University of Limpopo

School of Accountancy
Department of Financial Management

BACHELOR OF ACCOUNTANCY
(B ACC)
MANAGEMENT ACCOUNTING AND FINANCE
(MACN 350)
MODULE NOTES: 1B
Introduction to cost terms and concepts

© 2015 University of Limpopo, Private Bag X1106, Sovenga, 0727, South Africa
Printed and published by the University of Limpopo
All rights reserved. Apart from any reasonable quotations for the purpose of research, criticism or review as permitted under the
Copyright Act, no part of this book may be reproduced or transmitted in any form or by any means, electronic or mechanical,
including photocopy and recording, without permission in writing from the publisher.

2
INTRODUCTION TO COST TERMS AND CONCEPTS

BACKGROUND

Product costing deals with determining the total costs involved in the production of a good or
service. In order to calculate the product cost, it is important to classify these costs into
subcategories based on their behaviour, for example variable, fixed, direct, or indirect costs.

Before we get into the classification and behaviour of costs, it is important for the student to
understand the meaning of this basic terms and concepts utilised in this module. This will
enable you to identify and classify these costs properly based on their behaviour.

ASSUMED PRIOR KNOWLEDGE

Students in Managerial Accounting and Finance 350 are expected to have an understanding
of these concepts covered in this module in prior courses during their undergraduate studies
and therefore should use this module to reinforce the knowledge previously gained.

EXAMINATION PERSPECTIVE

This module is normally integrated with other modules. The student might be required to
explain the terms, classify the costs, identify certain categories of costs, or even criticize
classification already done by someone.

LEARNING OUTCOMES

By the end of this module you should be able to:

• Understand the reasons for classifying costs according to each of the various
attributes

• Classify costs according to the criteria set out in each of the cost categories

• Identify whether a cost is fixed, variable, mixed or step in nature

• Determine the total cost of an expense, for a given level of activity

• Identify which costs are to be allocated to the cost of inventory produced and which
costs are expensed through the income statement

• Distinguish between direct and indirect costs and be aware of how these two types
of costs are traced or assigned to cost objects

• Identify the kinds of costs that are relevant and not relevant to decision making

3
LECTURE NOTES

Cost accounting deals with valuation of inventories and determination of cost of sales for
external and internal reporting. Therefore, and understanding of the difference between a
manufacturing and merchandising company is important.

Manufacturing companies convert raw materials into a product. The company then sells that
product either to other companies or, less commonly, directly to individuals. Merchandising
companies, on the other hand, buy finished products and resell the products to customers.
Valuing inventories and determining cost of goods sold is simple in a merchandising
company, but is difficult in a manufacturing company. For that reason, we concentrate
mainly on manufacturing in this module.

1. COST CLASSIFICATION AND BEHAVIOUR

Cost

The cost of any item, whether a product or service, is determined by a quantifiable

measurement (Quantity of units) and a value measurement (Cost of per unit). These would
be cost incurred to bring an item to its present condition and location.

Cost estimation

Different methods are used to estimate costs; high-low method is the most commonly used
method. These methods are obviously used where actual costs are not available.

Cost classification

Classification depends on the intended use of the cost information: i.e. for inventory
valuation (,decision-making

Costs can be classified in a number of ways—depending on the purpose of the

classification. For example, classification of costs for purposes of determining inventory
valuations and cost sales for external reports differs from the classification of costs that
would be carried out to aid decision-making. It is important to note that the classifications of
costs are not mutually exclusive. That is, a particular cost may be classified in many different
ways—depending on the purpose of the classification.

Cost behaviour

Managers often need to be able to predict how costs will change in response to changes in
activity. In this module, all of the illustrations assume that the activity is the output of goods
or services. While there are other ways to classify costs according to how they react to
changes in activity, in this chapter we introduce the simple variable and fixed classifications.

Cost behaviour is an indicator of how a cost will change in total when there is a change in
some activity (e.g volume of units produced). i.e Cost classification is used to describe
the behaviour of cost items. In cost accounting and managerial accounting, three types of
cost behaviour are usually discussed: Fixed, Variable and Mixed/Semi Variable

4
A variable cost is constant per unit of activity but changes in total as the activity level rises
and falls. E.g Arms used per chair.

