PART 1 LESSON 6

COST MANAGEMENT CONCEPTS

LESSON 6 COST MANAGEMENT CONCEPTS

CONTENT
1. Definition
2. Cost Classification
3. Costing & Cost Measurement
4. Cost Accumulation Methods
5. Cost Assignment
6. Other definitions
7. Cost Allocation Techniques
8. Relevant Cost for Specific Decision Making

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SUBDISCPLINES OF ACCOUNTING

Management Accounting Systems:

 Management accounting measures and reports financial information as well as
other type of information to the managers in fulfilling the goals of the
organization. Management Accounting is not restricted by GAAP.
 Managerial Accounting is concerned with providing information to managers.
 Management Accounting provides information to those inside the organization
and who are responsible for directing and controlling its operations/finance and
marketing.
 Managerial Accounting system provides support to the two fundamental
managerial functions viz Planning and Control.

Financial Accounting
Financial accounting focuses on external reporting and is guided by GAAP. The reporting
is constrained by GAAP which prescribe the revenue and cost measurement rules and
types of items that are classified as assets, liabilities or equity in balance sheets.

Cost Accounting
Cost Accounting measures and reports financial and other information related to
organization’s acquisition and consumption of resources. The information in cost
accounting system is used both by financial and management accounting. In India Cost
Accounting Record rules prescribe the cost accounting books to be maintained in
prescribed industries.

Cost Management:
Accounting systems help managers in Cost Management which involves actions by the
management to satisfy customers while continuously reducing and controlling costs.

Managers as customers of Accounting:

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Managers are becoming sensitive to providing quality and timeliness of goods/services

sold in the market. Managers therefore call for quality and timely information. Accounting
systems that provide quantifiable information must be aware that managers are the
customers of accounting and therefore must strive to provide quality and timely
information to the managers.

DEFINITIONS
Expenses:
The International Accounting Standards Board defines expenses as decreases
in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurrence of liabilities that result in decreases in equity, other
than those relating to distributions to equity participants.
Thus an expense results in decrease in assets either because of cash outflow,
or incurrence of a liability or using up of an asset.

Costs:
Costs are the amount of expenses incurred in production of a goods or
service. Cost is a resource sacrificed or foregone to achieve a specific objective. In
simple words an expense becomes a cost of a specified cost objective when that
expense is associated with that cost objective.

Cost is defined by the IMA as:

1. In management accounting, a measurement in monetary terms, of the amount of
resources used for some purpose. The term by itself is not operational. It becomes
operational when modified by a term that defines the purpose, such as acquisition
Cost, incremental cost, or fixed cost.

2. In financial accounting, the sacrifice measured by the price paid or required to

be paid, to acquire goods or services. The term “cost” is often used when referring to
the valuation of a good or service acquired. When “cost” is used in this sense, a cost is

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an asset. When the benefits of the acquisition (the goods or services) expire, the cost
becomes an expense or loss.

Cost objects:
Management is interested in knowing how much it would cost to make a
specific item or to run a specific department. That specific item or entity is called a
cost object.
Any product, service, customer, contract, project, process or other work unit
for which a separate cost measurement is desired.

Cost Accounting Systems:

The system within an entity that provides for the collection and assignment of
costs to cost objects.

Cost Accounting:
It means classification, recording, allocation, summarization, and reporting of
current and prospective costs. Included in the field of cost accounting are the design
and operation of cost systems and procedures; the methods of determining costs by
departments, functions, responsibilities, activities, products, territories, periods and
other units; the methods of determining forecasted future costs, desired or standard
costs, and historical costs; the comparison of costs of different periods, and of actual
with estimated, budgeted or standard costs; the comparison of alternative costs; and the
presentation and interpretation of cost data to help management control current and
future operations.
Cost drivers:
It is a factor that causes a change in the cost of an activity. There are two kinds of
cost drivers.
Resource cost driver:
It is a measure of the quantity of resources used for an activity. It is used to assign
the cost of a resource to an activity or cost pool.

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Activity cost driver:

It is a measure of the frequency and intensity of demand placed on the activities by
cost objects. It is used to assign activity cost to cost objects.
The cost drivers for research & development and customer service are as follows.

