Learning objectives

LO1: Understand costs concepts and terms

LO2: Describe the components of conventional and
contemporary management accounting systems;
LO3: Analyse costs using the classifications
commonly used in manufacturing businesses;
LO4: Classify costs according to cost behaviour and
apply the classification in preparing reports.

2-2
 Cost definition
• What are costs?
• Resources given up to achieve a particular
objective
• In financial accounting
• if the benefit extends beyond the current accounting
period these costs are classified as assets
• If the benefit is used up in the generation of revenue,
the costs are classified as expense
• Measured in monetary terms

3
 Emphasis on costs
• Why do management accountants pay so much attention
to costs?
• Historic focus on production costs—to value inventory
and cost of goods sold for external reporting
• Ready availability of cost data within the transaction-
based accounting system
• Importance of cost information in managers’ decisions

• Non-financial information assumes increased importance

in contemporary management accounting systems
• Used to make decisions and manage various sources of
customer value and shareholder wealth 4
1

2 3 4

2-5
2-6
 Cost classifications
“different classifications for different purposes”

• Before classifying costs, consider how managers

intend to use the information
• Different costs and classifications are used for
different purposes
• The same cost can be classified in a number of
ways depending on the intended use of the cost
information

7
 Cost classifications
• according to function: production costs and period
costs/ manufacturing costs and non-manufacturing
costs
• according to identifiability/traceability with cost
units: direct costs and indirect cost/ traceable costs
and common costs
• according to their behaviour/variability: variable
costs, fixed costs or mixed costs)
• according to controllability: controllable costs and
uncontrollable costs
• Classification on the basis of time: historical costs 8
and pre-determined costs
 Classifying costs according to
function/financial reporting
 Manufacturing costs: are incurred within the
factory area. They are the costs of the sequence
of operations which begin with supplying
materials, labour and services and end with
completion of production. They appear on the
income statement as cost of goods sold and on
the balance sheet as inventory.
 Non-manufacturing costs: the costs of resources
used during accounting period that are not
assigned to products. They appear as operating
9
expense on the income statement.
 Classifying costs according to
function/financial reporting
Manufacturing vs non- manufacturing costs
Manufacturing costs are incurred within the factory
area. This is the cost of the sequence of operations
which begins with supplying materials, labour and
services and ends with completion of production.
+ Manufacturing costs include three categories:
direct material, direct labour and manufacturing
overhead
+ Under conventional product costing, only
manufacturing costs are included in product costs
10
 Classifying costs according to
function/financial reporting
Manufacturing costs
• Direct material costs
Direct material costs are the costs of raw materials or parts that go
directly into producing products. For example, if Company A is a toy
manufacturer, an example of a direct material cost would be the plastic
used to make the toys.
• Direct labor costs
Direct labor costs are the wages, benefits, and insurance that are paid to
employees who are directly involved in manufacturing and producing
the goods – for example, workers on the assembly line or those who use
the machinery to make the products.
• Manufacturing overhead costs
Manufacturing overhead costs include direct factory-related costs that 11
are incurred when producing a product, such as the cost of machinery
and the cost to operate the machinery. Manufacturing overhead costs
12
 Classifying costs according to
function/financial reporting
Product costs vs Period costs

• Product costs include all costs involved in acquiring or

making a product. In the case of manufactured goods,
these costs consist of direct materials, direct labor, and
manufacturing overhead.
• Period costs are all the costs that are not product costs.
All selling and administrative expenses are considered to
be period costs.

13
 Classifying costs according to
function/financial reporting
Product costs vs Period costs

• 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.

14
 Classifying costs according to
function/financial reporting
Period costs

• 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 dispatch and ends with
making the re-conditioned returned empty package
for re-use. 15
16
• Manufacturing costs vs non-manufacturing costs
• Product costs vs period costs

Manufactoring costs = Product costs ?

Non-manufactoring costs = Period costs ?

17
 Classifying costs according to
function/financial reporting
Conversion costs vs Prime costs

• Conversion costs
• The total of direct labour cost and manufacturing
overhead cost
• The cost of converting material into a product

• Prime costs
• The total of direct material cost and direct labour
cost
• The major cost associated with producing a 18
product
 Classifying costs according to
function/financial reporting
Manufacturing costs
Manufacturing costs are often
combined as follows:

1-19
Direct Direct Manufacturing
Material Labor Overhead

Prime Conversion
Cost Cost
20
Example 1: ALD Manufacturing Company produces
12,000 products a year. Each product requires 3kg of
materials A at £10 per kg, and 5kg of materials B at £5
per kg. The product requires 1 hours of labour at £ 12
per hour. Supervisor costs, factory rental costs and
other fixed production costs are £80,000 per annum.
Selling, distribution and administration costs are £
30,000 per annum.

