PDE4232 –Lecture 6:

An Introduction to
Management Accounting -
Cost Terms & Concepts

1
 Management Accounting
• In the first class, we talked about accounting
being divided between two main branches :

• Financial Accounting; and

• Management Accounting

• See summary of the two branches 

2
 The Accounting System
Financial Accounting Management Accounting
Satisfy the information needs of Satisfy the information needs of the
people external to the business people managing the business

Summarised reports Detailed and specific reports

Timing: usually annually Timing: whenever needed

Historical Future and historical

Legislation No legislation

3
 Management Accounting
• Have just finished looking at Financial Accounting.

• Attention now turns to Management Accounting.

• Note that the two do have some things in common.

For example both derive from the same basic
accounting system.

• The terminology tends to be slightly different.

4
 Management Accounting
• Internal to the business

• Day-to-day operations

• Budgeting

• Planning

• Management control
5
 Management Accounting - Costs
Main points to be covered:
• Definition of a Cost Object
• Cost Accumulation & Cost Assignment
• Classification of Costs:
 Direct & Indirect Costs
 Product & Period Costs
 Variable, Fixed, Semi-Variable & Stepped Costs
 Relevant & Irrelevant Costs
 Avoidable & Unavoidable Costs
 Sunk Costs
 Opportunity Costs
 Incremental Costs
6
 Cost Objects:
• Accountants usually define cost as a resource
sacrificed to achieve a specific objective, such as
acquiring a good or service.

• To guide their decisions, managers often want to

know how much a certain thing (such as a new
product) costs. We call this “thing” a cost object,
which is anything for which a separate measurement
of costs is desired.
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Cost Accumulation & Cost Assignment:
• A costing system typically accounts for costs in
2 basic stages:

1. It accumulates costs by classifying them

into certain categories such as labour,
materials or advertising.
2. It then assigns these costs to cost objects.

8
 Cost Terms & Concepts: I. Direct & Indirect Costs:

• Costs that are assigned to cost objects can be divided

into two categories: direct costs & indirect costs:

• Direct costs are those costs that can be specifically &

exclusively identified with a particular cost object.

• In contrast, indirect costs cannot be identified

specifically & exclusively with a given cost object.
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 Cost Assignment
Direct Costs:
Direct material
Direct labour Cost
Cost tracing
Objects:
an example
Indirect Costs: might be
Indirect material “A Desk”
Indirect labour
Rent,
Electricity, etc. Cost allocation

Relationship of direct & indirect costs to a cost object 10

 From the previous figure, it is obvious that:

• Cost tracing is the assigning of direct costs to the

chosen cost object.

• Cost allocation is the assigning of indirect costs to

the chosen cost object

• Cost assignment encompasses both cost tracing &

cost allocation.
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 An Important Remark
• The definition of direct and indirect costs depends on
the purpose for which the cost will be used.

• For example, the electricity of a specific department is

a direct cost within that department; however, for each
unit produced in that department that cost is an
indirect cost.

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 Prime Cost & Manufacturing Overhead:
• Prime cost refers to the direct costs of the product &
consists of direct labour costs plus direct material costs
plus any direct expenses such as the cost of hiring a
machine for producing a specific product .

• Manufacturing overhead consists of all indirect

manufacturing labour & materials costs plus indirect
manufacturing expenses. Examples include rent of the
factory & depreciation of machinery.
13
 II. Product & Period Costs:
• Product costs are those costs associated with goods
or services purchased, or produced, for sale to
customers (in other words, these are the production
costs).

• Period costs are those costs which are treated as

expenses in the period in which they are incurred (in
other words, these are the selling & administrative
expenses).

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 III. Cost Behaviour: Variable, Fixed, Semi-Variable &
Semi-Fixed Costs:
• Variable costs are those costs which vary in
direct proportion to the volume of activity; for example,
doubling the level of activity will double the total variable
cost.

• Consequently, total variable costs are linear

& unit variable cost is constant.

• The following example illustrates a variable cost where the

variable cost per unit is £10.
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 Variable Costs:
Output 100 200 300
(Number of units)
Unit Cost (£s) 10 10 10
Total Cost (£s) ------ ------- -------
1 000 2 000 3 000

----------------------------------------------------------------
An Important Remark: However the variable costs
----------------------------------------------------------------
do change in their total but the unit cost is fixed.

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 Graph of Total Variable Cost against Activity

Total
Cost

Level of Activity 17
 Graph of Unit Variable Cost against Activity

Unit
Cost

Level of
18
Activity
 Examples of Variable Costs:
• Materials used to manufacture a unit of output or to
provide a type of service

• Labour costs of manufacturing a unit of output or

providing a type of service

• Commission paid to a salesperson.

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 Fixed Costs:
• A fixed cost is one which is not affected by changes
in the level of activity, for a specified period of time.

