CHPTER 1

COST TERMS AND CONCEPTS

Introduction
- Accounting systems are designed to provide information to decision-makers. Accounting language
has two primary “variations”: financial accounting and management accounting. Cost
accounting is a bridge between financial and management accounting.
- Financial accounting reports the financial performance of the company mainly to external users. It
reports financial position and income according to Generally Accepted Accounting Principles
(GAAP). Data should be comparable across firms.
- Management accounting provides information for internal users (managers) who direct and control
its operations. The reports are not governed by GAAP.
- Cost accounting is defined as “a technique or method for determining the cost of a product, service,
project, process, or thing. . . It integrates with financial accounting by providing product costing
information for financial statements and with management accounting by providing some of the
quantitative, cost-based information managers need to perform their tasks.
- Cost accounting has long been used to help managers understand the costs of running a business.
Modern cost accounting originated during the industrial revolution, when the complexities of running
a large scale business led to the development of systems for recording and tracking costs to help
business owners and managers make decisions.
- Organizations that do not manufacture products may not require elaborate cost accounting systems.
However, even service companies need to understand how much their services cost so that they can
determine whether it is cost-effective to be engaged in particular business activities.
This course focuses on the concepts and procedures of cost accounting

The Purposes of Cost Accounting Systems.

Cost accounting systems provide information useful:

 For managing the activities that consume resources.
 For planning and control and for performance evaluation. Budgeting is the most commonly
used tool for planning and control and forces managers to: Look ahead, translate strategy into
plans, coordinate and communicate within the organization and provide a benchmark for
evaluating performance
 In addition, the cost information is reported on external financial statements as, for example,
inventories, cost of goods sold, and period expenses. The costs of products and services
produced and sold are needed for tax purpose.
 Information about costs is also needed for a variety of management decisions (both strategic
and short-term decisions).
For example, product pricing, product discontinuance (Shut-down), make (produce) or buy,
acceptance of a special order.
Cost accounting is linked to tax accounting, financial accounting and managerial accounting because
both depend on cost accounting to provide cost information.

Cost Accounting, AAUCC, 2010 Page 1 of 20

Cost Terms
- An understanding of cost terms and concepts provides the foundation for the understanding of cost
accounting and mgt accounting. The terminology and concepts introduced in this chapter will be
used extensively throughout the remaining chapters in this course.
- Note that since cost accounting is not for external reporting purposes, there is frequently a lack of
communication between companies, and no standard terminology developed. Many cost accounting
terms lack a uniform definition, and many practices may go by different names.

Cost
o The monetary measure of economic resources (tangible or service) given up/sacrificed to attain a
specific objective/purpose such as acquiring a good or service.
o One guiding principle is that the term cost is a relative term, dependent both on the “cost object”
chosen and the purpose for which cost is being calculated and reported.
o “Cost” is often actually “estimated cost” due to difficulties involved in cost tracing and
allocation, relevant range issues, which cost method is used, and the cost-benefit approach to
measuring costs.

Expense
o A cost that has given a benefit and is now expired. Expenses are incurred intentionally in the
process of generating revenues. E.g cost of goods sold, selling and adm. expenses. Unexpired
costs that can give future benefit are classified as assets.
Loss
o Losses are unintentionally incurred in the context of business operation. E.g losses resulting from
damage related to fire, flood, abnormal production waste, sale of productive asset below book
value.

Cost object
o To guide their decisions, managers often want to know how much a particular thing costs. This
“thing” is called a cost object, anything for which a measurement of costs is desired
E.g. products, services, projects, departments, division, branch, customer etc
o Different cost objects tend to be used in different industries. Using products as cost objects in a
manufacturing company makes sense because product cost information can be used to determine
product profitability and to make various strategic decisions. Services are more appropriate cost
objects for many other firms in the service industry. On the other hand a retailer might find it
more useful to treat departments as cost objects.
o Two steps (stages) to arrive at the cost of a cost object:
1. Cost accumulation
• the collection of cost data (e.g., on wages or overhead) in some organized way by means of an
accounting system.
2. Cost assignment
• the cost accumulated must be assigned to various cost objects in order to provide managers
needed information for decision making purposes.
• is a general term that includes:
i) Allocating accumulated costs with an indirect relationship to a cost object and
ii) Tracing accumulated costs with a direct relationship to the cost object

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Cost Classification
- Costs vary with purpose and the same cost data cannot serve all purposes equally well. The word
cost is used in such a wide variety of ways that is advisable to use it with an adjective or phrase,
which will convey the meaning intended.
- Now consider some ways of classifying costs:
 Based on business function (R&D, Design, Production(manufacturing), Marketing,
Distribution, Customer service)
For purposes of contracting with government agencies design & R&D costs are treated as
product costs
 Based on financial statement presentation (capitalized, noncapitalized, iventoriable, non-
iventoriable: product vs. period)
 Based on assignment to cost object (direct vs. indirect)
 Based on whether or not the specified subunit can control or significantly influence the
cost(controllable cost, uncontrollable cost)
 Based on behavior in relation to cost driver (variable vs. fixed)
 Based on aggregation (total vs. unit)
 Based on economic characteristics of costs ( opportunity cost, sunk cost, incremental cost,
marginal cost)

