Cost concepts, Cost
Classification and Estimation
BY GHANENDRA FAGO
Cost Concepts
 Cost refers the amount of expenses spent to generate product or services.
 Cost refers expenditure that may be actual or nominal expenses incurred to
generate output.

Cost is the value of economic resources used as result of producing or doing
the things.
 Cost has many meaning but in management cost refers the expenditure not the
price.
 As a manager we use cost information for taking decisions and making plans,
programs and policies and strategies.
Cost according to elements of cost
Direct material
Direct labor
Direct expenses
Overheads
Cost According to function- Manufacturing Vs. Non-manufacturing
costs
Manufacturing Costs
 Manufacturing costs involves the cost of raw
material, labour and use of equipment to finished
goods
 Composed up of the following elements.



Direct material
Direct labour
Overheads
Elements of Manufacturing Cost
 Materials
 Labour
 Overheads- indirect material labors and factory
expenses
Non manufacturing Cost
 Cost other than manufacturing cost that are incurred
for sale
 Non-manufacturing costs are:



Selling expenses /marketing expenses
Promotion, or Advertisement costs,
Administrative costs
Cost according to behavior
 Variable cost
 Mixed cost
 Fixed cost
Variable costs
 Variable costs are based on activity.
 The variable costs should be zero at zero activity.
 They change directly with changes in activity level in a
responsibility center.
 If output is doubled, variable expenses is to be doubled,
 if output increases by 15% the variable expenses also
increase by 15%,
 if output is zero, the variable cost also zero.
Variable costs are usually characterized by:
 Unit cost remains constant.
 Total costs that increase as activity increases.
 Total costs that decrease as activity decreases.
 Total costs changes proportionality with changes
in output.
Variable cost
cost
Variable
cost
Variable cost per unit
0
Units of products
Fixed Cost
 Fixed cost is also called period cost or capacity
cost.
 It does not change in short term period or within a
relevant range.
 They accrue primarily with the passage time.
 Fixed costs are caused by holding of assets and other
factors of production in a state of readiness to
produce.
Characteristics of fixed cost

Unit cost increase as activities/outputs decrease.

Costs that remain constant even activities are
decreased or decreased

Cost per unit that increases as activity decreases
and vice versa

Total costs that remain constant.
Fixed cost curve
cost
Fixed cost
0
Units of products
Committed fixed cost
 Committed cost arises from the ownership,
facilities or possession of assets.
 Committed cost can not be changed by a simple
decision.
 Major decisions to change.
For example: property tax, Loan installments
depreciation, insurance etc.
Discretionary fixed Cost
 Arises from management decision
 Controllable costs
 Can be easily changed by decisions
 Examples:
Advertisement,
Training costs
marketing expenses,
promotional expenses etc.
Step fixed costs
Remains constant over fixed range of activities but jumps to
different amount for the activities levels outside the range
Semi–Variable Expenses/ Mixed costs
 Semi–variable expenses also changes with changes in
output or activity but not in proportion to changes in
activity or output
 Semi
variable expenses have some of the
characteristics of both fixed and variable costs.
 Semi variable expenses are caused by combined effect
of passage of time, activity or output and management
discretion decisions.
Methods of Cost Segregation
 Engineering analysis
 Accounting analysis
 High Low point methods
 Least Square Regression Analysis
Engineering Analysis
 Systematic review of costs for product and services
 Measuring cost behaviors according to what cost
should be, not by what have been
Mixed Cost Function = Rs4,000 + Rs.600 X Per Day
Accounting analysis
 This is a simple method
 Segregates cost into fixed and variables based on
certain cost driver.
Example:
The Directorium Manufacturing Company produced and
sold 80,000 units at Rs. 50 each. The cost for 1976 were as follows:
Particular
Fixed Cost
Variable
Cost
Direct materials
-
Rs.200,000
Direct labour
-
160,000
Rs.440,000
20,000
280,000
100,000
Manufacturing overhead
Selling and admi. expenses
Mixed cost function = Rs.720,000 + Rs.6 X units of
production
High Low Point method
 Under this method, semi variable cost can be segregated into




variable and fixed cost based on the two extreme levels of
activities using the following formulas.
Variable rate (b)
= [Cost at high point- Cost at low Point]/
[High point –Low point]
Fixed cost (a) = Total cost – Variable rate  Level of activities
Therefore, the cost volume formula:
Total cost = Fixed cost + (Variable rate  levels of
activities)
Advantages and Disadvantages
Advantages:
 It is easy and less time consuming.
 Cost behavior is restricted to the relevant ranges.
 It will be more suitable when there are two levels of
activities to estimate cost.
Disadvantages
 Use of only two extreme conditions may not be
representative of normal conditions
 It may give the unreliable estimate of fixed cost (a)
and variable rate (b).
 It does not specify the fixed cost below and above
the two levels of activities.
Least Square Analysis
 One of the best and widely used methods in cost estimation,
 A statistical procedure for estimating mathematically the
average relationship between the dependent variable (y) and
independent variable (a).
 It includes all the observed data and attempts to find the line
of best fit in estimation of variable and fixed cost.
 Under this method, the following least square formula can be
used to estimate cost.
Y = a + bx
Where,
a = Estimated fixed cost i.e. constant
b = Variable rate i.e. slope of regression line
Y = Dependent variable i.e. estimated total cost
X = Independent variable i.e. Level of activity or
units of products, hours etc
Least Square Formula
b
N  XY   X  Y
N  X 2   X 
2
 X  Y   X  XY

