2. Cost Concepts
Cost refers the amount of expenses spent to generate product or services.
Cost refers expenditure that may be actual or nominal expenses incurred to
generate output.
Cost is the value of economic resources used as result of producing or doing
the things.
Cost has many meaning but in management cost refers the expenditure not the
price.
As a manager we use cost information for taking decisions and making plans,
programs and policies and strategies.
3. Cost according to elements of cost
Direct material
Direct labor
Direct expenses
Overheads
4. Cost According to function- Manufacturing Vs. Non-manufacturing
costs
Manufacturing Costs
Manufacturing costs involves the cost of raw
material, labour and use of equipment to finished
goods
Composed up of the following elements.
Direct material
Direct labour
Overheads
5. Elements of Manufacturing Cost
Materials
Labour
Overheads- indirect material labors and factory
expenses
6. Non manufacturing Cost
Cost other than manufacturing cost that are incurred
for sale
Non-manufacturing costs are:
Selling expenses /marketing expenses
Promotion, or Advertisement costs,
Administrative costs
8. Variable costs
Variable costs are based on activity.
The variable costs should be zero at zero activity.
They change directly with changes in activity level in a
responsibility center.
If output is doubled, variable expenses is to be doubled,
if output increases by 15% the variable expenses also
increase by 15%,
if output is zero, the variable cost also zero.
9. Variable costs are usually characterized by:
Unit cost remains constant.
Total costs that increase as activity increases.
Total costs that decrease as activity decreases.
Total costs changes proportionality with changes
in output.
11. Fixed Cost
Fixed cost is also called period cost or capacity
cost.
It does not change in short term period or within a
relevant range.
They accrue primarily with the passage time.
Fixed costs are caused by holding of assets and other
factors of production in a state of readiness to
produce.
12. Characteristics of fixed cost
Unit cost increase as activities/outputs decrease.
Costs that remain constant even activities are
decreased or decreased
Cost per unit that increases as activity decreases
and vice versa
Total costs that remain constant.
14. Committed fixed cost
Committed cost arises from the ownership,
facilities or possession of assets.
Committed cost can not be changed by a simple
decision.
Major decisions to change.
For example: property tax, Loan installments
depreciation, insurance etc.
15. Discretionary fixed Cost
Arises from management decision
Controllable costs
Can be easily changed by decisions
Examples:
Advertisement,
Training costs
marketing expenses,
promotional expenses etc.
16. Step fixed costs
Remains constant over fixed range of activities but jumps to
different amount for the activities levels outside the range
17. Semi–Variable Expenses/ Mixed costs
Semi–variable expenses also changes with changes in
output or activity but not in proportion to changes in
activity or output
Semi variable expenses have some of the
characteristics of both fixed and variable costs.
Semi variable expenses are caused by combined effect
of passage of time, activity or output and management
discretion decisions.
18. Methods of Cost Segregation
Engineering analysis
Accounting analysis
High Low point methods
Least Square Regression Analysis
19. Engineering Analysis
Systematic review of costs for product and services
Measuring cost behaviors according to what cost
should be, not by what have been
Mixed Cost Function = 4,000 + 600 X Per Day
20. Accounting analysis
This is a simple method
Segregates cost into fixed and variables based on
certain cost driver.
21. Example: The Directorium Manufacturing Company produced and
sold 80,000 units at Rs. 50 each. The cost for 1976 were as follows:
Particular Fixed Cost Variable
Cost
Direct materials - Rs.200,000
Direct labour - 160,000
Manufacturing overhead Rs.440,000 20,000
Selling and admi. expenses 280,000 100,000
Mixed cost function = 720,000 + 6 X units of production
22. High Low Point method
Under this method, semi variable cost can be segregated into
variable and fixed cost based on the two extreme levels of
activities using the following formulas.
Variable rate (b) = [Cost at high point- Cost at low Point]/
[High point –Low point]
Fixed cost (a) = Total cost – Variable rate Level of activities
Therefore, the cost volume formula:
Total cost = Fixed cost + (Variable rate levels of
activities)
23. Advantages and Disadvantages
Advantages:
It is easy and less time consuming.
Cost behavior is restricted to the relevant ranges.
It will be more suitable when there are two levels of
activities to estimate cost.
Disadvantages
Use of only two extreme conditions may not be
representative of normal conditions
It may give the unreliable estimate of fixed cost (a)
and variable rate (b).
It does not specify the fixed cost below and above
the two levels of activities.