Direct Costs and Indirect costs

- A key question in cost assignment is whether costs have a direct or an indirect relationship to the
particular cost object. The direct/indirect classification has no meaning unless one first identifies the
cost object to which the costs are to be related.
Direct Costs
- Are costs related to a cost object and can be conveniently and economically traced (tracked) to that
cost object [product, department, etc.]. It is a cost used by a single cost object and would be
eliminated if the cost object is eliminated. Many costs may be able to be traced to the cost object, but
it is not always practical to do so from a cost-benefit perspective.
- Includes - the cost of materials and labor specifically used in manufacturing a product or providing a
service. Examples are:
• the cost of the cans or bottles of Pepsi-colas,
• the cost of the metal frame and the lumber to make a chair;
• the cost of cloth and buttons used in manufacturing clothings,
• A supervisor's salary is a direct cost to the production department he or she is in charge of or
managing.
• Specific labor costs that can be identified with the work involved in manufacturing a product or
providing a service and other expenses that can be specifically identified with a product or
service.
- The term cost tracing describes the assignment of direct costs to the particular cost object.
Indirect Costs
- Are costs related (directly or indirectly) to a cost object but cannot be conveniently or economically
traced (tracked) to that cost object. Instead of being traced, these costs are allocated to a cost object

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in a rational and systematic manner. The term cost allocation is used to describe the assignment of
indirect costs to a particular cost object.
- Indirect costs are also known as common costs--costs shared by more than one cost object.
- For example, the salaries of supervisors who oversee production of many different soft drink
products bottled at a Pepsi plant is an indirect cost of Pepsi-colas. Supervision costs are related to the
cost object (Pepsi-cola) because supervision is necessary for managing the production and sale of
Pepsi-colas. Supervision costs are indirect cost because supervisors also oversee the production of
other products such as 7-up. Unlike the cost of cans or bottles, it is difficult to trace supervision costs
to the Pepsi-cola line.
- Other examples include Factory accountant’s salary, Electricity, Rent, Property taxes, janitors,
factory supplies are examples.

Factors affecting direct/Indirect cost classification

Several factors affect this classification
1. The materiality (relative importance) of the cost
o The larger the amount of a cost, the more likely that it is economically feasible to trace that cost
to a particular cost object. But if it is small, it should be classified as indirect cost as it would
not be economically feasible (cost>benefit). That is why minor items such as nails and glue are
treated as indirect costs.
2. Information gathering technology
o improvement in technology have enabled to treat more and more cost as direct costs, which
were previously treated as indirect costs.
e.g. many components parts display a bar code that can be scanned at every point in the
production process
3. Design of operation
o Classifying a cost as direct is easier if a company's facility (or some part of it) is used
exclusively for a specific cost object, such as a specific product or a particular customer. E.g.
depreciation on special-purpose equipment.
- The direct/indirect classification depends on the choice of the cost object. A specific cost may be
both a direct cost of one cost object and an indirect cost of another cost object. The definition of a
cost as direct or indirect changes if the cost object changes.
E.g Take a production department manager’s salary. If the cost object is the production department,
the salary is a direct cost because it can be traced to the cost object. But if the cost object is one
of the many products manufactured in the production department, the salary is an indirect cost
because it can be allocated (but cannot be traced) to the cost object.
- Generally, managers are more confident about the accuracy of direct costs of cost objects. Indirect
costs pose more problems.

Tracing versus Allocating Costs – Example

ABC, Inc. makes two products; bricks and play sand. The products are produced in two separate
facilities, and the plant supervisors work at both plants. Allocate rent and salaries based on revenues.

Product Units produced and Sold Sales price per unit

Bricks 2,000,000 tons $0.75
Sand 30,000 tons $90.00

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The brick operation consumes 70% of the material purchased. The play sand uses the remaining 30%.
Labor has an average cost of $10 per hour. The brick operation uses 21,000 labor hours. The play sand
operation uses 14,000 labor hours. The company pays all utilities on one bill that goes to the
headquarters. Headquarters allocates 50% of the utilities cost to each product. (Note: total costs of
material, labor, supervisors, and utilities are assumed)
Required: Show how revenue and cost are assigned to each product (cost object)
Solution:
Cost type Total cost bricks sands How assigned
Sales revenue $4,200,000 $1,500,00 $2,700,000 Traced
0
Materials 800,000 560,000 240,000 Traced
Labor 350,000 210,000 140,000 Traced
Supervisors 140,000 50,000 90,000 Allocated
Plant rent 700,000 250,000 450,000 Allocated
Total utilities 160,000 80,000 80,000 Allocated

Managers want to accurately assign costs to cost objects. Inaccurate product costs will mislead
managers about the profitability of different products; as a result, managers might promote products
that are not profitable while deemphasizing products that are profitable.

Manufacturing and Nonmanufacturing Costs

- The costs associated with a manufacturing firm are separated into two broad categories. These
include manufacturing costs and nonmanufacturing (selling and administrative) costs. This
functional separation is important because each category of cost is treated differently in the
accounting records. Manufacturing costs are capitalized (recorded as asset) and expensed in the form
of cost of goods sold at time of sale. Nonmanufacturing costs are immediately expensed. The
different treatments are required to obtain proper matching.
Manufacturing Costs:
- Manufacturing is the process of converting materials into finished goods by using labor and
incurring other costs, generally called, manufacturing overhead. Manufacturing costs are costs
associated with the production of products.
- Three terms are widely used in describing manufacturing costs. In the following definitions, “the cost
object” refers to “work in process and then finished goods.”

