COST: Definition

“Cost is the cash or cash-

equivalent value sacrificed for
goods and services that is
expected to bring a current or
future benefit to the
organization.”
Basic Cost Terminology

 Actual cost – a cost that has occurred

 Budgeted cost – a predicted cost
 Cost object – anything of interest for which a cost is desired
A cost object may be a product (e.g. Cost of a television type
1001) or a process (e.g. Cost of painting gas cylinders). A service
may be a cost object.
Cost centre is defined as the smallest segment of activity or area of
responsibility for which costs are gathered. accounts office;
materials handling department, quality department, IT
department.
Cost Unit
 Cost Unit – A unit of quantity of product , service or time , in
relation to which cost may be ascertained or expressed
 Examples

Industry Cost Unit

Building House or Square Foot area
Cement Tonne
Cables Meter
Power Kilowatt Hour
Automobiles Number
Direct Cost
1. Direct costs – can be conveniently and economically traced
(tracked) to a cost object
 Direct material: Those materials that become an integral part
of finished product. Plastic, wood etc. plastics produced by Du
Pont becomes raw material for Compaq Computers in its PC
 Indirect material: Sometimes it is not worth the effort to trace
the cost of relatively insignificant material to end product.
Examples, nails and glue
2. Direct and Indirect Labour

Physically and conveniently traced to individual

units or product
Ex: Assembly line workers for Toyota, Carpenter
for furniture

Labour cost that cannot be traced to a product.

Janitors, security guards, supervisors.
Direct and indirect Expenses

Direct Expense: Hire charge of machinery exclusively for a cost object

Indirect expenses: rent, depreciation, insurance .

Indirect material+ Indirect labour + Indirect expenses = Overheads

Overheads are manufacturing (cost associated with operating the factory

and non manufacturing costs are the selling and administrative costs.

Direct material+ Direct labour = Prime Cost

Direct Labour + Manufacturing overhead cost = Conversion cost

(because these costs are needed To convert materials into finished
products.
BMW: Assigning Costs to a Cost Object
Classification by cost behaviour
• Important to predict costs and revenues at different activity levels for many
decisions.

• Variable costs vary in direct proportion with activity.

• Fixed costs remain constant over wide ranges of activity.

• Semi-fixed costs are fixed within specified activity levels, but they eventually
increase or decrease by some constant amount at critical activity levels.

• Semi-variable costs include both a fixed and a variable component (e.g telephone
charges).
 The Trend Toward Fixed Costs
The trend in many industries is toward greater
fixed costs relative to variable costs.

As machines take over Knowledge workers

many mundane tasks tend to be salaried,
previously performed highly-trained and
by humans, difficult to replace. The
“knowledge workers” cost of compensating
are demanded for these valued employees
their minds rather is relatively fixed
than their muscles. rather than variable.1
Cost Behavior Summarized
Total Dollars Cost per Unit
Total Dollars Cost Per Unit
Change in
Change in with Unchanged in
proportion
Variable Costs proportion
Variable with relation to output
output
output
Costs More =output
More output = More
More cost
cost

Fixed Costs Unchanged in Change

Change
inversely
relation to output withwith
inversely
Unchanged in output
output
More output = lower cost
Fixed Costs relation to More output = lower
per unit
output cost
Relevant and irrelevant costs and revenues

• Relevant costs and revenues are those future costs and revenues that will
be changed by a decision,whereas irrelevant costs and revenues will not be
changed by a decision.
The cost which differs between two alternatives for decision making is called
relevant cost. It is a future cost that differs between two alternative courses
of action. For example, a garment exporter plans to manufacture either
of two types of garments and export. The following are the cost related to
the alternatives I and II. Assume that the garments will have the same selling price.
Cost Alternative I Alternative II
Designing cost Rs. 50000 Rs. 50000
Material (per meter) Rs. 500 Rs. 600
Labour (per unit) Rs. 350 Rs. 200
Other expenses Rs. 500 Rs. 520

