Costs L1

Study Unit 32: D.1. Cost Measurement Concepts

Costs Based on Level of Activity (Fixed, Variable and Mixed

Costs)
the main groups of costs based on their behavior as the level of activity
changes consists of :
1. Fixed costs
Fixed costs do not change within the relevant range of activity, As long
as the activity level remains within the relevant range.
Total amount of fixed costs does not change. BUT cost per unit
decreases as the activity level increases and increases as the activity
level decreases.
Examples : Salary, Rent, Depreciation.

2. Variable costs
Variable costs are Costs that change depending on The level of Activity,
like costs such as material and labor. Variable cost is a cost that changes
in total as the level of activity changes.
Per unit variable cost remains unchanged despite the change of level of
production. total variable cost increases as the activity level increases
and decreases as the activity level decreases.
Examples : Things that change depending on other things, like Sales
Commission. Depending on the sales it will increase or decrease.
 3. Mixed costs
have both a fixed and a variable component.
An example of a mixed cost is a contract for electricity that includes a
basic fixed fee that covers a certain number of kilowatts of usage per
month, and usage over that allowance is billed at a specified amount
per kilowatt used.

Cost Behavior in the Production Process

Fixed costs, variable costs, and mixed costs behave in fundamentally
different ways in the production process as the production level
changes.
Variable Costs :
Are incurred only when the company actually produces something.
Note: The selling price per unit minus all unit variable costs is equal to
the unit contribution margin.
Fixed Costs :
Fixed costs are costs that do not change in total as the level of
production changes, as long as production remains within the relevant
range.
Note: Over a long enough period, all costs will behave like variable
costs.
Mixed Costs :
Mixed costs have a combination of fixed and variable elements. Mixed
costs may be semi-variable costs or semi-fixed costs
A semi-variable cost has both a fixed component and a variable
component. It has a basic fixed amount and added to that fixed amount
is an amount that varies with activity.
Utilities provide an example. Some utility contracts incorporate a basic
fixed fee per month plus a separate variable charge per unit used. Also
an example is a Salesperson, his basic salary is Fixed, and Selling
commestions are variable and depend on how much he sells.
A semi-fixed cost is fixed over a given, small range of activity, and
above that level of activity, the cost suddenly jumps.
a semi-fixed cost is fixed over a smaller range than the relevant range
of a wholly fixed cost.
Example: The nursing staff in a hospital is an example of a semi-fixed
cost. The hospital needs one nurse for every 25 patients, so each time
the patient load increases by 25 patients an additional nurse will be
hired. When each additional nurse is hired, the total cost of nursing
salaries jumps by the amount of the additional nurse’s salary.

The difference between a semi-variable and a semi-fixed cost is that

the semi-variable cost starts out at a given base level and moves
upward smoothly from there as activity increases. A semi-fixed cost
moves upward in steps.

Introduction to Cost Measurement Methods

There are 3 main ways to measure costs. These three cost
measurement methods are used for allocating both direct and indirect
manufacturing costs. Like so :
M1

Manufactoring Actual Costing Normal Costing Standard

Cost Costing
Var. Direct M/L AP x AQU AP x AQU SP x SQA
Var. OVHD AR x AQU BR x AQU SR x SQA
Fixed Direct M/L AP x AQU AP x AQU SP x SQA
Fixed OVHD AR x AQU BR x AQU SR x SQA

AP/ AR Actual Price/Rate

AQU Actual Quantity Units
BR Budgeted Rate/Price
SP Standard Price
SQA Standard Quantity Allowed

1. Standard Costing
standard cost system, standard, or planned, costs are assigned to
units produced.
In a standard cost system, overhead is generally allocated to units
produced by calculating a predetermined rate that is applied to the
unitsproduced on the basis of the standard amount of the allocation
base allowed for the actual output.
The predetermined overhead application rate is calculated as : M2
Budgeted Monetary Amount of Manufacturing Overhead
Budgeted Activity Level of Allocation Base
*the same is used in normal costing.

