Cost and management

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Chapter – One (B)
Cost Concepts, Classifications and Terminologies

2. Cost and Cost Terminologies
 According to J. Horngren cost refers to resource sacrificed or
foregone to achieve a specific objective.
 It is usually measured as the monetary amount that must be paid
to acquire goods and services.
 Understanding different cost concepts and terms used in
accounting reports enables to:
 Best use the information provided, and
 Avoid misuse of the information.
Features of Costs
1. Cost measures the use of resources like material, labor, etc.
2. Cost measurements are expressed in monetary terms.
 Cost measure the use of labor hours, materials, machine
hours, and inputs in terms of monetary units.
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3. 3. Cost measurements always relate to a purpose or activit
is cost object
 E.g. If some one says to you that the cost is Birr 14
you understand what he/she means? Surely you
question- cost of what? Therefore, Birr 14,000 is no
data because it is not related to a particular cost o
it is said that the cost of the Sony television is Birr
this will be meaningful.
 Managers want to know how much a particular thi
as a product, machine, department, customer, service or
costs.
 We call this “thing” a cost object, which is anyt
which a separate measurement of costs is desired.
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costing system accounts for costs in two basic stages
ost accumulation
Is the collection of cost data in some organized way.
g. A plant that purchases paper rolls for printing magazines accumulates the cost of ind
purchased in any one month to obtain the total monthly paper purchase costs.
Cost assignment
Encompasses both tracing and allocating accumulated costs to a cost objec
.g. Cost may be assigned to a department to facilitate decisions about departmental efficien
a product to facilitate product profitability analysis.
. Cost tracing: assignment of direct costs to the particular cost object. Cost
to a cost object in an economically feasible (cots effective) way.
. Cost allocation: assignment of indirect costs to the particular cost object. Cost
traced to a cost object in an economically feasible way.

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Classification of Costs
1. Relationship of the costs to the products
The cost elements of a product (product cost) are;
A. Materials costs: cost of principal substances (materi
in production that are traced into finished goods by the
of direct labor, and factory overhead.
i. Direct materials cost: are materials that can be id
with the production of finished goods (products), w
be easily traced to the product, and that represents
materials cost of producing that product.
 E.g., leather in shoe industry (cost of purchasing l
direct material cost for leather shoe industry).
ii. Indirect materials cost: all materials that are inv
the production process of a product that are no
materials.
 E.g. Nails, lubricating oils, cleaning materials and
(paper, pens and pencils,…. etc.).

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B. Labor cost: cost of physical and mental effort expende
production of a product.
i. Direct labor cost: all labor directly involved
production that can be easily traced to the prod
represents a major labor costs of producing the produ
 E.g. wages for machine operator, ass
painters, etc…
ii. Indirect labor cost: all labors involved outside th
labor are included as part of factory overhead.
 E.g. Supervisor’s and cleaner’s salaries,
labor for maintenance, inspection, engi
design, supervision, materials handlin
machine handling etc.
C. Factory Overhead (FOH), (Manufacturing Over
Burden costs):
 Includes; indirect labor, indirect material, and
indirect manufacturing costs
 Can’t be directly identified with specific products

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2. Relationship of the costs to the production
a. Prime Costs: are direct material cost and direct la
which are directly related to production.
Prime Costs = Direct Material cost + Direct Labor cos
b. Conversion costs: costs concerned with trans
materials into finished products, namely, costs for DL a
Conversion costs = Direct labor cost + FOH costs
Direct Materials Direct Labors Factory Overhead
Prime Costs Conversion Costs
GENERAL COST CLASSIFICATIONS

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Marketing/Selling Costs Administrative Costs
Conversion
costs
Direct labor
costs
Prime costs
Total
manufacturin
g cost
+ + =
=
+
Direct
materials
costs
Manufacturin
g overhead
costs

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3. Relationship of costs to the volume of producti
i. Variable costs: are those costs in which the total
changed in direct proportion to changes in volume of o
within the relevant ranges, while the unit cost re
constant.
 E.g. a department store sales pencils for Birr 0.50 e
pays a 10% commission to sales persons on each
sold. The volume of activity is the number of pencil
and the 10% commission is a variable cost.
 Variable cost per unit is Birr 0.05 (10% of birr
Regardless of the number of pencils sold the va
cost per unit (birr 0.05) remains constant throu
However, the total commission paid is determined
total volume of sales. If 10 pencils are sold, the
commission would be Birr 0.50 (i.e. 0.05*10 pencil
so on. Therefore, total commission paid- which is va
cost- varies with volume of activity- number of
sold.
Total variable cost = variable cost per unit * total volume
activity
E.g. Variable cost includ
commissions, direct lab
cost of raw materials
production, and utility cos