Cost driver
Research & development -No. of. Research projects
-No. of. Hrs spent for each project
-Length & complexity of each project

Customer service -No. of. Service calls

-No. of. Customers serviced
-Time devoted for each service

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THE FIGURE BELOW GIVES THE DETAILS REGARDING COST ACCOUNTING

SYSTEM

Management/Cost Accounting System

I IV
Standard Costs/Flexible Cost Estimation and
Budgets/Activity Based Performance
Costs/Forecasts Evaluation

II III
Budgeting Responsibility
Accounting

FINANCE Expense/Price paid

(Assets)
(Outflow of assets/cash)

OPERATIONS/MARKETING
(Value Addition Activities)

Direct Costs

(Traced)
Inputs
Cost Outputs
Cost
Object Goods/Services/Sales
(expenses associated with
cost object)
Indirect Costs (Allocated)
(Cost Pools)

Costs are
classified
depending on
the objective

Planning Control

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Cost Classification:
Management seeks information on different aspects like:
1. Products
2. Services
3. Volume of production/sales
4. Prices
5. Make or buy
6. Cost control- standard costs, variances
7. Capital budgeting- Investments in new equipment/capital expenditure
8. Operational efficiency
9. Improvements required in the manufacturing process
The answers to these questions can be very easily determined if management has
cost data available.

Types of Cost Classification:

In management accounting, a measurement in monetary terms, of the
amount of resources used for some purpose. The term by itself is not operational. It
becomes
operational when modified by a term that defines the purpose, such as acquisition
cost, incremental cost, or fixed cost.

Costs are required to be accumulated for different objectives. Data accumulated

for one objective may not be suitable for another objective. Data accumulated to measure
income and financial position may not be useful in cost control. Therefore costs are
classified into different categories depending on the objective.

1. Classification of cost according to traceability:

A. Direct Costs:
Costs that can be traced to a cost object are “Direct Costs”. A cost that is
directly charged (as opposed to being allocated) to a cost object since a direct or

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repeatable cause-and-effect relationship exists. A direct cost uses a direct assignment

or cost causal relationship to transfer costs.

B. Indirect Costs and Indirect Cost Pools:

Indirect Costs:
Costs that cannot be traced to a cost object are “Indirect Costs”. Indirect Costs are
allocated to cost objects using a cost allocation method (or cost basis)
1. A cost item that is common to two or more cost objects and cannot be identified
specifically with any one of these cost objects in an economically feasible manner. All
costs other than direct materials and direct labor. Also called Overhead Cost.

2. Any cost not directly identified with a single final cost object, but identified with two or
more final cost objects or with at least one intermediate cost object (CASB)

Indirect Cost Pools:

A grouping of incurred costs identified with two or more cost objects but not
identified specifically with a single final cost object (CASB).An accounting device for
collecting cost elements that have a common cause and that can be assigned to other cost
objects according to a common basis of allocation.

An overhead cost pool aggregates overhead costs and distributes them as a group
to all products or production runs on some basis, such as direct labor hours, machine
hours, or number of parts. For example, an organization could use separate cost pools for
general overhead, set up costs and material handling costs and apply each to production
on a different basis. It could also place all manufacturing overhead costs in a common
cost pool and use a single application rate to assign manufacturing overhead to
production runs or products.

Under traditional Normal costing or “peanut butter” costing all the indirect costs
are pooled into one category and allocated on a uniform predetermined rate to the cost
objects The concept of cost pools is unique to Activity Based costing where indirect costs

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are further segregated into separate pools depending on the cost drivers that drive these
costs.
Factors Affecting Direct/Indirect Cost Classifications:
a) Whether the cost tracing is material?
Tracing is recommended for high costs items. Because higher the cost, the
more is the economic feasibility of tracing that cost than to allocate.
b) Available information gathering technology:
Use of high tech like bar codes, RFID etc has made it easier to gather cost data
which were not possible before. Improvements in information gathering
technologies make it easier to trace costs and reduce the need for allocation
c) Design of operations:
If an operation is exclusively for a particular product or service then it can be
directly traced to that product or service
d) Contractual arrangement:
Where the contract is for procuring an input that is exclusively used in
production of a particular product or rendering a service then its cost can be
directly traced to that product/service.

2. Cost according to timings of charges against sales revenue (Financial

Accounting classification):
Costs can be capital cost or non capital cost depending how they are recorded.
• Capitalized costs are first recorded as an asset
• Non capitalized costs are recorded as expenses of the accounting period
when they are incurred.

1. Service Sector companies:

Service companies do not hold inventories. So the costs in these companies may be
(1) Capitalized cost (Assets) or (2) Non Capitalized costs (Expenses)

2. Merchandising and Manufacturing sector companies.

Merchandising sector companies provide tangible products.

