Chapter 1: COST CLASSIFICATIONS, TERMINOLOGY,

AND PROFIT CONCEPTS

Differences Between Financial and Managerial Accounting
COST CONCEPTS AND TERMS
Cost
(a) The amount of expenditure (actual or notional) incurred on or attributable to a specified
article, product or activity. (here the word cost is used as a noun)
(b) To ascertain the cost of a given thing. (here the word cost is used as a verb)

Cost object Anything for which a separate measurement of cost is desired.

Examples of cost objects include a product, a service, a project, a customer, a brand category, an
activity, a department, a programme.

Pre-determined - A cost which is computed in advance before production or operations start,

on the basis of specification of all the factors affecting cost, is known as a predetermined cost.
Standard Cost - A pre-determined cost, which is calculated from managements expected
standard of efficient operation. and the relevant necessary expenditure. It may be used as a basis
for price fixing and for cost control through variance analysis.

Marginal Cost - The amount at any given volume of output by which aggregate costs are
changed if the volume of output is increased or decreased by one unit.
Total Cost - The sum of all costs attributable to the cost object under consideration
Explicit Costs - These costs are also known as out of pocket costs and refer to costs involving
immediate payment of cash. Salaries, wages, postage and telegram, printing and stationery,
interest on loan etc. are some examples of explicit costs involving immediate cash payment.

Implicit Costs - These costs do not involve any immediate cash payment. They are not
recorded in the books of account. They are also know as economic costs.

Cost pool—the total costs to allocate

Cost Centre - It is defined as a location, person or an item of equipment (or group of these)
for which cost may be ascertained and used for the purpose of Cost Control.

Examples of cost centers:

• a department
• a machine
• a project
• award (in a hospital).
In a manufacturing concern there are two main types of Cost Centres as indicated below:

(i) Production Cost Centre : It is a cost centre where raw material is handled for conversion into
finished product. Here both direct and indirect expenses are incurred. Machine shops, welding
shops and assembly shops are examples of production Cost Centres.

(ii) Service Cost Centre : It is a cost centre which serves as an ancillary unit to a production cost
centre. Power house, gas production shop, material service centres, plant maintenance centres are
examples of service cost centres.

cost allocation is a procedure that allocates, or distributes, a common cost. It is defined as the
assignment of the indirect costs to the chosen cost object.

Cost driver (allocation basis)—attributes that we can measure for each cost object; they are
used to distribute costs in the cost pool among cost objects
Cost unit - It is a unit of product, service or time (or combination of these) in relation to which
costs may be ascertained or expressed. We may for instance determine the cost per ton of steel,
per ton kilometer of a transport service or cost per machine hour. Sometime, a single order or a
contract constitutes a cost unit.

Responsibility Centre - It is defined as an activity centre of a business organization

entrusted with a special task. Under modern budgeting and control, financial executives tend to
develop responsibility centres for the purpose of control. Responsibility centres can broadly be
classified into three categories. They are:

(a) Cost Centres ;

(b) Profit Centres ; and
(c) Investment Centres;

Profit Centres - Centres which have the responsibility of generating and maximizing profits are
called Profit Centres.
Investment Centres - Those centres which are concerned with earning an adequate return on
investment are called Investment Centres.

Example 1
Example 2
Suppose two families share a $60 meal. The Smith family has three members—an adult couple
and their child. The Jones family has two members—an adult couple. How might we allocate the
$60 cost of their meal?
ELEMENTS OF COST

Direct materials: Materials which are present in the finished product (cost object) or can be
economically identified in the product are called direct materials. For example, cloth in dress
making; materials purchased for a specific job etc.
Note: However, in some cases a material may be direct but it is treated as indirect, because it
is used in small quantities and it is not economically feasible to identify that quantity.

