Introduction to

Cost Terms
Accounting systems measure costs
which are used for

• profit measurement,
• inventory valuation,
• decision making.
What is a cost ?

Cost is a monetary measure of the resources

sacrificed to achieve a specific objective, like
producing a product or rendering a service.

A cost object is any activity for which a

separate measurement of costs is desired.
Examples of cost objects include
. the cost of a product
. cost of rendering a service to a
bank customer
. the cost of operating a particular
department
. cost of operating a sales territory
Various cost terms are
• Direct and indirect costs
• Product costs and period costs
• Cost behavior in relation to volume of activity
• Relevant and irrelevant costs
• Sunk costs
• Opportunity costs
• Incremental and marginal costs
• Joint product costs and separable costs
Direct and indirect costs

Direct costs are those costs that can be

specifically identified with a particular cost
object.
Ex : Direct material, Labor
Indirect costs cannot be identified with a
given cost object.
Ex : Manufacturing overheads like
indirect labor, indirect material
Manufacturing Overhead
Manufacturing costs that cannot be traced directly to
specific units produced.

Examples:
Examples: Indirect
Indirect labor
labor and
and indirect
indirect
materials
materials

Wages paid to employees Materials used to support

who are not directly the production process.
involved in production
work. Examples: lubricants and
Examples: maintenance cleaning supplies used in the
workers, and security automobile assembly plant.
guards.
Product costs and period
costs
Product costs are those costs that are
identified with goods produced for resale.
Ex : Raw materials, direct labor

Period costs are those costs which are

matched against the revenue of the current
period.
Ex : Non manufacturing costs like rent,
insurance, S & D expenses.
Non manufacturing Costs

Marketing and selling costs . . .

 Costs necessary to get the order and deliver the
product.
Administrative costs . . .
 All executive, organizational, and clerical costs.
Product Costs Versus Period Costs

Product costs include Period costs are not

direct materials, direct included in product
labor, and costs. They are
manufacturing expensed on the
overhead. income statement.
Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement
A company produces 100000 identical units of a
product. Costs are
Manuf. Costs
Rs. Rs.
Direct material 400000
Direct labor 200000
Manuf. O/H 200000 800000

Non manuf. Costs 300000

a) Sale of 50000 units for Rs.750000

Sales (50000 units) 750000
Manuf. Costs ( product costs )
Direct material 400000
Direct labor 200000
Manuf. O/H 200000
800000
Less: Cl. Stock 400000

Cost of goods produced 400000

Gross profit 350000

Less : non–manuf.Costs(period costs) 300000

Net profit 50000

 Cost behavior in relation to volume of
activity

Activity of an organisation may be

measured in terms of
• units of production
• hours worked
• distance travelled
• students enrolled

A knowledge of how costs and revenues

will vary with different levels of activity is
essential for decision making.
 Fixed costs and variable costs
The terms fixed cost, semi-fixed cost, variable
cost, semi-variable cost have been used in
management accounting to describe how a cost
reacts to changes in level of activity.

Fixed costs remain constant over wide ranges of

activity for a specified time period
Ex : Depr. Of factory, supervisor’s salaries

Variable costs vary in direct proportion to the

volume of activity
Ex : Direct material, labor, energy
charges.
Semi fixed costs are those costs that
remain fixed within specified activity levels,
within a given time period but they
eventually increase or decrease at various
critical activity levels.
Ex : direct labor, salaries, energy
charges, telephone bills
Cost Classifications for Predicting
Cost Behavior

How
How aa cost
cost will
will react
react to
to
changes
changes in
in the
the level
level of
of
business
business activity.
activity.
Total Variable Cost

Your total long distance telephone bill is

based on how many minutes you talk.
Total Long Distance
Telephone Bill

Minutes Talked
 Variable Cost Per Unit

The cost per long distance minute talked is

constant. For example, Rs.1.25 per minute.

Telephone Charge
Per Minute

Minutes Talked
 Fixed Cost Per Unit
The average cost per local call decreases as
more local calls are made.