1. Direct Material Costs

 Are the acquisition costs of all materials that eventually become part of the cost object and that
can be traced to the cost object in an economically feasible way.
 They must be a significant part of the finished good. For example the metal frame and the
lumber used in manufacturing a chair, steel in the manufacture of automobiles, wires for TV
sets, and the buttons used in manufacturing clothing, costs of paper and ink for a printer
 DMs do not include minor items such as nails or glue. Why? Because the costs of tracing
insignificant items do not seem worth than the possible benefit of precise product costs. So,
such items as supplies or indirect materials are classifies as FOH.
2. Direct labor Costs

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 Include the compensation of all manufacturing labor who work directly in the production
process that can be traced to the cost object in an economically feasible way.
E.g. in a factory that makes chairs, wages of workers who cut and sand lumber and of those
who assemble the parts into finished chairs, wages of carpenters for a construction
company
 The labor must clearly be associated with a particular cost object, in order for the labor to be
called "direct labor." An example would be a production supervisor in a factory with multiple
product lines. The supervisor would go from machine to machine inspecting the different types
of products to make sure there were not any defects. Although the supervisor did an important
job, it was impossible to assign his time to any particular product. As a result, the inspector's
labor was not considered direct labor.
 In highly automated factories with a flexible workforce, there may be no direct labor costs.
Why? Because workers spend time on numerous products, which makes it economically
infeasible to physically trace any labor cost directly to specific products.
3. Indirect Manufacturing Costs (also called manufacturing overhead costs or factory
overhead costs, factory burden)
 The generic term "overhead" can refer to all the costs in a company that are not direct labor or
direct material. But there is a distinction between overhead and manufacturing overhead.
 Manufacturing overhead means the same thing all costs except direct labor and direct
materials. The difference is that manufacturing overhead refers to those costs closely related to
the factory or production process and therefore excludes administrative and selling expenses
(e.g the president's salary, accountants, lawyers, interest expense, advertising, marketing,
secretarial staff, distribution costs, income taxes, etc, and any other).
 Manufacturing overhead costs are all manufacturing costs that are related to the cost object
but that cannot be traced to that cost object in an economically feasible way. You cannot easily
determine how much of these costs it takes to make one product. The total dollars spent support
the manufacturing of many products.
 Indirect cost of a cost object are divided into cost pools(a grouping of individual cost items)
and allocated to the cost object
 Usually subdivided into three categories:

i) Indirect materials-- the cost of materials of two types:

a) Materials that are not physically incorporated in the product (such as the cost of lathe
blades in a furniture plant factory, supplies or operating supplies -cleaning supplies,
gloves, brushes, repair parts, light bulbs etc ). These are materials used in production
which do not end up as part of the finished product;
b) The cost of minor materials, even if they are physically incorporated in the product
(such as glue in manufacturing arm chairs, some paints and lubricants oils, and
greases, small amounts of wire, thread in sewing a suit). These are materials used in
small amounts in the mfg process that cannot easily be allocated to specific products.
ii) Indirect labor
- The cost of compensating employees who are necessary for production (work in the
factory), but don’t actually transform the materials or assemble the product.
E.g. Wages of plant janitors, storeroom clerks, timekeepers, superintendents, maintenance
crew, factory foremen/supervisors, quality inspectors, cost accountants, engineers,
plant guards, wages of custodial personnel etc.

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Note: For the above items, the company will incur costs for salaries, wages, Social
Security and Medicare taxes, unemployment compensation tax, worker
compensation insurance, health insurance, holiday pay, vacation pay, sick pay,
pension or retirement plan, seminars and training, and perhaps more.)
iii) Other mfg OH
- However, many costs are incurred so that the business can operate.
E. g. Payroll taxes on factory wages, rent, depreciation, taxes, insurance on factory
buildings and machines, heat, light and power. Also includes service department
costs, such as costs incurred in the maintenance department or the engineering
department, personnel, cafeteria. Service departments are not directly related to the
production of an item. Their function is to provide services for other departments. A
portion of the service department's cost should be allocated to the production
department and will become part of product cost (to be discussed in chapter 5). The
portion not allocated to the production department may be allocated to another service
department or to a nonplant department, such as the sales department, and will be an
expense for that department for the current period.
- Many of them relate to the physical plant (bldg, machinery and equipment)
- It is important to remember that these expenses must be on the factory facilities and not on
the administrative and selling offices in which case it will be nonmanufacturing costs.
 Note that precise classification of some costs in to one of these categories (DM, DL & FOH) may be
difficult and judgment may be required in the classification process.
 Two main categories of indirect labor in manufacturing and service companies are overtime
premium and idle time.
The Overtime Premium pay and Idle Time pay
- Overtime premium is the wage rate paid to workers (for direct labor and indirect labor) in excess of
their straight-time wage rates.
- Idle time is wages paid for unproductive time caused by lack of orders, machine breakdowns,
material shortages, poor scheduling, and the like.
- The Overtime Premium pay and Idle Time pay related to the DL or Indirect work force is most
appropriately classified as Indirect Costs. These costs come about because of the totality of business
(randomly), or inefficiencies of businesses, not as a result of any one particular job. A particular job
should not bear the total overtime premium for the mere reason that it happened to be worked during
the overtime hours.
- But sometimes overtime is not random. For example, a customer demanding a "rush job" may clearly
be the sole source of the overtime. In such instances, the overtime premium is regarded as a direct
cost of that job.
- Payroll Taxes and Fringe Benefits related to the DL (who work directly on the manufactured
product) costs are most appropriately classified as Direct Labor Costs also. Businesses know that
additional costs for payroll taxes and fringe benefits will be required of all employees, therefore, the
portion attributable to the direct labor should also be categorized as DL. The portion attributable to
IDL would, therefore, be categorized as IDL. Sometimes payroll taxes and/or fringe benefits will be
classified as IDL because of Materiality or Cost-Benefit analysis.
Nonmanufacturing Costs
- In addition to DM, DL and FOH, all manufacturing companies also incur costs associated with the
other value chain functions (R & D, design, marketing, distribution, and customer service). Most

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firms’ financial statements report these costs as selling and administrative expenses. In short, these
costs do not become a part of the reported inventory cost of the manufactured products.
Selling Costs:
• The costs associated with selling the product are Selling Costs. These include sales salaries and
commissions, payroll tax sales salaries, advertising, delivery expenses (Freight Out), depreciation
on store equipment, stores and their related fixtures and equipment etc . Warehouse costs and
people who move inventory are period costs.

