CHAPTER

2
COST CLASSIFICATION
IN MANAGEMENT
ACCOUNTING
PERSPECTIVE
1. Classification according to function:

 Manufacturing cost

 Administration cost

 Selling and distribution costs

 Financial costs

 Research and development costs

2. Classification according to variability

 Fixed Cost

 Variable Cost

 Semi-variable or semi-fixed costs

3. Classification according to identifiability with cost units:

 Direct costs

 Indirect costs

4. Classification according to controllability

 Controllable costs

 Uncontrollable Costs

5. Classification on the basis of time.

 Historical costs

 Predetermined Costs

6. By department

7. Budgeted Cost and Standard Costs

8. For Analytical Process

1. Functional Classification:-

This is a traditional classification. A business has to perform a number of functions like

manufacturing, administration, selling, distribution and research. Cost may have to be
ascertained for each of these functions. On this basis, costs are classified into the
following groups:

a) Manufacturing Cost: Also named “Production Cost” or “factory cost”. This is the
cost of the sequence of operations which begins with supplying materials, labour and
services and ends with completion of production.
 b) Administration Cost: This is general administrative cost and includes all expenditure
incurred in formulating the policy, directing the organization and controlling the
operations of an undertaking, which is not directly related to production, selling and
distributions, research and development activity of function.

c) Selling & distribution costs: Selling cost is the cost of seeking to create and
stimulating demand and securing orders.

Distribution cost is the cost of sequence of operations which begins with making the
packed product available for despatch and ends with making the re-conditioned returned
empty package for re-use.

d) Financial Cost: It includes Interest/mark-up, bank charges and various fees paid to
lenders for borrowing funds.

e) Research and development cost: Research cost is the cost of searching new or
improved products or methods. It includes the cost incurred at Pre-production stage
which is the core focus of Life Cycle Costing.

2. Behavioural Classification:-
Costs sometimes have a definite relationship to volume of production. They behave
differently when volume of production rises or falls. As such they are described as fixed,
variable and semi-variable or semi-fixed.

a) Fixed Cost: These cost remain fixed in ‘total amount’ and do not increase or decrease
when the volume of production changes. But the fixed cost per unit decreases when
volume of production increases and vice versa.

(a) (b)

Total Unit

Fixed Fixed

Cost Cost

(Rs.) (Rs.)

FIGURE 2.1 Fixed Costs (a) total; (b) unit

Activity Level Activity Level
(Colin Drury Cost & Management Accounting 7th edition, pg: 38)
 The characteristics of fixed cost are:

1. Fixed in total amount within a relevant output range

2. Increase or decrease in per unit fixed cost when quantity of production changes

3. Apportioned to departments on some arbitrary basis

4. Controllable by top management

5. Over a long period of time fixed cost is also variable.

b) Variable Cost: These costs tend to vary in direct proportion to the volume of output. In
other words, when the volume of output increases, the total variable cost will increase
and when volume of output decreases, total variable cost also decreases. But the
variable cost per unit remains fixed.

(a) (b)

Total Unit
Variable variable
Cost
Cost
(Rs.)
(Rs.)

Activity Level Activity Level

FIGURE 2.2 Variable Costs (a) total; (b) unit

(Colin Drury Cost & Management Accounting 7th edition, pg:38)

The characteristics of variable cost are:

1. Variability in total amount in direct proportion to the volume of output

2. Fixed amount per unit in the face of changing volume

3. Easy and reasonably accurate allocation and apportionment to departments

4. Controllable by functional managers

c) Semi-variable or semi-fixed costs: These costs are partly fixed and partly variable. A
semi-variable cost has often a fixed element below which it will not fall at any level of
output. The variable element in semi-variable costs changes either at a constant rate or
in lumps. For example, introduction of an additional shift in the factory will require
 additional supervisors and certain costs will increase in lumps. In the case of telephone,
there is a minimum rent and after a specified number of calls, the changes are according
to the number of calls made. Thus, there is no fixed pattern of behaviour of semi-variable
cost.

3. Classification according to identifiability with cost

units:-
Costs are classified into direct and indirect on the basis of their identifiability with cost units
or jobs processes;

a) Direct Costs: Those costs that can be specifically and exclusively identified with a
particular cost object.

b) Indirect Costs: In contrast, those costs which cannot be identified specifically and
exclusively with a given cost object.

