Managerial Accounting

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SLMtitle.png Cost Classifications and Cost Behavior

By Mohammad Jafaur Ahamed

Chapter Outline

  1. Introduction
  2. Learning Objectives
  3. Define cost and expense
    1. Cost classifications according to manufacture
    2. Cost Classifications according to Cost Behavior
    3. Cost Classification for assigning Costs to Cost Objects
    4. Cost Classification for Decision Making
    5. Cost classification according to accounting treatment
  4. Let's Sum Up
  5. Key Points
  6. Glossary
  7. Practice Test
  8. ASnswers to SAQs
  9. References and Further Readings

SLMinto.png Introduction

Manufacturing a commodity related with various types of costs, but it does not mean the total cost of a product because a commodity is produce in different stages and every stage are related with many costs. Total cost means the manufacturing costs and non-manufacturing cost. Manufacturing cost are those which related with production directly such as direct material, direct labor and manufacturing overhead. On the other hand, non-manufacturing costs are those which are required to make a product for sale, such as marketing cost, selling and advertising cost, and sales person commission.

SLMobj.png Learning Objectives
After reading this chapter, you are expected to learn about:

  • Define cost and expenses
  • Classify cost on the basis of different variability.
  • Identify the formula for calculating cost.
  • effect cost classification on decision making.

Idea about Cost and Expenses

Many peoples are mistakenly use costs and expenses are same things, but cost and expenses are not the same things. Cost means the sacrifice for acquiring something, for example, purchase a car for taka 5,00,000. On the other hand, expense means the sacrifice for consuming something, for example, you give taka five for riding a car. Here, taka 5,00,000 is treated as cost and taka 5 is treated as expense.

SLMsaq.gif Self-Assessment Questions (SAQs) - 1
How cost is differ from expenses

Cost classification according to manufacture

Manufacturing costs: Manufacturing costs are those costs that are used to manufacture goods directly. There are three types of manufacturing costs, which are as follows:

Direct Material: Direct materials are whose materials that become an integral part of the finished product and that can be physically and conveniently traced to the final product. It can be included directly in calculating the cost of the product, such as the steel to make automobile bodies. Generally raw materials are known as direct materials that go into the final product.

Direct Labor: Direct labor costs are those costs that can be easily i. e., physically and conveniently traced to individual units of product. Direct labor is sometimes called touch labor, since direct labor workers typically touch the product while it is being made, e.g., labor costs of machine operators.

Manufacturing Overhead: Manufacturing overhead is the third element of manufacturing cost that includes all costs of manufacturing except direct materials and direct labor. Manufacturing overhead includes items such as indirect materials, indirect labor. The terms indirect manufacturing costs, factory overhead and factory burden, are synonymous with manufacturing overhead. Such as Electricity cost, gas bill, water bill.

Direct Material + Direct Labor = Prime Cost
Prime Cost + Manufacturing Overhead = Manufacturing Cost
Direct Labor + Manufacturing Overhead = Conversion Cost

Non-manufacturing Costs: Generally, non-manufacturing costs are sub-classified into two categories:

  1. Marketing Costs / Selling & Distribution Costs: Marketing expenses cover the expenses of making sales and delivering products. These costs are necessary to secure customer orders and get the finished product into the hands of the customer. These costs are called order getting and order filling costs. Examples of marketing cost include advertising, shipping, sales travel, sales commission etc.

  2. Administrative Expenses : Administrative expenses include expenses incurred in the direction, control, and administration of the organization. These include all executive, organizational and clerical costs associated with the general management of an organization rather than with manufacturing, marketing, or selling. For example, executive compensation, general accounting expenses.
Marketing Costs + Administrative Expenses = Commercial Expenses
Manufacturing Cost + Non-manufacturing Cost = Total Operating Cost

SLMsaq.gif Self-Assessment Questions (SAQs) - 2
Distinguish between manufacturing & non-facturing cost

Cost Classifications According to Cost Behavior

Cost behavior refers to how a cost will react or respond to changes in the level of business activity. As the activity level rises and falls, a particular cost may rise and fall as well—or it may remain constant. From the view point of cost behavior, costs are three types:

Fixed Costs : A fixed cost is a cost that remains constant, in total, regardless of changes in the level of activity. Fixed costs are not affected by changes in activity. Consequently, as the activity level rises and falls, the fixed costs remain constant in total amount unless influenced by some outside force, such as a price change. Fixed costs are total fixed for a relevant range of activity level but per unit variable. For planning purposes fixed costs can be viewed as being either committed or discretionary;

  • Committed Fixed Cost: Committed fixed costs relate to the investment in facilities, equipment, and the basic organizational structure of a firm. Examples of such costs include depreciation of buildings and equipment, taxes on real estate, insurance, and salaries of top management and operating personnel. They are long term in nature and can not be significantly changed for short period.
  • Discretionary Fixed Cost: Discretionary fixed costs usually arise from annual decisions by management to spend in certain fixed cost areas. Examples of discretionary fixed costs include advertising, research, public relations, management development programs etc. Discretionary fixed cost is fairly short term, usually a single year and can be cut for short periods of time with minimal damage to the long-run goals of the organization.

