Presentation 04 (1slide-Pg)

ECONOMICS FOR MANAGERS
COST CONCEPTS II
BASIC TERMS
The cost collection system typically accounts for costs in two broad stages:
it accumulates costs by classifying them into certain categories,
it assigns these costs to cost objects.
Cost object - anything for which cost data are desired (products, product lines,
customers, jobs, and organizational subunits such as departments).
In other words, if we want to know the cost of something, this something is called cost
object.
Cost pool – grouping of individual cost items

Cost driver - any factor that causes a change in the cost. It is the level of
activity or volume whose change causes proportionate changes in variable costs
(e.g. direct labour hours, machine hours)
Cost centre - an area of an organization for which costs are collected for the
purposes of cost ascertainment, planning, decision making, and control (e.g.
departments).
ECONOMICS FOR MANAGERS 2023/24

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DIRECT AND INDIRECT COSTS
Costs may be classified as direct costs and indirect costs

on the basis of whether they can be attributed to the
production of specific goods, services, departments or
not.
Direct costs - those costs that can be easily and
accurately identified with a particular cost object.
Indirect costs - those costs that cannot be easily and
accurately identified with a particular cost object.

3
DIRECT AND INDIRECT COST
Direct costs Indirect costs

Direct materials – all those Indirect materials – materials
materials that can be identified that cannot be identified with
with a particular product (wood any one product, because they
that is used to manufacture a are used for the benefit of all
desk) products (materials used for the
repair of a machine that is used
Direct labour – those labour for the manufacture of many
costs that can be identified with different products).
a particular product (wages of Indirect labour – labour costs
workers who assembly that cannot be identified with a
products) particular product (salaries of
factory supervisors)
Direct expenses - other Indirect expenses - other
expenses incurred specifically expenses that cannot be directly
for a particular product traced to a product.
____________________________ ____________________ ____
= Prime cost = Overheads
ECONOMICS FOR MANAGERS 2023/24 4
DIRECT / INDIRECT VERSUS VARIABLE / FIXED
COSTS
Variable/fixed costs and direct/indirect costs are determined by two quite
distinct principles:
behaviour in relation to changes in activity level (variable/fixed)
direct indentification with a product (direct/indirect)
Direct
Electricity cost of a Depreciation of a

single-purpose machine single-purpose machine
Variable
Fixed
Electricity cost of a Depreciation of a multi-
multi-purpose machine purpose machine

Indirect 5
MANUFACTURING AND
NON-MANUFACTURING COST
Manufacturing (production) Costs - Non-Manufacturing Costs – costs
costs associated directly with the that are incurred outside the
manufacturing process. production process
+ Direct materials + Selling
+ Direct labour + Administrative cost
+ Direct expenses
+ Interest expenses
= Prime cost
+ Research and development
+ Manufacturing overheads
= Total non-manufacturing cost
= Total manufacturing cost
Prime cost Manufacturing

Example of manufacturing overheads: depreciation cost
of machinery in multi-product company
Overheads Non-manuf.
ECONOMICS FOR MANAGERS 2023/24 cost 6
PRODUCT AND PERIOD COSTS
Product costs are part of the cost of goods manufactured. Such

costs are incurred on the manufacturing process either directly as
material and labour costs or indirectly as overheads.
Examples: raw material, labour, factory depreciation, fuel and
packaging costs
Period costs are all costs other than product costs. These are not
incurred on the manufacturing process, and therefore these cannot
be assigned to cost goods manufactured. Period costs are thus
expensed in the period in which they are incurred.
Examples: advertising, sales commissions, office supplies, research
and development.

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COST ASSIGNMENT
Cost assignment is the process of identifying,

aggregating, and assigning costs to cost objects.
The aim is to find out the unit cost related to a specific
cost object to determine if the cost object is profitable
enough.
Cost assignment encompasses:
tracing direct costs
allocating indirect costs
There is no overly precise method available for an allocation
a cost to a cost object, so the allocating entity is using an
approximate method for doing so.

