Chapter03.ppt/Management Accounting Classification

© McGraw-Hill Education (UK) Limited 2013
The
Classification
of Cost(s)
Chapter 3
1

Learning Outcomes
• LO1 Appreciate different perspectives and
classifications of cost
• LO2 Define and illustrate a cost object
• LO3 Explain the principles of cost accumulation, cost
assignment and cost allocation
• LO4 Define and distinguish between direct costs and
indirect costs
• LO5 Define and distinguish between fixed costs and
variable costs
• LO6 Have a basic knowledge of how product costs
are treated in different organizational and sector
types
2

Learning Outcomes
• LO7 Define and distinguish between job and process
costing
• LO8 Identify which costs are (not) relevant to a
particular decision-making situation
• LO9 Define and distinguish between absorption
costing and variable costing
• LO10 Recite some technological developments that
have impacted cost accounting
• LO11 Appreciate the importance of measuring and
managing costs in an organization
3

Introduction
COST – Defined:
The monetary value of the resources forgone or
sacrificed in order to achieve a specific objective
such as acquiring a good or service
• Before we start to calculate and measure costs,
we need to learn more about what costs mean,
not least because the reality is that costs have
multiple meanings, and different outlooks on cost
can be used according to different scenarios
4

Accounting for Costs – in General
There are multiple purposes (and users) of cost
information. Examples of the use of cost-related
information include:
• What price for a new product?
• Who are our most profitable customers?
• Which of our services gain highest profits margins?
• How should we best finance our new acquisition?
• Which of our various departments are least
economical?
• What are the social and environmental costs of our
products?
5

Cost Objects
A cost object is something for which a separate cost
measurement is required
• If someone wishes to know the cost of
something, that ‘something’ is the cost object
• It can be many things – e.g.: a product or service,
a customer, a supplier, a project, a new product
launch, an acquisition, and more
• Organizations measure the costs associated with
a particular cost object, following which that cost
object then becomes the focal point of analysis,
monitoring and cost management
6

Cost Objects
7

Cost Accumulation and Cost Assignment
Cost Systems capture cost data, which then forms
the basis of an organization’s cost information.
They comprise 2 stages:
1. Cost accumulation – organizing cost data via
classification systems that identify a group of
costs in a particular (usually obvious) way
2. Cost assignment – where accumulated costs
(see 1., above) are attributed to specific cost
objects
8

Cost Classifications
9

Assigning Costs to Cost Objects
In attempting to measure a cost object, an
important distinction to make is that between
direct and indirect costs:
• Direct costs – easily associated with a particular
cost object
• Indirect costs – evidently support more than one
cost object
10

Direct costs, by definition, tend not to be difficult to
identify because they are incurred as a direct
consequence of the cost object’s existence or
occurrence
• Direct costs are assigned to a particular cost
object through tracing – i.e., identified to a
specific cost object without any doubt
– E.g.: the music system inside a high-performance
motor car
11

• Indirect costs (or overheads) cannot be identified
with a single cost object
– E.g.: maintenance costs in a (ladies’ fashionable) shoe
factory, where the cost object is a specific shoe design
• When assigning indirect costs to a cost object, we
need a method that accurately reflects the cost
object’s actual usage of total indirect cost inputs.
This is done through cost allocation
12

The same cost can be both a direct and an indirect cost
at the same time - depending on what the cost
object is
E.g., Think of the salary costs of a service engineer at
Rolls-Royce aero-engines, who services the
manufacture of different types of engines for aircraft
– If our cost object is the engineering department, the
engineer’s salary would be classified as a direct cost
– If our cost object is specifically a T900 aero-engine, the
engineer’s salary would be classified as an indirect cost
13

Ideally organizations would prefer to be able to classify
as much of their costs as possible as direct costs,
thus relying on little or no arbitrary spreading of
costs (or allocation) over different cost objects
Inappropriate techniques and ill-designed (cost)
systems can produce misleading information
which, in turn, has potential to drive poor decision-
making. Organizations normally have two choices:
1. Design more sophisticated accounting methods for dealing
with the assignment (or allocation) of indirect costs to
different cost objects, or;
2. ‘Convert’ as many indirect costs as possible into direct
costs.- e.g., utilities meters on factory machines
14

