III.

Costs in aofmanufacturing
Overview firmFor A
Cost Classifications
Manufacturing Firm
• Our initial focus is on basic activities of manufacturing companies.
• Manufacturing is the process of converting materials into finished goods using
labor and other operating costs (F.O.H).
• In such a type of a business Managers need to rely upon different classifications
of costs for different purposes. It is necessary for them to able to classify
Cost using any one or combination of the different means or purpose.
• The First four main purposes are emphasized in this discussion include preparing
external financial reports, predicting cost behavior, assigning costs to cost
objects, and making business decisions.

[Link] Classification by assigning costs to cost

objects/traceability
[Link] Classification by preparing report or financial statements
C. Cost Classification by Function of payment
[Link] Classification by predicting cost behavior
E. Others Cost Classification by
 Management hierarchical level (for controllability)
 Opportunity cost (for relevance)
 Classification by manufacturing-cost system
 Classification by relevance (avoidable x unavoidable)
 Classification by aggregate or average
 Concept of incremental and marginal costs,
 A. Cost Classification by assigning costs to
cost objects or traceability
• Cost object is anything for which cost data are
desired such as products, customers, jobs,
organizational subunits, etc.
• For purposes of assigning costs to cost objects costs
are classified two ways:

Direct costs Indirect costs

• Costs that cannot be easily and
• Costs that can be
conveniently traced to a unit of
easily and conveniently product or other cost object.
traced to a unit of product • Common costs are indirect
or other cost object. costs incurred to support a
• Examples: direct material number of cost objects.
and direct labor • These costs cannot be traced
to any individual cost object.
• Example: manufacturing overhead
Fall 2010 Mugan 2/82
 cost objects or
traceability
• The classification of costs as direct and indirect is,
therefore, defined in relation to the cost object.. The
diagram on the next page shows direct and indirect
cost assignment to a cost object.
• Cost accumulation Cost assignment

Cost tracing
Direct costs

Cost object

Indirect costs Cost allocation

 A. Cost Classification by assigning costs to cost
objects or traceability

Prime Cost and Conversion Cost

Prime Cost:
• is a term referring to all direct manufacturing costs (labor
and materials).
• It is also called manufacturing cost.
• The total costs which can be directly identified with a job, a
product or service is known as Prime cost.
• It expenditures directly associated with the manufacture of
finished products.
• Thus prime cost = direct materials + direct labor
+ other direct expenses.
P.C = DM + DL
 A. Cost Classification by assigning costs to cost
objects or traceability

Prime Cost and Conversion Cost

Conversion cost
 is a term referring to total of direct labor and factory
overhead costs, collectively.
 It is total expenditures incurred in the process of
converting raw materials in to finished products.
 It is also called processing cost.
 Conversion cost is the production cost of converting raw
materials into finished product
 C.C = DL + MOH
2-5
 A. Cost Classification by assigning
costs to cost objects or traceability

Prime Cost and Conversion Cost

Manufacturing costs are often combined as follows:

Direct
Direct Direct
Direct Manufacturing
Manufacturing
Materials
Materials Labor
Labor Overhead
Overhead

Prime Conversion
Cost Cost
 A. Cost Classification by assigning costs to
cost objects or traceability

Prime Cost and Conversion Cost

Direct Materials

Direct Labor Prime Cost

Elements
of Cost
Conversion
Factory Overhead
Cost
 Classification by element
Materials Labour
Current

Direct Indirect Direct Indirect

Expenses
Product costs =
Materials+Labour+Expenses
Or
Direct Indirect Direct costs + Indirect costs
 B. Cost Classification by report in
financial statements
 All costs incurred by mfg. firm must be accounted for in the

book of accounts and reported in its financial statements to

external information users based on the following
Classification.
1. MANUFACTURING COSTS
A. Direct Labor Cost (DLC)
B. Direct Materials Cost(DMC)
C. M. Overhead Cost (MOHC)
[Link] Materials Cost
[Link] Labor Cost
[Link] Cost
2. NON-MANUFACTURING COSTS
[Link] or Selling Costs
[Link] Costs
 1. MANUFACTURING COSTS
Elements of Manufacturing Costs
Direct Direct Manufacturing
Materials Labor Overhead

The Product
 1. MANUFACTURING COSTS
Elements of Manufacturing Costs

Direct
Direct Direct
Direct Manufacturing
Manufacturing
Materials
Materials Labor
Labor Overhead
Overhead

The Product
 1. MANUFACTURING COSTS
A. Direct Materials (DM)
• Materials that are consumed in the manufacturing
process and physically incorporated in the finished
product
• Materials whose cost is sufficiently large to justify the
record keeping expenses necessary to trace the costs
to individual products
 1. MANUFACTURING COSTS
A. Direct Materials
it is Raw materials that become an integral part of the
finished product and whose costs can be conveniently
traced directly to it.

Example: The flour in Example:

Example: A A radio
radio
the dough. installed
installed in
in an
an automobile
automobile
 1. MANUFACTURING COSTS
B. Direct Labor Cost(DLC)
• DL is Labor of employees who work directly
on the product manufactured.
• DLC is Labor time cost that is physically
traceable to the products being
manufactured & whose cost is sufficiently
large to justify the record keeping expenses
necessary to trace the costs to individual
products. It is also called touch labor.
Example: Direct labor for manufacturing
Comp includes Line workers, robot
operators, painters, assembly workers
 1. MANUFACTURING COSTS

Direct Labor Cost(DLC) is labor costs that can be

easily traced to individual units of product.

Example:
Example: Wages
Wages paid
paid to
to
Example: Wages paid automobile
automobile assembly
assembly
to bakers. workers
workers
 Key issues in determining direct labor
[Link] there Any labor cost probably not included in direct
labor?
 Ans yes Factory janitors, factory supervisors, factory
secretaries
2. Is idle time generally considered as direct labor? Why or why
not?
 Usually not. It is not usually due to one product, hence it is not
traceable
3. What are the typical fringe benefits an assembly line worker
receives?
 Health insurance, pension plan, disability insurance
4. Is the cost of fringe benefits for the assembly line workers
generally considered direct labor?
 Usually yes, the costs can be traced
5. When an assembly line worker works overtime, he/she is paid
a regular wage plus an overtime premium. Would most
companies treat his/her regular wage as a direct labor cost?
 Yes, the amount of time an employee works can be traced to the
products.
Further Classification of Labor Costs

Treated as overhead
Idle Time
cost

Overtime
Treated as overhead
Premium of Lab
cost
Workers

Labor Fringe Treated as indirect

Benefits labor
 Idle Time
Machine Material
Breakdowns Shortages

Power
Failures

The labor costs incurred

during idle time are ordinarily
treated as manufacturing
overhead.
 Overtime

The overtime premiums for all factory

workers are usually considered to be part
of manufacturing overhead.
 Labor Fringe Benefits
Fringe benefits include employer paid
costs for insurance programs, retirement
plans, supplemental unemployment
programs, Social Security, Medicare,
workers’ compensation and
unemployment taxes.

Some companies Other companies treat

include all of these fringe benefit
costs in expenses of direct
manufacturing laborers as additional
overhead. direct labor costs.
 1. MANUFACTURING COSTS
C. Manufacturing Overhead (OH)
 Are All manufacturing costs related to production
except direct materials and direct labor.
 They also called indirect manufacturing cost, factory
overhead, and factory burden
 Theses includes indirect materials, indirect labor & other cost
that are part of the finished product, but that cannot be easily
traced to specific units produced directly. such as
a. Indirect Materials (IM) – Materials, used in the
manufacturing of products, which are difficult to trace
to particular products in an economical way
• Glue, nails, cleaning supplies
b. Indirect Labor (IL) – Labor, used in the
manufacturing of products, which is difficult to trace
to particular products in an economical way
• Wages for maintenance workers, factory supervisor’s
salary, idle time
c. All other types of manufacturing overhead
• Depreciation on machinery, depreciation on factory
building, factory insurance, utilities for factory
 1. MANUFACTURING COSTS
C. Manufacturing Overhead

Materials used to support Wages paid to employees

the production process. who are not directly
Examples: lubricants and involved in production
cleaning supplies to work. Examples: clean-
maintain the bakery up workers, janitors, and
equipment. security guards.

Other examples of manufacturing overhead include:

maintenance and repairs on production equipment, heat and
light, property taxes, depreciation and insurance on
manufacturing facilities, etc.
 1. Quick Check 
1. Which of the following costs would be considered
manufacturing overhead at Boeing? (More than one
answer may be correct.)
A. Depreciation on factory forklift trucks.
B. Sales commissions.
C. The cost of a flight recorder in a Boeing 767.
D. The wages of a production shift supervisor.
 2. NON-MANUFACTURING COSTS
A manufacturing company incurs many other
costs in addition to manufacturing costs. For
financial reporting purposes, most of these other
costs are typically classified as selling costs and
administrative costs.
1. Marketing or Selling Costs
• Costs incurred in securing orders from customers and
providing the finished product into the hands of the customer.
• Eg Sales commissions, costs of shipping products to
customers, storage of finished goods, depreciation of
selling equipment (cash register)
2. Administrative Costs
• This includes all costs associated with the general management
of an organization. Such as Executive, organizational, and
clerical costs that are not related to manufacturing or marketing
• Eg CEO’s salary, cost of controller’s office, depreciation on
administrative building.
 2. Non-manufacturing Costs

Marketing or Administrative
Selling Costs Costs

Costs necessary to All executive,

secure the order and organizational, and
deliver the product. clerical costs.
 Self check Exercise
Classify the following cost items
1) Depreciation on factory building
2) Depreciation on office equipment
3) Property tax on finished goods warehouse
4) Wages paid to forklift operator in finished goods
warehouse
5) Wages paid to forklift operator in factory
6) Wages paid to welders when welding equipment is
not working area
7) Paper used in textbook production
8) Paper used in central office computer
9) Wages paid to assembly line workers
10)Maintenance cost for machines
 C. Classification of Costs by
Function
Product Costs Vs. Period Costs
I. Product costs:-
 is a cost that is incurred in producing goods and
services.
 Are costs assigned to products that becomes part of
inventory cost purchased for manufacturing firm.
 are refer to necessary and reasonable expenditures
pertain to activities carried out to manufacture the
product and integral to finished products.
 When products are sold, product costs are recognized
as an expense (cost of goods sold or COGS).
 The costs of unsold products remain in inventory and
are not expensed (i.e. not deducted from revenue in
calculating net income). They are assigned to inventory
in the balance sheet.
(direct material + direct labor + overhead =Product costs)
 C. Classification of Costs by
Function
Product Costs Vs. Period Costs
II. Period Costs:-
 refer to expenditures that are made for activities not
related to manufacturing product. such as marketing or
selling and administrative activities.
 Are not product costs or not part of the manufacturing
process and they associated more with a time period in
which they are incurred than with finished products.
(selling and general administrative expenses =Period
costs )
• This cost is considered to be expired during the accounting period
and is charged to the profit & loss account.
 They are expensed in the income statement(i.e.
deducted from revenue in calculating net income) in the period.
 C. Classification of Costs by Function

Product Costs Period Costs

• Direct materials • Selling
• Direct labor • General and
• Overhead administrative
expenses
B. Classification of Costs by Function
Product Costs Versus Period Costs
Product costs include Period costs are not
direct materials, direct
included in product
labor, and manufacturing
overhead. costs. They are
expensed on the
Inventory Cost of Good Sold
income statement.
Expense

Sale

Balance Income Income

Sheet Statement Statement
 Quick Check 
Which of the following costs would be
considered a period rather than a product
cost in a manufacturing company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production facility.
E. Sales commissions.
 Quick Check 
Which of the following costs would be
considered a period rather than a product
cost in a manufacturing company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production
facility.
E. Sales commissions.
 Illustration 1-3
Summary on Cost accumulation
 Summary on Cost accumulation
• Prime cost = Direct materials + Direct Labor

• Conversion cost = Direct Labor + factory overhead

•Production cost = Prime cost + factory overhead

OR
= Direct materials + Conversion cost

•Total cost = Prime cost + Overheads +(admin, selling, distribution cost)

OR
= Production cost + period cost (administrative, selling,
distribution and finance cost)

34
 D. Cost Classifications for Predicting Cost
Behavior

• Cost behavior refers to how a cost will react to

changes in the level of business activity. This means

Just about any cost will change if there is a big

enough change in activity.

• Thus Managers often need to be able to predict how
costs will change in response to changes in activity.
business Activity :-
• is a quantitative measure of a firm’s output of goods or
services
• it might be some measure of activity internal to the company such as
 The number of purchase orders processed during a period.
 Number of kitchen mate
 Pairs of Nike shoes
 Tons of cement produced
D. Cost Classifications for Predicting Cost Behavior
 While there are other ways to
classify costs according to how
they react to changes in activity,
 The most common classifications
are:
i. Variable costs.
ii. Fixed costs
iii. Mixed costs.
Semi-fixed Costs
Semi-Variable
D. Cost Classifications for Predicting Cost Behavior
I. Variable Costs
:- are costs that change proportionately (in total) with
the level of activity changes .
:- are those cost that various as the volume of activity
changes directly. This means When
 The volume of activity increases then the total dollar
amount of cost increase.
 The volume of activity decrease then the total dollar
amount of cost decrease
Variable costs for Publishing a magazine
 Cost of paper
 Cost of ink
 Sales Commissions
 Cost of lubricants for machine
 Cost of operating press
What is the concepts of activity level ?
What is the concepts of activity base/level ?

The Activity level

Units
produced Machine
hours

A measure of what
causes the incurrence
of a variable cost

Miles Labor
driven hours
 Extent of Variable Costs :- across
Different organizations
The proportion of variable costs differs across organizations. For example . . .

A
A public
public utility
utility with
with
large
large investments
investments in in property,
property, A manufacturing company
plant
plant and
and equipment
equipment thatthat will often have many
will
will tend
tend to
to have
have fewer
fewer variable costs.
variable
variable costs.
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.

Fall 2010 Mugan 39/82

 Extent of Variable Costs:- Examples
Here are some examples of variable costs we are likely to find in different types of businesses.

Merchandisers Service Organizations

 Supplies
Cost of Goods Sold
 travel
 clerical

Examples of variable costs

Manufacturers Merchandisers and

 Direct Material, Manufacturers
 Sales commissions
 Direct Labor,
 shipping costs
 Variable Manufacturing  clerical costs such as invoicing
Overhead
 Extent of Variable Costs: Expression
 There is no variable cost if the firm does
not engaged in any of business
activity Level
 Variable Costs can be expressed or
stated as
A. Total variable cost
B. variable cost per unit
 Extent of Variable Costs:-Expression
A. Total Variable Cost
A cost that varies, in total, in direct proportion to changes in the level of activity.
Eg.
1. In some cases your total texting bill is based on how many texts you send.
2. Your total long distance telephone bill is based on how many minutes you talk
Total Texting Bill

Number of Texts Sent

 Illustrative Example
E.g. assuming that the unit cost of a tire (for car) is br.
500, the table show how the total cost of the material
changes as the volume of the material increases.

Volume of Tires Cost of total

Activity required tire

6,000
1 4 2,000
2 8 4,000 4,000
3 12 6,000
4 16 8,000
2,000
1 2 3 4 Activities
 Extent of Variable Costs:-Expression
B. Variable Cost Per Unit. Or U.C = Total Cost /No. of Production
 Variable cost per unit is a cost for each single level of activity.
 However, On a per unit basis, a variable cost remains constant
over a wide range of activity.
 E.G In some cases
- the cost per text sent is constant at constant cost per text
- The cost per long distance minute talked is constant. For example, 10 cents per minute.