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Merchandising and manufacturing companies differ from service companies in that they
hold inventories. The capitalized costs of merchandising and manufacturing companies are
classified as:
• Capitalized costs which are assets and depreciated over the life of the asset.
• Product cost or capitalized inventoriable costs: The cost of inventories held
for resale.
• Period costs or non capitalized costs: All costs that are not product costs are
period costs. Period costs are recognized as an expense during a specific
period and do not create assets. Administrative and Selling/Distribution
overheads are charged to period rather than the product.
3. Manufacturing Companies:
• Manufacturing sector companies provide tangible products that have been
converted to a different form from that of the products purchased from
suppliers
Calculation of Cost of Goods Sold and Cost of Goods Manufactured:
• Cost of goods sold is simple for merchandising company because
merchandizing companies have only single class of inventory which is
finished goods. In case of merchandising company cost of goods sold is
calculated as:
Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold
• In case of manufacturing companies there are three different kinds of
inventories. So in case of manufacturer cost of goods sold is calculated as:
Beginning work in process inventory + manufacturing costs – ending work
in process = Cost of Goods Manufactured

4. Cost according to management function:

• Manufacturing costs
• Non manufacturing costs

a. Manufacturing cost:

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Manufacturing costs are costs associated with production activities of an

organization. Manufacturing costs may be:

A. Direct Manufacturing Costs:

i. Direct materials costs: costs used in the acquisition of all materials that
eventually become part of the cost object

The quantity of material that is specifically identified with a cost object,

priced at the unit price of direct material.

ii. Direct manufacturing labor costs: They include compensation to

manufacturing labor identified with the cost object. Labor amounts that are caused
by a specific cost object

B. Indirect Manufacturing Costs:

Indirect manufacturing costs are all manufacturing costs that become
part of cost object but cannot be individual traced to the cost object.
Indirect manufacturing costs are also called manufacturing overhead
costs and factory overhead costs.
a. Indirect materials. The cost of materials that do not
enter directly into the production of a product. Examples
are supplies consumed in cleaning, oiling, and
maintenance generally replacement of small parts.
b. Labor costs that are not identifiable directly with a single
cost object, such as supervision. (Often used in the
narrower sense of labor not specifically used on a
product.)
c. Factory operating costs: include utilities, real estate
taxes, insurance, depreciation on factory equipment etc

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C. Prime Costs:
Prime cost equals Direct Material plus Direct Labor i.e. those costs
directly attributable to the product
D. Conversion costs
Conversion cost equals direct labor plus manufacturing overhead i.e. the
cost of converting raw materials into the finished product

2. Non manufacturing costs:

These include Selling expenses and Administrative expenses. These are not
considered as product costs and are not assigned to inventory or cost of goods sold. Non
manufacturing costs are simply reported as expense on income statement.

• Selling costs

• Distribution expenses

• Administrative expenses

NON MANUFACTURING COSTS INCLUDE

Selling Costs:

Any expense or class of expense incurred in selling or marketing. Examples

include sales representatives’ salaries, commissions, and travelling expense;
advertising; selling department salaries and expenses; samples; credit and
collection costs. Shipping costs are also often classified as selling costs.

Distribution Expenses:

Generally, any expense incurred in moving a product from the factory to the
customer, including transportation and warehousing expenses. In some
industries, it may also include the expense of selling and advertising.

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Administrative Expenses:

Expenses incurred for the general operation of an enterprise as a whole, as

contrasted with expense of a more specific function such as manufacturing or
selling. Items included vary with the nature of the business, but usually include
salaries of top officers, rent, and other general office expense. They are also called
as General and Administrative Expense. Although non manufacturing costs are not
assigned to products for purposes of reporting inventory and cost of goods, they
should always be considered as part of total cost of providing a specific product to
a specific customer.

5. Cost classification in accordance with behavior with changes in activity:

Relevant Range:

The range of economic activity within which estimates and predictions are
valid. This range is normally viewed in the context of variable budgets and

Cost/volume/profit analysis. Outside of this range, the relationship assumed

may need to be reexamined in a breakeven analysis.

Relevant range is same as “short term” for economists. Costs are fixed or
variable in a relevant range. Economists and management accounts consider all
costs to be variable in long run.

Costs are classified according to how they vary in relation to changes in

activity level. Activity level is the number of units of the product or service
produced.

• Fixed cost

• Variable costs

• Mixed costs

• Step costs

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• Marginal costs

• Total costs and unit costs

i. Fixed Cost:

Fixed cost is cost or expense element that does not vary with the volume of
activity in the short term. Also called Nonvariable Cost or Constant Cost.
Contrast with.

