MA-2, Cost Terms

8/6/2019 MA-2, Cost Terms

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Managerial Accounting

Cost term, concepts and classifications

Planning and control are the two majorcomponents of Management task. Planning

includes setting of objectives and outlinesfor achieving the objective. Control includesthe steps to be initiated for ensuring theachievement of the objectives.

To ensure proper and effective planningand control, management need informationand very often the required informationrelate to Cost of the organization.


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Cost term, concepts and classifications

Classifications : There are many types ofcosts ad they are classified into groupsaccording to the immediate requirement of

Management.

For example Management my require costdata to prepare financial statement forexternal users, or for preparing sales

forecasts. Since the purpose of using costdata is not same and as such classificationis necessary to meet the requirement.


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Cost term, concepts and classifications Classifications:

- General classifications (Basic manufacturingcategories)

- Behavioral classifications (Response to changesin the level of activity)

- Assignment to cost objectives (Prominence inparticular cost objective)

- Decision making (Relevance in decision makingprocess)

- Financial statement (Relation with preparation offinancial statement)


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General cost classification

Under general cost classification costs

are classified into two broad categories.

They are

- Manufacturing costs

- Non manufacturing costs


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General cost classificationManufacturing Cost:

Manufacturing costs are those costs that are

directly related with manufacturing productsOr rendering services

- Components of Manufacturing cost

- Direct material costs

- Direct labour costs

- Manufacturing overhead cost


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- Direct materials : Direct materials are those

materials that become an integral part of thefinished product and that can be physically and

conveniently traced to it. Finished product of oneproduct line can become direct material of anotherproduct line. For example : Brick is one of the rawmaterials for housing industry

- Direct labour: It is the amount paid to theworkers who are directly involved if the process. Forexample in a manufacturing unit, the paymentmade to a machine operator.


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- Manufacturing overhead Cost:

It is another element of manufacturing cost that

include all cost elements other than direct materialand direct labour. The components usually are

- Indirect materials

- Indirect labour

- Other indirect expenses


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- Indirect materials: Materials those can notbe traced in the basic output. For example

warping material used is medicines.

- Indirect labour: Expenses incurred formaking payments to those who areinvolved in manufacturing process but do

not directly participate in productionprocess. For example :salary of thefactory manager, supervisor, storekeeper,watchmen etc.


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- Other indirect expenses : Expenses incurred infactory other that direct material, direct labour,indirect material, indirect labour. The expenses

may be- depreciation of the machineries used inproduction process

- depreciation of factory office equipment- repair factory building- depreciation factory building

- fuel, power used in production- cost of electricity of factory- factory canteen subsidy- contribution to workers welfare fund etc.


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General cost classificationNon manufacturing cost :

It consider the costs those are not

incurred to manufacture a product. Itcan be classified as

- Marketing and selling costs

- Administrative costs


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Marketing and selling costs: All costsnecessary to secure customer orders and

get the finished product or service in to thehands of the customer, such as salescommission, advertising, depreciation ofdelivery equipments and finished productstore, salary of marketing and sales force,promotional expenses etc.


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General cost classificationAdministrative costs : All costs

associated with the general

management of the company as awhole, such as executivecompensation, executive travel costs,

secretarial salaries and rent ordepreciation of office building andequipment etc.


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General cost classificationFurther classification of costs (General):

In addition to classifying costs into Manufacturing

& Non manufacturing costs, costs may further beclassified as

- Product costs or Inventoriable costs

- Period costs

- Prime costs- Conversion costs


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General cost classificationProduct costs orInventoriable cots:Costs incurred for acquiring ormanufacturing goods for sales. For atrading house it include the costsincurred for procurement of the items tobe sold. For manufacturing units it is thetotal of

- Direct Material- Direct Labour- Manufacturing Overhead


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Prime costs :

These costs are the sum of direct materialcosts and direct labour costs

Conversion costs :

These costs are incurred to convert

materials into the finished products. It isthe sum of direct labour cost andmanufacturing overhead costs.


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Behavioral cost classificationsBehavioral cost classification :

In addition to classifying costs on the basisof their nature, costs can also be classifiedon the basis of their nature of responsetowards changes in the level of activity.

On the basis of behavior towards changescosts may be classified broadly in to two

categories- Fixed cost

- Variable cost


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Behavioral cost classifications.

Fixed cost:It is a cost that remain same regardless to the size ofoperation i.e. this cost is not responsive to any change inoperation. More specifically the total amount of fixed cost will

not increase or decrease in response to increase or decrease ofunits manufactured, sold or service offered within a given limitof installed capacity.

Example: Cost of a printer : Tk. 10,000.00

Rated printing capacity : 50,000 pages

Fixed cost upto 50,000 pages will remain same i.e. at operativelevel of 01 pages to 50,000 pages the total fixed cost will beTk.10,000. Per unit cost however will be reducing with increasein the number of pages printed.


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Managerial AccountingBehavioral cost classifications

Characteristics ofCommitted fixed cost :

They are long term in nature

They can not be significantly reduced even for short

period of time even if operations are interrupted or cutback, the committed fixed will still continue

Characteristics of Discretionary fixed cost

Though the cost arise out of annual managementdecision, management can also be adjust such expenses

according to the prevailing circumstances. For example,in the mid of the year management may shorten thearea of research.


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Behavioral cost classificationsDifference between Committed Fixed cost and

Discretionary Fixed cost :

- The planning area for Committed Fixed cost is long

term. The planning area of Discretionary Fixed costis fairly short term usually one year

- Cost cut is case of Committed Fixed cost causesubstantial damage to long run goals of theorganization. Cost cut is case of Discretionary

Fixed cost is possible with minimal damage to thelong run goals of the organization.


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Behavioral cost classifications

Variable cost:

It is a cost the total of which varies in direct

proportion to the changes in the size of operation. Inother words, variable costs are positively responsiveto any change in the units of goods manufactured,sold, service rendered.

Example : Variable cost of printing 01 page :Tk. 1.00

Cost of printing 100 pages = 100x1=100/=Cost of printing 800 pages = 800x1=800/=


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Behavioral cost classifications Classification of Variable costs

True Variable costs :Costs that vary in direct proportion to change in the level of activity. Direct

material is the best instance of true variable cost since the total cost ofdirect material will change in same proportion to the change in the numberof units manufactured.

Semi Variable (Step-variable) costs :There are some costs which vary with change in the level of activity but notin direct proportion i.e. this type of expenses contain a mixed character,both fixed and variable.

For instance electricity and telephone bills. A portion ofthese expenses are usually consist line rent which is fixed irrespectiveof units consumed.


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Behavioral cost classifications Cont Example of Semi variable expenses

Example of Photocopy machine:

Cost of electricity per minute : Tk.0.15

Per minute copying capacity of the machine:10Warming up period per start up : 30 Seconds

Electricity cost for 50 copies= Tk. 0.825 (50/10=5+.5=5.5x.15)cost per unit: 0.0165 (0.825/50)

Electricity cost for 60 copies= Tk.0.975(60/10=6+.5=6.5x.15)

cost per unit : 0.01625

Electricity cost for 40 copies= Tk.0.675 (40/10=4+.5=4.5x.15) costper unit : 0.0168


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Behavioral cost classifications Cont

Summary of variable and Fixed costbehavior

Cost In total In unitVariablecost

Total variable cost increases anddecreases in proportion to changein the activity level

Variable cost remainsconstant per unit

Fixed Cost Total fixed cost is not affected bychanges in the activity level withinthe given level of installedcapacity

Fixed cost per unitdecreases as theactivity level rises andincreases as theactivity level decreases


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Behavioral cost classifications Cont Advantages ofVariable costing

- Necessary data for Cost Volume Profit (CVP) analysiscan easily be available from an income statement

prepared following variable costing system- The impact of fixed costs on profits is highlighted. The

total amount of fixed costs appears in the incomestatement

- Variable costing data make it easier to estimate the

profitability of different segments (products,customers) of a business

- Under variable costing method, net operating income iscloser to net cash flow.


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Cost classification for assigning costs to Cost Objects

Cost object:

IT Is that functional area of an enterprise for which costdata are required. The area may be production, marketing,

employment etc.

Classification:

From the standpoint of assigning costs to cost objects, costsare classified into three categories. They are

- Direct cost

- Indirect cost- Common Cost


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Cost classification for assigning costs to Cost Objects

Direct Cost:It is a cost which can specifically be assigned to a particularcost object. For example when a company distribute its totalamount incurred for managers salary to its different divisions,

salary of the manager of say human resources division wouldbe a direct cost of that division

Indirect Cost :The nature of this type of cost is just reverse to that of directcost. It can not be assigned specifically upon any costobjective. For instance, a pharmaceutical unit produce anumber of finished formulations (medicines). The amount of

factory managers salary can not be assigned to a particularproduct since the salary is not caused only due to aparticular product and as such for a particular product sayproduct X, the cost will be indirect cost.


