Cost and management accounting-I
CHAPTER- 2
COST CONCEPTS AND ITS CLASSIFICATION
Introduction:
To carry out their planning, control, and decision-making responsibilities, managers need
information about the organization. Much of this information, provided by managerial
accountants, emphasizes on the costs incurred in the organization.
Different people use the word ‘cost’ in different senses for different purposes. In common use,
the word cost means price. In management terminology, the term cost refers to expenditures but
not the price.
British institute of cost and works accountants:
Cost is the amount of expenditure incurred on or attributable to a given thing.
W.M.Harper:
Cost is the value of economic resources (money, material, and men) used as a result of producing
or doing a thing.
In managerial accounting, the term cost is used in many different ways. The reason is that there
are many types of costs, and these costs are classified differently according to the immediate needs
of management. For instance, managers may want cost data to prepare external financial reports,
to set forth planning budgets, or to make decisions. Each different use of cost data demands a
different classification and definition of costs. The preparation of external financial reports, for
example, requires the use of historical cost data, whereas decision-making may require current
and/or future cost data.
An important first step in studying managerial is to gain an understanding of the various types of
costs incurred by organizations. In this chapter, therefore, you will study the cost terms, concepts,
and classifications routinely used by managerial accountants.
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Cost and management accounting-I
Classification of costs:
1. Manufacturing and Non-manufacturing costs:
We discuss the above classification keeping in view a manufacturing company.
A. Manufacturing costs (Direct cost):
Manufacturing costs are broadly classified into four categories:
1. Direct material
2. Direct labor
3. Direct expenses`
4. Manufacturing overheads (Factory overheads)
Let us see each of these categories in the discussion that follows.
1. Direct Material:
Raw material that is consumed in the manufacturing process and which become interval
part of the finished product and can be identified or traced to products conveniently is
called Direct Material.
For example: For automobile manufacturer engines, tires, scats, glass battery Direct
Material wood in furniture is sugarcane in case sugar company cotton in textiles company
cartoons used for packing.
2. Direct labor:
It consists of cost of wages paid to workers engaged in manufacturing or handling a
product, or job or process. It means, it is the cost and wages paid to only those workers
who are engaged on the actual production of the product.
Example: Machine operators, assembly – line workers, carpenters bride layers, shoe maker,
tailors, baker etc.
3. Direct Expenses:
These are also known as changeable expenses. These are other than Direct Material and
Direct labor. For example, Architect or surveyor’s fees, cost of drawings and patterns,
royalty, excise duty, mine changes of special equipment, repairs to hired equipment etc.
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4. Manufacturing overheads:
Manufacturing overheads (also called as factory overheads or indirect manufacturing
expenses) includes all costs of manufacturing except direct materials, direct labor, and
direct expenses.
Manufacturing overheads are further classified into three categories which are as follows:
i.
Indirect Materials
ii.
Indirect labor
iii.
Indirect Manufacturing expenses
i.
Indirect Material:
The costs of materials that are required for the production process but not become an
integral part of the finished product are classified as indirect material costs.
Examples: lubricating oil, grease, cleaning rags, brushes, and glue are but some examples
of indirect materials.
However, some materials that do become an integral part of the finished product but the
consumption of which is so minimal (or in significant) or so complex to assign to a
particular product or process are also classified as indirect materials. Note that, sometimes,
it is not worth the time and effort to trace the costs of relatively in significant or complex
material to the end products. Consequently, for the sake of convenience and economy, such
materials can be treated as elements of indirect materials and included in manufacturing
overhead cost category. Such materials as nails used in furniture making, thread, buttons
used in stitching, soldering etc.
ii.
Indirect labor:
Workers or employees who do not work directly on the product but their services are
required in manufacturing process, are classified as indirect labor. This labor cannot be
traced to a particular job or process or product.
Examples of indirect labor include costs of workers in store keeping, material handling,
store keeper, time-keepers, general supervisors, inspectors, factory clerks and cleaners,
night security guards etc.
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iii.
Indirect Manufacturing Expenses:
These costs include all other indirect manufacturing costs except indirect materials and
indirect labor. These costs include depreciation of plant and equipment, rental cost for
manufacturing facilities and equipment, insurance on factory building and facilities,
property taxes on factory maintenance and repair cost for the manufacturing facilities and
production equipment, and utility costs (such as heat, light, and power) on factory, etc.
B. Non-Manufacturing costs:
Non-manufacturing costs are sub-classified into two categories.
i.
General and Administrative Expenses
ii.
Selling and Distribution Expenses
i.
General and Administrative Expenses:
These costs include all costs of running the organization a whole. In brief, administrative
costs of all executive, organizational, and clerical costs associated with the general
management of an organization rather than with manufacturing or marketing. Examples
of administrative costs include executive compensation (salaries of top – management
personnel), costs of general accounting, legal, public relations, secretarial salaries,
executive travel costs, and similar costs involved in the overall general administration of
the organization as a whole.
Some other examples for administrative expenses are Office lighting, rent, insurance,
property taxes, repairs and maintenance, and depreciation fixed assets except on plant and
machinery.
iii.
Selling and Distribution Expenses:
These include all costs necessary to secure customer orders and place the finished product
or service into the hands of customers. Examples of selling and distribution expenses
include sales salaries, sales commissions, travel costs of sales personnel, costs of
advertising and promotion, warehousing expenses, packing expenses, costs of shipping
finished product, and similar costs involved in selling functions of the organization.
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2. Product costs Vs. Period Costs:
A. Product costs:
Product costs include all the costs that are involved in making a product i.e. cost of goods
manufactured. It consists of Direct Material, Direct labor, direct expenses and manufacturing
overheads. These are often called inventorial costs because these costs go directly into inventory
accounts as they are incurred. If these inventories are sold, this cost will appear as expense called
“cost of goods sold” in income statement and unsold inventory cost will appear as “inventory” cost
in Balance Sheet. These costs may be incurred in one year and may be charged as expense in the
other year/years.
Example: Matching principle: Sales – Cost of goods sold
B. Period Costs:
These costs include all costs other than product costs. Period costs are identified with period of
time in which they are incurred. It means, period costs are recognized as expense during the period
in which they are incurred. If they are incurred in 2015, they are shown as expense in income
statement of 2015. Example: Salaries, Rent, Advertising, depreciation on equipment etc.
3. Cost classification based on cost behaviour:
Cost behaviour: Cost behaviour means how cost will react or respond to changes in levels of
business activity (volume of production). If a business activity increases or decreases, a particular
cost may also increase or decrease or it may remain constant.
Based on their behaviour, costs are categorized into two groups.
A. Variable Cost
B. Fixed Cost
Of course there are other two costs are there called Semi-variable costs/mixed costs
and step costs which will be finally added to variable and fixed costs after
segregation.
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A. Variable Cost:
Variable cost very in direct proportion to the changes in level of activity (volume of
production). For instance, if volume of production increases by 10%, variable cost also
increases by 10%, and if production decreases by 10%, variable cost also decreases by
10%. If there is no production at all, no variable cost is incurred.
Example: Direct Material, Direct labor etc.
Illustration: ABC Automobile manufacturing company produces and sells cars. The production
details are as under:
Month
No. cars produced
cost per battery
Total variable cost
January
500
$30
15,000
February
1000
$30
30,000
March
1500
$30
45,000