24. Least Square Analysis
One of the best and widely used methods in cost estimation,
A statistical procedure for estimating mathematically the
average relationship between the dependent variable (y) and
independent variable (a).
It includes all the observed data and attempts to find the line
of best fit in estimation of variable and fixed cost.
Under this method, the following least square formula can be
used to estimate cost.
Y = a + bx
Where, a = Estimated fixed cost i.e. constant
b = Variable rate i.e. slope of regression line
Y = Dependent variable i.e. estimated total cost
X = Independent variable i.e. Level of activity or
units of products, hours etc
25. Least Square Formula
2
2
X
X
N
Y
X
XY
N
b
2
2
2
X
X
N
XY
X
Y
X
X
b
Y
a
activities
of
levels
X
rate
aible
b
t
fixed
a
Where
var
cos
26. Regression Statistics
Least square regression method is used to estimate variable
and fixed cost.
However, it doses not explain the accuracy and the
reliability of the regression result.
To explain the accuracy and reliability of the regression
result, Correlation coefficient (r) and Coefficient of
Determination (r2)
27. Data for total power costs and machine hours are given below:
Power Costs (000 omitted) Machine Hours (000 omitted)
Rs.7
60
80
200
40
80
500
60
70
50
9
8
8
2
6
7
9
5
8
6
Rs.62 70 hours
1. Required:
a) Separate the power costs into the fixed and variable components using
the method of least squares. V-42.35 F- 114.3
b. Estimate the power costs when 6.5 machine hours are used.
c. Compute the coefficient of determination.
d. Does the regression equation need to be improved?
e. t-value,
e) Standard error of coefficient (Sb)
28. Classification of cost according to decision making
Relevant Cost and Irrelevant Cost
Avoidable and Unavoidable Costs
Out of pocket costs, Opportunity, Sunk costs
Period Cost and Product Cost
Direct Vs. Indirect cost
Controllable and Uncontrollable Cost
Incremental Cost/Differential Cost
Committed fixed cost and Discretionary fixed Cost
29. Relevant cost
Costs and expenses which are directly influenced by
decision are relevant costs.
All future cost are relevant cost. They are pertinent
and valid costs.
Relevant costs include all variable costs and
additional fixed costs which are incurred because of
the decision being taken
30. Irrelevant Cost
In other hand, costs that cannot be changed are called
irrelevant costs. Irrelevant costs include the existing
fixed costs which are going to exist even after the
decisions are taken. Such costs do not affect the
decision
31. Controllable and Uncontrollable Cost
Controllable and uncontrollable cost depends on the
point of reference.
Uncontrollable cost at lower level may be
controllable at top level, uncontrollable in short term
may be controllable in the long run. etc.
A cost is a called controllable at particular level if the
level has power to authorize the cost.
If it has not, it is called uncontrollable cost.
32. Avoidable VS Unavoidable Costs
Avoidable costs can be saved simply by not doing the
alternative courses of action.
They are relevant in decision making
Unavoidable costs are irrelevant cost because they can not
be avoided or eliminated by taking decisions or
alternatives.
If the revenue generated by avoidable cost is high, we have
to take decisions
33. Direct Cost and Indirect Cost
Direct costs are directly traceable or identifiable to a
particular job or department or product and are
controllable.
Indirect costs are uncontrollable and no-traceable
costs.
Cost may be direct but the same may be indirect
depends on the situation.
34. Incremental Cost/Differential Cost
Cost difference between two alternatives
If differential costs are increased, it is called incremental
cost and decreased, and called decremental cost
Incremental cost refers the only the increased cost from
one alternative to another.
Differential cost or incremental cost can also be used to
analyses alternatives for decision-making purpose
35. Period Cost
Period costs are not manufacturing cost. However, they are
incurred and paid based on the period
They are deductible from revenue.
Example: Rent, salaries, telephone etc.
36. Product Costs
Product costs are manufacturing costs
They are incurred for the manufacturing of goods
They include direct material, direct labour, and
manufacturing overheads.
Example: direct material, labour cost, manufacturing
overhead etc.
37. Out of pocket expenses
Expenses incurred for activities for raw materials,
labour overheads etc.
38. Opportunity Cost
Not recordable in the books of account but are
considered in every decisions of managers.
It is the amount of benefit that is sacrificed when one
alternative is selected.
39. Sunk costs
Costs are the cost incurred a result of past decisions.
Cost can not be changed by taking operating decision
Sunk costs are irrelevant from decision making.
Sunk costs are depreciation of assets, lease rent etc.