Cost Concepts

for
Decision-making

07/09/09 Chandrakant@SOM,KIIT University 1

 Learning Objectives
Define cost and cost object.
Understand cost accumulation and cost

assignment.
Understand “Cost Center”

Distinction between Direct Cost and Indirect Cost.

What is a ‘Cost Driver’?

Classification of “COST”

07/09/09 Chandrakant@SOM,KIIT University 2

 Cost and Cost Terminology

Cost is a resource sacrificed or forgone to

achieve
a specific objective.
An actual cost is the cost incurred (a
historical cost)
as distinguished from budgeted cost,
which is a predicted
A cost object is anything for which a
separate
measurement of costs is desired.

07/09/09 Chandrakant@SOM,KIIT University 3

 Cost and Cost Terminology

Cost Object
Cost
Accumulation
(Collection of cost
data Cost Object
in some organized
way
by means of an
Cost Object

Cost Tracing
Assignment
Allocating

07/09/09 Chandrakant@SOM,KIIT University 4

 Cost Assignment
 Encompasses both:
– Tracing accumulated costs that have a
direct relationship to a cost object.
– Allocating accumulated costs that have
an indirect relationship to a cost object.

07/09/09 Chandrakant@SOM,KIIT University 5

 Cost Center
 CIMA defines as “a production or service,
function, activity or item of equipment whose
costs may be attributed to cost units. A cost
center is the smallest organizational sub-unit for
which separate cost allocation is attempted.”
 Any part of an enterprise to which costs can be
charged is called as Cost Center. The objective
behind this:
– Clear cut responsibility placed on a person.
– Cost center-wise recovery of cost is possible.

07/09/09 Chandrakant@SOM,KIIT University 6

 Cost Driver
Bicycles by the Sea buys a handlebar
at $52 for each of its bicycles.
What is the total handlebar cost when
1,000 bicycles are assembled? 1,000 units × $52 = $52,000

What is the total handlebar cost

when 3,500 bicycles are assembled? 3,500 units × $52 = $182,000
Bicycles by the Sea incurred $94,500 in
a given year for the leasing of its plant. This is an example of fixed
costs with
respect to the number of bicycles assembled.
What is the leasing (fixed) cost per bicycle
when Bicycles assembles 1,000 bicycles? $94,500 ÷ 1,000 = $94.50
What is the leasing (fixed) cost per bicycle
when Bicycles assembles 3,500 bicycles? $94,500 ÷ 3,500 = $27
The cost driver of variable costs is the level of activity or volume
whose change causes
the (variable) costsChandrakant@SOM,KIIT
07/09/09
to change proportionately.
University
The number of 7
bicycles assembled is a
 Direct and Indirect Costs
Direct Costs:
Cost related to the particular
cost COST OBJECT
object and can be traced to it
in an Example:
economically feasible way. Pepsi Colas

Indirect Costs:
Cost related to the particular
cost
object but can’t be traced to it
in
an economically feasible way.
Example: Salaries of
supervisors
who oversee production
07/09/09
of
Chandrakant@SOM,KIIT University 8
 Prime Costs

Direct Direct Prime

Materials Labor Costs
+ =

07/09/09 Chandrakant@SOM,KIIT University 9

 Conversion Costs

Direct Manufacturing Conversion

Labor Overhead Costs
+ =

Indirec Indirec
t t Other
07/09/09 Chandrakant@SOM,KIIT University 10
 Classification of Cost
Time Based: Controllability
2. Historical Based:
Payment Based: 2. Controllable
2. Explicit 3. Current
4. Budgeted 3. Non-
3. Implicit controllable

Normality Based:
Elements Based:
2. Normal
2. Materials
COST 3. Abnormal
3. Labour
4. Expenses
Association
Function Based: Based:
2. Production 2. Period
3. Administratio Nature Based:
2. Variable 3. Product
n
3. Fixed Decision making
4. Selling
4. Semi- Based:
5. Distribution
Variable 2. Relevant
6. R & D
3. Irrelevant
7. Conversion
07/09/09 Chandrakant@SOM,KIIT University 11
 On the basis of behavior
 Variable cost: Tend to vary or change in
relation to the volume of production.
However, remained constant per unit.
Exp: raw materials, direct wages, etc.
 Fixed cost: Remain constant at various
level of production. These are not
affected by volume of production.
However, varies per unit. Exp: factory
rent, Insurance, etc.
 Semi-variable cost: These are fixed up
to a particular volume of production
and become variable thereafter for the
next level of production. Exp: repairs
and maintenance, electricity,
07/09/09 Chandrakant@SOM,KIIT University 12
 Variable and Fixed Costs
Variable Cost $
 a cost which is constant per unit
but changes in total in proportion
to changes in the cost driver
 Exp: materials (parts), fuel costs
for a trucking company Volume

