1 1 Accounting The Make up of Costs Dr Clive Vlieland-Boddy.

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AccountingAccounting The Make up of CostsThe Make up of Costs

Dr Clive Vlieland-BoddyDr Clive Vlieland-Boddy

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Strategy Evaluation

Feedback

Forecasting

The Functions of ManagementThe Functions of Management

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• Behavior – how costs react to changes in underlying cost driver– Variable or Fixed

• Function – related to production or sales– Product or Period– Product costs –

• Direct Material• Direct Labor• Factory Overhead

• Traceability (cost of tracing cost to a cost driver directly should be lower than the benefits.

Summary of ObjectivesSummary of Objectives

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CostsCosts• Anything incurred during the production of

the good or service to get the output into the hands of the customer

• The customer could be the public (the final consumer) or another business

• Controlling costs is essential to business success

• Not always easy to pin down where costs are arising!

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CostCost

• A cost may be defined as a sacrifice or giving up of resources for a particular purpose.

• Costs are frequently measured by the monetary units that must be paid for goods and services.

• Costs are different from expense

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Direct Vs Indirect CostsDirect Vs Indirect CostsDirect / Indirect costs

Direct costs

Direct labor

Direct materials

Whether the cost can be directly allocated to a given product

Indirect costs (overheads)

Managing director’s salary

Rent rates

Administration expenditure

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Cost Concepts for Decision MakingCost Concepts for Decision Making

A relevant cost is a cost that differs between alternatives.

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2

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Relevant CostsRelevant Costs

• Relevant

• Irrelevant

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Identifying Relevant CostsIdentifying Relevant Costs

• Costs that can be eliminated (in whole or in part) by choosing one alternative over another are avoidable costs. Avoidable costs are relevant costs.

• They are costs that will be incurred and can be traced to the product or process.

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Product CostProduct Cost

• Product cost is the traceable costs that are attributable to a product or process.

• Calculations under any costing system will include be the Actual Cost.

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Non-manufacturing CostsNon-manufacturing Costs

Marketing or Selling Costs

Costs necessary to get the order and deliver

the product.

Administrative Costs

All executive, organizational, and

clerical costs.

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Product Costs Vs Period CostsProduct Costs Vs Period Costs

Product costs include direct materials, direct

labor, and manufacturing overhead.

Period costs include all marketing or selling

costs and

administrative costs. Inventory Cost of Good Sold

BalanceSheet

IncomeStatement

Sale

Expense

IncomeStatement

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Manufacturing Cost FlowsManufacturing Cost Flows

FinishedGoods

Cost of GoodsSold

Selling andAdministrative

Period CostsSelling andAdministrative

ManufacturingOverhead

Work in Process

Direct Labor

Balance Sheet Costs Inventories

Income StatementExpenses

Material Purchases Raw Materials

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WorkRaw Materials In Process

Beginning raw Direct materials materials inventory

+ Raw materials purchased

= Raw materials

available for use in production

– Ending raw materials inventory

= Raw materials used

in production

Product Cost FlowsProduct Cost Flows

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General Cost TermsGeneral Cost Terms

• Manufacturing CostsDirect materialsDirect laborMfg. Overhead

• Non-manufacturing Costs

OverheadMarketingAdministrative

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Classifying Costs for Financial StatementsClassifying Costs for Financial Statements

• Matching Concept: The costs incurred to generate particular revenue should be recognized as expenses in the same period that the revenue is recognized.

• Period costs: Those costs that are matched against revenues on a time period basis

• Product costs: Those costs that are matched against revenues on a product basis.

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Cost Classification for Predicting Cost Cost Classification for Predicting Cost BehaviorBehavior

• Volume index• Cost Behaviors

Fixed costs

Variable costs

Mixed costs

Stepped costs• Average unit costs

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Cost Classifications for Cost Classifications for Predicting Cost BehaviorPredicting Cost Behavior

By reaction to changes in the level of activity within the relevant range.

– Total variable costs change when activity changes.

– Total fixed costs remain unchanged when activity changes.

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Types of cost behaviour

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Fixed CostsFixed Costs

• Fixed costs remain the same even if output changes. ( They are costs that must be paid on a regular basis.)

• There is a minimum charge for the telephone and utilities that must be paid every month whether they are used or not.

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Fixed CostsFixed Costs

• Definition: The costs of providing a company’s basic operating capacity

• Cost behavior: Remain constant over the relevant range

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Fixed Costs - ExampleFixed Costs - Example

Damon Company leases its productive facilities for $10,000 per month

Total fixed costs of the facilities remain constant at all levels of activity - $10,000 per month

On a per unit basis, the cost of rent decreases as activity increases and vice versa

At 2,000 radios, the unit cost is $5 ($10,000 ÷ 2,000 units)

At 10,000 radios, the unit cost is $1 ($10,000 ÷ 10,000 units)

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Fixed Costs GraphsFixed Costs Graphs

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Variable CostsVariable Costs

• Variable costs are costs that change with production or sales.

• The costs of raw materials increase as more of a product is produced (made).

• Labour costs (wages) also increase with production as more workers are needed.

• Utility (electricity, water, telephone) costs may increase also.

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Variable CostsVariable Costs

• Definition: Costs that vary depending on the level of production or sales

• Cost behavior: Increase or decrease proportionally according to the level of volume

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Variable CostsVariable Costs• Costs that vary in total directly and

proportionately with changes in the activity level

• Example: If the activity level increases 10%, total variable costs increase 10%

• Example: If the activity level decreases by 25%, total variable costs decrease by 25%

• Variable costs remain constant per unit at every level of activity.

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Variable Costs - ExampleVariable Costs - Example

• Damon Company manufactures radios that contain a $10 clock

• Activity index is the number of radios produced• For each radio produced, the total cost of the

clocks increases by $10:• If 2,000 radios are made, the total cost of the

clocks is $20,000 (2,000 X $10)• If 10,000 radios are made, the total cost of the

clocks is $100,000 (10,000 X $10)

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Variable Costs – GraphsVariable Costs – Graphs

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Costs that have both a variable cost element and a fixedcost elementSometimes calledsemi-variable cost Change in total but not proportionately with changes inactivity level

Mixed CostsMixed Costs

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Activity (minutes)

Mixed CostsMixed Costs

Fixed Monthly

Phone Charge

Fixed Monthly

Phone Charge

To

tal M

ob

ile P

ho

ne

Co

st

X

Y

Total mixed cost

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Fixed Monthly

Phone Charge

Variable

Cost per minute

Activity (minutes)

To

tal M

ob

ile P

ho

ne

Co

st

X

Y

Mixed CostsMixed Costs

Total mixed cost

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Mixed costs must be classified into their fixed and variable elementsOne approach to separate the costs is called the high-low methodUses the total costs incurred at both the high and the low levels of activity to classify mixed costsThe difference in costs between the high and low levels represents variable costs, since only variable costs change as activity levels change

Mixed Costs: High–Low MethodMixed Costs: High–Low Method

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Mixed costs consist of what?

a. Variable cost element and a fixed cost element.

b. Fixed cost element and a controllable cost element.

c. Relevant cost element and a controllable cost element.

d. Variable cost element and a relevant cost element.

Let’s Review - TestLet’s Review - Test

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Stepped CostsStepped Costs

Volume of activity

Stepped costs

Definition: A stepped cost is one that will vary with levels of activity but not directly.

Example: A company may rent a warehouse that is able to store say 100 tons of material. When they reach 101 tons then an additional warehouse is required.

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What is a Variable Costing System?

• A cost accounting system which treats fixed manufacturing overheads as a period cost and values stock on hand at the variable cost of production.

• Technique/Method of reporting – Internal Reporting– Contribution Concept

Product

Variable

Costs

Fixed

Costs

I/S

B/S

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What is an Absorption Costing What is an Absorption Costing System?System?• A financial accounting system which values stock on

hand at the variable and fixed cost of production.

• Technique/Method of reporting

– External and Internal Reporting

– GAAP, AC108

Product

Variable

Costs

Fixed

Costs I/S

B/S

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What is the difference What is the difference between Variable and between Variable and Absorption Costing?Absorption Costing?

• Variable costing just takes the variable costs. Fixed Costs are written off as incurred.

• Absorption Costing is Variable and traceable Fixed Costs.

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Relevant CostsRelevant Costs

• Relevant

• Irrelevant

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Identifying Relevant CostsIdentifying Relevant Costs

• Costs that can be eliminated (in whole or in part) by choosing one alternative over another are avoidable costs. Avoidable costs are relevant costs.

• Unavoidable costs are never relevant and include:Sunk costs.Future costs that do not differ between the

alternatives.

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Irrelevant CostsIrrelevant Costs• Irrelevant cost: not relevant for decision

making• Example: Sunk costs: Sunk cost is the cost

of abandoned plant less salvage value. Not relevant for decision making.

• Imputed (Notional cost): Actually not incurred (interest on own capital, rent on owned building, etc.) Taken into account in capital budgeting decisions.

• Replacement cost: Cost of replacing at current market price.

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Cont…..Cont…..• Avoidable and unavoidable cost:

Cost that can be avoided by eliminating a product or department is avoidable and that which cannot be, is unavoidable.

Ex. – Rent of factory is unavoidable if a product is discontinued.

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Other costs:Other costs:• Future costs: cost to be incurred in future• Programmed cost: Cost incurred as per policy of top

management. Ex.- Donation to charity.• Joint cost: cost of joint or by-products incurred

before separation, which cannot be traced to particular products.

• Conversion cost: cost of converting raw material to finished goods = Production cost- direct material.

• Discretionary cost: not essential for decision on hand. Ex.- Training expenses of workers, R&D cost.

• Committed cost: Costs incurred due to past decisions and are not within control in the short run at present. Ex.- Depreciation on Plant, Rent, etc.

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CostsCosts

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Fixed and Variable CostsFixed and Variable Costs

Fixed / Variable costs

Volume of activity

Cost or revenue

Sales revenue

Variable cost

Fixed cost

Total costBreak-even point

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Stepped and Variable CostsStepped and Variable CostsStepped / Variable costs

Volume of activity

Stepped cost

Volume of activity

Variable cost

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Assigning Costs to Cost ObjectsAssigning Costs to Cost Objects

Direct costs

• Costs that can beeasily and conveniently traced to a unit of product or other cost object.

• Examples: direct material and direct labor

Indirect costs

• Costs that cannot be easily and conveniently traced to a unit of product or other cost object.

• Example: manufacturing overhead

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Cost Classifications for Decision Cost Classifications for Decision MakingMaking

• Every decision involves a choice between at least two alternatives.

• Only those costs and benefits that differ between alternatives are relevant in a decision. All other costs and benefits can and should be ignored.

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Opportunity CostsOpportunity Costs

The potential benefit that is given up when one alternative is selected over another.

Example: If you were not attending this program, you could save €10,000 per year. Your opportunity cost?

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Sunk CostsSunk Costs

Sunk costs have already been incurred and cannot be changed now or in the future. They 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.

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Idle TimeIdle Time

The labor costs incurred during idle time are ordinarily

treated as manufacturing overhead.

Machine Breakdowns

Material Shortages

Power Failures

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OvertimeOvertime

The overtime premiums for all factory workers are usually considered to be part

of manufacturing overhead.

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Problems in Identifying and Problems in Identifying and Measuring CostsMeasuring Costs

What is the cost of a dissatisfied

customer?

What is the cost of a dissatisfied

customer?

How do I measure the

cost of setting my price too

high?

How do I measure the

cost of setting my price too

high?

How do I measure the cost of poor

quality?

How do I measure the cost of poor

quality?

What is the cost of postponing

this year’s training

program?

What is the cost of postponing

this year’s training

program?