Total variable cost very in (Increase or decrease) direct proportion to volume of
production.

Variable cost per unit remains same irrespective of volume of production.
B. Fixed Costs:
Fixed costs, as the name suggests, remain fixed in total amount irrespective of the volume
of production or level of activity.
Examples: Salaries, rent, insurance, depreciation etc.
Illustration:
Selam clinic hired a diagnostic machine for Birr 15,000 p.m. to test blood samples. The
capacity of the machine is 30,000 tests per month.
Month
Total Fixed Cost
No. of test performed
Fixed Cost per unit/test
January
15,000
1000
15
February
15,000
1500
10
March
15,000
5000
3
April
15,000
15000
1

Total fixed cost remains same irrespective of level of activity

Fixed cost per unit very inversely with changes in the level of activity
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Variable and Fixed Cost Behaviour
Level of activity change
1. Variable cost
Total Cost
Cost per unit
Change in direct
Remains constant
proportion
2. Fixed cost
Remains constant
Changes inversely
3. Absorption costing versus Variable costing:
Income is one of the many important measures used to evaluate the performance of both
segments and entire companies. Depending on the accounting treatment of fixed
manufacturing overhead, there are two general approaches or alternatives for costing products
for the purposes of valuing inventories and cost of goods sold as well as reporting income in a
manufacturing firm. One approach called absorption costing is generally used for external
financial reports. Managers, for internal decision-making, prefer the other approach called
variable costing. Ordinarily, absorption costing and variable costing produce different figures
for net income and the difference can be quite large.
Absorption costing assigns both variable and fixed costs to products-mingling them in a way that
makes it difficult for managers to distinguish between them. This lead to the development of
variable costing which focuses on cost behaviour. In the discussion that follows, the difference
between the two approaches is briefly shown.
Absorption costing method:
Absorption costing, also called full costing treats all costs of production as product costs,
regardless of whether they are variable of fixed. Consequently, the cost of a unit of product under
the absorption costing method consists of the following:

Direct Material,

Direct labor, and

Both variable and fixed overhead
Therefore, absorption costing allocates a portion of fixed manufacturing overhead cost to each unit
of product, along with the variable manufacturing costs. As absorption costing includes all costs
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Cost and management accounting-I
of production as product cost, it is frequently referred to as the full cost method. In brief, absorption
costing method applies all manufacturing overhead (MOH) costs to manufactured goods.
Variable Costing Method:
Under variable costing method, only those costs of production that vary with output (i.e. variable
costs of production) are treated as product costs. Consequently, the cost of a unit of product under
the variable costing method consists of the following:

Direct Materials

Direct labor, and

Only the variable portion of manufacturing overhead
Note that, under this method, fixed manufacturing overhead is not treated as a product cost.
Rather fixed manufacturing overhead is treated as a period cost and, along with selling and
administrative expenses, it is charged off in its entirety against revenue each period. Therefore, the
cost of a unit of product in inventory or cost of goods sold contains no element of fixed overhead
cost. In brief, the variable costing method applies only the variable manufacturing overhead
(MOH) costs to manufactured goods.
Differences between Absorption Costing and Variable Costing
1. Absorption costing is the total cost technique. Thus, under absorption costing all costs
weather variable or fixed, are treated as product costs. In variable costing technique only
variable costs are treated as product costs. Fixed costs are treated as period costs.
2. In Absorption Costing, the inventory of finished goods and work in-process is valued at
total cost which includes both variable and fixed cost. In variable costing, such inventories
are valued only at variable cost. Hence, absorption costing results in higher valuation of
inventories as compared to variable costing.
3. In Absorption Costing, managerial decision making is based upon ‘profit’ which is the
excess of sales value over total cost. In variable costing the managerial decisions are guided
by ‘Contribution’, which is the excess of sales value over variable cost.
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Income Determination: Under Absorption and Marginal Costing /variable costing
Illustration 2.1: (Comparative Income Statements)
Green-Green Limited furnishes the following details for the year ended 31 December 1992 for
preparing the income statement of the year:
Sales
1,000 units @ birr10 per unit
Manufacturing costs
birr, 200
Variable manufacturing cost
1,100 units @ birr 6 per unit
Fixed manufacturing costs
2,200
Inventory at close
100 units
Fixed selling & admin. Expenses
birr500
Variable selling &admin. Expenses
birr400
Solution
Green-Green Limited
Income Statement
For the year ended 31st December, 1992
(A)Under Absorption Costing
Sales 1,000 unit @ birr10 each----------------------------------- 10,000
Less: Cost of sales:
Variable manufacturing cost:
1,100 units @ birr6 each-------- 6,600
Fixed manufacturing costs---------------------- 2,200
8,800
Les: Inventory at close:
100 units @ birr8 each
800
(8,000)
Gross Margin or profit----------------------------------------------- 2,000
Less: Total selling & admin. exps. ----------------------------------900
Net Income---------------------------------------------------------- 1,100
Workings:
The Cost of inventory at close, as well as cost of each unit of inventory at close, has been calculated
as follows:
Units manufactured----------------------------------------1,100
Units of inventory at close--------------------------------100
Ratio of closing inventory to total production =
100 = 1
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1,100 11
Cost of Inventory at close = 1 x 8, 800 = birr 800
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Thus, the cost of each unit of inventory at close
= 800 = 8 per unit
100 units
(b) Under Marginal Costing
Sales: 1,000 units @ 10 each-------------------------------------- 10,000
Less: variable cost of sales:
Variable manufacturing cost
1,100 units @ each----------6,600
Less: Inventory at close:
100 units @ 6 each--------------------- 600
6,000
Variable Gross Margin------------------------------------------- 4,000
Less: Variable selling & Admin. exps. -------------------------- 400
Operating contribution margin ------------------------------------3,600
Less: Fixed Costs:
Fixed manufacturing costs----- 2,200
Fixed selling & admin. exps. ----500
2,700
Net Income-------------------------------------------------------- 900
Workings
The cost of inventory at close, as well as the cost of each unit of inventory at close, has been
calculated as follows:
Ratio of closing inventory to total production
= 100 = 1
1,100
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Cost of Inventory at close = 1 x 6, 600 = 600
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Thus, the cost of each unit of inventory at close
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= 600 = 6 per unit
100 units
Note:
The difference of 200 in the net income calculated under the two methods is due to the difference
between the costs of closing inventory which, under absorption costing, is 800 and, under marginal
costing, is 600. This is the result of holding back 200 out of the total fixed manufacturing cost of
2,200 as cost of inventory under absorption costing, whereas 200 is released immediately as period
charge under marginal costing.
Role of Contribution
Contribution is of vital importance for the system of marginal costing. The rationale of contribution
lies in the fact that, where a business manufactures more than one product, the profit realized on
individual products cannot be possibly calculated due to the problem of apportionment of fixed
costs to different products which is done away with under marginal costing. Therefore, some
methods are required for the treatment of fixed costs and marginal costing and answer to the
challenge is 'contribution'.
Contribution is the difference between sales and the variable cost of sales and is, therefore,
sometimes referred to as a 'gross margin'. It is visualized as some sort of a 'fund' or 'pool' out of
which all fixed costs, irrespective of their nature, are to be met and to which each product has to
contribute its share. The difference between contribution and fixed costs is either profit or loss as
the case may be.
The concept of contribution is useful in the fixation of selling prices, determination of break-even
point, selection of product mix for profit maximization, make or buy decision, acceptance or
rejection of special orders and ascertainment of the profitability of products, departments, etc.
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