Managerial Accounting

Cost term, concepts and classifications

Planning and control are the two major components of Management task. Planning includes setting of objectives and outlines for achieving the objective. Control includes the steps to be initiated for ensuring the achievement of the objectives. To ensure proper and effective planning and control, management need information and very often the required information relate to Cost of the organization.

Managerial Accounting
Cost term, concepts and classifications
Classifications : There are many types of costs ad they are classified into groups according to the immediate requirement of Management. For example Management my require cost data to prepare financial statement for external users, or for preparing sales forecasts. Since the purpose of using cost data is not same and as such classification is necessary to meet the requirement.

Managerial Accounting
Cost term, concepts and classifications
Classifications: General classifications (Basic manufacturing categories) Behavioral classifications (Response to in the level of activity) changes

Assignment to cost objectives (Prominence in particular cost objective) Decision making (Relevance in decision making process) Financial statement (Relation with preparation of financial statement)

Managerial Accounting General cost classification

Under general cost classification costs are classified into two broad categories. They are - Manufacturing costs - Non manufacturing costs

Managerial Accounting General cost classification

Manufacturing Cost: Manufacturing costs are those costs that are directly related with manufacturing products Or rendering services - Components of Manufacturing cost - Direct material costs - Direct labour costs - Manufacturing overhead cost

Managerial Accounting General cost classification

Direct materials : Direct materials are those materials that become an integral part of the finished product and that can be physically and conveniently traced to it. Finished product of one product line can become direct material of another product line. For example : Brick is one of the raw materials for housing industry Direct labour : It is the amount paid to the workers who are directly involved if the process. For example in a manufacturing unit, the payment made to a machine operator.

Managerial Accounting General cost classification

Manufacturing overhead Cost: It is another element of manufacturing cost that include all cost elements other than direct material and direct labour. The components usually are - Indirect materials - Indirect labour - Other indirect expenses

Managerial Accounting General cost classification

- Indirect materials: Materials those can not be traced in the basic output. For example warping material used is medicines. - Indirect labour : Expenses incurred for making payments to those who are involved in manufacturing process but do not directly participate in production process. For example :salary of the factory manager, supervisor, storekeeper, watchmen etc.

Managerial Accounting General cost classification

Other indirect expenses : Expenses incurred in factory other that direct material, direct labour, indirect material, indirect labour. The expenses may be - depreciation of the machineries used in production process - depreciation of factory office equipment - repair factory building - depreciation factory building - fuel, power used in production - cost of electricity of factory - factory canteen subsidy - contribution to workers welfare fund etc.

Managerial Accounting General cost classification

Non manufacturing cost : It consider the costs those are not incurred to manufacture a product. It can be classified as - Marketing and selling costs - Administrative costs

Managerial Accounting General cost classification

Marketing and selling costs: All costs necessary to secure customer orders and get the finished product or service in to the hands of the customer, such as sales commission, advertising, depreciation of delivery equipments and finished product store, salary of marketing and sales force, promotional expenses etc.

Managerial Accounting General cost classification

Administrative costs : All costs associated with the general management of the company as a whole, such as executive compensation, executive travel costs, secretarial salaries and rent or depreciation of office building and equipment etc.

Managerial Accounting General cost classification

Further classification of costs (General): In addition to classifying costs into Manufacturing & Non manufacturing costs, costs may further be classified as - Product costs or Inventoriable costs - Period costs - Prime costs - Conversion costs

Managerial Accounting General cost classification

Product costs or Inventoriable cots: Costs incurred for acquiring or manufacturing goods for sales. For a trading house it include the costs incurred for procurement of the items to be sold. For manufacturing units it is the total of - Direct Material - Direct Labour - Manufacturing Overhead

Managerial Accounting General cost classification

Period costs : These costs are not related with production or procurement. It is incurred over a period. The components are Marketing and selling costs - Administrative costs
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Managerial Accounting General cost classification

Prime costs : These costs are the sum of direct material costs and direct labour costs Conversion costs : These costs are incurred to convert materials into the finished products. It is the sum of direct labour cost and manufacturing overhead costs.

Managerial Accounting Behavioral cost classifications

Behavioral cost classification : In addition to classifying costs on the basis of their nature, costs can also be classified on the basis of their nature of response towards changes in the level of activity. On the basis of behavior towards changes costs may be classified broadly in to two categories - Fixed cost - Variable cost

Managerial Accounting Behavioral cost classifications

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Fixed cost: It is a cost that remain same regardless to the size of operation i.e. this cost is not responsive to any change in operation. More specifically the total amount of fixed cost will not increase or decrease in response to increase or decrease of units manufactured, sold or service offered within a given limit of installed capacity. Example: Cost of a printer : Tk. 10,000.00 Rated printing capacity : 50,000 pages Fixed cost upto 50,000 pages will remain same i.e. at operative level of 01 pages to 50,000 pages the total fixed cost will be Tk.10,000. Per unit cost however will be reducing with increase in the number of pages printed.

Managerial Accounting Behavioral cost classifications

Classification of Fixed cost : For planning purpose Fixed cost may be classified into two categories Committed Fixed cost Discretionary Fixed cost

Committed Fixed costs: These costs arise out of long term investment. The cost components are depreciation of machineries, equipments, building, real estate taxes, payment of salaries etc. Discretionary Fixed costs :These costs usually arise out of annual decisions by management to incur expenses in certain areas where the costs are fixed. Such as Advertisement , Research etc.

Managerial Accounting Behavioral cost classifications

Characteristics of Committed fixed cost : They are long term in nature They can not be significantly reduced even for short period of time even if operations are interrupted or cut back, the committed fixed will still continue Characteristics of Discretionary fixed cost Though the cost arise out of annual management decision, management can also be adjust such expenses according to the prevailing circumstances. For example, in the mid of the year management may shorten the area of research.

Managerial Accounting Behavioral cost classifications

Difference between Committed Fixed cost and Discretionary Fixed cost : The planning area for Committed Fixed cost is long term. The planning area of Discretionary Fixed cost is fairly short term usually one year Cost cut is case of Committed Fixed cost cause substantial damage to long run goals of the organization. Cost cut is case of Discretionary Fixed cost is possible with minimal damage to the long run goals of the organization.

Managerial Accounting Behavioral cost classifications

Variable cost: It is a cost the total of which varies in direct proportion to the changes in the size of operation. In other words, variable costs are positively responsive to any change in the units of goods manufactured, sold, service rendered. Example : Variable cost of printing 01 page :Tk. 1.00 Cost of printing 100 pages = 100x1=100/= Cost of printing 800 pages = 800x1=800/=

Managerial Accounting Behavioral cost classifications

Classification of Variable costs
True Variable costs : Costs that vary in direct proportion to change in the level of activity. Direct material is the best instance of true variable cost since the total cost of direct material will change in same proportion to the change in the number of units manufactured. Semi Variable (Step-variable) costs : There are some costs which vary with change in the level of activity but not in direct proportion i.e. this type of expenses contain a mixed character, both fixed and variable. For instance electricity and telephone bills. A portion of these expenses are usually consist line rent which is fixed irrespective of units consumed.

Managerial Accounting Behavioral cost classifications Cont

Example of Semi variable expenses
Example of Photocopy machine: Cost of electricity per minute : Tk.0.15 Per minute copying capacity of the machine:10 Warming up period per start up : 30 Seconds Electricity cost for 50 copies= Tk. 0.825 (50/10=5+.5=5.5x.15) cost per unit: 0.0165 (0.825/50) Electricity cost for 60 copies= Tk.0.975(60/10=6+.5=6.5x.15) cost per unit : 0.01625 Electricity cost for 40 copies= Tk.0.675 (40/10=4+.5=4.5x.15) cost per unit : 0.0168

Managerial Accounting Behavioral cost classifications Cont

Summary of variable and Fixed cost behavior
Cost
Variable cost Fixed Cost

In total
Total variable cost increases and decreases in proportion to change in the activity level Total fixed cost is not affected by changes in the activity level within the given level of installed capacity

In unit
Variable cost remains constant per unit Fixed cost per unit decreases as the activity level rises and increases as the activity level decreases

Managerial Accounting Behavioral cost classifications Cont

Advantages of Variable costing - Necessary data for Cost Volume Profit (CVP) analysis can easily be available from an income statement prepared following variable costing system The impact of fixed costs on profits is highlighted. The total amount of fixed costs appears in the income statement Variable costing data make it easier to estimate the profitability of different segments (products, customers) of a business Under variable costing method, net operating income is closer to net cash flow.

Managerial Accounting
Cost classification for assigning costs to Cost Objects
Cost object: IT Is that functional area of an enterprise for which cost data are required. The area may be production, marketing, employment etc. Classification: From the standpoint of assigning costs to cost objects, costs are classified into three categories. They are - Direct cost - Indirect cost - Common Cost

Managerial Accounting
Cost classification for assigning costs to Cost Objects
Direct Cost: It is a cost which can specifically be assigned to a particular cost object. For example when a company distribute its total amount incurred for managers salary to its different divisions, salary of the manager of say human resources division would be a direct cost of that division Indirect Cost : The nature of this type of cost is just reverse to that of direct cost. It can not be assigned specifically upon any cost objective. For instance, a pharmaceutical unit produce a number of finished formulations (medicines). The amount of factory managers salary can not be assigned to a particular product since the salary is not caused only due to a particular product and as such for a particular product say product X, the cost will be indirect cost.

