Cost Concepts

What are Costs?

In economics and business, costs refer to the monetary value of the resources used to produce
a good or service. These resources can include labor, raw materials, energy, rent, and other
expenses. The study of cost concepts is important because understanding costs is crucial for
determining prices, profits, and business decisions.

Types of Costs

There are various types of costs, including:

1. Fixed Costs:

Fixed costs are those costs that remain constant regardless of the level of production. Examples
include rent, salaries, insurance premiums, and property taxes. Fixed costs are typically
associated with the production of goods and services, but they can also refer to the general
overhead costs of a business.

2. Variable Costs:

Variable costs are those costs that vary with the level of production. Examples include raw
materials, labor, and energy. Variable costs are directly related to the production of goods and
services and increase or decrease as production levels change.

3. Total Costs:

Total costs refer to the sum of fixed costs and variable costs. This represents the total amount a
business spends on producing a good or service. Understanding total costs is important for
businesses because it helps them determine the minimum price they must charge to cover their
costs and make a profit.

4. Marginal Costs:

Marginal costs refer to the cost of producing one additional unit of a good or service. Marginal
costs are calculated by dividing the change in total cost by the change in the quantity produced.
Marginal costs are important for businesses because they help them determine the optimal level
of production at which they can maximize profits.

Cost Concepts in Decision Making

Understanding cost concepts is important for decision making in business. The following are
some cost concepts used in decision making:

1. Opportunity Cost:

Opportunity cost is the cost of choosing one option over another. It represents the value of the
benefits foregone by choosing one option instead of another.
2. Sunk Cost:

Sunk costs are costs that have already been incurred and cannot be recovered. Sunk costs
should not be considered in decision making because they are irrelevant to future costs and
benefits.

3. Relevant Cost:

Relevant costs are costs that are relevant to a particular decision. They are future costs that will
be affected by the decision.

4. Incremental Cost:

Incremental costs are the additional costs incurred by a business as a result of a particular
decision. They are the difference between the costs of two alternatives.

5. Break-Even Analysis:

Break-even analysis is a tool used to determine the level of production at which a business will
break even and earn zero profit. It is calculated by dividing the fixed costs by the difference
between the price of a good or service and its variable cost.

Understanding cost concepts is crucial for businesses to make informed decisions, set prices,
and maximize profits. By understanding different types of costs and cost concepts, businesses
can make more effective and efficient decisions.

Exercise

1. Direct costs are costs that can be easily traced to a particular product or department.
(True)
2. Indirect costs are costs that cannot be easily traced to a particular product or
department. (True)
3. Fixed costs are costs that vary in direct proportion to changes in the level of activity.
(False - fixed costs remain constant regardless of changes in the level of activity)
4. Variable costs are costs that remain constant regardless of changes in the level of
activity. (False - variable costs vary in direct proportion to changes in the level of activity)
5. Mixed costs are costs that contain both fixed and variable components. (True)
6. The break-even point is the point where total revenue equals total cost. (True)
7. Marginal cost is the cost of producing one additional unit of output. (True)
8. Absorption costing includes only variable manufacturing costs in the cost of goods sold.
(False - absorption costing includes both variable and fixed manufacturing costs in the
cost of goods sold)
9. Job order costing is used for mass-produced products. (False - job order costing is used
for unique or custom-made products)
10. Process costing is used for products that are produced in batches. (True)
11. Standard costing is a method of cost accounting that involves comparing actual costs to
predetermined standards. (True)
12. The flexible budget adjusts for changes in the level of activity. (True)

13. Operating leverage refers to the use of fixed costs in the production process. (True)
14. The contribution margin is equal to sales revenue minus variable costs. (True)
 15. Target costing is a cost management technique that involves determining the target cost
for a product and then designing the product to meet that target cost. (True)
16. Cost-volume-profit analysis is a method of cost accounting that involves analyzing the
relationship between sales volume, costs, and profits. (True)
17. Variable costing includes all manufacturing costs, both variable and fixed, in the cost of
goods sold. (False - variable costing includes only variable manufacturing costs in the
cost of goods sold)
18. Differential costs are costs that remain constant regardless of the decision being made.
(False - differential costs are costs that differ between alternatives)
19. Sunk costs are costs that have already been incurred and cannot be recovered. (True)
20. Incremental costs are costs that do not change as a result of a decision. (False -
incremental costs are costs that change as a result of a decision)

CVP Analysis
CVP (Cost-Volume-Profit) analysis is a tool used by businesses to understand how changes in
costs, volume, and price affect profits. The analysis helps businesses make informed decisions
about pricing, production, and marketing.

