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COST CLASSIFICATION AND COST BEHAVIOR INTRODUCTION:COST CLASSIFICATION, |
| IMPORTANT TERMINOLOGIES:Cost Center, Profit Centre, Differential Cost or Incremental cost >> |
Cost
& Management
Accounting(MGT-402)
VU
LESSON#
1
COSTCLASSIFICATION
AND COSTBEHAVIOR
INTRODUCTION
Cost
Accounting
CostAccounting
is an expanded phase of financial
accounting which provides
management
promptlywith
the cost of producingand/or
selling each productand rendering a
particularservice.
Management
Accounting
Management
accounting is application of professional knowledge
and skill in the preparation
and
presentation
of financial information in such a way as to
assist management in decision making
and
in
the planning and control of
operations of the entity
Objectives
Objective
of cost
accounting is
computation of cost perunit,
whereas the objective of
management
accountingis to
provide information to
themanagement for decision
making purposes.
Users
Users
of cost & management
accountingare the decision
makersand the managers of
the
entity/organizationfor
which all thisexercise is
undertaken.
Uses
of Cost and Management
Accounting
1.
It determines total cost of
production and cost of
sales
2.
It determines appropriate selling
price
3.
It discloses the
profitableproducts, areas
andactivity/capacity
levels
4.
It is used to decide whether to
manufacture or purchase for
outside
5.
It helps in planning
andcontrolling the cost of
production
Elements
of Cost
Anyproduct
that is manufactured is the
result of consumption of some
resources. The
management,for
its planning andcontrolling
functions, mustknow the
cost of using these
resources.The
constituent elements of cost
are broadly classifiedinto
three
distinctelements:
1
Direct Material Cost
2
Direct
LaborCost
3
Other
ProductionCost
a)
Direct Cost
b)
Indirect Cost
COSTCLASSIFICATION
Elements
of cost (Direct Material,
DirectLabor, Other
Productioncosts) can be
classified as direct
cost
or indirect cost.
DirectCost
A
direct cost is a cost
thatcan be traced in full to
theproduct or service for
whichcost is being
determined.
Coststhat
can be economically identifiedwith a
specific saleableproduct or
service (cost unit).
a)
Direct
material costs arethe
costs of materials thatare
known to have beenused
in
producingand
selling a product or rendering a
service.
1
Cost
& Management
Accounting(MGT-402)
VU
b)
Directlabor
costs arethe
specific costs of
theworkforce used to produce a
product or
rendering
a service.
c)
Otherdirect
production costs are
those expenses that
havebeen incurred in full as
a
direct
consequence of producing a product, or
rendering a service.
IndirectCost/Overhead
Cost
An
indirect cost or
overheadcost is a cost that
is incurred in the course of
producing product or
rendering
service, but which cannot be
traced in the product or
service in full.
Expenditureincurred
on labor, material or otherservices
which cannot be economically
identified
with
a specific cost product or
service (cost unit).
Examples
include:
Wages
of supervisor, cleaning material,
workshop insurance.
MaterialCost
Labor Cost Other Production
Cost TotalProduction
Cost
PriceCost
Direct
Direct
Direct
FactoryOverhead
Cost
Indirect
Indirect
Indirect
1.
Prime Cost
Direct
Material
+DirectLabor
+Other
direct production cost
Prime
cost
.
2.
Total Production Cost
Prime
Cost
+Factoryoverhead
cost
Totalproduction
cost
.
3.
Conversion Cost
Directlabor
cost
+Factoryoverhead
cost
Conversioncost
.
COSTBEHAVIOR
Costbehavior
is the way in whichtotal
production cost is affected by
fluctuations in
theactivity
(production)level.
Activitylevel
Theactivity
level refers to theamount of
work done, or thenumber of
events that have
occurred.
Depending
on circumstances, the level of
activity may refer to
thevolume of production in
a
period,
the number of items sold,
the value of items sold,
thenumber of invoices
issued,the
number
of invoices received, the number or
units of electricity consumed,
thelabor turnover
etc.
etc.