Managerial Accounting
Cost classification for assigning costs to Cost Objects

Common cost : It is a cost that is common to a number of costing objects but can not be traced individually. For instance salary paid to a marketing manager is a common cost of all the products being marketed since the cost is not initiated by an individual product. A particular cost may be direct or indirect depending on the cost object. It is apparent from the above instances that the salary of factory manager is a direct cost of manufacturing department but indirect cost for a particular product and same with that of marketing department.

Managerial Accounting
Cost classifications for Decision Making
For decision making, costs may be classified as - Differential (Incremental / Decremental) Cost
Opportunity Cost Sunk Cost Prevention Cost Appraisal Cost Internal Appraisal Cost External Appraisal Cost

Managerial Accounting
Cost classifications for Decision Making
Differential (Incremental/Decremental ) Cost : Decision making is the process of selection between alternatives. Each alternative will have different cost and revenue. The difference of cost between two alternatives is the Differential Cost which may by higher or lower than that of other alternative. Thus the differential cost may be Incremental or Decremental. The expected revenue between two alternatives will not be same. The difference of revenue between two alternatives is the Differential Revenue which may be Incremental or Decremental as well. The term Differential cost and Differential revenue is also spelt as Marginal cost and Marginal Revenue

Managerial Accounting
Cost classifications for Decision Making
Opportunity Cost: It is the amount of given up benefit of selecting a particular alternative over another. For example, rate of interest on deposit offered by bank Y is 12%. On the other hand rate offered by bank Z is 11.50%. Opportunity cost of selection the offer of bank Y is 11.50% i.e. the rate offered by bank Z.

Managerial Accounting
Cost classifications for Decision Making
Sunk Cost : Sunk cost is the cost that has already been incurred and can not be recovered in full or in part under existing circumstances. For example Company X incurred Tk. 10,000.00 for developing a particular product. Due to changed circumstances, production of the particular product no longer considered viable and the company have to give up the idea of producing that particular product. The amount incurred for developing the product become Sunk Cost.

Managerial Accounting
Cost classifications for Decision Making
Prevention Cost: It is the cost incurred to support the activities to reduce the number of defects. For instance the cost of introducing Total Quality Management System. Appraisal Cost : It is the cost that incurred to identify any defective product well before handing over to consumer. It is also termed as Inspection Cost. Internal failure cost: Failure cost arises when a product fail to confirm with the design or quality specification. Internal failure cost is incurred to make good any defect before handing over to consumer. For instance, rework cost of defective product, production cost of rejected products etc. External failure cost : External failure cost is incurred to make good of defective units after being delivered to customers. Example of such costs are Warranty, Product replacement, Decrease in Sales, Compensation etc.

Managerial Accounting
Cost Classification on Financial Statements

Financial statements are prepared by firms irrespective of their nature of business. Financial statements of a trading firm is less complicated than that of manufacturing firm. Contents of Financial statement - Balance Sheet - Income Statement

Managerial Accounting
Cost classification on Financial Statement
Balance Sheet : Balance sheet is a pictorial representation of the financial state of affairs of a firm at particular date. Cost component on Balance Sheet : The cost component on balance sheet is only the inventory accounts. For a trading firm inventory consists of only the goods purchased from suppliers that are awaiting resale to customers. On the other hand inventory component of a manufacturing firm consists of raw materials, work in progress and finished goods

Managerial Accounting
Cost classification on Financial Statement

Income statement Income statement is a statement made by the management of a firm stating the results of financial activities for a given period of time.

Managerial Accounting
Cost classification on Financial Statement
Cost components of Income Statement:
Basic Equation for Inventory Accounts Direct Materials Consumed Manufacturing Cost Cost of Goods Manufactured Cost of Goods Sold in a Trading Enterprise Cost of Goods Sold in a Manufacturing Enterprise

Managerial Accounting
Cost classification on Financial Statement Basic Equation for Inventory Account Opening Inventory + Purchase = Consumption + Closing Inventory

Direct Materials Consumed :

Opening Stock of Raw Materials+ Purchase during the year Closing stock of Raw Materials

Managerial Accounting
Cost classification on Financial Statement

Manufacturing cost:
Direct materials consumed + Direct Labour + manufacturing overhead

Cost of Goods Manufactured :

Manufacturing cost + Opening balance of Work in Progress Closing balance of Work in Progress

Managerial Accounting
Cost classification on Financial Statement
Cost of Goods Sold in a Trading Enterprise : Opening Inventory + Purchase during the period-Closing Inventory Cost of Goods Sold in a Manufacturing Enterprise : Opening stock of Finished goods + cost of goods manufactured - Closing stock of Finished goods