Here designing cost is irrelevant for decision making as the cost between
the two alternatives is the same.
Other costs are relevant since there is a difference in costs between
the alternatives. The exporter should go ahead with alternative II as the total cost per
unit is Rs. 1320 as compared to Rs.1350 in alternative I.
Fixed cost is an irrelevant cost for decision making up to a

relevant range.
For example, a plant has the maximum operational capacity to produce
20000 units of a product per annum. At present the plant produces
12000 units and has a spare unused capacity of 8000 units.
Current selling price of each unit is Rs. 100, the
variable cost (direct material, labour and variable overhead)
is Rs. 50 and the total fixed cost incurred is Rs. 300000.
If the manufacturer gets a onetime order from the neighbouring state to supply
6000 units at Rs. 80. Should he accept the order?

Assume that the transportation cost will be borne by the buyer.

Solution
Total capacity 20000 units
Used capacity 12000 units
Spare capacity 8000 units
Special order 6000 units

Present (12000 units) Proposed (18000 units) Difference

A. Total Sale (Rs.) 1200000 (12000 x Rs. 100) 1680000 (12000 x Rs. 100 + 480000
6000 x Rs. 80)
Less Total cost

Variable cost @Rs. 50 600000 900000 300000

per unit

Fixed cost (Rs.) 300000 300000 0

A. Total cost (Rs.) 900000 1200000 300000

Profits (A-B) 300000 480000 180000

Sunk costs

• Sunk costs are the costs of resources already acquired and are
unaffected by the choice between the various alternatives are irrelevant for
decision-making.

Opportunity costs

• A cost that measures the opportunity that is lost or sacrificed when the
choice of one course of action requires that an alternative course of action
be given up.
 Manufacturing Versus
Nonmanufacturing Costs

Manufacturing Costs
Costs incurred in the factory
or plant
Nonmanufacturing Costs
Costs that are incurred outside the
plant or factory and typically
categorized as selling and
administrative costs.
 Manufacturing Costs
Direct Direct Manufacturing
Materials Labor Overhead
•Various •Labor costs •Indirect materials
materials that of assembly- such as welding
can be directly line workers. material, glue,
and screws, etc.
conveniently •Indirect labor such
traced to a as factory
product. maintenance
workers and
factory janitors
•Other factory costs
Nonmanufacturing Costs
Also called Period
Costs.

Nonmanufacturing Costs
are not directly incurred
in the production of
products. They are
typically selling and
administrative costs.
Expensed on
the income
statement.
Nonmanufacturing Costs

Examples of
Nonmanufacturing
Costs include:

Rent
Expense
Product Cost

In the case of manufactured goods, these costs consist of direct

materials, direct labour, and manufacturing overhead.

Product costs “attach” to units of product as the goods are purchased or

manufactured, and they remain attached as the goods go into inventory
awaiting sale. Product costs are initially assigned to an inventory
account on the balance sheet. When the goods are sold, the costs are
released from inventory as expenses (typically called cost of goods sold)
and matched against sales revenue.

Since product costs are initially assigned to inventories, they are also
known as inventoriable costs.
Period Costs

Period costs appear on the income

statement as expenses in the period in
which they are incurred. For example,
sales commissions and the rental costs of
administrative offices are period costs.

All selling and administrative expenses are

considered to be period costs. Advertising,
executive salaries, sales commissions,
public relations, and other
nonmanufacturing costs are all examples
of period costs.
Prime Cost and Conversion Cost

Prime cost is the sum of direct materials cost and direct labour cost.

Conversion cost is the sum of direct labour cost and manufacturing

overhead cost.

The term conversion cost is used to describe direct labour and

manufacturing overhead because these costs are incurred to convert
materials into the finished product.
 Marginal Cost

At any given volume of output, the amount by which aggregate cost changes
with the change in volume of output by one unit, is termed as marginal cost.
The unit may be a single article, or an order, or level of production capacity,
or process of a department.
By definition, only total variable cost changes with the volume of production
or sales and total fixed cost remains fixed, irrespective of the changes in the
activity level. In practice, therefore, marginal cost is the total of all items of
variable cost.
Sucheta Toys produces a very attractive toy named ‘Devdas’.

