FINANCE ELECTIVE – FIN 03

CREDIT - 30

COST & Management Accounting

MODULE 2:

Cost Terms and Purposes. Costs and Cost Terminology, Direct Costs and Indirect Costs, Challenges in Cost Allocation,
Factors Affecting Direct/Indirect Cost, Cost-Behavior Patterns: Variable Costs and Fixed
Costs, Cost Drivers, Relevant Range, Total Costs, Unit Costs, Inventorial Cost and Period Costs, Prime Costs and Conversion Costs.

REFERENCE NOTES:

Cost - Cost OBJECTS – Cost UNITS and Cost DRIVERS

Cost refers to the expenditure incurred in the production of goods or services. It includes both monetary and non-monetary resources, such as time and
labor.

Cost Object: Cost object can be a product (book), a service (airline), a project, a customer, a brand category etc. It helps in determining the cost of
producing goods or services, evaluating the profitability of specific products or projects, and making informed decisions about resource allocation.

Cost Units: It is a unit of product, service or time (or combination of these) in relation to which costs may be ascertained or expressed. Example for power
industry is kilo Watt hour (kWh). These are standard unit of measurement used to quantify and allocate costs within an organization. Cost units are
essential for determining the cost of producing specific goods or services, evaluating profitability, and making informed decisions about resource allocation.

Cost Drivers: A Cost driver is a factor or variable which effect level of cost.

Example for a purchase department it is the number of purchase orders (Cost Objects)
Types of Cost for Managerial Decision Making:

1. Pre-Determined Cost – Pre-estimated Cost

2. Standard Cost – Pre-determined cost at expected level of Performance

3. Marginal Cost - additional cost incurred by producing one more unit of a good or service.

4. Estimated Cost – Expected Cost

5. Differential Cost - (increase or decrease) in total cost (variable as well as fixed) due to change in activity level

6. Imputed Cost – Implied Cost

7. Opportunity Cost – Cost of benefit foregone

8. Sunk Cost – Historical (Past Expenses) cost that cannot be recovered.

9. Implicit Cost - Costs do not involve any immediate cash payment.

10. Explicit Cost - Costs that involve cash outflows and are easy to identify and quantify.

Key terms related to costs:

1. Direct Costs:

These are expenses that can be traced directly to a specific product, project, or department.

Examples include raw materials, labour, and manufacturing supplies.

2. Indirect Costs (Overheads):

These cannot be recognized directly to a particular product or project. Instead, they support overall operations.

Examples include rent, utilities, and administrative salaries.

3. Variable Costs:

Variable costs fluctuate with changes in production or activity levels. These costs remain constant on per unit basis but fluctuate in totality.
 Example the cost of raw materials increases as production volume rises.

4. Fixed Costs:

Fixed Costs remain constant within a certain range of production or activity. These cost fluctuate on per unit basis but remains constant in
totality up to a certain level.

Example: Rent for a factory it does not change with production volume.

5. Semi-Variable Costs: Hybrid

These costs have both variable and fixed components.

Example: Salesperson's salary may include a fixed base pay and a variable commission based on sales.

6. Marginal Costs:

Marginal cost is the additional cost incurred in producing one more unit of a product or providing one more service. It helps in pricing
decisions. Marginal cost is the change in total production cost that comes from making or producing one more unit.

MC = Change in Cost / Change in Quantity

Marginal costing is the increase or decrease in the overall cost of production due to changes in the quantity of desired output.

7. Total Costs:

Total cost is the sum of all costs, including both variable and fixed costs, associated with producing a specific quantity of a product or
delivering a service.

8. Opportunity Costs:

Opportunity cost represents the benefits or profits foregone when one choice is made over another. It's often used in decision-making.
An opportunity cost is the value of the option not taken when a business makes a decision.

9. Period Costs:

Period costs are expenses incurred during a specific accounting period, such as marketing and administrative expenses.
10. Product Costs:

Product costs include direct materials, direct labour, and manufacturing overheads. They are associated with the production of goods and
are capitalized as inventory until the goods are sold.

11. Avoidable Costs

An Avoidable cost is a cost that can be eliminated by not engaging in or no longer performing an activity. For example, if the decision is
made to close a production line, then the cost of the building in which it is housed is now an avoidable cost, because it can be sold without
harming the business.

