What are costs

Management accounting: identifying, classifying and recording info in order to support internal
decision make

Core component: cost

Cost definition: value of resources express in monetary terms which is used in order to realize
a certain object: cost object (product or service)

Ex:
Cost object=table

Resources to realize the table: wood, employee, tools and equipment. The value of this
resources=cost

Cost object=dinner service in restaurant

Resources=rent of rest, food, waiter, drinks=cost

Why we need to deal with costs? Data about costs is useful to support these 3 kinds of
activities:

- Inventories: We need costs to define the value of inventories. If in the end of the
period we have inv not sold, the value should be defined by dealing with cost
management
- Short-term decision making
- Responsibility centres: organizational units that we have inside the enterprise. We can
use data about costs in order to evaluate the performance of these units

Costs classification

3 dif classifications:

- Direct vs indirect
- Product vs period
- Variable vs fixed

Direct vs indirect

Direct: cost related to resources that can be exclusively assign to one unit of object

Ex: table

Direct cost=wood (we can realize how much wood we need exactly to make 1 table), employee
that is directly involved in the realization of the table

- Costs of direct material and direct labour

Indirect (overheads): resources that can be used to realize more than one product
Indirect cost=overhead (OVH): equipment (can be used to make multiple tables), marketing
team

Overhead can be divided into:

- Manufacturing overhead (indirect resources involved in the production process)

- non-manufacturing overhead (selling expenses, general expenses, administrative
expenses)

Product cost vs period cost

Ex: cost object=table

Product cost=value of resources that are involved in the transformation of input into output
(production costs)

- Direct material, direct labour, manufacturing overhead (resources used within the
production process)

Period cost= general expenses that are not specifically related to the production process

- includes the non-manufacturing overhead

Variable and fixed

Variable (VC): costs that increase proportionally with the increase in the activity level

- direct costs are the typical VC

Fixed (FC): the overall amount remains the same even though the activity level increases (ex:
depreciation of equipment, rent of fabric)

U (C) = unitary cost

- unitaryVC remains the same for every activity level (quantity produced)
- unitaryFC decreases with the increase in activity level
3rd component: semi variable cost (SC): they have a component that is fixed and a component
that is variable (ex: lightning cost: have a fixed amount but also a variable amount that
increases with the amount of light utilized)

Costs configuration: direct vs full costs

One of the purposes of management accounting is defining the value of the inventories

To define the value of a product/service we need to define the resources that we want to
assign to our final cost object: we use cost configuration

Cost configurations:

1. Cost prime: we assign direct material+direct labor to the final product

Configuration that is really precise but not complete because we are avoiding
manufacturing and non manufacturing costs
2. Full manufacturing cost: direct material+direct labor+ Manufacturing overhead (ex:
depreciation of week)
3. Full cost configuration: direct material + direct labor+ Manufacturing overhead (ex:
depreciation of week)+ non-manufacturing overhead/SGA/Period
We are very complete but not that precise because we need approaches in order to
share the general expenses (non-manufacturing costs) among several products

The distinguish between 2 and 3 it’s important in terms of impact on the financial statement

Ex:

Data: Revenue=100€, Production costs=80€, 50% of products are not sold and enter the stock,
Period cost=10€

Net Operating Income (NOI)? Financial data

NOI=(Revenues-cost of goods sold) (=gross profit) – SGA (same as period cost)

Cost of goods sold: consider just production costs of the goods sold

NOI=100-80*0,5-10=50€

- Period costs enter as expenses immediately in the income statement. Which means
that they are defined as non inventoriable costs: their impact is immediate in the IS.
This is not the case with production costs: they enter the IS only in the moment that
we have the selling activity because the remaining part (this case, the remaining 50%)
enters the balance sheet as inventory

PERIOD COSTS: Non inventoriable costs

PRODUCTION COSTS: Inventoriable costs: means they affect the IS only when we have the
selling activity

Cost tracing vs cost allocation

Given a cost object the objective is to assign the value of resources that are absorbed by this
cost object

- Direct cost: can be traced directly to the cost object: TRACING

Because we can know exactly the amount used to produce one product

- Indirect costs=overhead: by definition they are absorbed jointly by several objects

We perform ALLOCATION: we introduce subjectivity in order to “share” this value by
the multiple objects

Ex:

Machine depreciation=90€

This machine is used to produce:

- 12 chairs (10min/unit)
- 2 tables (30 min/unit)

We need to divide the value of the depreciation for these goods

Allocation coefficient: coefficient that explains the relation between the use of the resources
and final product