Direct labour: Labour which can be economically identified or attributed wholly to a cost
object is called direct labour. For example, labour engaged on the actual production of the
product or in carrying out the necessary operations for converting the raw materials into finished
product.
Example
The direct costs associated with a shirt (cost unit) manufactured by a clothing company would
be:
• direct materials – cloth for making shirts
• direct labor – the wages of the workers stitching the cloth to make the shirts
• direct expenses – the royalties paid to a designer.

The total of direct costs is known as the prime cost.

Indirect materials: Materials which do not normally form part of the finished product (cost
object) are known as indirect materials. These are.
 Stores used for maintaining machines and buildings (lubricants, cotton waste, bricks etc.)
 Stores used by service departments like power house, boiler house, canteen etc.
Indirect labour: Labour costs which cannot be allocated but can be apportioned to or
absorbed by cost units or cost centres is known as indirect labour. Examples of indirect labour
includes - charge hands and supervisors; maintenance workers; etc.

Indirect expenses: Expenses other than direct expenses are known as indirect expenses.
Factory rent and rates, insurance of plant and machinery, power, light, heating, repairing,
telephone etc., are some examples of indirect expenses.

The total of indirect costs is known as overheads.

Overheads: It is the aggregate of indirect material costs, indirect labour costs and indirect
expenses. The main groups into which overheads may be subdivided are the following:

COST CLASSIFICATIONS
Costs can be classified into various categories, according to:
 Explanation
Costs by Management Function
In a manufacturing firm, costs are divided into two major categories, by the functional activities
they are associated with: (1) manufacturing costs and (2) nonmanufacturing costs, also called
operating expenses.
MANUFACTURING COSTS.
 Manufacturing (production) costs are those costs associated with the manufacturing
activities of the company.
 Manufacturing costs are subdivided into three categories: direct materials, direct labor,
and factory overhead. Direct materials (also called raw materials) are all materials that
become an integral part of the finished product. Examples are the steel used to make an
automobile and the wood to make furniture. Glues, nails, and other minor items are called
indirect materials (or supplies) and are classified as part of factory overhead,
  Direct labor is the labor directly involved in making the product. Examples of direct labor
costs are the wages of assembly workers on an assembly line and the wages of machine
tool operators in a machine shop.
 Indirect labor, such as wages of supervisory personnel and janitors, is classified as part of
factory overhead.
 Factory overhead can be defined as including all costs of depreciation, rent, property
taxes, insurance, fringe benefits, payroll taxes, setup costs, waste control costs, quality
costs, engineering, workmen's compensation, and cost of idle time. Factory overhead is
also called manufacturing overhead, indirect manufacturing expenses, factory expense,
and factory burden.

NON MANUFACTURING COST

 selling expenses, general administrative expenses, and research and development costs.
marketing costs etc.

Product Costs and Period Costs

By their timing of charges against revenue or by whether they are inventoriable, costs are
classified into:
(a) product costs and
(b) period costs.

Product cost
Product costs are inventoriable costs, identified as part of inventory on hand. They are treated as
an asset until the goods they are assigned to are sold. At that time, they become the expense, cost
of goods sold. All manufacturing costs are product costs.

Period cost
Period costs are all expired costs that are not necessary for production and hence are charged
against sales revenues in the period in which the revenue is earned. Firms treat all
nonmanufacturing costs--selling, general and administrative expenses, and research and
development costs--as period costs.
Direct Costs and Indirect Costs
 Costs may be viewed as either direct or indirect in terms of the extent that they are
traceable
to a particular cost object. Direct costs can be directly traceable to the costing object. For
example, if the object of costing under consideration is a product line, then the materials and
labor involved in the manufacture of the line would both be direct costs.

 Factory overhead items are all indirect costs since they are not directly identifiable to any
particular product line. Costs shared by different departments, products, or jobs, called common
costs or joint costs, are also indirect costs.

Example

The following examples illustrate a cost object and its related direct costs for nonmanufacturing
firms.
 In a retail firm, such as a department store, costs can be traced to a department. For
example, the direct costs of the shoe department include the costs of shoes and the wages
of employees working in that department.
 Indirect costs include the costs of utilities, insurance, property taxes, storage, and
handling.
 In a service organization, such as an accounting firm, costs can be traced to a specific
service, such as tax return preparation.

