Cost Concepts

Chapter-1

Learning Objectives• Relation between cost concepts, cost objects and

cost drivers• Difference between direct and indirect cost• Cost behaviour• Inventoriable cost and period cost• Different cost for different purposes• Judgment and cost• Present features of cost accounting and cost

management

What is cost?

• COST is a resource that is consumed to attain an objective.

Actual Cost – incurred Budgeted cost- forecasted• Cost is determined for something called

cost object. (product, service, time or any combination thereof etc.)

Cost Objects

Examples:• Product: Pentacool refrigerator• Service: Telephone hotline service information to

users of Pentacool• Project: R&D project on optimizing inner space of

the refrigerator• Customer: Raj Electronics, a dealer who purchases

all products of Godrej• Department: Accounting department

What is cost driver?

Understanding CD is the key for competitive cost advantage

- A variable like level of activity that drives the cost over a period of time.

Types of cost drivers

• Activity based cost drivers

• Volume based cost drivers

• Structural cost drivers

• Executional cost drivers

Activity based cost drivers

Activity Cost driverProvide ATM service ?Update account balance ?Interbank fund transfer ?Process loan applicationsMail customer statements

Volume based cost drivers

Many costs are volume based- DM, DL Total volume based cost – nonlinear relation with

cost driver- due to increasing marginal productivity – then law of diminishing productivity sets in as you reach capacity limit

A linear approximation of the total cost curve within a small range will be a straight line – relevant range

Structural cost drivers

• Strategic in nature• Involve plans of long term effect around scale,

experience, technology and complexity Scale- how much to invest Experience- prior experience in its current and

planned products and services Technology- huge cost saving – ex- computers Complexity- how many products, what markets?

Executional cost drivers

Factors the firm can manage in the short-term operational decisions to reduce cost

Workforce involvement Process design- faster movement of the

product Supplier relationship – quality, timeliness,

cost

What is relevant range?

• A band of normal activity level where the activity level has relation with the cost in question.

Ex. – Fixed cost is fixed in relation to a range of output and a given time span.

• Variable cost may not rise proportionately beyond a range- Ex.- may be due to discount on material purchase.

COST BEHAVIOUR

Fixed (fixed in short run) may have cost drivers in a long run. Ex.- Testing cost (equipment and staff cost) may be pruned down in

accordance with production level in the long run.

VaribleSemi-variablePeculiarities: A cost could be variable for one level of activity whereas it could be

fixed for another. Not inherently fixed or variable

Many costs are semi-variable in nature Impact of business process

Relation

Cost

Cost pool:

Meaningful groups

Cost object: Product

Cost determination

Cost accumulation (data collection) Assignment to cost pool or cost object

Cost tracing (direct relation Cost allocation (Indirect cost)with the cost object)

Direct and Indirect cost

- Direct cost -can be traced in economically feasible manner – volume is the driver

- Indirect cost- no traceability- find the driver and allocate

Factor affecting direct and indirect cost classification:

• Materiality of cost• Information gathering technology• Design of operations• Cost object chosen

Cost, cost pool, cost object, cost driver in consumer durables mfg.

Cost drivers & cost assignmentCosts

Electric motor

Materials handling

Supervision

Packing mat.

Final inspection

Cost pools

Assembly

Packing

Cost objects

Dishwasher

Washing machine

Cont…

Examples of costs, cost pools, cost drivers & cost objectscosts Cost driver Cost pool Cost driver

DIRECT COSTS

El.motor Direct trace Ass. Dept. Direct trace DW & WM

Pack. Mat Direct trace Pack. Dept. Direct trace DW & WM

Final insp. Direct trace Not applicable NA DW & WM

INDIRECT COSTS

Supervision No. of Both. Depts DLHs DW & WM

employees

Mat. Handling No. of parts Both. Depts No. of parts DW & WM

in the product in the product

Cost object

Relationships of types of costs

(Ex.- Cost object: Zen Classic)• Direct and variable: Cost of steering wheels• Direct and fixed: Salary of supervisor in

ZEN classic section• Indirect and variable: Power of the plant• Indirect and fixed: Lease rent of plant

Total cost & Unit cost

Unit cost is an averageTotal cost is difficult to interpret: so unitizeBut unit cost is misleading in some cases:Level of prod. Unit cost USP6000 units Rs.105 Rs.1007000 units Rs.97 Rs. 998000 units Rs.89 --------Ritesh offers Rs.70 per unit for 1000 units.

