Select Business & Technology

College
Department of Business
Administration
Course Title: Financial And Managerial
Accounting
Course Code: MBA 611
CHAPTER 4:- COST ACCOUNTING

Instructor :- [Link] R. (Asst Prof)

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 Cost Accounting: Definition

Cost is the resources that have been sacrificed or

must be sacrificed to attain a particular objective.
In other words, cost is the amount of expenditure
related to a specific thing or activity.
A cost is the amount of resources given up in
exchange for some goods or services. Cost is an
exchange price or a sacrifice made to secure
benefit.
The term, "cost is not synonymous with expense".

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 Cost Accounting: Definition (Cont.)
Expense means a decrease in owners’ equity that
arises from the operation of a business during a
specified accounting period,
Whereas cost means any monetary sacrifice
whether or not the sacrifice affects the owners’
equity during a given accounting period.

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 Cost Accounting: Definition (Cont.)
Basically, when cost is incurred, it could be in the
form of deferred costs (asset) or expired costs
(expense). Deferred costs are unexpired costs
which provide benefits in the future periods and
are known as assets.
When the deferred cost (assets) are used up, to the
extent used they will become an expense. In other
words, expenses are expired costs incurred and
used up in the process of generating revenue.

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 Cost Accounting: Definition (Cont.)
Cost Accounting is a branch of accounting
dealing with the classification, recording,
allocation, summarization and reporting of current
and prospective costs and analyzing their
behaviors.
Cost accounting is frequently used to facilitate
internal decision making and provides tools with
which management can appraise performance and
control costs of doing business.

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 Cost Accounting: Definition (Cont.)
Cost Unit is a unit of quantity of product, service
or time in relation to which costs may be
determined or expressed.
Unit cost is computed by dividing the
accumulated costs by the number of equivalent
units produced in the period.
 Cost per equivalent unit = Product costs for the period
Equivalent units for the period

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Cost Accounting Systems

There are two major types of costing a product

or service:
1. Job order costing system
2. Process costing system

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 Cost Accounting Systems….
1) Job order cost system: Job order costing is used in
those business concerns where production is carried out
as per the customer’s order and specifications.
That means, each job or product is considered to be
separate and distinct from the other jobs or products.
Therefore, under this method costs are collected and
accumulated for each job, work order, or project
separately.
This method is adopted in furniture manufacturers,
construction companies, printing (publishing) companies,
accounting firms, research firms etc
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 Cost Accounting Systems….
2) Process cost system: This costing system is used in
those industries where manufacturing is done
continuously through different processing cycles.
Companies which are using this method produce
homogeneous or similar products in a repetitive manner
through different process. The finished product for one
process becomes the raw material for the subsequent
process.
 This method of costing is suitable for textile industries,
chemical industries, paper manufacturers, cement
factories etc.
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 Objectives of Cost Accounting
a) To ascertain the cost of production on per unit basis,
for example, cost per kg, cost per meter, cost per
liter, cost per ton etc.
b) Cost accounting helps in the determination of
selling price. Cost accounting enables to determine
the cost of production on a scientific basis and it
helps to fix the selling price.
c) Cost accounting helps in cost control and cost
reduction.
d) Cost accounting helps in presentation of relevant
data to the management which helps in decision
making etc.
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 Classification of Costs
 Classification of costs is the process by which costs
are grouped according to some common
characteristics.
 Classification is the arrangement of cost items in
logical groups having regard to their nature
(subjective classification) or purpose (objective
classification) to be achieved and requirement of an
organization.
 Subjective classification is used to indicate the nature
of the expenditure, for example, material, labor;
whereas objective classification indicates the cost
center or cost unit where the costs are to be charged.
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 Classification of Costs….
 In general costs can be classified in the following
ways:
▪ Based on natural characteristics
▪ Based on changes in the volume/levels of activity
▪ Based on tractability of the product
▪ Based on association with product or period
▪ Based on the nature of functions
▪ Based on relation with accounting period
▪ Based on the time of cost determination
▪ Based on the management policies
▪ Based on relevance for decision making and analysis

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 Classification of Costs….
A. Classification of Cost According to Natural
Characteristics:
 According to this classification, costs are divided into
three categories; i.e.
a) Material
b) Labour and
c) Other costs

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 Classification of Costs….
 Classification of Cost According to Natural
Characteristics…..
a) Material: Material is rated as the first element of
cost because without material to work upon nothing
can be manufactured.
Material can be divided as
✓ Direct Material and
✓ Indirect Material.