• A fixed cost that may be eliminated under some circumstances is

termed as avoidable fixed cost.

• If the organization ceases to exist or its activities are scaled down, fixed
costs associated with those activities may be avoidable.
ii. Variable cost:
An operating expense, or operating expenses as a class, that varies directly, and
proportionately, with sales or production volume, facility utilization, or some
other measure of activity. Examples include materials consumed, direct labor,
power, factory supplies, depreciation (on a production basis), and sales
commissions.
iii. Mixed costs/Semi Fixed Cost/Semi variable cost
A cost composed of fixed and variable elements.
In case of Mixed Costs, the fixed and variable portion in the total cost is
separated using different techniques like high low method or regression
method.
iv. Step Cost:
A cost that is constant for a volume of demand within a specified range, but
those changes once demand volume moves outside that range. Step increase
may occur both in fixed costs and variable costs.

v. Marginal costs

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a. Marginal cost: The cost incurred by a one unit increase in the activity level of
a particular cost driver. Marginal cost remains constant across the relevant
range

1. The difference in cash flow, both as to amount and as to timing, between

two alternative courses of action.

2. The additional cost caused by some specific project or group of projects

as compared with the cost of some specific base case or reference standard.
It is also called Incremental Cost. Incremental cost is the additional cost in a
given decision. Marginal cost is same as incremental cost

b. Differential cost: The cost difference expected if one course of action is

adopted as compared with the costs of an alternative course of action; used in
decision making. Differential cost is the difference in cost between two
decisions.

vi. Total Cost Vs Unit Cost:

Total Cost:
The costs of production, both variable and fixed. Also includes cost of
capital to secure resources.
Unit Cost:
The cost of one unit of a product or of one unit of a cost element of a
product. It is usually obtained by dividing a total cost by the total number of
units.
6. Cost classification according to relevance to control and decision making:

a. Incremental vs. differential cost

b. Avoidable vs. committed cost

c. Controllable vs. non controllable cost

d. Sunk cost

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e. Opportunity cost

a. Incremental cost Vs Differential cost

Incremental cost: Incremental cost is same as marginal cost. Incremental

cost is the addition cost in a given decision. Incremental cost is additional
cost within a given decision

1. The difference in cash flow, both as to amount and as to timing,

between two alternative courses of action.

2. The additional cost caused by some specific project or group of

projects as compared with the cost of some specific base case or reference
standard. It is also called Marginal Cost.

Differential cost: The cost difference expected if one course of action is

adopted as compared with the costs of an alternative course of action;
used in decision making.

This is difference in cost between two different decisions

The terms Incremental and Differential costs are often used

interchangeably

b. Avoidable costs Vs Committed costs:

Avoidable costs: An ongoing cost that may be eliminated by ceasing to

perform some activity or by improving the efficiency with which such
activity is accomplished. Also called Escapable Cost.
Committed costs: Fixed costs arising from a plant, equipment and other
costs basic to the entity and thus affected primarily by long-term
decisions about the desired level of capacity. Committed costs are
unlikely to be changed in the short term.

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c. Controllable and non-controllable costs:

Controllable costs: A cost that can be influenced by the action of the
responsible manager. The term always relates to a specified manager
since all costs are controllable by someone
Non controllable costs: A cost that is not controllable by a particular
manager
d. Sunk costs:
A past cost which cannot now be revised and hence cannot (or should not)
enter into current decisions for increasing or decreasing present profit
levels (aside from any income tax effects).
e. Opportunity costs:
They are the value of the alternatives forgone by adopting a particular
strategy or employing resources in a specific manner. Also called
Alternative Cost or Economic Cost.

Costing and Cost Measurement:

Costing is: The accumulation and assignment of costs to cost objects such as units of
production, departments, or other activities for which management desires a separate
measurement or evaluation.

1. Cost accumulation:
Cost accumulation refers to collection of cost data. Cost accumulation is the process of
collecting and recording cost data of historic cost.
2. Cost Assignment:
The accumulated cost data is assigned to “Cost Object”. Sometimes assignment is made
on the basis of BUDGETED COSTS rather than HISTORIC COSTS.
Cost Assignment involves two activities:
(i) Cost Tracing: Direct costs are traced to cost object
(ii) Cost allocation: Indirect costs are allocated to cost object
Cost Measurement is: An assignment and accumulation of monetary amounts for the
recognition, classification, and assignment of costs to goods and services acquired or used.