Variable Costs: Variable cost is a cost that varies, in total, in direct proportion to changes in the level of activity. The activity can be expressed in many ways, such as units produced, units sold, miles driven, lines of print, hours worked and so forth. A good example of a variable cost is direct materials. The cost of direct materials used during a period will vary, in total, in direct proportion to the number of units that are produced. Variable cost is variable in total but per unit fixed. Variable costs are two types;

  • True Variable Costs: Direct material is a true or proportionately variable cost because the amount used during a period will vary in direct proportion to the level of production activity. Moreover, any amounts purchased but not used can be stored and carried forward to the next period as inventory.
  • Step-Variable Costs: Those costs that increase or decrease only in response to fairly wide changes in activity is known as a step-variable cost. The behavior of a step-variable cost is that it will vary with step by step of activity level. Best example of step-variable cost is labor cost.

Mixed Costs: A mixed cost is one that contains both variable and fixed cost elements. Mixed costs are also known as semi-variable or semi-fixed cost. For example, in case of telephone bill, line rent is fixed cost and call charge is variable cost.

SLMsaq.gif Self-Assessment Questions (SAQs) - 3
What is fixed cost? How it is differ ferom variable cost?

Cost Classification for Assigning Costs to Cost Objects

For purposes of assigning costs to cost objects, costs are classified into two categories;

Direct Cost : A direct cost is a cost that can be easily and easily and conveniently traced to the particular cost object under consideration. Examples of direct costs are direct materials, direct labor etc.

Indirect Cost: An indirect cost is a cost that cannot be easily and conveniently traced to the particular cost object under consideration, for examples, indirect materials, indirect labor etc.

SLMsaq.gif Self-Assessment Questions (SAQs) - 4
For making a shirt, indicate cloths are direct or indirect cost?

Cost Classification for Decision Making

Differential Cost and Revenue: Decisions involve choosing between alternatives, in business decisions, each alternative will have certain costs and benefits that must be compared to the costs and benefits of the other available alternatives. A difference in costs between any two alternatives is known as a differential cost. A difference in revenues between any two alternatives is known as differential revenue. A differential cost is also known as an incremental cost, although technically and incremental cost should refer only to an increase in cost from one alternative to another; decreases in cost should be referred to as decremented costs. Differential costs refer both cost increases and cost decreases between alternatives.

Opportunity Cost : Opportunity cost is the potential benefit that is given up when one alternative is selected over another. Opportunity cost is not usually entered in the accounting records of an organization, but it is a cost that must be considered in making decision by management. For example, Tk. 100000 can be invested @ 10% interest in bond or deposited into bank @ 7% interest, if the amount is invested in bond then the bank interest (100000 X 7%) Tk. 7000 will be the opportunity cost of bond interest.

Sunk Cost: A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future. Since sunk costs cannot be changed by any decision, they are not differential costs. Therefore, they can and should be ignored when making a decision. For example, a company paid Tk. 50000 before 5 years for purchase a machine.

Cost classification according to accounting treatment

Product Costs: Product costs include all the costs that are involved in acquiring or making a product. In case of manufactured goods, these costs consist of direct materials, direct labor, and manufacturing overhead. Product costs are viewed as attaching to units of product as the goods are purchased or manufactured and they remain attached as the goods go into inventory awaiting sale. So initially, product costs are assigned to an inventory account on the balance sheet. When the goods are sold, the costs are released from inventory as expenses (known as Cost of Goods Sold) and matched against the revenue. Product cost is also known as inventoriable cost. Product costs are not treated as expense in the period in which these are incurred. They are treated as expense in the period in which the related products are sold.

Period costs: Period costs are all the costs that are not included in product costs. These costs are expensed on the income statement in the period in which they are incurred using the usual rules of accrual accounting. Period costs are incurred for a specific period rather than to a specific product. They are not included as part of the cost of either purchased or manufactured goods. All selling and administrative expenses are considered to be period costs. Sales commission, office rent, executive salaries etc. are the examples of period costs.

SLMsaq.gif Self-Assessment Questions (SAQs) - 5
Are there any differences between product costs and period costs

SLMsum.png Results

SLMkp.png Key Points

The key points of this chapter are as follows:

Manufacturing cost, Non- manufacturing cost

SLMgloss1.png Glossary

  • Cost: sacrifice for acquiring somethings
  • Expense:sacrifice for consuming somethings
  • Manufacturing cost: directly related with manufacture
  • Non- manufacturing cost: cost incurred with a product for ready to sale it.
  • Direct material: directly related with production and also pyhsically identified
  • Indirect material:indirectly related with production and not easy to pyhsically identified
  • Direct labor: directly associate with production
  • Indirect labor:indirectly associate with production
  • Fixed cost: remain unchanged within a relevant range
  • Variable cost: change accorsing to the level of production
  • Product cost: involved in making a product
  • Period cost: expensed within the period when it incurred
  • Sunk cost: already been occured, not been recovered.
  • Opportunity cost: cost for sacrificing an opportunity.

SLMfeedb.png Answers to SAQs

SAQ 1: Cost is related with acquision, expense is related with consumption.
SAQ 2. Directly related with production. Cost incurred after production
SAQ 3. Fixed cost is fixed upto a relevant range. Variable cost is vary according to the level of production SAQ 4. Direct cost SAQ 5. One is production oriented, another is income statement oriented.

SLMref.png References and Further Readings

Introduction to Management accounting, Garison, 10th edition

Management Accounting, B. Benergee, 6th edition