EMAC2714

LEARNING UNIT 2 – COST TERMS AND CONCEPTS

 LEARNING OUTCOMES
At the end of this learning unit, a student should be able to:
1. Explain why it is necessary to understand the meaning of different cost
terms;
2. Define and illustrate a cost object;
3. Explain the meaning of each of the key terms or concepts highlighted in
bold in this chapter;
4. Explain why in the short term some costs and revenues are not relevant for
decision-making;
5. Describe the three purposes for which cost estimation is required.
 COSTS…..WHAT IS A COST?
Cost is …………………………………………………………………………………………….

…………………………………………………………………………………………………….

The cost is the “asset” that you had to give up to get something (this “asset” is
normally cash but can also be other assets that are exchanged for something)

Cost is a very broad term – so in management accounting there will always be

an adjective (a descriptive word before cost to make the term more specific)

We, as management accountants, must understand what a cost is as well as

the different types of costs so that we can communicate and calculate these
costs correctly
 WHY DO WE NEED TO
CALCULATE “COSTS”
1……………………………………………………………………………………..

2……………………………………………………………………………………..

3……………………………………………………………………………………..

1. PRODUCT costs are very important in order to calculate the value of inventory (goods that
have not yet been sold will lie in the statement of financial position as inventory)as well as
the value of goods that have been sold (these will lie in the statement of comprehensive
income as cost of sales)
2. Cost information, all the different types of costs that we have in a company (we will look at
some of these “types” in this learning unit) is VITAL for decision making purposes – this affects
things like product cost, selling price, whether we will introduce new products or remove
certain products from production, whether we will accept special orders, etc.
3. Costs, and revenues, and the resulting profit (the performance of the company) becomes
very important for performance management purposes as well as in setting budgets
(planning) and determining whether the company is operating effectively and efficiently
(control).
 DIFFERENT COST TYPES
How is the classification by type determined?

…………………………………………………………………………………………………..

Different cost types that we will look at this year are:

Material and labour costs
Direct and indirect costs
Product and period costs
 DIFFERENT COST BEHAVIOR
How is the classification of costs, using behaviour, determined?

……………………………………………………………………………………….

Cost behavior deals with how the cost changes if the company produces
more or less units – so if production changes, what happens to the cost

Different cost behaviors that we will look at this year are:

Fixed and variable costs
Semi-fixed and semi-variable costs
Relevant and irrelevant costs
Sunk costs
Opportunity costs
Incremental costs and marginal costs
 COST OBJECT

What is a cost object?

……………………………………………………………………………
…………………..

The cost object is the “something” that we are assigning costs to (or calculating the
cost of) – for EMAC2714 this “something” is normally a product (or inventory)
If we are calculating the cost of a table that we are manufacturing, the cost object is
the table
If we are calculating the cost of a mtor vehicle that we are manufacturing, the cost
object is the motor vehicle
If we are calculating the costs to run a department, the cost object is the department
INVENTORY
 FORMAT TO CALCULATE THE COST
OF INVENTORY
Cost of inventory (structure)

_________________________ This format is VERY important – and we

_________________________
_________________________
_________________________
___________
___________
will be working with it in almost every
chapter for the rest of the semester!
We will now look at the different cost
terms and this will also help to explain
the difference between the “direct”
costs listed in the format and the
“overheads”……
 DIRECT AND INDIRECT COSTS
Direct cost:…………………………………………………………………………………………

Indirect cost:…………………………………………………………………………………........

Direct material – if we are manufacturing a
wooden table, wood is a direct material.
If we are manufacturing cooldrink, the
water and sugar added are direct materials.
Direct materials will increase when a
company increases production levels
For it to be a direct cost – we must be able
to MEASURE exactly how much is used for
each unit of production
All direct costs are referred to as PRIME costs
Indirect costs – costs like electricity, rates
and taxes, or material that we can’t trace
directly to a specific product
Indirect costs are also called OVERHEADS
Indirect costs incurred in the manufacturing
process – MANUFACTURING OVERHEADS
Overheads PLUS direct labour = Conversion
costs
QUIZ
 PERIOD AND PRODUCT COSTS
Period Costs:
……………………………………………….
……………………………………………….
…………………………………………........
Costs like advertising, rental expense
These costs are not included in inventory
valuation
Period costs are recognized as an expense
in the period in which they are incurred
(recognized in the statement of
comprehensive income)
Normally non-manufacturing expenses
Product Costs:
……………………………………………….
……………………………………………….
……………………………………………….
Costs like direct material and direct labour
These are included in inventory valuation
(costs of goods that are not yet sold will be
in inventory in the SFP, costs relating to
goods sold will be reported in SCI as Cost of
sales)
Normally manufacturing expenses
 QUIZ

• Work through example 2.1

 FIXED AND VARIABLE EXPENSES
Fixed Costs:
……………………………………………….
……………………………………………….
…………………………………………........
Example – RENT (monthly rent stays
constant irrelevant of how many
units we produce per month)
In the long term (several years) ALL
costs are variable
Variable Costs:
……………………………………………….
……………………………………………….
…………………………………………........
Example – Direct material (the more
units we produce the higher this cost
is going to be) – it increases in direct
proportion to the increase in activity
level
 FIXED AND VARIABLE EXPENSES
These graphs are VERY important!!!!!!!!!!!!

• Total cost graphs:

FIXED COSTS VARIABLE COSTS

• Cost per unit graphs:

FIXED COSTS VARIABLE COSTS

 SEMI VARIABLE COSTS
• These costs have a fixed portion as well as a variable portion

• Cellphone contracts are the most practical example – you have an amount
per month for your handset (FIXED) PLUS your monthly calls that you make
and the data that you use (VARIABLE)
 SEMI-FIXED COSTS
• These costs are also known as “stepped fixed costs”
• They are constant (fixed) for a certain activity range – above this activity
range the cost will increase/decrease with a fixed amount
• An example of this is if we use rented machines in our production process.
One machine can produce for example 10 000 units, as soon as we need to
product 10 001 units we need to rent another machine, and therefore the
“fixed” cost for rental, will increase after 10 000 units.
QUIZ
 RELEVANT AND IRRELEVANT COSTS
Relevant Costs:
……………………………………………….
……………………………………………….
…………………………………………........
Examples of relevant costs = Direct
material/direct labour
Relevant costs are important for
decision-making purposes
Relevant costs are AVOIDABLE
Irrelevant Costs:
……………………………………………….
……………………………………………….
…………………………………………........
Examples of irrelevant costs = Rent
(no decision we make today will
affect the rental expense for the
foreseeable future)
Irrelevant costs are ignored for
decision-making purposes
Irrelevant costs are UNAVOIDABLE
 OTHER COSTS
• Sunk Costs:………………………………………………………………………………..

• Opportunity costs:……………………………………………………………………….

• Incremental costs:………………………………………………………………………

• Marginal costs:…………………………………………………………………………..
 HOMEWORK
• Example 2.1 and 2.2

• Review questions 2.1-2.6, 2.8 – 2.12

• Review problems 2.17 – 2.19

• Running Ltd

• Assignment!!!!