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 Classification of Costs….
 Classification of Cost According to Natural
Characteristics…..
b) Labor: Labor is considered as the second element of
cost because without labor the form, shape or nature of
material cannot be changed to increase its usefulness.
✓ This cost can also be of two types, (a) direct labor and
(b) indirect labor.
✓ Wage which can be economically traced to the output is
known as direct labor and on the other hand, salaries
paid to supervisor, cleaner, guard and production
manager are treated as indirect labor/wages.

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 Classification of Costs….
 Classification of Cost According to Natural
Characteristics…..
•Other Costs: All other manufacturing costs are
classified as the third elements i.e. other costs, because,
unless certain other costs are incurred, material cannot
be worked upon by labor.
✓ Examples of this types of costs include tools must be
supplied, supervision must be exercised, machinery
must be maintained, a place of work must be
furnished to make possible labors work upon the raw
material furnished.

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  Prime costs are all of the costs that are directly
attributed to the production of each product. Prime
costs are direct costs, meaning they include the
costs of direct materials and direct labor involved
in manufacturing an item.
 The costs of converting the materials into finished
products consists of direct labor and factory
overhead. These two costs combined are often
referred to as conversion costs.

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 Classification of Costs….
B. Classification according to changes in the
volume/levels of activity:
 Within a period, a particular cost may be observed
changing with corresponding changes in some
measures of activity.
▪ On this basis, costs can be classified into four
categories, viz.,
→ Fixed,
→ Variable,
→ Mixed, and
→ Step Costs

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 Classification of Costs….
 Classification according to changes in the
volume/levels of activity…..
▪ Fixed Costs: A fixed cost is that which tends to remain
unchanged despite often wide changes in output or
activity. Fixed costs remain fixed only over a given
period of time usually the budget period.
✓ The rent of buildings of an organization, supervisor’s
salaries, taxes on real estate, insurance are good examples of
fixed costs.
✓ On a per unit basis, a fixed cost varies inversely with
changes in the level of activity. This means that the per unit
fixed cost decreases with increase in the activity level, and
increases with decrease in the activity level.
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 Fixed Costs

Total
Cost
$3,000

$2,000

$1,000
Total Fixed Cost

10 20 30
Units of the Cost Driver
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 Classification of Costs….
 Classification according to changes in the
volume/levels of activity…..
▪ Variable Costs: A cost that changes in direct
proportion to changes in the cost driver. A variable
cost must be a constant amount per unit. The cost of
raw materials, wages, sales commission, use of
machine on rental basis is the good examples of
variable costs.
✓ Thus, as activity changes, total variable cost
increases or decreases proportionately with the
activity changes, but unit variable cost remains
the same.
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 Variable Costs

Total
Total Cost
Cost
$3,000
$2,000
Total Variable Cost
$1,000
10 20 30
Units of the Cost Driver

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 Classification of Costs….
 Classification according to changes in the
volume/levels of activity…..
▪ Mixed Costs/Semi-variable costs: A mixed cost is a
semi-variable cost (sometimes known as a semi-fixed
cost) that has both a fixed and variable element to it.
✓ So a mixed cost has both a variable and a fixed
component.
✓ On a per unit basis, a mixed cost does not
fluctuate in direct proportion with changes in
activity nor remains constant with changes in
activity.

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 Classification of Costs….
 Classification according to changes in the
volume/levels of activity….
▪ Step Costs: Step costs, sometimes called semi-
fixed costs, remain fixed over a range of activity,
but beyond some activity level they change usually
by intermittent jumps rather than continuously.

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 Classification of Costs….
C. Classification of cost based on degree of
traceability to the product
 Based on the degree of traceability to the product costs
are classified as direct and indirect.
Direct Costs
 A direct cost is a cost that can be easily and
conveniently traced to the particular cost objects
under consideration in an economically feasible way.
"Traceability” refers to the existence of a clear cause
-and- effect relationship between the cost object and
the incurrence of a cost. Direct costs are those which
are incurred for a particular cost unit.
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 Classification of Costs….
 Classification of cost based on degree of traceability
to the product….
Indirect Costs
✓ An indirect cost is a cost that cannot be easily and
conveniently traced to the particular cost object under
consideration. Indirect costs are those of a more
general nature or common costs which cannot be
identified primarily as part of the cost of a given
product. Examples of indirect costs include
supervisors' salary, rent, rates and taxes.