General and Administrative Costs

• Viewed as the core of necessary costs to manage the entire firm.
• This includes costs that are part of the administrative arm of the business, provided these costs can't
be traced directly or indirectly to the manufacturing function.
E.g Officers' salaries expense, office salaries expense, payroll tax expense – administrative,
office supplies and expense, Bad debt expense, depreciation on office buildings and eqts,
Insurance, and Property Tax on executive headquarters etc
- Theoretically, if there are future benefits associated with a cost, the cost should be capitalized as an
asset rather than expensed. Certainly there are some future benefits associated with costs such as
research and development, training, market promotion and advertising.
- However, these costs are expensed as incurred because it is difficult if not impossible to relate them
to the future benefits. As a result, these costs are referred to as period costs.
Prime and Conversion costs
- Based on its relation to production, manufacturing cost can be classified into:

Prime Costs:
• Prime costs are all direct manufacturing costs. Under the three-part classification of manufacturing
costs, prime costs are equal to direct material costs plus direct manufacturing labor costs. In cases
where other direct manufacturing cost categories are used, they too are prime costs. For example,
power costs could be classified as a direct cost if the power is metered to specific areas of a plant
that are dedicated to manufacturing separate products.
• It reflects the primary sources of costs for units in production (i.e in many cases they constitute the
major portion of mfg costs)
Conversion costs:
• Conversion costs are all manufacturing costs other than direct material costs; they are incurred to
convert direct materials into finished goods. Under the three-part classification of manufacturing
costs, conversion costs are equal to direct manufacturing labor costs plus indirect manufacturing
costs.

The many meanings of product costs

Many cost terms found in practice have ambiguous meanings. Consider the term product cost. A
product cost is the sum of costs assigned to a product for a specific purpose. Different purposes can
result in different measures of product cost:
1. For purposes of calculating inventory costs (financial reporting) product costs include only
inventoriable (manufacturing) costs
2. For purposes of pricing and product-mix decisions product costs include costs incurred in all
business functions of the value chain.

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3. For purposes of reimbursement under a government contract product costs include R&D costs,
design costs, and production (mfg) costs.
Government contracts often reimburse contractors on the basis of the "costs of a product" plus a
pre-specified margin of profit. Government agencies provide detailed guidelines as to which
costs are eligible for reimbursement.
 The classification that a manager uses to cost products and services for external reporting may not be
the same classifications that are used to control operations(performance evaluation), to make
decision, and to plan for the future(budget preparation). For control and other purposes, costs are
often classified as being variable, and fixed, and in a variety of other ways. Some of these
classifications are discussed in the following section.

Cost behavior pattern: Variable and Fixed costs

- Cost behavior is the manner in which costs change as the level of activity or volume (units of output,
DL hrs, of some other factor) changes.
- The major types of costs, in terms of cost behavior, are: 1) variable costs, and 2) fixed costs, 3) semi-
variable costs and 4) semi-fixed costs.
- This separation is helpful for budget preparation and control and evaluation of operation.
Variable Costs
• Changes in total in proportion to changes in the related level of activity or volume
• The major activity that affects manufacturing costs is production volume. Production volume is
frequently measured in terms of units produced, direct labor hours used, machine hours used,
materials costs or some other production volume related measure. Total variable costs vary in total
proportionately for any change in the level of these factors.
• These would include DM, DL and in some instances indirect materials(power and fuel,
lubricants),
• The wood materials used to make a desk is an example. The total amount of wood needed would
be directly proportional to the number of desks made, but the amount of wood needed for each
desk would be the same. For example, if the wood for one desk cost $10, then the total cost for 5
desks would be $50 ($10 * 5).
• Variable costs remain constant on a per unit basis. The implication of this for management in
planning and controlling of variables cost is that the company should expand its productive activity
as long as the selling price per unit exceeds the variable cost per unit.
• But not all direct costs are variable. For example, the depreciation of a special piece of equipment
bought to manufacture a single product line
• However, other activities that are not related to production volume might also be important in
analyzing cost behavior. The recognition that non-production volume related activities also cause,
or drive costs is a fundamental idea associated with activity based costing (ABC).
Fixed Costs
• Remain unchanged in total regardless of changes in the related level of activity or volume. These
are ‘stand-by cost’ costs because they will be incurred even when no production activity take place.
• Fixed costs tend to be capacity related costs such as the salary of the plant mgr, depreciation of
machinery and equipment(except for units of production method), a supervisor's salary, property
taxes, rent of building(mfg and warehouse). Thus they arise in relation to the passage of time.

