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Cost Concepts and Behaviour

A central problem facing organisations is how to
identify and evaluate the relevant costs and
benefits resulting from the various available
alternatives.
The cost concepts and behaviour will be of help
in demonstrating the multiple purposes of cost
and management accounting systems.

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Cost Concepts and Behaviour
Costing
It is the ascertainment of costs.
Costing includes techniques (principles and rules
applied for ascertaining costs of products or serviced)
and processes of ascertaining costs.
Cost
Accountants usually define cost as a resource sacrificed
or foregone to achieve a specific objective.
Other researchers (Jack Gray & Don Ricketts) define a
cost as the total resources consumed to accomplish a
specific objective.
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Cost Concepts and Behaviour
Cost Object
 To guide decisions, managers need the cost of something.
 This something can be referred to as the cost object which is
anything for which a separate measurement of cost is desired.

 Examples of cost objects include: a product, service, a project, a

customer, a brand category, an activity, a department, and a
program.
 Cost objects are chosen to guide in decision-making.
Cost Driver
 This is any factor that affects costs.
 That is a change in the cost driver will cause a change in the
total cost of a related cost object.
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Business function Examples of cost drivers
Research and Development No. of projects
Personnel hours on a project
Technical complexity of a project
Design of products, services and processes No. of products
No. of parts per product
No. of engineering hours
Production No. of units produced
No. of set-ups
No. of engineering change orders
Direct manufacturing labour
cost
Marketing No. of advertisements run
No. of sales personnel
Distribution No. of items distributed
No. of customers
Weight of items

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Cost Concepts
Relevant Range
This is the range of the cost driver in which a specific
relationship between cost and the driver is valid.
Cost Centre
This refers to a production or service department in an
organisation where costs are incurred for the
production of goods or the provision of services.
Cost centres accumulate the cost directly incurred and
the costs apportioned.
Cost centres enable the ascertainment of total cost
accumulated by a department for a particular period of
time.

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Cost Concepts
Profit Centre
This refers to a production or service department where
costs as well as revenues are accumulated.
Profit centres measure the revenue and the cost
accumulated over a period of time, thus giving the
profit earned by the centre for the period.

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Cost Behaviour
Cost behaviour is the way in which total
costs or costs per unit are affected by
fluctuations in the level of activity.
‘costs’ can refer to particular items of cost,
such as:
 the total annual cost of motor vehicle
insurance or
the total cost of postage and packing during a
given period.

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Cost Behaviour
Costs belong to one of the following categories:
Entirely fixed. Costs such as periodic rental charges
and senior management salaries are fixed
Entirely variable. Costs such as direct materials costs
are entirely variable
Semi-fixed and semi-variable, although the fixed and
variable elements can be separated into their fixed and
variable parts. Examples of mixed costs are telephone
charges.

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 Why the Need for Cost Behaviour
Budgeting

Control of costs

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Factors Affecting Cost Behaviour
Volume or activity level
Nature of the cost
Nature of the production process
The existence of spare capacity
Whether a cost is incurred solely because of one
activity or more activities
Degree of efficiency

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Cost Classification for Control
There are three broad classifications
of costs:
1. Behavioural classification
2. Natural classification
3. Functional classification

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Behavioural Classification
Classification based on how costs react to
certain conditions
Four subcategories

1. According to variability
2. According to normality
3. According to traceability
4. According to controllability

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Classification of costs according to
variability
how costs change/respond with changes
in the activity levels in the short run
Fixed Costs
Variable Costs
Semi-variable or semi-fixed or mixed
costs

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Fixed Costs
These costs remain constant in the short run
irrespective of change in the activity levels.

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Types of Fixed Costs
Standing Fixed Costs - these are costs incurred even
when production has not commenced, e.g. salaries of
management staff, rent.
Running Fixed Costs - these are fixed costs incurred
only when production commences and remains
constant in the short run, e.g. salaries of production
staff, insurance of production staff, etc.

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Types of Fixed Costs
Committed Costs - these are costs incurred by the
firm and may not easily be reduced without affecting
the long-term strategy of the firm, e.g. salaries of
established staff, rent, etc.
Discretionary Fixed Costs - these are fixed costs
incurred by the firm only when the firm can meet
them. They may be easily reduced without seriously
affecting the operations of the firm, e.g. advertising
costs, donations, etc.

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Step Fixed Costs
Step costs are costs which are constant for a range of
activity and rise to a new constant level once that
range is exceeded.
Some costs rise in a series of steps.
Large steps (renting a second factory) or
Small steps (renting a desktop computer) might occur.