• Total fixed costs are constant for all levels of

activity whereas unit fixed costs decrease
proportionally with the level of activity.

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 Fixed Costs:
Total Cost (£s)
3 000 3 000 3 000
Rent
Output
100 200 300
(Number of units)

Unit Cost (£s) 30 15 10

Total fixed costs are constant for all levels whereas

unit cost is decreasing as output increases, because
the fixed cost is spread over more units
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 Graph of Total Fixed Cost against Activity
Total
Cost

Level of
Activity 22
 Graph of Unit Fixed Cost against Activity

Unit
Cost

Level of
Activity 23
 Examples of Fixed Costs:
• Advertising in the trade journals

• Salaries & wages of administrative duties

• Depreciation of building.

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 Semi-Variable Costs:
• A semi-variable cost is one which varies, however
not in a direct proportion, with changes in the level
of activity, over a defined period of time.

• It includes both a fixed element that is fixed

whatever the level of activity & a variable
component that is directly related to the level of
activity.
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 Semi-Variable Costs:
Activity (Number of 100 200 300
units)
Total Cost (£s) 2100 2200 2300

Total cost increases as activity increases but

not in the same proportion

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 Graph of Total Semi-Variable Cost against Activity

Total
Cost

Variable
-----------

--------
Fixed

Level of
Activity
27
 Examples of Semi-Variable Cost:
• Office salaries where there is a core of long-term
secretarial staff plus employment of temporary staff
when activity levels rise;

• Maintenance charges where there is a fixed basic

charge per year plus a variable element depending on
the number of call-outs per year.
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 Semi-Fixed or stepped Costs:
• The cost will take the shape of a step-cost whenever
the cost is fixed over a fixed period of time but there
is a revised increase in the cost to a higher level than
the previous one in subsequent periods.

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 Example of a Stepped Cost:
Quarters of the year £ Cost of the Rent
First Quarter £ 1000
Second Quarter £ 1200
Third Quarter £ 1400
Fourth Quarter £ 1600

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Graph of Stepped Cost against Activity
1600
1400
1200
1000
800
Rent
600
400
200
0
1st Qtr 2nd Qtr 3rd Qtr 4th Qtr

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 IV. Relevant & Irrelevant Costs:
• For decision making, costs & revenues can be
classified according to whether they are relevant to a
particular decision.

• Relevant costs & revenues are those future costs &

revenues that will be changed by a decision, whereas
irrelevant costs & revenues are those that will not be
affected by the decision.
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 Illustration:
• A company can meet its sales demand by purchasing
either machine A or machine B. The output of both
machines is identical, but the operating costs & purchase
costs of the machines are different. In this situation the
sales revenue will remain unchanged irrespective of which
machine is purchased.

• Consequently, sales revenue is irrelevant for this decision;

the relevant items are the operating costs & the cost of the
machines.
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 V. Avoidable & Unavoidable Costs:
• Sometimes the terms avoidable & unavoidable costs
are used instead of relevant & irrelevant costs.
Avoidable costs are those costs that may be saved by
not adopting a given alternative, whereas unavoidable
costs cannot be saved.

• Therefore, only avoidable costs are relevant for

decision-making purposes.
34
 Illustration:
• Consider the example we used to illustrate relevant &
irrelevant costs. The sales revenue is unavoidable &
irrelevant, because it is identical for both machines, but
the operating costs & purchase costs of the machines are
avoidable & hence relevant because they differ.

• The decision rule is to accept those alternatives that

generate revenues in excess of the avoidable costs.

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 VI. Sunk Costs:
• These are the costs that have been created by a
decision made in the past & that cannot be changed
by any decision that will be made in the future.

• For example, the purchase price of a machine that has

been purchased in the past is considered to be a sunk
cost. This cost cannot be changed by any future
decision & is therefore classified as a sunk cost.
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 An Important Remark
• Sunk costs are irrelevant for decision-making, but they are
distinguished from irrelevant costs because not all
irrelevant costs are sunk costs.

• For example, a comparison of two alternative production

methods may result in identical direct material expenditure for
both alternatives, so the direct material cost is irrelevant
because it will remain the same whichever alternative is
chosen, but the material cost is not a sunk cost since it will be
incurred in the future. 37
 VII. Opportunity Costs:
• An opportunity cost is a cost that measures the opportunity that
is lost or sacrificed when the choice of one course of action
requires that an alternative course of action be given up.

• For example, a company is having a warehouse built, and it is

either to be used to store extra output which will save the
company £500, or be used as a parking area which will get the
company £400. So if the company chose the first alternative,
the opportunity cost is £400.
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 VIII. Incremental Costs:
• Incremental (also called differential) costs & revenues
are the difference between costs & revenues for the
corresponding items under each alternative being
considered.

• For example, the incremental costs of increasing output

from 1000 to 1100 units are the additional costs of
producing an extra 100.

