Managerial Accounting and

Cost Concepts

Session 2
 Costs

Consumptions of resources (in an effort

to generate future economic resources)
Classifications

Direct vs. Indirect Costs

Fixed vs. Variable Costs
Period vs. Product Costs
Direct vs. Indirect Costs

Are following salary costs, direct or

indirect?

Salary of the instructor teaching a

course
Salary of the dean of the business
school
Salary of the Vice Chancellor
Salary of AV Technicians
Direct vs. Indirect Cost
Direct vs. indirect costs is a function of
traceability of particular costs to specific
cost objects that we chose.
A Cost Object is anything (product,
department, function etc.) with respect to
which, you want to know the costs.
For ‘larger’ cost objects, more and more
costs will be direct costs and vice versa. If
LUMS is the cost object, then even the
VC’s salary is a direct cost. If PMA course
is the cost object, then most costs will be
indirect costs.
Honda Pakistan
Honda Pakistan
Rs. in M

Mfg. Expense :28,800

Operating Expense: 750
Total Expense :29,550
Total cars Mfg. :19,000 units (approximately)
Total cost/unit :1.5 M Rs.
Fixed vs. Variable Cost

Behavior of cost with respect to

change in the level of activity
Cost of steering wheel vs. Production
Manager’s salary
Variable Cost
Rs

Level of activity
Fixed Costs
Rs

Level of activity
Fixed vs. Variable Cost

Behavior of Cost (within the relevant range)

Cost In Total Per Unit

Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Average fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.
Types of Fixed Costs

Fixed Costs

Committed Discretionary
Long-term, cannot be May be altered in the
reduced in the short term short-term by current
(< 1 year) managerial decisions

Examples Examples
Depreciation on Buildings Advertising; Research and
and Equipment Development

Committed and discretionary depends on strategy.

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Trend Toward Fixed Costs

Increased automation.
Replacement of shop floor workers with
‘managerial cadre’.

Implications
Managers are more “locked-in” with fewer decision
alternatives.
Planning becomes more crucial because fixed costs
are difficult to change with current operating
decisions.
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Period vs. Product Costs

Is Production director’s salary at

Honda Pakistan, a direct cost or an
indirect cost?
Is Marketing director’s salary in the
same company, a period or a product
cost?
Period vs. Product Cost
A financial accounting concept, determined
on the basis of ‘accounting standards’. (IAS
2, para 10)
costs of purchase (including taxes, transport,
and handling) net of trade discounts received
costs of conversion (including fixed and
variable manufacturing overheads) and
other costs incurred in bringing the inventories
to their present location and condition
 Product vs. Period Costs
Product Unsold
Recorded as Asset
(Inventory)
Manufacturing in the Balance Sheet
Cost
Product Cost
Product Sold
Becomes Expense in the
Profit and Loss Account

Recorded as an
Non- Manufacturing Expense
Period Cost in the Profit and Loss
Cost (Admin+Selling+Fin) account in the current
accounting period

Source: Drury (2000)

Treatment of Product and Period Cost
Period vs. Product Costs
Rs. (M)
Mfg. Expense :28,800
Operating Expense: 750
Total Expense :29,550

Let us assume that none of the 19,000 cars

manufactured by Honda were sold during
the year. What is going to be the balance
sheet and income statement implication, if
the entire expense amount is treated as
A) Product Cost
B) Period Cost
Period vs. Product Cost
If the entire expense is considered as
product cost, and no unit is sold during the
year, then income statement will appear
like this:
Sales :Nil
COS :Nil
Expenses :Nil
Profit :Nil
Balance Sheet will show an inventory of Rs.
29,550M (19,000 units)
Period vs. Product Cost
If on the contrary, entire expense is
considered as period expense, then the
income statement will appear like following:
Sales :Nil
COS :Nil
Expenses :29,550M
Net Loss :29,550M

Balance sheet will show an inventory value of

zero.