N  X   X 
2
a  Y  bX
Where
a  fixed cost
b  var aible rate
X  levels of  activities
2
2
Regression Statistics
 Least square regression method is used to estimate variable
and fixed cost.
 However, it doses not explain the accuracy and the
reliability of the regression result.
 To explain the accuracy and reliability of the regression
result, Correlation coefficient (r) and Coefficient of
Determination (r2)
Correlation Coefficient (r)
 Goodness of fit regressions line can be measured by
assessing correlation coefficient. The correlation coefficient
can be computed as follows:
Correlation coefficient (r) =
N  XY   X  Y
N  X 2   X   N  Y 2   Y 
2
2
Explanation:
 The correlation coefficient measures the degree of correlation
between y and x. Therefore, it should be between +1 and –1. If
not, it means, it is unclear about the results. Then, coefficient
of determinant should be computed to find the meaningful
result using the following formula.
Coefficient of Determination (r2)
r2 =
[
N  XY   X  Y
]
N  X 2   X   N  Y 2   Y 
2
2
2
Explanation:
 It means that ….%
of the goodness of fit in
regression line. Therefore, higher the degree, more
the confidence in cost estimation. In other words, ….
% means the total variation of total cost is due to
change in levels of activities and remaining in due to
other factors other than the independent variable.
Data for total power costs and machine hours are given below:
Power Costs (000 omitted)
Machine Hours (000 omitted)
Rs.7
9
6
8
8
8
3
4
4
6
8
7
8
9
6
5
7
8
5
6
Rs.62
70 hours
1. Required:
a) Separate the power costs into the fixed and variable components using
the method of least squares.
b. Estimate the power costs when 6.5 machine hours are used.
c. Compute the coefficient of determination.
d. Does the regression equation need to be improved?
e. t-value,
e) Standard error of coefficient (Sb)
Classification of cost according to decision making

Relevant Cost and Irrelevant Cost

Avoidable and Unavoidable Costs

Out of pocket costs, Opportunity, Sunk costs

Period Cost and Product Cost

Direct Vs. Indirect cost

Controllable and Uncontrollable Cost

Incremental Cost/Differential Cost

Committed fixed cost and Discretionary fixed Cost
Relevant cost
 Costs and expenses which are directly influenced by
decision are relevant costs.
 All future cost are relevant cost. They are pertinent
and valid costs.
 Relevant costs include all variable costs and
additional fixed costs which are incurred because of
the decision being taken
Irrelevant Cost
In other hand, costs that cannot be changed are called
irrelevant costs. Irrelevant costs include the existing
fixed costs which are going to exist even after the
decisions are taken. Such costs do not affect the
decision
Controllable and Uncontrollable Cost
 Controllable and uncontrollable cost depends on the
point of reference.
 Uncontrollable cost at lower level may be
controllable at top level, uncontrollable in short term
may be controllable in the long run. etc.
 A cost is a called controllable at particular level if the
level has power to authorize the cost.
 If it has not, it is called uncontrollable cost.
Avoidable VS Unavoidable Costs
 Avoidable costs can be saved simply by not doing the
alternative courses of action.
 They are relevant in decision making
 Unavoidable costs are irrelevant cost because they can not
be avoided or eliminated by taking decisions or
alternatives.
 If the revenue generated by avoidable cost is high, we have
to take decisions
Direct Cost and Indirect Cost
 Direct costs are directly traceable or identifiable to a
particular job or department or product and are
controllable.
 Indirect costs are uncontrollable and no-traceable
costs.
 Cost may be direct but the same may be indirect
depends on the situation.
Incremental Cost/Differential Cost
 Cost difference between two alternatives
 If differential costs are increased, it is called incremental
cost and decreased, and called decremental cost
 Incremental cost refers the only the increased cost from
one alternative to another.
 Differential cost or incremental cost can also be used to
analyses alternatives for decision-making purpose
Period Cost
 Period costs are not manufacturing cost. However, they are
incurred and paid based on the period
 They are deductible from revenue.
 Example: Rent, salaries, telephone etc.
Product Costs
 Product costs are manufacturing costs
 They are incurred for the manufacturing of goods
 They include direct material, direct labour, and
manufacturing overheads.
 Example: direct material, labour cost, manufacturing
overhead etc.
Out of pocket expenses
 Expenses incurred for activities for raw materials,
labour overheads etc.
Opportunity Cost
 Not recordable in the books of account but are
considered in every decisions of managers.
 It is the amount of benefit that is sacrificed when one
alternative is selected.
Sunk costs
 Costs are the cost incurred a result of past decisions.
 Cost can not be changed by taking operating decision
 Sunk costs are irrelevant from decision making.
 Sunk costs are depreciation of assets, lease rent etc.