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ii. Fixed costs: are those costs in which the total cost
constant over relevant range of outputs, where as the fi
per unit varies with outputs.
 Relevant range is a range of activity for a definite p
time.
 The total fixed cost changes only when the releva
changes.
 In the long run, fixed costs also change in total.
 The fixed costs become progressively smaller on a
basis as volume increase.
 E.g., a department store subscribes a monthly maga
Birr 1,000 for advertising for pencil sales. If only on
10,000 or more pencil are sold, the total advertisem
of birr 1,000 does not change and it remains c
during the month. However, fixed cost per unit cha
the volume of activity- number of pencil sold cha
only one pencil is sold, the unit fixed cost is Birr 1,0
1, 000 divided by one pencil), it would Birr 1.00

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E.g. fixed costs include insurance premium, propert
depreciation when straight line method is used, e
salaries etc
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit
Variable
Changes as activity level changes. Remain the same over
wide ranges of activity.
Fixed
Remains the same even when
activity level changes.
Decrease as activity level
increases.

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iii. Mixed costs: These costs contain both fixed and
characteristics.
 It is not possible to classify all costs as purely varia
purely fixed.
 These are costs which have a mixed behavior (som
cost nature and some variable cost nature).
 E.g. for using rented machinery the rental char
20,000 per year and $ 2 per each machine hour used
 If the machinery is used for 30,000 hours, th
rental charges are $ 80,000 (20,000 + 60,000)
 If the machinery is used for 20,000 hours the
charges are $60,000 (20,000+(20,000x2)) and so o
 Other example of mixed costs includes monthly
electricity: fixed service charge and variable cha
kilowatt hour used, telephone cost and the like.

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 Total cost:- is simply the sum of variable cost and fixed
 The total cost can be expressed in an equation form:
Y=AX+ B, where
Y= Total cost
A= Variable cost per unit of volume
X= Total volume of activity
AX= Total variable cost.
B= Total fixed costs

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Cost drivers
 Cost behavior is how costs are related to, and affected
activities of an organization.
Cost drivers, any factor whose change “causes” a ch
the total cost of a related cost object.
A cost driver is the unit of an activity that causes the c
activity's cost.
The activities that cause costs to be incurred are call
drivers.”
 The cost driver of variable costs is the level or vo
activity whose change causes the variable costs to
proportionately.
 Costs that are fixed have no cost driver in the shor
may have a cost driver in the long run.

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Cost Examples of cost Drivers.
Cost of food at hospital Number of days of patient care.
Fuel cost at transport
corporation
Number of tons of cargo
transported; distance flown
Cost of handling insurance
claims by Insurance
Corporation.
Number of claims processed.
Cost of material handling
at manufacturing company
Number of materials moves, weight
of material handled, type of
material handled.
Cost of taking customer
orders at manufacturing
company
Number of customers’ orders, type
of products ordered.
The following are the examples of cost and cost drivers.

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Relevant Range
 A relevant range is the level of activity or volume in
specific relationship between the level or volume of act
the cost in question is valid.
 Fixed cost remains constant up to maximum level of act
for the budget period.
 Fixed costs are fixed only in relation to a given range
wide) of the total activity or volume and for a given ti
(usually a particular budget period).
 If the level of activity varies, exceeding the m
capacity the fixed costs also varies.
 And also the fixed cost changes of the budge
changes.

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4. Cost Classification Based on the Respon
Center
 In manufacturing organization there are two basic depart
i. Production department: are responsibility center
operations are performed to produce product.
 Costs incurred by such departments are charge
product.
 Costs incurred in the production departments ar
production department cost.
E.g. includes assembly department, cutting department
department, finishing department, packing department
ii. Service department: These responsibility centers
directly involved in production process.
 In service department, service is rendered for the b
other departments.

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 This department will support the production departm
does not directly engage in production;
 Its costs are part of the total factory overhead and
included in the cost of the product.
 Costs incurred in this department are called
department costs.
Example of such departments include maintenance dep
information processing departments, payroll departmen
services etc.

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5. Cost Classifications by Functional Areas
 This groups costs by the type of activity (function) perform
i. Manufacturing cost: these are all costs incurred to produc
goods.
 These are the sum of DM costs, DL costs and MoH costs.
ii. Marketing and distribution costs: these are all costs incurred
sell a product or service.
 Costs included are cost of processing orders, cost of getting
cost of retaining customers, cost of transportation, etc.
iii. Administrative and general expenses: are costs incurred
control, and operate the company.
 They are incurred in the administration of the organization.
iv. Financing costs: these are costs incurred in relation to obta
operating funds for the company.
 Usually they include cost of borrowing (interest expense).
v. Research and development costs: include all costs of devel
products and services.
 The costs of running laboratories, building sample of new
and testing new products

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Millennium Manufacturing Company
Income Statement
For the month ended, Dec 30, 2011
Sales………..…………………………………………………….……………..xxx
Cost of Goods Sold (Manufacturing costs)……………………….……………xxx
Gross profit …………………………………………………………………….xxx
Operating expenses:
Selling and distribution………………….xxx
Administrative and general……………..xxx
Financing (Interest expense)……………xxx
Total operating expense……………………………………………………….xxx
Net income …………………………………………………………………… xxx
Income statement to explain the presentation of the above costs
and expenses

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6. Cost Classification by Period Charged to Revenue
 On the basis of time period costs are charged against rev
i. Product costs: these costs are initially inventories (rec
cost of inventory) and when goods are sold they are ch
cost of goods sold.
 Product Costs are composed of DM, DL and Factory o
 These costs are treated as assets (inventory) until the p
sold.
 For merchandising sectors, product costs are the
purchasing the goods that are resold in the same form i
freight cost.
 For service sectors, the absence of inventories means
no inventorable costs.