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Thus Cost Accounting system adopts a two step process for ascertaining costs.

o The first step is costing where the accumulated (or budgeted) costs are
assigned to the cost objects through tracing and allocation.

o The second step involves cost measurement where the assigned cost is
accumulated to determine the cost of goods and services acquired or used.

Cost Accumulation Methods

There are different cost accumulation methods depending on the nature of production and
operations.

1. Job Order Costing:

A method of cost accounting that accumulates costs for individual jobs or

lots. A job may be a manufactured item or a service, such as the repair of an
automobile or the treatment of a patient in a hospital.

2. Batch OR Operation Costing:

A method of cost accounting in which costs are accumulated by batches or

runs, as in the petroleum, chemical, and rubber industries. Costs are
attached to a specified quantity of raw materials as it enters into a refining
or other process. Often, in addition to the cost of the material itself, batch
costs include the operating expense of the plant or process during the
treatment period.

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3. Process Costing:

A method of cost accounting that first collects costs by cost centers and
then allocates the total costs of each cost center equally to each unit flowing
through it during an accounting period.

4. Life Cycle Costing:

The accumulation of costs for activities that occur over the entire life cycle
of a product, from inception to abandonment by the consumer. It is a
measure of the total costs over the product’s life including design and
development, acquisition, operation, maintenance, and service. Service
costs include marketing, distribution, administration, and after-sales service
costs.

5. Back flush Costing:

A costing methodology used in JIT operations. Avoids need for detailed

tracking of costs as in absorption costing. After production is completed,
standard costs are assigned to finished products (flushed backwards) on the
basis of one cost driver.

Cost Assignment:

Assignment means to attribute a cost item to one or more cost objects that presumably
caused it. Direct costs are assigned directly; indirect costs are allocated.

1. Cost Tracing:

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A Traceable cost is a cost that can be identified with or assigned to a specific

product or service. The terms assignment and tracing can be used
synonymously. Direct costs can be directly assigned (or traced) to cost objects.

2. Allocation: The process of determining what costs need to be apportioned to

what departments or products (either intermediate or final) and what bases
should be used to split these costs among the products.

Indirect costs are allocated to cost objects on some basis. Indirect costs are first
collected in cost pools and then allocated to cost objects using costing
techniques.

SCRAP:
• Scrap results when some part of the raw material is not usable in making the
product.
• This happens when the raw material being processed is not of the exact length,
width, or thickness required for the product being made
• Scrap has minor economic value
Accounting for Scrap:
• There are two methods of accounting for scrap.
o Under method I the sales proceeds of the scrap are deducted from the cost
of the job that yielded the scrap.
o Under method II the sales proceeds of the scrap are deducted from actual
overhead.
WASTE:
• The term waste is used to refer to the portion of material inputs that
o either disappears in the production process
o Or has no economic value.
SPOILAGE:

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• Spoilage results when either the material being processed or the finished products
is discovered are unusable because of defects in workmanship or material.
• Like scrap, the spoilage occurs after the raw material has entered the production
process.

Normal Vs Abnormal Spoilage:

Abnormal Spoilage:
Unacceptable units that are not expected to occur under an efficient production
process.
Abnormal spoilage is the spoilage above normal spoilage for production technology.
Normal Spoilage:
Normal spoilage is the amount expected given the production technology. Costs
incurred because of spoilage that cannot be eliminated in a cost effective manner; these
costs should be assigned to cost objects as elements of product cost.

Treatment of Spoilage under Process Costing:

Nature of Spoilage:
• Spoilage may be either continuous or discrete.
• Continuous spoilage occurs fairly uniformly throughout the production process.
o For instance A continual breakage may occur in glass production,
shrinkage caused by inherent character of production process such as
evaporation, leakage, or oxidation
• Discrete spoilage is assumed to occur precisely at an inspection point.
o Examples include, Wrong amount of color added or fixing a wrong size
tires or sewing wrong size button etc.
o Such spoilages will be detected during inspection and all the units that
pass inspection are good units at quality control points

Accounting for Normal Spoilage:

Continuous Spoilage:

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• The costs of continuous spoilage are handled through method of neglect,

which simply excludes the spoiled units in the equivalent units schedule.
• Ignoring the spoilage results in a smaller number of equivalent units of
production and, thus raises cost per unit of equivalent unit.