Example: Let us assume that our cost object is a product, or to be more specific a particular
type of desk that is manufactured by an organization. In this situation the wood that is used
to manufacture the desk can be exclusively and specifically identified with a particular desk
and can thus be classified as a direct cost. Similarly, the wages of workers whose time can
be traced to the specific desk are a direct cost. In contrast, the salaries of factory supervisors
or the rent of the factory cannot be specifically and exclusively traced to a particular desk
and these costs are therefore classified as indirect. More examples of indirect costs are
repairs, depreciation, managerial salaries.

Sometimes, however, direct costs are treated as indirect because tracing costs directly to
the cost object is not cost effective. For example, the nails used in manufacturing the desk
can be identified specifically with the desk, but, because the cost is likely to be insignificant,
the expense of tracing such items does not justify the possible benefits from calculating
more accurate product costs.

(Colin Drury Cost & Management Accounting 7th edition, pg: 34)

4. Classification according to Controllability:-

Costs can also be classified into controllable and uncontrollable.

a) Controllable Costs: is a ‘cost which can be controlled, typically by a cost, profit or

investment centre manager’.

CIMA official Terminology

These are the cost which may be directly regulated at a given level of management
authority.

b) Uncontrollable Costs: These are those costs which cannot be influenced by the action
of a specified member of an enterprise.
Variable costs are generally controllable by department heads. For example, cost of raw
material may be controlled by purchasing in larger quantities. In contrast, fixed costs are
generally uncontrollable. For example, it is very difficult to control costs like factory rent,
managerial salaries etc.

Two important points should be noted regarding this classification.

A cost which is not controllable by a junior manager might be controllable by a senior

manager. For example, due to excessive overtime working there may be high direct labour
costs in a department. The junior manager may feel obliged to continue with the overtime to
meet production schedules, but his senior may be able to reduce costs by hiring extra full-
time staff, thereby reducing the requirements for overtime.

(CIMA performance Management 3rd edition, pg: 413)

A cost which is not controllable by a manager in one department may be controllable

by a manager in another department. For example, an increase in material costs may be
caused by buying at higher prices than expected (controllable by purchasing department) or
by excessive wastage (controllable by production department) or by a faulty machine
producing rejects (controllable by the maintenance department).

(CIMA performance Management 3rd edition, pg: 413)

5. Classification on the basis of Time:-

a) Historical Costs: These are the costs which are ascertained after these have been
incurred. Historical costs are thus nothing but actual costs. These costs are not available
until after the completion of the manufacturing operations.

b) Pre-determined costs: These are future costs which are ascertained in advance of
production on the basis of the specification of all the factors affecting cost.

6. Classification by departments:-
An organization can be divided into two main departments. Manufacturing departments,
which directly engage in the process of production of goods and services and Service
departments, which indirectly help the production department in providing services to
facilitate production process.

7. Budgeted Cost and standard Costs:-

These are predetermined total costs or unit costs of good and service
used for control purpose.

8. For analytical process:-

Management decisions involve a selection between alternative courses of action and costs
play a very prominent role in decision-making. For analytical process, costs are classified as
under:
a) Differential or Incremental Costs: Differential cost is the increase or decrease in total
cost which results from an alternative course of action. It is ascertained by subtracting
the cost of one alternative from the cost of another alternative. The alternative choice
may arise because of change in method of production, changes in sales volume, change
in product mix, make or buy decisions, accept or reject order.

Example: Current manufacturing cost of XYZ Co. is Rs.100,000. Due to expansion

operations, costs increase by 25%. So this incremental cost of Rs.(100,000*.25 = 25000) is
the differential or incremental cost.

b) Imputed Costs: These are hypothetical costs which are specifically computed for the
purpose of decision making. Interest on capital is a common type of imputed cost. The
failure to consider imputed interest cost may result in an erroneous decision. For
example, project A requires a capital investment of Rs. 50,000 and project B Rs.40,000.
Both the projects are expected to yield Rs. 10,000 as additional profit. Obviously, these
two projects are not equally desirable since project B requires less investment and thus
should be preferred.

c) Opportunity Costs: ‘The value of a benefit sacrificed when one course of action is
chosen, in preference to an alternative. The opportunity cost is represented by the
foregone potential benefit from the best rejected course of action’.

CIMA official Terminology

Example: Assume a company owns a building which has been fully depreciated in the
books of accounts. Yet, it has a rental value of Rs.5000 per annum. Now, if the company is
considering the use of this building in a special project a change in lieu of rent of 5000
(opportunity cost) should be included in evaluating the desirability of the project despite the
fact that books of accounts show it at nil value. Opportunity cost is a pure decision-making
cost and is not entered in the books of accounts.

c) Replacement Cost: This is the cost at which there could be purchased an asset
identical to that which is being replaced. In simple words, replacement cost is the current
market cost of replacing an asset. When the management considers the replacement of
an asset, it has to keep in mind its replacement cost and not the cost at which it was
purchased earlier.

d) Sunk Cost: A sunk cost is ‘cost that has been irreversibly incurred or committed
and cannot therefore be considered relevant to a decision. Sunk cost costs may
also be deemed irrecoverable costs’.

CIMA official Terminology

Example: An example of a sunk cost could be development costs already incurred.

Suppose that a company has spent Rs.250,000 in developing a new service for customers,
but the marketing department’s most recent findings are that the service might not gain
customer acceptance and could be a commercial failure. The decision whether or not
abandon the development of the new service would have to be taken, but the Rs. 250,000
spent so far should be ignored by the decision makers because it is a sunk cost.

(CIMA performance Management 3rd edition, pg: 12)

e) Out-of-pocket Costs: Out-of-pocket costs represent cash payments to be incurred
(such as rent, wages) as against costs which do not require cash outlay (such as
depreciation). This is frequently used by business concerns as an aid in making
decisions pertaining to price fixation during depression, make or buy decisions, etc.

f) Future Costs: No decision can change what has already happened. The past is history
and decisions made now can affect only what will happen in the future. Thus, the only
relevant costs for decision- making are pre-determined or future costs. But, it is the
historical costs which generally provide a basis for computing future costs.

g) Discretionary Cost: A discretionary cost is a cost whose amount, within a particular

time period, is determined by, and can be altered by, the budget holder. Discretionary
fixed costs, such as advertising and research and development costs, are incurred as a
result of a top management decision, but could be raised or lowered at fairly short
notice (irrespective of the actual volume of production and sales).

(CIMA performance Management 3rd edition, Pg: 413)

h) Committed Cost: A committed cost is a future cash outflow that will be incurred any
way, whatever decision is taken now about alternative opportunities. Committed costs
may exist because of contracts already entered into by the organization, which it cannot
now avoid.

(CIMA performance Management 3rd edition, Pg: 32)

Question No.1
The following information has been taken from the accounting records of Klear-Seal
Company for the year 2012

Selling expenses………………………………………………………. $140,000

Raw materials inventory, January 1…………………………………. 90,000

Raw materials inventory, December 31…………………………….. 60,000

Utilities, factory………………………………………………………… 36,000

Direct labor cost……………………………………………………….. 150,000

Depreciation, factory………………………………………………….. 162,000

Purchases of raw materials…………………………………………… 750,000

Sales……………………………………………………………………. 2,500,000

Insurance, factory……………………………………………………… 40,000

Supplies, factory………………………………………………………. 15,000

Administrative Expenses ......................................................... 270,000

Indirect labor…………………………………………………………… 300,000

Maintenance, factory………………………………………………….. 87,000

Work in process inventory, January 1………………………………. 180,000

Work in process inventory, December 31………………………….. 100,000

Finished goods inventory, January 1………………………………… 260,000

Finished goods inventory, December 31……………………………. 210,000

Management wants these data organized in a better format so that financial statements can
be prepared for the year.

Required:

1. Prepare a schedule of cost of goods manufactured.

2. Compute the cost of goods sold.
3. Using data as needed from (1) and (2) above, prepare an income statement.
SOLUTION – “Klear-Seal Company”
(1). Klear-Seal Company
Schedule of Cost of Goods Manufactured
For the year ended December 31, 2012
$
Direct materials:
Raw material inventory, Jan 1 90,000
Add: purchases of raw material 750,000
Raw material available for use 840,000
Less: raw material inventory, Dec 31 (60,000)
Raw material used 780,000

Direct labor 150,000

Manufacturing overhead:
Indirect labor 300,000
Supplies, factory 15,000
Utilities, factory 36,000
Insurance, factory 40,000
Depreciation, factory 162,000
Maintenance, factory 87,000
Total manufacturing overhead 640,000
Total manufacturing costs 1,570,000
Add: work in process inventory, Jan 1 180,000
Less: work in process inventory, Dec 31 (100,000)
Cost of Goods Manufactured 1,650,000