Basicprinciple
Thebasic
principle of costbehavior is
that as thelevel of activity
rises,costs will usually
raise.For
example;
it will cost more to produce
500 units of output than it
will cost to produce
100units; it
willusually
cost more to travel 10 km
than to travel 2 km.Although
the principle is based on
the
commonsense,
but the costaccountant
has to determine, foreach
cost elements,
whetherwhich
costrises
by how much by thechange in
activitylevel.
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Cost
& Management
Accounting(MGT-402)
VU
Division
of cost by its behavior
Basicallythe
cost of production hastwo
behaviors:
1.
Fixed Cost
2.
Variable Cost
FixedCost
It
is a cost which tends to be
constant by increases or decreases in
the activity level.
Graph
of Fixed Cost
Rs
5000
4000
3000
2000
1000
100
200
300
400
500
Volume
of output
This
graph shows that the
costremains fixed regard
less of the volume of
output.
Examples
include:
a.
Salary of the
productionmanager
(monthly/annual)
b.
Insurance premium of
factorywork shop
c.
Depreciation on straight
linemethod
VariableCosts
A
variable cost is a costwhich
tends to very directlywith
the change in activitylevel.
The variable
costper
unit is the sameamount
for each unit produced
whereas total variablecost
increases as
volume
of output increases.
Graph
of Variable Cost
Rs.
Cost
4000
3000
2000
1000
Volume
of output
100
200
300
400
500
This
graph shows a proportionate increase in
the cost by the increase in
the activity level.
Examples
include:
a.
Cost of raw-material consumed
b.
Direct labor cost
c.
Selling commission
3
Cost
& Management
Accounting(MGT-402)
VU
Further
division of cost behavior
1.
Step fixed cost
2.
Semi variable cost
Stepfixed
cost
A
step fixed cost is
thecost which is constant
for a specific range of
activityand rises to a
new
constantlevel
once the rangeexceeds.
The range overwhich
the fixed costremains
constant is
known
as the
relevantrange.
Forexample;
the depreciation of a machine may be
fixed if productionremains
below 100number
of
units per month, but if
the production exceeds
100number of units, a second
machine may
now
be required, and the cost of
depreciation would go up a
step.Other
examplesinclude:
a.
Rent of workshop (in case of
increase in the production one
needs to rent one
moreworkshop)
b.
Salary of supervisor (increase in
outputwill be supervised by
increasednumber of
supervisors)
Graph
of Step
fixedCost
Rs.
Cost
4000
3000
2000
1000
Units
100
200
300
Volume
of output
This
graph shows a stepwise increase in
the total cost. Relevant
range in this graph is of
100
numbers
of units.
Semi
Variable Cost
It
is also known as mixed
cost. It is the cost which
is partfixed and par
variable. It is in fact
the
mixture
of both behaviors.
Examples
include: Utility bills
there is a fixed line
rentplus charges for
units consumed.
Salesman'ssalary
there is a fixedmonthly
salary plus commission per
units sold.
Thegraph
of semi variable cost is as
follow:
4
Cost
& Management
Accounting(MGT-402)
VU
Rs.
Cost
4000
Variable
cost portion
3000
2000
1000
Fixed
cost portion
100
200
300
400
500
Volume
of output
This
graph shows a fixed cost of
Rs. 2,000 and
thereafter the cost is
variable.
COSTBEHAVIOR
PER UNIT OF PRODUCTION
Costper
unit behaves differentlythan
the total cost of
production. Following
tablesshow the
difference
in behavior.
Increasing
Production
VolumeSituation
DecreasingProduction
VolumeSituation
PerUnit
Total
FixedCost
Increase
Constant
VariableCost
Constant
Decrease
TotalCost
Increase
Decrease
Increase
or decrease in production
volumecauses no change to
thevariable cost per
unit it remains
constant,assuming
there is not rebate in case
of bulk purchase andthe
labor receives
constantrate
despitechange
in productionvolume.
Whereas,increase
in production volumecauses a
decrease in fixedcost per
unit and in the
same
way
a decrease in production
volumecauses an increase in
fixedcost per
unit.
Followingexample
helps understanding this concept.