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Cost classifications for Decision MakingFor decision making, costs may be classified

as

- Differential (Incremental / Decremental) Cost- Opportunity Cost- Sunk Cost

- Prevention Cost

- Appraisal Cost

- Internal Appraisal Cost

- External Appraisal Cost


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Cost classifications for Decision MakingDifferential (Incremental/Decremental ) Cost :

Decision making is the process of selection betweenalternatives. Each alternative will have different cost andrevenue. The difference of cost between two alternatives

is the Differential Cost which may by higher or lowerthan that of other alternative. Thus the differential costmay be Incremental or Decremental.

The expected revenue between two alternatives will notbe same. The difference of revenue between two

alternatives is the Differential Revenue which may beIncremental or Decremental as well.

The term Differential cost and Differential revenue is alsospelt as Marginal cost and Marginal Revenue


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Cost classifications for Decision MakingOpportunity Cost:

It is the amount of given up benefit ofselecting a particular alternative over

another. For example, rate of interest ondeposit offered by bank Y is 12%. On theother hand rate offered by bank Z is11.50%. Opportunity cost of selection the

offer of bank Y is 11.50% i.e. the rateoffered by bank Z.


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Cost classifications for Decision MakingSunk Cost :

Sunk cost is the cost that has already beenincurred and can not be recovered in full or in

part under existing circumstances. Forexample Company X incurred Tk. 10,000.00for developing a particular product. Due tochanged circumstances, production of theparticular product no longer consideredviable and the company have to give up the

idea of producing that particular product. Theamount incurred for developing the productbecome Sunk Cost.


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Managerial AccountingCost classifications for Decision Making

Prevention Cost:It is the cost incurred to support the activities to reduce the number of defects. Forinstance the cost of introducing Total Quality Management System.

Appraisal Cost :It is the cost that incurred to identify any defective product well before handing over to

consumer. It is also termed as Inspection Cost.Internal failure cost:

Failure cost arises when a product fail to confirm with the design or qualityspecification. Internal failure cost is incurred to make good any defect before handingover to consumer. For instance, rework cost of defective product, production cost ofrejected products etc.

External failure cost :External failure cost is incurred to make good of defective units after being delivered tocustomers. Example of such costs are Warranty, Product replacement, Decrease inSales, Compensation etc.


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Managerial AccountingCost Classification on Financial Statements

Financial statements are prepared byfirms irrespective of their nature of

business. Financial statements of atrading firm is less complicated thanthat of manufacturing firm.

Contents of Financial statement

- Balance Sheet

- Income Statement


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Managerial AccountingCost classification on Financial Statement

Balance Sheet :

Balance sheet is a pictorial representation of thefinancial state of affairs of a firm at particular date.

Cost component on Balance Sheet :

The cost component on balance sheet is only theinventory accounts. For a trading firm inventoryconsists of only the goods purchased from suppliersthat are awaiting resale to customers. On the otherhand inventory component of a manufacturing firm

consists of raw materials, work in progress andfinished goods


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Cost components of Income

Statement:

- Basic Equation for Inventory Accounts

- Direct Materials Consumed

- Manufacturing Cost

- Cost of Goods Manufactured

- Cost of Goods Sold in a Trading Enterprise- Cost of Goods Sold in a Manufacturing

Enterprise


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Basic Equation for Inventory Account

Opening Inventory + Purchase =

Consumption + Closing InventoryDirect Materials Consumed :

Opening Stock of Raw Materials+Purchase during the year Closing stockof Raw Materials


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Manufacturing cost:

Direct materials consumed + Direct

Labour + manufacturing overheadCost of Goods Manufactured :

Manufacturing cost + Opening balanceof Work in Progress Closing balance ofWork in Progress


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Cost of Goods Sold in a Trading Enterprise :

Opening Inventory + Purchase during the

period-Closing Inventory

Cost of Goods Sold in a Manufacturing

Enterprise :

Opening stock of Finished goods + cost ofgoods manufactured - Closing stock of Finishedgoods

Documents

MA-2, Cost Terms