Dr.

Nikhil Chandra Shil

East West University

Cost and Its Classification

 'the resources consumed or used up to achieve a
certain objective'

In accounting, cost is defined as the cash amount (or

the cash equivalent) given up for an asset. Cost
includes all costs necessary to get an asset in place
and ready for use. For example, the cost of an item in
inventory also includes the item's freight-in cost. The
cost of land includes all costs to get the land ready
for its use.
Cost analysis involves classifying costs according to
their common characteristics. There are a number
of different classification systems, each differing
according to the purpose to which the cost data is
to be used.
 Cost classification based on assignment
 Cost classification based on manufacturing process
 Cost classification based on reporting
 Cost classification based on behaviour
 Cost Classification based on decision making
Purpose of Classification Cost Classifications
Assigning costs to cost objects • Direct cost (can be easily traced)
• Indirect cost (cannot be easily traced)
Accounting for costs in • Manufacturing costs
manufacturing Direct materials
companies Direct labor
Manufacturing overhead
• Nonmanufacturing costs
Selling costs
Administrative costs
Preparing financial • Product costs (inventoriable)
statements • Period costs (expensed)
Predicting cost behavior in • Variable cost (proportional to activity)
response • Fixed cost (constant in total)
to changes in activity • Mixed cost (has variable and fixed elements)
Making decisions • Differential cost (differs between alternatives)
• Sunk cost (should be ignored)
• Opportunity cost (foregone benefit)
 Direct

Cost
Cost
Object
Indirect

Cost Driver

Direct Direct Material, Direct Labor

Cost
Indirect Rent, Depreciation, Utilities
‘expenditure that can be attributed to a specific cost
unit’
 CIMA Official Terminology

‘expenditure on labour, materials or services that

cannot be economically identified with a specific
saleable cost unit’.
 CIMA Official Terminology
Product / Direct Materials Direct Labor Direct Expenses
Department
Accommodation Laundry & Clearing Staff TV and Cable
Toiletries License
Restaurant Bar Food Kitchen Staff Plates & cutlery
Beverages Bar Staff Glasses

Indirect Costs
Insurance
Administration
Accounting
Advertising
Adapted from Peter Clarke (2002), Accounting Information for Managers
The clients for the wedding function have chosen a steak meal for the main
course. The ingredients, quantities required, quantities purchased and costs
are given below:

Ingredients Quantities Quantities ordered/ Cost per Purchase

required per meal purchased Order
Steak 0.25 kg 20 kg box of assorted $300 per box
cuts
Mixed salad 1 bag 50 bags $20 per 50 bags
French fries 0.25 kg 30 kg box $50 per 30 kg box
Onion rings 5 1 bag of 60 $5 per bag

Calculate the direct material cost per meal

The quantities required are multiplied by the relevant price

Ingredients Quantities required Formulae Total Cost ($)

Steak 0.25 kg $300 ÷ 80 3.75
Mixed salad 1 bag $20 ÷ 50 0.40
French fries 0.25 kg $50 ÷ 120 0.42
Onion rings 5 $5 ÷ 12 0.42
Total cost per meal 4.99
Returning to the example of the steak dinner chosen for the wedding
function at the Newtown Castle Hotel, the following information is provided
regarding relevant staff, wage rates and standard hours worked per category
of employee.

Staff Number of Wage rates per Standard hours

Persons hour ($) worked per person
Chef 1 25 3
Commis chef 3 10 4
Waiting staff 5 10 2

The wedding function is to cater for 50 guests

Calculate the direct labor cost per meal

The total cost is established by multiplying the hours worked by the rate of
pay:

Staff Number Hours worked Total hours Rates per Total

of Persons per person worked hour ($) cost ($)
Chef 1 3 3 25 75
Commis chef 3 4 12 10 120
Waiting staff 5 2 10 10 100
Total direct labor cost 295

The $295 represents the total direct labor cost for the function. As the
wedding function will cater for 50 guests, the direct labor cost per meal is
$5.90 ($295 ÷ 50 meals).
In catering for the meal at the wedding function, it is anticipated that direct
expenses including fresh table arrangements, serviettes, place cards and
sundry items will amount to $150 for a wedding party of 50.

Calculate the direct expense cost per meal.

