UNIVERSITY OF WEST INDIES DEPARTMENT OF MANAGEMENT STUDIES Introduction to Cost & Management Accounting MS15B

Cost may be defined as the sacrifice required or whatever is given up to attain or achieve a given objective or to acquire or obtain an object. Cost can be expressed in both monetary and non-monetary terms. [Financial Accounting deals with only items which can be quantified in monetary terms Money Measurement Concept]. Cost classification is the grouping of costs based on specific or common characteristics. Some of the main groupings of costs are !. #. %. ,. -. "unctional Costs $roduct Costs $roduction &olume 'elated Costs ()ctivity *evel+ Control 'elated Costs 'elevant Costs

1. (a+

Functional Costs
Production Costs .hese are costs incurred to transform the raw material into finished goods and are inclusive of the raw material costs e.g. cost of raw material used to ma/e the product0 wages of persons wor/ing on the production floor0 production foreman1s wages0 lubricating oil for machines0 electricity expense associated with running of machines on the production floor0 insurance of plant. Administrative Costs Costs incurred in directing and managing the organi2ation. 3xamples of these are office space rental cost0 salaries of executive cler/s0 property insurance0 stationery expense0 in/ for printers etc. Selling Costs Costs incurred in an effort to stimulate interest in a product or service and or in securing orders from customers e.g. sales commission0 salesmen salaries0 advertising expenses0 samples and displays0 catalogues etc. Distribution Costs Costs incurred from the product is finished or manufactured until it reaches the end user or customer e.g. warehouse expenses0 pac/aging costs0 loading costs0 delivery vehicle running costs. Service Costs .hese are costs incurred in providing the support necessary for the efficient operation of the other functional areas. .hese costs are common to the functional areas and are usually shared on equitable bases e.g. maintenance costs.

(b+

(c+

(d+

(e+

2. Product/Production Costs
$roduction cost is the cost of a finished product built up from its cost elements. $roduct costs are identified with goods produced or purchased for resale. $roduct costs0 also referred to as inventoriable costs0 become expenses (in the form of cost of goods sold+ only when the inventory is sold. (a) Direct Product Cost .hese are costs0 which can be specifically identified with or trac/ed to the finished product. .hese costs can be clearly identified as being a constituent part of the end product i.e. they can be economically identified with the unit of production with reasonable precision. 4irect costs include direct material0 direct labour and direct expenses. Direct Material cost of raw materials that can be physically identified as part of the manufactured goods and may be traced to the manufactured goods in an economically feasible way. 3xamples are the cost of paper used to ma/e a boo/0 cost of flour in bread0 cost of board used to ma/e a piece of furniture. 4irect materials often do not include minor items such as tac/s or glue because the cost of tracing these costs is greater than the possible benefit of having more precise product costs. Such items are usually called supplies or indirect materials. Direct Labour payroll cost of the production staff (also called production operatives+0 directly employed in the ma/ing of the end product. 5t covers their gross pay0 as well as0 other related costs such as 65S and pension costs bourne by the company. Costs such as holiday pay and idle time costs are non-production overheads0 as they do not relate to the product. 3xamples are the wages of machine operators and of assemblers. 7ages relating to janitors0 for/lift truc/ operators0 plant guards and storeroom cler/s are considered to be indirect labour. Direct e !ense any other cost except direct material and direct labour which can be precisely identified with the finished product e.g. royalties payable to an inventor8 hire of equipment cost for a specific job and cost of a special design.

"#e sum o$ all direct costs is re$erred to as t#e !rime cost o$ t#e !roduct. (b) %ndirect Product Costs ) catch all category which includes all manufacturing costs other than direct costs. .hese are costs that are part of the cost of the product but cannot be directly traced to the product. .hese costs are very often charged to the product using estimates e.g. the glue used to assemble a piece of furniture. )ll indirect costs are referred to as overheads. .he indirect costs relating to the production function are therefore referred to as production overheads factory!overhead costs factory burden or manufacturing overhead. $roduction overheads include expenditure of labour0 material or services0 which cannot be economically identified with the finished product. $roduction overheads relate to the production floor and include indirect materials0 electricity expense relating to the running of production machines and lighting of the production area0 production manager1s salary0 production floor cleaners wages0 for/lift truc/ operators wages0
#

salary of security in raw material warehouse and protective clothing of production machine operatives. $roduction overheads are usually passed on or applied to production using overhead absorption rates (9)'s+. )ll other indirect costs not related to the production floor are termed non-production overhead costs. Direct e !enses are not !resent in all situations& #ence t#e main elements o$ t#e inventoriable cost o$ a manu$actured !roduct are direct material' direct labour and !roduction over#eads.