A fixed cost is constant in total for changes in activity within the relevant range. E.g Monthly
rental for a building (Just about any cost will change if there is a big enough change in
activity.

A step-fixed cost is a cost that does not change within certain high and low thresholds of
activity, but which will change when these thresholds are breached. E.g If you hire 1 to 10
tents the total cost is fixed at R1 000, however should you hire 11 to 20 tents the total cost
will now change to R 1 800

A mixed cost/semi variable/semi fixed cost is a cost composed of a mixture of both fixed
and variable components. Costs are fixed for a set level of production or consumption, and
become variable after this production level is exceeded. E.g Water usage may cost R1 per
litre for the first 100 kilolitres, then increases to R 2 per litre for all litres above.

A direct cost is a cost that can be conveniently and easily traced to a particular cost object.

A cost would be considered indirect for one of two reasons: either it is not economically
feasible or it is impossible to trace the cost to the cost object.

For example, it is impossible to trace the factory managers’ salary in a multi-product plant to
any particular product made in the plant. Even if a product were dropped entirely, we would
ordinarily expect the factory manager’s salary to remain the same. This is an example of a
“indirect cost”.

For example, it is not economically feasible to trace the precise amount of miscellaneous
supplies such as glue and nails used on each chair manufactured. It might be possible, but it
wouldn’t be worth the effort. Instead, glue and nails would typically be considered an indirect
material cost

5
2. MANUFACTURING AND NON MANUFACTURING COSTS

Manufacturing/ Production costs

These costs are incurred in the production process. Manufacturing costs are usually grouped
into three main categories: direct materials, direct labour, and manufacturing overheads.

Direct materials

Direct materials consist of those raw material inputs that become an integral part of a
finished product and can be easily traced into it. Examples include wood used to make a
chair.

Direct Labour

Direct labour consists of that portion of labour cost that can be easily traced to a product.
Direct labour is sometimes referred to as “touch labour” since it consists of the costs of
workers who “touch” the product as it is being made.

Prime versus Conversion Costs

Prime cost consists of direct materials plus direct labour. Conversion cost consists of direct
labour plus manufacturing overhead.

Non-manufacturing

A manufacturing company incurs many other costs in addition to manufacturing costs. For
financial reporting purposes most of these other costs are typically classified as selling
(marketing) costs and administrative costs. Marketing and administrative costs are incurred
in both manufacturing and merchandising firms. These costs are not incurred in the process
of making a product.

Marketing Costs

These costs include the costs of making sales, taking customer orders, and delivering the
product to customers. These costs are also referred to as order-getting and order-filling
costs.

Administrative Costs

These costs include all executive, organizational, and clerical costs that are not classified as
production or marketing costs.

6
3. PERIOD VS PRODUCT COSTS

Costs can also be classified as period or product costs.

Period Costs

Period costs are expensed in the time period in which they are incurred. All selling and
administrative costs are typically considered to be period costs. You should be careful to
point out that the usual rules of accrual accounting apply. For example, administrative salary
costs are “incurred” when they are earned and not necessarily when they are paid to
employees.

Product Costs

Product costs are added to units of product (i.e., “inventoried”) as they are incurred and are
not treated as expenses until the units are sold. This can result in a delay of one or more
periods between the time in which the cost is incurred and when it appears as an expense
on the income statement. Product costs are also known as inventoriable costs. The
discussion in the chapter follows the usual interpretation of IFRS in which all manufacturing
costs are treated as product costs.

4. INVENTORY VALUATION AND COST OF SALES PROCESS

In a manufacturing company, raw materials purchases are recorded in a raw materials

inventory account. These costs are transferred to a work in process inventory account when
the materials are released to the production departments. Other manufacturing costs—direct
labor and manufacturing overhead—are charged to the work in process inventory account as
incurred. As work in process is completed, its costs are transferred to the finished goods
inventory account. These costs become expenses only when the finished goods are sold.
Period expenses are taken directly to the income statement as expenses of the period.