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 Key Terms:
• Cost object • Variable costs
• Direct costs • Fixed costs
• Indirect costs • Semi-variable costs
• Cost tracing • Stepped costs
• Cost allocation • Relevant & irrelevant costs
• Cost assignment • Avoidable & unavoidable costs
• Prime cost • Sunk costs
• Manufacturing overhead • Opportunity costs
• Product costs • Incremental (differential) costs
• Period costs 40
 Seminar 6
Questions on Lecture 6
 Questions for Seminar 6:
• Q.1: For each of the following cost items, explain how it could
be classified under each of the following headings given in
the following table:

(a) raw materials to be used in production;

(b) the cost of hiring a machine for producing a specific

product; and

(c) rent of a warehouse for one year to allow temporary

expansion of output.

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 Q.1: Answer
Item Variable / Direct / Product /
Fixed Indirect Period

Variable Direct Product

Material

Cost of hiring Fixed Indirect Product

machine

Fixed Indirect Period

Rent

43
 Q. 2:
Classify each of the following as being primarily a
direct OR an indirect cost for each unit produced:
(a) Wood used to manufacture a desk

(b) Materials used for the repair of a machine that is used for the
manufacture of many different desks

(c) Factory insurance

(d) Salaries of factory supervisors

(e) The wages of operatives engaged in the production process

(f) Canteen manager’s salary.

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 Q.2: Answer
Item Direct/Indirect
Wood Direct

Repair Indirect

Insurance Indirect
Supervisors’ salaries Indirect
Operatives’ wages Direct

Canteen manager’s salary Indirect

45
 Q.3:
• (a) Identify the cost behaviour in each of the
following tables as:
(i) fixed cost; or
(ii) variable cost; or
(iii) semi-variable cost

• (b) Draw a graph for each table to illustrate the cost

behaviour 46
 Cost X
Output Units 100 200 300 400 500

Total Cost (£) 600 600 600 600 600

Unit Cost (£) 6 3 2 1.50 1.20

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 Q.3: Answer
• Since the total cost is fixed and the unit cost is
decreasing with the increases in units of production,
therefore this is considered to be a fixed cost.
 Graph of Total Fixed Cost against Activity

Total
Cost

600

100 200 300 400 500 Output

Units
 Cost Y
Output Units 100 200 300 400 500

Total Cost (£) 300 600 900 1, 200 1, 500

Unit Cost (£) 3 3 3 3 3

50
 Answer:
• Since the total cost is varying directly and the unit
cost is fixed with the increases in units of production,
therefore this is considered to be a variable cost.
Graph of Total Variable Cost against Activity
Total
Cost

1, 500
1, 200
900
600
300

100 200 300 400 500 Output

Units
 Cost Z
Output Units 100 200 300 400 500
Total Cost (£) 660 720 780 840 900
Unit Cost (£) 6.60 3.60 2.60 2.10 1.80

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 Answer:
• Since the total cost is varying but not directly and
the unit cost is decreasing with the increases in
units of production, therefore this is considered to
be a semi-variable cost.
Determining the fixed part of the semi-variable cost:
• 1: Determining the variable unit cost =
The second cost – the first cost
The second level – the first level
So = £ 720 - £ 660 = £ 0.60 / unit
200 - 100

• 2: Determining the total variable cost for the first level = first level’s units
* variable unit cost
So = 100 units * £ 0.60 = £ 60

• 3: Determining the fixed cost for the first level = total cost for the first
level – total variable cost for that level
So = £ 660 - £ 60 = £ 600 this cost is fixed in all levels of production because
it is known as fixed costs.
 Graph of Total Semi-Variable Cost against Activity
Total Cost

900 Variable
840
780
720
660
600
Fixed

100 200 300 400 500 Output

Units
 Q.4:
Peter Bright is a well-known professional Management
Accounting for Business Decisions speaker. The Essex Business
Bureau wants Bright to be the sole speaker at an all-day seminar.
Bright’s agent offers Essex the choice of three possible fee
arrangements:

• Schedule 1: £8000 fee

• Schedule 2: £20 per person + £2000 fixed fee

• Schedule 3: £50 per person

Each person attending will be charged a £200 fee for the all-day
seminar. 57
 Required:
1. What is Essex’s fixed cost and variable cost for
hiring Bright under each alternative schedule?