Totalfixed
cost
=
Rs. 4,000
Perunit
variable cost
=
Rs. 3
Costper
unit at differentactivity
levels 1000, 2000,4000,
and 5000units
1000
units
2000
units
4000
units
5000
units
Rs.Per
Total Rs.Per
Total Rs.Per
Total Rs.Per
Total
Unit
Rs.
Unit
Rs.
Unit
Rs.
Unit
Rs.
Fixed
4
4,000
2
4,000
1
4,000
0.8
4,000
Cost
5
Cost
& Management
Accounting(MGT-402)
VU
Variable
3
3,000
3
6,000
3
1,200
3
15,000
Cost
Total
7
7,000
5
10,000
4
16,000
3.8
19,000
Cost
IMPORTANT
TERMINOLOGIES
CostUnit
It
is a unit of a product or service in
relation to which the cost
is ascertained, i.e. it is
theunit
of
the out put or product of
the business. In simplewords
the unit forwhich
cost of
producingthe
units is
identified/allocated.
Example
Ballpoint
for a Ball
pointmanufacturing
entity
Bottlefor
Beverage
producingentity
Fanfor
a Fan
manufacturingentity
Cost
Center
Cost
centre is a location where costs
areincurred and may or
maynot be attributed to
cost
units.
Examples
Workshop
in a manufacturing concern
Autoservice
department
Electricalservice
department
Packagingdepartment
Janitorial
service department
Revenue
Centre
It
is part of the entity
thatearns sales revenue.
Itsmanager is responsible
forthe revenue
earnednot
for the cost of
operations.
Examples
Salesdepartment
Factoryoutlet
Profit
Centre
Profit
centre is a section of an
organizationthat is responsible
forproducing profit.
Examples
A
branch
A
division
Investment
Centre
An
investment centre is a segment or a
profit centre where the
managerhas
significantdegree
of
control over
his/herdivision's
investmentpolicies.
Examples
A
branch
A
division
Relevant
Cost
Relevant
cost is which changes with a
change in decision. Theseare
future costs thateffect
the
currentmanagement
decision.
Examples
Variable
cost
Fixed
cost which changes with in
an alternatives
Opportunitycost
6
Cost
& Management
Accounting(MGT-402)
VU
IrrelevantCost
Irrelevantcosts
are those costs thatwould
not affect thecurrent
managementdecision.
Example
A
building purchased in
lastyear, its cost is
irrelevant to affect
managementdecisions.
SunkCost
Sunk
cost is the cost expended in
the past that cannot be
retrieved on product or service.
Example
Theentity
purchase stationary in bulklast
moth. This expensehas
been incurred
andhence
willnot
be relevant to themanagement
decisions to be taken subsequent to
thepurchase.
OpportunityCost
Opportunitycost
is the value of a benefitsacrificed in
favor of an alternative.
Example
An
investor invests in stock exchange he
foregoes the opportunity to
invest further in his
hotel.The
profit which theinvestor
will be getting fromthe
hotel is
opportunitycost.
Product
Cost
Productcost
is a cost that is incurred in
producing goodsand services.
This costbecomes
part
of
inventory.
Example
Direct
material, direct labor and
factoryoverhead.
Period
Cost
Thecost
is not related to production
and is matched against on a time period
basis. This cost is
considered
to be expired during the accounting
period and is charged to
theprofit & loss
account.
Example
Sellingand
administrative expenses
HistoricalCost
It
is the cost which is
incurred at the time of
entering into the transaction.
This cost is
verifiablethrough
invoices/agreements. Historicalcost 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
historicalcost
is
Rs. 400,000.
StandardCost
Standardcost
is a Predetermine cost of the
units.
Example
Standardcost
for a unit of product`A' is
set at Rs 30. It is compared
with actualcost
incurredfor
control purposes.
ImplicitCost
Implicitcost
imposed on a firm includes cost
when it foregoes an alternative action
but doesn't
make
a physical payment. Such
costsare related to forgone
benefits of any single transaction,
andoccur
when a firm:
Example
Uses
its own capital or
7
Cost
& Management
Accounting(MGT-402)
VU
Uses
its owner's time
and/orfinancial
resources
ExplicitCost
Explicitcost
is the cost that is subject to
actual payment or will be
paid for in future.