Discrete Spoilage:
• The cost of normal discrete spoilage is assigned only to the good units that
have passed the inspection points.
• Normal, discrete spoilage is assumed to occur precisely at inspection point;
the units past this point should be good units, while the units prior to this
point may be good or may be spoiled.
Thus we may have two kinds of situations here as shown in the figures below:

Ending
Work in
Process

Production Cost of normal spoilage

Process allocated entirely to the good
units completed and
transferred out
Inspection
point

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Ending
Work in
Process

Production Cost of normal spoilage

Process allocated between good units
completed and ending work
in process inventory
Inspection
point

Source: Bierman, Dyckman, Hilton

Case 1:
• If the inspection point precedes ending work in process inventory the normal
spoilage cost is allocated entirely to the cost of good units completed and
transferred.
• Cost of normal spoilage is treated as a product cost.
• In this situation the normal spoilage units are included in the equivalent units
produced.
Case 2:
• If the inspection is made after ending work in process inventory, the cost of normal
spoilage is allocated between the good units completed and the ending work in
process inventory.
• The normal spoilage units are included in the equivalent units of production to the
extent completed (percentage completed) at the point of inspection.

Abnormal Spoilage:

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• Whether the spoilage is continuous or discrete, the abnormal spoilage is always

accounted for as an equivalent unit basis and is assigned to a loss account during
the period in which spoilage occurred.

Treatment of Spoilage under Job Order Costing:

• Under job order costing, the costs of abnormal spoilage are considered a period
cost.
• There are two methods to account for costs of normal spoilage under job order
costing.
o In method I the cost of the normal spoilage associated with a particular job
is considered a product cost of that job.
o Under method II the cost of normal spoilage for all jobs is added to actual
overhead and then this normal spoilage cost is spread over all jobs through
the application of overhead.

Treatment of Spoilage under Standard Costing:

• Under standard costing the cost of normal spoilage is incorporated into the
standards.
• The cost of normal spoilage is not reported separately. The unit standard cost of the
product includes the cost of normal spoilage and is not affected by the actual
amount of spoilage

REWORKED UNITS:
• Reworked units are those that do not initially meet product quality specifications
but have subsequently been reworked so that they may be sold as good units

Accounting for Reworked Units:

• Reworked units are units that were originally identified as spoiled or defective but
that have subsequently been reworked to make them acceptable as good output.

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• As in case of accounting for normal spoilage under job order costing, there are two
methods of accounting for reworked units:
o Under method I, the costs of rework are added to the cost of particular job
from which the reworked units came
o Under method II, the costs f rework are added to actual overhead

Standard Costing and Flexible Budgeting:

Standard costs:
1) In a standard costing system the estimated (rather than actual) costs of direct material,
direct labor, and overhead are assigned to products or services. These estimated costs
are referred to as standard costs.
i. Standard costing uses estimated costs to cost the products
ii. All the costs viz direct material, direct labor and overheads are
estimated costs
iii. The estimated costs are called standard costs
iv. Actual costs are compared with standard costs to make performance
evaluation
v. Setting standard costs requires an assessment of how efficiently a
production task should be accomplished.

2) In a standard cost system, both standard costs and actual costs are recorded in the
accounting records.
a. This dual recording enables exercise of control by facilitating comparison
of standards with actual.
3) Standard cost systems make use of standard costs, which are budgeted or estimated
costs to manufacture a single unit of product or perform a single service.
a. Almost all products can be manufactured with a variety of inputs that would
generate the same basic output.
b. Even after the product design has been selected, wide spectrums of input
factors are available.

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c. This requires selection of standard inputs.

Material Standards:

1) The first step in developing material standards is to identify the specific direct material
components used to manufacture the product.
2) In making quality decisions, managers seek the advice of materials experts, engineers,
cost accountants, marketing personnel and suppliers.
3) Physical quantity estimates is made in terms of weight, size, volume or other measures.
These estimates are based on result of engineering tests, opinions of managers and
workers using the materials.
4) Information about product material components, their specifications and quantities are
compiled on a document called bills of materials.

Labor Standards:

1) In selecting labor standards, each production operation performed by either workers or

machinery is identified.
2) These operations include various tasks involved in manufacturing like bending,
reaching, lifting, moving materials, decorating, packing etc.
3) Time and Work study help in fixing these standards.
4) Sometimes, there exist predetermined time and motion study standards available for
the specific industry
5) After analyses of tasks are completed, operation flow (or routing) documents are
prepared. This document lists all operations necessary to make one unit of product.
6) Labor rate standards reflect the wages paid to employees who perform various
production tasks and also related employer costs such as fringe benefits and FICA
(Social Security).

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Standard cost cards:

1) After bill of materials and the operations flow document have been developed, a
standard cost card is prepared.
2) A standard cost card is a record of the direct material and direct labor standard
quantities and costs needed to complete one unit of product.