In general Variable costs are considered to be an avoidable cost, while a fixed cost is not considered to be an avoidable cost.

12. Committed Costs

Committed costs are Investments that a business has already made and cannot recover by any means. For example, if a company buys a
machine for 40,000 and also issues a purchase order to pay for a maintenance contract for 2,000 in each of the next three years, all 46,000
is a committed cost, because the company has already bought the machine, and has a legal obligation to pay for the maintenance.

13. Conversion Costs

Conversion costs are those costs required to convert raw materials into finished goods that are ready for sale.

Conversion costs = Direct labor + Manufacturing overhead

Examples of Conversion costs are:

1. Direct labor and related benefits

2. Equipment depreciation

3. Equipment maintenance

4. Factory rent

5. Factory supplies

6. Factory insurance
 7. Machining

8. Inspection

9. Production utilities

10. Production supervision

11. Small tools charged to expense

14. Deferred Costs

A deferred cost is a cost that a business has already incurred, but which will not be charged to expense until a later reporting period and till
then they appear on the balance sheet as an asset. For example, if 1,000 is paid in February for March rent, it is a deferred cost in February,
and is shown as a prepaid asset. In March the rent (prepaid asset) is consumed, and is changed into rent expense. Insurance paid in advance
is a deferred cost.

Cost Classification: Grouping of cost according to their common features.

B. Classification of Cost by FUNCTION

C. Classification of Cost by BEHAVIOUR

F. Classification of Cost by NORMALITY

Challenges in Cost Allocation

Cost allocation can be challenging due to various factors:

1. Overhead Allocation:

Determining how to allocate indirect costs (overheads) to different products or departments can be complex.

Selecting the appropriate allocation method is crucial.

2. Cost Heterogeneity:

It refers to difficulty in allocating cost that vary significantly within an overhead category.

Example: Office rent supporting support multiple departments.

Factors Affecting Direct/Indirect Cost

1. Traceability:

Traceability is the degree to which a cost can be traced to a specific product or activity impacts whether it is classified as direct or indirect.
 2. Nature of the Cost:

These are costs that can be directly assigned to the product like raw materials and direct labour.

3. Volume of Production:

The volume of production or level of activity can affect whether a cost is variable or fixed. As production increases, variable costs rise.

Cost Behavior: Variable and Fixed Costs

Cost behavior refers to how costs change or respond to changes in the level of activity or production within a business.

Understanding cost behavior is important for effective financial management, budgeting, and decision-making.

Variable Costs:

Variable costs are expenses that increases or decreases in direct proportion to the level of production or activity within a business. These costs fluctuate as
the volume of output or sales changes (Linear relation)

Characteristics of Variable costs:

Direct Relationship: Variable costs increase when production or sales volume increases and decrease when volume decreases. There is a direct and linear
relationship between these costs and activity levels.

Examples: Cost of raw materials, direct labour and shipping costs based on the number of units shipped.

Total Variable Cost: The total variable cost for a specific period can be calculated by multiplying the variable cost per unit by the number of units produced
or sold during that period.

Variable Cost per Unit: Variable Cost per Unit remains relatively constant but varies in total with production or sales volume.

Decision-Making Significance: Variable costs are essential in determining break-even points, pricing strategies, and assessing the profitability of specific
products or services.

Fixed Costs:

Fixed costs remain constant within a certain range of production or activity levels. These costs do not change with short-term fluctuations in production or
sales volume.
Characteristics of fixed costs:

Constant Nature: Fixed costs do not vary with changes in production or sales levels over a specific range. They remain stable for a given time period, such as
a month or a year.

Examples: Common examples of fixed costs include rent or lease payments for facilities, salaries of permanent staff, insurance premiums, and annual
depreciation of assets.

Total Fixed Cost: The total fixed cost remains the same regardless of changes in production or sales volume. It is a set amount that the business incurs
regularly.

Fixed Cost per Unit: To calculate the fixed cost per unit, divide the total fixed cost by the number of units produced or sold. As production increases, the
fixed cost per unit decreases.

Decision-Making Significance: Fixed costs are crucial in determining the break-even point, which is the level of production or sales at which total revenue
equals total costs. Beyond the break-even point, fixed costs contribute to profit.