(.

Production )olume or Activit* Level

.hese cost behaviour patterns are being examined in the short-term (an accounting period+0 as well as0 within the relevant range i.e. the normal range of operation. Fi ed Costs (Also re$erred to as constant' ca!acit*' !eriod or unavoidable costs.) .hese are costs that are independent of activity level within the short-term i.e. they remain the same in total in the short-run0 irrespective of the level of production or activity. 3xamples of fixed costs are rent0 insurance0 property taxes0 staff salaries0 interest0 depreciation on plant and equipment. "ixed cost per unit varies inversely with activity i.e. as production volume increases0 fixed cost per unit decreases and vice versa.

)symptote

.otal "ixed Cost

"ixed0 Cost per unit

)ariable Costs .hese are costs that tend to move in relation to the volume of activity in the short-term. &ariable costs are said to vary linearly or in direct proportion with changes in activity i.e. if production volume increases by #:;0 total variable costs would also increase by #:;. &ariable cost per unit is constant. 5t is important to note that direct costs are usually also variable costs0 but the two are not synonymous0 as in many cases it is not practical (not economically feasible+ to apply some variable costs to the production units e.g. Small items of hardware0 such as nuts and bolts0 paint0 glue0 nails etc.0 which are frequently variable but can rarely be applied with precision to jobs0 hence they are deemed to be production overheads. ["ecall# $he main elements of production cost are direct material direct labour and production overheads.] 3xamples of variable costs include direct productive labour cost0 direct material cost0 sales commission0 selling expenses and pac/aging charges.

.otal &ariable Cost

&ariable cost per unit

Mi ed Costs .hese are costs0 which tend to move in relation to activity but not directly. 5n order to ma/e costs more meaningful for the purpose of forward planning0 they must be resolved or separated into their fixed and variable elements. 3xamples of mixed costs include utility bills and some production wages.

&ariable Component

"ixed Component

"ixed Component

&ariable Component

.otal <ixed Cost

<ixed Cost per unit

Se!arating Mi ed Costs
<ixed costs are invariably part of any organi2ation=s structure. "or $urposes of C&$ )nalysis0 all costs must be separated into their fixed and variable components. Met#ods o$ Se!arating Mi ed Costs !. >igh-*ow method #. Scatter 4iagrams? &isual "it %. *east-Square )nalysis 1. High-Low Method

.his is a mathematical technique0 which uses the changes in activity level and costs as a means of identifying variable costs. (i+ (ii+ (iii+ (iv+ @et the highest level of activity and its associated costs and the lowest level of activity and its associated costs. Calculate the change in cost and the change in activity. Since by definition0 total fixed costs remain the same in total despite the level of activity0 this implies that any change in costs must be variable in nature. Calculate the variable cost per unit by dividing the change in total cost by the change in activity. Calculate total fixed cost at either of the two levels of activity based on the equation "otal Cost + "otal Fi ed Cost , "otal )ariable Cost.
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- am!le

) company wants to develop a monthly cost function for its pac/aging department. .he number of shipments mainly influences this cost. .he following information is available for the first four months of !ABA Month Canuary "ebruary <arch )pril # of Shipments D0::: A0::: !#0::: !:0::: E%#0::: E!F0::: E%#0::: - E!F0::: G E!-0::: !#0::: I D0::: G D0::: G E!-0:::?D0::: G E#.-: G E#0::: G E#0::: Packaging Costs E!F0::: E#D0::: E%#0::: E#:0:::

(i+ (ii+ (iii+ (iv+

>igh *ow

!#0::: shipments D0::: shipments

Change in total cost Change in H of shipments &ariable cost per shipment

.otal fixed cost G .otal cost I .otal variable cost J high level ."C G E%#0::: I (!#0::: K E#.-:+ ./ J low level ."C G E!F0::: I (D0::: K E#.-:+

.he cost function would be "otal Pac0aging Cost + 12'222 , 12.32 4 5 o$ s#i!ments or Advantages o$ 6ig#7Lo8 met#od .he method is very easy to use 6ot many data points are needed Disadvantages o$ t#e 6ig#7Lo8 met#od Choice of high and low point is subjective .he method does not use all available data .he method may not be reliable.

* + 2'222 , 2.3

2.