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COST ASSIGNMENT APPROACHES
Identifying the cost object (products, jobs,

departments, processes)
Accumulating the costs: collecting costs by some
“natural” classification such as materials or labour.
Assigning costs to cost objects
Direct cost Cost tracing

Cost
object
Indirect cost Cost allocation

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Single Stage Multi-Stage Equivelence Joint Product Job Order
Costing Costing Coeff. Costing Costing Costing
COST ALLOCATION - METHODS
Traditional Methods
Single Stage Costing
Multi-Stage Costing
Equivalence Coefficient Costing
Joint Product Costing
Residual Value Method
Proportional Value Method
Job Order Costing
Activity Based Costing (ABC)

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SINGLE STAGE COSTING
Single Stage method - simple method of cost allocation

Total costs are divided by the total output to determinate the
average cost per unit (unit cost)
The method is useful in single product firms
Example: power plants (production of electrical power as a single
product)
Where:
TC UC = Total average cost per unit
UC = TC = Total cost
X
X = Output

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SINGLE STAGE COSTING

Winery Pinot produced 20,000 bottles of Chardonnay in 2020
Total manufacturing costs amounted € 56,000
Non-manufacturing costs (selling costs) amounted € 9,000
All production will be sold on the market
Total Production 20,000 units

Manufacturing cost € 56,000
Non-manufacturing cost € 9,000
56000 + 9000
Cost per unit = = 3.25
20000
Cost per bottle sold on the market = € 3.25

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MULTI-STAGE COSTING
Multi-Stage method is used when a product is manufactured in

two or more stages.
Manufacturing costs are ordered to single production stages.
The level of production in each production stage must be known.
CP 1 CP 2 CP n CA S
UC = UCMat + + +. . . + +
X X X PS
UC = Total average cost per unit

UCMat = Unit cost of material
CP = Manufacturing costs related to given production stage
CA+S = Administration and Sales costs
X = Output of given production stage
PS = Products sold

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MULTI-STAGE COSTING
Winery Pinot produced 20,000 bottles of Chardonnay in 2020
Total manufacturing costs amounted € 56,000
Non manufacturing costs amounted € 9,000
The Winery wants to keep 1,000 bottles for representative
purposes, and the rest will be sold on the market
Total Production 20,000 units
Production for Sale 19,000 units
Manufacturing cost € 56,000
Non-manufacturing cost € 9,000
56000 9000
Cost per unit = + = 2.8 + 0,47
20000 19000
Cost per bottle sold on the market = € 2.80 + € 0.47 = € 3.27

Cost per bottle kept in the firm = € 2.80
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EQUIVALENCE COEFFICIENT COSTING
Equivalence Coefficient costing is suitable for similar

products with a common process of manufacturing.
Final products have the same material basis
The cost allocation is based on a hypothetical conversion of
several final products into one product
MCGP MCPG
UC = =
∑ equivalent units E × X + E × X + ⋯ + E × X
Where:
UC = UC × E MCGP = Manufacturing cost of goods
produced
X1…Xn = Quantity of goods produced
UC = UC × E E1…En = Equivalence coefficients
UC1… UCn = Unit costs

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EQUIVALENCE COEFFICIENT COSTING

The Soft Beverage LLC produced the following numbers of
lemon lemonade bottles during the first quarter 2021
Total cost of production reached € 89,280
Product Quantity Equivalence Equivalent units
coefficient
1 (bottle 0.5 l) 38,000 1 38,000
2 (bottle 1.5 l) 18,000 3 54,000
3 (bottle 2.0 l) 13,000 4 52,000
Σ 144,000
89,280 Cost to produce 1 unit (bottle)

UC = = 0.62
144,000
1 0.5 l € 0.62
UC2 = 0.62 × 3 = 1.86 2 1.5 l € 1.86
3 2.0 l € 2.48
UC3 = 0.62 × 4 = 2.48
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JOINT PRODUCT COSTING
Joint product costing is used when a given product cannot

be produced without producing other product(s).
The products are not identifiable as different product until
a specific point in the production process is reached.
Methods:
Residual value method - if one product is considered as
a main product and other products as by-products.
Proportional value method – if there is no hierarchy
between joint products.