 Direct costs for tax return preparation services include the costs of tax return forms,
computer usage, and labor to prepare the return.

 Indirect costs include the costs of office rental, utilities, secretarial labor, telephone
expenses and depreciation of office furniture.
By behavior and variability
By reaction to changes in the level of activity within the relevant range.
 Total variable costs change when activity changes.
 Total fixed costs remain unchanged when activity changes.
Examples of Variable Costs
 Merchandising companies – cost of goods sold.
 Manufacturing companies – direct materials, direct labor, and variable overhead.
 Merchandising and manufacturing companies – commissions, shipping costs, and
clerical costs such as invoicing.
 Service companies – supplies, travel, and clerical

Types of Fixed Costs

What is the relevant range?
Definition of Relevant Range
In accounting, the term relevant range usually refers to a normal range of volume or normal
amount of activity in which the total amount of a company's fixed costs will not change as the
volume or amount of activity changes. The term relevant range is included in the definition of
fixed costs because if a company's volume were to decline to an extremely low level, the
company would take action to decrease its total amount of fixed costs. Similarly, if the
company's volume were to increase dramatically, the company would likely have to increase the
total amount of its fixed costs.

Costs for Planning, Control, and Decision Making

Sunk costs - Historical costs incurred in the past are known as sunk costs. They play no role in
decision making in the current period. For example, in the case of a decision relating to the
replacement of a machine, the written down value of the existing machine is a sunk cost and
therefore, not considered.
Example

Out-of-pocket cost - It is that portion of total cost, which involves cash outflow. This cost
concept is a short-run concept and is used in decisions relating to fixation of selling price in
recession, make or buy, etc. Out.of.pocket costs can be avoided or saved if a particular proposal
under consideration is not accepted.

Classification by Normality
This classification determines the costs as normal costs and abnormal costs. The norms of normal
costs are the costs that usually occur at a given level of output, under the same set of conditions in
which this level of output happens.
 Normal Costs: This is a part of the cost of production and a part of the costing profit
and loss. These are the costs that the firm incurs at the normal level of output in
standard conditions.
 Abnormal Costs: These costs are not normally incurred at a given level of output in
conditions in which normal levels of output occur. These costs are charged to the
profit and loss account, they are not a part of the cost of production.

INCREMENTAL (OR DIFFERENTIAL) COSTS. The incremental cost is the

difference in costs between two or more alternatives. Incremental costs are increases or decreases
in total costs; or changes in specific elements of cost (e.g., direct labor cost), that result from any
variation in operations. Incremental costs will be incurred (or saved) if a decision is made to go
ahead (or to stop) some activity, but not otherwise.
Example

The incremental costs are simply B-A (or A - B) as shown in the last column. The incremental
costs are relevant to future decisions

RELEVANT COSTS. Relevant costs are expected future costs that will differ between
alternatives. This concept is a key to short- and long-term decisions

OPPORTUNITY COSTS. An opportunity cost is the net benefit foregone by using a

resource for one purpose instead of for another. There is always an opportunity cost involved in
making a choice decision. It is a cost incurred relative to the best alternative given up.

EXAMPLE
Suppose a company has a choice of using its capacity to produce an extra 10,000 units or renting
it out for $20,000. The opportunity cost of using the capacity is $20,000.
CONTROLLABLE AND NONCONTROLLABLE COSTS. A cost is said to be
controllable when the amount of the cost is assigned to the head of a department and the level of
the cost is significantly under the manager's influence. For example, marketing executives
control advertising costs. Noncontrollable costs are those costs not subject to influence at a given
level of managerial supervision.

EXAMPLE
All variable costs such as direct materials, direct labor, and variable overhead are usually
considered controllable by the department head. On the other hand, fixed costs such as
depreciation
of factory equipment would not be controllable by the department head, since he/she would have
no power to authorize the purchase of the equipment.