(2). Klear-Seal Company

Schedule of Cost of Goods Sold
For the year ended December 31, 2012
$
Finished goods inventory, Jan 1 260,000
Add: cost of goods manufactured 1,650,000
Goods available for use 1,910,000
Less: finished goods inventory, Dec 31 (210,000)
Cost of Goods Sold 1,700,000
(3). Klear-Seal Company
Income Statement
For the year ended December 31, 2012
$
Sales 2,500,000
Less: cost of goods sold (1,700,000)
Gross margin 800,000
Less: selling& admin costs
Selling exp. 140,000
Admin exp. 270,000
Total selling& admin costs (410,000)
Net operating income 390,000
Question No.2
The records of the Deltex Ltd., show the following information for the quarter ended
September 30, 2012

Rs.
Material purchased 1,946,700
Direct labor 2,125,800
Factory overhead 764,000
Selling& Distribution expenses 516,000
General and administrative
expenses 461,000
Sales (12400 Videos) 6,364,000

30th
STOCKS September
1st oct 2011 2012
Rs Rs
Raw materials 268,000 167,000
Finished goods (100 Videos) 43,000 200 Videos
No unfinished work on hand

Required:

1. The cost of goods manufactured.

2. The number of units manufactured
3. The value of closing finished goods inventory
4. The cost of goods sold
5. The unit cost of Videos manufactured
6. An income statement for the period
7. The gross profit per unit sold
8. The net profit per unit sold
9. The ratio of gross profit to sales
10. The profit to sales percentage
SOLUTION: “Deltex Company”

(6). Deltex Company

Income Statement

For the Year ended June 30, 2012

Rs.

Sales 6,364,000

Cost of sales

Opening stock raw material 268,000

Add: purchases 1,946,700

2,214,700

Less: closing stock raw material 167,000

Cost of material used 2,047,700

Direct labor 2,125,800

Prime cost 4,173,500

Factory overheads 764,000

Cost of Goods Manufactured 4,937,500

Add: opening finished goods 43,000

 Cost of goods available for sales 4,980,500

Less: closing finished goods (200*395) 79,000

Cost of Goods Sold 4,901,500

Gross profit 1,462,500

Less: selling& distribution expenses 516,000

general& admin expenses 461,000

Expenses 977,000

Net Profit 485,500

(1). Cost of Goods Manufactured

Cost of Goods Manufactured = Rs. 4,397,500

(2). Units Manufactured

Units manufactured = Sales units + Closing finished goods - Opening finished goods

Units manufactured = 12400+200-100

Units manufactured = 12,500 units

(3). Value of Finished Goods

 Value of finished goods = Cost of goods manufactured per unit*Closing finished goods

Cost of goods manufactured per unit = Cost of goods manufactured/ Number of units

= 4397500/ 12500 = Rs. 395

Value of finished goods = 395*200

Value of finished goods = Rs. 79,000

(4). Cost of Goods Sold

Cost of goods sold = Rs. 4,901,500

(5). Unit cost of videos manufactured

Unit cost of videos manufactured = Rs. 395

(6). Income Statement at 1st

(7). Gross profit per unit sold

Gross profit per unit sold = Gross profit/ Sales units

Gross profit per unit sold = 1462500/ 12400

Gross profit per unit sold = Rs. 117.94

(8). Net profit per unit sold

 Net profit per unit sold = Net profit/ Sales units

Net profit per unit sold = 485500/ 12400

Net profit per unit sold = Rs. 39.15

(9). Ratio of Gross profit to Sales

Ratio of gross profit to sales = (Gross profit/ Sales) * 100

Ratio of gross profit to sales = (1462500/ 6364000) * 100

Ratio of gross profit to sales = 22.98%

(10). Ratio of Net profit to Sales

Ratio of net profit to sales = (Net profit/ Sales) * 100

Ratio of net profit to sales = (485500/ 6364000) * 100

Ratio of net profit to sales = 7.63%

Costing Methods:
There are two basic types of systems that companies can adopt-job costing and process
costing systems.

Job Order Costing:

Job costing relates to a costing system that is required in organizations where each unit or
batch of output of a product or service is unique. This creates the need for the cost of each
unit to be calculated separately. The term ‘job’ thus relates to each unique unit or batch of
outpu the nature of job which determines the department through which it is to be processed.

Job costing is applied to such activities as printing work, motor car repair, machine tools,
general engineering, and audit firms.

Process Costing: Process costing relates to those situations where masses of identical
units are produced and it is unnecessary to assign costs to individual units of output. An
input of material passes through a number of processes before it reaches to finished goods
store room. The output of one process may become the input of other process.

(Colin Drury Cost & Management Accounting 7th edition, pg: 43)

Industries where process costing is applied:

 Furniture Industry

 Meat Industry

 Chemical Industry

 Oil refinery

 Steel industries

Operating Costing: Operating costing method is applied in those organizations which

provide services and are not engaged in manufacturing process. The cost of providing a
service is termed as “operating cost”. In many manufacturing companies, operating costing
is used in certain departments which renders services, e.g. internal transport, power house,
personnel department etc.

TRANSPORT COSTING

Objects:

The main objects of transport costing are:

1. To fix the rates of carriage of goods or passengers on the basis of operating costs

2. To decide the hire charges where vehicles are given on hire

3. To determine what should be charged against departments or others, using a service

4. To compare the cost of using own motor vehicles and that of using alternate forms of
transport

5. To compare the cost of maintaining one vehicle with another or one group of vehicles
with another group

Determination of Number of Cost Units

The cost unit in passenger transport is usually a passenger kilometer and in goods transport
it is a ton-kilometer. The calculation of the total number of cost units is illustrated below:

Illustration 2.1 Firstflight Transport Co. runs four lorries between two towns which are 50
kms Apart. The seating capacity of each bus is 50 passengers and actual passengers
carried are 80% of the seating capacity. All the 4 buses run on 25 days in the month and
each bus makes one round trip per day.

Passengers Kilometers =

No. of Distance Capacity Actual Round trip No. of

Lorries Of each Capacity Days

Lorry Utilized

4 x 50 x 50 x 80% x 2 x 25

= 4,000,000 passenger kilometers

Collection of Data:

Most of the details required for transport costing are obtained from log book. A log book is
maintained for each vehicle to record details of trips, running time, capacity, mileage, etc on
daily basis. These details also enable the management to avoid idleness of vehicles, to
prevent waste of the capacity and to guard against unnecessary duplication of trips.

Compilation of costs:

Costs are classified and accumulated under the following heads:

Standing Charges

Garage rent

License fees and taxes

Insurance

Drivers’ wages

Depreciation

Administrative Costs
Interest on capital

Standing or fixed Charges: These are constant costs and are incurred irrespective of the
basis of mileage run. Such costs, therefore, should not be allocated to specific journeys on
the basis of mileage. Some of these costs are direct or traceable fixed costs and can be
allocated to specific vehicles. Other such costs are suitably apportioned to each vehicle.

Opinions differ as to whether depreciation is to be regarded as a fixed cost or a variable

cost. It is thus sometimes regarded as a variable or running cost and sometimes as a fixed
cost. Interest on capital might also be included in fixed charges.

Running or variable charges: Petrol/diesel oil, lubricating oil, Tyres and tubes, repairs and
maintenance, drivers’ wages. These costs vary more or less in direct proportion to mileage
and so a cost per unit may be computed. Wages of drivers, conductors and cleaners are
sometimes regarded as running or variable costs if payment is according to distance or trips.

The above two types of costs are compiled periodically in an operating cost sheet.

Quotations while preparing quotations, then in addition to cost figures, certain non-cost
factors like strength of competition possibly to return loads, likelihood of repeat business,
etc. must also be considered even though these are outside the sphere of cost accounting.
An example of compilation of a typical quotation is given below:

Illustration 2.2

A vehicle costs Rs. 650,000 and its life is estimated at 8 years, after which its residual value
is estimated at Rs. 200,000. Standing charges per annum are estimated at following figures:
Insurance Rs. 6500, License Rs. 8000, and Administration overheads Rs. 350,000.

