VRS & YRN COLLEGE :: CHIRALA

I.Mcom – I Semester
Accounting For Managers
Unit II

 Cost concepts – & Classification of cost - (Fixed, Variable,

semi variable) :

1. Accounting costs - Accounting costs are those for which the

entrepreneur pays direct cash for procuring resources for
production. These include costs of the price paid for raw materials
and machines, wages paid to workers, electricity charges, the cost
incurred in hiring or purchasing a building or plot, etc. Accounting
costs are treated as expenses. Chartered accountants record them
in financial statements.
2. Economic costs- There are certain costs that accounting costs
disregard. These include money which the entrepreneur forgoes but
would have earned had he invested his time, efforts and
investments in other ventures.
3. Opportunity costs- Opportunity costs are incomes from the next
best alternative that is foregone when the entrepreneur makes
certain choices.
4. Outlay costs- The actual expenses incurred by the entrepreneur in
employing inputs are called outlay costs.
5. Direct costs- Direct costs are related to a specific process or
product. They are also called traceable costs as we can directly
trace them to a particular activity, product or process.
6. Indirect costs- Indirect costs, or untraceable costs, are those which
do not directly relate to a specific activity or component of the
business.
7. Sunk costs- Suck costs are costs which the entrepreneur has
already incurred and he cannot recover them again now. These
include money spent on advertising, conducting research, and
acquiring machinery.
8. Fixed costs- Fixed costs are those which do not change with the
volume of output. The business incurs them regardless of their level
of production. Examples of these include payment of rent, taxes,
interest on a loan, etc.
9. Variable costs- These costs will vary depending upon the output
that the business generates. Less production will cost fewer
expenses, and vice versa, the business will pay more when its
production is greater. Expenses on the purchase of raw material and
payment of wages are examples of variable costs.

 Cost Behaviour – Cost behaviour is an indicator of how a cost will

change in total when there is a change in some activity. In cost
accounting and managerial accounting, three types of cost
behaviour are usually discussed:
 Variable costs. The total amount of a variable cost increases in
proportion to the increase in an activity. The total amount of a variable
cost will also decrease in proportion to the decrease in an activity.
Formula
Variable Cost = Total variable cost/Units Produced
Example: An example of a variable cost is the cost of flour for a
bakery that produces artisan breads. The greater the number of loaves
produced, the greater the total cost of the flour used by the bakery.

Fixed costs. The total amount of a fixed cost will not change when an
activity increases or decreases
Fixed Cost = Total fixed cost/Units Produced
Example: An example of a fixed cost is the depreciation and insurance
on the bakery facility and equipment. Regardless of the quantity of
artisan breads produced in a month, the total amount of depreciation
and insurance cost for the month will remain the same.

Mixed or semi variable costs. These costs are partially fixed and
partially variable

 Cost volume analysis –

Introduction:

CVP analysis looks at the effect of sales volume variations on costs and
operating profit. The analysis is based on the classification of expenses as
variable (expenses that vary in direct proportion to sales volume) or fixed
(expenses that remain unchanged over the long term, irrespective of the
sales volume). Accordingly, operating income is defined as follows:

Operating Income = Sales – Variable Costs – Fixed Costs

A CVP analysis is used to determine the sales volume required to achieve

a specified profit level. Therefore, the analysis reveals the break-even
point where the sales volume yields a net operating income of zero and
the sales cutoff amount that generates the first dollar of profit.

Cost-volume profit analysis is an essential tool used to guide managerial,

financial and investment decisions.

Cost-Volume Profit Analysis-

Cost-volume-profit analysis or CVP analysis, also known as break-even

analysis, is a financial planning tool leaders use to create effective short-
term business strategies.

It conveys to business decision-makers the effects of changes in selling

price, costs, and volume on profits (in the short term).
Financial planning and analysis (FP&A) leaders commonly apply CVP to
break-even analysis.

Simply put, break-even analysis calculates how many sales it takes to pay
for the cost of doing business to reach a break-even point (neither making
nor losing money).

CVP analysis formula- The formula for the CVP analysis is:

Break-even sales volume = FC / CM

FC is the fixed costs and CM is the contribution margin per unit, or sales
revenue minus all variable costs.

Key components of CVP analysis- A CVP analysis features several

components that require different calculations. These components
include:

Fixed costs: These are any costs that remain the same in the short-term,
unaffected by a change in sales or production. This includes things like
renting equipment or advertising products.

Variable costs: This includes any costs that are variable or change over
time in the short-term, such as the price of raw materials or labour costs.

Contribution margin: A numeral calculated when subtracting the total

variable costs from the revenue of the company.

Contribution ratio: The contribution margin when it’s represented as a

percentage, after dividing the numeral by the unit selling price.

Sales volume: A figure that represents the total amount of products that
a company sells over a specified time period.

Break-even point: This is the result when the cost of production and
revenue generate equilibrium. A company isn’t making a profit here, but
they aren’t losing revenue either.

Selling price: This is a cost figure representing the total amount

customers pay for the final product.

 What Is Break-Even Analysis?

A break-even analysis is a financial calculation that weighs the costs of a

new business, service or product against the unit sell price to determine
the point at which you will break even. In other words, it reveals the point
at which you will have sold enough units to cover all of your costs. At that
point, you will have neither lost money nor made a profit.

How Break-Even Analysis Works?

A break-even analysis is a financial calculation used to determine a
company’s break-even point (BEP). It is an internal management tool, not
a computation, that is normally shared with outsiders such as investors or
regulators. However, financial institutions may ask for it as part of your
financial projections on a bank loan application.

 The formula takes into account both fixed and variable costs relative
to unit price and profit. Fixed costs are those that remain the same
no matter how much product or service is sold. Examples of fixed
costs include facility rent or mortgage, equipment costs, salaries,
interest paid on capital, property taxes and insurance premiums.
 Variable costs rise and fall according to changes in sales. Examples
of variable costs include direct hourly labor payroll costs, sales
commissions and costs for raw material, utilities and shipping.
Variable costs are the sum of the labor and material costs it takes to
produce one unit of your product.
 Total variable cost is calculated by multiplying the cost to produce
one unit by the number of units you produced. For example, if it
costs $10 to produce one unit and you made 30 of them, then the
total variable cost would be 10 x 30 = $300.

When to Use a Break-Even Analysis?

1.Expanding a business

Break-even points (BEP) will help business owners/CFOs get a reality

check on how long it will take an investment to become profitable. For
example, calculating or modeling the minimum sales required to cover the
costs of a new location or entering a new market.

2. Lowering pricing

Sometime businesses need to lower their pricing strategy to beat

competitors in a specific market segment or product. So, when lowering
pricing, businesses need to figure out how many more units they need to
sell to offset or makeup a price decrease.

3. Narrowing down business scenarios

When making changes to the business, there are various scenarios and
what-ifs on the table that complicate decisions about which scenario to go
with. BEP will help business leaders reduce decision-making to a series of
yes or no questions.

 What Is Relevant Cost?

Relevant cost is a managerial accounting term that describes avoidable

costs that are incurred only when making specific business decisions. The
concept of relevant cost is used to eliminate unnecessary data that could
complicate the decision-making process. As an example, relevant cost is
used to determine whether to sell or keep a business unit.

The costs that are relevant to decision-making are relevant costs such as
avoidable costs, incremental costs, opportunity costs, and future cash
flows.

Avoidable Costs: If the decision to modify the course of a project or

business is taken, avoidable costs can be avoided. Unlike most fixed
expenses, it generally refers to variable costs that may be eliminated from
a commercial process.

Incremental Costs: Incremental costs are the costs of producing one

extra unit that would not have occurred if production had not increased.
These costs rise as output rises or falls as production falls.

Opportunity Costs: When presented with several options, a company

must weigh the costs of each option for decision-making. The difference in
the costs of the two options is opportunity cost, and it serves as a
reminder to consider all acceptable alternatives before making a decision.

Future Cash Flows: Future cash flow occurs in the future due to actions
taken today since the present value is used to anticipate future income to
calculate if an activity would entail future expenditures.

 Costing Method-

Costing methods in manufacturing, also known as production costing

methods, are techniques for determining how much it costs to produce
finished goods. Some methods can be used to determine total
manufacturing costs, while others focus on evaluating specific processes,
materials, or labour.

The 6 main costing methods for manufacturing are:

 Absorption costing
 Job costing
 Process costing
 Direct costing
 Throughput costing
 Target costing
1. Absorption costing: Absorption costing, also called full costing or
total absorption costing, is a production costing method that’s used
to calculate all the direct and indirect costs required to manufacture
a particular product. It allocates fixed overhead costs to a product
regardless of whether it was sold in the measured period or not. The
absorption costing method considers manufacturing costs such as:
  Raw materials
 Utility costs
 Employee wages
 Insurance
 Rent

This costing method is typically used for external reporting purposes, such
as calculating your cost of goods sold.