CVP analysis consists of three components:

● Cost: The cost of producing a good or service.

● Volume: The quantity of goods or services produced.
● Price: The price at which the goods or services are sold.

Formulas

The following are some formulas used in CVP analysis:

● Contribution Margin = Sales Revenue – Variable Costs

● Break-Even Point (Units) = Fixed Costs ÷ Contribution Margin per Unit

● Break-Even Point (Sales Revenue) = Fixed Costs ÷ Contribution Margin Ratio

● Target Profit (Units) = (Fixed Costs + Target Profit) ÷ Contribution Margin per Unit

● Target Profit (Sales Revenue) = (Fixed Costs + Target Profit) ÷ Contribution Margin Ratio

Exercises and Problems

1. A company sells a product for $10 per unit. The variable cost per unit is $5, and the fixed
costs are $5,000. Calculate the break-even point in units.

2. A company sells a product for $20 per unit. The variable cost per unit is $10, and the
fixed costs are $10,000. Calculate the contribution margin per unit.
 3. A company sells a product for $15 per unit. The variable cost per unit is $10, and the
fixed costs are $15,000. Calculate the break-even point in sales revenue.

4. A company sells a product for $25 per unit. The variable cost per unit is $10, and the
fixed costs are $20,000. Calculate the target profit in units if the company wants to make
a profit of $10,000.

5. A company sells a product for $30 per unit. The variable cost per unit is $15, and the
fixed costs are $25,000. Calculate the target profit in sales revenue if the company wants
to make a profit of $20,000.

Answers
1. Break-Even Point (Units) = Fixed Costs ÷ Contribution Margin per Unit

● Break-Even Point (Units) = $5,000 ÷ ($10 - $5) = 1,000 units

● Answer: The break-even point in units is 1,000 units.

2. Contribution Margin per Unit = Sales Revenue – Variable Costs

● Contribution Margin per Unit = $20 - $10 = $10

● Answer: The contribution margin per unit is $10.

3. Break-Even Point (Sales Revenue) = Fixed Costs ÷ Contribution Margin Ratio

● Contribution Margin Ratio = (Sales Revenue - Variable Costs) ÷ Sales Revenue

● Contribution Margin Ratio = ($15 - $10) ÷ $15 = 0.33 or 33.33%
● Break-Even Point (Sales Revenue) = $15,000 ÷ 0.33 = $45,454.55
● Answer: The break-even point in sales revenue is $45,454.55.

4. Target Profit (Units) = (Fixed Costs + Target Profit) ÷ Contribution Margin per Unit

● Target Profit (Units) = ($20,000 + $10,000) ÷ ($25 - $10) = 1,333.33 units

● Answer: The company needs to sell 1,333.33 units to make a profit of $10,000.

5. Target Profit (Sales Revenue) = (Fixed Costs + Target Profit) ÷ Contribution Margin Ratio

● Contribution Margin Ratio = (Sales Revenue - Variable Costs) ÷ Sales Revenue

● Contribution Margin Ratio = ($30 - $15) ÷ $30 = 0.5 or 50%
● Target Profit (Sales Revenue) = ($25,000 + $20,000) ÷ 0.5 = $90,000
● Answer: The company needs to generate sales revenue of $90,000 to make a profit of
$20,000.

Capital Budgeting
Capital budgeting is the process of making investment decisions in long-term assets that
generate future cash flows. These investments include buying or replacing equipment, building
new facilities, and developing new products or services. Capital budgeting is important because
it helps businesses make informed decisions about allocating resources and investing in
projects that will maximize their value.
Methods of Capital Budgeting

There are several methods of capital budgeting that businesses can use to evaluate investment
opportunities. The following are some of the most common methods:

1. Payback Period

The payback period is the amount of time it takes for a project to generate enough cash flows to
recover the initial investment. Projects with shorter payback periods are generally preferred
because they generate cash flows sooner and are less risky.

2. Net Present Value (NPV)

The net present value is the difference between the present value of a project's cash inflows
and the present value of its cash outflows. Projects with positive NPVs are generally preferred
because they generate cash flows that are worth more than the initial investment.

3. Internal Rate of Return (IRR)

The internal rate of return is the discount rate that makes the present value of a project's cash
inflows equal to the present value of its cash outflows. Projects with higher IRRs are generally
preferred because they generate higher returns.

Factors to Consider in Capital Budgeting

When making capital budgeting decisions, businesses should consider several factors,
including:

1. Timing of Cash Flows

The timing of cash flows is an important factor to consider because cash flows that occur sooner
are generally preferred to those that occur later.

2. Risk

The risk of an investment should also be considered, as riskier investments generally require
higher returns to compensate for the additional risk.

3. Project Size

The size of a project should be considered because larger projects generally require more
resources and are more difficult to manage.

4. Capital Structure

The capital structure of a business should also be considered, as it affects the cost of capital
and the required rate of return.

Exercises and Problems

 1. A project has an initial investment of $10,000 and is expected to generate cash flows of
$2,000 per year for 7 years. Calculate the payback period of the project.

2. A project has an initial investment of $50,000 and is expected to generate cash flows of
$10,000 per year for 8 years. The discount rate is 10%. Calculate the net present value
of the project.

3. A project has an initial investment of $100,000 and is expected to generate cash flows of
$20,000 per year for 10 years. The discount rate is 15%. Calculate the internal rate of
return of the project.

Answers:

1. Payback Period = Initial Investment ÷ Annual Cash Flows

● Payback Period = $10,000 ÷ $2,000 = 5 years

● Answer: The payback period of the project is 5 years.

2. Net Present Value = Present Value of Cash Inflows - Present Value of Cash Outflows

● Present Value of Cash Inflows = $10,000 x [(1 - (1 / (1 + 10%)^8)) / 10%] =

$51,161.53
● Present Value of Cash Outflows = $50,000
● Net Present Value = $51,161.53 - $50,000 = $1,161.53
● Answer: The net present value of the project is $1,161.53.

3. Internal Rate of Return is the discount rate that makes the present value of a project's
cash inflows equal to the present value of its cash outflows. In this case, we need to find
the discount rate that will make the NPV of the project equal to zero.

● NPV = Present Value of Cash Inflows - Present Value of Cash Outflows

● NPV = $100,000 x [(1 - (1 / (1 + IRR)^10)) / IRR] - $100,000
● Solving for IRR using a financial calculator or trial and error, we get IRR =
22.57%.
● Answer: The internal rate of return of the project is 22.57%

.
Flexible Budgeting
Flexible budgeting is a budgeting technique that allows businesses to adjust their budget based
on changes in activity levels. It helps businesses to understand how changes in activity levels
affect their financial performance and to adjust their budgets accordingly. Flexible budgets are
particularly useful for businesses with variable costs, such as manufacturing and service
businesses.

Components of a Flexible Budget

A flexible budget consists of two components:

1. Fixed Costs
Fixed costs are costs that do not vary with changes in activity levels, such as rent and salaries.

2. Variable Costs
Variable costs are costs that vary with changes in activity levels, such as direct materials and
direct labor.

Advantages of a Flexible Budget

Flexible budgeting offers several advantages for businesses, including:

1. More Accurate Budgeting

Flexible budgeting allows businesses to create more accurate budgets by accounting for
changes in activity levels and their impact on costs.

2. Better Decision Making

Flexible budgeting provides businesses with more information about their costs and revenues,
which enables them to make better decisions about pricing, production, and marketing.

3. Improved Cost Control

Flexible budgeting helps businesses to control costs by identifying areas where costs can be
reduced or eliminated.

Exercises and Problems

1. A manufacturing company has a fixed cost of $50,000 per month and a variable cost of
$20 per unit. The company's budget for 10,000 units was $250,000. Calculate the
company's flexible budget for 12,000 units.

2. A service company has a fixed cost of $10,000 per month and a variable cost of $5 per
customer. The company's budget for 200 customers was $20,000. Calculate the
company's flexible budget for 250 customers.

3. A manufacturing company has a fixed cost of $100,000 per month and a variable cost of
$40 per unit. The company's budget for 5,000 units was $300,000. Calculate the
company's flexible budget for 6,000 units.