• What is the prime cost of the product?

• What is conversion cost of the product?
21
• What is the production cost of the product?
 Example 2: The following data for 20X1 relates to Heartstrings
Pty. Ltd
Direct material used in production £550,000
Rental of office space for sales personnel £7,500
Fringe benefits for production supervisor £ 4,500
Direct workers overtime premiums paid £27,500
Advertising expense £60,000 Direct workers £290,000
Depreciation on factory building £ 57,500 Indirect workers £85,000
Service-department costs £50,000 Cost of idle time £20,000
Production supervisor’s salary £ 22,500 Promotion costs £5,000
Administrative costs £75,000 Sales commissions £2,500
REQUIRED: Calculate each of the following costs for 20X1.
A. total prime costs. B. total manufacturing overhead costs.
C. total conversion-costs. D. total product costs.
E. total period costs.

22
Classifying costs according to traceability with cost units
Direct and indirect costs
A cost object is something for which a cost is
compiled, such as a product, service, customer, project,
or activity.

 Direct Costs: Those costs that can be specifically

and exclusively identified with a particular cost
object.
 Indirect Costs: Those costs which can not be
identified specifically and exclusively with a given
cost object.
23
Classifying costs according to traceability with cost units
Direct and indirect costs
- Manufacturing costs that can be traced to products in an economic
manner are direct product costs: Raw material, wages on labor,
production overheads, rent on the factory
- Manufacturing costs that cannot be traced to products in an economic
manner are indirect costs
Examples: Manufacturing overhead cost as indirect costs
+ Indirect materials: Indirect materials are materials that are used in
the production process but that are not directly traceable to the
product. For example, glue, oil, tape, cleaning supplies, etc. are
classified as indirect materials.
+ Indirect labor: Indirect labor is the labor of those who are not
directly involved in the production of the products. An example would
be security guards, supervisors, and quality assurance workers in the 24
factory. Their wages and benefits would be classified as indirect labor
costs.
Classifying costs according to identifiability with cost units

Direct and indirect costs

• Responsibility centres
• A responsibility centre is a unit of an organisation
where the manager is held accountable for the
unit’s activities and performance
• The costing system may measure the costs of
managers’ individual areas of responsibility
• Costs that can be traced to a particular
responsibility centre are direct costs of that centre
• Costs that relate to responsibility centres but
cannot be traced precisely to specific responsibility 25
centres are indirect costs of those centres
 Discussion
Choose a manufacturing company
1. Determine manufacturing costs for goods
produced
2. Analyze impacts of manufacturing costs to
financial statements with assumption of suitable
data of costs

26
Classifying costs according to traceability with cost units
Example 3: overtime and idle time
Given below are the labour costs incurred by a
manufacturing business for the week commencing 23
July 20X5.
Direct production workers 1,200 hours @ $6.40 per hour
Direct production workers overtime hours 200 @ $9.40
per hour
Indirect workers 400 hours @ $5.20 per hour
Indirect workers overtime hours 50 @ $8.00 per hour
Of the hours paid to the direct production workers 40 of
these were idle time hours.
1. What types of costs above that classifying according
to function? 27
2. What is the total for direct labour and indirect labour
for the week?
Classifying costs according to traceability with cost units

Practice 1: overtime and idle time

During the week ending 30 June 20X3 the direct
production workers in a factory worked for 840
hours in total. Of these hours 60 were idle time
hours and 100 were overtime hours. The hourly rate
of pay is £8.00 with overtime hours being paid at
time and a half.
During the same week the indirect workers worked
for 120 hours at a rate of £6.00 per hour with no
overtime hours.
28
What is the direct labour cost and the indirect
labour cost for the week?
Controllable and uncontrollable costs

• Managers’ performance evaluation can be enhanced

by classifying responsibility centre costs as either
controllable by the manager or uncontrollable

• Ideally, managers should be held responsible only for

costs they can control or significantly influence

• Some costs are controllable in the long term but not in

the short term
29
2-30
Cost behaviour, cost drivers, and cost
estimation

31
 Classifying costs according to their
behaviour
• Managers must understand how costs change as the
level of activity in the business changes
• The level of activity is the level of work
performed in the organisation
• Units produced, kilometres driven, hours worked
• Variable costs
• Change in total in direct proportion to a change in
the level of activity
• Fixed costs
• Remain unchanged in total despite changes in the 32
level of activity
• Cost behaviour
• The relationship between a cost and the level of
activity or cost driver
• Cost estimation
• The process of determining the cost behaviour of
a particular cost item
• Cost prediction
• Using knowledge of cost behaviour to forecast
the level of cost at a particular level of activity