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Step Fixed Costs

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Variable Costs
These are costs that change with activity levels, e.g.
materials, production labour, etc.

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 Semi-variable Costs/
Semi-fixed Costs
These costs contain both variable and fixed elements.
They change with activity at one point and remain
constant at other points, e.g. production overheads
like factory power, fuel, employees receiving salary
packages based on basic pay (fixed) and remuneration
based on either time worked or units produced.

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 Semi-variable Costs/
Semi-fixed Costs

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 The Analysis of Mixed Costs and
Cost Estimation Methods

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Account Analysis
Also known as the inspection of accounts method,
the departmental manager and the accountant
examine each item of expense for a particular period
and then classify it as a wholly fixed, wholly variable
or a semi-variable cost.
Each account is classified as either fixed or variable
based on the analyst’s knowledge of how the account
behaves
A very subjective (involves individual and arbitrary
judgements).
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Engineering Estimates
This approach is based on the use of engineering
analyses of technological relationships between
inputs and outputs –for example methods study, work
sampling and time and motion studies.

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High-Low Method
This method involves:
Selecting the periods of highest and lowest
activity levels,
Comparing the changes in costs that result from
the two levels to determine variable cost per unit
of output, and
Estimating the fixed cost at any level of activity
(assuming a constant unit variable cost) by
subtracting the variable cost portion from the
total cost
This method ignores all cost observations other
than the observations for the lowest and highest
activity levels.

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The High-Low Method-Example
A firm recorded the following production
activity and maintenance costs for two
months

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Solution

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Solution contd....

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Activity 1
If sales salaries and commissions are
£10,000 when 80,000 units are sold
and £14,000 when 120,000 units are
sold, what is the variable portion of
sales salaries and commission?

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The Scatter graph Method
This method involves:
Plotting on a graph the total costs (represented on the
vertical axis -Y) for each activity (recorded on the
horizontal axis –X).
The point where the straight line cuts the vertical axis
represents the fixed cost.
The unit variable cost is found by observing the
differences (in costs and activity levels) between any
two points on the straight line.
However,
Determination of exactly where the straight line should
fall is subjective

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The Scatter graph Method

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Regression Method
This involves writing regression equation
Y = a +bX
Where Y is the dependent variable
a is a constant: where the regression line cuts the y-axis
b is gradient of the regression line
X is the independent variable

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Regression Method: Example
The following activities and total costs were recorded
by a firm over a period of time
Units Total Cost
1200 290,000
1400 330,000
1500 350,000
1650 380,000
1760 402,000
1840 418,000
1960 442,000
2025 455,000

Using regression, separate fixed and variable costs.

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 Classification of costs according to
normality
Normal costs - these are costs that are incurred in
the usual conditions in which normal production is
attained. These costs are vital for routine decision
making, e.g. hydroelectric power would be a normal
cost if this is the power usually used for production.
Abnormal costs - these are costs that are incurred in
unusual conditions from those that normal production
is attained. These costs would not influence routine
decisions, e.g. thermal power being used to clear
production in case of hydroelectric power failure.

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 Classification of costs according to
traceability
Traceable costs - these are costs that can
easily be identified in the final product, e.g.,
materials.

Untraceable costs - these are costs that

cannot be easily identified in the final
product.

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Classification of costs according to
controllability
Controllable costs - these are costs that can be
easily controlled by the actions of a cost pool/cost
centre manager in a given time period.

Uncontrollable costs - these are costs that cannot

be easily influenced by the actions of a cot pool/cost
centre, e.g. rent, salaries, and depreciation.

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Classification of costs according to
function
This classification is based on what
segments or functions of the organisation
the costs relate.
The costs may be:
Production costs
Administration costs
Selling and distribution costs
Research and development costs
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Activity 2
A manufacturing company produces a single
product, the widget. It has established that its
costs are as follows.
Direct materials $4 per unit
Direct labour, 20 minutes per unit. Direct labour is paid
at $6 per hour
Production overheads consist of fixed costs of $60000
each month and variable costs of $0.90 per direct
labour hour.
Administration overheads are fixed, $20000 per month
Sales and distribution overheads are fixed costs of
$30000 per month plus variable selling costs of $2 per
unit sold
During a given month, 10,000 widgets were produced
and sold. What should be the total costs in the month?

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Natural Classification
Classification done based on the nature of
the costs.
Costs can be categorised naturally into 3
groups.
1. Materials: - inputs to be worked on directly or
indirectly in the process of producing output.
2. Labour: human effort
3. Expenses: others  
The natural classification is further
subdivided into two: Direct costs and
indirect costs.
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