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Lecture 02

Cost Concepts and Classifications

Md. Shawfiqul Islam (MSI)


MBA (HRM), BBA (MGT Studies)
Lecturer, Dept. of Management Studies
Jagannath University, Dhaka
shawfiqul@mgt.jnu.ac.bd 01913079059
Learning objectives
LO1 Identify and give examples of each of the three basic manufacturing cost
categories.
LO2 Distinguish between product costs and period costs and give examples of each.
LO3 Understand cost behavior patterns including variable costs, fixed costs, and mixed
costs.
LO4 Analyze a mixed cost using a scatter graph plot and the high-low method.
LO5 Prepare income statements for a merchandising company using the traditional and
contribution formats.
LO6 Understand the differences between direct and indirect costs.
LO7 Understand cost classifications used in making decisions: differential costs,
opportunity costs, and sunk costs
Definition of Cost

Cost is ''the amount of expenditure actual (or notional)


incurred on or attributable to a specific thing or activity".

Cost is incurred (or potentially to be incurred) to achieve a


specific objective.

It is the amount of resources given up in exchange for goods


and / or services.
Classification of Cost
Expired Cost

Expired cost represents an expenditure from which no further benefit is


expected.

Expired cost may be either an 'expense' or a 'loss'.


Expired Cost
a. Expense
Expense is that part of expired cost, the benefit (or utility) of which is
directed towards productive activities.
Expense may also be referred to as utilized part of expired cost.
An expired cost becomes an expense when the asset (or service) is used up
for economic benefit.
Thus, expense represents sacrifice of resources for an economic benefit.
Expense is matched (or charged) against revenue in order to arrive at the
profit or loss of the period.
b. Loss
Loss may be defined as an expired cost without any matching
economic benefit (such as : loss of stock by fire, abnormal idle
time, etc.).
Loss is that part of expired cost, the utility of which is lost
before it is being used for productive purposes.
Loss may also be referred to as unutilized part of expired cost.
Loss can also be termed as the difference between the
expenses and revenue (when expenses exceed revenue) for an
accounting period.
Unexpired Cost

Unexpired (or deferred) cost refers to the cost for which


expenditure has been incurred but the economic benefit
has not been received during the current accounting
period. e.g. prepaid rent, prepaid insurance, unutilized part
of asset, etc.

Unexpired (or deferred) cost does not form part of


product cost. It is shown as an asset in the Balance sheet.
Cost Classifications for Assigning Costs to Cost Objects

Cost object is anything for which cost data are desired


including
-products, customers, jobs, and organizational subunits.
For purposes of assigning costs to cost objects, costs are
classified as either direct or indirect.
Direct Cost
A direct cost is a cost that can be easily and conveniently traced
(cost-effective) to a specified cost object.
Cost Object Illustration
Product A BMW X5 sports activity vehicle
Service Telephone hotline providing information and
assistance to BMW dealers
Project R&D project on enhancing the DVD system in BMW
Customer Herb Chambers Motors, the BMW dealer that
purchases a broad range of BMW vehicles
Activity Setting up machines for production or maintaining
production equipment
Department Environmental, health, and safety department
Direct Cost
For example, the cost of steel or tires is a direct cost of
BMW X5s. The cost of the steel or tires can be easily
traced to or identified with the BMW X5. The workers on
the BMW X5 line request materials from the warehouse
and the material requisition document identifies the cost
of the materials supplied to the X5.
If a printing company made 10,000 brochures for a
specific customer, then the cost of the paper used to make
the brochures would be a direct cost of that customer.
Indirect Cost
An indirect cost is a cost that cannot be easily and conveniently
traced to a specified cost object.
For example, the salaries of plant administrators (including plant
manager) who oversee production of the many different types of
cars produced at the plant are an indirect cost of the X5s.
Plant administration costs are related to the cost object (X5s)
because plant administration is necessary for managing the
production of X5s. Plant administration costs are indirect costs
because plant administrators also oversee the production of other
products
Indirect Cost
To be traced to a cost object such as a particular product,
the cost must be caused by the cost object.
The factory managers salary is called a common cost of
producing the various products of the factory.
A common cost is a cost that is incurred to support a
number of cost objects but cannot be traced to them
individually. A common cost is a type of indirect cost.
Direct Costs and Indirect Costs
Direct Costs Indirect Costs
Costs that can be easily and Costs cannot be easily and
conveniently traced to a unit of conveniently traced to a unit of
product or other cost objective. product or other cost object.
Examples: direct material and Example: manufacturing
direct labor overhead
Cost assignment is a general term that encompasses both
(1) tracing direct costs to a cost object and
(2) allocating indirect costs to a cost object.

Cost Allocation is A Challenging task


Factors Affecting Direct/Indirect Cost
Classifications
The materiality of the cost in question
Available information-gathering technology
Design of operations
Identify Direct-Indirect Costs: Northwest Hospital is a full-service hospital, provides
everything from major surgery and emergency room care to outpatient clinics.
Cost Cost Object Direct Indirect
Ex. Catered food served to patients A particular patient X
1. The wages of pediatric nurses The pediatric department
2. Prescription drugs A particular patient
3. Heating the hospital The pediatric department
4. The salary of the head of pediatrics The pediatric department
5. The salary of the head of pediatrics A particular pediatric patient
6. Hospital chaplains salary A particular patient
7. Lab tests by outside contractor A particular patient
8. Lab tests by outside contractor A particular department
Cost Cost Object Direct Indirect
Ex. Catered food served to patients A particular patient X
1. The wages of pediatric nurses The pediatric department X
2. Prescription drugs A particular patient X
3. Heating the hospital The pediatric department X
4. The salary of the head of pediatrics The pediatric department X
5. The salary of the head of pediatrics A particular pediatric patient X
6. Hospital chaplains salary A particular patient X
7. Lab tests by outside contractor A particular patient X
8. Lab tests by outside contractor A particular department X
Cost Classifications for Manufacturing Companies
Direct Direct Manufacturing
Materials Labor Overhead

The Product
Direct Materials
Direct material costs: the acquisition costs of all materials that
eventually become part of the cost object and can be traced to the cost
object

Those materials that become an integral part of the product.

Example: A radio installed in an automobile


Direct Labor

Direct manufacturing labor costs: the compensation of all manufacturing


labor that can be traced to the cost object (or can be easily traced to
individual units of product).

Example: Wages paid to automobile assembly workers


Manufacturing Overhead
Manufacturing costs that cannot be traced directly to specific units
produced.
(also called manufacturing overhead/factory overhead costs)
Costs Related
Indirect Indirect to the
Materials Labor Manufacturing
Facility

Manufacturing Overhead
Manufacturing Overhead
Materials used to support the
Indirect production process.
Examples: lubricants and cleaning
Materials supplies used in the automobile
assembly plant.
Wages paid to employees who are not
Indirect directly involved in production work.
Labor Examples: maintenance workers,
janitors and security guards.
Costs Related Costs related to the manufacturing
to the facility.
Manufacturing Examples: property taxes, utilities,
Facility depreciation, insurance, repairs.
Nonmanufacturing Costs
(1) Selling costs (order-getting and order-filling costs): All costs that are
incurred to secure customer orders and get the finished product to the
customer e.g., advertising, shipping, sales travel, sales
commissions, sales salaries, and costs of finished goods
warehouses.
(2)Administrative costs: All costs associated with the general
management of an organization rather than with manufacturing or
selling e.g., executive compensation, general accounting,
secretarial, public relations, and general administration of the
organization as a whole.
Manufacturing Cost Flows
Balance Sheet Income Statement
Costs Inventories Expenses
Material Purchases Raw Materials

Direct Labor Work in


Process
Manufacturing Cost of
Overhead Finished Goods
Goods Sold

Selling and Period Costs Selling and


Administrative Administrative
Cost Classification on The Basis of Inventory
Product Costs versus Period Costs
Product costs include direct Period costs are not included in
materials, direct labor, and product costs. They are expensed
manufacturing overhead. on the income statement.

Inventory Cost of Good Sold Expense

Sale

Balance Income Income


Sheet Statement Statement
The PC Works assembles custom computers from components supplied by
various manufacturers. Listed below are some of the costs that are incurred
at the company.
For each cost, indicate whether it would most likely be classified as direct labor, direct
materials, manufacturing overhead, selling, or an administrative cost.
1. The cost of a hard drive installed in a computer.
2. The cost of advertising in the Puget Sound Computer User newspaper.
3. The wages of employees who assemble computers from components.
4. Sales commissions paid to the companys salespeople.
5. The wages of the assembly shops supervisor.
6. The wages of the companys accountant.
7. Depreciation on equipment used to test assembled computers before release
to customers.
8. Rent on the facility in the industrial park.
1. The cost of a hard drive installed in a computer: direct materials.
2. The cost of advertising in the Puget Sound Computer User newspaper: selling.
3. The wages of employees who assemble computers from components: direct labor.
4. Sales commissions paid to the companys salespeople: selling.
5. The wages of the assembly shops supervisor: manufacturing overhead.
6. The wages of the companys accountant: administrative.
7. Depreciation on equipment used to test assembled computers before release to
customers: manufacturing overhead.
8. Rent on the facility in the industrial park: a combination of manufacturing
overhead, selling, and administrative. The rent would most likely be prorated on the
basis of the amount of space occupied by manufacturing, selling, and administrative
operations.
Types of inventories for Manufacturing-sector companies
1. Direct materials inventory. Direct materials in stock
and awaiting use in the manufacturing process
2. Work-in-process inventory. Goods partially worked
on but not yet completed. This is also called work in
progress.
3. Finished goods inventory. Goods (for example,
cellular phones) completed but not yet sold.
Step 1: Cost of direct materials used

Beginning inventory of direct materials, January 1, 2011 $11,000


+ Purchases of direct materials in 2011 73,000
Cost of Direct Materials 84,000
Ending inventory of direct materials, December 31, 2011 8,000
Direct materials used in 2011 $76,000
Step 2: Total manufacturing costs incurred

(i) Direct materials used in 2011 $ 76,000


(ii) Direct manufacturing labor in 2011 9,000
(iii) Manufacturing overhead costs in 2011 20,000
Total manufacturing costs incurred in 2011 $105,000
Step 3: Cost of goods manufactured

Beginning work-in-process inventory, January 1, 2011 $ 6,000


+ Total manufacturing costs incurred in 2011 105,000
Total manufacturing costs to account for 11 1,000
Ending work-in-process inventory, December 31, 2011 7,000
Cost of goods manufactured in 2011 $104,000
Step 4: Cost of goods sold
Beginning inventory of finished goods, January 1, 2011 $ 22,000
+ Cost of goods manufactured in 2011 104,000
Cost of goods available for sale 126,000
Ending inventory of finished goods, December 31, 2011 18,000
Cost of goods sold in 2011 $108,000

Gross Profit/Margin = Revenues CGS= $210,000- $108,000 = $102,000


Prime Cost and Conversion Cost
Prime cost is the sum of direct materials cost and direct
labor cost.
Conversion cost is the sum of direct labor cost and
manufacturing overhead cost. The term conversion cost is used
to describe direct labor and manufacturing overhead because
these costs are incurred to convert materials into the finished
product.
Direct materials . . . . . . . . . . . . . . . . . . . . . $69,000
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . $35,000
Manufacturing overhead . . . . . . . . . . . . . . $14,000
Selling expenses . . . . . . . . . . . . . . . . . . . . $29,000
Administrative expenses . . . . . . . . . . . . . . $50,000
Product cost=Direct materials + Direct labor+ Manufacturing overhead
= $69,000 + ? + $14,000 = $118,000
Period cost = Selling expenses + Administrative expenses
= $29,000 + ? = $79,000
Conversion cost + Direct labor + Manufacturing overhead
= $35,000 + ? = $49,000
Prime cost = Direct materials + Direct labor
= $69,000 + ? = $104,000
Suppose, you have been given a job at Issac.Aircams, that manufactures spy cameras. You have been asked to prepare
the financial statements and were given list of costs to Classify those as either product costs or period cost
1. Depreciation on salespersons cars.
2. Rent on equipment used in the factory.
3. Lubricants used for machine maintenance.
4. Salaries of personnel who work in the finished goods warehouse.
5. Soap and paper towels used by factory workers at the end of a shift.
6. Factory supervisors salaries.
7. Heat, water, and power consumed in the factory.
8. Materials used for boxing products for shipment overseas. (Units are not normally boxed.)
9. Advertising costs.
10. Workers compensation insurance for factory employees.
11. Depreciation on chairs and tables in the factory lunchroom.
12. The wages of the receptionist in the administrative offices.
13. Cost of leasing the corporate jet used by the companys executives.
14. The cost of renting rooms at a Florida resort for the annual sales conference.
15. The cost of packaging the companys product.
Pro Pre
1. Depreciation on salespersons cars. x
2. Rent on equipment used in the factory. x
3. Lubricants used for machine maintenance. x
4. Salaries of personnel who work in the finished goods warehouse. x
5. Soap and paper towels used by factory workers at the end of a shift. x
6. Factory supervisors salaries. x
7. Heat, water, and power consumed in the factory. x
8. Materials used for boxing products for shipment overseas(Units, normally unboxed) x
9. Advertising costs. x
10. Workers compensation insurance for factory employees. x
11. Depreciation on chairs and tables in the factory lunchroom. x
12. The wages of the receptionist in the administrative offices. x
13. Cost of leasing the corporate jet used by the companys executives. x
14. The cost of renting rooms at a Florida resort for the annual sales conference. x
15. The cost of packaging the companys product. x
Cost Classifications for Predicting Cost Behavior
How a cost will react to
changes in the level of
business activity?
Total change when activity
changes.
Total remain unchanged when
activity changes.
Cost behavior refers to how a cost reacts to changes in
the level of activity
The level of activity or volume is a cost driver if
there is a cause-and-effect relationship between a
change in the level of activity or volume and a change
in the level of total costs.
Costs are defined as variable or fixed with respect to a
specific activity and for a given time period.
A variable cost changes in total in proportion to
changes in the related level of total activity or volume.
A fixed cost remains unchanged in total for a given
time period, despite wide changes in the related level
of total activity or volume.
If BMW buys a steering wheel at $60 for each of its BMW X5 vehicles,
then the total cost of steering wheels is $60 times the number of vehicles
produced, as the following table illustrates.
Total cost changes in proportion to changes in the
number of vehicles produced.
The cost per unit of a variable cost is constant.
When considering how variable costs behave, always
focus on total costs.
Suppose BMW incurs a total cost of $2,000,000 per year for supervisors
who work exclusively on the X5 line. These costs are unchanged in total
over a designated range of the number of vehicles produced during a
given time span
Fixed costs become smaller and smaller on a per unit basis as
the number of vehicles assembled increases.
The same fixed cost is spread over a larger number of X5s.
Do not be misled by the change in fixed cost per unit.
Just as in the case of variable costs, when considering fixed
costs, always focus on total costs.
Costs are fixed when total costs remain unchanged despite
significant changes in the level of total activity or volume.
Cost Classifications for Predicting Cost
Behavior
Behavior of Cost (within the relevant range)
Cost In Total Per Unit

Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.
Mixed Cost or Semi-variable Cost
A mixed cost contains both variable and fixed cost elements. Mixed costs are
also known as semi variable costs.
Examples of mixed costs include electricity and telephone bills. A portion of
these expenses are usually consists line rent. Line rent normally is fixed for
each month. Variable portion consists units consumed or calls made.
Mixed cost and level of activity can be expressed by the following equation :
Y = a + bX In this equation,
Y = The total mixed cost
a = The total fixed cost (the vertical intercept of the line)
b = The variable cost per unit(the slope of the line)
X = The level of activity
The Nooksack Expeditions incurs a mixed cost called fees paid
to the state.
It includes a license fee of $25,000 per year plus $3 per
rafting party paid to the states Department of Natural
Resources.
If the company runs 1,000 rafting parties this year, then the
total fees paid to the state would be $28,000, made up of
$25,000 in fixed cost plus $3,000 in variable cost.
Relationships of Types of Costs
We have introduced two major classifications of costs:
direct/indirect and variable/fixed.
Costs may simultaneously be as follows:
Direct and variable
Direct and fixed
Indirect and variable
Indirect and fixed
Cost Classifications for Preparing
Financial Statements
Merchandising and manufacturing firms, both prepare financial
statement reports for creditors, stockholders, and others to show the
financial condition of the firm and the firm's earnings performance over
some specified intervals.

Merchandising companies simply purchase goods and resale them to


customers. Financial statement reports are therefore simple in case of
merchandising companies.

Manufacturing companies are more complex organizations than


merchandising companies because the manufacturing companies must
produce its goods as well as market them.
Balance Sheet
The balance sheet or statement of financial position of a
manufacturing company is similar to that of a merchandising
company.

However, the inventory accounts differ between two types of


companies.
Balance Sheet
A Manufacturing Corporation Inventory Accounts

A Manufacturing Corporation
Inventory Accounts
Beginning Balance Ending Balance

Raw materials

Work in process

Finished goods
A Merchandising Company Inventory Accounts

A Merchandising Corporation
Inventory Accounts

Beginning Balance Ending Balance

Merchandising Inventory
Income Statement
Manufacturing Company Merchandising Company

Beginning Finished Goods Beginning Merchandise


Inventory Inventory
Add: Cost of Goods Add: Purchase
Manufactured
Cost of Goods Available for Goods Available for Sale
Sale
Less: Ending Finished Goods Less: Ending Merchandise
Inventory Inventory
Cost of Goods Sold Cost of Goods Sold
Schedule of Cost of Goods Manufactured

Direct Materials:
Beginning Raw Material Inventory ****
Add: Purchase of Raw Materials ****
Cost of Raw Materials Available for Use ****
Less: Ending Raw Material Inventory ****
Cost of Raw Material Used in Production ****
(ii) Direct Labor ****
(iii) Manufacturing Overhead ****
Total Manufacturing Cost (i+ii+iii) ****
Beginning Work in Process Inventory ****
Cost of Goods in Process ****
Less: Ending Work in process ****
Cost of Goods Manufactured ****
Income Statement-Manufacturing Company

Net Sales
Less: Cost of good sold ****

Gross Profit
Less: Operating Expense/ Non-Manufacturing Cost
Selling & Distribution ****
Administrative & General ****
Operating Profit/EBIT
Less: Non-operating Expense:
Bank Interest ****
Bank Charges & Commission ****
Profit Before Tax
Provision For Taxes ****
Net Profit After Taxes
Income Statement-Manufacturing Company

Balance of Profit B/F from previous year ****

Surplus Available for Appropriation ******

Less: Appropriation
Transfer to General Reserve ****

Proposed Dividend ****

Balance of Profit/ Retained Earning to B/S ******


Income Statement Merchandising Company

Sales
Less: Cost of good sold
Beginning merchandising inventory ****
Add: Purchases ****
Goods Available for Sale ****
Less: Ending Merchandising Inventory ****

Gross Margin
Less : Operating Expenses
Selling Expenses ****
Administrative Expenses ****

Net Operating Income


Cost Classification for Decision
Making
For the purpose of decision making, costs are usually
classified as-
Differential cost,
Opportunity cost, and
Sunk cost.
Relevant cost
Imputed cost
Out-of-pocket cost
Shutdown cost
Differential Costs and Revenues
Costs and revenues that differ among alternatives.

Example: You have a job paying $1,500 per month in your


hometown. You have a job offer in a neighboring city that
pays $2,000 per month. The commuting cost to the city is
$300 per month.

Differential revenue is:


$2,000 $1,500 = $500

Differential cost is:


$300
Opportunity Costs
The potential benefit that is
given up when one
alternative is selected over
another.

Example: If you were


not attending college,
you could be earning
$15,000 per year.
Your opportunity cost
of attending college for one
year is $15,000.
Sunk Costs
Sunk Cost is the sum that has already been incurred and cannot be recovered by
any decision made now or in future.

Example: A special purpose machine was bought by a company for $ 100,000. The
machine was used to make the product for which it was bought and now it is
obsolete and cannot be sold. And it will be unwise to continue using that obsolete
product to recover the original cost of the machine. In order words, $ 100000
already spent on that machine cannot be recovered in future. Such costs are said to
be sunk costs and should be ignored in decision making process.
Northwest hospitals Radiology Department is considering replacing an old inefficient X-ray
machine with a state-of-the-art digital X-ray machine. The new machine would provide higher
quality X-rays in less time and at a lower cost per X-ray. It would also require less power and would
use a color laser printer to produce easily readable X-ray images. Instead of investing the funds in
the new X-ray machine, the Laboratory Department is lobbying the hospitals management to buy a
new DNA analyzer.
Item/Costs: Differential Opportunity Sunk
Ex. Cost of X-ray film used in the old machine x
1. Cost of the old X-ray machine . . . . . . . . . . . . . . . . . . . . . x
2. The salary of the head of the Radiology Department . . .
3. The salary of the head of the Pediatrics Department . . .
4. Cost of the new color laser printer . . . . . . . . . . . . . . . . . . x
5. Rent on the space occupied by Radiology . . . . . . . . . . .
6. The cost of maintaining the old machine . . . . . . . . . . . . . x
7. Benefits from a new DNA analyzer . . . . . . . . . . . . . . . . . x
8. Cost of electricity to run the X-ray machines . . . . . . . . . x
Note:
the salaries of the head of the Radiology Department
the salaries of the head of the Pediatrics Department and
the rent on the space occupied by Radiology are
neither differential costs, nor opportunity costs, nor sunk costs.
These costs do not differ between the alternatives and therefore are
irrelevant in the decision, but they are not sunk costs because they
occur in the future.
Relevant and Irrelevant Cost
In any managerial decision involving two or more alternatives, the prime focus of
analysis is to find out which alternative is more profitable.
The profitability of alternatives is determined by considering the revenues generated by
and costs incurred under each alternative.
Such costs, stay the same regardless of which alternative is chosen while some costs may
vary between the alternatives, is either relevant or irrelevant.
Examples of situations in which the relevant vs irrelevant classification is useful include
decisions regarding:
Shutting down a division of a business,
Accepting an special order at lower price,
Making a product in-house or purchasing it from outside,
Selling a semi-finished product or processing it further, etc.
Relevant costs are costs that are affected by a managerial decision in a particular
business situation. In other words these are the costs which shall be incremental
(additional) or avoidable cost.
Incremental cost refers to an increase in cost between two alternative.
Avoidable costs are those which are not incurred from one alternative to
another.

As the name suggests they are relevant for managerial analysis and should be
considered in all calculations made for the purpose.
Irrelevant costs are costs that are not affected by the ultimate decision. In
other words, these are the costs which shall be incurred in the all managerial
alternatives being considered.

Since they are the same in all alternatives, they become irrelevant and need not
be considered in calculations made for managerial analysis.
Example: Vital Industries is a company that manufactures personal care products. It
has three divisions: hair care, skin care and dental care. Following is an extract from
the financial statements for the year ending 31 December 2014:
Hair Care Skin Care Dental Care
Revenue $900 million $600 million $300 million
Net income/(loss) $210 million $100 million ($50 million)

The company should dispose of the dental care division because it is loosing
money. The CEO argued that the board cant conclude that a segment is losing
money just because it generated net loss for a period. The CFO is asked to identify
which of the following costs are relevant for the decision:
1.CEOs salary
2.Salaries of Dental Care workers who can be laid-off
3.Salaries of Dental Care workers who cant be laid-off
4.One-time retirement benefits to be paid to laid-off workers
5.Cost of raw materials consumed by Dental Care division
6.Annual directors fee
7.Interest paid on loans raised for Dental Care division
8.Salary of the Dental Care chief operating officer
9.Company-wide quality certification fee
10.License fee paid for the rights to manufacture dental care products
11.Head office rent
12.Audit fee (if it doesnt depends on the number of divisions)
Two alternatives, (a) dental care division is sold off & (b) dental care division
continues to operate, are dependent to relevant costing
2. Salaries of employees who can be laid off-relevant, the cost shall continue to be
incurred if the division exists but it shall be reduced to zero if the division is disposed off.
4. One-time retirement benefits cost-relevant, it shall be incurred only if the division is
disposed off. If the division continues to operate, the cost shall continue to be incurred
5. Cost of raw materials-relevant cost, it shall be zero if the division no longer operates
because then there will be no production
7. Interest paid on dental care division loans-relevant, if the division is sold off the loan
could be paid off which shall cease the interest cost.
8. Salary of the dental care chief operating officer-relevant, he will most likely lose his job.
If he is accommodated in another division, this cost shall be irrelevant.
10. License fee paid for manufacturing dental care products-relevant cost, it shall cease
with disposal of the division.
1. CEOs salary- irrelevant, it shall remain the same whether the dental care division exists
or it is disposed off.
3. Salaries of employees who cant be laid-off- irrelevant, it shall continue to be incurred
regardless of whether the division is disposed off or not.
6. Annual directors fee- irrelevant cost, it shall stay the same even if dental care is disposed
off.
9. Company-wide quality certification fee- irrelevant, it shall continue to be incurred even if
dental care division is no longer there.
11. Head office rent- irrelevant, it shall remain the same regardless of the number of
divisions. If a division is sold-off, head-office will still exist and the office rent shall be
incurred.
12. Audit fee- irrelevant if it does not depend on the number of divisions. Audit shall be
conducted even if there is one division less.
Imputed or Notional Cost
It is a hypothetical cost taken into account in a particular situation to
represent a benefit enjoyed by an entity in respect of which no actual
expense is incurred.
This cost does not enter into traditional accounting system.
Example:
A business own a building that is used as a warehouse. The building
could have been rented. Here, imputed cost of using building as a
warehouse is rentals sacrificed.
Interest on internally generated fund i.e. interest on own capital,
Salaries of owners of a single proprietorship.
Imputed or Notional Cost
The revenue foregone (loss of interest) represent an opportunity cost.

Thus imputed costs are opportunity cost.

It does not involve cash outlay.


Out-of-Pocket Cost
o Out-of-pocket costs are those costs that require a cash payment in the current
period or during a project.
o It refers to costs that individuals pay out of their own cash reserves to
maintain a fixed asset.
o Examples of out-of-pocket expenses:
o gasoline for a car,
o repairing an old building,
o taking a business client to lunch, and
o certain medical payments such as prescription costs.
For example, if one purchases a car and later pays to have it repaired and filled
with gas, the repairs and the gas are both out-of-pocket expenses, as they are costs
above and beyond the cost of purchasing the car, which the car owner has to pay
out of his personal budget.
Shut Down Cost

o Shut down costs are those costs which have to be incurred under
all situations in the case of stopping manufacture of a product or
closing down a department or division.

o These costs refer to minimum fixed costs which are incurred in the
event of closure of a department or division.
Shut Down Cost
o If the manufacture of a product is stopped, variable costs like direct
materials, direct labor variable factory overhead will not be incurred.

o However, a part of fixed costs associated with the product will be incurred
such as rent, watchmans salary, property tax etc.

o Such fixed costs are unavoidable.


Cost Classification on the Basis of
Controllability
Controllable Cost

Uncontrollable Cost

Standard Cost
Controllable Cost

Controllable costs are those which can be controlled or regulated through


observation by an executive and therefore they can be used for assessing the
efficiency of the executive. Most of the costs are controllable.
Example: Inventory costs can be controlled at the shop level etc.

This is the cost which can be influenced by the action of a specified member of
an undertaking.

It is the cost over which a manager has direct & complete decision authority.
e.g. indirect labor, lubricant, cutting tools & power cost.
Uncontrollable Cost
Non Controllable Costs, the which cannot be subjected to administrative
control and supervision are called non controllable costs.
Example: Costs due obsolesce and depreciation, capital costs etc.
This is the cost which can not be influenced by the action of a specified
member of an undertaking.

Standard Costs
These costs are planned or predetermined cost estimates for a unit of
output in order to provide a basis for comparison with actual cost.
Classification of Labor Costs

o Idle Time
o Overtime premium
o Fringe Benefits
Idle Time
o Machine break downs, materials shortages, power failure, and the like result in idle time.
o The labor costs incurred during idle time are ordinarily treated as manufacturing
overhead cost rather than as a direct labor cost.
o For example, the normal weekly working hours of a worker are 48 and he is paid @
$8 per hour. If he remains idle for 6 hours due to power failure, then the cost of 42
hours would be treated as direct labor cost and the cost of 6 hours (idle time) would be
treated as indirect labor cost and included in manufacturing overhead cost.
Overtime Premium
o The overtime premium paid to all factory workers (direct labor as well as indirect
labor) is usually considered to be part of manufacturing overhead and is not
assigned to any particular order.
o For example, a worker normally works for 48 hours per week @ $8 per hour. In
a particular week, if he works for 52 hours and company pays him $12 for every
hour worked in excess of 48 hours, the allocation of the labor cost of the worker
would be made as follows:
Labor Fringe Benefits
Labor fringe benefits are made up of employment-related costs paid by
the employer and include the cost of
Insurance programs,
Retirement plans,
Various supplemental unemployment benefits, and
Hospitalization plans.
Employer's share of social security,
Medicare,
Workers' commission,
Federal employment tax,
State unemployment insurance.
Cost Classification on the Basis of Normality
Normal Cost
Regular costs which are incurred in the normal conditions
during the normal operations of the organization. They are the
sum of actual direct materials cost, actual labor cost and other
direct expense. Example: repairs, maintenance, salaries paid to
employees.
Abnormal Cost
Abnormal Cost are the costs which are unusual or irregular which are
not incurred due to abnormal situation s of the operations or
productions. Example: destruction due to fire, shut down of
machinery, lock outs, etc.
Cost Classification on the Basis of Accounting Period
Capital Expenditure
A capital expenditure is an amount spent to acquire or improve a
long-term asset such as equipment or buildings.
Usually the cost is recorded in an account classified as Property,
Plant and Equipment.
The cost will then be charged to depreciation expense over the
useful life of the asset.
Revenue Expenditure
A revenue expenditure is an amount that is expensed immediately
thereby being matched with revenues of the current accounting period.
Routine repairs are revenue expenditures because they are charged
directly to an account such as Repairs and Maintenance Expense.
Even significant repairs that do not extend the life of the asset or do
not improve the asset.
Basis for
Capital expenditure Revenue expenditure
comparison
Term Long Term Short Term
Shown in Income Statement & Balance Sheet Income Statement
Outlay Non-recurring Recurring
Only in current accounting
Benefit More than one year
year
Earning capacity Seeks to improve earning capacity Maintain earning capacity
Matching Matched with revenue
Not matched with capital receipts
concept receipts
Cost Classification on the Basis of Quality

Preventing, detecting & dealing with defects cause costs that


are called quality cost or the cost of quality.

It does not refer to costs such as using a higher-grade


items/component to make a product. It includes
Prevention cost
Appraisal cost/inspection cost
Internal failure cost
External failure cost
Prevention costs
Prevention costs are incurred to prevent or avoid quality problems. These costs are
associated with the design, implementation, and maintenance of the quality
management system. They are planned and incurred before actual operation, and
they could include:
Product or service requirementsestablishment of specifications for incoming
materials, processes, finished products, and services
Quality planning creation of plans for quality, reliability, operations, production,
and inspection
Quality assurance creation and maintenance of the quality system
Trainingdevelopment, preparation, and maintenance of programs
Appraisal costs
Appraisal costs are associated with measuring and monitoring activities related to
quality. These costs are associated with the suppliers and customers evaluation of
purchased materials, processes, products, and services to ensure that they conform
to specifications. They could include:
Verificationchecking of incoming material, process setup, and products against
agreed specifications
Quality audits confirmation that the quality system is functioning correctly
Supplier ratingassessment and approval of suppliers of products and services
Internal failure costs
Internal failure costs are incurred to remedy defects discovered before the product
or service is delivered to the customer. These costs occur when the results of work
fail to reach design quality standards and are detected before they are transferred to
the customer. They could include:
Wasteperformance of unnecessary work or holding of stock as a result of
errors, poor organization, or communication
Scrapdefective product or material that cannot be repaired, used, or sold
Rework or rectificationcorrection of defective material or errors
Failure analysisactivity required to establish the causes of internal product or
service failure
External failure costs
External failure costs are incurred to remedy defects discovered by customers.
These costs occur when products or services that fail to reach design quality
standards are not detected until after transfer to the customer. They could include:
Repairs and servicingof both returned products and those in the field
Warranty claimsfailed products that are replaced or services that are re-
performed under a guarantee
Complaintsall work and costs associated with handling and servicing customers
complaints
Returnshandling and investigation of rejected or recalled products, including
transport costs
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