An important aspect of MA is how and when to recognize the
costs of making, acquiring or providing products and services.
Reasons why this is important include: setting product prices,
compiling the annual report, seeking operational efficiencies,
and more:
– Expense - a cost incurred when an asset is used up or sold for
the purpose of generating revenues.
There are two ways to treat costs for their conversion to an
expense:
1. A product cost is a cost assigned to goods either purchased or
manufactured for (re-)sale. Treated as current assets when
incurred, and posted to the balance sheet as inventory until the
final product is sold
2. A cost that is not a product cost is called a period cost. Period costs
are not specifically related to making or acquiring a product, or
providing a service that generates revenues
15
Preparing Financial Statements

The identification and treatment of product costs
differs according to the type of sector, including:
• Manufacturing
• Merchandising
• Service
16
Different Costs for Different Sector Types

Manufacturing
• Organizations purchase materials and components, and
convert them into finished products. All manufacturing costs
are product costs. Costs are accumulated, and presented in
the balance sheet at different stages of the inventory process
• Manufacturers will normally have three types of inventory:
1. Direct materials inventory
2. Work-in-progress inventory
3. Finished goods inventory
• Traditionally, manufacturing organizations will accumulate
their costs, the total of which is held as an asset in the
balance sheet until the finished product is sold. Upon the
sale of a product, the manufacturing costs are charged to the
organization’s income statement (as costs of goods sold)
17

Manufacturing
• Manufacturing costs comprise:
– Direct materials - materials that are easily identified with a
finished product
– Direct labour - labour that can be easily identified with
(traced to) a finished product
• All the direct costs incurred when making a particular
product are called: prime costs
• Conversion costs comprise all manufacturing costs
other than direct materials costs
19

Manufacturing
Indirect manufacturing costs (or manufacturing
overhead) are all manufacturing costs other than
direct materials, direct labour and any other direct
expenses:
• Indirect materials – e.g., the maintenance costs for a
factory machine used to make several products
• Indirect labour – e.g., the wages of factory-wide health
and safety officers
• Indirect manufacturing expenses – e.g., the electricity
costs incurred in a factory
20

Merchandising
• Merchandising organizations purchase and then sell tangible
products without altering their basic form
– They generate profits or surplus by selling their merchandise for a
price that is higher than its cost of purchase
– Examples include wholesalers and retailers
• Merchandisers hold only one type of inventory, the purchased
products in their original form
– The product costs recorded for inventory will be the actual price paid,
in addition to any incoming freight costs and any insurance or handling
costs that were incurred in getting the goods on site and ready for
resale to customers
• Product costs in merchandising do not include costs incurred
after a product is ready for re-sale
21

Service sector
• Service sector organizations provide services and/or
intangible products to their customers
– E.g., professional accounting firms, lawyers, health-care
organizations, airlines, and Internet service providers
• Service organizations do not normally hold
inventories of any tangible products that are for sale
or re-sale
– There is no need to inventorize costs in service
organizations, and all such costs are charged as an expense
to the current period
22

• There are different ways to value inventory in the
management accounts, which potentially have different
impacts on profit or surplus calculations
– Absorption costing - when all manufacturing costs are
regarded as being inventoriable, all manufacturing costs
are absorbed into the valuation of inventory, whereas;
– Variable costing describes when only variable
manufacturing costs are inventorized, and fixed
manufacturing cost is treated as an expense at the time
period in which it is incurred (i.e., period costs)
• In most countries, it is a professional requirement for
organizations to use absorption costing
23
Valuation of Inventory for Reporting Purposes

• Job Costing: accumulates the costs incurred in the production
of a single unit or a single batch of units, where unit(s)
produced for one job are dissimilar from the unit(s) produced
for another job.
– E.g., the production of a cruise-liner, a grand-prix motor car, a legal or
audit project
• Process Costing: is most appropriate when an organization’s
units of production are identical, or almost identical, such that
each individual unit of production consumes the same
amount of manufacturing input resource
– In such cases, an average per unit cost can be applied across the board
– E.g., the production of canned drinks, tinned foods and beers
• Process costing tends to be appropriate for an organization
whose individual products all consume roughly equal amounts
of resource
24
Costing Systems for Different Organizational Types

The distinction between variable costs and fixed costs
underpins how we might view costs changing in
response to changes in organizational activity
• Variable costs - change (in total) in proportion to the
level of activity
– E.g., the cost of windscreens for an Audi A4 motor car
• Fixed costs - do not change (in total) as activity levels
fluctuate
– E.g., the factory rent for a motor car manufacturing plant
25
Predicting Cost Behaviour When Output/Activity
Levels Change