The total direct expenses of $150 divided by 50 meals will amount to $3.00
per meal
The prime cost can be established as follows:

Element of Costs Amount ($)

Direct Materials 4.99
Direct Labor 5.90
Direct Expenses 3.00
Prime cost per meal 13.89
 Direct Material

Manufacturing Direct Labor

Manufacturing
Overhead
Costs

Selling Costs
Non-
Manufacturing
Administrative
Costs
Manufacturing costs are often combined as follows:

Costs

Manufacturing
Direct Material Direct Labor
Overhead

Prime Cost Conversion Cost

 Direct Material Direct Labor Manufacturing Overhead
All manufacturing costs that
The acquisition costs of are related to the cost object
all materials that The compensation of but cannot be traced to that
eventually become part all manufacturing cost object in an
of the cost object and can labor that can be economically feasible way.
be traced to the cost traced to the cost Examples include supplies,
object in an economically object in an indirect materials such as
feasible way. Acquisition economically lubricants, indirect
costs of direct materials feasible way. manufacturing labor such as
include freight-in Examples include plant maintenance and
(inward delivery) wages and fringe cleaning labor, plant rent,
charges, sales taxes, and benefits paid to plant insurance, property
custom duties. Examples machine operators taxes on the plant, plant
of direct material costs and assembly-line depreciation, and the
are the steel and tires workers who convert compensation of plant
used to make the BMW direct materials managers. This cost
X5, and the computer purchased to category is also referred to
chips used to make finished goods. as manufacturing overhead
cellular phones. costs or factory overhead
costs.
All costs incurred in acquiring stock All costs involved in getting stock
and getting it ready for sale from store to customers

Supplier Business Customer

Cost of Goods Sold Other Expenses

Cost of Sales Cost of Sales

Cartage In Cartage In
Packaging Packaging
Buying Expenses Buying Expenses
Customs Customs
 Product Cost

Manufacturing
Direct Materials Direct Labor
Overhead

Period Cost

Marketing and Administrative

Interest Expenses
Selling Expenses Expenses
Product Cost Period Cost
Product costs are only incurred if Period costs are associated with the
products are acquired or produced passage of time, i.e., a business that has
no production or inventory purchasing
activities will incur no production costs,
but will still incur period costs
It comprises of manufacturing or Non-manufacturing cost, i.e., office and
production cost administration, selling & distribution
etc.
Reported in Cost of Goods Reported in Income Statement
Manufactured Statement
It is variable cost It is fixed cost
Part of inventory Not a part of inventory
Expensed when sold Expensed when incurred
Cost of raw material, manufacturing Salary, rent, audit fees, depreciation on
overheads, depreciation on machinery, office assets etc.
wages to labor
In a manufacturing firm, product costs include -
O all fixed costs
O al variable costs
O all manufacturing costs
O all non-manufacturing costs
O all GAAP costs

In a manufacturing firm, period costs include -

O all manufacturing costs
O all fixed costs
O all non-manufacturing costs
O all non-GAAP costs
O all variable costs
Classify the following items as product or period costs:

Items Product Period

Rent for the factory building
Rent for the sales office
Depreciation on production equipment
Depreciation on sales office equipment
Production supervisor's salary
Marketing manager's salary
Assembly workers wages
Materials used in production
Office supplies used in the customer service department
Example:

Elements of Costs Amount ($)

Direct materials $69,000
Direct labor $35,000
Manufacturing overhead $14,000
Selling expenses $29,000
Administrative expenses $50,000

Calculate:

Amount ($)
Product Costs
Period Costs
Prime Costs
Conversion Costs
 Cost classification by behaviour is primarily used for
management planning decisions. It is a crucial
classification in that it allows an insight into how
costs react to different circumstances. In trying to
predict and plan for the future, it is essential to
understand costs and what drives and creates costs. In
particular, this classification looks at the relationship
between costs and sales volume / production output.
When planning to increase output (sales volume), it is
important to understand and appreciate how costs
will react to this.
 Cost

Fixed Variable

Mixed
  Variable costs are costs that
increase as sales or production
volume increases.
 Examples would include direct
materials (cost of food or beverages
for a restaurant or toys in a
toyshop)
 Variable costs in total change in
response to changes in activity
levels.
 Variable cost per unit will remain
constant in relation to changes in
sales activity.
The graph illustrates the variable cost of producing a meal in a restaurant is €2 and, as sales
volume increases, the variable costs increase. The variable cost graph shows that the
variable cost of producing 2,000 meals is €4,000 and the variable cost of producing 4,000
meals is €8,000.
The proportion of variable costs differs across organizations. For
example . . .

