2BUS0259 Lecture 2:An Introduction to Cost Terms & Concepts
Reading: Atrill Chapter 2 Drury Chapter 2
Outline:Definition of a Cost Object; Cost Accumulation &
Cost Assignment; Direct & Indirect Costs; Product & Period
Costs; Variable, Fixed, Semi-Variable & Stepped Costs.
Cost Objects:Accountants usually define cost as a resource
sacrificed to achieve a specific objective, such as acquiring a
good or service. To guide their decisions, managers often want to
know how much a certain thing (such as a new product) costs. We
call this thing a cost object, which is anything for which a
separate measurement of costs is desired.
Cost Accumulation & Cost Assignment:A costing system
typically accounts for costs in 2 basic stages: 1. It accumulates
costs by classifying them into certain categories such as labour,
materials or advertising. 2. It then assigns these costs to cost
objects.
Cost Terms & Concepts: I. Direct & Indirect Costs:Costs
that are assigned to cost objects can be divided into two
categories: direct costs & indirect costs. Direct costs are
those costs that can be specifically & exclusively identified
with a particular cost object. In contrast, indirect costs cannot
be identified specifically & exclusively with a given cost
object.
Direct Costs: Direct Material Direct LabourCost
--------------assignment
Cost tracing -------
Indirect Costs: Indirect Material Indirect Labour Rent,
Electricity Etc.
Cost Objects: an example might be
A DeskCost --------allocation
Relationship of direct & indirect costs to a cost object
An Important RemarkThe definition of direct and indirect costs
depends on the purpose for which the cost will be used. For
example, the electricity of a specific department is a direct cost
within that department, however for each unit produced in that
department that cost is an indirect cost.
Prime Cost & Manufacturing Overhead:Prime cost refers to the
direct costs of the product & consists of direct labour costs
plus direct material costs plus any direct expenses such as the
cost of hiring a machine for producing a specific product .
Manufacturing overhead consists of all indirect manufacturing
labour & materials costs plus indirect manufacturing expenses.
Examples include rent of the factory & depreciation of
machinery.
II. Product & Period Costs: Product costs are those costs
associated with goods or services purchased, or produced, for sale
to customers (in other words, these are the production costs).
Period costs are those costs which are treated as expenses in the
period in which they are incurred (in other words, these are the
selling & administrative expenses).
III. Cost Behaviour: Variable, Fixed, Semi-Variable &
Semi-Fixed Costs:Variable costs are those costs which vary in
--direct proportion to the volume of activity, that is, doubling
the level of activity will double the total variable cost.
Consequently, total variable costs are linear & unit variable
cost is constant . The following example illustrates a variable
cost where the variable cost per unit is 10.
Variable Costs:Output (Number of units) Unit Cost (s) Total Cost
(s)
100 10 1-----000
200 10 ------2 000
300 10 ------3 000
An Important Remark: However the variable costs
---------------------------------------------------------------do
change in their total but the unit cost is fixed.
----------------------------------------------------------------
Graph of Total Variable Cost against Activity
Total Cost
Level of Activity
Graph of Unit Variable Cost against Activity
Unit Cost
Level of Activity
Examples of Variable Costs:Materials used to manufacture a unit
of output or to provide a type of service; Labour costs of
manufacturing a unit of output or providing a type of service;
Commission paid to a salesperson.
Fixed Costs: A Fixed cost is one which is not affected by
changes in the level of activity, for a specified period of time.
Total fixed costs are constant for all levels of activity whereas
unit fixed costs decrease proportionally with the level of
activity.
Fixed Costs:Total Cost (s) Rent Output (Number of units) Unit
Cost (s)
3 000
3 000
3 000
100 --30
200 --15
300 --10
Total fixed costs are constant for all levels whereas
---------------------------------------------------------------unit
cost is decreasing as output increases, because
------------------------------------------------------------------------------------------------------------------------------the
fixed cost is spread over more units.
Graph of Total Fixed Cost against ActivityTotal Cost
Level of Activity
Graph of Unit Fixed Cost against Activity
Unit Cost
Level of Activity
Examples of Fixed Costs:Advertising in the trade journals;
Salaries & wages of administrative duties; Depreciation of
building.
Semi-Variable Costs:A Semi-Variable cost is one which varies,
however not in a direct proportion, with changes in the level of
activity, over a defined period of time. It includes both a fixed
element that is fixed whatever the level of activity & a
variable component that is directly related to the level of
activity.