Monthly Basic Telephone

Bill per Local Call
Number of Local Calls
Cost Behavior

Variable costs are usually characterized by

???
a. Unit costs that decrease as activity
increases.
b. Total costs that increase as activity
decreases.
c. Total costs that increase as activity
increases.
d. Total costs that remain constant.
Cost Behavior

Fixed costs are usually characterized

by ???
a. Unit costs that remain constant.
b. Total costs that increase as activity
decreases.
c. Total costs that increase as activity
increases.
d. Total costs that remain constant.
 Cost Classifications for Predicting
Cost Behavior

Behavior of Cost (within the relevant range

Cost In Total Per Un

Variable Total variable cost changes Variable cost per

as activity level changes. the same over w
of activi
Fixed Total fixed cost remains Fixed cost per
the same even when the down as activity le
activity level changes.
Relevant costs and irrelevant costs
For decision making, costs can be classified
according to whether they are relevant to a
particular decision.

Relevant costs are those future costs that

will be changed by a decision, whereas

Irrelevant costs are those future costs that

will not be changed by a decision.
Ex : Choice of making a journey by car or
public transport
Relevant costs and irrelevant costs
Example:

Do not
accept order Accept order
Rs. Rs.
Material 100 100
Conversion costs nil 200
Revenue nil ( 250 )
Net costs 100 50
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 Rs.10,000 two years ago. The
Rs.10,000 cost is sunk because whether
you drive it, park it, trade it, or sell it, you
cannot change the Rs.10,000 cost.
Opportunity Costs

An opportunity cost
is a cost that
measures the
opportunity that is
lost or sacrificed
when the choice of
one course of action
requires that an
alternative course of
action be given up.
 Opportunity Costs

The potential benefit

that is given up when
one alternative is
selected over another.

Example: If you were

not attending college,
you could be earning
Rs.1,50,000 per year.
Your opportunity cost
of attending college for
one year is Rs.1,50,000.
Incremental and marginal costs

Incremental cost ( also called

differential cost ) is the difference in
total costs between two alternatives.

While assessing the profitability of a

proposed change, the incremental
costs are matched with incremental
revenue.

Marginal cost represents the

Incremental and marginal costs

A company is producing 1000 units.

Selling price per unit Rs.11

Variable cost per unit Rs.5
Fixed costs Rs.4000

a)To accept another order for 500 units at a

selling price of Rs.9 per unit. This also increases
fixed costs by Rs.500
 Present proposed
situation situation
Rs. Rs.
Sales 11000 15500
Less:
Variable costs – 5000 7500
Fixed costs - 4000 9000 4500 12000

Profit 2000 3500

Incremental cost = Rs.3000

Marginal cost = Rs. 3000/500 = Rs.6 per extra unit.
Differential Costs and Revenues

Costs and revenues that differ among

alternatives.
Example: You have a job paying Rs.7,500 per month
in your hometown. You have a job offer in a
neighboring city that pays Rs.10,000 per month. The
commuting cost to the city is Rs.1000 per month.

Differential revenue is:

Rs.10,000 – Rs.7,500 = Rs.2500
Differential Costs and
Revenues
Costs and revenues that differ among
alternatives.
Example: You have a job paying Rs.7,500 per month
in your hometown. You have a job offer in a
neighboring city that pays Rs.10,000 per month. The
commuting cost to the city is Rs.1000 per month.
.

Differential revenue is:

Rs.10,000 – Rs.7,500 = Rs.2500
Differential cost is:
Rs.1000
Joint product costs and separable costs
Joint product costs are the costs of a single
process or a series of processes that
simultaneously produce two or more
products of significant sales value.

These costs are not attributable to different

individual products until after a certain
stage of production known as “Split off
point”
Joint product costs and separable costs

Separable cost refers to any cost that can

be attributed exclusively and wholly to a
particular product, process, division or
department.
Cost Sheet

Cost sheet is a document that provides for

the estimated detailed cost in respect of
cost centres.

Cost sheet may be prepared on the basis of

actual data or on the basis of estimated
data.
Cost Sheet Rs.
Opening stock of raw materials – 30000
Add : Purchase of RM - 450000

480000
Less : Cl. Stock of RM 15000

Value of RM consumed 465000

Add : Wages paid 230000

PRIME COST 695000

Cost Sheet Rs.
PRIME COST 695000
Add : Factory overheads 92000

787000
Add : Op. stock of work in progress 12000
799000
Less : cl.stock of work in progress 10000

FACTORY COST 789000

 Cost Sheet Rs.
FACTORY COST 789000
Add : Admin. Overheads 30000

Cost of goods produced 819000

Add : Op. stock of finished goods 60000

879000

Less : Cl. Stock of finished goods 55000

Cost of goods sold 824000
Cost Sheet Rs.

Cost of goods sold

824000
Add : S & D overheads
20000
Cost of Sales
844000

Profit 46000

Sales
900000