Fixed Cost $
 a cost which does not change in
total as volume changes but
changes on a per-unit basis as the
cost driver increases and
Volume
decreases
Exp: amortization,
 07/09/09 insurance
Chandrakant@SOM,KIIT University 13
 On the basis of
 controllability
Controllable cost: Cost which can be
influenced and controlled by
managerial action. A relative term but
subject to:
– Time: long run vs. short run
– Location: Lease agreements of factory
being executed centrally at the HO.
– Product/Output: Certain costs are
controllable by reference to one product or
market segment and not by reference to
the other. Exp: cost of raw materials for
export.
 Non-controllable cost: Costs that can
not be influenced and controlled by a
07/09/09 Chandrakant@SOM,KIIT University 14
 On the basis of Association
Period costs are all costs in the income
statement other than cost of goods sold.
Exp: General Administration, Salesman's Salary,
Depreciation of office
Facilities, etc
Period costs are recorded as expenses of the
accounting period in which they are incurred
since these are not assigned to the products

Product costs are all costs which can be

identified to
different products purchased or produced for
resale and are
included in Inventory Valuation.
Exp:
07/09/09
cost of rawChandrakant@SOM,KIIT
materials,University
direct wages, all 15
 Product Costs Versus Period
Costs
Product costs Period costs are not
include direct included in
materials, direct product costs.
labor, and They are
manufacturing expensed on the
Inventor overhead.
y
Cost of Good
Sold income
Expens
e
Sale statement.

Balance Income Income

Sheet Statement Statement

07/09/09 Chandrakant@SOM,KIIT University 16

 Manufacturing Company
BALANCE INCOME
Inventori SHEET STATEMENT
able Revenues
w dedu
Materials Finished hen
Goods sale Cost of
Inventory Goods Sold
Inventory
Equals Gross
Margin
Work in Period
Process Costs
Inventory
Equals Operating
07/09/09
Income
Chandrakant@SOM,KIIT University 17
 Merchandising Company

BALANCE INCOME
Inventori SHEET STATEMENT
able Revenues
w dedu
Merchandis hen
e Inventory sale Cost of
Purchases Goods Sold
Equals Gross
Margin
Period
Costs
Equals Operating
07/09/09
Income
Chandrakant@SOM,KIIT University 18
 On the basis of payment

07/09/09 Chandrakant@SOM,KIIT University 19

 On the basis of relevance to
decision-making
 Relevant costs
– Marginal cost
– Differential cost
– Opportunity cost
 Irrelevant costs
– Absorbed fixed cost
– Sunk cost
– Committed cost

07/09/09 Chandrakant@SOM,KIIT University 20

 Relevant Cost
 Expected future costs that are essential
but differ for alternative courses of
action. Hence it is a cost that would
arise as a direct consequence of the
decision under review.
 Exp: One is faced with a choice of
making a journey by car or by public
transport, the car tax and insurance
costs are irrelevant since they will
remain the same whatever alternative
is chosen. However, the petrol costs for
the car will differ depending on which
07/09/09 Chandrakant@SOM,KIIT University 21
 Marginal Cost
 Total variable cost i.e. Prime Cost +
Variable Overheads. This cost is
relevant for decision making as this
will be incurred in future for
additional units of production.
 It will be a relevant cost for decision
making as this will be incurred in
future for additional units of
production.

07/09/09 Chandrakant@SOM,KIIT University 22

 Differential Cost
 It is the increase or decrease in total
cost or change in specific elements of
cost that result from any variation in
operations. It represents an increase or
decrease in total cost resulting out of:
– Producing or distributing a few more or few
less of the products
– A change in the method of production or of
distribution
– An addition or deletion of a product or a
territory and
– Selection of an additional sales channel
07/09/09 Chandrakant@SOM,KIIT University 23
 Opportunity Costs
The value of sacrifice made or
benefit of opportunity
foregone by selecting one
particular alternative in
preference to other
Example:
alternatives. If you were
not attending college,
you could be earning
$15,000 per year.
Your opportunity cost
of attending college
for one year is
$15,000.
 Cont…
 Example: A firm operates at full
capacity. If a new order is to be
undertaken, contribution foregone on
the existing sales (i.e. due to full
capacity) constitutes opportunity
cost for the new order.
 It is relevant cost where alternatives
are available. However, opportunity
cost does not find any place in formal
accounts and is computed only for
comparison purposes.
07/09/09 Chandrakant@SOM,KIIT University 25
 Sunk Costs
Sunk costs cannot be changed by any decision.
They are not differential costs and should be
ignored when making decisions.

Example: You bought an automobile

that cost $10,000 two years ago. The
$10,000 cost is sunk because whether you
drive it, park it, trade it, or sell it, you
cannot change the $10,000 cost.

07/09/09 Chandrakant@SOM,KIIT University 26

 Committed Cost
 A cost, which has been committed by
the management, is not relevant for
decision making.
 Exp: costs arising from the
possession of plant, building and
equipment (e.g. depreciation, rent,
taxes, insurance premium, etc).
 These are un-avoidable cost.

07/09/09 Chandrakant@SOM,KIIT University 27

 Concept Problem: 1
 ABC Ltd is tendering a six-month
contract which would require the use of
a specialized machine. The machine
was purchased 4 years ago for Rs
90,000 and now has a net book value of
Rs 35,000. The company was about to
sell the machine for Rs 40,000 but if
they used it on this contract they can
sell it after 6 months for Rs 25,000.
Variable cost of operating the machine
for 6 months would be Rs 60,000.
Ignoring interest costs, identify the
relevant cost of using the machine on
07/09/09 Chandrakant@SOM,KIIT University 28