SNM Cost Concepts - Unit III Ch 3

8/8/2019 SNM Cost Concepts - Unit III Ch 3

1/36

BASIC COST CONCEPTS

Unit III Chapter 3

1


2/36

Introduction Cost data is an important input in managerial

decision making.

There is, however, no single concept of cost whichcan cater to all management needs.

Different cost data is required based on purpose,objective and situation.

Management needs can be classified into four groups Income Measurement Division/ Segment Profit Planning How much to produce, Pricing etc.

Costs Control Reduce and Monitor costs

Decision making - Situations requiring special decisions

2


3/36

Concept of Cost Amount of resources (expressed in terms of Money)

given up in exchange for some of goods or services.

According to CIMA, it is the amount of expenditure(actual or notional) incurred on or attributable to agiven thing or activity.

The term cost cannot be exactly defined.

Its interpretation depends on The nature of business, or industry, and

The context in which it is used.

3


4/36

Cost, Expense and Loss Cost: Total amount incurred.

Expense: Cost which has brought matching

economic benefits. Loss: the possibility of receiving benefits may have

been lost.

P&L: Expense and Loss

Balance Sheet: Unexpired cost Expense: Timing concept

Cost: Valuation concept

4


5/36

Elements of Cost Material:

a) Direct: All material or components,primary packing material

b) Indirect: Consumable stores, Oil, Waste

Labor:

a) Direct: Process, Productive, Operating

B) Indirect: Store-keepers salary,Salesman salary, Directors fees

5


6/36

Elements of Cost Expenses:

a) Direct: Expenses which can be directly,conveniently allocated to specific costcenters or cost units. Hire of specialmachinery for a specific contract.

b) Indirect: Expenses which cannot bedirectly, conveniently allocated to specificcost centers or cost units. Ex: Rent, rates,insurance, salaries, lighting charges etc.

6


7/36

Overheads Indirect material

Indirect labor Indirect expenses

Functionally:

Factory overheads Office and Administration overheads

Selling and Distribution overheads

7


8/36

Overheads Functionally:

Factory overheads:

Indirect material lubricant, oil etc. Indirect labor time keepers salary, work managers

salary

Indirect expenses factory rent, insurance

Office and Administration overheads Indirect material printing and stationery

Indirect labor office manager, accountant

Indirect expenses rent, insurance

8


9/36

Overheads Functionally:

Selling and Distribution overheads:

Indirect material secondary packing material Indirect labor salaries of salesman

Indirect expenses sales office rent, advertising, salespromotion expenses

9


10/36

Components of Total Cost Primecost:

Prime cost = Direct material + Direct Labor + Directexpenses

Adjustment of Raw Material consumed

Factory Cost:

Prime cost + Factory Overheads

Adjustment of Work in Progress stocks

The Result gives Cost of Production

Adjustment ofFinished Goods stocks

The Result gives Cost of Goods Sold.

10


11/36

Components of Total Cost Office Cost: (Redundant)

Factory cost + Office & Administration Overheads

Office cost is not in use these days. Acountants prefer TotalCost in stead of Office Cost.

Total Cost of Sales orTotal Cost:

Cost of Goods Sold + Office and Administrative Overheads +Selling and Distribution costs

11


12/36

Costs relating to Profit Planning Fixed, Variable, and Semi-variable/Mixed Costs

Fixed Costs: These are costs which do not vary with changesin the volume of output or activity within a specified range of

output or activity. Ex: Rent, Salary, Depreciation

However, Fixed costs, like any other costs, are subject tochange over time. Ex: Rent may increase, salary goes up

With increase in volume, fixed costs per unit decrease.However, total fixed costs remain the same.

Figure on page 3.48

Expansion of activity beyond a capacity will entail more Totalfixed costs. TFC remain constant for a specified range of output.

12


13/36

Costs relating to Profit Planning Committed Fixed costs: Purchase of capacity

producing assets such as Plant and Equipment arecommitted costs. Unavoidable in the short run.

Discretionary Fixed costs: These are calledprogrammed costs or managed costs. The costscaused by management policy decisions to undertakeactivities such as R&D, training programs, politicaldonations, Advertising, Market research etc.

The amount of discretionary fixed assets is decidedby the top management at the beginning of thebudget period.

13


14/36

Cost Concepts relating to Profit

Planning Variablecosts: Costs that tend to

change in direct proportion to changes

in production activity, sales activity etc. Expressed mathematically, there is a

linear relationship between volume andvariable costs. Ex: Direct labor, directraw material costs.

Figure on page 3.48

14


15/36

Costs relating to Profit Planning Semi variablecosts (Mixedcosts):

These costs are neither perfectly variable norabsolutely fixed.

Telephone, Electricity, R&M costs are somesuch examples.

Telephone Fixed charges + Variable pertelephone call

Semi variable costs need to be bifurcatedinto fixed and variable components.

Figure on page 3.49.

15


16/36

Costs relating to Income

Measurement Product Costs: Costs which become part of the Product. They

can be fixed or variable. They are included in the Inventoryvalues. Part of asset and are expensed when goods they areassigned to are sold.

Ex: RM, Direct labor, Depreciation on Plant, Repairs andMaintenance Factory Rent (Factory Overheads).

Period Costs: Costs not associated with the Product orProduction. They are considered expenses in the period (year)they are incurred.

They may be Fixed or Variable (Mostly fixed). Example: Office Rent, Insurance, Salary of Sales person, Office

and Admininstration Overheads, Selling and Distributionoverheads.

16


17/36

Costs relating to Income

Measurement Period Costs: They are charged as expense in the Period they

are incurred because:

Most of the expenses are fixed.

Cannot be easily assigned to specific Products.

Difficult to establish relationship between such costs and theProduction.

The benefits arising from such costs cannot be easilyestablished.

17


18/36

Cost Concepts relating to Income

Measurement Traceable Cost: Costs which can be

easily identified with a department,

process, or product. DM, DL NonTraceable: Costs which cannot be

so identified. Ex.: Selling Overheads.

Incurred collectively for a number ofCost centres.

They are also called Commoncosts.

18


19/36

Cost Concepts relating to Income

Measurement Joint product costs: These are costs of a single process, or a

series of processes that simultaneously produce two or moreproducts of significant sales value. The cost incurred till the split

off are Joint Costs. One product cannot be produced without producing the other.

Ex: Wax, Coal tar, Petroleum from Crude oil.

Common Costs: Incurred for more than one product, territory,job etc. They are not separately allocable to individual Products.

Difference: Joint costs in Process industries where Productcannot be independently produced.

Common costs can be incurred in addition to Joint costs, in thesame industry.

They can be incurred in all kinds of industries.

19


20/36

Cost Concepts relating to Control Control:Actual Costs vs. Planned Costs

Responsibility Costs: In a responsibility accounting system,costs are classified, identified, accumulated with the person

responsible for their incurrence.

Individuals in the organization are held accountable only forthose costs which are under their control and have authority toincur.

They are not accountable for costs which they cannot control.

Ex: A foreman is not responsible for excess price paid onmaterial by the purchase manager.

20


21/36

Cost Concepts relating to Control ControllableandNon-Controllablecosts:An item of cost is

controllable if the amount of cost incurred in a responsibilitycenter is significantly influenced by the action of the manager of

the responsibility center. Important characteristics of controllable costs are:

They are in relation to a particular responsibility center. All costsare controllable at one level or another level of management.

Head of the responsibility centre has significant influence but not

complete influence. They are relevant for the time period under review. For e.g.,

purchase manager has entered into a price contract for a period ofthree months, then price is not controllable by him for threemonths.

21


22/36

Cost Concepts relating to Control The allocated costs are not controllable by the responsibility

centre to which allocation has been made.

For e.g., a sales manager has no control over the cost at which

goods have been transferred to the sales department by theproduction department.

Costs are uncontrollable only at lower or intermediate levels.

Top mgt. can close down entire department or division tocontrol costs.

Cost control does not mean eliminating costs but bringing itdown to the desired levels.

22


23/36

Cost Concepts relating to Control Direct and Indirect costs: If a cost can be directly traced to a

particular responsibility center, it is a Direct cost. Direct costsare easily and economically tracable to the Product.

Indirect costs are common costs which are to be allocatedbetween two or more departments/ divisions/products etc.

A division managers salary is a direct cost if Division happens tobe the responsibility center. But if Division has many productsand each Product Segemnt is a responsibility center, then

division mangers salary is indirect cost. Costs are classified with a view to Control costs.

23


24/36

Cost Concepts relating to

Decision - Making Decision makingis of two types:

Long-range (Capacity) decisions Short-range or Operating decisions

Decisions involving production, output, make or buy, temporaryshutdown are short range decisions. We are talking about cost concepts for short range decisions. Relevant and Irrelevant costs: Cost which are influenced by

a decision is a Relevant cost. Cost which are not affected by adecision are irrelevant costs. Committed fixed costs areirrelevant costs.

