Cost Concepts, Cost Analysis, And Cost Estimation

To begin with, lets take a look on the roles of cost into the various management
processes-- With regard to strategy formulation issues like cost savings, what is the
lowest possible cost? How do we cut down costs of a certain project?
In planning to continue or shut down a business unit, how do you factor in still
cost savings, allocated fixed costs, and traceable fixed costs?
In controlling efficient and effective measurement and management of
production costs, how can costs be controlled in the best possible ways?
Organizing and directing normal operating transactions, operating expenses
like salaries, security, utilities and the like.
Decision making, say for example, locating a new business unit, cost under
consideration would include cost of constructing a building, maintenance of
facilities, cost of staffing the business, etc.
To achieve success in this highly-competitive business world, efficient and effective
management and control of costs of operating a business are very important. Costs
entail outflow of resources specifically, cash. Therefore, emphasis of management
accounting information is more of costs.
What is cost? It is an outflow of resources that is given up for an expected future
benefit or for the accomplishment of a certain goal/objective. Let me explain cost
from various perspectives:
1. Product
2. Volume of Production or Activity Level of Operation
3. Decision-making Process, and
4. Cost of Quality
1. Costs Related to the Product
Product signifies the major objective of a business operation. For a
manufacturing concern, it is finished goods. For a trading business, it is
merchandise available for sale. And for a service provider entity, it is the type of
service (skills, expertise, or profession) rendered to clients.
Lets start on the product costs factors of a manufacturer:
the manufacturing cost also known as production cost and the period
costs. As you learned in your Cost Accounting subject, the manufacturing costs
components are direct materials, direct labor, and manufacturing overhead,
whereas, the period costs are the popularly known as your operating expenses or
period costs. Thus, manufacturing costs plus period costs equals the total operating
costs of a manufacturing entity.
For a trader, costs of operations include the cost of merchandise available for
resale (inventoriable costs) plus the operating expenses. A service provider
entity has the cost of supplies directly attributable to the service rendered to
customers plus operating expenses.
2. Costs Related to Volume of Production
One vital concern in an effective cost management system is cost
behaviour - the tendency of costs to change proportionately with the activity level
of production or output. Management accountants identified three cost items in

Cost Concepts, Cost Analysis, And Cost Estimation

relation to volume of production namely, variable costs, fixed costs, and mixed
costs (or semi-variable costs).
Variable costs change totally in direct proportion to the activity level of
output, but remain constant on a per unit basis within a relevant range. In a
manufacturing set up, the direct materials and direct labor are normally variable
costs whereas, factory overhead, some are variables, some are fixed, and some are
mixed costs. Examples of variable factory overhead are factory supplies, gasoline,
lubricants and oil, as well as overtime premium of factory workers. In terms of
control, variable costs are controllable, meaning, the operating supervisors exert
influence on the incurrence of these costs and on a per unit amount, tend to
decrease as the activity increases within a relevant period also. Because total fixed
costs remain constant as activity changes, it follows that fixed costs per unit vary
inversely with activity, meaning as volume increases fixed cost per unit declines
and vice versa (Weygandt, et al. 2008). Fixed costs are non-controllable at the
operating management level. Thus, the responsibility to control fixed costs rests at
the executive management level. Some examples of fixed costs are salary of
production managers and supervisors, wages of factory clerks and security staff,
depreciation of factory property and equipment, factory rent, and property taxes.
Some costs have both variable and fixed elements known as mixed costs.
Mixed costs or semi-variable costs change in total but not proportionately with
changes in the activity level (Weygandt, et al. 2008). For CVP analysis, which will
be discussed in the next module, it is very important that the variable and fixed
component of a mixed cost must be specifically identified. In the segregation of the
variable and fixed components of mixed costs, the high and low method, methods
of least squares or scatter graph may be used.
3. Costs in relation to decision making
In a decision making process, one very significant factor to consider is to
identify costs that are relevant and those that are irrelevant. For the last cost
classification in this module, we have opportunity costs, sunk costs, and differential
costs. Detailed discussions on the nature and application of these costs are to be
taken in your next Managerial Accounting subject under Relevant Costing Shortterm non routine decisions.