Introduction to Cost Terms

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Introduction to CostTerms

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What is the cost of producing one unit or providing services?

What should be the sales-mix to achieve a target net income?

What is the break-even point?

Is it cheaper to buy products from outside vendors or to do

manufacturing in-house?

Is it worthwhile to invest more resources in design and

manufacturing if it reduces costs in marketing and customer

service or increase revenue?

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Cost and Cost TerminologyCostis a resource sacrificed or forgone to achieve

a specific objective.

Actual cost-cost incurred, a historical cost

Budgeted cost-predicted/forecasted cost, future cost

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When a manager thinks of cost, he invariably thinks of it in

the context of finding the cost of a particular thing.

A cost object/cost unitis a particular thing for which a

separate measurement of costs is desired.Product

Service

Bank: customer

Hospital: patientProject

E & P company: a well, lease, block

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Direct and Indirect CostsDirect Costs

Related to particular cost object and can be traced

in an economically feasible (cost-effective) way

to the cost object

Example:Paper on whichIndia Today magazine

is printed

Indirect Costs

Related to particular cost object but cannot be

traced in a cost effective way to the cost object

Example:Lease cost for India Today Group

Building, housing the senior editors of its

MagazinesMoney Today, Business Today,

Fortune, Care Today

COST OBJECT

India Today

magazine

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A costing system typically accounts for costs in two basic

stages:

- Cost accumulation: collection of cost data

- Cost assignment: cost tracing and cost allocation

Cost tracing: assignment of direct costs to a particular cost

object

Cost allocation: assignment of indirect costs to a particular

cost object

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Why to assign costs to cost objects?

- Costs assigned to a department facilitate decisions about

department efficiency.

- Costs assigned to products help inpricingvariousproducts and in analyzing how profitable different

products are

- Costs assigned to customers help in understandingprofit

earned from different customers and in making decisionsabout how to allocate resourcesto support different

customers

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Factors affecting Direct/Indirect Cost Classifications

Materiality of the cost in question

Smaller the amount of cost, less likely that it is economically feasible totrace that cost to a particular cost object

Shoe manufacturing company

economically feasible to trace the cost of leather used in each pair of

shoe

cost of thread used in each pair is likely to be classified as indirect cost

Not cost effective to trace nominal amount of thread to each pair

Available information gathering technology

Design of operationswhether facility is used exclusively for a specific cost object

Toyota Vs General Motors

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Variable CostChanges in total in proportion to changes in the related level

of total activity or output

e.g. Tata Motors buys a steering wheel at Rs.400 for each ofits Nano car

No. of cars Cost of steering Total cost of steering

assembled wheel per car (Rs.) wheel (Rs.)

1 400 400

10 400 4,000

100 400 40,0001,000 400 4,00,000

10,000 400 40,00,000

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Variable Cost

No. of cars assembled

Steering

wheel cost

Total

steering

wheel cost

Steering

wheel cost

per car

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Fixed CostRemains unchanged in total for a given time period, despite

wide changes in the related level of total activity or

volumee.g. Tata Motors incurs Rs. 1 cr. in leasing cost for its Nano

car plant

No. of cars Total Leasing Leasing cost

assembled Cost (Rs.) per car (Rs.)

1 1,00,00,000 1,00,00,000

10 1,00,00,000 10,00,000100 1,00,00,000 1,00,000

1,000 1,00,00,000 10,000

10,000 1,00,00,000 1,000

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Fixed Cost

No. of cars assembled

Leasing

Cost

Leasing cost

per car

Total

LeasingCost

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Why are some costs variable and other costs fixed?Tata buys steering wheels only when they are needed

The leased plant facility is acquired and put in place well

before Tata uses itSuppose that Tata puts in place the leased plant facility

capable of assembling 10,00,000 cars per year

If the demand is only for 7,00,000 cars, there will be idle

capacity

But Tata has to pay for the unused plant capacity, because the

cost of supervision cannot be reduced in the short run

Unlike VC, FC of resources cannot be quickly and easilychanged to match the resources needed or used

Unlike VC that go away automatically if the resources are not

used, reducing FC requires active intervention on the part

of managers

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Fixed Cost and Variable CostDo not assume that individual cost items are inherently

variable or fixed

Costs are defined as variable or fixed with respect to a specificactivity and for a given time period.

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Relationships of Types of Costs

Direct Costs

Indirect Costs

VariableCosts

FixedCosts

Cost Object: Tata Indica

Tires used in assembly

of a car

Cost Object: Tata Indica

Power costs of the plant.

Power usage is metered

only to the plant wheremultiple cars are

assembled

Cost Object: Tata Indica

Salary of supervisor on

Tata Indica assembly

line

Cost Object: Tata IndicaLease rent of plant,

where multiple cars are

assembled

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Skoda Octavia, plant of NUMML, a joint venture of GM and

Toyota, assembles 2 types of cars (Corolla and Geo Prism).

Separate assembly lines are used for each type of car.

Answer D or I; V or F for each of the following items.

If in doubt, select on the basis of whether the total costs will

change substantially if there is a large change in the number of

cars assembled.

1.Cost of tires used on Geo Prism

2.Salary of PRO for NUMML plant

3.Annual awards dinner for Corolla suppliers

4.Salary of engineer who monitors design changes on Geo Prism

5.Freight costs of Corolla engines shipped from Japan to California

6.Electricity costs for NUMML plant, single bill covers entire plant

7.Wages paid to temporary assembly-line workers hired in periods

of high production, paid on hourly basis

8.Annual fire-insurance policy cost for NUMML plant

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Cost Behavior Patterns Example

Hero Bicycles buys a handlebar

at Rs.52 for each of its bicycles.