You can use this formula to calculate absorption costs:

(Direct Labour Costs + Variable Overhead Costs + Fixed Overhead Costs +

Direct Material Costs) / Number of Items Produced = Absorption Cost

2. Job costing : Job costing, also called job order costing, tracks all
the costs and revenue of a specific manufacturing project or ‘job’.
This can include a specific, one-off manufacturing service; the
development of new products; or the production of a set number of
products that are manufactured at the same time. Job costing can
be broken down into four components:
 Materials
 Direct labour
 Direct expenses

If you’re a manufacturer producing goods with varying costs to produce,

job costing can help break down what those costs are so you can
accurately determine profits later.

Products you believe are winners can often contain hidden costs that are
eating away at profit. Similarly, products that appear to sell poorly may
generate higher profits due to lower job costs. Job costing mitigates the
risk of grouping big variations, which can hide some of your potential wins
and losses.

3. Process costing: Process costing is a cost accounting method that

calculates the cost of each manufacturing process involved in
producing finished goods. Process costing is mainly used in
businesses where it can be safely assumed that the cost to produce
each order is going to be the same, such as mass-produced food or
chemical processing.

The process costing method first considers the total number of units
passing through a particular part of the production process, then tallies up
the total costs and divides the result into a per-unit cost.

4. Direct costing: The direct costing method only takes into account
the variable costs associated with production, ignoring fixed costs
 such as factory overheads. Instead, fixed costs are assumed to be
tied to the accounting periods in which they happened.

Direct costing is useful when you want to make short-term business

decisions about strategic direction but can be harmful if used for long-
term decision-making as it excludes important indirect costs.

Some examples of useful applications for the direct costing method:

 For determining the cost benefits of automation

 For determining the break-even point in a break-even analysis
 For checking the profitability of an individual customer
 For plotting changes in profit margins as sales volumes scale.

Important: Direct costing is prohibited under both the GAAP and IFRS for
reporting inventory costs; you must also include accurate allocation of
indirect costs.

5. Throughput costing: Throughput costing is a manufacturing cost

accounting method that takes direct materials into account as an
inventory cost and regards all other expenses (such as labour and
overheads) as period expenses relevant only to the time when they
were incurred.

Throughput costing is mostly used for short-term, incremental cost

analysis. For example, to identify whether you can afford to offer a special
deal to a new customer.

6. Target costing: Target costing is an accounting method that’s

calculated based on forecasts, rather than historic data. Research
and expected material costs are used to estimate targets for pricing,
margins, and product costs in advance of production.

Using the target costing method, you would follow this process:

 Identify a competitive market price for the product you wish to

develop.
 Decide your desired profit margin and subtract it from the
competitive market price to find your target cost.
 Use forecasted material and production costs to determine whether
the product can be produced at your target cost.

 Activity-based costing (ABC)-

Activity-based costing or ABC costing is a method that calculates the costs

of specific activities and divides them into a per-product cost based on the
cost consumption of that specific product. In essence, this costing method
assigns overhead and other indirect costs into direct costs.

In traditional cost accounting, you usually tally up your overheads and

split them evenly across your activities. This can help to understand costs
at a glance, but it doesn’t take into account significant variations between
activities. For example, one product might require more electricity to
produce than another.

In an ABC system, the goal is instead to split those overheads up and work
out how your different production activities affect or are affected by
indirect costs.

For example, a computer equipment manufacturing company might

produce monitors that contribute towards 5% of the monthly electrical
usage and also produce towers that account for 20% of the usage.

In traditional cost accounting, both products would be assigned the same

share of the electricity costs. But ABC costing would distribute those costs
based on usage, so you could price the products with a more accurate
understanding of their true production costs.

The ABC calculation & applications is as follows:

 Identify all the activities required to create the product.

 Divide the activities into cost pools, which include all the individual
costs related to an activity. Calculate the total overhead of each cost
pool.
 Assign each cost pool activity cost drivers, such as hours or units.
 Calculate the cost driver rate by dividing the total overhead in each
cost pool by the total cost drivers.
 Multiply the cost driver rate by the number of cost drivers.

As an activity-based costing example, consider Company ABC, which has a

$50,000 per year electricity bill. The number of labor hours has a direct
impact on the electric bill. For the year, there were 2,500 labor hours
worked; in this example, this is the cost driver. Calculating the cost driver
rate is done by dividing the $50,000 a year electric bill by the 2,500 hours,
yielding a cost driver rate of $20. For Product XYZ, the company uses
electricity for 10 hours. The overhead costs for the product are $200, or
$20 times 10.