COST,CONCEPT,CLASSIFICA
TION AND BEHAVIOR
CHAPTER 2
INTRODUCTION
• The collection, classification and analysis of cost are fundamental to management
accountants as it assist them in planning, control and decision making.
• Understanding these basic concept is essential because of the multiple and diverse
needs in cost accumulation, planning, control and decision making.
• You should realize that information used to record the transaction of a business and
subsequent compilation of the annual financial statements is not necessarily the
only information used by management in making decisions.
• Management accounting information should provide relevant facts,wherether
financial or non –financial, actual or estimated, to enable management to make
decisions that will create value over a long term for a company.
CONTINUATION
• A lot of reference is made with respect to "big data’ ’in
business circles these days. ’Big data’ ’refers to large
volumes of data that are available to companies by means of
analyzed data obtained from loyalty cards, social media,
business- to business machines,etc
• The importance is not the volume of available but uses the
data to make better decisions, to explore new strategies and
so forth, for the purpose of creating value over time for a
company.
DECISION MAKING INCLUDE
• Behaviour of cost-in relation to changes in volume/activity. Fixed, variable and
mixed costs are discussed later in the chapter.
• Relevant of cost- are cost that will change in future because of a decision
made. The same principle applies to relevant revenue or income.
• Sunk cost- are costs that are unaffected by the choice between different
decisions and usually would have been included in the past.
• Opportunity cost-is revenue forfeited because one decision is selected above
another. Opportunity cost is not a cost that can be obtained from the
accounting system but it is used in decision making.
CONTINUATION
• Incremental cost-is a cost of producing an additional group or
batch of units of production. The same principles applies to
incremental revenue or income.
• Cost accumulation- involves the calculation of product cost
for inventory valuation and profit measurement
WHAT IS MEANT BY COST?
• According to Charted Institute of Management
Accountants(CIMA), the word ‘’cost” can be used in two
contexts: it can be used as noun, referring to the cost of item,
but it can be used as verb when we attempt to cost
[Link] definition of cost in these two context is as
follows:
• As a noun: the amount of expenditure incurred on, or
attributable to, a specific cost or object or activity.
• As a verb: to ascertain the cost of specific cost object or
COSTING CONCEPT
• Cost unit- is a unit of output(product/service)for an
organisation,for example the cost of ton of gold from gold mine
or the cost per book of the tittle published by the publisher.
• Cost centres -can be defined as follows
A production or service location, function, activity or item or
equipment for which costs are accumulated separately
A collection point or pool created to accumulate costs
TYPES OF COST CENTRE AND EXAMPLES
Service location Stores, canteen
Function Marketing division
Activity Quality control
Item of equipment Packing machine
COST OBJECT
Managers want to know how much a particular “item’’(product
or service ) cost.
We call this “item’’ a cost of object. Examples of cost of object
are cost of a product, the cost of operating a particular
department or the cost of rendering a [Link] the cost
of a specific object enables management to control costs ,to
determine selling prices and evaluate performance
EXAMPLES OF COST OBJECT
Cost object Examples
Project Construction of offices in Mut.
programme An Accounting degree at a university
Service Flights from Durban to Johannesburg
Product Electrical toothbrush
COST POOL
• A cost pool can be described as a grouping of various individuals
cost items. Cost pools are mainly used in an activity- based costing
system. For example, all costs related to ordering and receiving of
inventory items may be “pooled’’ together. Examples of the
individuals cost items that will be “pooled "together in this case
could be salaries of warehouse foreman, the cost of placing an
order, salaries and clerk receiving inventory items, etc. All these
cost items are related to ordering and receiving of inventory, and
therefore pooled together
COST ASSIGNMENT
• Cost assignment is a general term that encompasses both
Tracing accumulated costs that have a direct relationship to
cost a cost object, and
Allocating accumulated costs that have an indirect relationship
to cost object.
COST TRACING
• The term cost tracing is used to described the assignment of
direct costs to a particular cost object. For example, a chair is
made of wood. Source documents, such as requisition or an
invoice, assist in tracing the axact quantity of wood used in
producing the chair. Wood is an example of direct(raw)
materials. Employees directly involved in producing the chair
e.g. carpenters(people who physically produce the chair
during the production process),are classified as “direct
labour”.This is illustrated in figure 2.1
FIGURE 2.1 SUMMARY
• Types of cost
Direct cost -related to particular cost object(e.g. direct material)
Indirect cost-related to a particular cost object but cannot be traced
directly to it in an economically feasible way(e.g. rent of factory)
Cost assignment-Encompasses both cost tracing and cost allocation
Cost object-it is anything for which a separate measurement of cost is
desired([Link]
COST ALLOCATION
• The term cost allocation is used to describe the assignment
of indirect costs to a particular cost object, for example
indirect material, rent of factory and depreciation of plant
and equipment that are necessary to secure orders and get
the finished product directly to the customer.
MANUFACTURING AND NON-
MANUFACTURING COSTS
• It was mentioned in the introduction to this chapter that cost
can be classified according to the purpose of the
classification. If the propose is to determine the
manufacturing costs of a cost object, the classification of
costs will be categorized into manufacturing or non-
manufacturing costs. Determining the value of inventory of a
manufacturing company typically warrants classification of
costs as either manufacturing or non- manufacturing
MANUFACTURING COSTS
• Manufacturing cost-also called product cost or factory cost- is
usually defined as the sum of three cost elements: Direct
material, direct labour, and manufacturing or factory
overheads.
• Direct labour plus direct material is called prime(primary
cost).
• Conversion costs refers to the cost of converting purchased
raw (direct)materials into finished [Link],direct
labour plus manufacturing overhead are conversion costs.
CONTINUATION
• A distinction between manufacturing and non- manufacturing
costs are made for the purpose of inventory measurement.
The international Financial Reporting Standards(IAS2) state
that inventory should be valued at manufacturing costs, i.e.
direct material plus direct labour plus manufacturing
overheads. Chapter 3 elaborates on inventory valuation
DIRECT MATERIALS
• These are materials that are directly related to the cost of a
unit. They form an integral part of the finished product and
are included explicitly in calculating the cost of the product.
Examples of direct material are wood to manufacture
furniture,and crude oil to manufacture petrol. Certain costs,
related to the purchasing of direct materials, are usually
included in direct material cost, for example import duties
paid and delivery cost of direct materials
DIRECT LABOUR
• Direct labour is the cost of labourers who convert direct
materials into finished [Link] forms part of the total
manufacturing costs that can be traced to, or-otherwise
identified with, the units of output produced. Direct labour
comprises those employees who are directly involved in the
manufacturing or assembling process. Direct labour must be
measured in terms of time spent and rate of
remuneration(cost).it is obvious that the cost of labour is
necessary to determine the cost of a product(and eventually
the selling price).
MANUFACTURING/FACTORY OVERHEADS
• This is a broad category include all indirect manufacturing cost other than direct
material, direct labour. These costs are classified as indirect cost because they
are not directly traceable to a product(or cost object).An indirect cost is not
directly traceable to a product when the indirect cost is not devisable to each
individual product or when it is not economically feasible to trace the indirect
cost to a product. Examples are indirect labour of those employees indirectly
associated with production,suppliers,factory water and electricity, supervisors
in the production process, machine maintenance and depreciation of factory
buildings. These costs are apportioned(or allocated) to individual products by
one of a variety of methods that are discussed in chapter 5
NON -MANUFACTURING COSTS
• Non –manufacturing costs fall into two broad classifications: marketing
costs(selling and distribution)and administrative costs.
• Marketing cost begin at the point at which the manufacturing cost end. That
is when manufacturing has been completed and the product is in a seable
[Link] includes the cost of promotion, selling and delivery(distribution).
• Administrative costs include costs incurred in directing and controlling the
[Link] salary of a manager in charge of administration will be
treated as administrative overheads. Finance costs(e.g. interest paid) could
also be included in administrative costs.
DIRECT AND INDIRECT COSTS
• All costs can be classified as either direct or an indirect cost. Direct
cost are specifically cost that can be conveniently identified with a
product or service, cost object, costs centre etc.
• Direct cost can be easily traceable to product or services(cost objects)
• There are three principal categories of direct cost are direct material,
direct labour and manufacturing overheads.
• It is worth nothing that costs may be classified as direct in one
instance, but indirect in another instance.
CONTINUATION
• Direct and indirect costs may be classified as manufacturing
or non- manufacturing, fixed or variable([Link]
classification),etc.
• In general variable costs are by and large classified as direct
cost and fixed cost as indirect cost.
• However, some fixed costs can also be directly traceable to a
specific product or service, for example a machine
specifically rented or leased in order to manufacture a
particular product.
CONTINUATION
• It is thus important(as with any classification)to evaluate
each classification instance on its merit and circumstances.
DIRECT COSTS
• Direct costs are those costs that can be easily traced to a
cost object. A source document, such a requisition form for
material or a cost of production report indicating the labour
hours of the employees directly involved in the production
process, is usually available to ensure accurate tracing of the
costs. Examples include direct materials and direct labour.
INDIRECT COSTS
• Indirect costs are costs that are necessary, for example, in
the process to produce a product, but are difficult or not
economically feasible to trace directly to the product.
• Indirect material, depreciation of plant and indirect labour are
examples of indirect costs. Note the similarity thereof to
manufacturing(or non-manufacturing)overheads.