A public utility with

large investments in A manufacturing company
equipment will tend will often have many
to have fewer variable costs.
variable costs.

A merchandising company
A service company
usually will have a high
will normally have a high
proportion of variable costs
proportion of variable costs
like cost of sales.
Merchandising companies – cost of goods sold

Manufacturing companies – direct materials, direct labor,

and variable overhead

Merchandising and manufacturing companies –

commissions, shipping costs, and clerical costs such
as invoicing

Service companies – supplies, travel, and clerical

 Fixed costs are costs that are a
function of time rather than
sales activity and thus are not
sensitive to changes in sales
volume.
 Examples of fixed costs would
include rent, rates, insurance
and management salaries.
 Fixed costs in total do not
change in response to changes
in sales activity levels.
 Fixed cost per unit will change
in relation to changes in sales
activity.
The graph shows that fixed costs are
€2,000 per week.
 Fixed Costs

Committed Discretionary
Long-term, cannot be May be altered in the
significantly reduced short-term by current
in the short term managerial decisions
Examples Examples
Depreciation on Advertising and
Equipment and Real Research and
Estate Taxes Development
 Total Curvilinear Total
Dollars Cost Curve

Output
Start-up Normal Exceeding
Range Operations Capacity
 In some situations increases in activity (volume)
can affect the cost structure.

 For example a significant increase in volume

could result in an increase in fixed costs, if the
activity increases to a level where additional
fixed resources are required then there will be
can be a significant increase in fixed cost.
 The relevant range
is the portion of the
Total curvilinear total cost
Dollars Relevant curve that appears
Range Total in the normal
Cost operations area.
}
Output
Start-up Normal Exceeding
Range Operations Capacity
 A straight line
Economist’s
closely
Curvilinear Cost
approximates a
Function
curvilinear
variable cost
line within the
Relevant
relevant range.
Total Cost

Range

Accountant’s Straight-Line
Approximation (constant unit
variable cost)

Activity
Behavior of cost within the relevant range:

Cost In Total Per Units

Variable Total variable cost changes as Variable cost per unit remains the
activity level changes same over wide ranges of activity
Fixed Total fixed costs remains the Average fixed cost per unit goes
same even when the activity down as activity level goes up
level changes
Graphically:

Algebraically: Y = Cost Function

a = constant / total fixed cost
Y=a b = slope of the line/ vc per unit
Y=bx x = volume/ production units
  Some costs are called step
costs due to the fact that
they are fixed for a given
level of activity but they
eventually increase by a
significant amount at
some critical point.
 Examples include renting
an additional warehouse
unit or hiring an
additional supervisor
when activity reaches a
critical point.
The graph shows that fixed costs are €2,000 up to an activity level of 2,000
meals. At this point the fixed costs increase significantly. Again at 4,000
meals another critical point is reached and fixed costs increase again.
This graph shows the fixed and This graph shows the fixed and
variable elements of a typical variable elements of a mobile
landline telephone charge. phone charge where the user
pays a fixed charge for a
required level of usage (number
of minutes) after which the user
pays for each phone call.
 Y
Total Mobile Phone Cost

Fixed Monthly
Phone Charge

Fixed Monthly
Phone Charge
X
Activity (minutes)
 The total mixed cost line can be expressed
as an equation: Y = a + bX
Y
Where: Y = the total mixed cost
a = the total fixed cost (the
vertical intercept of the line)
Total Mobile Phone Cost

b = the variable cost per unit of

activity (the slope of the line)
X = the level of activity

Variable cost
per minute

Fixed Monthly
X Phone Charge
Activity (minutes)
 Accounts analysis method
 Scatter-graph method
 High-low method
 Linear regression
Under this method each cost is examined and, using
judgement and experience, classified into fixed,
variable and semi-variable categories. The semi-
variable category is further apportioned individually
into its fixed and variable components, normally on a
percentage basis. This method is based mainly on
experience and personal judgement and thus can be
quite subjective. Management can however, reduce this
level of subjectivity as follows.

 Asking a person associated with the cost item who knows its
behavioural pattern and can give a best estimate of the variable
and fixed components to the cost.