Closing a division labor costs are relevant and Prepaid rentirrelevant.

24


25/36


Decision - Making But additional fixed costs are relevant costs.

Relevant costs could be fixed or variable. Relevant costs areincremental costs.

Incremental Costs orDifferentialcosts: Incremental costsare the additional costs which will be incurred if managementchooses one course of action as opposed to another.

Differential cost is the difference between any two available,acceptable alternatives.

For e.g.., make or buy components

Differential costs will change with passage of time and changeof situation.

Illustration 3.8 on page 3.53.

25


26/36


Decision - Making Out ofPocket Costs and Sunk Costs:A cost which requires

current or future cash expenditure as a result of a decision is anOut of Pocket costs.

Whereas Sunk costs are costs already incurred in the past anddo not require any cash expenditure.

Depreciation, depletion and amortization of intangible assets areexamples of sunk costs. We should ignore sunk costs for thepurpose of decision-making.

It is wrong to infer all fixed costs are sunk costs or all variablecosts are Out of Pocket expenses.

In certain circumstances, variable costs remain unchanged, likea change in the manufacturing process.

26


27/36


Decision - Making Out ofPocket Costs and Sunk Costs Example:

Company wants to replace its own Trucks with Public carrier orhiring from external agency.

Depreciation of existing fleet : Sunk cost.

Cost savings (Out of Pocket Costs) will be on expenditure offuel, Salary to Drivers, Maintenance costs.

Company wants to use external Water Supply iso current Boringwell.

Cost of digging Borewell sunk cost.

Expenses of Electricity, Maintenance of Pump Out of Pocketexpenses.

27


28/36

Costs relating to Decision-Making Sunkcosts are historical or past costs.

An expenditure which has no economic relevance to the presentdecision making process.

Investment in Plant and machinery.

Example on page 3.51

Shutdowncosts: No work is done yet - certain fixed costs,such as, rent and insurance of buildings, depreciation,maintenance etc.

However, sunk costs is a cost which has no relevance to thepresent decision making process.

28


29/36


Decision - Making Opportunity Costs: Opportunity cost is the benefit forgone by

not choosing the second best alternative. If we choose onealternative over another, all the benefits that would have

accrued in the foregone alternative are given up. For example, there is a building which could be used for own

purposes or rented out. If the management decides to use it forits own purpose, foregone rent is the opportunity cost.

Opportunity costs are associated with feasible alternatives. The

lost rent is an opportunity cost only if there are potentialtenants.

They are not recorded in the accounting books, but the cost isto be taken into account before taking a decision.

29


30/36


Decision - Making Imputed Cost: They are hypothetical costs which are to be

taken into account to arrive at the correct decision.

They do not involve any Cash outflow.

Ex: Salary of the Proprietor/ Partner.

Interest on Internal Cash generated is an example of imputedcost.

They are also not recorded in the accounting books.

30


31/36


Decision - Making Avoidable Costs: Those costs which are eliminated, if

segment of business is closed or shutdown. They are directlyrelated to that segment.

Labor of specific plant. Unavoidablecosts: Costs which will continue to be incurred,

even if the segment is shut down.

Ex: Salary of CEO.

Only avoidable costs are to be taken into account for decision

making.

31


32/36

COSTING COST ASCERTAINMENT Techniques of Costing involves: (i) collection and classification

of expenditure according to cost elements (ii) allocation andapportionment of the expenditure to the cost centres or cost

units or both. Cost Unit: Unit in which expenditure is to be defined.

Quantity upon which costs can conveniently be allocated isknown as cost unit or unit of cost.

Cost Centre: It is a convenient Unit into which whole

organization is divided for costing purposes. Department/ SubDepartment/ Item of equipment or machinery or a person or agroup of persons.

32


33/36

COSTING COST ASCERTAINMENT Profit Centre: Both Revenues and Costs Performance

measurement.

Decentralization of Business opportunities.

Has a Profit target.

Cost Centre:Ascertaining and Controlling Costs.

Target is minimizing Costs.

33


34/36

METHODS OF COSTING

Job Costing

Contract Costing

Cost plus Costing

Batch Costing

Process Costing Operation Costing

Unit Costing (Output or Single)

34


35/36

METHODS OF COSTING

Operating Costing

Departmental Costing

Multiple Costing Motor Cars, Bicycles

Assembly units

Figure on page 3.60

35


36/36

Assignment Exercise

Questions on page 3.71

36

SNM Cost Concepts - Unit III Ch 3

Documents