Considerations in Establishing Standards:

1. Appropriateness:
a. Standards are developed from past and current information, but they must
reflect technical and environmental factors expected during the period when
the standards are applied.
b. Material quality, ordering quantities, expected employee wage rates, degree
of plant automation, facility layout, and mix of employee skills etc must be
taken into account

2. Attainability:
a. Standards are targets for performance and they can be set at different levels
and rigor. Standards can be classified as
i. Ideal standards: also called theoretical standards. Ideal standards
encompass the highest level of rigor and do not allow for operating
delays or human limitations such as fatigue, boredom, or
misunderstanding.
ii. Practical standards: these standards allow for normal, unavoidable time
problem or delays such as machine downtime and worker breaks.

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Practical standards represent attainable standards under most efficient

work conditions.
iii. Expected standards: these standards are set at level that reflects what is
actually expected to occur in future period. Such standards anticipate
waste and inefficiencies and allow for them.

3. Use of Theoretical Standards:

a. Of late there has been considerable influence of Japanese management
techniques like Just in Time (JIT) and Total Quality Management (TQM).
b. These concepts are based on adoption of theoretical standards.
i. Rather than providing for inefficiencies and wastes while fixing
standards, these concepts aim at adopting zero defects, zero inefficiency
and zero downtime.
ii. Thus under these systems Theoretical Standards become Practical
standard
4. Decline in Direct Labor:
a. The proportion of Direct Labor is declining as operations become more and
more automated.
b. Now, direct labor is often considered as a small portion of conversion costs
or be regarded as indirect cost.
5. Adjusting Standards:
a. Currently, manufacturing environment is changing rapidly due to changes
in technology, competition, product design, manufacturing methods etc.
b. Management must decide on whether to incorporate the impact of changes
on standards or ignoring them.

Flexible budgets:

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1. Standard costs are useful for controlling direct costs. An overhead budget is useful
in controlling indirect costs.
2. In developing an overhead budget, managers estimate the overhead costs that
should be incurred at different levels of production activity.
3. This overhead budget is called flexible budget because it is adjusted to the actual
level of activity.
4. A flexible budget is a series of budgets that present costs at different levels of
activity. In a flexible budget, all costs are treated as either variable or fixed.
5. Flexible budget can be prepared for product or period costs

Flexible Budgets and Fixed Overhead:

1. Fixed overhead remain constant in total at different levels of activity in a flexible

budget, except when the fixed cots increase in steps.
2. Fixed overheads tend to remain constant over a relevant range.
3. Although total fixed overheads remain constant over relevant range of activity,
fixed overhead per unit decreases with increase in volume of activity.

Extended Normal Costing:

Under extended normal costing, direct costs are traced using budgeted rates instead of
actual rates. (In normal costing actual costs are used for tracing direct costs). Extended
Normal costing is also known as budgeted costing.

Extended normal costing method traces direct costs to a cost object by using the budgeted
direct cost rates times the actual quantity of the direct cost input and allocated indirect
costs based on budgeted indirect cost rates times the actual quantity of cost allocation base.

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The distinctive feature of extended normal costing is that it used budgeted rates for both
direct costs and indirect costs.

Relevant Costing:
1) One of management’s important tasks is to allocate resources effectively and
efficiently to accomplish company’s goals and objectives.
2) Accounting information can improve management’s understanding of
consequences of alternative resource allocations.
3) Relevant costing allows managers to disregard extraneous information about
economic alternatives and focus on decision’s relevant facts.
4) The costs which should be used for decision making are often referred to as
"relevant costs". CIMA defines relevant costs as 'costs appropriate to aiding the
making of specific management decisions'.
5) To affect a decision a cost must be:
a. Future: Past costs are irrelevant, as we cannot affect them by current
decisions and they are common to all alternatives that we may choose.
b. Incremental: Expenditure which will be incurred or avoided as a result of
making a decision. Any costs which would be incurred whether or not the
decision is made are not said to be incremental to the decision.
c. Cash flow: Expenses such as depreciation are not cash flows and are
therefore not relevant. Similarly, the book value of existing equipment is
irrelevant, but the disposal value is relevant.

For information to be relevant, it must possess 3 characteristics:

1. Association with Decision:

a. Information is relevant when it is related to a decision and affect the
decision making process.
b. No single cost can be relevant in all decisions or to all managers.
i. To be relevant a cost must be differential cost that is it varies in
amount among the alternatives being considered.

