Cost Concepts
Chapter-1
Learning Objectives
• Relation between cost concepts, cost objects and
cost drivers
• Difference between direct and indirect cost
• Cost behaviour
• Inventoriable cost and period cost
• Different cost for different purposes
• Judgment and cost
• Present features of cost accounting and cost
management
What is cost?
• COST is a resource that is consumed to
attain an objective.
Actual Cost – incurred
Budgeted cost- forecasted
• Cost is determined for something called
cost object. (product, service, time or any
combination thereof etc.)
Cost Objects
Examples:
• Product: Pentacool refrigerator
• Service: Telephone hotline service information to
users of Pentacool
• Project: R&D project on optimizing inner space of
the refrigerator
• Customer: Raj Electronics, a dealer who purchases
all products of Godrej
• Department: Accounting department
What is cost driver?
Understanding CD is the key for
competitive cost advantage
- A variable like level of activity that drives
the cost over a period of time.
Types of cost drivers
• Activity based cost drivers
• Volume based cost drivers
• Structural cost drivers
• Executional cost drivers
Activity based cost drivers
Activity
Provide ATM service
Update account balance
Interbank fund transfer
Process loan applications
Mail customer statements
Cost driver
?
?
?
Volume based cost drivers
Many costs are volume based- DM, DL
Total volume based cost – nonlinear relation with
cost driver- due to increasing marginal
productivity – then law of diminishing
productivity sets in as you reach capacity limit
A linear approximation of the total cost curve
within a small range will be a straight line –
relevant range
Structural cost drivers
• Strategic in nature
• Involve plans of long term effect around scale,
experience, technology and complexity
 Scale- how much to invest
 Experience- prior experience in its current and
planned products and services
 Technology- huge cost saving – ex- computers
 Complexity- how many products, what markets?
Executional cost drivers
Factors the firm can manage in the shortterm operational decisions to reduce cost
Workforce involvement
Process design- faster movement of the
product
Supplier relationship – quality, timeliness,
cost
What is relevant range?
• A band of normal activity level where the
activity level has relation with the cost in
question.
Ex. – Fixed cost is fixed in relation to a range
of output and a given time span.
• Variable cost may not rise proportionately
beyond a range- Ex.- may be due to discount
on material purchase.
COST BEHAVIOUR
Fixed
(fixed in short run) may have cost drivers in a long run.
Ex.- Testing cost (equipment and staff cost) may be pruned down in
accordance with production level in the long run.
Varible
Semi-variable
Peculiarities:
A cost could be variable for one level of activity whereas it could be
fixed for another.
Not inherently fixed or variable
Many costs are semi-variable in nature
Impact of business process
Relation
Cost
Cost pool:
Meaningful
groups
Cost object: Product
Cost determination
Cost accumulation
(data collection)
Assignment
to cost pool or cost object
Cost tracing (direct relation
with the cost object)
Cost allocation (Indirect cost)
Direct and Indirect cost
- Direct cost -can be traced in economically
feasible manner – volume is the driver
- Indirect cost- no traceability- find the driver
and allocate
Factor affecting direct and indirect cost
classification:
• Materiality of cost
• Information gathering technology
• Design of operations
• Cost object chosen
Cost, cost pool, cost object, cost
driver in consumer durables mfg.
Costs
Electric motor
Materials
handling
Cost drivers & cost assignment
Cost objects
Cost pools
Dishwasher
Assembly
Supervision
Packing mat.
Final inspection
Packing
Washing
machine
Cont…
Examples of costs, cost pools, cost drivers & cost objects
costs
Cost driver
Cost pool
Cost driver
Cost object
DIRECT COSTS
El.motor
Direct trace
Ass. Dept.
Direct trace
DW & WM
Pack. Mat
Direct trace
Pack. Dept.
Direct trace
DW & WM
Final insp.