PERIOD COSTS AND INVENTORIABLE COSTS

• Inventoriable cost/ product cost is that cost which is regarded as asset when incurred, but becomes a part of cost of goods sold when the product is sold. For MUL, all manufacturing cost is inventoriable cost. (Raw material to WIP to Finished goods) For a service sector unit, absence of inventory means all are period costs. (Contrary to IAS)

• Period costs(nonproduct cost): all costs in P&L account except cost of goods sold. So, in a mfg. sector unit, all non-manufacturing costs are period costs. (Ex. Distribution cost, design cost, R&D costs, Marketing costs, customer-service costs, etc.)

Many meanings of product cost

Pricing and product-mix decisions: Cost incurred in all business functions of the

value chain (R& D cost to customer service cost)

Contracting with Government agencies: Scope of the contract defines

Preparing FSs: Production cost

Cost flow in mfg. company

1st. step Mat. purchase Mat inventory

Mat. used

WIP inventory

Cost of goods mfg.

FG-inventory

COGS

OHLabour

2nd. step

3rd. step

Opening inventory

Closing inventory

COST MEASUREMENT AND JUDGMENT

When is overtime premium on direct labour considered as indirect cost?

• Overtime premium: generally considered as overhead. The reason is that it is not prudent to burden the last batch of work simply because it is a work during the overtime period. It is only a scheduling. As opposed to this, if overtime is due to a rush job, it is a direct cost of that job.

• Idle time due to breakdown, scheduling problems, lack of order, etc. is overhead.

COST CLASSIFICATION

Element or analytical classification of cost: Material, Labour, Other Expenses

Functional Classification:• R&D cost• Design cost• Production- Expenses till goods are ready for despatch• Administration- Directing the organisation• Selling (to create demand and secure orders) – Ex. Bad debts,

market research, price lists, catalogues,etc.• Distribution-(from point of production till consumption) –Ex.-

Warehouse expenses, carriage outward, depreciation of delivery vans, etc.

• Financing costs: costs for raising and using capital• Commercial cost is cost beyond manufacture, i.e., Admin. and

S&D cost.

Cont…..

As per assignment to cost object:1. Direct cost2. Indirect costAs per behaviour in relation to change in volume:1. Fixed2. VariableAssets / Expenses: Inventoriable or period cost

Cont………

By Controllability: from responsibility point of view: controllable / uncontrollableBy Normality: normal/abnormalAccording to planning & control:• Budgeted Cost: estimate of expenditure for

different business operations• Standard Cost: for prescribed set of operating

conditions, labour, material and overheads are predetermined; budget translated into actual operation through standard costs.

Relevant cost what is pertinent for decision on hand• Out of pocket costs: cash outflow involved

• Differential costs: Change in total cost due to change in level of activity or method of production. Could be incremental or decremental.

• Opportunity cost: Benefit forgone from not choosing the next best alternative available.

Cont…..

• Irrelevant cost: not relevant for decision making

• Example: Sunk costs: Sunk cost is the cost of abandoned plant less salvage value. Not relevant for decision making.

• Imputed (Notional cost): Actually not incurred (interest on own capital, rent on owned building, etc.) Taken into account in capital budgeting decisions.

• Replacement cost: Cost of replacing at current market price.

Cont…..

• Avoidable and unavoidable cost: Cost that can be avoided by eliminating a product or department is avoidable and that which cannot be, is unavoidable.

Ex. – Rent of factory is unavoidable if a product is discontinued.