Fuel costs Rs. 400 per gallon and based on an estimated kilometers of 30,000 per year the
cost of lubricants is Rs. 12000. The estimated consumption of fuel is 20 miles per gallon. A
set of tyres costs Rs. 20,000 and their expected mileage is 16000. The driver is paid Rs. 50
per week of 44 hours and is entitled to a fortnight’s paid holiday per annum. The company’s
contribution towards national Insurance Scheme is Rs. 1000 per week. For each night spent
away from home, the driver is paid a subsistence allowance of Rs.1000. It is estimated that
the vehicle will run 220 days per annum and depreciation is regarded as a running cost.
Repairs over the life of the vehicle are estimated at Rs. 150,000. (a) Compute figures which
may be used as a basis for quoting, if the company adds 10% to the total cost for profit.

Prepare a quotation for a journey of 100 miles and return, assuming no return load and a
total time of two days.

2.2.2 Costing Techniques:

There are two basic types of systems that companies can adopt-job costing and process
costing systems.

1. Absorption costing

2. Marginal Costing

3. Budgetary control
4. Standard Costing

5. Relevant Costing

6. Responsibility Accounting

Marginal Costing: ‘The costing method in which variable costs are charged to cost units
and fixed costs of the period are written off against the aggregate contribution. Its special
value is in recognizing cost behavior, and hence assisting in decision-making’.

(CIMA official Terminology)

Absorption Costing: ‘A method of costing that, in addition to direct costs, assigns all, or a
proportion of, production overhead costs to cost units by means of one or a number of
overhead absorption rates’.

(CIMA official Terminology)

Budgetary Control: ‘is the comparison of actual results with budgeted results’. It is carried
out through a Master Budget devolved to responsibility centers, allowing continuous
monitoring of actual results versus budget, either to secure by individual action the budget
objectives or to provide a basis for budget revision.’

(CIMA official Terminology)

In other words, individual managers are held responsible for investigating differences
between budgeted and actual results, and are then expected to take corrective action or
amend the plan in the light of actual events.

(CIMA performance Management 3rd edition, pg: 402)

Standard Costing: ‘is a pre-determined cost of manufacturing a single unit or a number of

product units during a specific period in the immediate future’

(Matz Usry Cost Accounting 7th edition, pg: 544)

It is the planned cost of a product under current and/or anticipated operating condition.

A standard cost has two components: a standard and a cost. A standard is like a norm and
whatever is considered normal can generally be accepted as standard.

Example: If a score of 72 is a standard for a golf course, a golfer’s score is judged on the
basis of this standard.

Relevant Costing: ‘The costs which should be used for decision-making and are often
referred to as relevant costs’

‘Costs appropriate to a specific management decision. These are represented by future cash
flows whose magnitude will vary depending upon the outcome of the management decision
made’.

(CIMA official Terminology)

Responsibility Accounting: ‘is a system of accounting that segregates costs and revenues
into areas of personal responsibility in order to monitor and assess the performance of each
part of an organization’.

(CIMA official Terminology)

2.5 Not-for-profit organizations:-

Some organizations are set up with a prime objective which is not related to making profits.
Examples are NGO’s, charities. These organizations exist to pursue non-financial aims, such
as providing a service to the community. However, there will be financial constraints which
limit what any organization can do.

1) A not-for-profit organization needs finance to pay for its operations, and the major
financial constraint is the amount of funds that it can obtain from its ‘donors’ (its
customers)

2) Having obtained funds, a not-for-profit organization will use the funds to help its ‘clients’,
for example by alleviating suffering. It performance is judged how it uses its funds on the
following three grounds:

a) Economically- that is not spending Rs.2 when the same thing can be bought for
Re.1

b) Efficiently- getting the best use out of what the money is spent on.

c) Effectively-spending funds so as to achieve the organization’s objectives

(CIMA performance Management 3rd edition, Pg: 456)

High-low method: The high-low method consists of selecting the periods of highest and
lowest activity levels and comparing the changes in costs that result from the two levels. This
approach is illustrated in the following example:

Example

The monthly recordings for output and maintenance costs for the past 12 months have been
examined and the following information has been extracted for the lowest and highest output
levels:

The non-variable (fixed) cost can be estimated at any level of activity (assuming a constant
unit variable cost) by subtracting the variable cost portion from the total cost. At an activity
level of 5000 units the total cost is Rs. 22000 and the total variable cost is Rs. 10,000 (5000
units @ Rs.2 per unit). The balance of Rs. 12000 is therefore assumed to represent the non-
variable cost. The cost function is therefore:

Y = Rs. 12000 + (Rs.2)(x)

The method is illustrated in Figure, with points A & B representing the lowest and highest
output levels, and TC1 and TC2 representing the total cost for each of these levels. The
other crosses represent past cost observations for other output levels. The straight (blue)
line joining the observations for the lowest and highest activity levels represent the costs that
would be estimated for each activity level when the high-low method is used.