 Analysing how the cost item has responded to sales volume

levels in past periods before categorising the cost.
 The main advantages of the accounts analysis
method is that it is quick and inexpensive,
however the subjectivity involved can lead to
inaccuracies. Where the cost item is immaterial
and is largely fixed or variable, then the
accounts analysis method is acceptable.
However if this is not so, other more scientific
methods should be used with the accounts
analysis method providing the first stage of a
more analytical approach to cost behaviour
analysis.
 The scatter-graph approach is a statistical method that
uses historical data to determine cost behaviour. The
scatter-graph approach plots on a graph, all the historic
observations of the cost items in relation to the activity
levels of the business, within the relevant range. A line
of best fit is then drawn visually through the data on
the graph. The angle or gradient of the line represents
the variable cost per unit and the fixed cost is the point
where the fitted line intersects the vertical axis.
 Plot the data points on a graph
(total cost vs. activity).
Y
20

* * * ** *
**
Cost

10 * *

0 X
0 1 2 3 4
Activity Level
 Draw a line through the data points with about an
equal numbers of points above and below the line.

Y
20

* * * ** *
**
Cost

10 * *

0 X
0 1 2 3 4
Activity Level
 Use one data point to estimate the total level of
activity and the total cost.

Y Total cost = $11

20

* * * ** *
**
Cost

10 * *
Intercept = Fixed cost: $10

0 X
0 1 2 3 4
Activity Level
Activity 0.8 units
Make a quick estimate of variable cost per unit and determine the cost equation

Total cost at 0.8 units $ 11

Less: Fixed cost 10
Estimated total variable cost at 0.8 units $1

$1
Variable cost per unit = = $ 1.25/ unit of output
0.8

Y = $10 + $1.25X

Total cost Number of units

This example is based on establishing the relationship between the overhead
cost of repairs and maintenance in a hotel, to the occupancy levels of the hotel

Month Rooms Repairs and Maintenance ($)

January 600 5,000
March 800 5,800
May 900 6,000
July 300 4,200
September 560 4,900
November 350 4,000

Establish the cost function using the scatter-graph method.

The data is plotted on the graph and a line of best visual fit is drawn and extends down
to the Y (total cost) axis. The point of intersection with the Y axis represents the
estimated fixed costs in this cost equation, which amounts to €2,900. The variable
costs can be calculated by inputting the fixed cost and the total cost figures into a cost
function based on any activity point on the line of best fit.
 The high-low method is a statistical method that establishes a
cost to sales volume relationship based on past observations of
how the cost reacted to changes in sales volume.
 This relationship is expressed in terms of the cost function y = a
+ b (x).
 The high-low method focuses on the highest and lowest levels
of activity (sales volume) within the relevant range over a
period of time.
 The total cost at these two extreme levels of activity is recorded
and the difference is attributed to the behaviour of the variable
cost element, which changes as activity levels change. The
process seeks to calculate this variable element. The fixed
element can then be calculated to complete the cost function.
1. Identify the high and low activity levels and
record the cost at each level.
2. Calculate the difference in activity levels and the
difference in costs.
3. Divide the cost difference by the difference in
activity levels. This gives us the variable cost per
room sold (b).
4. Take either the high or the low activity level and
input the data including (b) as calculated in step 3
and solve the equation by finding the fixed cost
element.
The example is based on establishing the relationship between the overhead
cost of repairs and maintenance in a hotel, to the occupancy levels of the hotel.

Month Rooms Repairs and Maintenance ($)

January 600 5,000
March 800 5,800
May 900 6,000
July 300 4,200
September 560 4,900
November 350 4,000

Establish the cost function for repairs and maintenance using high-low method.
 Activity Cost ($)
Step 1 High 900 6,000
Low 300 4,200
Step 2 Difference 600 1,800
Step 3 Variable cost per unit 1,800 ÷ 600 = $3.00
Step 4 Total Cost Fixed Cost + VC per Unit × No. of Units
Y =a +b ×X
6,000 =a + $3.00 × 900
6,000 =a + $ 2,700
a = 6,000 – 2,700 = 3,300

Thus, the cost function for repair and maintenance in this hotel is
summarized as:

Y = $3,300 + $3X
This method is a statistical approach to determine the line
of best fit for a given set of data. It is an extension of
the scatter-graph approach and is based on the
principle that the sum of the squares of the vertical
distances from the regression line to the plots of the
data points is less than the sum of the squares of the
vertical distances from any other line that may be
determined. In other words a truly objective line of
best fit is calculated which minimises the squared
deviations between the regression line and the
observed data.
Consider the same example below:

Month Rooms Repairs and Maintenance ($)

January 600 5,000
March 800 5,800
May 900 6,000
July 300 4,200
September 560 4,900
November 350 4,000

Determine the total cost function for repairs and maintenance using linear
regression
Each method will give a different cost function.

Of the three methods, the linear regression model is

considered to have the least number of limitations.
The cost function can be used in the intelligent
prediction of future costs based on forecast sales
activity
Traditional Contribution
VS.
Format Format
 Traditional Format
Particulars Amount ($) Amount ($)
Sales ***
Less: Cost of Goods Sold
Beginning merchandise inventory **
(+) Merchandise purchase **
Cost of merchandise available for sale **
(-) Ending merchandise inventory **
Cost of goods sold ***
Gross margin/profit ***
Less: Selling and administrative expenses
Selling expense **
Administrative expense ** ***
Net operating income ***
 Contribution Format
Particulars Per Unit ($) Total ($)
Sales ***
Less: Variable expenses
Cost of goods sold **
Variable selling **
Variable administrative ** ***
Contribution margin ***
Less: Fixed expenses
Fixed selling **
Fixed administrative **
Net operating income ***
 Traditional Contribution

Gross Margin Contribution Margin

Functional Classification of Cost Behavioral Classification of Cost

External Reporting Purpose Internal Reporting Purpose

Total is focused Per unit is also focused

No chance of misinterpretation Chance of misinterpretation

 Differential / Incremental Costs
Differential or incremental cost is that additional cost which will incur if one
alternative is chosen in place of other.

It is conducted to take important decisions such as ‘make or buy’, change in the

level of activity, adding/sinking a product, change in product mix etc.

Only relevant costs are taken into consideration (No fixed costs are taken)

This analysis is only for the purpose of taking managerial decisions and has no
relevance in book keeping and accounting

Differential
Cost to
Option C
Costs for Costs for
Option A Option B
Costs for
Option C
 Opportunity Costs
Opportunity cost is the potential benefit that is given
up when one alternative is selected over another.

Assume that you have a part-time job while

attending college that pays $200 per week. If you
spend one week at the beach during spring break
without pay, then the $200 in lost wages would be an
opportunity cost of taking the week off to be at the
beach.
 Sunk Costs
A sunk cost is a cost that has already been incurred and that cannot be changed
by any decision made now or in the future.
Sunk costs are costs that must be
incurred no matter what the decision.
These costs are not part of opportunity
costs

Non-Sunk costs are costs that must be

incurred only if a particular decision is
made.

Fallacy:
People find it hard to abandon their past
investment and continue investing
although the past investment does not
influence on the future outcome
 CoQ

Cost of Good Quality Cost of Poor Quality

Prevention Appraisal Internal Failure External Failure

Problem Problem
Problem/Cause
Problem/Cause Solving / Solving /
Preventive
Detection Corrective Corrective
Action
Action Action
Prevention costs support activities whose purpose is to reduce the number of
defects.

Prevention Costs

Systems development
Quality engineering
Quality training
Quality circles
Statistical process control activities
Supervision of prevention activities
Quality data gathering, analysis, and reporting
Quality improvement projects
Technical support provided to suppliers
Audits of the effectiveness of the quality system
Appraisal costs , which are sometimes called inspection costs, are incurred to
identify defective products before the products are shipped to customers.

Appraisal Costs

Test and inspection of incoming materials

Test and inspection of in-process goods
Final product testing and inspection
Supplies used in testing and inspection
Supervision of testing and inspection activities
Depreciation of test equipment
Maintenance of test equipment
Plant utilities in the inspection area
Field testing and appraisal at customer site
Internal failure costs result from identifying defects before they are shipped to
customers.

Internal Failure Costs

Net cost of scrap

Net cost of spoilage
Rework labor and overhead
Re-inspection of reworked products
Retesting of reworked products
Downtime caused by quality problems
Disposal of defective products
Analysis of the cause of defects in production
Re-entering data because of keying errors
Debugging software errors
External failure costs result when a defective product is delivered to a customer.

External Failure Costs

Cost of field servicing and handling complaints

Warranty repairs and replacements
Repairs and replacements beyond the warranty period
Product recalls
Liability arising from defective products
Returns and allowances arising from quality problems
Lost sales arising from a reputation for poor quality
External failure costs result when a defective product is delivered to a customer.

External Failure Costs

Cost of field servicing and handling complaints

Warranty repairs and replacements
Repairs and replacements beyond the warranty period
Product recalls
Liability arising from defective products
Returns and allowances arising from quality problems
Lost sales arising from a reputation for poor quality
Department of Business Administration
East West University

01819 289 589

nikhil@[Link]