Direct trace
Not applicable NA
DW & WM
INDIRECT COSTS
Supervision
No. of
Both. Depts
DLHs
DW & WM
employees
Mat. Handling No. of parts Both. Depts
in the product
No. of parts
in the product
DW & WM
Relationships of types of costs
(Ex.- Cost object: Zen Classic)
• Direct and variable: Cost of steering wheels
• Direct and fixed: Salary of supervisor in
ZEN classic section
• Indirect and variable: Power of the plant
• Indirect and fixed: Lease rent of plant
Total cost & Unit cost
Unit cost is an average
Total cost is difficult to interpret: so unitize
But unit cost is misleading in some cases:
Level of prod. Unit cost USP
6000 units
Rs.105
Rs.100
7000 units
Rs.97
Rs. 99
8000 units
Rs.89
-------Ritesh offers Rs.70 per unit for 1000 units.
PERIOD COSTS AND INVENTORIABLE
COSTS
• Inventoriable cost/ product cost is that cost which is
regarded as asset when incurred, but becomes a part of cost
of goods sold when the product is sold. For MUL, all
manufacturing cost is inventoriable cost. (Raw material to
WIP to Finished goods) For a service sector unit, absence
of inventory means all are period costs. (Contrary to IAS)
• Period costs(nonproduct cost): all costs in P&L account
except cost of goods sold. So, in a mfg. sector unit, all nonmanufacturing costs are period costs. (Ex. Distribution
cost, design cost, R&D costs, Marketing costs, customerservice costs, etc.)
Many meanings of product cost
Pricing and product-mix decisions:
Cost incurred in all business functions of the
value chain (R& D cost to customer service
cost)
Contracting with Government agencies: Scope
of the contract defines
Preparing FSs: Production cost
Cost flow in mfg. company
1st. step
Mat. purchase
Mat inventory
Labour
2nd.
step
Mat. used OH
WIP
inventory
Cost of
goods mfg.
3rd.
step
FG-inventory
Opening inventory
COGS
Closing inventory
COST MEASUREMENT AND JUDGMENT
When is overtime premium on direct labour
considered as indirect cost?
• Overtime premium: generally considered as
overhead. The reason is that it is not prudent to
burden the last batch of work simply because it is
a work during the overtime period. It is only a
scheduling. As opposed to this, if overtime is due
to a rush job, it is a direct cost of that job.
• Idle time due to breakdown, scheduling problems,
lack of order, etc. is overhead.
COST CLASSIFICATION
Element or analytical classification of cost: Material, Labour, Other
Expenses
Functional Classification:
• R&D cost
• Design cost
• Production- Expenses till goods are ready for despatch
• Administration- Directing the organisation
• Selling (to create demand and secure orders) – Ex. Bad debts,
market research, price lists, catalogues,etc.
• Distribution-(from point of production till consumption) –Ex.Warehouse expenses, carriage outward, depreciation of delivery
vans, etc.
• Financing costs: costs for raising and using capital
• Commercial cost is cost beyond manufacture, i.e., Admin. and
S&D cost.
Cont…..
As per assignment to cost object:
1. Direct cost
2. Indirect cost
As per behaviour in relation to change in volume:
1. Fixed
2. Variable
Assets / Expenses: Inventoriable or period cost
Cont………
By Controllability: from responsibility point of view:
controllable / uncontrollable
By Normality: normal/abnormal
According to planning & control:
• Budgeted Cost: estimate of expenditure for
different business operations
• Standard Cost: for prescribed set of operating
conditions, labour, material and overheads are
predetermined; budget translated into actual
operation through standard costs.
Relevant cost
what is pertinent for decision on hand
• Out of pocket costs: cash outflow involved
•
Differential costs: Change in total cost due to
change in level of activity or method of
production. Could be incremental or
decremental.
•
Opportunity cost: Benefit forgone from not
choosing the next best alternative available.
Cont…..
• Irrelevant cost: not relevant for decision
making
• Example: Sunk costs: Sunk cost is the cost of
abandoned plant less salvage value. Not relevant
for decision making.
• Imputed (Notional cost): Actually not incurred
(interest on own capital, rent on owned building,
etc.) Taken into account in capital budgeting
decisions.
• Replacement cost: Cost of replacing at current
market price.
Cont…..
• Avoidable and unavoidable cost: Cost that
can be avoided by eliminating a product or
department is avoidable and that which
cannot be, is unavoidable.
Ex. – Rent of factory is unavoidable if a
product is discontinued.
Other costs:
• Future costs: cost to be incurred in future
• Programmed cost: Cost incurred as per policy of top
management. Ex.- Donation to charity.