AC=K= total overhead (=90)/total allocation bases

Allocation bases: gives the percentage of absorption of the machine by each product

ABchairs=12 (amount of chairs)*10 (10min to produce one)

ABtables=2*30
Every minute that the machine was used it absorbed 0,5€ of resources

Now we need to assign the value of the depreciation of the machine to the 2 dif products

Overhead(chairs)=K*ABchairs=0,5*120=60€

Overhead(table)=0,5*60=30€

Assign the overhead to the cost object: 2 approaches

- Traditional costing system: just perform one time the allocation

- Activity based cost system (ABC): we calculate the allocation coefficient (k) twice with
the final objective of improving the precision

JOC

Job order cost: given a cost object, direct material and labor are traced and overhead is
allocated

JOB: core component is job! Job can be referent to a unit or a batch

- Unit output: we have phases

- Batch: we have departments

Our unit/batch enters the dif phases/departments and in the end we arrive at the final product
(where we have the job complete)

When we want to calculate the total job, we assign the direct material and direct labor of each
phase/department to the job.

This is not the case for overheads! Ex: electricity. You receive the bill of the electricity for the
entire company, you cannot know the electricity of each department. You need to have a
method to assign these overheads
Job order costing system: Job order sheet: first part where we find general info (job n,
customer, etc). Second part: DM+DL (traced immediately) and overhead

How to calculate overhead?

K=Overhead total (D1)/AB total (D1)

Overhead (Job D1)=K*AB total (D1)

Ex: Batch=10bags

Production process:3 phases (preparation department, machining, finishing)

Machine hours: total number of hours worked in that department

H10bag=hours used to produce the 10 bags in that department

We already have the value of the overhead in each department but we want to know the
overhead that relates to the production of our batch

Total cost of job=217€

Exercise on JOC
Rent and cleaning: we use the square meters as the base for the calculation of overhead

Preparation/finishing departments: AB is the same

Preparation department: k=total overhead/(number of hours worked*number of

workers=total direct labor hours=160*6)

Machining department: AB is represented by the number of machines hours=100hours

K=total overhead/100

ABC

Activity basis costing system: another approach to assign overhead

Overhead is assign to activities first and then they are allocated again to the final cost object
Traditional costing system (ex: JOC): OVH is assign to the final cost object by calculating an
allocation coefficient K

Activity base costing system: OVH is assign to the activities for which our resource is used (ex:
if we have a machine we identify the activities carried by it): calculate K(R) -> resource driver.
Then we assign the value of our activity to the final cost object: again by calculating K(A) ->
activity driver

The main dif between the 2 approaches: ABC increases complexity of the system but also
increases the precision because we are identifying the activities that actually consume the
resource

Resource driver: time

Ex: indirect resource=machine depreciation=90€ and we want to assign it to chairs (12 units,
10min/u) and tables (2 tables, 30min/u)

Overall we need 10*12+2*60=180min for production

We also have a total time of setup for the machines. We have a setup for chairs and a setup for
tables

1ST: identifying the activities carried out: production and setup

2nd:calculate K (machine depreciation)=total overhead/AB(total)=90/(180+20)=0,45€/min

AB(total)=AB(production)time for production (180)+AB(setup)=20

OVH (Production)=0,45*180=81

OVH (setup)=0,45*20=9

3rd:We need to calculate a K for production and a K for setup

K (P)=total cost of production/AB(total)=0,45€/min : in this case we have the same K but that is
only because we are using time as a driver

AB(total)=AB(chairs)+AB(tables)=120+60

4th: assign the K for tables and chairs

Cost of production assign to the chairs=0,45*120

- We need to repeat this approach for all activities. If we move to the activity of setup
we need again to identify an activity driver (quantity that explains the relationship
between the setup and the realization of the tables and the chairs). We don’t have the
data for the time of setup for each product, so we can’t use time as a driver. We are
going to use quantity
 - Each setup costs 4,5€. Each activity requires 1 setup so the cost of the setup is 4,5€ for
each activity

Exercise on ABC

ABC approaches, 3 steps:

1. Identify the overheads

2. Identify the activities for which the resources are absorbeb
 3. Identify the products and calculate the Ks

Total cost for each activity:

Now we need to identify the activity driver: quantity that explains the relationship between
the activity and the final product
Now we need to share the cost of the activity among the 3 products

3000€: share of the costs of paper prototyping for producing the t-shirts
Overall costs for realizing each product: