An Introduction to Cost

Terms and Purpose

Learning Objective
• Define and illustrate a cost object
Distinguish between direct costs and indirect costs
• Explain variable costs and fixed costs
• Interpret unit costs cautiously
• Distinguish inventoriable costs from period costs
• Illustrate the flow of inventoriable and period costs
• Explain why product costs are computed in different ways for
different purposes
• Describe
Basic Cost Terminology
• Cost – a sacrificed or forgone resource to achieve a specific objective.
• Actual cost – a cost that has occurred
• Budgeted cost – a predicted cost
• Cost object – anything for which a cost measurement is desired
Cost Object
Cost Object Illustration
Product A BMW X6 sports activity vehicle
Telephone hotline providing information and assistance to BMW dealers
Service

R&D project on DVD system enhancement in BMW cars

Project

Herb Chambers Motors, a dealer that purchases a broad range of BMW

Customer
vehicles
Setting up machines for production or maintaining production equipment
Activity

Department Environmental, Health and Safety department

Basic Cost Terminology (2 of 2)
• Cost Accumulation – the collection of cost data in an organized way by means of
an accounting system
• Cost Assignment – a general term that encompasses the gathering of accumulated
costs to a cost object in two ways:
• Tracing costs with a direct relationship to the cost object, and
• Allocating accumulated costs with an indirect relationship to a cost object.
Direct and Indirect Costs
• Direct costs can be conveniently and economically traced (tracked) to
a cost object.
• Indirect costs cannot be conveniently or economically traced (tracked)
to a cost object. Instead of being traced, these costs are allocated to a
cost object in a rational and systematic manner.
Cost Assignment to a Cost Object (BMW
Example
Cost Allocation Challenges
Direct Costs
Material (steel or tires for a car, as an example)
Labor (Assembly line wages)
Indirect Costs
Electricity
Rent
Property taxes
Plant administration expenses
Factors Affecting Direct /Indirect Cost
Classifications
• The materiality of the cost in question.
• The available information-gathering technology.
• Design of operations.
NOTE: a specific cost may be both a direct cost of one cost object and
an indirect cost of another cost object.
The direct/indirect classification depends on the choice of the cost
object.
Cost Behavior Patterns: Variable Costs And
Fixed Costs – (1 of 2
• Variable costs change, in total, in proportion to changes in the related
level of activity or volume of output produced.
• Fixed costs remain unchanged, in total, for a given time period,
despite changes in the related level of activity or volume of output
produced.
• Costs are fixed or variable for a specific activity and/or for a given
time period.
Cost Behavior Patterns: Variable Costs and
Fixed Costs – (2 of 2)
• Variable costs are constant on a per-unit basis. If a product takes 5
pounds of material each, it stays the same per unit regardless if one,
ten or a thousand units are produced.
• Fixed costs per unit change inversely with the level of production. As
more units are produced, the same fixed cost is spread over more and
more units, reducing the cost per unit
 Cost Behaviour Summarized
- TOTAL DOLLARS COST PER UNIT

VARIABLE COSTS Change in proportion with output Unchanged in relation to output

(more output = more cost)

FIXED COSTS Unchanged in relation to output Change inversely with output

(within the relevant range) (more output = lower cost per unit)
Other Cost Concepts
• Mixed costs have both fixed and variable elements
• Cost driver – a variable, such as the level of activity or volume, that
causally affects costs over a given time span.
• Relevant range – the band or range of normal activity level (or
volume) in which there is a specific relationship between the level of
activity (or volume) and the cost in question.
• Fixed costs are considered fixed only within the relevant range.
Multiple Classification of Costs
• Costs may be classified as:
• Direct/Indirect, and
• Variable/Fixed
• These multiple classifications give rise to important cost combinations:
• Direct and variable
• Direct and fixed
• Indirect and variable
• Indirect and fixed
Examples of the Multiple Classifications Of
Costs
Use Unit Costs Cautiously
• Although unit costs are regularly used in financial reports and for
making product mix and pricing decisions, managers should
think in terms of total costs rather than unit costs for many
decisions.
Different Types of Firms
1. Manufacturing-sector companies purchase materials and components
and convert them into various finished goods.
2. Merchandising-sector companies purchase and then sell tangible
products without changing their basic form.
3. Service-sector companies provide services (intangible products) like
legal advice or audits.
Commonly Used Classifications of
Manufacturing Costs
• Also known as inventoriable costs:
• Direct materials – acquisition costs of all material that will become
part of the cost object.
• Direct labor – compensation of all manufacturing labor that can be
traced to the cost object.
• Indirect manufacturing – all manufacturing costs that are related to
the cost object but cannot be traced to that cost object in an
economically feasible way.
Inventoriable Costs vs Period Costs
• Inventoriable costs are all costs of a product that are considered
assets in a company’s balance sheet when the costs are incurred and
that are expensed as cost of goods sold only when the product is
sold. For manufacturing companies, all manufacturing costs are
inventoriable costs.
• Period costs are all costs in the income statement other than cost of
goods sold. They are treated as expenses of the accounting period
in which they are incurred.
Cost Flows
The Cost of Goods Manufactured and the cost of goods sold
section of the income statement are accounting representations of
the actual flow of costs through a production system.
Note how inventoriable costs go through the balance sheet
accounts of direct materials, work-in-process and finished goods
inventory before entering the cost of good sold in the income
statement.
Scope of Cost Accounting
• Following functional activities are included in cost accounting
• Costing: It is concerned with ascertainment of cost of products,
processes, jobs, services etc
• Cost book keeping: It involves maintaining complete records of all
costs incurred from their incurrence up to the charging to final products/
service.
• Cost analysis: Costs recorded in the books are analyzed according to
categories
• Cost Control: Cost Accounting includes the comparison of actual cost
incurred with the predetermined standard cost so that the difference can
be analyzed
Scope contd.
• Cost reports: Cost Accounting includes presentation of periodical
cost reports such as weekly , monthly reports for use by
management at different levels.
• Cost Audit: is the verification of cost accounts and a check on the
adherence to the cost accounting plan
Statement of Cost
Total Product X Product Y Product Z
Materials 75000 40000 12000 23000
Wages 20000 10000 5000 5000
Other Expenses 25000 20000 3000 2000
Total Cost
Sales 1,50,000 96,000 28,000 26,000
Cost vs Expense and Loss
• Often the terms cost and expense are used interchangeably .
• Expense is defined as an expired cost resulting from a productive
usage of an asset
• Loss is defined as reduction in a firm’s equity other than firm
withdrawals of capital for which no compensating value has been
received.