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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 Manufacturing

Buy finished goods Buy raw materials Sell finished goods 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

Basis Financial accounting Cost Accounting

Objective Provides information about the financial

performance and financial position of

the business.

Provides information of ascertainment of

cost to control and decision making about

the cost.

Nature Classifies records, presents and

interprets transaction in terms of

money.

Classifies records, presents and interprets in

a significant manner the material, labor and

overhead cost.

Recording of data Records historical data. Records and presents the

estimated/budgeted data. It makes use of

both the historical costs and pre-

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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 Direct Materials

Publishing company Paper, ink, book covers

Automobile manufacturer 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.

determined costs.

Users of

Information

Shareholders, creditors, financial

analysts and government

Used by internal Management at

different levels

Analysis of costs

and profits

Shows the profit/loss of the

organization

Provides the details of cost and profit of

each product, process, job, contracts,

etc.

Time period F/S are prepared for a definite

period, usually a year.

Its report and statements are prepared

as and when required.

Presentation of

information

A set format is used for presenting

financial information

There are not any set formats for

presenting cost information.

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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.

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

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

work

overheads

administration overheads

selling and distribution overheads

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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

𝑀𝐶 = 𝑆𝑎𝑙𝑒𝑠 𝑝𝑟𝑖𝑐𝑒 – 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡

Application: Break-even volume analysis

𝐵𝑟𝑒𝑎𝑘 𝐸𝑣𝑒𝑛 𝑉𝑜𝑙𝑢𝑚𝑒 =𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡

𝑀𝐶

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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