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 Classification of Costs….
Determining the costs that should attach to a cost object is called
cost assignment. cost tracing

▪ Direct costs are

Direct easily traced to the
Cost Assignment

cost object.
Costs
Cost
▪ Indirect costs are
Object not easily traced to
the cost object, and
Indirect must be allocated to
Costs all of the products
they are used to
produce.
cost allocation
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 Classification of Costs….
D. Classification as Product versus Period Costs
▪ Costs related to time periods are either:
✓ product costs or
✓ period costs

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 Classification of Costs….
Classification as Product versus Period Costs…..
 Product Costs- refer to those items of cost that are
included in the costs of inventory and become
expenses when the product is sold subsequently.
✓Product costs include only the costs necessary to
complete the product at the manufacturing step in the
value chain (manufacturing) or to purchase and
transport the product to the location of sale
(merchandising).
✓For examples, the cost of direct materials, direct labor,
and manufacturing overhead consist product costs for
manufactured goods

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 Classification as Product versus Period Costs…..

The cost of materials that

Direct are an integral part of the
Materials product.

The cost of labor directly

Product Direct involved in converting
Costs Labor material into the product.

All manufacturing costs

Factory
other than direct materials
Overhead and direct labor fall into this
category.

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 Classification of Costs….
Classification as Product versus Period Costs…..
 Period costs- refer to those items of cost which are
recognized as expenses for the period in which they are
incurred and are charged against the revenue for the
period.
✓ Period costs include all other costs incurred by the firm in
managing or selling the product (indirect costs outside the
manufacturing step of the value chain).
✓ Examples of period costs are salaries of sales personnel,
sales representatives’ commission, administrative expenses,
selling expenses, distribution expenses, and finance
expenses etc.
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 Classification of Costs….
E. Classification according to the nature of functions
 Manufacturing Costs
 Administrative Costs
 Marketing Costs
 Research and Development Costs

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 Classification of Costs….
F. Classification according to the time of cost
determination
 Costs classified in relation to the time of incidence
include
➢ Historical Costs,
➢ Replacement Costs
➢ Budgeted Costs and
➢ Standard Cost

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 Classification of Costs….
Classification according to the time of cost
determination….
Historical Costs/Actual costs:
 Historical costs or actual costs refer to the costs
actually incurred and ascertained after they have been
incurred. Historical costs were incurred in the past
and are normally used in financial accounting.
 Historical costs are frequently not useful for decision
making because conditions may have changed since
the costs were incurred.

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 Classification of Costs….
Classification according to the time of cost
determination…..
Replacement Costs:
 A replacement cost is an amount that a firm would
currently have to pay to replace an asset or to buy one
that performs functions similar to an asset currently
held.
 It is the cost of replacement at current market price.
So replacement cost valuation states the costs at
prices that would have to be paid currently.

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 Classification of Costs….
Classification according to the time of cost
determination….
Budgeted Costs:
✓ A budgeted cost is a planned future expenditure.
Standard Cost:
✓ An estimated or predetermined cost of performing
an operation or producing goods or services under
normal conditions.
✓ Standard costs are used as target costs (or basis for
comparison with the actual costs), and are
developed from historical data analysis or from
time and motion studies.
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 Classification of Costs….
G. Classification of costs according to their
relevance for decision making and analysis:
 Opportunity Cost and Outlay Cost
 Relevant Costs and Irrelevant Costs
 Incremental Cost and Differential Cost
 Sunk Cost
 Controllable Costs and Uncontrollable Costs
 Avoidable costs vs. Unavoidable costs
 Shut-down Costs and Abandonment Costs

