TOPIC Cost terms,

2a Concepts and
Classifications

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After studying this chapter, you should be able to:
* Explain cost terms such as cost, cost object, cost
unit and cost centre.
* Classify costs according to their traceability,
behaviour, function, external financial reporting,
controllability and relevance in making business
decisions.
* Allocate manufacturing overhead costs to products.
* Compute cost of goods manufactured and sold.

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*Cost is a resource sacrificed or foregone to achieve a

specific objective.
*Cost is usually expressed as the monetary amount that
must be paid in exchange for acquired goods and
services.

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Actual vs. Budgeted Cost:
*Actual cost—a cost that has occurred
*Budgeted cost—a predicted or planned cost

Cost vs. Expenses:

*Costs—sacrificed resource to achieve a specific
objective
*Expenses are expired costs

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* Cost object—anything of interest for which a cost is
desired
* Any item such as products, customers, departments,
projects, activities, and so on, for which costs are
measured and assigned.
* A cost object can be any unit of analysis including
product, product line, customer, department, division,
geographical area, or country
* Example: A car is a cost object if we are determining
the cost to produce a car.

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* A cost unit is a quantitative unit of either a product or
service in relation to which costs can be computed.
* The cost per unit is the amount of total cost divided by
the total output.
* Example: For a delivery company, an appropriate cost
unit is the cost per kilometer of delivery; for a
university—cost per student enrolled; for electricity
generator company—cost per kilowatt of electricity

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* A cost centre is a part of the organization which is
responsible only for the amount of costs incurred in that
particular centre.
* Examples of cost centres are divisions which provide
services such as maintenance and computing services.
* Although these service centres do not manufacture
products, they provide essential services like repairs and
maintenance.
* When providing the services, they have to be
accountable for costs incurred.

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*By Traceability
*By Behaviour
*By Function
*For Financial reporting
*For Performance evaluation
*For Decision-making

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* Direct and Indirect Costs:
Direct costs
 can be conveniently and economically traced (tracked) to a cost
object
 can be specifically identified with a cost object
 examples: Cost of wood used in making dining table, cost of flour in
roti canai
Indirect costs
 cannot be conveniently or economically traced (tracked) to a cost
object
 acquired or used by more than one cost object
 due to the difficulty to trace, indirect costs need to allocated to a cost
object
 examples: Costs of screws to make dining table, costs of cook’s
salary in making roti canai

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* Cost allocation is the process of sharing the indirect costs
among the cost objects.
* It is a process of giving some portion of indirect costs to the
cost object.

Indirect Cost allocation

costs Cost object
e.g. rental e.g. product line:
of factory dining table

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*Cost behaviour refers to the way in which costs change

with the changes in the levels of activity or volume of
production.
*Three behaviour of costs:
*Variable Costs
*Fixed Costs
*Semi-variable Costs

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*Variable costs: Changes in total in proportion to changes
in the related level of activity or volume
*Fixed costs: Remain unchanged in total regardless of
changes in the related level of activity or volume
*Semi-variable Costs: Have both variable and fixed
behaviour—thus, also called mixed costs

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*Total variable cost varies in direct proportion to volume.
*Since total variable cost varies directly and
proportionately with volume, variable cost per unit is
constant.
*Variable cost per unit is constant but total variable cost is
not constant.

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*Total fixed costs remain constant with volume but with

more units, the same fixed cost is spread over more and
more units, reducing the cost per unit.
*Hence, total fixed costs remain constant but fixed cost
per unit reduces as production increases, i.e. fixed cost
per unit will vary at different levels of activity.

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*Costs are fixed or variable only with respect to a

specific activity or a given time period.
*This specific activity is called relevant range.
*Assumptions of cost behaviour only applies over the
activity within the relevant range.

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*Three methods to separate fixed from variable costs:

–High-low method
–Scattergraph method
–Least-squares Regression Method

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* Identify the highest and lowest volume or points.