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RESIDUAL VALUE METHOD
 Residual value method is used when the production results in

main product(s) and by-product(s) which have no or minor
sales value compared with main product(s)
JC − (UP2 × X2 ) Where:
UC. = A = Main product
X.
B = By-product
XA = Quantity of main products A
XB = Quantity of by-products B
Assumption: JC = Joint costs
UCA = Unit cost of main product A
UPB = UCB UCB = Unit cost of by-product B
UPB = Unit price of by-product B

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RESIDUAL VALUE METHOD
Farmer Ben has achieved a yield of 60 t wheat grain per hectare. He

has also harvested 45 t of wheat straw per hectare as a by-product.
Total cost per 1 hectare of wheat: € 6,000
Estimated value of wheat straw: € 30/t
Price of wheat straw: € 30 per t (= cost)
Total cost of straw: 30 × 45 = 1,350

Total cost of wheat grain: 6,000 – 1,350 = 4,650
Unit cost of 1 t wheat grain: 4,650/60 = 77.5
Farmer`s cost to produce 1 t wheat = € 77.50

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PROPORTIONAL VALUE METHOD
 Proportional value method is used when the production

results in joint product(s) where each product has a significant
relative sales value.
Where:
JC A = Product A
UC. = × UP. B = Product B
UP. × X. + UP2 × X2 XA = Quantity of products A
XB = Quantity of products B
JC = Joint costs
JC UCA = Unit cost of product A
UC2 = × UP2 UCB = Unit cost of product B
UP. × X. + UP2 × X2
UPA = Unit price of product A
UPB = Unit price of product B

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PROPORTIONAL VALUE METHOD
A crude oil refinery produces couple products: heating oil, petrol and
technical gases. Total costs in January amounted € 192,440 ths.
Cost allocation according to the selling price
Tonnes ths Price €/t Rev. € ths Cost/t

Heating oil 800 230 184,000 € 195.50
Petrol 125 320 40,000 € 272.00
Technical gases 24 100 2,400 € 85.00
Heating oil: 230 x 0.85 = 195.50

192,440
= 0.85 Petrol: 320 x 0.85 = 272,00
184,000 + 40,000 + 2,400
Technical gases: 100 x 0.85 = 85.00
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JOB ORDER COSTING
Job order costing is used when the products are sufficiently different
from each other.
It is based on an allocation of indirect cost by using an absorption rate.
The base for an absorption of indirect cost is an item of direct costs
(material cost, labour cost or total direct cost).
Basic formula:
Unit cost = direct cost per unit + a portion of indirect costs
Steps:
Tracing direct costs to the job (cost object)
Identifying the indirect costs i.e. manufacturing overheads and finding the
cost allocation (absorption) base
Applying the indirect costs to the job using the pre-determined allocation rate
Finding total cost by summing up all the cost components
22
JOB ORDER COSTING
Using direct cost of materials as an allocation base

TOC UC = Cost per unit
UOC = × UMC TMC = Total direct cost of materials
TMC
TLC = Total direct cost of labour
TOC = Total overheads costs
UC = UMC + ULC + UOC UMC = Direct cost of materials per unit
ULC = Direct cost of labour per unit
UOC = Overhead per unit
Using direct cost of labour as an allocation base

TOC
UOC = × ULC
TLC
UC = UMC + ULC + UOC

23
USING DIRECT MATERIAL AS AN ALLOCATION BASE
A manufacturer that produces two

products needs to calculate the total unit Unit cost calculation
cost of both for purposes of setting prices
A B
Product A Product B Direct material/unit 30.00 32.00
Direct material/unit € 30.00 € 32.00 Direct labour/unit 10.00 8.00
Direct labour/unit € 10.00 € 8.00
Overheads/unit 18.00 19.20
Quantity 2,100 4,000
Total cost/unit 58.00 59.20
Total overheads € 114,600
Assumption: The base for an allocation of

overheads is an item of direct material cost
A: overheads/unit: 30 x 0.6 = 18
@@A, BCC
67789:;<8= >:;? = = C. B
DC × E, @CC + DE × A, CCC
B: overheads/unit: 32 x 0.6 = 19.2