From this illustration, we come to know that the method ignores all cost observations other
than the observations for the lowest and highest activity levels. Unfortunately, cost
observations at the extreme ranges of activity levels are not always typical of normal
operating conditions, and therefore may reflect abnormal rather than normal cost
relationships. Figure 23.2 indicates how the method can give inaccurate cost estimates
when they are obtained by observing only the highest and lowest output levels. It would
obviously be more appropriate to incorporate all of the available observations into the cost
estimate, rather than to use only two extreme observations.

Illustration: Georgia Woods, Inc., manufactures furniture to customers’ specifications and

uses a job order cost system. A predetermined overhead rate is used in applying
manufacturing overhead to individual jobs. In department One, overhead is applied on the
basis of machine-hours, and in Department Two, on the basis of direct labor hours. At the
beginning of the current year, management made the following budget estimates to assist in
determining the overhead application rate:

Department Department

One Two

Direct labor cost …………………………….. Rs. 30,000,000 Rs. 22,500,000

Direct labor hours ……………………….. ……... 20,000 15,000

Manufacturing overhead ………………………Rs. 42,000,000 33,750,000

Machine hours …………………………………… 12000 7500

Production of a batch of custom furniture ordered by City Furniture (job no.58) was started
early in the year and completed three weeks later on January 29. The records for this job
show the following cost information:

Department Department

One Two

Job order for City Furniture (job no. 58):

Direct materials cost ………………………… 1,010,000 760,000

Direct labor cost ……………………………... 1,650,000 1,110,000

Direct labor hours …………………………… 1100 740

Machine-hours ………………………………. 750 500

Selected additional information for January is given below:

Department Department

One Two

Direct labor hours-month of January ………… 1,600 1,200

Machine hours – month of January …........... 1,100 600

Manufacturing overhead incurred in January… 3,901,000 2,654,000

a) Compute the predetermined overhead rate for each department.

b) What is the total cost of the furniture produced for City Furniture?

c) Prepare the entries required to record the sale (on account) of the furniture to City
Furniture. The sales price of the order was Rs. 14,700,000.

d) Determine the over-or under-applied overhead for each department at the end of
January.
Question No.1

Midstate University is trying to decide whether to allow 100 more students into the university.
Tuition is $5,000 per year. The controller has determined the following schedule of costs to
educate students:

Number of Students Total Costs

4,000 $30,000,000

4,100 30,300,000

4,200 30,600.000

4,300 30,900,000

The current enrollment is 4,200 students. The president of the university has calculated the
cost per student in the following manner: $30,600,000 / 4,200 students = $7,286 per student.
The president was wondering why the university should accept more students if the tuition is
only $5,000.

a. What is wrong with the president’s calculation?

b. What are the fixed and variable costs of operating the university?
SOLUTION :1

Number
of Total Cost
Students ($)
Minimum 4,000 30,000,000
Maximum 4,300 30,900,000
Difference 300 900,000

Thus, our total cost per student becomes: 900,000/ 300 = $3,000

If we consider the total cost per student as Variable cost and the Tuition fee as selling price,
our contribution per student becomes

Contribution per student $2,000

(5,000 - 3,000)

Also if total cost per student is considered as variable cost, the fixed cost can be derived out
as follows:

Number Variable cost

of Total Cost ($3000 per Fixed cost
Students ($) student) (Total - Variable)

Minimum 4,000 30,000,000 12,000,000 18,000,000

Maximum 4,300 30,900,000 12,900,000 18,000,000

Difference 300 900,000 900,000

This means that we are maintaining the same $18,000,000 fixed cost, while retaining $2,000
margin per new student enrolled, therefore, 100 more students should be enrolled as far as it
gives benefit with subject to the persistent fixed costs.
Question No. 2

The Small Bike Company is the idea of Charles Johnson. Charles has designed a portable
bicycle that can be disassembled easily and placed in a suitcase. He is thinking about
implementing the idea and going into production. Charles estimates that the fixed costs of
producing between 1,000 and 3,000 portable bicycles will be $50,000 annually. In addition,
the variable cost per portable bicycle is estimated to be $40 per bicycle. Charles could
outsource the suitcase production, which would reduce the fixed costs to $40,000 annually
and the variable costs to $35 per bicycle. If the company makes less than 2,000 portable
bicycles, there would be excess capacity that could be used to make 1,000 regular bicycles.
There would be no additional fixed costs and the variable costs would be $60 per regular
bicycle. There is no other use of the space.