* Compute difference in cost at these highest and lowest
volumes
* Divide by changes in volume to determine the variable
cost per unit
* Calculate the total variable costs at that specific volume
* Deduct total variable from total cost to determine total
fixed costs

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* Plot on the graph the different costs at various levels

of activity
* The best fit line is drawn approximately, use
judgment so that an equal number of points fall
above and below the line
* The line of best fit is called the regression line
* The y-intercept of the regression line shows total
fixed costs while the slope of line is the variable cost
per unit

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* Similar to scattergraph method but uses mathematical

formulae rather than visual inspection to fit the regression
line
* Differences or deviations of observed data points to the
regression line are measured vertically
* Vertical distance is the difference between the actual cost
and the cost predicted by the line or cost function called
regression errors
* Regression line is computed as that which minimizes the
sum of the squared errors

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*Two functions: Manufacturing and Non-manufacturing

*Manufacturing costs:
*Direct Materials
*Direct Labour
*Factory/Manufacturing Overhead

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* Non-manufacturing costs:
*Selling expenses
*Administrative expenses
*Marketing expenses

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* Materials that are directly traceable to the goods or

services being produced.
* Examples:
*Flour in roti canai
*Steel in an automobile
*Wood in dining table

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* Labour that is directly traceable to the goods or services

being produced.
* Examples: Wages paid to workers who only
manufacture the dining tables
*(note: dining table is the cost object)

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* Factory overhead are indirect manufacturing costs

* Examples include:
– Depreciation on building and equipment
– Maintenance
– Supplies
– Supervision (salary of plant manager)
– Factory utilities
– Property taxes

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Product vs Period Costs:

*Product Costs
*Reported as asset inventory but later as expenses
when the inventory is sold
*Sum of the three elements of manufacturing cost:
Direct materials cost
Direct labour cost
Factory overhead cost

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* Period Costs:
*Period/Non-inventoriable cost
*Non-manufacturing costs such as selling,
administrative and marketing expenses
*The whole amount shown as expenses in the income
statement

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 Manufacturing and Non-
Manufacturing Costs

Total Costs

Manufacturing Cost Non-Manufacturing Cost

Product Cost Period Cost

Direct Direct Factory Selling Exp Adm Exp Mkting Exp

Material Labour Overhead

Prime Costs Conversion Costs

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Controllable or uncontrollable costs:

* Controllability refers to whether manager can control
and consequently, be held accountable
* Controllable costs are within the influence of the
manager and hence, included for performance
evaluation
* Uncontrollable costs are beyond the influence of the
manager and hence, excluded for performance
evaluation

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Relevant vs irrelevant costs:

* Relevant costs are relevant and are therefore included
or considered for decision-making.
* Relevant costs are affected by the choice of
alternatives in the decision-making process and are
costs that will incur in future.
* Irrelevant costs are costs that have incurred or remain
unaffected by the decision.
* Irrelevant costs are historical or past costs and will not
change with the decision thus, are not relevant for
decision-making.

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 Avoidable and unavoidable costs:
* Avoidable costs are future costs which can be
changed.
* Unavoidable costs are past costs which cannot be
changed or costs which will continue in the future,
thus are irrelevant.
* Avoidable costs are relevant costs because these
costs are future costs which have not been
incurred. Examples of avoidable costs are variable
or incremental costs and opportunity costs.

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Differential and non-differential costs:
* Differential costs are costs that will differ in amount at the
different decision-making alternatives.
* Non-differential costs are the costs that do not differ with
the choice of alternatives.
* Only costs that will change by the decisions to be made
and are yet to be incurred are relevant. Differential costs
such as variable costs are relevant.

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Opportunity and Sunk Costs:
* Opportunity costs do not involve cash outlay because
they are valued as the forgone benefits. Since
opportunity costs will change by the decisions to be
made and are yet to incur, opportunity costs are
classified as relevant cost for decision-making.
* Sunk cost due to being historical or past cost is
irrelevant cost

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