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COST CLASSIFICATION AND COST BEHAVIOR

INTRODUCTION

Cost Accounting

Cost Accounting is an expanded phase of financial accounting which provides management promptly with the cost of producing and/or selling each product and rendering a particular service.

Management Accounting

Management accounting is application of professional knowledge and skill in the preparation and presentation of financial information in such a way as to assist management in decision making and in the planning and control of operations of the entity

Objectives

Objective of cost accounting is computation of cost per unit, whereas the objective of management accounting is to provide information to the management for decision making purposes.

Users

Users of cost & management accounting are the decision makers and the managers of the entity/organization for which all this exercise is undertaken.

Uses of Cost and Management Accounting

1.  It determines total cost of production and cost of sales

2.  It determines appropriate selling price

3.  It discloses the profitable products, areas and activity/capacity levels

4.  It is used to decide whether to manufacture or purchase for outside

5.  It helps in planning and controlling the cost of production

Elements of Cost

Any product that is manufactured is the result of consumption of some resources. The management, for its planning and controlling functions, must know the cost of using these resources. The constituent elements of cost are broadly classified into three distinct elements: 1 Direct Material Cost 2 Direct Labor Cost 3 Other Production Cost

a) Direct Cost b) Indirect Cost

COST CLASSIFICATION

Elements of cost (Direct Material, Direct Labor, Other Production costs) can be classified as direct cost or indirect cost.

Direct Cost

A direct cost is a cost that can be traced in full to the product or service for which cost is being determined. Costs that can be economically identified with a specific saleable product or service (cost unit).

a) Direct material costs are the costs of materials that are known to have been used in producing and selling a product or rendering a service.

b) Direct labor costs are the specific costs of the workforce used to produce a product or rendering a service.

c) Other direct production costs are those expenses that have been incurred in full as a direct consequence of producing a product, or rendering a service.

Indirect Cost/Overhead Cost

An indirect cost or overhead cost is a cost that is incurred in the course of producing product or rendering service, but which cannot be traced in the product or service in full. Expenditure incurred on labor, material or other services which cannot be economically identified with a specific cost product or service (cost unit). Examples include:

Wages of supervisor, cleaning material, workshop insurance.

1. Prime Cost

Direct Material

+Direct Labor

+Other direct production cost

Prime cost .

2. Total Production Cost

Prime Cost

+Factory overhead cost

Total production cost .

3. Conversion Cost

Direct labor cost

+Factory overhead cost

Conversion cost .

COST BEHAVIOR Cost behavior is the way in which total production cost is affected by fluctuations in the activity (production) level.

Activity level

The activity level refers to the amount of work done, or the number of events that have occurred. Depending on circumstances, the level of activity may refer to the volume of production in a period, the number of items sold, the value of items sold, the number of invoices issued, the number of invoices received, the number or units of electricity consumed, the labor turnover etc. etc.

Basic principle

The basic principle of cost behavior is that as the level of activity rises, costs will usually raise. For example; it will cost more to produce 500 units of output than it will cost to produce 100 units; it will usually cost more to travel 10 km than to travel 2 km. Although the principle is based on the common sense, but the cost accountant has to determine, for each cost elements, whether which cost rises by how much by the change in activity level.

Division of cost by its behavior

Basically the cost of production has two behaviors:

1.  Fixed Cost

2.  Variable Cost

Fixed Cost

It is a cost which tends to be constant by increases or decreases in the activity level.

Graph of Fixed Cost

This graph shows that the cost remains fixed regard less of the volume of output.

Examples include:

a.Salary of the production manager (monthly/annual)

b.Insurance premium of factory work shop

c.Depreciation on straight line method

Variable Costs

A variable cost is a cost which tends to very directly with the change in activity level. The variable cost per unit is the same amount for each unit produced whereas total variable cost increases as volume of output increases.