Other costs:• Future costs: cost to be incurred in future• Programmed cost: Cost incurred as per policy of top

management. Ex.- Donation to charity.• Joint cost: cost of joint or by-products incurred before

separation, which cannot be traced to particular products.• Conversion cost: cost of converting raw material to

finished goods = Production cost- direct material.• Discretionary cost: not essential for decision on hand.

Ex.- Training expenses of workers, R&D cost. • Committed cost: Costs incurred due to past decisions and

are not within control in the short run at present. Ex.- Depreciation on Plant, Rent, etc.

Defn.

COST UNITS• Unit of output in production or service in relation to which

cost may be ascertained or expressed. Ex.- Motor car in MUL, Passenger km. for a transport

operator, Cubic meter for gas, 1000 no. of capsules in pharmaceutical industry, etc.

COST CENTRES• smallest segment of activity or area of responsibility for

which cost is accumulated. A department might have many cost centers. Ex.- location, a person, a machine, etc.

P-1• Rahim had placed an order for purchase of a special machine from

Ram. Rahim had given a non-refundable security deposit of Rs.10,000 for the contract, to be adjusted against the price. Ram has incurred Rs.60,000 till date. Shyam needs the machine with slight modification. Shyam is prepared to pay Rs.30,000 for the machine. The modification would entail these costs:

• Old material costing Rs.5000 will fetch Rs.1,000 if not used for the machine.

• Additional labour of Rs.10,000 is needed for this. Labour has to be diverted from another division. The revenue earned from that unit would be Rs.35,000 and direct cost excluding labour is : Material Rs. 10,000, and allocated fixed overhead Rs.5,000.

• For the old machine, Ram had entered into a contract with Rome for design for a fee of Rs.7,000. If his contract is cancelled, Rome will get Rs.4,000.

• General overheads of Rs. 6,000 will be added to the additional work for new machine.

Show the benefit of accepting the new order.

P-2 A machine which originally cost Rs.12,000 has an

estimated life of 10 years and is depreciated at the rate of Rs.1,200 per year. It has been unused for sometime, however, as expected production orders did not materialise. A special order has now been received which would require the use of the machine for two months.

The current net realizable value of the machine is Rs.8,000. if it is used for the job, its value is expected to fall to Rs.7,500. The net book value of the machine is Rs.8,400. Routine maintenance of the machine currently costs Rs.40 per month. With use, the cost of maintenance and repairs would increase to Rs 60 per month. What is the machine cost for the new job?

P-3 X Ltd. has been approached by a customer who would like a

special job to be done for him and is willing to pay Rs.22,000 for it.

Material B is used regularly by X Ltd. and if stocks are required for this job, they would need to be replaced to meet other production demand.

Materials C and D are in stocks as a result of previous excess purchase and they have restricted use. No other use could be found for material C but material D could be used in another job as substitute for 300 units of material E which currently costs Rs. 5 per unit (of which the company has no units in stock at the moment).

What are the relevant costs of material, in deciding whether or not to accept the contract? Assume all other expenses on this contract to be specially incurred besides the relevant cost of material is Rs. 550.

P-3 cont………

Material Total units

required

Units in stock

Book value of units in

stock Rs./unit

Realisable valueRs./unit

Replacement cost

Rs./unit

A 1000 0 0 0 6

B 1000 600 2 2.5 5

C 1000 700 3 2.5 4

D 200 200 4 6 9

The job would require the following materials:

P-4• Estimated direct material requirements of a business

concern viz., ABC Ltd. for the year 1998-99 are 1,20,000 units. Unit cost for orders below 1,20,000 units is Rs.10. When size of order equals 1,20,000 units or more the concern received a discount of 2% on the above quoted per unit price. Keeping in view the following two alternatives:

i. Buy 1,20,000 units at the start of the year; ii. Buy 10,000 units per month.• Calculate the opportunity cost, if the concern has the

facility of investing surplus funds in government bonds at the rate of 10% interest.

P&G’s learnings

• Early 1990s- 50 brands, different size containers, different prices, discounts, no. of trade promotions etc.

• High complexity in product and pricing- huge cost• 5 years- half of product variety- profit surged--------------------------------------------------------------- Compete with the best but reduce product and

process complexity