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• Thus fixed cost per unit will change inversely with the level of production. An increase in
production will cause the average fixed cost per unit to decrease and vice-versa.
For example, if rent expense (generally a FC) is $1,000 per month and we produce 200 units, the
cost per unit, for rent, is $5 ($1,000 / 200 = 5). But if we produce 500 units, then the cost per unit
would be $2 ($1,000 / 500 = 2).
The implication of this for management in planning and controlling of fixed costs is that ,with all
other things held constant, such as selling price per unit and variable cost per unit, productive
activity should be expanded as far as possible, which will reduce the fixed cost per unit to its
lowest amount. This is the very essence of the important concept of fully utilizing productive
capacity.
 Note that costs are variable or fixed with respect to a specific cost object. Consider annual
registration and license costs for a fleet of planes owned by an airline company. Registration and
license costs would be a variable cost with respect to the number of planes owned. But these costs
are fixed with respect to the miles flown by that plane during a year.
 Costs are variable or fixed for a given time period. It is important to understand that the notion of
fixed and variable costs is a short run concept. All costs tend to be variable in the long run.
Short run is the time period where a decision maker cannot adjust capacity. Long run is the opposite of
the above where capacity can be increased or decreased.
Traditionally, examples of variable costs have been taken as materials used, labor directly employed on
production, and selected overheads such as power used to drive machines. However, with the
exception of materials used, many costs are in practice (at least in the short term) effectively fixed: for
example, if production workers are paid wages independent of the volume of production, and it is
difficult to increase or decrease the size of the workforce, labor costs behave as if they are fixed in the
short term. This may entail higher labor costs, particularly in economic downturns, but this may have
increased loyalty and dedication to the company and higher productivity. But labor costs can be purely
variable with respect to units produced when workers are paid on a piece-unit (piece-rate) basis. Some
garment workers are paid on a per-shirt-sewed basis.
Semi-Variable (Mixed) Costs
• These are costs that reflect both a fixed and a variable component.
• The fixed part usually represents a minimum fee for making a particular item or service available
(paid whatever quantity is consumed). The variable portion is the cost charges for actually using
the service(which will therefore vary with the level of activity).
E.g. - Telephone charges contain a fixed charge for being allowed to receive or make a phone call
plus additional amount for each phone call made (eg. 10 cents per minute).
- The electricity bill contains a fixed or standing charge (paid whatever quantity of electricity
is consumed) and the variable aspect which depends on usage.
• On a per-unit basis, a mixed cost does not fluctuate in direct proportion to change in activity nor
does it remain constant with change in activity.
Semi-Fixed Costs
• This is a cost that is fixed over relatively short activity ranges, but which increases dramatically
(abruptly) as the level of activity moves from one range to another. This is because these costs are
acquired in indivisible portion.

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• They do not change continuously as the level of activity changes, but do increase in steps as
activity increases beyond various levels. As a result they are sometimes referred to as step cost and
step functions.
• A good example is a supervisor's salary. For a particular range of outputs, a business may need to
employ only one production supervisor on a fixed salary (which normally represents a fixed cost).
However, to increase production beyond this range will require the employment of a second
supervisor. The fixed cost of supervisory salaries increases suddenly and then continues at the new
level until output is such that a third supervisor needs to be employed. Supervisory costs might also
be driven by the number of production shifts.
 Variable costs are usually taken as varying linearly with the level of activity (that is, a graph of cost
against activity level is an upward-sloping straight line, and this implies that the variable cost per unit
of output is constant at all levels of output.
 Expressed algebraically, we can define total cost using the following equation:
y = a + bx
where y = total cost, a = fixed cost
b = unit variable cost, x = units of output.
 However, in practice variable costs might not be linearly related: for example, unit variable costs
might gradually decrease relative to the level of output (as would be the case where there are
economies of scale available from production), gradually increase (if there are diseconomies of scale)
or exhibit a more complex relationship. But for many purposes we can assume that (at least over the
range of output that interests us) total cost may be divided into a fixed element, which does not vary
over the range of output, and a variable element, related linearly to output.

 Do not mistakenly equate variable costs with direct costs and fixed costs with indirect costs
(overheads). Often variable costs are direct (e.g. direct material costs) and fixed costs are indirect
(e.g. rent), but this is not always the case. Importantly, what is classified as direct and indirect
depends on the cost object!
 Understanding the types of behaviors exhibited by costs is necessary to make valid estimates of cost
at various activity levels.

Cost Drivers and Relevant Range

Cost Driver
- Understanding cost behavior requires an understanding of “cost drivers”
- A cost driver is a variable, such as the level of activity or volume, that causes costs to increase or
decrease over a given time period. It is an activity that causes a cost to be incurred.
- In other words, a cause-and-effect relationship exists between a change in the level of activity or
volume and a change in the level of total costs. Cost accountants often attempt to select a ‘suitable’
driver in the light of the cost being apportioned.
- The cost driver of variable costs is the level of activity or volume whose change causes these costs to
change proportionately.
E.g If labor cost changes with the number of hours worked, the number of hrs is the cost driver,
Number of parts/material used is a cost driver for costs of materials,
Similarly miles driven is a cost driver of distribution cost
- Fixed costs have no cost driver in the short run but may have a cost driver in the long run.
E.g The equipment and staff costs of product testing typically are fixed in the short run with respect
to changes in the volume of production. In the long run, however, the company increases or
decreases these costs to the levels needed to support future production levels.

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- The cost driver is used as cost-allocation base - a factor that is a common denominator for
systematically linking an indirect cost or group of indirect costs to a cost object.
- However, simply because the cost and the cost driver change together doesn't prove that the cost
driver caused the change in the other item.
- In most situations the cause -effect relationship is less clear because costs are commonly caused by
multiple factors. For example, factors including production volume, material quality, worker skill
levels, and levels of automation.
- Traditionally, a single cost driver has been used to predict all types of costs. Accountants and
managers, however, are realizing that single cost driver do not necessarily provide the most
reasonable forecasts. This realization has caused a movement towards ABC costing.

Relevant Range
- Although fixed costs are unchanging regardless of changes in the cost driver, this rule of thumb holds
true only within reasonable limits.
- The relevant range is the range of the cost driver over which the basic cost behavior assumptions will
be valid (i.e the relationship between costs and cost drivers.) For volumes outside these ranges, costs
will behave differently and will alter the assumed relationship.
- Take fixed costs, for example, rent costs, supervisory salary, insurance, property tax. Rent costs, will
rise if increased production requires a larger or additional building or decreases if you move to
smaller buildings. For a particular range of outputs, a business may need to employ only one
production supervisor on a fixed salary (which normally represents a fixed cost). However, to
increase production beyond this range will require the employment of a second supervisor resulting
change in fixed cost.
- Even within the relevant range, a fixed cost remains fixed only over a given period of time, usually
the budget period. So fixed costs may change from one year to the next. e.g. insurance, property
taxes, rental levels. But these items are unlikely to change within a given year.
- The basic assumption of the relevant range also applies to variable costs. i.e. outside the relevant
range, VCs , such as DMs , may not change proportionately with changes in production volume. For
example, above a certain volume DM cost may increase at a lower rate because of price discounts on
DMs purchases greater than a certain quantity.

Unit (Average) Costs

- A manufacturing company can make thousands of units of product in a given time periods. Some
make millions of units per year. Ultimately those products have to be sold, and they are sold one at a
time. So it is important for companies to know the unit cost of the products. This unit cost should
include all costs when setting a selling price.
- So in many decision contexts, calculation of unit costs is essential
UC = TC/TQ = VC + FC
TQ
- The unit cost may be used to: determine inventory costs, determine selling prices, for make or buy
decision, add/drop decisions, etc.
- We can also analyze our production efficiency by looking at how unit costs change from month to
month. We can break unit costs down into component parts as well, such as labor, material and
overhead. This gives managers even more control over the manufacturing process.
- By comparing standard and actual costs per unit we can reduce waste, increase productivity, and
manage resources more carefully.
Example:
ABC Bicycles assembles bikes at a variable cost of $52 each. Assume that ABC Bicycles incurred
$94,500 in a given year for the leasing of its plant.
Cost Accounting, AAUCC, 2010 Page 12 of 20
What is the unit cost (leasing and assembling) when ABC Bicycles assembles 1,000 bicycles?
• Total fixed cost $94,500 + Total variable cost $52,000 = $146,500
• $146,500 ÷ 1,000 = $146.50

Use unit cost cautiously

- Unit costs are regularly used in financial reports. However, for many decisions, managers should
think in terms of total costs rather than unit cost. This is so when there are both variable and fixed
cost elements.
- VC/unit is constant within its relevant range
- FC/unit- decreases if output increases and increases if output decreases
- Therefore, we have different total unit costs at various levels of output. So it is difficult to depend on
a single unit cost. Unit costs, therefore, should be interpreted with caution if they include a fixed-cost
component.
- There exists also a potential misuse of unitized fixed cost. The fact that fixed cost per unit changes as
production changes does not mean that fixed cost should be treated like variable costs. The
responsibility lies with the need for management accountants to help management understand fixed
cost behavior from a total and per unit viewpoint so as not to misuse fixed costs, especially in their
decision making.
- Reductions in unit cost may be result of economies of scale that can be achieved through a higher
volume of activity. One economy of scale is fixed costs that are spread over a larger number of units,
thus reducing unit cost.
Example
1. Assume that ABC Bicycles management uses a unit cost of $146.50 (leasing and handlebars).
Management is budgeting costs for different levels of production.
a. What is their budgeted cost for an estimated production of 600 bicycles?
b. What is their budgeted cost for an estimated production of 3,500 bicycles?
2. Assume normal selling price is $170. Suppose a request for a special order (100 bikes at a
selling price of $120) is made. ABC has idle capacity and the special order would have no
impact on regular sales. Should they take the special order?

Differential Costs
- Differential costs are defined as the difference in total cost between any two acceptable alternatives.
An example is the difference in total cost of two vehicles (price paid plus operating costs).
Differential costs are also known as incremental costs, although technically an incremental costs
should refer only to an increase in cost from one alternative to another. For example, the incremental
cost of increasing production from 1000 units to 1200 is the cost of producing the additional 200
units. Decreases in cost should be referred to as decremental costs, differential cost is a broader term
encompassing both cost increases and cost decreases between alternatives.
- But incremental cost is different from Marginal cost (economists view), which is the cost of
producing one more unit during a specified time period.
- Differential costs can be either fixed or variable.
Controllable and Noncontrollable Costs
- As with direct and indirect costs, whether a cost is controllable or noncontroallbe depends on the
point of reference. All costs are controllable at some level or another in a company.
- Controllable cost is any cost that is influenced by a manager’s decisions and actions. The manager
has the power to authorize the cost. Eg entertainment expense for a sales manager if he has the power
to authorize it.

Cost Accounting, AAUCC, 2010 Page 13 of 20

- Uncontrollable cost is any cost that cannot be affected by the decision of a manager within a given
time span. For example, depreciation of warehouse facilities would not be controllable the sales
manager. The higher the management level, the higher the number of controllable costs and the vice-
versa.
- Costs that are controllable over the long run may not be controllable over the short run. For example,
once an advertising contract is signed, mgt has no power to change the amount of spending. But
when the contract expires, advertising costs can be renegotiated, and thus become controllable.

Out of Pocket Cost

- These are costs which involve cash outflow (disbursements). Depreciation on assets is an item of
cost, which will not form part of out of pocket cost, because it does not entail cash outflow.

