxx
Less:
Merchandise Cost of Goods Sold (xxx)
Purchases Gross Margin xxx
Less:
Operating Exp
(Period costs) (XXX)
Operating Income xxx
Inventory
When sales occur
 Activity 2.4
Benadic Enterprises produces a special door lock. During the year,
5,000 units were produced 3 500 units were sold at Rs. 450 each.
The costs for the year are as follows;

◼ Direct material cost 450,000

◼ Direct labour cost 270,000
◼ Direct other cost 80,000
◼ Manufacturing overheads 200,000
◼ Administration & selling expenses 150,000

 There were no opening finished goods and Work-In-Progresses at

the beginning of the year.

Required:
I. Calculate the total product cost and period cost to be recognized
in the year.
II. The profit or loss statement for the year.
Cost Classifications for Decision
Making
Every decision involves a
choice between at least two
alternatives.

Only those costs and benefits

that differ between alternatives
are relevant in a decision. All
other costs and benefits can and
should be ignored.
Relevant and irrelevant costs

 Relevant costs - costs which affect to

a decision

 Irrelevant costs - costs which do not

affect to a decision
Activity 2.5
ABC Company purchased Rs. 20,000 worth of raw
materials a few years ago. Currently there is no possibility
of selling these materials or using them in future
production. Recently a customer saw these materials at the
company premises and requested the company to sell
those materials to him. However, this customer is not
prepared to pay more than Rs. 12,000. The additional cost
of Rs. 5,000 would be required to change these materials
according to the customer requirement.
1. What are the relevant costs and revenues in this case?
2. Should company sell these materials to the customer?
Avoidable and unavoidable costs

 Avoidable costs – can be saved by

not adopting a given alternative.

 Unavoidable costs - cannot be saved

by not adopting a given alternative.

◼ Only avoidable costs are relevant for

decision making.
 Activity 2.6
XYZ Company was manufacturing a product ‘X’. However, due to the
outdated design of the product, the company had to cease its
manufacturing. There is a materials stock which was purchased at Rs.
32,000 a few months ago for product X. Currently there is no possibility
of selling these materials. If these materials are not used, it requires
disposing them at a cost of Rs 4,500. Further, the company had entered
to five year rent agreement at the beginning of the current year and the
monthly rental is Rs 20,000. The company is planning to develop a new
product ‘Y’ and if product Y is manufactured, the available material stock
could be used after these materials are further processed at a cost of Rs
2,000.
Required:
 What is the avoidable cost in the decision to produce product Y?
 What is the un-avoidable cost in the decision to produce product Y?
 What are the relevant costs in the decision to produce product Y?
 Should company use these materials to produce product Y?
 Sunk Costs
Sunk costs have already been incurred and
cannot be changed now or in the future.
These costs should be ignored when making
decisions.

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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Activity 2.7

S & S Company came into a rent agreement with a

building owner on 30th June 2017. As per the
agreement, Rs. 20 000 monthly rent should be paid
for a minimum of one year. It further says that the
agreement cannot be cancellable. By end of 2017,
company thinks whether to construct its own
building or to continue the rent. What is the sunk
cost of this decision?
Activity 2.8

Give an example to a situation where

the irrelevant cost is not a sunk cost.
Opportunity costs
 Classified based on the economic
perspective of costs
 The potential benefit that is given up when
one alternative is selected over another.
 Value of the next best alternative that is
foregone due to selecting one alternative
when there are two or more alternatives

Example: If you were not attending university, you could

be earning $40,000 per year. Your opportunity cost of
attending university for one year is $40,000.
Activity 2.9

A company has received a special order from a customer to

produce 750 units of a customized product. This special
order requires additional variable cost of Rs. 20,000. To
produce one unit of this product two machine hours are
required. Currently machines are working are at their full
capacity. If the special order is accepted, current output of
product A (the standard product) will have to be reduced.
To produce one unit of product A 1.5 machine hours are
required. The contribution per unit of product A is Rs. 30.

1. Find the opportunity cost of fulfilling the customer’s

order
2. What is the minimum price that should be charged to
the order?
Incremental costs

 Incremental costs/ revenues -

difference between costs/ revenues
under each alternative being
considered
Activity 2.10

Following is the costs and revenue of the machine A and

machine B.
Machine A Machine B
Revenue 5,000 3,000

Operating Cost (3,000) (2,000)

Profit 2,000 1,000

a) What is the incremental cost and revenue if machine A is
selected over machine B?
b) What is the incremental cost and revenue if machine B is
selected over machine A?
Controllable and uncontrollable costs

 Controllable costs - costs which can

be influenced by the action of a
particular member of an undertaking

 Uncontrollable cost - cannot be

influenced by the action of a
particular member
Activity 2.11
 Identify the factors that affect to the
controllability of costs.

 “The uncontrollable costs at certain level

of management may be controllable at
another level of management.” Do you
agree with this statement? Justify your
answer with examples.
Summary of the Types of Cost
Classifications
Financial Predicting Cost
Reporting Behavior

Assigning Costs to Making Business

Cost Objects Decisions

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 Summary of the Types of Cost
Classifications
Direct costs
Research and development costs
Indirect costs
Design costs
Production costs
Marketing costs Total Cost
Distribution costs Average cost
Customer service costs

Product Costs
Fixed costs Period costs
Variable costs
Differential cost
Sunk cost
Opportunity cost

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 Management Accounting

Part II
Maintaining cost data base and estimation of costs
 Learning outcomes
After studying this section, you should be able to:

 Explain the importance of a cost data base

and
 Explain cost estimation methods.
Maintaining a Cost Database

Cost and management accounting system should generate

information to meet the following requirements.

 To allocate costs between cost of goods sold and inventories for

internal and external profit measurement and inventory valuation;

 To provide relevant information to help managers make better

decisions; and

 To provide information for planning, control and performance

measurement.

A database should be maintained, with costs appropriately

coded and classified.
Cost classifications in cost databases

 Cost classification depends on the purpose.

◼ Inventory Valuation
◼ Cost Control & Performance Measurement
◼ Decision making

E.g. the allocation of costs to products is inappropriate for cost control and
performance measurement, as the manufacture of the product may
consist of several different operations, all of which are the
responsibility of different individuals. To overcome this problem, costs
and revenues must be traced to the individuals who are responsible for
incurring them. This system is known as responsibility accounting.

 Typical cost classifications within the database - by

categories of expense (direct materials, direct labour and
overheads) and by cost behavior (fixed and variable).
Cost classifications in cost databases
contd.

 Costs are not classified as relevant or irrelevant within

the database because relevance depends on the
circumstances.

 When the activities of an organization consist of a series

of common or repetitive operations, targets or standard
product costs, rather than actual costs, may be recorded
in the database.

 Future costs, rather than past costs, are required for

decision-making. Therefore, if required, costs in the
database may be adjusted for anticipated price changes.
Cost Estimation and Cost Behavior

 General Principles Applying to Estimating Cost

Functions (Assuming a liner cost function)

 A regression equation identifies an estimated

relationship between a dependent variable (cost) and
one or more independent variables (i.e. an activity
measure or cost driver). If there is only one independent
variable and the relationship is liner, the regression line
can be described as follows;

y = a + bx
Activity 2.12

Fixed costs for a period are Rs 5000. Total

variable cost is Rs 7500. The cost driver
for variable cost is direct labour hours and
total direct labour hours are 5000.

Required:
Derive the total cost function.
Cost Estimation Methods

 Engineering Methods

 Inspection of the Accounts Method

 Graphical or Scatter-graph Method

 High-low method
Engineering Methods

 This is based on the use of engineering

analysis of technological relationships between
inputs and outputs.
◼ E.g. Method study, work sampling and time,
motion study

 This approach is appropriate when there is a

physical relationship between cost and the cost
driver
Inspection of Accounts

 The inspection of accounts method requires

that the departmental manager and the
accountant inspect each item of expenditure
within the accounts for a particular period, and
then classify each item of expense as a wholly
fixed, wholly variable or a semi-variable costs.

◼ A single average unit cost figure for variable

◼ A single total cost for fixed.
◼ For semi-variable items the departmental manager and the
accountant agree on a cost function
 Activity 2.13
Following cost information has been obtained from the latest monthly accounts
for an output level of 10,000 units for a cost centre. Total capacity is 20 000
units.
Rs
Direct materials 100 000
Direct labour 140 000
Indirect labour 30 000
Depreciation 15 000
Repairs and maintenance 10 000

 The departmental manager and the accountant inspected each item of

expenditure and came to the following conclusions.
◼ Direct material and direct labour costs are varying with direct proportion of units.
◼ Indirect labour and depreciation costs are fixed.
◼ The fixed element of the repairs and maintenance is Rs 5 000.

 It’s expected to increase the production by 50% in the next year.

Required: Estimate the total cost of the next year.

Graphical or Scatter-graph Method

 This method involves plotting on a graph

the total costs for each activity level.
The total cost is represented on the
vertical (Y axis) and the activity levels
are recorded on the horizontal (X axis).

 A straight line is fitted on the scatter of

plotted points by visual approximation.
Activity 2.14

 The total maintenance costs and the machine hours for the past ten four
weekly accounting periods were as follows;

Period Machine hours (x) Maintenance cost (Y)

1 400 960
2 240 880
3 80 480
4 400 1200
5 320 800
6 240 640
7 160 560
8 480 1200
9 320 880
10 160 440

You are required to estimate the regression equation using the graphical method.
 Activity 2.14 - Answer

1400
Maintenance cost

1200
1000
800
600
400
200
0
0 100 200 300 400 500 600
Machine hours
High-low Method

 The high low method consists of

selecting the periods of highest and
lowest activity levels and comparing
the changes in costs that results from
the two levels.
Activity 2.15
The monthly recordings for outputs and maintenance costs for the past 12 months
have been examined and the following information has been extracted.

Month Volume (Unit) Maintenance costs

January 6000 25 500
February 6200 27 000
March 7000 30000
April 8000 31500
May 5000 22000
June 5500 23000
July 5800 24200
August 5500 24000
September 5800 25000
October 6000 26300
November 7900 29000
December 10000 32000
Estimate the variable cost and fixed cost using high-low method.