The most frequently used allocation bases are direct labor hours, direct
labor costs, or machine hours.
To apply overhead cost to production, the predetermined overhead rate
is multiplied by the standard amount of the allocation base allowed for
producing one unit of product, and then that standard overhead
amount for one unit is multiplied by the actual number of units
produced to calculate the standard overhead cost to be applied to the
units produced.
Flexible budgeting and use of a standard costing system go together.
One is not meaningful without the other.
Standard costing enables management to compare actual costs with
what the costs should have been for the actual amount produced
The emphasis in standard costing is on flexible budgeting, where the
flexible budget for the actual production is equal to the standard cost
per unit of output multiplied by the actual production volume.
Standard costing can be used in either a process costing or a job-order
costing environment.
 Manufacturing companies use standard costing with flexible
budgeting to control direct inputs to production as well as
manufacturing overhead costs.
 Retailers and service companies use standard costs to control
their direct inputs and overhead too. For example, direct inputs
for a fast-food restaurant include food costs and labor. Examples
of overhead costs for a fast-food restaurant are the manager’s
salary, rent for the premises, utilities, and janitorial costs.

2. Normal Costing
In a normal cost system, direct materials and direct labor costs are
applied to production differently from the way they are applied in
standard costing.
In normal costing, direct materials and direct labor costs are applied at
their actual rates per unit of input multiplied by the actual amount of
the direct inputs used for production. Like shown in M1 above.
To apply overhead to production, a normal cost system uses a
predetermined manufacturing overhead. The same one used in
Standard Costing in M2 above.
Normal costing is not appropriate in a process costing environment .
Normal costing is used mainly in job costing.
because it is too difficult to determine the actual costs of the specific
direct materials and direct labor used for a specific production run.
Process costing is used when many identical or similar units of a
product or service are being manufactured.

3. Actual Costing
In an actual costing system, no predetermined or estimated or
standard costs are used. Instead, the actual direct labor and materials
costs and the actual manufacturing overhead costs are allocated to the
units produced. The Calculation method is shown in M1 above.
Actual costing is practical only for job order costing for the same
reasons that normal costing is practical only for job order costing.
actual costing is Rarely used because it can produce costs per unit
that fluctuate significantly.‫تتقلب كتير‬
This fluctuation in costs can lead to errors in management decisions
such as pricing of the product, decisions about adding or dropping
product lines, and performance evaluations.
The difference between normal and actual costing systems is in the
way the amount of overhead to be applied to production is calculated.

Variable and Absorption Costing

Variable and absorption costing are two different methods of inventory
costing. Under both variable and absorption costing, all variable
manufacturing costs are inventoriable costs. They differ in :
 Their treatment of fixed manufacturing overhead
 The income statement presentation of the different costs

Fixed Factory Overheads Under Absorption Costing

For a manufacturing company, absorption costing is required for
external financial reporting by GAAP. Under absorption costing fixed
factory overhead costs are allocated to the units produced during the
period according to a predetermined rate.‫بينطرح من الدخل طوالي و بيكون تبع الكوقس‬

Factory Overheads Under Variable Costing

Under Variable Costing fixed factory (manufactoring) overheads are
reported as period costs and are expensed in the period in which they
are incurred
‫بتنتطرح من هامش المساهمة‬

Variable costing does not conform to GAAP. And can only be used for
internal analysis (it’s a better tool for it).
Income Statement Presentation
The presentation of the income statement will also be different under
absorption costing and variable costing.
An allocation of fixed manufacturing costs is included in Cost of Goods
Sold under absorption costing.
Under variable costing, fixed manufacturing costs are expensed as
incurred.

The Income Statement under Absorption (full) Costing

Under absorption costing gross profit is calculated by subtracting from
revenue the cost of goods sold,(which includes all variable and fixed
manufacturing) costs for goods sold. Like :

All variable and fixed nonmanufacturing costs (period costs) are then
subtracted from gross profit to calculate operating income.

The Income Statement under Variable (Direct) Costing

Under variable costing a manufacturing contribution margin is
calculated by subtracting all variable manufacturing costs for goods
that were sold from revenue. From this manufacturing contribution
margin is resulted, Then non-manufacturing variable costs are
subtracted to arrive at the contribution margin Like :

All fixed costs (manufacturing and non-manufacturing) are then

subtracted from the contribution margin to calculate operating income.

Process Costing and Job Order Costing

Cost accumulation systems are used to assign costs to products or
services. Process Costing and Job Order Costing are different systems of
cost accumulation used in manufacturing.

Process costing
It is used when many identical or similar units of a product or service
are being manufactured, such as on an assembly line. Costs are
accumulated by department or by process.
Process costing is used when the manufacturing process is similar
between different products and the main difference is in the raw
materials.
A clothing factory is a good example of process costing. The shirts that
are made are all made in basically the same way, with the main
difference between different models of shirts is the fabric that goes into
the shirts.
A Prosses Costing System is used when a company Mass-Produces a
product on Continous basis. The Production Department becomes the
Cost Center

Job Costing
It is used when units of a product or service are distinct and separately
identifiable.
Costs are accumulated by job. Accounting firms and lawyers use job
order costing to allocate costs (largely labor) to the different, specific
jobs that the company has.
Job Costing is used when each item is Unique.
---
NOTE : The difference between net income under absorption costing
and under variable costing is fixed manufacturing overhead. Under
variable costing, all of the fixed manufacturing overhead is expensed as
it is incurred. Under absorption costing, an allocated amount of fixed
manufacturing overhead for the units that were sold is expensed.
Variable costing separates fixed manufacturing cost from variable
manufacturing cost by not including fixed manufacturing cost in the
calculation of the cost to produce.
 L2
Variable and Fixed Overhead Expenses
overheads are costs that cannot be traced directly to a specific product
or unit. This unit talks about overheads allocation.
Two ways are used to allocate overheads :
 The traditional method of overhead allocation involves grouping
all manufacturing overhead costs into a cost pool and allocating
them to individual products based on a single cost driver.
 Activity-based costing (ABC) involves using multiple cost pools
and multiple cost drivers to allocate overhead on the basis of a
cost driver specific to each cost pool.

Note : A cost pool is a group of indirect costs that are being grouped
together for allocation based on some cost allocation base.
A cost driver is anything that causes costs to be incurred each time the
driver occurs.

Traditional method
Traditionally, manufacturing overhead costs have been allocated to the
individual products based on either the direct labor hours, machine
hours, materials cost. Its called Activity Base.
When choosing the allocation base (for example, direct labor hours or
machine hours), the base used should closely reflect what causes costs
to be incurred.
Plant-Wide versus Departmental Overhead Allocation
A company can choose to use plant-wide overhead allocation or
departmental overhead allocation.
Plant-wide overhead allocation involves putting all the overhead costs
for the whole plant into one cost pool and allocating the costs in that
cost pool to products using one allocation base. (traditional?)

Departmental overhead allocation Each department’s overhead costs

are put into a separate cost pool, and then each department’s
overhead is allocated according to the allocation base that managers
believe is best for that department. (each department allocate alone?)
Departmental overhead allocation is preferable to Plant-wide overhead
allocation. The greater the number of manufacturing overhead
allocation rates used, the more accurate and meaningful the overhead
allocation will be.
Departmental overhead allocation requires a lot more administrative
and accounting time than Plant-wide allocation and thus is more
Expensive. BUT It could be used by the management for the reason of
acquireing addistional information.

Note: When process costing is being used and products pass through
several different processes or departments before becoming finished
goods, departmental overhead allocation is essential so that each
department’s overhead costs can be applied to the units worked on in
that department as production activities take place and the units move
from department to department.
Calculating the Predetermined Manufacturing Overhead Allocation
Rate
Once the allocation base for manufacturing overhead has been
determined, the predetermined manufacturing overhead allocation
rate is calculated. Its usually calculated at the beginning of the year and
then used throughout the year unless it becomes necessary to change it
during the year.
Predetermined Budgeted Manufactoring Overhead Rate =
Budgeted Monetary Amount of Manufacturing Overhead
Budgeted Activity Level of the Allocation Base
Its Also Means :
Predetermined rate × Budgeted Activity Level (Production) = Budgeted
Manufacturing Overhead (Monetary Amount)

Activity Based Costing (ABC)

