Explain

• The effect of cost towards

business’ operations.
Define
Chapter 2 Objective • Cost classifications and their
effect towards decision
making process.
Cost & Cost classification
Distinguish
• Costs under different cost
classifications.
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Contents Cost definition

• Resources (material, labour…) that have

been “sacrificed” by the business in order to
Cost Cost attain specific objectives.
definition classification

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 Cost classification Cost classification
in relation with operational
• Classification = the arrangement of function
items in logical groups having
regard to their nature or purpose.
• Production cost
✓operational function
• Non-production cost
✓cost object
✓decision making
✓controllability
✓unit-of-production

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Production cost Production cost

Direct material cost is the cost of raw
Direct Material Direct Labour Overheads materials and components used to create a
product that must be easily identifiable with
the resulting product.

Product Ex: Radio set on a car

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 Production cost
Production Overheads
Direct labour costs are costs paid to employees who
produce product and these costs can be easily Production costs that cannot be directly attributed
traced back and assigned to individual product. to any specific product

Ex: Indirect production labour cost and indirect

material cost

Ex: Amount paid to assembling employees

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Production cost Non-production cost

Production costs could also be sub-classified as:

Administrative
Selling costs costs
Direct Direct Production
Material Labour Overheads
Cost Cost

Salaries of
Commission and executives,
distribution costs accounting costs,
Prime cost Conversion cost etc

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 Cost classification in relation with
Quick Check ✓ operational function

• Provide information to:

✓ Determine unit cost
✓ Control the application of standard
cost.

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Cost classification in relation to Cost classification in relation to

cost object cost object

• Costs that can be traced

directly to a specific cost
Direct costs Direct costs object (or cost center) such
as a department, process, or
product.

• Costs that are related to more

Indirect costs Indirect than one cost object (or cost
center). These costs would be
costs allocated on a reasonable
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basis. 16

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 Cost classification in relation to Cost classification in relation to
cost object
decision making

• Provide information to:

✓Determine standard unit cost • Differential costs.
✓Control the application of standard cost. • Sunk costs.
• Opportunity costs.

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Differential Costs Sunk Costs

• Every decision would involve as • Costs that has

least two options. already been incurred
• Differential costs: and thus cannot be
❑ Costs that incur in one option recovered. These
but not in others. costs are excluded
from future business
❑ Costs that incur in all options,
decision.
however, at different amounts
• Example?
• Differential costs are considered
when making decision.
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 Opportunity Costs

• The money or other benefits lost

when pursuing a particular
course of action instead of an
alternative.
• This is just an assumption; thus,
cannot be recorded in accounting Cost classification in relation to
books. However, Opportunity decision making
costs are still considered for
decision making. Provide information for decision making
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Controllable cost is
Cost classification
the cost that manager according to the
could have an controllability
Cost influence on it.
classification Provide information
according to for performance
the evaluation.
controllability Uncontrollable cost is
the cost that manager
doesn’t have an
influence on it.
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 Cost
classification ❑Variable costs.
in relation ❑Fixed costs. • Variable costs are costs that changes
according to the change of unit of
with unit-of- ❑Mixed costs.
production production.
• In a manufacturing business,
✓Unit of production could
variable costs include direct material
be producing units, Variable cost cost, direct labour cost and energy
sales units, machine
cost.
hours or revenue
earned... • In trading business, variable costs
include cost of goods sold and
commission fee.

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• Linear variable cost:

this is the costs that go Variable cost
up or down as unit of
production increases or
decreases as
Variable cost demonstrated by the Total
variable
Variabl
e Unit
linear relationship. cost
y = ax
Cost
However, variable cost
y=a
over a unit of
production would
remain constant.
Unit of production Unit of production

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 Variable cost

• Fixed cost: A fixed cost is a cost

Step variable cost: is a cost that generally that does not vary in the short
varies with the level of activity, but which term, irrespective of changes in
tends to be incurred at certain discrete points unit of production. However, fixed
and to involve large changes in amounts Fixed cost cost over a unit of production
when such a point is reached. (average fixed cost) would
decrease when the unit of
production increase.

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Fixed cost
Discussion task

➢Why do we could have lower price per unit with

Total Average higher quantity of order?
fixed fixed
cost cost ➢Why does telecommunication expenditure
become cheaper nowadays?
AFC = C/ x ➢Why do big, multination company could take
TFC = C the market share from the smaller companies
easily?