Answers

1. Flexible Budget = Fixed Costs + (Variable Costs per Unit x Actual Units)

● Flexible Budget = $50,000 + ($20 x 12,000) = $290,000

● Answer: The company's flexible budget for 12,000 units is $290,000.

2. Flexible Budget = Fixed Costs + (Variable Costs per Customer x Actual Customers)

● Flexible Budget = $10,000 + ($5 x 250) = $11,250

● Answer: The company's flexible budget for 250 customers is $11,250.

3. Flexible Budget = Fixed Costs + (Variable Costs per Unit x Actual Units)
 ● Flexible Budget = $100,000 + ($40 x 6,000) = $340,000
● Answer: The company's flexible budget for 6,000 units is $340,000.

Standard Costing
Standard costing is a cost accounting technique that involves setting predetermined costs for
materials, labor, and overhead, and comparing them with actual costs. Standard costing is used
to help businesses to control costs, improve decision-making, and evaluate performance.

Components of Standard Costing

Standard costing consists of three components:

1. Standard Material Cost

Standard material cost is the cost that a business expects to pay for the materials used in
production. This includes the cost of direct materials and indirect materials.

2. Standard Labor Cost

Standard labor cost is the cost that a business expects to pay for labor used in production. This
includes the cost of direct labor and indirect labor.

3. Standard Overhead Cost

Standard overhead cost is the cost that a business expects to incur for overhead expenses.
This includes rent, utilities, depreciation, and other indirect costs.

Advantages of Standard Costing

Standard costing offers several advantages for businesses, including:

1. Cost Control
Standard costing helps businesses to control costs by identifying areas where costs can be
reduced or eliminated.

2. Performance Evaluation
Standard costing provides businesses with a framework for evaluating performance by
comparing actual costs to standard costs.

3. Decision Making
Standard costing provides businesses with more accurate cost information, which enables them
to make better decisions about pricing, production, and marketing.

Exercises and Problems

1. A manufacturing company has a standard material cost of $10 per unit and a standard
labor cost of $15 per unit. The company produced 5,000 units, and the actual material
cost was $12 per unit, while the actual labor cost was $16 per unit. Calculate the
material and labor variances.
 2. A service company has a standard labor cost of $20 per hour. The company's
employees worked 1,000 hours, and the actual labor cost was $21 per hour. Calculate
the labor variance.

3. A manufacturing company has a standard overhead cost of $10 per unit. The company
produced 10,000 units, and the actual overhead cost was $11 per unit. Calculate the
overhead variance.

Answers

1. Material Variance = (Standard Material Cost - Actual Material Cost) x Actual Units
Produced

Labor Variance = (Standard Labor Cost - Actual Labor Cost) x Actual Units Produced

● Material Variance = ($10 - $12) x 5,000 = -$10,000

● Labor Variance = ($15 - $16) x 5,000 = -$5,000
● Answer: The material variance is -$10,000 and the labor variance is -$5,000.

2. Labor Variance = (Standard Labor Cost - Actual Labor Cost) x Actual Hours Worked

● Labor Variance = ($20 - $21) x 1,000 = -$1,000

● Answer: The labor variance is -$1,000.

3. Overhead Variance = (Standard Overhead Cost - Actual Overhead Cost) x Actual Units
Produced

● Overhead Variance = ($10 - $11) x 10,000 = -$10,000

● Answer: The overhead variance is -$10,000.

Variable Costing and Absorption Costing

Variable costing and absorption costing are two different approaches to costing that are used by
businesses to calculate the cost of goods sold and to value inventory.

Variable Costing

Variable costing is a method of costing in which only variable manufacturing costs are included
in the cost of goods sold. Fixed manufacturing costs are treated as period expenses and are not
included in the cost of goods sold. Variable costing is also known as direct costing.

Advantages of Variable Costing

Variable costing offers several advantages for businesses, including:

It provides more accurate cost information for decision-making by separating fixed and variable
costs.
It makes it easier to understand the impact of changes in sales volume on profits.

Disadvantages of Variable Costing

Variable costing has some disadvantages as well, including:

It does not comply with generally accepted accounting principles (GAAP) and is not allowed for
external reporting purposes.

It can lead to lower profits in periods of low production because fixed costs are not allocated to
inventory.