Activity-based costing (ABC) is another way of allocating overhead costs
to cost objects (usually products, services, or customers), and it is based
on multiple cost drivers which can be resource consumption or Activity
Cost Drivers.
Activity-based costing determines product cost by identifying the costs
of individual tasks and then assigning these costs to products on the
basis of the tasks needed to produce each product.
ABC is used to trace overhead costs to cost objects by identifying
resources and their costs, the consumption of the resources by
activities, and the consumption of the activities by cost objects.
 L3
Variances
Material Variances
Fixed Overhead Variances
Labor Variance
 L4
Performance Measurement
Customer and Product Profitability Analysis
80-20 rule : 80% of profits usually come from 20% of a firm’s customers.
Furthermore, 20% of a firm’s customers are usually completely
unprofitable. Profitable customers can be attracted and kept through
outstanding customer service and unprofitable customers can be
discouraged with fewer discounts and promotional offers.
Product profitability analysis is just as important as customer
profitability analysis. Product profitability analysis can identify products
and services that are unprofitable so that those products and services
can be either re-priced or discontinued and replaced with new
products and services that are more profitable.

Performance Measurement
The financial success of a segment and the performance of its manager
can be measured in many ways.
Return on Investment (ROI) and Residual Income (RI) are the primary
means of segment financial measurement.

Return on Investment (ROI)

ROI can be used to evaluate the performance of the entire firm or
single divisions of it. It measures the percentage of return that was
earned on the amount of the investment (that is, assets). AND its
calculated as follow :
ROI = Income of Business Unit or Operating Income
(Average) Total Assets of Business Unit or Investment

A manager can also use ROI in determining if the division should accept
a capital investment or project. It helps in the decision prosses.
If the ROI is greater than the expected rate of return the project should
be Accepted.
The required rate of return, also called the hurdle rate, is the minimum
rate of return that a segment or project must earn to justify the
investment of resources. Senior management of the company
determines what the company’s required rate of return should be.
Generally the WACC is the rate of return.
NOTE : Usually average total assets would be used to calculate ROI.
Assuming the information on assets given in the question is year-end
balances and not average balances, information on average total assets
is not available and cannot be calculated from the information given, so
the information that is available is used.

NOTE : If the expected rate of retum on a new investment is greater

than the required rate of retum (usually the cost of capital), residual
income (RI) will increase due to the new investment, even if the ROI
for the new project is lower than the current return on investment.
Residual Income (RI)
Residual Income (RI) attempts to overcome the weakness in ROI by
measuring the amount of monetary return that is provided to the
company by a department or division.
Residual income is the operating income earned after the division has
covered the required charge for the funds that have been invested by
the company in its operations.
Any project that has a positive RI will be accepted, even if it will reduce
the overall company’s or unit’s ROI. Its calculated as follow :

Operating (net) income of business unit

– (Assets of business unit × required/target rate of return)
= Residual Income

Residual Income is the business unit’s actual operating income minus

its target operating income (target return)

NOTE : RI is focused on the monetary amount of income that is in

excess of a targeted amount. It is not focused on a percentage of return
as ROI is.
When using RI to evaluate investment opportunities, any project that
has a positive RI will be accepted even if it will reduce the overall
company's or business unit's ROI. Thus, desirable investment decisions
will not be neglected by high return business units.
 L5
Cost Information for Decision Making

Break-even Analysis
Also known as Cost-volume-profit analysis (CVP), It is used primarily for
short-run decision-making.
Companies use CVP analysis to determine which products they will
supply and the amount they will supply at a given price and cost.
CVP analysis examines the relationship among revenue, costs, and
profits. And to use it several assumptions need to be made :
 All costs are either variable or fixed costs. No mixed or semi.
 Total costs and total revenues are predictable and linear in
relation to output units within the relevant range.
 Changes in the level of total revenues and total costs arise only
because of changes in the number of units produced and sold.
 Total Fixed costs remain constant over the relevant range.
 Unit variable costs remain constant over the relevant range.
 The unit selling price remains constant over the relevant range.
 The time value of money is ignored.
 When a company sells two or more products, a constant sales mix
is assumed.