• Therefore, indirect costs are costs are the same as
overheads.
CONTINUATION
• Indirect materials are materials that are needed for the completion of a product
but that are not classified as direct materials, because it is not worth the effort
to trace the cost of relatively insignificant materials consumed(generally
because of their low value) to the final product.
• Examples include nails, screws and glue. Indirect materials form part of
manufacturing overheads
• Indirect labour is labour that is not directly traced to the construction,
composition or production of finished product. Indirect labour includes the wages
of supervisors, general helpers, maintenance workers and usually material
handlers. Indirect labour forms part of manufacturing overheads.
COST VERSUS EXPENSES
• Cost is used in management accounting. Product cost(cost of inventory of raw
materials, work in process(WIP)and finished goods)
• Expense are used in Financial Accounting
• A cost is a sacrifice of resources, while an expense measures the outflow of
assets.
• All expenses are costs, but not all costs are expenses in the period in which they
are incurred, even though they become expenses in a later period, for example
finished goods inventory in one period is classified as cost, but when it is sold in
a future period, it is then expensed in the statement of comprehensive income.
PRODUCT AND PERIOD COSTS
• Product costs are costs that are identified with goods produced with the purpose
of selling them. In a manufacturing organization these are costs that are
attached to the product such as direct material, direct labour and manufacturing
overheads which are included when valuing inventory for finished goods or work
in process until they are sold. Thereafter the profit and loss are debited for the
purpose of calculating profit.
• Period costs are costs that are included in the inventory valuation. They are
therefore treated as expenses in the period in which they are incurred. An
example of period costs are companies that incur cost for marketing their
product and administering day to day operations
COST BEHAVIOUR
• Cost behaviour is a major factor in the
planning,control,performance measurement and decision
making functions.
• When we talk about cost behaviour we are referring to the
way in which costs are affected by fluctuations in level of
activity(volumes such as products produced, labour time
used,etc)
• Variable cost and fixed cost are two most frequently
recognized cost behaviour patterns.
CONTINUATION
• Fixed costs may be thought of as the costs of being in business, while
variable costs are costs of doing business. Semi-variable(mixed)costs
have a fixed element regardless of the level of output(within the
relevant range)in addition to a variable cost element.
• The distinction drawn between variable, semi-variable(mixed)and
fixed costs based on important underlying assumptions:
• Cost are defined as variable(or semi-variable) or fixed with respect to
a specific cost object.
CONTI…
• The time span must be specified
• Total costs are linear
• There is only one cost driver
• Variation in the level of the cost driver are within a relevant range
• The range of activity that reflect a company’s normal operating
range is referred to as the relevant range(volume such as
products produced, labour time used,etc)
CONTI…
• Fixed costs- a fixed cost in total remain unchanged irrespective of the level of
output(volume)e.g. rent within a relevant range and example
• A company rents a factory building in which it could manufacture up to
600 000 products per month. Assume that the rent is R40 000 per month. If the
company only produces 400 000 products during a specific months, the total rent
paid will remain R40 [Link] is thus a fixed cost in this scenario because within
the relevant range of 0-600 000 products the total cost remained at R40 000.
Fixed cost per unit will decrease as activity/output increases and fixed cost per
unit will increase as activity/output decreases(see figure 2.6(4)
FIXED COST
Table 2.2 Analysis of a company’s fixed cost
Units Produced Total costs Cost per unit
1 R40 000 R40 000.00
40 000 R40 000 R1.00
200 000 R40 000 R0.20
600 000 R40 000 R0.07
TABLE 2.3 FIXED COST BEHAVIOUR
Volume increases Volume decreases
Total fixed costs Remain constant Remain constant
Fixed cost per unit Decrease Increase
EXAMPLES OF FIXED COSTS ARE:
• Salaries of production executives
• Depreciation
• Supervisory salaries
• Insurance of property
• Rent
VARIABLE COSTS
• A total costs varies in direct proportion to changes in
activity(volume) is a variable cost. Variable costs per
unit,however,remain constant when volume changes within
the relevant range. Thus if the company produces toys with a
material cost of R200 per toy and production is ten toys, the
cost of material is R2 000(R200*10).
• When production double to 20 toys the cost of material
doubles as well to
R4 000(R2 000*20).
TABLE 2.4 ANALYSES OF A COMPANY’S
VARIABLE COSTS
UNITS PRODUCED MATERIAL COST PER TOTAL MATERIAL COST
UNIT
300 R200 R60 000
600 R200 R120 000
1 200 R200 R240 000
2 400 R200 R480 000
TABLE 2.5 VARIABLE COST BEHAVIOUR
Activity increases Activity decreases
Total variable cost Increases proportionately Decreases proportionately
Variable cost per unit Remain constant Remain constant