24
USING DIRECT LABOUR AS AN ALLOCATION BASE
A manufacturer that produces two

products needs to calculate the total unit Unit cost calculation
cost of both for purposes of setting prices
A B
Product A Product B Direct material/unit 30.00 32.00
Direct material/unit € 30.00 € 32.00 Direct labour/unit 10.00 8.00
Direct labour/unit € 10.00 € 8.00
Overheads/unit 21.62 17.30
Quantity 2,100 4,000
Total cost/unit 61.62 57.30
Total overheads € 114,600
Assumption: The base for an allocation of

overheads is an item of direct labour cost
A: overheads/unit: 10 x 2.16 = 21.62
@@A, BCC
67789:;<8= >:;? = = E. @BED
@C × E, @CC + F × A, CCC
B: overheads/unit: 8 x 2.16 = 17.30

25
USING BOTH DIRECT MATERIAL AND DIRECT LABOUR

AS AN ALLOCATION BASE
Product A Product B Unit cost calculation
Direct material/unit € 30.00 € 32.00 A B

Direct labour/unit € 10.00 € 8.00 Direct material/unit 30.00 32.00
Quantity 2,100 4,000 Direct labour/unit 10.00 8.00
Total overheads € 114,600 DM overheads/unit 12.60 13.44
Percentage of overheads depending on direct DL overheads/unit 6.49 5.19

material: 70% Total cost/unit 59.09 58.63
Percentage of overheads depending on direct
labour: 30%
Allocation base: direct material A: overheads/unit: 30 x 0.6 x 0.7 = 12.60

67789:;<8= >:;? = C. B B: overheads/unit: 32 x 0.6 x 0.7 = 13.44
Allocation base: direct labour A: overheads/unit: 10 x 2.16 x 0.3 = 6.49
67789:;<8= >:;? = E. @BED
B: overheads/unit: 8 x 2.16 x 0.3 = 5.19
26
PROBLEM OF TRADITIONAL PRODUCT COSTING
SYSTEM
Traditional product cost systems, which assume that
products consume all resources in proportion to their
production volumes, can report distorted product costs:
Product undercosting - a product consumes a high
level of resources but is reported to have a low cost per
unit
Product overcosting - a product consumes a low level
of resources but is reported to have a high cost per unit
Product-cost cross-subsidization - if a company
undercosts one of its products, then it will overcost at
least one of its other products

27
ACTIVITY BASED COSTING (ABC)
Activity based costing seeks to deal with the fact that

many overhead costs vary not with the volume of items
produced but with the range of the items of the production
processes.
Direct cost Overhead cost
Activity Activity Activity

cost cost cost
centre 1 centre 2 centre 3
Cost Object
28
STEPS IN ABC COSTING
 Identification of products that are chosen to cost objects

 Identification of direct costs of the products
 Selecting activities and cost allocation bases for allocating indirect
costs to the products
 Identification of indirect costs associated with each cost-allocation
base
 Computing the rate per unit of each cost-allocation base
 Computing indirect costs allocated to the products
 Computing total unit cost of the products by adding all direct and
indirect costs assigned to the products

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TRADITIONAL VERSUS ABC APPROACH
The company ABC produces monthly 2,000 units of each product X and Y.
Overhead costs: € 113,000
Direct labour hours per month: 5,000
Product X Product Y
Hours of direct labour per unit 1 1.5
Direct materials per unit € 17.50 € 12.00
Direct labour per unit € 7.00 € 10.50
Prime cost € 24.50 € 22.50
TRADITIONAL APPROACH
Allocation base: direct labour Product X Product Y
Overhead allocation rate: Prime cost € 24.50 € 22.50

113,000/5,000 = € 22.60 Overhead € 22.60 € 33.90
Total cost/unit € 47.10 € 56.40
ABC APPROACH
Identification of basic activities:

Machining
Finishing
Materials ordering
Materials handling
Scheduling, control and quality testing of production
Indirect cost apportion:

Machining € 45,000
Finishing € 25,000
Materials ordering € 4,000
Materials issue to production € 12,000
Scheduling € 27,000
€ 113,000

ABC APPROACH
Activity Cost driver Total Prod. X Prod. Y €
Machining Machine hours 3,000 2,000 1,000 45,000
Finishing Direct labour hours 5,000 2,000 3,000 25,000
Materials ordering Number of order placed 25 16 9 4,000
Materials issue to Number of materials issues
75 47 28 12,000
production made
Scheduling Number of production runs 36 22 14 27,000
Σ 113,000
Machining: 45,000/3,000 = € 15 per machine hour

