Cost Concepts

Cost Concepts for Decision-making

07/09/09

Chandrakant@SOM,KIIT University

1

Learning Objectives Define cost and cost object. Understand cost accumulation and cost assignment. Understand “Cost Center” Distinction between Direct Cost and Indirect Cost. What is a ‘Cost Driver’? Classification of “COST” 

    

07/09/09

Chandrakant@SOM,KIIT University

2

Cost and Cost Terminology Cost is a resource sacrificed or forgone to achieve a specific objective. An actual cost is the cost incurred (a historical cost) as distinguished from budgeted cost, which is a predicted A cost object is anything for which a separate measurement of costs is desired. 07/09/09

Chandrakant@SOM,KIIT University

3

Cost and Cost Terminology Cost Object

Cost Accumulation

(Collection of cost data in some organized way by means of an

Cost Assignment

Cost Object

Cost Object Tracing Allocating

07/09/09

Chandrakant@SOM,KIIT University

4

Cost Assignment  Encompasses both: – Tracing accumulated costs that have a direct relationship to a cost object. – Allocating accumulated costs that have an indirect relationship to a cost object.

07/09/09

Chandrakant@SOM,KIIT University

5

Cost Center  CIMA defines as “a production or service, function, activity or item of equipment whose costs may be attributed to cost units. A cost center is the smallest organizational sub-unit for which separate cost allocation is attempted.”  Any part of an enterprise to which costs can be charged is called as Cost Center. The objective behind this: – Clear cut responsibility placed on a person. – Cost center-wise recovery of cost is possible.

07/09/09

Chandrakant@SOM,KIIT University

6

Cost Driver Bicycles by the Sea buys a handlebar at $52 for each of its bicycles. What is the total handlebar cost when 1,000 bicycles are assembled? 1,000 units × $52 = $52,000 What is the total handlebar cost when 3,500 bicycles are assembled? 3,500 units × $52 = $182,000 Bicycles by the Sea incurred $94,500 in a given year for the leasing of its plant. This is an example of fixed costs with respect to the number of bicycles assembled. What is the leasing (fixed) cost per bicycle when Bicycles assembles 1,000 bicycles? $94,500 ÷ 1,000 = $94.50 What is the leasing (fixed) cost per bicycle when Bicycles assembles 3,500 bicycles? $94,500 ÷ 3,500 = $27 The cost driver of variable costs is the level of activity or volume whose change causes the (variable) costsChandrakant@SOM,KIIT to change proportionately. The number of 07/09/09 University bicycles assembled is a

7

Direct and Indirect Costs Direct Costs: Cost related to the particular cost object and can be traced to it in an economically feasible way. Indirect Costs: Cost related to the particular cost object but can’t be traced to it in an economically feasible way. Example: Salaries of supervisors 07/09/09 Chandrakant@SOM,KIIT University who oversee production of

COST OBJECT Example: Pepsi Colas

8

Prime Costs

Direct Materials

07/09/09

+

Direct Labor

=

Chandrakant@SOM,KIIT University

Prime Costs

9

Conversion Costs

Direct Labor

Manufacturing Overhead

+

Indirec t 07/09/09

Indirec t

=

Conversion Costs

Other

Chandrakant@SOM,KIIT University

10

Classification of Cost Payment Based: 2. Explicit 3. Implicit Elements Based: 2. Materials 3. Labour 4. Expenses Function Based: 2. Production 3. Administratio n 4. Selling 5. Distribution 6. R & D 7. Conversion 07/09/09

Time Based: 2. Historical 3. Current 4. Budgeted

COST

Nature Based: 2. Variable 3. Fixed 4. SemiVariable

Chandrakant@SOM,KIIT University

Controllability Based: 2. Controllable 3. Noncontrollable Normality Based: 2. Normal 3. Abnormal Association Based: 2. Period 3. Product Decision making Based: 2. Relevant 3. Irrelevant 11

On the basis of behavior  Variable cost: Tend to vary or change in relation to the volume of production. However, remained constant per unit. Exp: raw materials, direct wages, etc.  Fixed cost: Remain constant at various level of production. These are not affected by volume of production. However, varies per unit. Exp: factory rent, Insurance, etc.  Semi-variable cost: These are fixed up to a particular volume of production and become variable thereafter for the next level of production. Exp: repairs and maintenance, electricity, 07/09/09

Chandrakant@SOM,KIIT University

12

Variable and Fixed Costs Variable Cost 



a cost which is constant per unit but changes in total in proportion to changes in the cost driver Exp: materials (parts), fuel costs for a trucking company

Fixed Cost  a cost which does not change in total as volume changes but changes on a per-unit basis as the cost driver increases and decreases  07/09/09 Exp: amortization, insurance Chandrakant@SOM,KIIT University

$

Volume $

Volume 13



On the basis of controllability Controllable cost: Cost which can be

influenced and controlled by managerial action. A relative term but subject to: – Time: long run vs. short run – Location: Lease agreements of factory being executed centrally at the HO. – Product/Output: Certain costs are controllable by reference to one product or market segment and not by reference to the other. Exp: cost of raw materials for export.