33
 The point of cost drivers…
• Cost behaviour
• The relationship between a cost and the level of
activity or cost driver
• Behaviour is understood in terms of cost drivers
• Cost estimation
• The process of determining the cost behaviour of
a particular cost item
• Potential drivers are identified and the preferred
one selected through the process of cost
estimation
• Cost prediction
• Using knowledge of cost behaviour to forecast
34
the level of cost at a particular level of activity
• Drivers are used to predict costs
 Cost drivers
• A cost driver
• An activity or factor that causes costs to be incurred
• The higher the correlation between the cost and the
cost driver, the more accurate is the description and
understanding of cost behaviours
• Conventional approaches
• Variable costs are assumed to vary in proportion
to the level of production or sales volume
• Fixed costs remain unchanged as production
volumes increase or decrease
• Volume-based cost drivers include units
produced, direct labour hours, direct labour cost 35
and machine hours
 Cost drivers (cont.)

• Contemporary viewpoints recognise that there are

a range of possible cost drivers other than
production volume
• A non-volume cost driver is a cost driver not
directly related to production volume
• Activity-based approaches classify activities
and costs into four levels
• Unit
• Batch
• Product
36
• Facility
 Cost drivers (cont.)
• Unit level costs
• Relate to activities performed for each unit
produced
• Use conventional volume-based cost drivers
• Batch level costs
• Relate to activities performed for a group of
product units, such as a batch or a delivery load
• Product (or product-sustaining) level
• Relates to activities performed for specific
products or product groups
• Facility level
• Costs incurred to run the business, not caused by 37

any particular product

 Cost drivers (cont.)

• When choosing cost drivers the costs and benefits

of each driver must be assessed, taking into
account
• Reasons for analysing cost behaviour, such as
cost prediction, product costing, cost
management, pricing
• Timeframe for analysing the cost behaviour
(short term or long term)
• Availability of data on cost drivers
• Any other uses that the cost behaviour
information might serve 38
Activities that cause costs to be incurred are called COST DRIVERS

Cost Driver Examples

Activity Cost Driver(level of activity)

1-39
Machining operations Machine hours
Setup Setup hours
Production scheduling Manufacturing orders
Inspection Pieces inspected
Purchasing Purchase orders
Shop order handling Shop orders
Valve assembly support Customer Requisitions
3-40
 Cost behaviour patterns

• Cost behaviour
• The relationship between a cost and the level of
activity (or cost driver)

3-41
• Cost behaviour patterns
• Variable costs
• Fixed costs
• Step-fixed costs
• Mixed costs: Semi variable costs and
curvilinear costs
3-42
3-43
3-44
3-45
3-46
Cost

Y =x a
Y = ax +b
Y = logx

0 min max Activity level

47
Examples?
 Example
The following table shows the costs during a month if 600
mufflers are replaced
Number of muffler replacements 500 600 700
Fixed Costs (a) £ 84 000 (b)
Variable costs (c) £ 60 000 (d)
Total costs (e) £ 144 000 (f)

Cost per muffler replacement:

Fixed cost (g) (h) (i)
Variable cost (j) (k) (l)
Total cost per replacement: (m) (n) (o)
48
Required: Fill in the values labelled (a) to (o) in the table
 Fixed costs Variable costs
Level of
activities
Total Unit Total Unit

49
 Chi phí variable
2.4 Mixed costs-Semi hỗn hợpcosts

Y = ax + b

Y = ax + b

50
2.4
Y = ax + b
Cost

Y = ax + b

Y=ax

Y=b

Activity level

51
The mixed cost equation: Y = ax + b
Y: Total cost(mixed cost)
x: level of activity (cost driver)
a: variable cost per unit
ax: total variable cost
b: total fixed cost

52
 Mixed cost-Semi-variable costs
Step 1: Determine cost driver and total costs at:
Highest activity point and Lowest activity point
Step 2: Calculate Variable cost per unit (coefficient a)