Absorption Costing

Absorption costing is a method of costing in which all manufacturing costs, both fixed and
variable, are included in the cost of goods sold. This includes direct materials, direct labor, and
all overhead costs.

Advantages of Absorption Costing

Absorption costing offers several advantages for businesses, including:

It complies with generally accepted accounting principles (GAAP) and is required for external
reporting purposes.

It provides a more accurate representation of the true cost of producing a product because all
costs are included.

Disadvantages of Absorption Costing

Absorption costing has some disadvantages as well, including:

It can lead to overvalued inventory in periods of high production because fixed costs are
allocated to inventory.

It makes it difficult to understand the impact of changes in sales volume on profits because fixed
costs are included in the cost of goods sold.

Exercises and Problems

1. A manufacturing company produced 1,000 units of product A in a month. The following

costs were incurred:

Direct materials: $10,000

Direct labor: $5,000
Variable overhead: $2,000
Fixed overhead: $3,000

Calculate the cost of goods sold and ending inventory under variable costing and absorption
costing.
 2. A manufacturing company produced 2,000 units of product B in a month. The following
costs were incurred:

Direct materials: $12,000

Direct labor: $6,000
Variable overhead: $2,500
Fixed overhead: $3,500
The company sold 1,500 units of product B during the month.

Calculate the profit under variable costing and absorption costing.

Answers

1. Variable and Absorption costing as follows:

1.1. Under variable costing:

Variable cost per unit = Direct materials + Direct labor + Variable overhead = $10 + $5 + $2 =
$17 per unit

Cost of goods sold = Variable cost per unit x Units sold = $17 x 1,000 = $17,000

Ending inventory = Variable cost per unit x Units in ending inventory = $17 x 0 = $0

1.2. Under absorption costing:

Total manufacturing cost per unit = Direct materials + Direct labor + Variable overhead + Fixed
overhead = $10 + $5 + $2 + ($3,000 ÷ 1,000) = $18 per unit

Cost of goods sold = Total manufacturing cost per unit x Units sold = $18 x 1,000 = $18,000

Ending inventory = Total manufacturing cost per unit x Units in ending inventory = $18 x 1,000 =
$18,000

1.3. Answer: The cost of goods sold is $17,000 under variable costing and $18,000
under absorption costing. The ending inventory is $0 under variable costing and
$18,000 under absorption costing.

2. Variable and Absorption costing as follows:

2.1. Under variable costing:

Variable cost per unit = Direct materials + Direct labor + Variable overhead = $12 + $6 + $2.50 =
$20.50 per unit

Cost of goods sold = Variable cost per unit x Units sold = $20.50 x 1,500 = $30,750

Variable cost of units in ending inventory = Variable cost per unit x Units in ending inventory =
$20.50 x 500 = $10,250
Ending inventory = Fixed overhead + Variable cost of units in ending inventory = $3,500 +
$10,250 = $13,750

Revenue - Cost of goods sold - Variable cost of units in ending inventory = Profit

Profit = $60,000 - $30,750 - $10,250 = $18,000

Answer: The profit under variable costing is $18,000.

2.2. Under absorption costing:

Total manufacturing cost per unit = Direct materials + Direct labor + Variable overhead + Fixed
overhead = $12 + $6 + $2.50 + ($3,500 ÷ 2,000) = $15.75 per unit

Cost of goods sold = Total manufacturing cost per unit x Units sold = $15.75 x 2,000 = $31,500

Total manufacturing cost of units in ending inventory = Total manufacturing cost per unit x Units
in ending inventory = $15.75 x 500 = $7,875

Ending inventory = Total manufacturing cost of units in ending inventory = $7,875

Revenue - Cost of goods sold - Fixed overhead in ending inventory = Profit

Profit = $60,000 - $31,500 - ($3,500 ÷ 2) = $25,250

Answer: The profit under absorption costing is $25,250.

Relevant Costing

Relevant costing is a method of cost accounting that involves identifying the costs and benefits
that will change as a result of a decision. Relevant costing is used to help businesses make
better decisions by providing more accurate cost information.

Components of Relevant Costing

Relevant costing consists of three components:

1. Relevant Costs
Relevant costs are costs that will change as a result of a decision. These costs are important in
decision-making because they will affect the profitability of a decision.