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ii. Out-of-pocket costs involve current or near current cash

expenditures and, if differential, these costs are also relevant costs.
c. Relevant costing compares the incremental revenues and incremental costs
of alternative decisions.
i. Incremental revenue is the additional revenue resulting from a
contemplated sale or provision of a service.
ii. An incremental cost is the additional cost of production, or selling
the same contemplated good or service.
iii. Incremental costs can be variable or fixed. Two general guidelines
are (1) most variable costs are relevant and (2) most fixed costs are
not.
d. Opportunity costs represent the benefits foregone because one course of
action is chosen over another. These costs are important in decision
making, but not included in account- ting records.
2. Importance to Decision Maker
a. The need for specific information depends on how important that
information is relative to the objectives that a manager wants or needs to
achieve.
b. Moreover, if all other factors are equal, more precise information is given
greater weight in the decision making process.
c. But if information is very urgent and immediate, less importance is given to
precision
3. Bearing on the Future
a. Information can be based on past or present data, but it can only be relevant
if it pertains to a future decision.
b. All managerial decisions are made to affect future events, so the
information on which decisions are based should reflect future conditions
c. Future costs are the only costs that can be avoided, and longer into the
future a decision’s time horizon, the more costs are controllable, avoidable,
and relevant.

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d. Only information that has a bearing on future events is relevant in decision

making.

RELEVANT COSTS FOR SPECIFIC DECISIONS:

 Make or Buy Decisions:

1. One of the questions facing managers is whether the right components are available
at right time to assure production.
a. Components must also meet quality specifications.
b. Further, an important consideration is the cost of the component.
2. Managers must consider whether the firm has capacity to produce components
internally.
a. The cost of internal production must be compared with the cost of acquiring
the components from other producers or in the open market.
b. Management will invariably opt for lesser cost option. If it is cheaper to buy
rather than make, the firm will opt to buy and vice versa.

Relevant information for this decision includes both qualitative and quantitative.

1. In make or buy decision, variable production costs are relevant if they can be
avoided by discontinuing production.
2. The opportunity cost of the facilities being used by production is also relevant in
make or buy alternative.
a. If a company chooses to buy a product rather than make it, an alternative
purpose may exist for the facility now being used for manufacturing.
b. If a more profitable alternative is available, management should consider
diverting the capacity to this alternative use.

 Scarce Resources Decision:

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1. Managers are confronted with short run problem of making the best use of scarce
resources.
a. Scarce resources create constraints on producing goods or providing
services and can include machine hours, skilled labor hours, raw materials,
and production capacity.
b. Determining the best use of a scarce resource requires recognition of
company objectives.

 Sales Mix Decisions:

1. Management is continuously striving to achieve a variety of company objectives

such as company profit maximization, improvement of the company’s relative
market share, and generation of customer goodwill and loyalty.
2. These objectives are accomplished by selling products or performing services.
3. Sales mix refers to the relative combination of quantities of sales of various
products that make up the total sales of a company

 Compensation Changes:

1. Many companies compensate their sales persons by paying a fixed rate of

commission on gross sales dollars.
2. Such a policy motivates sales people to sell the highest priced product rather than
product providing the highest contribution margin to the company.
3. If the company has a profit maximization objective, a commission policy of
percentage of sales will to be effective in achieving that objective.

 Advertising Budget Changes:

1. Another factor that may cause shifts in the sales mix involves either adjusting the
advertising budgets respective to each company product or increasing the
company’s total advertising budget.

 Product Line Decision:

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1. Operating results of multiproduct environments are often presented in a

disaggregated format indicating separate product lines within the organization or
division.
2. In reviewing these disaggregated statements, managers must distinguish relevant
from irrelevant information as that information relates to the individual product
lines.
a. If all costs (variable and fixed) are allocated to product lines, a product line
or segment may be perceived to be operating at a loss when actually it is
not.
b. This maybe caused by the commingling of relevant and irrelevant
information on the statement.
3. In classifying product line costs, managers should be aware that some costs may
appear to be avoidable but actually are not.
a. For example, the salary of a supervisor working directly with a product line
appears to be an avoidable fixed cost if the product line is eliminated.
b. However, if these individuals have significant experience, they are often
retained and transferred to other areas of the company if product lines are
cut. SS
4. Depreciation on factory equipment used to manufacture a specific product is an
irrelevant cost in product line decisions.
a. But if the equipment can be sold, the selling price is relevant to the decision
because it would increase the marginal benefit of the decision to
discontinue the product line.
b. Even if the equipment will be kept in service and be used to produce other
products, the depreciation expense on it is unavoidable and irrelevant to the
decision.

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