Chapter

2
COST TERMS,
CONCEPTS &
CLASSIFICATION
 WHY WE NEED COST INFORMATION?
1. To make informed management decisions
2. To plan, control and performance measurement
3. For inventory valuation and profit reporting
Cost
 A monetary measure of the resources that
must be sacrificed to attain a particular
objective.
Cost Object
 A Cost Object is any activity for which a separate
measurement of costs is desired.
Examples:
• Cost of a product
• Cost of rendering a service
• Cost of operating a particular department
Question
In Pizza Hut, if customer is treated as the cost object, what are the
costs that can be attributed to the cost object?
CLASSIFICATION OF COSTS
 Direct and indirect costs
 Manufacturing and Non – Manufacturing Costs
 Period and product costs
 Relevant and irrelevant cost
 Avoidable and unavoidable cost
 Sunk cost
 Opportunity cost
 Incremental and marginal cost
 DIRECT AND INDIRECT COSTS
 Direct Costs
Costs that can be specifically identified with a particular cost object

 Indirect Cost
Costs that cannot be specifically identified with a particular cost object

Direct Costs Indirect costs

- Wood - Salaries of factory
supervisors
- Wages of operatives - Rent of the factory
 CATEGORIES OF MANUFACTURING COST
 All costs incurred by the firm must be accounted for in its
financial statements
MANUFACTURING COSTS
Direct Labor (DL)
Direct Materials (DM) Prime Cost
Direct Expenses (DE) Total
Overhead (OH) Manufacturing
Indirect Materials Cost
Indirect Labor Manufacturing
Other Overhead
NON-MANUFACTURING COSTS
Marketing or Selling Costs
Administrative Costs
 MANUFACTURING COSTS
Direct Costs
Direct Materials (DM)
• Materials that are consumed in the manufacturing process and physically
incorporated in the finished product
Direct Labor (DL)
• Labor cost that is physically traceable to the products being manufactured
Direct Expenses (DE)
• Other direct expenses directly traceable to the product
 The three direct costs are summed to derive the prime cost or total direct cost
of a product
 MANUFACTURING COSTS
Indirect costs
Indirect materials
• production materials that do not actually become part of the finished
product. e.g. Lubricating oils and cleaning materials
Indirect labour
• production labour cost which cannot be directly associated with the
production of any particular product. e.g. Salaries of supervisory labour
Indirect expenses
• all the other production overheads associated with running the factory,
including factory rent and rates, heating and lighting, etc. These indirect
costs must be shared out over all of the batches produced in a period
e.g. Factory rent and power
 QUESTION
Would below costs be a direct cost or an indirect cost of the
quality control activity which is undertaken in a company’s
factory?
● The salary of the quality control supervisor.
● The rent of the factory.
● The depreciation of the quality testing machine.
● The cost of the samples destroyed during testing.
● The insurance of the factory.
NON MANUFACTURING COSTS
Selling and distribution overhead
• Includes the sales force salaries and commission, the cost of
operating delivery vehicles and renting a storage warehouse, etc.
These are indirect costs which are not specifically attributable to a
particular cost unit.
Administration overhead
• Includes the rent on the administrative office building, the
depreciation of office equipment, postage and stationery costs, etc.
These are also indirect costs which are not specifically attributable
to a particular cost unit
 PERIOD AND PRODUCT COST
Product Costs
 Costs that are identified with goods purchased or produced for
resale
 Product costs include direct materials, direct labor, and
manufacturing overhead
 Unsold part of product cost is Included in the inventory valuation.
Period Costs
 Period costs are non manufacturing costs such as selling and
administrative costs are expense
 Product costs are not included in the inventory valuation
• S & S Company came into a rent agreement with a building owner
on 30th June 2011. As per the agreement, Rs. 20 000 monthly rent
should be paid for a minimum of one year. It further says that the
agreement cannot be cancellable. By end of 2011, company thinks
whether to construct its own building or to continue the rent.
What is the sunk cost of this decision?
• A company has received a special order from a customer to
produce 750 units of a customized product. This special order
requires additional variable cost of Rs. 20,000. To produce one
unit of this product two machine hours are required. Currently
machines are working are at their full capacity. If the special order
is accepted, current output of product A (the standard product)
will have to be reduced. To produce one unit of product A 1.5
machine hours are required. The contribution per unit of product
A is Rs. 30.

• Find the opportunity cost of fulfilling the customer’s order

• What is the minimum price that should be charged to the order?
• ABC Company purchased Rs. 20,000 worth of raw materials a few
years ago. Currently there is no possibility of selling these
materials or using them in future production. Recently a customer
saw these materials at the company premises and requested the
company to sell those materials to him. However, this customer is
not prepared to pay more than Rs. 12,000. The additional cost of
Rs. 5,000 would be required to change these materials according
to the customer requirement.
•
• What are the relevant costs and revenues in this case?
•
• Should company sell these materials to the customer?
COST BEHAVIOUR
• Refers to the way in which costs are affected by fluctuations
in the level of activity
• Understanding cost behavior is essential for decision making.
• The level of activity can be measured in many different ways.
Example:
number of units produced, miles travelled, hours worked, meals
served, percentage of capacity utilized, students enrolled
Fixed Costs
• Costs that remain constant over a specific range of
activity for a specified time period
Ex: rent, insurance and executive salaries
Total Fixed
Cost,
Rs

Level of activity
Stepped Fixed Costs
• Costs that are constant for a given level of activity,
but increase or decrease once a threshold is reached
Ex: rent cost
Total Cost,
Rs

Level of activity
Fixed Cost per Unit
• Fixed cost per unit decrease proportionally with the
level of activity

Fixed Cost,
per unit
Rs

Level of activity
Variable cost
• Costs that varies in relation to changes in the volume
of activity

Total variable
cost
Rs

Level of activity
Variable cost per unit
• Variable cost per unit is constant

Per unit
variable
Cost,
Rs

Level of activity
 QUESTION
Are all direct costs variable and all indirect costs fixed?

All direct costs are not variable!

There could be direct fixed costs as well. e.g Labour in some instances
Also
Not all indirect costs are fixed!
There could be indirect variable costs. e.g power cost in a tile factory
 Practice Questions
Which of the following best describes a fixed cost?
a) Increases proportionately with output
b) Remains constant irrespective of the level of activity
c) Varies with the level of output
d) Has a direct relationship with output

Which of the following statements is TRUE?

a) Unit variable costs are constant as volume increases.
b) Unit fixed costs are constant as volume increases.
c) Unit variable costs decrease as volume decreases.
d) Unit fixed costs increase as volume increases

Prime cost is
a) all costs incurred in manufacturing a product
b) the total of direct manufacturing costs
c) the material cost of a product.
d) the cost of operating a department
 PRACTICE QUESTIONS
1. Explain the following commonly used cost terms in management accounting:
cost object
• direct and indirect costs
• variable and fixed costs
• product and period costs.
Illustrate your answer with examples

2. Describe how a direct cost can be both a direct cost and indirect tcost