Unit of production Unit of production

(X)

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 Mixed cost example
Mixed cost
➢A business hires a car. Under the agreement, the business has
Mixed cost could be to pay a fixed amount of $40,000 per year. In addition, for every
presented as: mile usage, an extra amount of $4 is required.
Y = ax + b Cost ➢Given that, in last year, the car has been driven for 2,500 miles,
the amount of payment would be:
Variable
part Y = ax + b
= 4x + 40,000
Fixed = 4*2,500 + 40,000
part
= $50,000
Unit of production

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Split a mixed cost Split a mixed cost:

high-low method
➢In order to aid the management with the
✓The high-low method’s key principle is that the
planning task, mixed cost need to be split into line that represent mixed cost would cross the
its fixed and variable components. highest and the lowest point of unit-of-
➢There are several techniques could be used, production.
such as:
✓High-low method.
✓Scatter graph.
✓Regression analysis.

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Ex: A company has kept the information for maintaining cost Split a mixed cost:
for this current year: high-low method
Unit-of-production Mixed cost
Highest 8,000 20,000
Month Labour Hours (Hour) Cost ($1,000)
Lowest 5,000 14,000
1 5,500 14,900
Difference 3,000 6,000
2 7,000 17,000
3 5,000 14,000 Difference of cost 6.000
4 6,500 16,400 Unit variable cost = = = 2
5 7,500 19,200 Difference of unit-of- 3.000
production
6 8,000 20,000
Replace this result into the highest or the lowest point:
7 6,000 16,500
The highest: 20,000 – (8,000 x 2) = 4,000
The lowest: 14,000 – (5,000 x 2) = 4,000
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So the line that represent the mixed cost is y = 2x +4,000 38

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Split a mixed cost: Split a mixed cost:

scatter graph method scatter graph method

Y Y
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* ** * * ** *
Mixed cost

Mixed cost

* * * *
($1,000)

($1,000)

** **
10 * * 10 * * Estimated fixed cost

0 X 0 X
0 1 2 3 4 0 1 2 3 4
Unit-of-production (‘000) Unit-of-production (‘000)
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 Split a mixed cost: Split a mixed cost:
scatter graph method regression analysis

Y
X
Y = a + bx
20
* ** *
X X X

Total mixed cost Y

Mixed cost

* * X X X
($1,000)

X
** X X

10 * *
Difference of
X
X
X
X
X

unit-of- Difference of cost X

X
production
0 X
0 1 2 3 4
Unit-of-production (‘000)
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Split a mixed cost: Split a mixed cost:

regression analysis regression analysis
n∑XY -∑X∑Y
- It is our goal to set out the line y = ax + b
b= ----------------- - Therefore, we have to solve the following simultaneous linear
n∑X2 – (∑X)2 equations:
∑xy = a ∑x² + b ∑x (1)
∑y = a ∑x + n b (2)
[ n∑XY -∑X∑Y]2 Y1 = a + bx1 y: mixed cost
R2 = ---------------------------------- --- x: unit of production
[n∑X2 – (∑X)2] [n ∑Y2 – (∑Y)2] Yn = a +bxn a: unit variable cost
b: total fixed cost
n: observation times

a = (∑y - b∑x)/n
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Ex: A company has kept the information for maintaining cost
for this current year:
Hours Cost
Month (n) xy x²
(x) (y)

Month Labour Hours (Hour) Cost ($1,000) 1 5.50 14.90 81.95 30.25
1 5,500 14,900 2 7.00 17.00 119.00 49.00
2 7,000 17,000 3 5.00 14.00 70.00 25.00
3 5,000 14,000 4 6.50 16.40 106.60 42.25
4 6,500 16,400 5 7.50 19.20 144.00 56.25
5 7,500 19,200
6 8.00 20.00 160.00 64.00
6 8,000 20,000
7 6.00 16.50 99.00 36.00
7 6,000 16,500
TỔNG 45.50 118.00 780.55 302.75

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Cost Provide information to:

classification • Plan and control cost.
in relation • Analyse the
relationship of Cost-
with unit-of- Volume-Profit (CVP).
production • Prepare contribution
margin income
statement.

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