This graph shows a proportionate increase in the cost by the increase in the activity level. Examples include:

Further division of cost behavior

1.  Step fixed cost

2.  Semi variable cost

Step fixed cost

A step fixed cost is the cost which is constant for a specific range of activity and rises to a new constant level once the range exceeds. The range over which the fixed cost remains constant is known as the relevant range. For example; the depreciation of a machine may be fixed if production remains below 100 number of units per month, but if the production exceeds 100 number of units, a second machine may now be required, and the cost of depreciation would go up a step. Other examples include:

a.Rent of workshop (in case of increase in the production one needs to rent one more workshop)

b.Salary of supervisor (increase in output will be supervised by increased number of supervisors)

Graph of Step fixed Cost

Rs.

This graph shows a stepwise increase in the total cost. Relevant range in this graph is of 100 numbers of units.

Semi Variable Cost

It is also known as mixed cost. It is the cost which is part fixed and par variable. It is in fact the mixture of both behaviors. Examples include: Utility bills – there is a fixed line rent plus charges for units consumed.

Salesman’s salary – there is a fixed monthly salary plus commission per units sold.

The graph of semi variable cost is as follow:

Rs.

Volume of output

This graph shows a fixed

cost of Rs. 2,000 and there after the cost is variable.

COST BEHAVIOR PER UNIT OF PRODUCTION

Cost per unit behaves differently than the total cost of production. Following tables show the difference in behavior. Increasing Production Volume Situation Decreasing Production Volume Situation

Increase or decrease in production volume causes no change to the variable cost per unit it remains constant, assuming there is not rebate in case of bulk purchase and the labor receives constant rate despite change in production volume. Whereas, increase in production volume causes a decrease in fixed cost per unit and in the same way a decrease in production volume causes an increase in fixed cost per unit. Following example helps understanding this concept.

Total fixed cost = Rs. 4,000 Per unit variable cost = Rs. 3 Cost per unit at different activity levels 1000, 2000, 4000, and 5000 units

IMPORTANT TERMINOLOGIES Cost Unit

It is a unit of a product or service in relation to which the cost is ascertained, i.e. it is the unit of the out put or product of the business. In simple words the unit for which cost of producing the units is identified /allocated.

Example

Ball point for a Ball point manufacturing entity Bottle for Beverage producing entity Fan for a Fan manufacturing entity

Cost Center

Cost centre is a location where costs are incurred and may or may not be attributed to cost units.

Examples

Workshop in a manufacturing concern Auto service department Electrical service department Packaging department Janitorial service department

Revenue Centre

It is part of the entity that earns sales revenue. Its manager is responsible for the revenue earned not for the cost of operations.

Examples

Sales department Factory outlet

Profit Centre

Profit centre is a section of an organization that is responsible for producing profit.

Examples

A branch A division

Investment Centre

An investment centre is a segment or a profit centre where the manager has significant degree of control over his/her division’s investment policies.

Examples

A branch A division

Relevant Cost

Relevant cost is which changes with a change in decision. These are future costs that effect the current management decision.

Examples

Variable cost Fixed cost which changes with in an alternatives Opportunity cost

Irrelevant Cost

Irrelevant costs are those costs that would not affect the current management decision.

Example

A building purchased in last year, its cost is irrelevant to affect management decisions.

Sunk Cost

Sunk cost is the cost expended in the past that cannot be retrieved on product or service.

Example

The entity purchase stationary in bulk last moth. This expense has been incurred and hence will not be relevant to the management decisions to be taken subsequent to the purchase.

Opportunity Cost

Opportunity cost is the value of a benefit sacrificed in favor of an alternative.

Example

An investor invests in stock exchange he foregoes the opportunity to invest further in his hotel. The profit which the investor will be getting from the hotel is opportunity cost.

Product Cost

Product cost is a cost that is incurred in producing goods and services. This cost becomes part of inventory.

Example

Direct material, direct labor and factory overhead.

Period Cost

The cost is not related to production and is matched against on a time period basis. This cost is considered to be expired during the accounting period and is charged to the profit & loss account.