Step 3: Calculate Fixed costs

Fixed cost = Highest activity cost – (Variable cost per
unit x Highest activity units);
Or
Fixed cost = Lowest activity cost – (Variable cost per 53
unit x Lowest activity units)
Example: High Low method
The prior year’s costs for diagnostic blood test are as follows:
Month Number of blood tests Cost
January 6,100 £90,000
February 5,300 £87,000
March 4,900 £76,200
April 4,800 £78,100
May 5,050 £80,700
June 3,050 £58,000
July 4,500 £74,500
August 7,100 £114,000
September 6,200 £95,600
October 4,700 £74,800
November 5,900 £89,000
December 6,000 £91,000 54
Required: Use the high–low method to estimate the company’s
electricity cost behaviour and express it in equation form.
Warmth Co. produces towels. The following data shows the
company's activities during the last six months:
The company uses the high-low method to estimate the
variable cost per unit and the fixed cost component of mixed
costs. Month Total Production (Units) Total production Cost (£)
January 4,000 55,500
February 6,000 84,000
March 9,000 98,000
April 8,500 93,000
May 9,500 105,000
June 7,300 88,000
•Compute the variable element production cost of per unit.
•Compute the fixed element of production cost.
•What is production cost formula? 55
•If production units in July are 8,000, what is the total
production cost?
56
Example: Prepare Statement of Comprehensive income
• Costs of good sold include: (in £)
• Direct materials: 600,000
• Direct labour: 200,000
• Wages for factory supervisor (pay per month) 100,000
• Maintenance costs
(according to no. of product): 50,000
• Straight line depreciation : 150,000
• Total packing costs (is calculated
according to number of products sold) 50,000
• Other manufacturing costs: 50,000
• Variable selling costs: 150,000
• Variable administration costs: 200,000
• Fixed selling costs 50,000 57
• Fixed administration costs 300,000
 3.
In £
1. Revenue (1000 units) 2,000,000

58
 3.
In £’000
1. Revenue 2.000.000

59
 Jan Feb Mar
COGs 462,000 548,000 711,000
- Direct materials costs
240,000 300,000 420,000
- Direct labour costs 132,000 158,000 201,000
- Manufacturing overheads costs 90,000 90,000 90,000
Selling costs 127,000 142,000 166,000
- Advertising costs 45,000 52,000 60,000
- Building renting costs 40,000 40,000 40,000
- Wages 32,000 40,000 56,000
- Others 10,000 10,000 10,000
Administration costs 180,000 180,000 180,000
Level of activities (units) 8000 10.000 14.000

1. Classify the above costs into variable costs, fixed costs and
mixed costs
60
2. Prepare an Managerial Income statement of March, the
revenue in March was £1,500,000
 Question: Prime cost
A service for a sports car requires 3 hours of a skilled mechanic’s
time followed by 1/2 hour of unskilled labour. Rates of pay are
(a) Skilled: £9 per hour
(b) Unskilled: £5 per hour
Oil, oil filter, screen wash and spark plugs cost £6.90 in total.
Rent and rates for the industrial unit from which the service
centre operates, work out at £4 per hour. Administration costs are
£2 per service.
The prime cost of the service is
A £29.50
B £36.40
C £50.40
D £52.40 61
Exercise: High – low method

62
 In £’000 Jan Feb Mar
- Direct materials costs 210.000 270.000 330.000
- Direct labour costs 140.000 180.000 220.000
- Manufacturing overheads 80.000 80.000 80.000
- Advertising cost 42.000 54.000 66.000
- Selling stores renting cost 30.000 30.000 30.000
- Selling wages 38.000 42.000 58.000
- Administration cost 150.000 150.000 150.000
Number of products sold 7.000 9.000 11.000
(units)
1. Classify the above costs into variable costs, fixed costs and
mixed costs.
63
2. Prepare an Managerial Income statement in March. The
revenue in March is £1,500,000.
Question 1. Which of the following statements is true?
A. The word cost has the same meaning in all situations in which it is used.
B. Cost data, once classified and recorded, can be used for any purpose.
C. Different cost concepts and classifications are used for different purposes.
D. All organisations incur the same types of costs.
E. None of the above.
Question 2. Which of the following statements is true? A cost is:
A. Always an expense.
B. Always an asset.
C. Something quite different from either an expense or an asset.
D. Can be either an expense or an asset.
E. Always a liability.
Question 3. Management accountants have concentrated mainly on cost data
because:
A. Cost data is all that is needed for planning and control purposes.
B. Qualitative information is not readily available.
C. Qualitative information is not relevant for planning and control purposes.
2-64
D. Cost data is readily available from the accounting information system
E. All of the above.
1. Review Problem 1: Cost Terms-page 55
2. Review Problem 2: Schedule of Cost of Goods
Manufactured and Income Statement-page 56
3. EXERCISE 2–3 Classification of Costs as Period or Product
Cost-page 60
4. EXERCISE 2–4 Constructing an Income Statement-page 60
5. EXERCISE 2–6 Classification of Costs as Fixed or
Variable-page 60
6. Review Problem 1: Cost Behavior-page 98
7. Review Problem 2: High-Low Method-page 99
8. EXERCISE 3–5 Cost Behavior; Contribution Format
Income Statement-page 103
9. EXERCISE 3–8 High-Low Method; Predicting Cost-page
104