Variable cost

Fixed cost

Types of decisions which might require information on how
costs can change in response to shifts in activity levels
include:
• How much output do we plan to produce next year?
• What price should we charge next year for product X?
• How will profitability change if we offer customers a 10%
discount next month?
• Is it more effective to pay our sales staff by fixed salaries, or
by commission?
28

Relevant range
• A term we use to describe a period over which the
definitions of variable and fixed costs hold.
– Is specific to a particular organization, and can change
over time for the same organization
• Beyond any relevant range period, the basic
principles of variable and fixed costs (as defined) do
not necessarily hold and thus cannot be relied upon
in decision-making
29

Standard Costs
• On the basis of careful analysis and estimation, standard costing
establishes an array of acceptable costs that an organization expects to
incur, and monitors actual costs against these standards.
– Traditionally standard costing systems would assist planning, establish
performance targets, and were used routinely to evaluate actual performance
against these targets.
Controllable Costs and Uncontrollable Costs
• Controllable costs - can be influenced by the actions of a particular person
(or group) in relation to a particular undertaking.
– Many organizations establish responsibility centres (e.g., cost centre) which
are held responsible for the costs incurred within the centre’s area of activity
and over which it has influence.
• Uncontrollable costs - cannot be influenced by the actions of an individual
(or group) for a particular undertaking.
Costs to Assist Planning and Evaluation

Relevant Costs
• Relevant information is that which is pertinent to a
particular decision in so far as it will influence which
decision alternative is chosen. Extrapolating from
this, a relevant cost is a cost (or cash outflow) that
would influence the choice amongst decision
alternatives.
• Relevant costs exhibit two main properties:
1. a cost which will be incurred in the future, and;
2. there must be cost differentials between decision
alternatives
Costs Used in Different Decision-Making Scenarios

Sunk Costs
• An organization’s current decisions have no bearing
on prior expenditure, and expenditures associated
with the past (called sunk costs) cannot be altered
through current or future decisions.
– Because sunk costs are unaltered by current and future
decisions, they are irrelevant to current and/or future
decisions.
• Although sunk costs are irrelevant to current
decision-making, they should however always be
considered independently to irrelevant costs,
because not all irrelevant costs are sunk costs.

Cost Differentials
• Future costs must differ between decision alternatives if
they are to be treated as relevant to a particular decision
scenario.
– Where future costs are the same regardless of alternative
choices made, they are deemed irrelevant.
• Sometimes, relevant costs are referred to as avoidable
costs and irrelevant costs referred to as unavoidable
costs.
– The overlap is fairly intuitive; that is, avoidable costs can be
saved if a particular decision alternative is not adopted, whereas
unavoidable costs, by definition, cannot be saved.

Opportunity Costs
• Opportunity cost is the value of something that a decision maker gives up
as one decision option is selected over another.
– It is equal to the benefits forgone by electing one decision alternative over
another, and can be a cost that implies no cash outlay.
• The opportunity cost concept is premised in resource scarcity.
– Given an organization’s portfolio of resource (e.g., its workforce, materials,
capital, finance, etc.), there is a limit to how much it can actually achieve with
such resources.
• If a particular resource has no use, there is zero opportunity cost.
However, where a resource has an alternative use, and especially when
such resource is scarce, we can say that an opportunity cost exists.
– This opportunity cost should be taken into consideration for any decision
about whether or not to engage in an alternative use of the resource.
• The opportunity cost perspective is an attempt to integrate ‘the bigger
picture’ into organizational decision-making scenarios, rather than basing
judgement entirely on financial or cash implications.

Technology and Cost Gathering
Developments in information technology,
particularly over the last two decades, have
fundamentally extended the capacity and
speed at which organizations can process cost
information. They include:
– Bar-coding
– Database technology
– Enterprise resource planning systems (ERPs)

Summary
Knowledge of costs is critical for any organization, especially in
today’s highly competitive, volatile and fast-moving economic
and social setting. Cost information has many purposes. We
have explored multiple meanings of, and different ways to
categorize and accumulate costs. In today’s organization,
multiple costs are incurred and there are multiple
perspectives from which they can be viewed. Costs can be
captured, identified and categorized in many ways; these
alternative views will shape different perspectives in respect
of managers’ decision-making.
– Accounting for costs is not an exact science; there is not necessarily
any ‘best’ way to configure an organization’s cost systems.
– Every organization has its own specific cost information needs, which
evolve and can change over time.
– Identifying appropriate means to capture, collate and use cost
information is a key task for management accountants.

Chapter03.ppt/Management Accounting Classification

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