• Joint cost: cost of joint or by-products incurred before
separation, which cannot be traced to particular products.
• Conversion cost: cost of converting raw material to
finished goods = Production cost- direct material.
• Discretionary cost: not essential for decision on hand.
Ex.- Training expenses of workers, R&D cost.
• Committed cost: Costs incurred due to past decisions and
are not within control in the short run at present. Ex.Depreciation on Plant, Rent, etc.
Defn.
COST UNITS
• Unit of output in production or service in relation to which
cost may be ascertained or expressed.
Ex.- Motor car in MUL, Passenger km. for a transport
operator, Cubic meter for gas, 1000 no. of capsules in
pharmaceutical industry, etc.
COST CENTRES
• smallest segment of activity or area of responsibility for
which cost is accumulated. A department might have many
cost centers. Ex.- location, a person, a machine, etc.
P-1
•
Rahim had placed an order for purchase of a special machine from
Ram. Rahim had given a non-refundable security deposit of
Rs.10,000 for the contract, to be adjusted against the price. Ram has
incurred Rs.60,000 till date. Shyam needs the machine with slight
modification. Shyam is prepared to pay Rs.30,000 for the machine.
The modification would entail these costs:
•
Old material costing Rs.5000 will fetch Rs.1,000 if not used for the
machine.
•
Additional labour of Rs.10,000 is needed for this. Labour has to be
diverted from another division. The revenue earned from that unit
would be Rs.35,000 and direct cost excluding labour is : Material
Rs. 10,000, and allocated fixed overhead Rs.5,000.
•
For the old machine, Ram had entered into a contract with Rome for
design for a fee of Rs.7,000. If his contract is cancelled, Rome will
get Rs.4,000.
•
General overheads of Rs. 6,000 will be added to the additional work
for new machine.
Show the benefit of accepting the new order.
P-2
A machine which originally cost Rs.12,000 has an
estimated life of 10 years and is depreciated at the
rate of Rs.1,200 per year. It has been unused for
sometime, however, as expected production orders
did not materialise. A special order has now been
received which would require the use of the machine
for two months.
The current net realizable value of the machine is
Rs.8,000. if it is used for the job, its value is
expected to fall to Rs.7,500. The net book value of
the machine is Rs.8,400. Routine maintenance of the
machine currently costs Rs.40 per month. With use,
the cost of maintenance and repairs would increase
to Rs 60 per month. What is the machine cost for the
new job?
P-3
X Ltd. has been approached by a customer who would like a
special job to be done for him and is willing to pay Rs.22,000
for it.
Material B is used regularly by X Ltd. and if stocks are
required for this job, they would need to be replaced to meet
other production demand.
Materials C and D are in stocks as a result of previous excess
purchase and they have restricted use. No other use could be
found for material C but material D could be used in another
job as substitute for 300 units of material E which currently
costs Rs. 5 per unit (of which the company has no units in
stock at the moment).
What are the relevant costs of material, in deciding whether
or not to accept the contract? Assume all other expenses on
this contract to be specially incurred besides the relevant cost
of material is Rs. 550.
P-3 cont………
The job would require the following materials:
Material
Total
Units Book value Realisable
units
in stock of units in value
required
stock
Rs./unit
Rs./unit
Replacement
cost
Rs./unit
A
1000
0
0
0
6
B
1000
600
2
2.5
5
C
1000
700
3
2.5
4
D
200
200
4
6
9
P-4
•
•
Estimated direct material requirements of a business
concern viz., ABC Ltd. for the year 1998-99 are
1,20,000 units. Unit cost for orders below 1,20,000
units is Rs.10. When size of order equals 1,20,000
units or more the concern received a discount of 2% on
the above quoted per unit price. Keeping in view the
following two alternatives:
i. Buy 1,20,000 units at the start of the year;
ii. Buy 10,000 units per month.
Calculate the opportunity cost, if the concern has the
facility of investing surplus funds in government bonds
at the rate of 10% interest.
P&G’s learnings
• Early 1990s- 50 brands, different size containers,
different prices, discounts, no. of trade promotions
etc.
• High complexity in product and pricing- huge cost
• 5 years- half of product variety- profit surged
--------------------------------------------------------------Compete with the best but reduce product and
process complexity