2. For each schedule, calculate the total cost and unit

cost per seminar attender if (a) 50 attend, (b) 200
attend, and (c) 500 attend. Comment on the
results

58
 Q.5:
• Oven Pies Ltd plans to buy a delivery van to
distribute pies from the bakery to various
neighbourhood shops. It will use the van for three
years. The expected costs are as follows:

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 1:
Schedule Fixed Costs Variable Costs
1 £8000 ------

2 £2000 £20 per person

3 ------ £50 per person

 2:
Schedule 50 people 200 people 500 people

1: /
Total costs £8000 £8000 £8000
Unit costs 160 40 16
2: ×
Total costs £3000* £6000** £12000***
Unit costs
60 30 24
3:
Total costs
£2500 £10000 £25000
Unit costs
50 50 50
 Remarks:
* (£20 per person × 50 persons) + £2000

** (£20 per person × 200 persons) + £2000

*** (£20 per person × 500 persons) + £2000

 Comments on the Results
• Schedule 1 has £8000 fixed costs; as the attendance
increases, the unit cost decreases.
• Schedule 2 has both a fixed cost component (£2000) and a
variable cost component (£20); the spreading of the £2000
amount over more units as attendance increases causes the
unit cost to decrease.
• Schedule 3 has only a variable cost component; there is no
change in unit cost as attendance increases.
 Q.5 cont’d:
Items £
New van 15 000
Trade-in price after 3 years 600
Service costs (every 6 months) 450
Spare parts, per 10 000 miles 360
Four new tyres, every 15 000 miles 1 200
Vehicle licence and insurance, per year 800
Fuel per litre (consumption is 1 litre every 5 mile) 0.70
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 You are required to do the following
1. Prepare a table of costs for mileages of 5 000,
10 000, 15 000, 20 000 and 30 000 miles per
annum, distinguishing variable costs from fixed
costs.

2. Calculate the average cost per mile at each of the

mileages set out in (1) above.

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 Mileage per 5 000 10 000 15 000 20 000 30 000
annum
Costs £ £ £ £ £
I: Variable
costs:
Spare parts 180 360 540 720 1 080
Fuel 700 1 400 2 100 2 800 4 200
Tyres 400 800 1 200 1 600 2 400

Total variable 1 280 2 560 3 840 5 120 7 680

costs
Mileage per 5 000 10 000 15 000 20 000 30 000
annum
Costs £ £ £ £ £
II: Fixed costs:
Service Cost/year
Insurance 900 900 900 900 900
Depreciation 800 800 800 800 800
Total Fixed costs 4 800 4 800 4 800 4 800 4 800
6 500 6 500 6 500 6 500 6 500
Total costs
(variable + fixed) 7 780 9 060 10 340 11 620 14 180
 Important Notes
• Variable Costs:

1: Spare Parts: for every 10 000 miles £ 360

Therefore for each mile the cost is:
= £ 360/10 000 = £ 0.036
So for the 5 000 miles the cost

= £ 0.036 * 5000 miles = £ 180 and for the 10 000

miles the cost is = £ 0.036 * 10 000 = £ 360 and
so on for the rest mileages mentioned.
 Important Notes
• Variable Costs:

2: Fuel: for every 5 miles 1 litre and the litre is for £

0.70 so the cost per mile is:
= 0.70 / 5 miles = £ 0.14 per mile
So for 5 000 miles fuel will be
= £ 0.14 * 5 000 miles = £ 700 and for the 10 000
miles the fuel will be
= £ 0.14 * 10 000 = £ 1 400 and so on for the
remaining mileages.
 Important Notes
• Variable Costs:

3: Tyres: for every 15 000 miles four new tyres are

bought for £ 1 200 so we can say that for each mile
the cost is
= £ 1 200 / 15 000 miles = £ 0.08 per mile so for the 5
000 miles the cost
= £ 0.08 * 5 000 miles = 400 and for the 10 000 miles
the cost is = £ 0.08 * 10 000 miles = £ 800 and so on
for the rest mileages.
 Important Notes
• Fixed Costs:

1: Service costs: for every 6 months the cost is £ 450

so the cost for the whole year, I.e. 12 months will
be = £ 450 * 2 parts of the year = £ 900. This
amount is paid annually regardless how many
mileages have been covered. So for the 5 000
miles the cost is £ 900 and it is so too for the rest
mileages as it is a fixed cost.
 Important Notes
• Fixed Costs:

2: Insurance costs: for the whole we pay £ 800, this

amount is going to be paid regardless of the mileages
the vehicle has covered. So it is fixed all over the
different mentioned mileages.
 Important Notes
• Fixed Costs:
3: Depreciation cost: it can be calculated using the
following equation:

The original price - Trade-in price of

of the fixed asset the fixed asset

The useful life of the fixed asset

 Thus the depreciation
= £ 15 000 - £ 600 = £ 4 800 per year
3 years

This amount is annually and fixed regardless of how

many mileages the van covered.
 Average cost per mile
Mileage per 5 000 10 000 15 000 20 000 30 000
annum
Variable cost 0.256 0.256 0.256 0.256 0.256
per mile
Fixed cost per 1.3 0.65 0.433 0.325 0.217
mile
Average cost 1.556 0.906 0.689 0.581 0.473
per mile