What is the total handlebar cost when

1,000 bicycles are assembled?

1,000 units Rs.52 = Rs.52,000

What is the total handlebar cost

when 3,500 bicycles are assembled?

3,500 units Rs.52 = Rs.1,82,000

When considering how VC behave, always focus on

total variable costs

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Cost Behavior Patterns Example

Hero Bicycles incurred Rs.94,500 in

a given year for the leasing of its plant.This is an example of fixed costs with

respect to the number of bicycles assembled.

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Cost Behavior Patterns Example

What is the leasing (fixed) cost per bicyclewhen Hero Bicycles assembles 1,000 bicycles?

Rs.94,500 1,000 = Rs.94.50

What is the leasing (fixed) cost per bicyclewhen Hero Bicycles assembles 3,500 bicycles?

Rs.94,500 3,500 = Rs.27

Do not be misled by the change in FC per unit.When considering FC, always focus on total

fixed costs

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Cost DriversThe cost driver of variable costs is the level

of activity or volume whose change causes

the variable costs to change proportionately.

The number of bicycles assembled is a

cost driver of the cost of handlebars.

Costs that are fixed in the short run have no

cost driver in the short run but may have a

cost driver in the long run

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Total Costs and Unit Costs Example

What is the unit cost (leasing and handlebars)

when Hero Bicycles assembles 1,000 bicycles?Total fixed cost Rs.94,500

+ Total variable cost Rs.52,000 = Rs.1,46,500

Rs.1,46,500 1,000 = Rs.146.50

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Assume that Hero Bicycles management uses a

unit cost of Rs.146.50 (leasing and handlebars).

Management is budgeting costs fordifferent levels of production.

What is their budgeted cost for an

estimated production of 800 bicycles?

800 Rs.146.50 = Rs.1,17,200

What is their budgeted cost for an estimated

production of 3,500 bicycles?3,500 Rs.146.50 = Rs.5,12,750

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Use Unit Costs Cautiously

Total fixed cost Rs.94,500

Total variable cost (Rs.52 800) 41,600Total Rs.1,36,100

Rs.1,36,100 800 = Rs.170.13

Using a cost of Rs.146.50 per unit would

underestimate actual total costs if output

is below 1,000 units.

What should the budgeted cost be for anestimated production of 800 bicycles?

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Use Unit Costs Cautiously

What should the budgeted cost be for an

estimated production of 3,500 bicycles?

Total fixed cost Rs.94,500

Total variable cost (Rs.52 3,500) 1,82,000

Total Rs.2,76,500

Rs.2,76,500 3,500 = Rs.79.00

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Elements of Cost

Material Cost Labour Cost Other Expenses

Direct

MaterialCost

Indirect

MaterialCost

-Factory

-Office

-Selling& Dist.

Direct

LabourCost

Indirect

LabourCost

-Factory

-Office

-Selling& Dist.

Direct

Expenses

Indirect

Expenses-Factory

-Office

-Selling

& Dist.

El f C

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Direct Material Cost

Direct Labour Cost, e.g., wages to workers, foremen

Direct Expenses, e.g., costs of special designs, drawings, layouts

Production Overheads

-Indirect Materials:consumables, materials used in small quantity-Indirect Wages:salary of gate keeper

-Indirect Expenses:rent, rates, insurance of factory premises

Administration Overheads-Indirect Materials:stationery, brooms, duster, etc.

-Indirect Wages:salary of office staff-Indirect Expenses:rent, rates, insurance of office premises

Selling and Distribution Overheads-Indirect Materials:stationery, catalogues, price lists, promotional material

-Indirect Wages:salary and commission of sales force

-Indirect Expenses:rent, rates, insurance of godown

Elements of Cost

C t Sh t

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Cost SheetOpening stock of raw materials x

Add: Purchase of raw materials x

Less: Closing stock of raw materials x

Cost of raw materials consumed x

Add: Direct wages x

Add: Direct expenses x

Prime Cost x

Add: Factory Overheads xAdd: Opening stock of work-in-progress x

Less: Closing stock of work-in-progress x

Cost of Production x

Add: Opening stock of finished goods xLess: Closing stock of finished goods x

Cost of Goods Sold x

St t t f P fit/L

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Statement of Profit/LossSales x

Less: Cost of Goods Sold x

Gross profit x

Less: Administrative overheads x

Less: Selling and Distribution Overheads x

Less: R & D Cost x

Operating Income/Net Profit x

Consider the following account balances for Candico Company:

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Consider the following account balances for Candico Company:

beginning of 2006 end of 2006

Direct materials inventory Rs.22,000 Rs.26,000

Work-in-process inventory 21,000 20,000

Finished goods inventory 18,000 23,000Purchases of direct materials 75,000

Direct manufacturing labour 25,000

Indirect manufacturing labour 15,000

Plant insurance 9,000Depreciation on Plant building and equipment 11,000

Repairs and maintenance of plant 4,000

Marketing, distribution and customer-service costs 93,000

General and administrative costs 29,000

Prepare a schedule of cost of goods manufactured for 2006

Prepare a schedule of cost of goods sold for 2006

Revenues in 2006 were Rs.3,00,000. Prepare the income statement for

2006

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Cost of Goods Manufactured 1 36 000

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Cost of Goods Manufactured 1,36,000

Add: opening stock of finished goods 18,000

1,54,000

Less: closing stock of finished goods 23,000

Cost of Goods Sold 1,31,000

Revenue 3 00 000

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Revenue 3,00,000

Less: Cost of goods sold 1,31,000

Gross margin 1,69,000

Less:

Marketing, distribution and customer-service costs93,000

General and administrative costs 29,000 1,22,000

Operating Income 47,000