Cost Per Text Sent

Number of Texts Sent

 Example
• Suppose 10,000 quintals of wheat flour are produced at a
total cost of Birr 2,500,000.00. If 7,500 quintal of flour has
been sold during the period, unit costs The unit cost would
be the total cost divided by the total units produced i.e.,
a. What is the unit cost that would are essential to assign the
total cost to cost of goods sold, and ending inventory.
Total manufacturing cost 2,500,000.00 $
250.00 / quintal
Number of units produced 10,000
b. Determine total cost to cost of goods sold, and ending
inventory.
• Cost of goods sold is then, Birr 250 X 7,500 1,875,000000
• Ending inventory Birr 250 X 2,500 625.000.00
 Summary of on Cost Behavior
Total Variable Costs & Variable Costs Per Unit

Total Variable Cost

Number of units
 Quick Check 

 Which of the following costs would be

variable with respect to the number of
cones sold at a Robbins shop? (There may
be more than one correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.
 Quick Check 

Which of the following costs would be

variable with respect to the number of
cones sold at a Robbins shop? (There
may be more than one correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.
 Quick Check 
3. Which of the following costs would be variable with
respect to the number of people who buy a ticket for
a show at a movie theater? (There may be more than
one correct answer.)
A. The cost of renting the film.
B. Royalties on ticket sales.
C. Wage and salary costs of theater employees.
D. The cost of cleaning up after the show.
 Quick Check 
3. Which of the following costs would be variable with
respect to the number of people who buy a ticket for
a show at a movie theater? (There may be more than
one correct answer.)
A. The cost of renting the film.
B. Royalties on ticket sales.
C. Wage and salary costs of theater employees.
D. The cost of cleaning up after the show.
 II. Fixed Cost
• A cost that remains constant, in total, regardless of
changes in the level of the activity.
• In other words, fixed costs do not change for changes
in activity that fall within the “relevant range.”
• This does not means fixed costs is always fixed

• For example, your monthly contract fee for your cell

phone is a fixed amount for a certain number of
minutes. B/c The monthly contract fee does not
change based on the number of calls you make.
• Of course, if you go over your monthly minutes
allotment, you have exceed the relevant range for
your monthly contract and will be charged above and
beyond your monthly contract fee.
Examples of fixed costs

Merchandisers, manufacturers, and service

organizations
Real estate taxes
Insurance
Sales salaries
Depreciation
Advertising
 Types of Fixed Costs

Committed Discretionary
Long-term, cannot be May be altered in the
significantly reduced in the short-term by current
short term. managerial decisions

Examples Examples
Depreciation on Buildings Advertising and Research
and Equipment and Real and Development
Estate Taxes
 Extent of fixed cost : Expression
 A fixed cost is constant within the
relevant range.
 However, if expressed on a per unit
basis, the average fixed cost per unit
varies inversely with changes in
activity.
 Thus fixed Costs can be represented or
stated as
[Link] fixed cost
[Link] cost per unit
 Extent of fixed cost : Expression
[Link] Fixed Cost
 Eg. Your monthly basic telephone bill probably does not change when you make more
local calls
 your monthly contract fee for your cell phone is a fixed amount for a certain number of
minutes. The monthly contract fee does not change based on the number of calls you
make.
Monthly Basic Telephone
Bill

Number of Local Calls

 Example: on fixed cost
• if a company pays br. 100,000 for a warehouse building that is used for car
assembly, the total cost of rent won’t change whether the company wants to
assemble 1000 cars or more. The following diagram shows the graph for fixed
cost.
100,000
75,000

50,000
25,000

1,000 2,000 3,000 4,000

• NB: if the company wants to assemble more than 10,000 cars the existing
building may not be enough to host the whole 10,000 cars. Thus the company
may need to rent other building. Therefore, the rent expense will vary if the
activity is out of the relevant range.
Extent of fixed cost : Expression
II. Fixed Cost Per Unit
• However, if expressed on a per unit basis, the average fixed cost
per unit varies inversely with changes in the volume activity.
• Eg The average cost per local call decreases as
more local calls are made.

Telephone Bill per Local

Monthly Basic

Call
Number of Local Calls
 Summary of on Cost Behavior
Total Fixed Costs and Fixed Costs Per Unit
Total fixed Cost Per Unit Fixed Cost

Number of units
Number of units
 Illustrative Example
• Assume that out of the 2,500,000 total cost, the 500,000
is fixed that does not change over the relevant range.
• Now Lets See the how variable and fixed cost are
changed for the upcoming period under different levels
of production. Look at the following budget:
Units to be Variable cost Total fixed fixed cost
Total variable cost Total cost Unit costs
produced per unit cost per unit

5,000 200 1,000,000.00 500,000.00 100.00 1,500,000.00 300.00

7,500 200 1,500,000.00 500,000.00 66.67 2,000,000.00 266.67

10,000 200 2,000,000.00 500,000.00 50.00 2,500,000.00 250.00

12,500 200 2,500,000.00 500,000.00 40.00 3,000,000.00 240.00

15,000 200 3,000,000.00 500,000.00 33.33 3,500,000.00 233.33

 Extent of fixed cost and Relevant Range

What is the concepts of a

relevant range ?
 Relevant range refer to as the range
of activity within which the company
usually operates or assume about
variable and fixed costs are valid.
The range of activity within which the firm’s
cost structure (i.e. variable cost per unit and
total fixed cost) remains unchanged
Extent of fixed cost and Relevant Range

The company’s
normal operating range
90
Thousands of Dollars

Total cost doesn’t

change for a wide
Rent Cost in

Relevant
60 range of activity.
Range It then jumps to a
new higher cost
30 for the next higher
range of activity.

00 1,000 2,000 3,000

Rented Area (Square Feet)
Fixed Costs and the Relevant Range

90
The relevant range
Thousands of Dollars

Relevant of activity for a fixed

Rent Cost in

60 cost is the range of

Range
activity over which
the graph of the
30 cost is flat.
0
0 1,000 2,000 3,000
Rented Area (Square Feet)
Extent of fixed cost & Relevant Range

For example, assume office space is available at a

rental rate of $30,000 per year in increments of 1,000
square feet.

Fixed costs would increase in a

step fashion at a rate of $30,000
for each additional 1,000 square
feet.
 Summary of on Cost Behavior

Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

proportional to the activity the same over wide ranges
level within the relevant range. of activity.
More output = More cost
Fixed Total fixed cost remains the Fixed cost per unit goes
same even when the activity down as activity level goes up.
level changes within the More output = lower cost per unit
relevant range.
 Summary of on Cost Behavior
To get total costs you need to add total variable
costs and total fixed costs

Total Costs(TC= TFC+TVC)

Total Cost

Fixed costs
The Slope is the
variable cost per
unit

Number of units
 III. Mixed Costs
(also called semi-variable costs)
A mixed cost contains both variable and fixed elements.
Consider the example of utility cost.
Y
Total Utility Cost

cost
xe d
m i
ta l
To Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
 III. Mixed Costs
(also called semi-variable costs)
Slope is
variable cost
per unit
of activity.
Total Utility Cost

ost
bl ec
r i a
iva Variable
sem
t al Utility Charge
To

Fixed Monthly
Utility Charge
Activity (Kilowatt Hours)
 III. Mixed Costs
(also called semi-variable costs)
The total mixed cost line can be expressed
as an equation: Y = a + bX

Where: Y = The total mixed cost.

a = The total fixed cost (the
vertical intercept of the line).
Y b = The variable cost per unit of
activity (the slope of the line).
X = The level of activity.
Total Utility Cost

cost
xe d
m i
ta l
To Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
 Mixed Costs – An Example
If your fixed monthly utility charge is $40, your
variable cost is $0.03 per kilowatt hour, and your
monthly activity level is 2,000 kilowatt hours, what
is the amount of your utility bill?

Y = a + bX
Y = $40 + ($0.03 × 2,000)
Y = $100
 Others Cost Classification
such as Decision Making

I. Management hierarchical level (for

controllability)
II. Opportunity cost (for relevance)
III. Classification by manufacturing-cost system
IV. Classification by relevance (avoidable x
unavoidable)
V. Classification by aggregate or average
VI. Concept of incremental and marginal costs,
 E. Others Cost Classifications such
as Decision Making
Identifying Relevant Costs and Benefits

• It is important to realize that every decision involves a choice

between at least two alternatives
• Information is relevant to a decision related problem
when . . .
It has a bearing on the future,
It differs among competing alternatives.
• Only those costs and benefits that differ between
alternatives are relevant in a decision. All other
costs and benefits can and should be ignored.
 Relevant Cost
Relevant CostVs. Irrelevant
Vs. Irrelevant CostCost

Relevant Cost:- is which changes with a

change in decision. These are future costs that
effect the current management decision.
Irrelevant Cost :- are those costs that
would not affect the current management
decision.
– Example; A cost OF building purchased in last year, is
irrelevant to affect management decisions.
 Quick Check 
Suppose you are trying to decide whether to drive or take
the train to Portland to attend a concert. You have ample
cash to do either, but you don’t want to waste money
needlessly. Is the cost of the train ticket relevant in this
decision? In other words, should the cost of the train ticket
affect the decision of whether you drive or take the train
to Portland?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not relevant.
 Quick Check 
Suppose you are trying to decide whether to drive or take
the train to Portland to attend a concert. You have ample
cash to do either, but you don’t want to waste money
needlessly. Is the cost of the train ticket relevant in this
decision? In other words, should the cost of the train
ticket affect the decision of whether you drive or take the
train to Portland?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not relevant.
 Quick Check 
Suppose you are trying to decide whether to drive or
take the train to Portland to attend a concert. You
have ample cash to do either, but you don’t want to
waste money needlessly. Is the depreciation on your
car relevant in this decision?
A. Yes, the depreciation is relevant.
B. No, the depreciation is not relevant.
 Quick Check 
Suppose you are trying to decide whether to drive or
take the train to Portland to attend a concert. You
have ample cash to do either, but you don’t want to
waste money needlessly. Is the depreciation on your
car relevant in this decision?
A. Yes, the depreciation is relevant.
B. No, the depreciation is not relevant.
 Quick Check 
Suppose you are trying to decide whether to drive or take
the train to Portland to attend a concert. You have ample
cash to do either, but you don’t want to waste money
needlessly. Is the annual cost of licensing your car relevant
in this decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.
 Quick Check 
Suppose you are trying to decide whether to drive or
take the train to Portland to attend a concert. You have
ample cash to do either, but you don’t want to waste
money needlessly. Is the annual cost of licensing your
car relevant in this decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.
 Quick Check 
Suppose that your car could be sold now for $5,000. Is
this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.
 Quick Check 
Suppose that your car could be sold now for $5,000. Is
this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.
 Differential Costs and Revenues
 Differential costs (or incremental costs) is a difference in
cost between any two alternatives .
 A difference in revenue between two alternatives is called differential
revenue. Differential costs can be either fixed or variable.

Example: You have a job paying $1,500 per month in

your hometown. You have a job offer in a neighboring
city that pays $2,000 per month. The commuting cost
to the city is $300 per month.

Differential revenue is:

$2,000 – $1,500 = $500

Differential cost is:

$300
 Historical Cost Vs Estimated Costs:
 Historical Cost:
These are costs from some period of time in the past over
which no control can be exercised but which represents data
that can be used to predict future performance.
It is the cost which is incurred at the time of entering into the
transaction. This cost is verifiable through
invoices/agreements.
Historical cost is an actual cost that is borne at the time of
purchase.
Example:- A building purchased for Rs 400,000, has market
value of Rs. 1,000,000. Its historical cost is Rs. 400,000.
 Estimated Costs:
 are those costs that are expected to be realized in the future.
 It is not the true cost because when we divide the total cost to the number of
production, that means we are allocating the total cost for different products
produced in different period which have different cost.
 True Cost: the average of total cost of the period.
 Budgeted Cost – a predicted cost
E. Standard Cost Vs. Actual Costs
 Standard Cost
 is a Predetermine cost of the units.
 It is a carefully projected but expected to incur for
a specific period.
 Example Standard cost for a unit of product ‘A’ is
set at Rs 30. It is compared with actual cost
incurred for control purposes.
 Actual Costs:
are division of the total expenditure and number of units
produced or it is an average cost.
a cost that has occurred.
 Implicit Cost
Implicit [Link].
Cost Explicit Cost
Explicit Cost:-
Implicit Cost:-
 are costs imposed on a firm includes cost when it foregoes an
alternative action but doesn't make a physical payment. Such costs
are related to forgone benefits of any single transaction, and occur
when a firm:
Example Uses its own capital or Uses its owner's time and/or
financial resources
 Explicit Cost:-
 is the cost that is subject to actual payment or will be paid for in
future.
Example
i. Wage
ii. Rent
iii. Materials
 Opportunity Costs Vs. Sunk Costs

Opportunity cost is The potential benefit that is given up when one
alternative is selected over another.
 These costs are not usually entered into the accounting records of an organization, but must be
explicitly considered in all decisions.

Example:
If you were not
attending college,
you could be earning
$15,000 per year.
Your opportunity cost
of attending college
for one year is
$15,000.
Opportunity Costs Vs. Sunk Costs
Sunk costs have already been incurred and cannot be
changed by any decision made now or in the future.
They should be ignored when making decisions.

Example: You bought an automobile that cost

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

Sunk costs
Cost that have already been incurred. They
do not affect any future cost and cannot be
changed by any current or future action.

Sunk costs are irrelevant to decisions.

Avoidable
Avoidable costs
costs Vs.
Vs. Unavoidable
Unavoidable costs
costs

 Costs that can be eliminated (in whole or in part) by

choosing one alternative over another are avoidable
costs.
 Avoidable costs are relevant costs.
 Unavoidable costs include:
Sunk costs.
Future costs that do not differ between the
alternatives.
 Unavoidable costs are never relevant.
Marginal Costs and Average Costs

The total cost to

The extra cost
produce a quantity
incurred to produce
divided by the
one additional unit.
quantity produced.

Marginal and average costs are

largely a function of cost behavior
-- variable and fixed costs.
 Unexpired cost Vs. Expired costs
• Unexpired costs are the resources that have
been acquired and are expected to contribute
to the future revenue
• They will be recorded as assets in current
period
• They will be charged as expenses when they
have been consumed in the generation of
revenue
• Expired costs are the expenses attributable to
the generation of revenue in the current period
90
 Incremental
Add or Drop a Product Costs

Keep Drop
Watch Watch Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Mfg. expenses 120,000 - 120,000
Freight out 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000 50,000 -
Advertising - direct 100,000 - 100,000
Rent - factory space 70,000 - 70,000
General admin. expenses 30,000 30,000 -
Total fixed expenses 400,000 140,000 260,000
Net loss $(100,000) $(140,000) $ (40,000)
 Summary
Summary
Contribution margin lost if digital
watches are dropped $ (300,000)
Less fixed costs that can be avoided
Salary of the line manager $ 90,000
Advertising - direct 100,000
Rent - factory space 70,000 260,000
Net disadvantage $ (40,000)

DECISION RULE
Swick should drop the digital watch segment
only if its fixed cost savings exceed lost
contribution margin.
 Summary of the Types of
Cost Classifications

Predicting Cost
Financial Reporting
Behavior

Assigning Costs to Making Business

Cost Objects Decisions
Costs and Benefits of Information

Costs Benefits

More information does not mean more

benefits if information overload results.
End of Part 2