2. Irrelevant Costs
Irrelevant costs are costs that will not change as a result of a decision. These costs do not affect
the profitability of a decision and can be ignored in decision-making.

3. Opportunity Costs
Opportunity costs are the benefits that are foregone as a result of a decision. Opportunity costs
are important in decision-making because they can help to identify the best course of action.
Advantages of Relevant Costing

Relevant costing offers several advantages for businesses, including:

1. Better Decision-Making
Relevant costing provides businesses with more accurate cost information, which enables them
to make better decisions about pricing, production, and marketing.

2. Improved Profitability
Relevant costing helps businesses to improve profitability by identifying the costs and benefits
that will change as a result of a decision.

3. Competitive Advantage
Relevant costing can provide businesses with a competitive advantage by enabling them to
make better decisions and to respond more quickly to changing market conditions.

Exercises and Problems

1. A company is considering whether to accept a special order for 1,000 units at a selling
price of $20 per unit. The variable cost per unit is $12, and the fixed costs are $4,000 per
month. Should the company accept the special order?

2. A company is considering whether to make or buy a component for its product. The
company currently produces 10,000 units per year at a cost of $8 per unit. The company
can buy the component for $6 per unit. The company has fixed costs of $20,000 per
year. Should the company make or buy the component?

Answers

1. Relevant costs:

Variable costs per unit = $12

Fixed costs = $4,000 per month = $4 per unit
Opportunity costs = None
Total relevant costs per unit = Variable costs per unit + Fixed costs per unit = $12 + $4 = $16 per
unit

Revenue from special order = 1,000 units x $20 per unit = $20,000

Total relevant costs of special order = 1,000 units x $16 per unit = $16,000

Profit from special order = Revenue - Total relevant costs = $20,000 - $16,000 = $4,000

Answer: The company should accept the special order because it will generate a profit of
$4,000.

2. Relevant costs:
Cost to make per unit = $8
Cost to buy per unit = $6
Fixed costs = $20,000 per year = $2 per unit
Opportunity costs = None
Total relevant costs per unit to make = Cost to make per unit + Fixed costs per unit = $8 + $2 =
$10 per unit

Total relevant costs per unit to buy = Cost to buy per unit = $6 per unit

If the company makes the component:

Total relevant costs to make = 10,000 units x $10 per unit = $100,000

If the company buys the component:

Total relevant costs to buy = 10,000 units x $6 per unit = $60,000

Answer: The company should buy the component because it will result in a cost savings of
$40,000 ($100,000 - $60,000).

Balance Scorecard, Responsibility Accounting, and Transfer Pricing

of Goods and Services

Balanced Scorecard

The balanced scorecard is a strategic management tool that helps businesses to measure and
manage performance. It provides a comprehensive framework for measuring and monitoring
performance across four perspectives:

● Financial perspective
● Customer perspective
● Internal business process perspective
● Learning and growth perspective
●
By using the balanced scorecard, businesses can ensure that they are taking a holistic
approach to measuring and managing performance.

Responsibility Accounting

Responsibility accounting is a management accounting system that assigns responsibility for

costs and revenues to specific individuals or departments. It is used to evaluate the
performance of these individuals or departments, and to hold them accountable for the costs
and revenues associated with their responsibilities.

The purpose of responsibility accounting is to provide managers with the information they need
to make informed decisions about resource allocation, and to motivate employees to perform
well by providing them with clear performance targets and incentives.
Transfer Pricing of Goods and Services

Transfer pricing is the process of setting prices for goods and services that are transferred
between different divisions or subsidiaries of the same company. The purpose of transfer pricing
is to ensure that each division or subsidiary is fairly compensated for the goods and services it
provides, and to minimize tax liabilities.

Transfer pricing can be a complex process, and it is important to ensure that prices are set at
market rates to avoid potential legal and financial issues.

Exercises and Problems

A company has four divisions: A, B, C, and D. Division A produces a component that is used by
all the other divisions. What transfer price should Division A charge for the component?

Answers

The transfer price that Division A should charge for the component will depend on a number of
factors, including the cost of production, market rates, and the pricing policies of the company.
Generally, the transfer price should be set at a rate that is fair and reasonable, and that ensures
that all divisions are fairly compensated for the goods and services they provide. To determine
the appropriate transfer price, the company may consider using a cost-plus pricing method or a
market-based pricing method.