Opportunity Costs
- In financial accounting the concept of opportunity cost is not popular because here historical cost is
given more attention. But in mgt accounting since managers use it to compare and contrast different
alternatives it is given a great attention.
- Opportunity cost is the benefit (profit) foregone by not accepting or pursuing the next best alternative
using limited resources.
E.g - The income or interest on an alternative investment.
- If you give up one hour of time to study for this class but instead you could have worked and
earned Br100, then your opportunity cost of studying for this one hour is Br100.
- Some decisions have opportunity costs and some do not. Of those that do, some can be quantified
and some cannot. Though not usually entered on the books of the organization, all decisions should
consider opportunity cost, if any.
Sunk Cost
- Sunk cost is a cost that has already been incurred (past costs/historical cost) and that cannot e
avoided regardless of which course of action the decision maker takes. Examples are book value and
depreciation on machinery.
- It has no relevance to future events and must be ignored in decision making. What has already
happened is no longer relevant for decisions. But it does not mean that past costs are useless. For
financial accounting purposes, historical costs are still important in practice. Past information is also
used to predict the future. In addition, past costs affect future cash payments (e.g income tax)
- Sometimes a sunk cost has already been expensed and sometimes not. For example, the cost
previously incurred to make ten units of inventory, eight of which have been sold and two not, is a
sunk cost. Some of the cost to make the ten units, for example DM, may or may not have been
already paid for. It would be paid for when the bill arrives.
Relevant and Irrelevant Costs
- Analyzing relevant information is a key aspect of making decisions. Management accountants help
mangers identify what information is relevant and what information is irrelevant.
- Relevant costs are expected future costs that differ among alternative courses of action and may be
eliminated if some economic activity is changed or deleted. i.e, any cost that is avoidable is relevant
for decision purpose. An avoidable cost is a cost that can be eliminated (in whole or in part) as a
result of choosing one alternative over another in a decision-making situation. All costs are
considered to be avoidable, except:
1. Sunk costs
2. Future costs the do not differ between the alternatives at hand
The term avoidable cost is synonymous with the term differential cost and are frequently used
interchangeably. Therefore, for making decisions, only differential costs should be considered.
Cost Accounting, AAUCC, 2010 Page 14 of 20
- Irrelevant costs are unaffected by management's actions. These are unavoidable costs—costs that do
not differ between alternatives. Unavoidable costs include many common costs. They would be
incurred whether or not the course of action is taken or not and should be ignored, as they would be
incurred under the next best alternative. Sunk costs are an example of irrelevant costs. In the short-
run all fixed costs remain unchanged and, therefore, are treated as irrelevant for short-run decision-
making. But in the long-run all costs are variable and are therefore relevant.
- Sometimes the term avoidable and unavoidable are used in place of the words variable and fixed,
respectively, but these terms are better used to describe costs associated with particular decisions.
The term variable cost should not be used interchangeably with avoidable cost because a fixed cost
also may be avoidable over some time period.
- Some care is needed in identifying the costs that are genuinely differential in the context of a
particular decision, especially where following a particular course of action would use resources that
would otherwise be allocated to the next best alternative. Where the action under consideration and
the next best alternative are mutually exclusive, and resources already contracted for would be used
either for ,the action under consideration or for the next best alternative action, then the cost of those
resources cannot be regarded as differential and should be ignored.
- Relevancy is not an attribute of a particular cost; the identical cost may be relevant in one
circumstance and irrelevant in another. The specific facts of a given situation will dictate which costs
are relevant and which are irrelevant.

Types of Inventories
1. Manufacturing-sector companies purchase materials and components and convert them into
various finished goods. These companies typically have three types of inventory:

a) DMs inventory
• DMs in stock and awaiting use in the manufacturing process
• They can be materials, supplies and/or component parts received from other sources that are in the
same condition as when received.
b) WIP inventory
• Goods partially worked on but not yet fully completed.
• This would include some DM, DL and FOH but not all that is necessary to complete the products.
c) Finished goods inventory
• Goods fully completed but not yet sold
2. Merchandise-sector companies purchase and then sell tangible products without changing their
basic form. These companies have one type of inventory: merchandise inventory.
3. Service-sector companies provide services (intangible products)—for example, legal advice,
checking accounts, or audits—to their customers. But they may have inventory of supplies and WIP
inventory but no finished goods inventory. These companies do not have an inventory of items for
sale.
- For companies with inventories, generally accepted accounting principles distinguish inventoriable
costs from period costs.

Inventoriable and Period Costs

- Based on the period charged against revenue all costs incurred by the firm during a given year can be
classified into: inventoriable costs and period costs.
- This classification aids management in measuring income, in preparing financial statements, and in
matching expenses to revenues in the proper period.

Cost Accounting, AAUCC, 2010 Page 15 of 20

Inventoriable costs
• Inventoriable costs are all costs of a product that are regarded as an asset when they are incurred
and then become cost of goods sold when the product is sold.
• For manufacturing-sector companies, all manufacturing costs are inventoriable costs. Thus goods
manufactured this year but not sold until next year are deducted from next year's revenue.
• For merchandising-sector companies, inventoriable costs are the acquisition costs of merchandise
which are resold in their same form.
• For service-sector companies, the absence of inventories means there are no inventoriable costs
except inventory of supplies and WIP. The firm does engage in productive activity, but the service
it produces is consumed as it is produced.

Period costs:
• Period costs are charged to expense in the accounting period in which they are incurred. They are
costs neither directly nor indirectly related to the product.
• Are noninventoriable costs and are reported in the income statement
• For manufacturing-sector companies, period costs include all non-manufacturing costs (research
and development, general and administrative expense, selling expense, interest expense, income
taxes expense, etc).
• For merchandising-sector companies, period costs include all costs not related to the cost of goods
purchased for resale (general and administrative expense, selling expense, interest expense, income
taxes expense, etc).
• For service-sector companies, all of their costs are period costs (operating expenses).
Financial statement presentations-Merchandising vs Manufacturing
For merchandising companies:
Balance sheet Income Statement
Mdse purchased ---- Mdse inventory Sales
(Invoice price, -COGS
Freight in, GP
Inventoriable Insurance in transit Less: Design costs
costs Etc) Purchasing dpt. Costs
Marketing costs Period
costs
Distribution costs
Customer-service costs
Operating income
For manufacturing type of businesses:

Balance sheet Income Statement

Materials purchased -- DM inventory Sales

- COGS*
DL,DM,FOH -- WIP inventory GP
Less: R&D costs
-- Finished goods inv. Design costs
Mktg costs Period costs
Inventoriable costs Distribution costs
Customer-service costs
Operating income

Cost Accounting, AAUCC, 2010 Page 16 of 20

NB. In service sector companies, the absence of inventories means there are no iventoriable costs. The
firm does engage in productive activity, but the service it produces is consumed as it is produced. In
service-industry the cost of producing the firm's service are usually called operation expenses.
Operation expenses are period costs.