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ii. Period costs: those costs are associated with the passage
rather than with the product.
 These costs are charged against revenue in the period i
 All operating expenses are grouped as period costs.
 Period costs treated as expenses because they are assu
to benefit future periods.
 For manufacturing sectors, period costs include
manufacturing costs; selling and distribution e
administrative expenses, financing expenses, and resea
development costs
 For merchandising-sectors, includes labor cost o
personnel and marketing costs.
 For service sectors, since there are no inventoriable c
their costs are period costs.

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7. Costs in relation to a proposed decision, action, or eval
i. Opportunity cost: amount of revenue or other ben
will be missed or cost if a particular alternative is cho
 These costs do not represent cash outlays
 It measure the benefit forgone by not taking a p
course of action.
 It have a great value for analysis of inv
alternatives.
 The cost of a particular investment is not only the
lay cost but also includes opportunity cost.
ii. Sunk Costs: Such costs are past or historical costs.
 Costs been created by a past decision that ca
changed by any decision that will be made in the f

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 Investments in plant and machinery, buildings,
examples of such costs.
 Since later decisions can’t alter (change) sunk cos
are irrelevant for decision-making.
Example: Assume ABC Ltd purchased a machine for $6
The machine has an operating life of 5 years hav
salvage value. After purchase the management fee
the machine should not have been purchased s
cannot yield the operating advantage expected. Alth
is expected to result in savings in operating co
$3million over a period of 5 years, the machine can
immediately for a sum of $4 million.
• In taking the decision whether the machine should
or be used, the relevant accounts to be compared
million in cost savings over five years and $4 milli
can be realized in case it is immediately disposed.
• The $6 million invested in the asset is not relevant
is the same in both cases and was made based o

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iii. Differential Cost: The difference in total cost betw
alternatives
 In case the choice of an alternative results in increas
cost, such increased costs are known as incremental
iv. Marginal Costs and Average Costs
a. Marginal cost: increase or decrease in the amount of
account of increase or decrease of production by a single
 Is the total variable cost because an increase of on
production will cause an increase in variable cost onl
b. Average cost per unit: is the total cost divided by the nu
units manufactured.

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8. Other Classification
 Controllable or Uncontrollable
 In classifying costs as controllable or uncont
managerial accountants generally focus on a manager’
to influence costs.
i. Controllable costs are those costs, which can be in
by the action of a specified member of the undertaking
 If a manager can control or heavily influence the
cost, then that cost is classified as a controllable
that manager.
ii. Uncontrollable cost are costs that a manager cannot i
significantly.

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 Avoidable and Unavoidable cost
a) Avoidable Cost: is a cost that is not incurred if the ac
not performed.
 You can simply decide not to buy, and no expense
incurred.
 These costs are often identified as variable costs
vary based on production.
 If there is no production, there is no cost.
b) An unavoidable cost: is a cost that is still incurred
the activity is not performed.
 These costs are often considered fixed costs that
depend on production.

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 Actual costs: Costs based on actual transactions and
operations during the period just ended, or going back to
earlier periods.
 Budgeted costs: Future costs, for transactions and operations
expected to take place over the coming period, based on
forecasts and established goals.
 Standard costs: Costs, primarily in the area of manufacturing,
that are carefully engineered based on detailed analysis of
operations and forecast costs for each component or step in an
operation.

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 Cost unit: also known as the cost per unit, the cost of goods sold
or the cost of sales, is the amount of money that a company invests
in manufacturing a single unit of a saleable product.
 Cost Centre: is that department within the organization which is
responsible for identifying and maintaining the cost of the
organization by analysing the processes.
 Profit Centre: focuses on generating and maximizing revenue
streams for the organization by identifying and improving activities
such as sales it is much more complex and has a wide area of scope.
Differences between cost centre and profit centre
 A cost centre is only responsible for its costs, while a profit centre
is responsible for both its revenues and costs.
 Cost centres tend to be organizationally simple, while profit
centres are more likely to have a complex structure.

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 Linear Cost Behaviour: cost behaviour where the relat
between cost and activity can be reasonably approxim
a straight line when plotted on a graph.

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 Curvilinear Costs: costs that show a curved relationship
cost and activity rather than a straight-line relationship.
 It is an irregular cost that increases at different rates
output increases.
Example: total direct labor for hourly workers is an irregular expe

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End of Chapter One