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 Classification of Costs….
 Classification of costs according to their relevance for
decision making and analysis….
Opportunity Cost and Outlay Cost:
✓ Opportunity cost is the cost of selecting one course of
action in terms of the opportunities which are given
up to carry out that course of action; that is, an
opportunity cost is the cost of an opportunity
foregone.
✓ Example: If fixed deposits in the banks are proposed
to be withdrawn for financing a project, the
opportunity cost would be the loss of interest on the
deposits.
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 Classification of Costs….
 Classification of costs according to their relevance for
decision making and analysis:
Opportunity Cost and Outlay Cost…
✓ Example: If you were not attending college, you could be
earning Br 36,000 per year in additional income. Your
opportunity cost of attending college for one
year includes the Birr 36,000.
✓ Opportunity costs are not recorded in the financial accounts,
but are relevant to decisions because they are a real sacrifice.
✓ On the contrary, the concept of cost which normally enters
into the accounts of a business is known as outlay cost.
✓ Outlay costs refer to the actual expenditures incurred on raw
materials and other productive facilities.
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 Classification of Costs….
Classification of costs according to their relevance for decision
making and analysis…..
Relevant Costs and Irrelevant Costs:
 Any cost which is relevant in making a decision is relevant cost.
Relevant cost refers to the incremental and avoidable cost of
implementing a business decision.
 Costs that will be incurred as a result of a decision and thus
appropriate to a specific managerial decision are known as
relevant costs. These costs are relevant for future decision
making.
 Relevant costs for decision making reflect the following two
important features:
✓ They must be expected future costs and
✓ They must differ among alternatives.
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 Classification of Costs….
Classification of costs according to their relevance for
decision making and analysis…
Relevant Costs and Irrelevant Costs…
✓ On the contrary, costs which are not affected by a
decision are irrelevant costs that are costs that have
already been incurred irrespective of what is being
done by the enterprise at present are irrelevant
costs.
✓ In any decision involving two alternatives, the
irrelevant cost may always be ignored.

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 Classification of Costs….
Classification of costs according to their relevance for decision
making and analysis…
Incremental Cost and Differential Cost:
 When the cost of an option is shown as additional to that
under another option it is called an incremental cost.
 On the other hand, differential cost is the difference in the
total cost of two options compared. It is noteworthy here
that, although technically an incremental cost should refer
only to an increase in cost from one alternative to another;
decrease in cost should be referred to as decrement cost.
 Differential cost is a broader term, encompassing both cost
increases (incremental costs) and cost decreases
(Detrimental costs) between alternatives.
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 Classification of Costs….
Classification of costs according to their relevance for
decision making and analysis…
Incremental Cost and Differential Cost…
For example; that a company is considering two
competing sites for a new factory. If the northern site is
chosen, the annual cost of transporting raw materials to
the site is estimated $185,000. If the southern site is
selected, annual transportation charge is estimated to be
$150,000. The annual differential cost of transporting raw
material is calculated as follows:
Annual cost of transporting raw materials to northern site -------$185,000
Annual cost of transporting raw materials to southern site----------150,000
Annual differential cost---------------------------------------------------35,000
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 Classification of Costs….
Classification of costs according to their relevance for
decision making and analysis…..
Sunk Cost:
Sunk costs are costs that have been incurred in the past
and consequently they do not affect future costs and
cannot be changed by any current or future action. Such
costs are irrelevant in a decision-making situation
because there is nothing that can be done to undo the
decision to invest in them. Example: You bought an
automobile that cost birr 500,000 two years ago. The birr
500,000 cost is sunk because whether you drive it, park it,
trade it, or sell it, you cannot change the birr 500,000
cost.
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 Classification of Costs….
Classification of costs according to their relevance for
decision making and analysis….
Controllable Costs and Uncontrollable Costs:
 The controllability of a particular cost depends upon the
level of management, that is, it is related to a special
center of managerial responsibility.
 Controllable costs are those which can be influenced by
the decisions and actions of a specified member of an
undertaking and uncontrollable costs are those which
cannot be influenced by a specified member of an
undertaking.
 Example: A lower level manager may have control over
overtime costs but not over the purchase of high-cost
46 machinery.
 Classification of Costs….
Classification of costs according to their relevance for
decision making and analysis….
Avoidable costs vs. Unavoidable costs:
 Whether certain costs are escapable/avoidable or
inescapable/unavoidable varies according to the
decision.
 Avoidable costs refer to those costs that may not only be
postponed but can also be avoided entirely as a result of
contraction of business activity.
 On the contrary, inescapable or unavoidable costs are
those that must be met even if there is contraction of
business activity. For example, manufacturing plants
must incur minimum power costs regardless of the
volume of sales.
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 Classification of Costs….
Classification of costs according to their relevance for
decision making and analysis….
Shut-down Costs and Abandonment Costs:
 Shutdown costs are those costs which have to be
incurred under all situations in the case of stopping
manufacture of a product or closing down a
department or a division.
 On the other hand, abandonment costs are those that
result from a permanent cessation of business
activities. In other words, when a fixed asset is
retired from service and is to be disposed of, the
costs connected with disposal are known as
abandonment costs.
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 End of Chapter 4

Thank you

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