 Non-controllable cost: Costs that can not be influenced and controlled by a 07/09/09

Chandrakant@SOM,KIIT University

14

On the basis of Association Period costs are all costs in the income statement other than cost of goods sold. Exp: General Administration, Salesman's Salary, Depreciation of office Facilities, etc

Period costs are recorded as expenses of the accounting period in which they are incurred since these are not assigned to the products

Product costs are all costs which can be identified to different products purchased or produced for resale and are included in Inventory Valuation. Exp: cost of rawChandrakant@SOM,KIIT materials,University direct wages, all 07/09/09

15

Product Costs Versus Period Costs Product costs include direct materials, direct labor, and manufacturing Cost of Good Inventor overhead. Sold

y

Sale

Balance Sheet 07/09/09

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

Income Statement Chandrakant@SOM,KIIT University

Income Statement 16

Manufacturing Company BALANCE Inventori SHEET able

Materials Inventory Work in Process Inventory 07/09/09

Finished Goods Inventory

INCOME STATEMENT Revenues w hen sale

dedu

Cost of Goods Sold Equals Gross Margin

Period Costs Equals Operating Chandrakant@SOM,KIIT University 17 Income

Merchandising Company BALANCE Inventori SHEET able

Merchandis e Purchases

Inventory

INCOME STATEMENT Revenues w hen sale

dedu

Cost of Goods Sold Equals Gross Margin

Period Costs 07/09/09

Equals Operating Chandrakant@SOM,KIIT University 18 Income

On the basis of payment

07/09/09

Chandrakant@SOM,KIIT University

19

On the basis of relevance to decision-making  Relevant costs – Marginal cost – Differential cost – Opportunity cost

 Irrelevant costs – Absorbed fixed cost – Sunk cost – Committed cost 07/09/09

Chandrakant@SOM,KIIT University

20

Relevant Cost  Expected future costs that are essential but differ for alternative courses of action. Hence it is a cost that would arise as a direct consequence of the decision under review.  Exp: One is faced with a choice of making a journey by car or by public transport, the car tax and insurance costs are irrelevant since they will remain the same whatever alternative is chosen. However, the petrol costs for the car will differ depending on which 07/09/09

Chandrakant@SOM,KIIT University

21

Marginal Cost  Total variable cost i.e. Prime Cost + Variable Overheads. This cost is relevant for decision making as this will be incurred in future for additional units of production.  It will be a relevant cost for decision making as this will be incurred in future for additional units of production. 07/09/09

Chandrakant@SOM,KIIT University

22

Differential Cost  It is the increase or decrease in total cost or change in specific elements of cost that result from any variation in operations. It represents an increase or decrease in total cost resulting out of: – Producing or distributing a few more or few less of the products – A change in the method of production or of distribution – An addition or deletion of a product or a territory and – Selection of an additional sales channel 07/09/09

Chandrakant@SOM,KIIT University

23

Opportunity Costs The value of sacrifice made or benefit of opportunity foregone by selecting one particular alternative in preference to other alternatives. If you were Example:

not attending college, you could be earning $15,000 per year. Your opportunity cost of attending college for one year is $15,000.

Cont…  Example: A firm operates at full capacity. If a new order is to be undertaken, contribution foregone on the existing sales (i.e. due to full capacity) constitutes opportunity cost for the new order.  It is relevant cost where alternatives are available. However, opportunity cost does not find any place in formal accounts and is computed only for comparison purposes. 07/09/09

Chandrakant@SOM,KIIT University

25

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 $10,000 two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost.

07/09/09

Chandrakant@SOM,KIIT University

26

Committed Cost  A cost, which has been committed by the management, is not relevant for decision making.  Exp: costs arising from the possession of plant, building and equipment (e.g. depreciation, rent, taxes, insurance premium, etc).  These are un-avoidable cost. 07/09/09

Chandrakant@SOM,KIIT University

27

Concept Problem: 1  ABC Ltd is tendering a six-month contract which would require the use of a specialized machine. The machine was purchased 4 years ago for Rs 90,000 and now has a net book value of Rs 35,000. The company was about to sell the machine for Rs 40,000 but if they used it on this contract they can sell it after 6 months for Rs 25,000. Variable cost of operating the machine for 6 months would be Rs 60,000. Ignoring interest costs, identify the relevant cost of using the machine on 07/09/09

Chandrakant@SOM,KIIT University

28