a. Charles would like to make $60,000 annually on his venture. If Charles makes and
sells 3,000 portable bicycles (with the suitcase), what price should Charles charge for
each portable bicycle?
b. If Charles decides to charge $80 per portable bicycle while making the suitcase, what
as the break-even number of portable bicycles?
c. If Charles makes 2,500 portable bicycles, should he consider buying the suitcases
from an outside supplier if the supplier’s price per suitcase is $10?
d. If Charles only makes and sells 2,000 portable bicycles because of limited demand,
what is the minimum price that he should consider in selling 1,000 regular bicycles
built with the excess capacity?

Solution:2

a. Profit =(Price per unit – Variable cost per unit) (Number of units) – Fixed cost
$60,000 = (Price per unit) - $40)(3,000) - $50,000
Price per unit = $76.67

b. Break – even quantity = Fixed cost/(Price per unit – Variable cost per unit) Break
– even Quantity = $50,000/($80 - $40) = 1,250 portable bicycles
c. Avoidable costs if the suitcase is not made in-house

Reduction in fixed costs ($50,000 - $40,000) $10,000

Reduction in variable costs (2,500 units)($40-$35) 7,500

Total Avoidable costs $17,500

Cost of purchasing suitcases ($10)(2,500) $25,000

Therefore, the suitcases should be made in-house.

d. Because the regular bicycles do not add to the fixed costs, the variable cost per
unit establishes the lower boundary for pricing the regular bicycles. As long as
the price is greater than the variable cost, the company has a positive
contribution margin from the regular bicycles.
Question No. 3

In year 2000, the G.P. Co. Produced a machine that sold for Rs. 6,000 of which Rs. 4,500
represented cost of goods sold and Rs. 400 represented selling and administrative
expenses. The cost of goods sold comprised of 50% material costs, 30% labor cost and 20%
factory overhead. During the year, numbers of machines sold were 2000. During year 2001,
an increase of 20% in the cost of material and an increase of 25% in the cost of labor are
anticipated. The company plans to raise the selling price to Rs. 7,000 per unit, with a
resulting decrease of 40% in the number of units to be sold.

Required:

a) A Projected profit and loss account for the year 2001 indicating the new cost per unit
Assume that material and labor cost will still equal 80% of the cost of the goods sold
for the year 2001 and selling and administrative expenses are still Rs.400 per unit.
b) After the statement required in (a) was prepared, it was ascertained that the 20%
factory overheads in Year 2000 consisted of Rs. 1,000,000 fixed expenses and
Rs.800,000 variable expenses. The decrease in the number of units to be sold in
Year 2001 does not influence fixed expenses. Prepare a revised profit& loss account
for Year 2001 disregarding the 80% relationship of material and labor cost to cost of
goods.
SOLUTION: 3
(a). New Profit& Loss Account
Rs.
Sales price per unit 7,000.00
Less: Cost of Goods Sold
Material cost [2,250 + (2,250*20%)] 2,700.00
Labor cost [1,350 + (1,350*25%)] 1,687.50
F. O/H [(2,700+1,688.8)/80%)*20%] 1,096.88 5,484.38
Gross profit per unit 1,515.63
Less: Selling expenses 400.00
Net profit 1,115.63

Working:
Rs.
Cost of Goods Sold 4,500.00

Material cost (50% of COGS) 2,250.00

Labor cost (30% of COGS) 1,350.00
F. O/H 900.00
4,500.00

(b). Profit & Loss Account

Rs.
Sales (7,000*1,200) 8,400,000.00
Less: Cost of Goods Sold
Material cost (2,700*1,200) 3,240,000.00
Labor cost (1,687.50*1,200) 2,025,000.00
F. O/H - Variable [(800,000/2,000)*1,200] 480,000.00
Fixed 1,000,000.00 6,745,000.00
Gross profit per unit 1,655,000.00
Less: Selling expenses (1,200*40%) 480.00
Net profit 1,654,520.00

Working:

New sales units [2000*(1-40%)] 1,200.00