Semi-Variable Costs:Activity (Number of units) Total Cost (s)
100 2 100 200 2 200 300 2 300
Total cost increases as activity increases but not in the same
proportion
Graph of Total Semi-Variable Cost against ActivityTotal Cost
Variable -----------
Fixed -------Level of Activity
Examples of Semi-Variable Cost:Office salaries where there is a
core of longterm secretarial staff plus employment of temporary
staff when activity levels rise; Maintenance charges where there is
a fixed basic charge per year plus a variable element depending on
the number of callouts per year.
Semi-Fixed or Stepped Costs:The cost will take the shape of a
step-cost whenever the cost is fixed over a fixed period of time
but there is a revised increase in the cost to a higher level than
the previous one in subsequent periods.
Example of a Stepped Cost:
Quarters of the year First Quarter Second Quarter Third Quarter
Fourth Quarter
Cost of the Rent 1000 1200 1400 1600
Graph of Stepped Cost against Activity
1600 1400 1200 1000 800 600 400 200 0 1st Qtr 2nd Qtr 3rd Qtr
4th Qtr
Rent
Key Terms:Cost Object; Direct Costs; Indirect Costs; Cost
Tracing; Cost Allocation; Cost Assignment; Prime Cost;
Manufacturing Overhead Product Costs; Period Costs; Variable Costs;
Fixed Costs; Semi-variable Costs; Stepped Costs;
Seminar 2 Questions Q.1:For each of the following cost items,
explain how it could be classified under each of the following
headings given in the following table: (a) raw materials to be used
in production; (b) the cost of hiring a machine for producing a
specific product; and (c) rent of a warehouse for one year to allow
temporary expansion of output.
Item
Variable / Fixed
Direct / Indirect
Product / Period
Material Cost of Machine Rent
Q.2: Classify each of the following as being primarily a direct
OR an indirect cost for each unit produced: (a) Wood used to
manufacture a desk; (b) Materials used for the repair of a machine
that is used for the manufacture of many different desks, (c)
Factory insurance; (d) Salaries of factory supervisors; (e) The
wages of operatives engaged in the production process; and (f)
Canteen managers salary.
Item Wood Repair Insurance Supervisors salaries
Direct/Indirect
Operatives wages Canteen managers salary
Q.3:(a) Identify the cost behaviour in each of thefollowing
tables as: (i) fixed cost; or (ii) variable cost; or (iii)
semi-variable cost. (b) Draw a graph for each table to illustrate
the cost behaviour.
Cost XOutput Units Total Cost () Unit Cost () 100 200 300 400
500
600
600
600
600
600
6
3
2
1.50
1.20
Cost YOutput Units Total Cost () Unit Cost () 100 200 300 400
500
300
600
900
1, 200
1, 500
3
3
3
3
3
Cost ZOutput Units Total Cost () Unit Cost () 100 200 300 400
500
660
720
780
840
900
6.60 3.60 2.60 2.10
1.80
Q.4:Peter Bright is a well-known professional Management
Accounting for Business Decisions speaker. The Essex Business
Bureau wants Bright to be the sole speaker at an all-day seminar.
Brights agent offers Essex the choice of three possible fee
arrangements: Schedule 1: 8000 fee Schedule 2: 20 per person + 2000
fixed fee Schedule 3: 50 per person Each attendee will be charged a
200 fee for the all-day seminar.
Required:1. What is Essexs fixed cost and variable cost for
hiring Bright under each alternative schedule? 2. For each
schedule, calculate the total cost and unit cost per seminar
attendee if (a) 50 attend, (b) 200 attend, and (c) 500 attend.
Comment on the results.
Q.5:Oven Pies Ltd plans to buy a delivery van to distribute pies
from the bakery to various neighbourhood shops. It will use the van
for three years. The expected costs are as follows:
Items New van Trade-in price after 3 years Service costs (every
6 months) Spare parts, per 10 000 miles Four new tyres, every 15
000 miles Vehicle licence and insurance, per year Fuel per litre
(consumption is 1 litre every 5 mile)
15 000 600 450 360 1 200 800 0.70
You are required to do the following 1. Prepare a table of costs
for mileages of 5 000, 10 000, 15 000, 20 000 and 30 000 miles per
annum, distinguishing variable costs from fixed costs. 2. Calculate
the average cost per mile at each of the mileages set out in (1)
above.