Example
Wage
Rent
Materials
DifferentialCost
or Incrementalcost
It
is the difference of the costs of
two or more alternatives.
Example
Differencebetween
costs of raw material of two
categories or quality.
Costing:
Themeasurement
of cost of a product or service is
called costing; however, it is not
a
recommended
terminology.
CostAccounting:
It
is the establishment of budgets,
standardcost and actual
costs of operations, processes,
activities
or products and the
analysis of variances, profitability or
socialuse of funds.
It
involves
a careful evaluation of
theresources used within
thebusiness. The
techniques
employed
are designed to
providefinancial information
aboutthe performance of a
business
and
possibly the direction
whichfuture operations
shouldtake.
PrimeCost:
Thetotal
costs which can be directly
identified with a job, a
product or service is known
as
Prime
cost. Thus prime cost =
direct materials + direct labor + other
direct expenses.
ConversionCost.
This
is the total cost of
converting the raw
materialsinto finished
products. Thetotal of
direct
laborother
direct expenses andfactory
overhead cost is known as
conversioncost
CostAccumulation
Cost
accumulations are the various ways in
which the entries in a set
of cost
accounts(costs
incurred)may
be aggregated to providedifferent
perspectives on
theinformation.
Methods
of cost accumulation
Processcosting
It
is a method of cost
accountingapplied to production
carriedout by a series of
operational
stages
or processes.
Joborder
costing
Generally,
it is the allocation of
alltime, material and
expenses to an individual project or
job.
8
Cost
& Management
Accounting(MGT-402)
VU
Assignment
Questions
Answer
to each of the following question
should not exceed
fivelines.
1.
Define CostAccounting
2.
What are the three broad
elements of cost?
3.
Give any five examples of
factory overhead cost. Also
explain.
4.
Give any two examples of
distribution overheads.
5.
Give any two examples of
office overheads
6.
Define direct cost and
givetwo examples.
7.
What is indirect cost?
Givethree examples.
8.
What is meant by step
fixedcost and semi-variable
cost?Also show
graphs.
9.
What is fixed cost?
Givethree items of fixed
cost,also show its
graph.
ExamType
Questions
1.
What is a cost unit?
Givetwo example
2.
Define cost centre. How does
it differ from
costunit
3.
What is the difference between direct
and indirect materials?
Givetwo examples of
each.
4.
Fixed cost per unit
remainsfixed. Do you
agree?
5.
How variable cost
perunit behaves? Give
twoexamples.
6.
What are semi-variablecosts?
Draw graph for such
costs
MultipleChoice
Questions
Choosethe
correct answer in each of
the following MCQ.
1.
The main purpose of
costaccounting is to
a
Maximize profits
b
Help in
inventoryvaluation
c
Provide information to
managementfor decision
making
d
Aid in the fixation of selling
price;
2.
Fixed cost per
unitincreases when
a
Variable cost per
unitincrease
b
Variable cost per
unitdecreases
c
Production
volumeincreases
d
Production
volumedecreases
3.
Variable cost
perunit
a
Varies when
outputvaries
b
Remains constant
c
Increases when
outputincreases
d
Decrease when
outputdecreases
4.
Which of the followings is
the reason of increase in
total variable cost:
a
Increase in
fixedcost
b
Rise in interest on capital
c
Increase in direct material
cost
d
Depreciation of machinery
5.
Which of the followings is an
example of fixedcost:
a
Direct material cost
b
Works manager'ssalary
c
Depreciation of machinery
d
Chargeable expenses
9
Cost
& Management
Accounting(MGT-402)
VU
6.
Cost accounting
conceptsinclude all of the
followingexcept
a
Planning
b
Controlling
c
Sharing
d
Costing
7.
