Cost Terms, Concepts, and Classifications

Concept of Cost Cost means the amount of expenditure incurred on, or attributable to a given thing. The term cost cannot be exactly defined. Its interpretation depends upon the following factors: The nature of business or industry The context in which it is used

Merchandising VS Manufacturing Merchandising Buy finished goods Sell finished goods Manufacturing Buy raw materials Produce and sell finished goods

Objectives of Cost Accounting Determining selling price Controlling cost Providing information for decision making o Determination of cost-volume-profit relationship o Make or buy component o Shut down or continue operation at a loss o Continuing with the existing machinery or replacing them by improved Ascertaining costing profit Facilitating preparation of financial and other statements Financial accounting Cost Accounting

Basis

Objective

Provides information about the financial performance and financial position of the business. Classifies records, presents and interprets transaction in terms of money. Records historical data.

Provides information of ascertainment of cost to control and decision making about the cost. Classifies records, presents and interprets in a significant manner the material, labor and overhead cost. Records and presents the estimated/budgeted data. It makes use of both the historical costs and pre-

Nature

Recording of data

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determined costs.
Users of Information Analysis of costs and profits Time period Presentation of information Shareholders, creditors, financial analysts and government Shows the profit/loss of the organization F/S are prepared for a definite period, usually a year. A set format is used for presenting financial information Used by internal Management at different levels Provides the details of cost and profit of each product, process, job, contracts, etc. Its report and statements are prepared as and when required. There are not any set formats for presenting cost information.

Manufacturing Costs

Direct Materials Those materials that become an integral part of the product and that can be conveniently traced directly to it. Cost of these materials can be directly traced to outputs. Examples Publishing company Automobile manufacturer Direct Materials Paper, ink, book covers Tires, automobile metal parts

Direct Labor Those labor costs that can be easily traced to individual units of product. Example: Wages paid to automobile assembly workers.

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Manufacturing Overhead Manufacturing costs that cannot be traced directly to specific units produced. Examples: Indirect labor and indirect materials. Indirect labor: Wages paid to employees who are not directly involved in production work. Examples: maintenance workers, janitors and security guards. Indirect materials: Materials used to support the production process. Examples: lubricants and cleaning supplies used in the automobile assembly plant.

NOTE: If there is a direct material with lass cost we can take that as an indirect material. In addition, as a example, if there is a sticker in the T-shirt and we can use the T without the sticker, Sticker is a indirect material. Classifications of Costs

Nonmanufacturing Costs

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NOTE: If there is a water or electricity bill in the head office, it is taken as a non-manufacturing cost. However, same thing in a manufacturing plant will be taken as a manufacturing cost.

Total cost (Cost of Sales)

Total cost of production(office)
manufacturing cost(factory/production/work)
Direct cost(Prime/First)
Direct material Direct labor Direct expenses administration overheads selling and distribution overheads

work overheads

ANS: A and D other two are not production costs.

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Product Costs versus Period Costs Product costs include only the costs necessary to complete the product at the manufacturing step in the value chain (manufacturing) or to purchase and transport the product to the location of sale (merchandising). This includes all the costs that are spent for producing the product (for a manufacturing company) (Or for buying and transportation in the case of merchandizing company) Period costs include all other costs incurred by the firm in managing or selling the product (indirect costs outside the manufacturing step of the value chain). This include all other costs

Balance Sheet

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The Income Statement When taking cost of the goods sold there is only small change between a merchandizing company and a manufacturing company.

Manufacturing Cost Flows

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Product Costs - A Closer Look

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How a cost will react to changes in the level of business activity. Total variable costs change when activity changes. Examples, Wages of laborers Cost of direct material Power

Total fixed costs remain unchanged when activity changes. Examples, Rent or rates Insurance charges Management salary

Differential Costs and Revenues

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A Question A company is manufacturing 1,000 units of a product. The present costs and sales data are as follows: Selling price per unit Rs 10 Variable cost per unit Rs 5 Fixed costs Rs 4,000

The management is considering the following two alternatives, which is better? 1. To accept an export order for another 200 units at Rs. 8 per unit. The expenditure of the export order will increase the fixed costs by Rs 500. 2. To reduce the production from present 1,000 units to 600 units and buy another 400 units from the market at Rs 6 per unit. This will result in reducing the present fixed costs from Rs 4,000 to Rs 3,000. Under proposal (ii), the company makes the maximum profit and therefore it should adopt alternative (ii). Opportunity Costs Opportunity cost refers to the potential benefit that is given up when one alternative is selected over another. Sunk Costs Sunk costs cannot be changed by any decision. They are not differential costs and should be ignored when making decisions Example: You bought an automobile that cost Rs 10,000 two years ago. The Rs10000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the Rs10000 cost. Unit Marginal Contribution Difference between the unit sales price and the unit variable cost = Application: Break-even volume analysis =

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Relevant and Irrelevant Costs Relevant costs are those, which change by managerial decision. Irrelevant costs are those, which do not get affected by the decision.

Example: if a manufacturer is planning to close down an unprofitable retail sales shop, Relevant - wages payable to the workers of a shop Irrelevant - prepaid rent of a shop or unrecovered costs of any equipment, which will have to be scrapped A Question Jolly Ltd. purchased a machine for Rs 30,000. The machine has an operating life of five years without any scrap value. Soon after making the purchase, management feels that the machine should not have been purchased since it is not yielding the operating advantage originally contemplated. It is expected to result in savings in operating costs of Rs 18,000 over a period of five years (If we use it for 5 years) . The machine can be sold immediately for Rs 22,000. Are you going to sell it or use? ANS To take the decision whether the machine should be sold or be used, the relevant amounts to be compared are Rs 18,000 in cost savings over five years and Rs 22,000 that can be realized in case it is immediately disposed. Rs 30,000 invested in the asset are not relevant since it is same in both the cases. The amount is the sunk cost. Jolly Ltd., therefore, sold the machinery for Rs 22,000 since it would result in an extra profit of Rs 4,000 as compared to keeping and using it. Here is a question to prepare a statement of cost

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