Cost Concepts

Introduction to Cost Terms

Accounting systems measure costs which are used for • profit measurement, • inventory valuation, • decision making.

What is a cost ? Cost is a monetary measure of the resources sacrificed to achieve a specific objective, like producing a product or rendering a service. A cost object is any activity for which a separate measurement of costs is desired.

Examples of cost objects include . the cost of a product . cost of rendering a service to a bank customer . the cost of operating a particular department . cost of operating a sales territory

Various cost terms are • Direct and indirect costs • Product costs and period costs • Cost behavior in relation to volume of activity • Relevant and irrelevant costs • Sunk costs • Opportunity costs • Incremental and marginal costs • Joint product costs and separable costs

Direct and indirect costs Direct costs are those costs that can be specifically identified with a particular cost object. Ex : Direct material, Labor Indirect costs cannot be identified with a given cost object. Ex : Manufacturing overheads like indirect labor, indirect material

Manufacturing Overhead Manufacturing costs that cannot be traced directly to specific units produced.

Examples: Examples: Indirect Indirect labor labor and and indirect indirect materials materials Wages paid to employees who are not directly involved in production work. Examples: maintenance workers, and security guards.

Materials used to support the production process. Examples: lubricants and cleaning supplies used in the automobile assembly plant.

Product costs and period costs Product costs are those costs that are identified with goods produced for resale. Ex : Raw materials, direct labor Period costs are those costs which are matched against the revenue of the current period. Ex : Non manufacturing costs like rent, insurance, S & D expenses.

Non manufacturing Costs Marketing and selling costs . . .  Costs necessary to get the order and deliver the

product.

Administrative costs . . .  All executive, organizational, and clerical costs.

Product Costs Versus Period Costs Product costs include direct materials, direct labor, and manufacturing overhead. Inventory

Cost of Good Sold

Period costs are not included in product costs. They are expensed on the income statement. Expense

Sale

Balance Sheet

Income Statement

Income Statement

A company produces 100000 identical units of a product. Costs are Manuf. Costs Rs. Rs. Direct material 400000 Direct labor 200000 Manuf. O/H 200000 800000 Non manuf. Costs a) Sale of 50000 units for Rs.750000

300000

Sales (50000 units) Manuf. Costs ( product costs ) Direct material 400000 Direct labor 200000 Manuf. O/H 200000 800000 Less: Cl. Stock 400000 Cost of goods produced

750000

400000

Gross profit 350000 Less : non–manuf.Costs(period costs) 300000 Net profit

50000

Cost behavior in relation to volume of activity

Activity of an organisation may be measured in terms of • • • •

units of production hours worked distance travelled students enrolled

A knowledge of how costs and revenues will vary with different levels of activity is essential for decision making.

Fixed costs and variable costs The terms fixed cost, semi-fixed cost, variable cost, semi-variable cost have been used in management accounting to describe how a cost reacts to changes in level of activity. Fixed costs remain constant over wide ranges of activity for a specified time period Ex : Depr. Of factory, supervisor’s salaries Variable costs vary in direct proportion to the volume of activity Ex : Direct material, labor, energy charges.

Semi fixed costs are those costs that remain fixed within specified activity levels, within a given time period but they eventually increase or decrease at various critical activity levels. Ex : direct labor, salaries, energy charges, telephone bills

Cost Classifications for Predicting Cost Behavior How How aa cost cost will will react react to to changes changes in in the the level level of of business business activity. activity.

Total Variable Cost

Total Long Distance Telephone Bill

Your total long distance telephone bill is based on how many minutes you talk.

Minutes Talked

Variable Cost Per Unit

Per Minute Telephone Charge

The cost per long distance minute talked is constant. For example, Rs.1.25 per minute.

Minutes Talked

Fixed Cost Per Unit

Monthly Basic Telephone Bill per Local Call

The average cost per local call decreases as more local calls are made.

Number of Local Calls

Cost Behavior Variable costs are usually characterized

???

a. Unit costs that decrease as activity increases. b. Total costs that increase as activity decreases. c. Total costs that increase as activity increases. d.

Total costs that remain constant.

by

Cost Behavior Fixed costs are usually characterized by ??? a. Unit costs that remain constant. b. Total costs that increase as activity decreases. c. Total costs that increase as activity increases. d. Total costs that remain constant.