Scatter Diagram or Vis a! "it

.his is a graph of past activity and cost data0 with individual observations represented by dots. 5t is a very useful approach to cost estimation. .he main objective here is to develop an equation to predict costs under normal o!erating conditions. .he periods of highest or lowest activity0 as used in the high-low method0 may not be representative because of factors such as costs of overtime0 poor equipment0 stri/es etc. .his method therefore see/s to overcome the wea/ness of the high-low method0 by helping to select high and low activity levels that are representative of normal operating conditions. 5t is very useful in determining if costs can be reasonably approximated by a straight line. 3xtreme activity levels may not be representative of the normal operating high and low activity0 hence the analyst will need to use the next highest or lowest activity level as representative of normal operation. .he scatter diagram is more reliable than the high-low method because it can use all the available data. 5f the cost function for the data is linear0 then it is possible to visuali2e a straight line through the scattered points that comes reasonably close to most of them and hence captures the general tendency of the data. .he major wea/ness of this method is that it can be subjective0 as the analyst has to eyeball a straight line i.e. the line of best fit0 by visually averaging the fit through the data. Method !. #. %. ,. -. @et several levels of activity and their associated costs $lot these on a graph. $ut in the line of best fit. .his line usually has equal amount of points on either side. 3xtend the line to cut the cost axis. .his is the intercept on the cost axis and represents total fixed cost. .o calculate variable cost per unit0 select any level of activity and its cost from the graph. Subtract the approximate total fixed cost as indicated in (,+ above from this total cost. .he difference represents variable costs. 4ivide this result by the number of units to get the variable cost per unit. - am!le Ste! 1 $roduction &olume !0::: !0-:: #0-:: %0::: ,0::: ,0-:: -0::: D0::: Costs E##0::: #F0::: %:0::: #L0::: %-0::: %L0::: ,#0::: D:0:::

Ste!s 2 7 9
70000 60000 50000 C o st s 40000 30000 20000 10000 0 0 2000 4000 6000 8000

.utlier "epresentative %igh &oint 'ine of (est Fit

"epresentative 'ow &oint

Production Volume

"otal $i ed cost is a!!ro imatel* 122'222 Ste! 3 Msing the : N ,0::: levels of activity "#e cost $unction: *+22'222 , (.;3

&C per unit

G (E%-0::: - E#:0:::+? ,0::: - : G E%.F-

Ste! Costs .hese are costs0 which change abruptly0 in lump sums0 with changes in output. .his means that a given amount of cost will sustain some increase in activity without a change in cost e.g. a bauxite mining company- when mining reaches a certain level0 additional mining equipment must be leased or supervisors1 salaries - as output increases0 the number of supervisors also increases. - am!le "ewer than -::: units produced -::!- !:0::: units produced !:0::! - !-0::: units produced ! supervisor # supervisors % supervisors

Mnits $roduced

)ote that within each relevant range this step cost behaves as a fi*ed cost. )ccountants describe step costs as variable when the OstepsO are relatively small and apply to a narrow range of activity. 5n this case the step function is said to simulate the .otal &ariable Cost function. 5n this case the cost behaviour approximates a variable cost function and could be used as such for planning0 as this would not greatly reduce the accuracy of the decision made.

9.

Controllable v <ncontrollable Costs

<anagement can influence cost behaviour through decisions about such factors as product or service0 capacity0 technology and policies to create incentives to control costs. .hey determine things li/e product mix0 product design0 quality distribution etc. .hese decisions are made in a cost?benefit setting. 5n a period of increased demand0 is it economically feasible in the long-run0 to increase production capacity or should we outsource production to a competitor out of an effort to /eep our costs under controlP Committed Fi ed Costs 3very organi2ation has some costs0 to which it is committed0 perhaps for several years0 unless some drastic change in operation ta/es place. .hese costs are referred to as committed fixed costs and management has no control over them. .hese are costs0 which the organi2ation is obligated to incur and would not consider avoiding e.g. mortgage or lease payments0 interest on long-term debt0 property taxes0 insurance and salaries of /ey personnel. .hese costs could only be altered in the future if major changes in say the scale or scope of operations e.g. expansion outside normal operations0 which would require increase in any lease payment say equipment. Discretionar* Fi ed Costs .hese are costs0 which bear no direct relationship to levels of production but are part of the periodic planning process. 3ach financial year or planning period0 management will determine how much to spend on discretionary items such as advertising0 research and development0 charitable donations0 employees training programmes and consultancy fees. Mnli/e committed fixed costs0 management can control or alter discretionary fixed costs. 4iscretionary fixed costs may be necessary to the achievement of the organi2ation=s goals in the long run0 but managers can vary these costs in the short-run.

3.

/elevant Costs
.hese are costs which have a direct impact on the decision ma/ing process. >istorical or past costs have an indirect bearing on decision ma/ing since they may help in predicting the future. >owever past costs in themselves are irrelevant to the decision itself0 as the decision cannot alter what has already ta/en place.

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