Cost Flow in an Accounting System

Manufacturing Firms:

Statement of Cost of Goods Manufactured

- In the income statement of a manufacturing company, cost of goods sold is computed as follows
(figures assumed):
Beginning finished goods $ 50,000
Add cost of goods manufactured 800,000
Cost of goods available for sale 850,000
Deduct ending finished goods 60,000
Cost of goods sold $790,000
- The line item, cost of goods manufactured, refers to the cost of all goods brought to completion,
whether they were started before or during the current accounting period. Cost of goods
manufactured is often computed in a supporting schedule-statement of cost of goods manufactured-
to the income statement as follows (figures assumed):
Beginning direct materials ………………….. $ 60,000
Add purchases of direct materials ………… 510,000
Direct materials available for use ………….. 570,000
Deduct ending direct materials …………….. 50,000
Direct materials used …………………………. 520,000
Add direct manufacturing labor ……………… 100,000
Add indirect manufacturing costs 230,000
Manufacturing costs incurred during the period 850,000

Add beginning work in process ……………….. 120,000

Total manufacturing cost to account for 970,000

Deduct ending work in process ……………….. 170,000

Cost Accounting, AAUCC, 2010 Page 17 of 20
Cost of goods manufactured …………………… $800,000
- The statement of cost of goods manufactured is a schedule that summarizes the flow of
manufacturing costs into and out of the Work in Process Inventory account. Its purpose is to assist
management in understanding and evaluating manufacturing costs incurred in the period. This
schedule is an internal report and generally is not made available to the public.
Illustration 1
Assume the following information is available for the HH Company for February 200X.
Indirect manufacturing costs:
Beginning inventories: Indirect materials 15,000
Direct materials $15,000 Indirect labor 40,000
Work in process 38,000 Depreciation 50,000
Finished goods 26,000 Electric power 60,000
Ending inventories: Property taxes & Insurance 5,500
Direct materials 20,000 Repair and maintenance 25,000
Work in process 40,000 Miscellaneous 8,500
Finished goods 28,000 Selling and Administrative expenses 45,000

Direct materials purchased 90,000 Sales 625,000

Direct labor used 100,000
Required
Assume full absorption costing is used prepare an Income Statement and separate Schedule of Cost
of Goods Manufactured for the HH Company for February.
Solution
HH Company
Income Statement
February 200X
Sales $625,000
Less: Cost of Goods Sold:
Beginning Finished Goods $26,000
Cost of Goods Manufactured* 387000
Cost of Goods Available for Sale $413,000
Less: Ending Finished Goods 28,000
Cost of Goods Sold 385,000
Gross Profit $240,000
Less: Selling and Administrative expenses:
Selling and Administrative Expenses 45000
Total Selling and Administrative expenses 45,000
Net Income $195,000
*See schedule below

HH company
Schedule of Cost of Goods Manufactured
February 200X
Direct materials:
Beginning inventory $15,000
Purchase of direct materials 90,000

Cost Accounting, AAUCC, 2010 Page 18 of 20

$105,00
cost of direct material available 0
Less: Ending inventory 20,000
Direct Materials used $85,000
100,00
Direct Labor 0
Manufacturing Overhead:
Indirect Materials $15,000
Indirect Labor 40,000
Depreciation 50,000
Electric power 60,000
Property, taxes and insurance 5,500
Repair and maintenance 25,000
Miscellaneous 8,500
$204,00
Total Manufacturing Overhead Costs 0
$389,00
Total Manufacturing Cost 0
Add: Beg. WIP Inventory 38,000
$427,00
Total Manufacturing Costs to account for 0
Less: End WIP Inventory 40,000
$387,00
Cost of Goods Manufactured 0

Exercise

The following costs are incurred in a typical manufacturing company. For each item, insert the type of
cost in Column 1. Insert whether the cost is a product cost or a period cost in Column 2. Use the
following abbreviations for your answers:
Column 1: Column 2:
DM = Direct material 1 = Product cost
DL = Direct labor 2 = Period cost
MO = Manufacturing overhead
S = Selling
A = Administrative

Column Column
1 2
_____ _____1. Cost of significant raw materials that becomes part of the products
_____ _____2. Factory manager’s office telephone costs
_____ _____3. Factory accountant’s salary
_____ _____4. Rent on the sales office

Cost Accounting, AAUCC, 2010 Page 19 of 20

_____ _____5. Insurance benefits for production-line supervisors
_____ _____6. Manufacturing vice president’s salary
_____ _____7. Company president’s salary
_____ _____8. Supplies used by the president’s secretary
_____ _____9. Depreciation on factory equipment
_____ _____10. Liability insurance on company headquarters
_____ _____11. Cost of assembly line workers
_____ _____12. Lubricants for factory machinery
_____ _____13. Corporate accounting department
_____ _____14. Freight expense on direct materials purchased
_____ _____15. Factory manager’s salary
_____ _____16. Storage costs for finished goods inventory
_____ _____17. Hazard insurance on factory
_____ _____18. Production supervisor’s salary
_____ _____19. Factory supplies used
_____ _____20. Freight expense to ship goods to customers

Cost Accounting, AAUCC, 2010 Page 20 of 20