Cost of Quality
A company may have a product with a high-quality design that uses high-quality components,
but if the product is poorly assembled or has other defects, the company will have high warranty
repair costs and dissatisfied customers. People who are dissatisfied with a product are unlikely to
buy the product again. They often tell others about their bad experiences. This is the worst
possible sort of advertising. To prevent such problems, companies expend a great deal of effort
to reduce defects. The objective is to have a high quality of conformance.
Quality costs can be broken down into four broad groups. Two of these groups known as
prevention costs and appraisal costs —are incurred in an effort to keep defective products from
falling into the hands of customers. The other two groups of costs—known as internal failure
costs and external failure costs —are incurred because defects occur despite efforts to prevent
them.
MERCHANDISING BUSINESS
Cost of goods sold

MANUFACTURING ORGANIZATIONS
 Why use normal costing instead of actual costing?
Definition of Normal Costing
For a manufacturer, normal costing means assigning the following costs to the actual goods
produced each month:
 Actual direct materials
 Actual direct labor
 Applying manufacturing overhead by using predetermined annual overhead rates times
actual goods produced
Definition of Actual Costing
For a manufacturer, actual costing means assigning the following costs to the actual goods
produced each month:
 Actual direct materials
 Actual direct labor
 Actual manufacturing overhead incurred during each month is applied to the goods
produced in that month
Examples of Normal Costing and Actual Costing
Assume that a manufacturer experiences an additional $200,000 in manufacturing overhead
costs (air conditioning and other) in each of the months of June, July, and August. The overhead
costs in each of the other 9 months is $1,000,000. Therefore, on an annual basis the
manufacturing overhead is $12,600,000.
Assume that the overhead costs are assigned/allocated/applied to products using machine
hours (MHs). MHs are 50,000 each month, except for December and January when each month
has 30,000 MHs. Therefore, for the year there are expected to be 560,000 MHs.
Using normal costing, the company applies the manufacturing overhead to products at a rate
of $22.50 per MH ($12,600,000/560,000 MH) throughout the year.
Using actual costing, the company will apply the manufacturing overhead to products at the
following rates:
 January and December: $33.33 per MH ($1,000,000/30,000 MH)
 February-May and September-November: $20.00 per MH ($1,000,000/50,000 MH)
 June through August: $24.00 per MH ($1,200,000/50,000 MH)
As shown above, normal costing results in an overhead rate that is uniform and realistic for all
units manufactured during an accounting year.

The Normal Capacity Vs. Expected Capacity in Cost Accounting

Capacity refers to the ability of a company to produce a product, or provide a service, within a
given period. It is defined by constraints such as space, labor, materials, equipment and access
to capital. Generally expressed in terms that are most appropriate for the business -- per night
for a hotel, per day for a resort stay or per hour for a therapist -- the difference between
normal and expected capacity is slight yet meaningful.
Ideal Capacity
Ideal is a word that usually describes the best situation. Ideal capacity is when the
volume of activity is at its peak performance, with no allowance for operational
inefficiency. This is also referred to as theoretical capacity or maximum capacity and is
often used as the upper limit for determining capacity limitations. Normal capacity and
expected capacity will always be lower than ideal capacity.
Practical Capacity
Practical capacity is the level of capacity a business can operate at that allows for a
certain amount of inefficiency, also known as human error or "Murphy's law." Like ideal
capacity, it is based on theory, not actual demand. Losses due to weather, holidays,
repairs and breakdowns are taken into consideration. Practical capacity is always lower
than maximum or ideal capacity. It may be lower or higher than normal or expected
capacity depending on the nature of the business.
Normal and Operating Capacity
Normal capacity has many similarities with practical capacity, which is based on a theory
of operational efficiency. Normal capacity is driven by business demand, not by
maximum capacity. It takes the seasonal and cyclical demand cycle into consideration
and is usually estimated over a two- to three-year period. Operating capacity is similar
to normal capacity except it is calculated over a daily, monthly or quarterly period.