Cost Classifications for Predicting Cost Behavior

Behavior of Cost (within the relevant range Cost

In Total

Per Un

Variable

Total variable cost changes as activity level changes.

Variable cost per the same over w of activi

Fixed

Total fixed cost remains the same even when the activity level changes.

Fixed cost per down as activity le

Relevant costs and irrelevant costs For decision making, costs can be classified according to whether they are relevant to a particular decision. Relevant costs are those future costs that will be changed by a decision, whereas Irrelevant costs are those future costs that will not be changed by a decision. Ex : Choice of making a journey by car or public transport

Relevant costs and irrelevant costs Example: Do not

accept order Rs. Material 100 Conversion costs nil Revenue nil Net costs 100

Accept order Rs. 100 200 ( 250 ) 50

Sunk Costs Sunk costs cannot be changed by any decision. They are not differential costs and should be ignored when making decisions.

Example: You bought an automobile that cost Rs.10,000 two years ago. The Rs.10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the Rs.10,000 cost.

Opportunity Costs An opportunity cost is a cost that measures the opportunity that is lost or sacrificed when the choice of one course of action requires that an alternative course of action be given up.

Opportunity Costs The potential benefit that is given up when one alternative is selected over another. Example: If you were not attending college, you could be earning Rs.1,50,000 per year. Your opportunity cost of attending college for one year is Rs.1,50,000.

Incremental and marginal costs

Incremental cost ( also called differential cost ) is the difference in total costs between two alternatives. While assessing the profitability of a proposed change, the incremental costs are matched with incremental revenue. Marginal cost represents the

Incremental and marginal costs A company is producing 1000 units. Selling price per unit Variable cost per unit Fixed costs

Rs.11 Rs.5 Rs.4000

a)To accept another order for 500 units at a

selling price of Rs.9 per unit. This also increases fixed costs by Rs.500

Present situation Rs. Sales 11000 Less: Variable costs – 5000 Fixed costs - 4000

9000

Profit

2000

proposed situation Rs. 15500 7500 4500

12000 3500

Incremental cost = Rs.3000 Marginal cost = Rs. 3000/500 = Rs.6 per extra unit.

Differential Costs and Revenues Costs and revenues that differ among alternatives. Example: You have a job paying Rs.7,500 per month in your hometown. You have a job offer in a neighboring city that pays Rs.10,000 per month. The commuting cost to the city is Rs.1000 per month.

Differential revenue is: Rs.10,000 – Rs.7,500 = Rs.2500

Differential Costs and Revenues Costs and revenues that differ among alternatives. Example: You have a job paying Rs.7,500 per month in your hometown. You have a job offer in a neighboring city that pays Rs.10,000 per month. The commuting cost to the city is Rs.1000 per month. .

Differential revenue is: Rs.10,000 – Rs.7,500 = Rs.2500 Differential cost is: Rs.1000

Joint product costs and separable costs Joint product costs are the costs of a single process or a series of processes that simultaneously produce two or more products of significant sales value. These costs are not attributable to different individual products until after a certain stage of production known as “Split off point”

Joint product costs and separable costs Separable cost refers to any cost that can be attributed exclusively and wholly to a particular product, process, division or department.

Cost Sheet Cost sheet is a document that provides for the estimated detailed cost in respect of cost centres. Cost sheet may be prepared on the basis of actual data or on the basis of estimated data.

Cost Sheet

Rs.

Opening stock of raw materials – 30000 Add : Purchase of RM - 450000 480000 Less : Cl. Stock of RM

15000

Value of RM consumed 465000 Add : Wages paid 230000 PRIME COST

695000

Cost Sheet

Rs.

PRIME COST Add : Factory overheads

787000 Add : Op. stock of work in progress 799000 Less : cl.stock of work in progress FACTORY COST

789000

695000 92000

12000 10000

Cost Sheet

Rs.

FACTORY COST 789000 Add : Admin. Overheads 30000 Cost of goods produced

819000

Add : Op. stock of finished goods

60000 879000

Less : Cl. Stock of finished goods Cost of goods sold

55000 824000

Cost Sheet

Rs.

Cost of goods sold 824000 Add : S & D overheads 20000 Cost of Sales 844000 Profit Sales 900000

46000