The following is the break down of costs incurred by the company in the year 2017.
Particulars Cost (Rs’000)
Raw materials and components 1,00,000
Direct wages paid on piece rate basis 25,000
Depreciation of the plant 1,000
Depreciation of other fixed assets 500
Supervisors’ salary 2,500
Power 550
Lighting expenses 50
Corporate office expenses 1,000
Marketing expenses (fixed) 500
Salespersons’ commission 1,000
The company produced and sold 50,000 units in the year 2017.
What is the marginal cost of sales?
Note: The cost of power is a semi-variable cost. It was INR 2,50,000
in the year 2016, when the company produced and sold 20,000 units.
 COMMITTED AND DISCRETIONARY FIXED COSTS

The following influence the size of fixed costs:

Technology determines predominance of machines over labour or otherwise,

and also the degree of sophistication of the equipment.
If technology demands heavy investment in sophisticated equipment,
fixed cost is likely to be large due to high depreciation and insurance premium,
fixed salaries to highly skilled workers and technically qualified supervisors a
and high costs on preventive maintenance.

Trade-offs between fixed costs and variable costs.

For example, managers have a choice between fixed salaries to sales staff
and sales commission. Similarly, managers may decide to install automatic
machines to reduce the labour cost.
Generally speaking, the higher the proportion of fixed costs to variable costs,
the lower is the flexibility and organization’s ability to respond to short-term changes
in external environment.

Discretionary fixed costs are, expenses on employee’s health care schemes,

training expenses, costs of management consultancy services, charitable donations,
expenses on research, salaries to sales personnel and advertising
 Controllable And Uncontrollable Costs

Controllable costs are those which can be influenced by the action of a specified
member of an enterprise.

Uncontrollable costs are those, which cannot be influenced by the action of a

specified member of the enterprise.

A cost may be uncontrollable for an individual manager but may be controllable at a

senior level.
Examples of uncontrollable costs are rent, depreciation of plant and machinery
and staff salary.
AVOIDABLE AND UNAVOIDABLE COSTS

Avoidable costs are defined as

“Those costs which can be identified with an activity or sector of a business and
which would be avoided if that activity or sector did not exist” (CIMA Terminology).

Common costs apportioned to a particular activity or a segment of business are

usually unavoidable because total common cost cannot be avoided or reduced
even if that activity or sector does not exist.
For example, rent of factory premises apportioned to various activities,
is unavoidable for a particular activity because a decision to discontinue the activity
does not help to reduce even a part of the rent.
However, rent will be considered as an avoidable cost if a decision is taken to close
the whole factory. Those costs that are specifically incurred on an activity are
avoidable, and therefore, relevant to the decision on continuance or otherwise
of the activity.
 Typical Cost Flows and T-Accounts in a
Traditional Manufacturing Environment

Finished
Storeroom Factory Goods Customer
Warehouse

Raw Materials Work-in-Process Finished Goods Cost of Goods Sold

Beg. Inv. Beg. Inv. Beg. Inv.

Raw + Raw Mat. Cost of
+ Purchases + Cost of Cost of
Mat. Used Goods
Used
Goods Goods X
Manu. Manu. SOLD
+ Direct
Labor
End Inv. + Man.
Overhead
End Inv. End Inv.
Cost Flows in a
Traditional Manufacturing Environment
Direct Materials
As
Products
Are SOLD
Direct Labor As
Products
Are Balance Sheet Income
Produced Inventories Statement
Manufacturing
Overhead

Period Costs
A Schedule of Cost of Goods Manufactured
NORTHERN LIGHTS CUSTOM CABINETS
SCHEDULE OF COST OF GOODS MANUFACTURED
FOR THE YEAR ENDED DECEMBER 31, 2010
Beginning Raw Materials Rs.500,000
Add: Raw Materials purchased 2,000,000
Raw Materials Available 2,500,000
Deduct: Ending Raw Materials 250,000
Raw Materials Used in Production Rs.2,250,000
Direct Labor 3,250,000
Manufacturing Overhead 4,250,000
Total Manufacturing Costs 9,750,000
Add: Beginning Work-In-Process 750,000
10,500,000
Deduct: Ending Work-In Process 1,000,000
Cost of Production Rs.9,500,000
Schedule of Cost of Goods Sold