Contribution Margin
The contribution margin represents the amount of revenues minus
variable costs available to cover fixed costs.
CVS assumes 2 types of costs. Fixed and Variable.
Contribution Margin Per Unit :
= Selling Price per Unit – Variable Costs per Unit

Total Contribution Margin (Fixed Costs) :

= Contribution Margin Per Unit × Number of Units Sold
Or :
Total Contribution Margin = Total Revenue – Total Variable Costs

Contribution Margin Income Statement

Under CVP analysis, the income statement shows variable costs
deducted from revenue, which then produces a key line item that does
not appear on the standard income statement, contribution margin,
and fixed costs are expensed below the contribution margin line, as
follows:
Sales revenue
− Variable costs
= Contribution margin
− Fixed costs
= Operating Income
The preceding formula can be used to check an answer on the exam. At
the breakeven point number of units, the operating income will be $0.
Breakeven Analysis
The Breakeven Point is the point where the Sales covers all the Costs
(Fixed and Variable) and the operating income equals zero.
Managers need to know the level of sales necessary to cover all costs,
both fixed and variable, to avoid a loss.
To calculate the breakeven volume, divide the fixed costs by the
contribution margin per unit:

Breakeven Volume (units) = Total Fixed Costs ÷ Unit Contribution Margin

It Gives us the total units needs to be sold in order to breakeven (not

making profit or loss).

- Marginal Analysis
Marginal analysis examines how benefits and costs respond to
incremental(‫ )تدريجي‬changes in production. Any incremental change
generates benefit And Incure Costs.
Marginal Revenue and Marginal Cost
It refer to the addition to total revenue and the addition to total cost
that result from a one-unit increase in the activity.
The marginal revenue resulting from an increase in activity is the
called the incremental revenue from the increased activity, for
example sale of the additional production. The incremental
 revenue is total revenue after the activity increase minus total
revenue before the activity increase.
The marginal cost resulting from an increase in activity such as
increased production is the called the incremental cost that is
incurred for the increased activity. The incremental cost is total
cost after the activity increase minus total cost before the
activity increase.

Relevant Information Versus Not Relevant Information

One of the primary challenges in the decision-making process is
distinguishing between factors that are relevant to the decision and
factors that are not relevant to the decision.
Relevent Information : They are Factors that focuses on the Future,
And Factors that differ among possible alternatives are relevant.
(wheither fixed,variable costs or revenue)
Not Relevent Information : They include Events or costs incurred in the
past and cannot be changed (like sunk costs), And Revenues and costs
that are the same for all the options under consideration are not
relevant.
Note : A sunk cost is a cost for which the money has already been spent
and cannot be recovered.

- Differential and Incremental Revenues and Costs.

Differential revenues and costs are those that differ between two
alternatives.
Incremental revenues are those that are received additionally because
of an activity, and incremental costs are those that are incurred
additionally because of an activity. (can be fixed or variable)

- Avoidable and Unavoidable Costs

An avoidable cost is an existing cost that can be avoided because the
cost will go away if a particular option is selected. Avoidable costs are
relevant to the decision-making process because they will continue if
one course of action is taken but they will not continue (that is, will be
avoidable) if a different course of action is taken.
An unavoidable cost is an expenditure that cannot be avoided and will
not go away, regardless of which course of action is taken. Unavoidable
costs are not relevant to the decision at hand because they do not
differ between alternatives.

Accounting Versus Economic Concepts of Costs and

Opportunity Costs

From an accounting perspective, only explicit costs (accounting costs)

are considered. An explicit cost is a cost that can be identified and
accounted for.
For the economists, not only the typical costs such as monetary
expenditures are part of all the costs that a company or an individual
incur, but the potential earnings from a forgone alternative that had to
be dismissed to achieve a particular goal are also considered.
The potential earnings from the forgone alternative are called an
opportunity cost.

- Opportunity cost:
By definition opportunity cost is the benefit to income (inflow) that is
lost by not using a limited resource for its best alternative use. Or :
Its is the benefit that could have been gained from an alternative use
of the same resource.
Opportunity cost is calculated only from the revenues that would not
be received and expenditures that would not be made for the other
available alternative.
An opportunity cost is a type of implicit cost. An implicit (or imputed)
cost is an implied cost that does not appear in the income statement,
but it affects the company’s net income just as if it were in the income
statement. An opportunity cost is an economic cost and an implicit cost.
Both explicit and implicit costs must be used in making decisions.
Therefore, relevant costs may include opportunity costs because
opportunity costs are in the future and differ between alternatives just
as surely as accounting costs do.
Opportunity costs can and should be estimated in any decision where
they are a factor.
Opportunity cost is calculated only from the revenues that would not
be received and expenditures that would not be made.