Finishing: 25,000/5,000 = € 5 per labour hour
Materials ordering: 4,000/25 = € 160 per order
Materials handling: 12,000/75 = € 160 per issue
Scheduling: 27,000/36 = € 750 per run

ABC APPROACH
Activity Product X Product Y
Machining 2,000×15 30,000 1,000×15 15,000
Finishing 2,000×5 10,000 3,000×5 15,000
Materials ordering 16×160 2,560 9×160 1,440
Materials issue to
47×160 7,520 28×160 4,480
production
Scheduling 22×750 16,500 14×750 10,500
Total 66,580 46,420
Production X: 2,000 units

Production Y: 2,000 units
Product X Product Y
66,580 Prime cost 24.50 22.50
GHI JKLM N = = 33.29
2,000 Overheads 33.29 23.21
Production cost (ABC) 57.79 45.71
46,420
GHI JKLM O = = 23.21 Prod. cost traditional 47.10 56.40
2,000

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ECONOMICS FOR MANAGERS

Cost pool – grouping of individual cost items

ECONOMICS FOR MANAGERS 2023/24

Costs may be classified as direct costs and indirect costs

ECONOMICS FOR MANAGERS 2023/24

Direct costs Indirect costs

Electricity cost of a Depreciation of a

ECONOMICS FOR MANAGERS 2023/24

Prime cost Manufacturing

Product costs are part of the cost of goods manufactured. Such

ECONOMICS FOR MANAGERS 2023/24

Cost assignment is the process of identifying,

ECONOMICS FOR MANAGERS 2023/24

Identifying the cost object (products, jobs,

Direct cost Cost tracing

ECONOMICS FOR MANAGERS 2023/24

COST ALLOCATION - METHODS

Activity Based Costing (ABC)

SINGLE STAGE COSTING

Single Stage method - simple method of cost allocation

ECONOMICS FOR MANAGERS 2023/24

SINGLE STAGE COSTING

Total Production 20,000 units

Cost per bottle sold on the market = € 3.25

ECONOMICS FOR MANAGERS 2023/24

Multi-Stage method is used when a product is manufactured in

UC = Total average cost per unit

ECONOMICS FOR MANAGERS 2023/24

Cost per bottle sold on the market = € 2.80 + € 0.47 = € 3.27

EQUIVALENCE COEFFICIENT COSTING

Equivalence Coefficient costing is suitable for similar

ECONOMICS FOR MANAGERS 2023/24

EQUIVALENCE COEFFICIENT COSTING

89,280 Cost to produce 1 unit (bottle)

JOINT PRODUCT COSTING

Joint product costing is used when a given product cannot

ECONOMICS FOR MANAGERS 2023/24

RESIDUAL VALUE METHOD

 Residual value method is used when the production results in

ECONOMICS FOR MANAGERS 2023/24

RESIDUAL VALUE METHOD

Farmer Ben has achieved a yield of 60 t wheat grain per hectare. He

Price of wheat straw: € 30 per t (= cost)

Total cost of straw: 30 × 45 = 1,350

Farmer`s cost to produce 1 t wheat = € 77.50

ECONOMICS FOR MANAGERS 2023/24

PROPORTIONAL VALUE METHOD

 Proportional value method is used when the production

ECONOMICS FOR MANAGERS 2023/24

PROPORTIONAL VALUE METHOD

Tonnes ths Price €/t Rev. € ths Cost/t

Heating oil: 230 x 0.85 = 195.50

JOB ORDER COSTING

JOB ORDER COSTING

Using direct cost of materials as an allocation base

Using direct cost of labour as an allocation base

UC = UMC + ULC + UOC

ECONOMICS FOR MANAGERS 2023/24

USING DIRECT MATERIAL AS AN ALLOCATION BASE

A manufacturer that produces two

Assumption: The base for an allocation of

ECONOMICS FOR MANAGERS 2023/24

USING DIRECT LABOUR AS AN ALLOCATION BASE