NORTHERN LIGHTS CUSTOM CABINETS

SCHEDULE OF COST OF GOODS SOLD
FOR THE YEAR ENDED DECEMBER 31, 2010
Beginning Finished Goods Inventory Rs.1,500,000
Add: Cost of Production 9,500,000
Goods Available for Sale 11,000,000
Deduct: Ending Finished Goods Inventory 250,000
Cost of Goods Sold 10,750,000
 The Income Statement
NORTHERN LIGHTS CUSTOM CABINETS
INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2010
Sales Rs.25,000,000
Cost of Goods Sold:
Beginning Finished Goods Inventory Rs.1,500,000
Add: Cost of Goods Manufactured 9,500,000
Goods Available for Sale 11,000,000
Deduct: Ending Finished Goods Inventory 250,000 10,750,000
Gross Margin 14,250,000
Less: Selling and Administrative Expense 8,750,000
Net Operating Income 5,500,000
Cost of Goods Manufactured
Pritvi Raj Enterprises has given the following financial information for the year ending 31st
March 2013. Prepare a cost of goods manufactured for the same year.

Rs.
Raw material purchased during the year 500000
Indirect material consumed 20000
Opening inventory of raw material 50000
Closing inventory of raw material 62000
Direct labour cost 300000
Manufacturing overheads 250000
Administration and selling overheads 100000
Opening Work- in - progress 100000
Closing Work- in - progress 120000
Apart from the information of Pritvi Raj Enterprises given above,
the following additional information is also given for the year
ending 31st March 2013. Prepare a cost of goods Sold and an
income statement for the same year.

Rs.
Opening Finished goods
200000
Closing Finished goods
130000
Sales
1400000
Rahul Agarwal is thoroughly confused as he has lost some of the records of his expenses and
inventory for the year ending December 31st 2013.

Please help him in finding the missing figures

Prepare a statement of cost of goods manufactured, cost of goods sold and a statement of
profit and loss account for the year ending 31st December, 2013.

Cost of raw material consumed Rs. 50000

Opening inventory of raw material Rs. 10000
Raw material purchased Rs. 60000
Closing inventory of raw material ?
Direct labour cost Rs. 30000
Manufacturing overheads Rs. 20000
Opening work- in progress Rs. 5000
Closing work- in progress Rs. 8000
Manufacturing cost ?
Cost of goods manufactured ?
Administration overheads Rs. 10000
Selling and distribution expenses Rs. 8000
Opening finished goods Rs. 13000
Closing finished goods Rs. 0
Sales Rs. 200000
Net operating income Rs. ?
 Sulekha Chaudhary is currently in the final year of MBA and
plans to join her newly set up family business ‘Olive Pvt.
Ltd.’ after her final examinations. At present the business is
managed by her traditional family members who are not
professionally qualified. They have prepared the following
statement of profit and loss account for the year ending 31st
March, 2013 and have sent a copy to Sulekha seeking her
opinion
Sales 6700000

Operating expenses

Direct material purchased 1800000

Direct labour cost 1100000

Indirect material purchased 100000

Indirect labour cost 467000

Office rent 200000

Depreciation of factory machinery 811000

Depreciation on computers and 100000

furniture in office
 Rs. Rs.
Salary of office staff 420000

Salary of sales staff 356000

Factory utility expenses 500000

Office utility expenses 166000

Sales expenses 400000

Insurance of factory machinery 80000

6500000

Net Profit 200000

 April 1, 2012 March 31st 2013
Rs. Rs.

Raw Material 310000 350000

Lubricants, nails, glue 10000 22000

Work – in – progress 400000 560000

Finished goods 60000 20000

Sulekha understood that the statement of profit and
loss account was not prepared properly. She seeks
your assistance in preparing the following:
•Statement of Cost of Goods Sold for the year
ending 31st March, 2013
•Corrected Statement of Income
•A reconciliation statement proving the difference in
profit between the statement of profit and loss given
by her family and the one prepared by you.