The three elements of
product cost are
allbut
a
Direct material cost
b
Factory overhead cost
c
Indirect
laborcost
d
Direct
laborcost
Answers:
Q1
Q2
Q3
Q4
Q5
Q6
Q7
c
d
b
c
c
c
c
10
Table of Contents:
- COST CLASSIFICATION AND COST BEHAVIOR INTRODUCTION:COST CLASSIFICATION,
- IMPORTANT TERMINOLOGIES:Cost Center, Profit Centre, Differential Cost or Incremental cost
- FINANCIAL STATEMENTS:Inventory, Direct Material Consumed, Total Factory Cost
- FINANCIAL STATEMENTS:Adjustment in the Entire Production, Adjustment in the Income Statement
- PROBLEMS IN PREPARATION OF FINANCIAL STATEMENTS:Gross Profit Margin Rate, Net Profit Ratio
- MORE ABOUT PREPARATION OF FINANCIAL STATEMENTS:Conversion Cost
- MATERIAL:Inventory, Perpetual Inventory System, Weighted Average Method (W.Avg)
- CONTROL OVER MATERIAL:Order Level, Maximum Stock Level, Danger Level
- ECONOMIC ORDERING QUANTITY:EOQ Graph, PROBLEMS
- ACCOUNTING FOR LOSSES:Spoiled output, Accounting treatment, Inventory Turnover Ratio
- LABOR:Direct Labor Cost, Mechanical Methods, MAKING PAYMENTS TO EMPLOYEES
- PAYROLL AND INCENTIVES:Systems of Wages, Premium Plans
- PIECE RATE BASE PREMIUM PLANS:Suitability of Piece Rate System, GROUP BONUS SYSTEMS
- LABOR TURNOVER AND LABOR EFFICIENCY RATIOS & FACTORY OVERHEAD COST
- ALLOCATION AND APPORTIONMENT OF FOH COST
- FACTORY OVERHEAD COST:Marketing, Research and development
- FACTORY OVERHEAD COST:Spending Variance, Capacity/Volume Variance
- JOB ORDER COSTING SYSTEM:Direct Materials, Direct Labor, Factory Overhead
- PROCESS COSTING SYSTEM:Data Collection, Cost of Completed Output
- PROCESS COSTING SYSTEM:Cost of Production Report, Quantity Schedule
- PROCESS COSTING SYSTEM:Normal Loss at the End of Process
- PROCESS COSTING SYSTEM:PRACTICE QUESTION
- PROCESS COSTING SYSTEM:Partially-processed units, Equivalent units
- PROCESS COSTING SYSTEM:Weighted average method, Cost of Production Report
- COSTING/VALUATION OF JOINT AND BY PRODUCTS:Accounting for joint products
- COSTING/VALUATION OF JOINT AND BY PRODUCTS:Problems of common costs
- MARGINAL AND ABSORPTION COSTING:Contribution Margin, Marginal cost per unit
- MARGINAL AND ABSORPTION COSTING:Contribution and profit
- COST – VOLUME – PROFIT ANALYSIS:Contribution Margin Approach & CVP Analysis
- COST – VOLUME – PROFIT ANALYSIS:Target Contribution Margin
- BREAK EVEN ANALYSIS – MARGIN OF SAFETY:Margin of Safety (MOS), Using Budget profit
- BREAKEVEN ANALYSIS – CHARTS AND GRAPHS:Usefulness of charts
- WHAT IS A BUDGET?:Budgetary control, Making a Forecast, Preparing budgets
- Production & Sales Budget:Rolling budget, Sales budget
- Production & Sales Budget:Illustration 1, Production budget
- FLEXIBLE BUDGET:Capacity and volume, Theoretical Capacity
- FLEXIBLE BUDGET:ANALYSIS OF COST BEHAVIOR, Fixed Expenses
- TYPES OF BUDGET:Format of Cash Budget,
- Complex Cash Budget & Flexible Budget:Comparing actual with original budget
- FLEXIBLE & ZERO BASE BUDGETING:Efficiency Ratio, Performance budgeting
- DECISION MAKING IN MANAGEMENT ACCOUNTING:Spare capacity costs, Sunk cost
- DECISION MAKING:Size of fund, Income statement
- DECISION MAKING:Avoidable Costs, Non-Relevant Variable Costs, Absorbed Overhead
- DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS
- DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS:MAKE OR BUY DECISIONS