Example

Selling and administrative expenses

Historical Cost

It is the cost which is incurred at the time of entering into the transaction. This cost is verifiable through invoices/agreements. Historical cost is an actual cost that is borne at the time of purchase.

Example

A building purchased for Rs 400,000, has market value of Rs. 1,000,000. Its historical cost is Rs. 400,000.

Standard Cost

Standard cost is a Predetermine cost of the units.

Example

Standard cost for a unit of product ‘A’ is set at Rs 30. It is compared with actual cost incurred for control purposes.

Implicit Cost

Implicit cost imposed on a firm includes cost when it foregoes an alternative action but doesn’t make a physical payment. Such costs are related to forgone benefits of any single transaction, and occur when a firm:

Example

Uses its own capital or

Uses its owner’s time and/or financial resources

Explicit Cost

Explicit cost is the cost that is subject to actual payment or will be paid for in future.

Example

Wage Rent Materials

Differential Cost or Incremental cost

It is the difference of the costs of two or more alternatives.

Example

Difference between costs of raw material of two categories or quality.

Costing:

The measurement of cost of a product or service is called costing; however, it is not a recommended terminology.

Cost Accounting:

It is the establishment of budgets, standard cost and actual costs of operations, processes, activities or products and the analysis of variances, profitability or social use of funds. It involves a careful evaluation of the resources used within the business. The techniques employed are designed to provide financial information about the performance of a business and possibly the direction which future operations should take.

Prime Cost:

The total costs which can be directly identified with a job, a product or service is known as Prime cost. Thus prime cost = direct materials + direct labor + other direct expenses.

Conversion Cost.

This is the total cost of converting the raw materials into finished products. The total of direct labor other direct expenses and factory overhead cost is known as conversion cost

Cost Accumulation

Cost accumulations are the various ways in which the entries in a set of cost accounts (costs incurred) may be aggregated to provide different perspectives on the information.

Methods of cost accumulation

Process costing

It is a method of cost accounting applied to production carried out by a series of operational

stages or processes.

Job order costing

Generally, it is the allocation of all time, material and expenses to an individual project or job.

Assignment Questions

Answer to each of the following question should not exceed five lines.

1.  Define Cost Accounting

2.  What are the three broad elements of cost?

3.  Give any five examples of factory overhead cost. Also explain.

4.  Give any two examples of distribution overheads.

5.  Give any two examples of office overheads

6.  Define direct cost and give two examples.

7.  What is indirect cost? Give three examples.

8.  What is meant by step fixed cost and semi-variable cost? Also show graphs.

9.  What is fixed cost? Give three items of fixed cost, also show its graph.

Exam Type Questions

1.  What is a cost unit? Give two example

2.  Define cost centre. How does it differ from cost unit

3.  What is the difference between direct and indirect materials? Give two examples of each.

4.  Fixed cost per unit remains fixed. Do you agree?

5.  How variable cost per unit behaves? Give two examples.

6.  What are semi-variable costs? Draw graph for such costs

Multiple Choice Questions

Choose the correct answer in each of the following MCQ.

1.  The main purpose of cost accounting is to a Maximize profits b Help in inventory valuation c Provide information to management for decision making d Aid in the fixation of selling price;

2.  Fixed cost per unit increases when a Variable cost per unit increase b Variable cost per unit decreases c Production volume increases d Production volume decreases

3.  Variable cost per unit a Varies when output varies b Remains constant c Increases when output increases d Decrease when output decreases

4.  Which of the followings is the reason of increase in total variable cost: a Increase in fixed cost b Rise in interest on capital c Increase in direct material cost d Depreciation of machinery

1. Which of the followings is an example of fixed cost: a Direct material cost b Works manager’s salary c Depreciation of machinery d Chargeable expenses

5.  Cost accounting concepts include all of the following except a Planning b Controlling c Sharing d Costing

6.  The three elements of product cost are all but a Direct material cost b Factory overhead cost c Indirect labor cost d Direct labor cost

Answers: