Professional Documents
Culture Documents
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INTRODUCTION TO COSTS
Types of organisation
Manufacturing organisations: and
Service organisations.
An organisation needs to know:
how much it costs to make the products that it produces, or
how much it costs to provide its services to customers.
To make a profit it is important to
control the entity;
measure to what extent it is achieving its objectives; and
plan expenditure for the future.
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Terminology
Cost object: Any activity for which a separate measurement of costs is
needed
Examples of cost objects include:
The cost of a product
The cost of a service
The cost of a department
The cost of a project
Cost unit: A unit of product or service for which costs are determined
Unit cost includes all fixed costs and all variable costs involved in
production
Cost objects and cost units should be selected so as to provide
management with the cost information they require
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OVERVIEW OF COST CATEGORIES FOR A
MANUFACTURING FIRM
All costs incurred by the firm must be accounted for in its financial
statements
MANUFACTURING COSTS
Direct labour (DL)
Direct Materials (DM)
Overhead (OH)
Indirect Materials
Indirect labour
Other
NON-MANUFACTURING COSTS
Marketing or Selling Costs
Administrative Costs
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MANUFACTURING COSTS
1. Direct Materials (DM)
Materials that are consumed in the manufacturing process and
physically incorporated in the finished product
Materials whose cost is sufficiently large to justify the record
keeping expenses necessary to trace the costs to individual
products
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DIRECT AND INDIRECT COSTS
Direct costs: Costs that can be traced in full to a cost unit.
For example, in a manufacturing company that produces
television sets, the direct cost of making a television consists
of direct materials and direct labour costs, and possibly some
direct expenses.
Direct materials are all materials that can be attributed
directly in full to a cost unit.
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Direct materials
Cost unit Direct materials
Office chair Wheels, a stand, a seat (with seat cushion), back rest, arm rests and
fabric
Car Steel, aluminium, windows, lights, gear box, engine, wheels etc.
etc.
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Key issues in determining direct labour
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Direct expenses
Direct expenses are expenses that can be attributed directly
in full to a cost unit.
Direct expenses are expenses that have been incurred in full
as a direct consequence of making a unit of product, or
providing a service, or running a department.
In construction of a house
Hire of equipment (for example a cement mixer) is a direct
cost.
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Prime cost
Rs.
Direct expenses X
PRIME COST X
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Indirect costs (overheads)
Indirect costs (overheads) cannot be attributed directly and in
full to a cost unit.
Indirect costs include production overheads and non-
production overheads. Each of these might include indirect
materials costs, indirect labour costs and indirect expenses
costs.
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Indirect materials
cleaning materials and any materials used by production
departments or staff who are not engaged directly in making
a product.
may also include some items of materials that are inexpensive
and whose cost or value is immaterial. These may include
nails, nuts and bolts, buttons and thread, and so on.
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Indirect labour costs
In a manufacturing environment, indirect labour employees
include staff in the stores and materials handling department
(for example, fork lift truck drivers), supervisors, and
repairs and maintenance engineers.
All employees in administration departments and marketing
departments (sales and distribution staff) - including
management - are normally indirect employees.
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Indirect expenses
indirect production costs (production overheads)
the rental costs for a factory and the costs of gas and
electricity consumption for a factory.
administration overheads
sales and distribution overheads
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To develop UNDERSTANDING
When making grocery bags, it is pretty easy to keep track of the
amount of paper being used for each bag, but it is very difficult to
know exactly how much glue is being used to hold the paper bag
together.
Of course, if a person got a magnifying glass and really examined
the bags, maybe the amount of glue could be determined. But
would it be worth all of the time and effort?
Compared to the paper, the glue is pretty inexpensive. Other
than holding the bag together, the glue is rather insignificant.
Sooooo..... The glue is not tracked on a product or job basis. It
is just not worth the effort. Since the glue is not tracked on a
product or job basis, the glue is not considered a direct material
even though the glue is part of the product.
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MANUFACTURING COSTS
3. Manufacturing Overhead (OH)
All of costs of manufacturing excluding direct materials and
direct labour
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NON-MANUFACTURING COSTS
1. Marketing or Selling Costs – Costs incurred in
securing orders from customers and providing
customers with the finished product
Sales commissions, costs of shipping products to
customers, storage of finished goods, depreciation of
selling equipment (cash register)
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OTHER COST CONCEPTS
Product Costs or Inventoriable Costs – costs assigned to products that
were either purchased for resale (merchandising firm or retailer) or
manufactured for sale (manufacturing firm)
When products are sold, product costs are recognized as an expense (cost
of goods sold or COGS). The costs of unsold products remain in
inventory and are not expensed (i.e. not deducted from revenue in
calculating net income)
Period Costs – costs that are not product costs and that are associated with
the period in which they are incurred
Period costs such as selling and administrative costs are expensed (i.e.
deducted from revenue in calculating net income) in the period they are
incurred
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Product Costs Versus Period Costs
Product costs include Period costs are not
direct materials, direct included in product
labour, and costs. They are
manufacturing expensed on the
overhead. income statement.
Cost of
Inventory Goods Sold
Expense
Sale
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Quick Check
Which of the following costs would be considered a period
rather than a product cost in a manufacturing company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production
facility.
E. Sales commissions.
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Answer
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Calculate: Cost per unit.
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Example : Valuing inventory
DEF Plc manufactures mechanical parrots, which trade under the name ‘Parker’. In the year
ended 31 December 2012, 10,000 Parkers are manufactured and the related costs were:
Rs.
Materials 3,000
Labour 4,000
Depreciation of Machinery 2,000
Factory rates 1,000
Sundry factory expenses 2,000
Production storage costs 1,000
Selling expenses 2,000
Expenses at head office 4,000
19,000
Requirement
At 31 December 2012, there were 1,000 Parkers in inventory. Assuming that these have a resale
value of Rs.4 each, what value should be placed on the closing inventory?
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Solution
Rs.
Materials 3,000
Labour 4,000
Depreciation of machinery 2,000
Factory rates 1,000
Sundry factory expenses 2,000
Production storage costs 1,000
Total cost 13,000
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Over-absorption Under-absorption
Fixed production overheads must be absorbed based on normal
production capacity even if this is not achieved in a period.
The amount of fixed overhead allocated to each unit of production is not
increased if actual production capacity falls short of the normal capacity
for any reason.
Similarly, the amount of fixed overhead allocated to each unit of
production is not decreased if actual production capacity is higher than
the normal capacity for any reason.
the actual fixed production overhead recognised as part of the inventory
cost differs from the actual fixed production overhead incurred. Any
difference is recognised as an expense or a reduction of an expense
(usually cost of sales).
Under-absorption (fixed production overhead in inventory is less than
fixed production overhead incurred) is a debit to cost of sales.
Over-absorption (fixed production overhead in inventory is greater than
fixed production overhead incurred) is a credit to cost of sales.
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Calculate:
1. Cost per unit
2. Cost of production
3. Cost of sales
4. Under or over absorbed production overheads
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Calculate:
1. Cost per unit
2. Cost of production
3. Cost of sales
4. Under or over absorbed production overheads
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Example: Valuing inventory 2
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Example : Valuing inventory (2) (Cont’d)
Rs.
Direct materials cost per unit 1
Direct labour costs per unit 1
Direct expenses per unit 1
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Example: Valuing inventory (2)
Solution
Cost per unit
Rs.
Direct material 1.00
Direct labour 1.00
Direct expenses 1.00
Production overhead (Rs.600,000 / 750,000 units) 0.80
3.80
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COST OF PRODUCTION/
Manufacturing Account Rs. Rs.
Raw materials
Purchases 150,000
Overheads
Light and power 72,000
Depreciation of production
40,000
machinery
Depreciation of factory 50,000 162,000
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First-In, First-Out (FIFO)
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First-In, First-Out (FIFO)
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First-In, First-Out (FIFO)
Yore Frame, Inc.
Frame Inventory
Date Units $/Unit Total
Beg. Inventory 800 $ 22.00 $ 17,600.00
3-9 300 24.00 7,200.00
15-9 250 25.00 6,250.00
21-9 200 27.00 5,400.00
29-9 400 28.00 11,200.00
Goods Available for
Sale 1,950 $ 47,650.00
Ending Inventory 600 These are the 600
most recently
Cost of Goods Sold 1,350 acquired units.
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First-In, First-Out (FIFO)
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Perpetual Average Cost
The following schedule shows the Frame inventory
for Yore Frame, Inc. for September.
The physical inventory count at September 30 shows
600 frames in ending inventory.
Use the perpetual average cost method to determine:
(1) Ending inventory cost
(2) Cost of goods sold
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Perpetual Average Cost
Yore Frame, Inc.
Frame Inventory
Date Units $/Unit Total
Beg. Inventory 800 $ 22.00 $ 17,600.00
3-9 300 24.00 7,200.00
15-9 250 25.00 6,250.00
21-9 200 27.00 5,400.00
29-9 400 28.00 11,200.00
Goods Available for Date Sales Units
9/1 600
Sale 1,950 9/10 300
$ 47,650.00
Ending Inventory 600 9/30 450
Cost of Goods Sold 1,350
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Perpetual Average Cost
Date Purchased Sold Balance
Beg. Inv. 800 x 22.00 = 17,600 $ 17,600.00
1-Sep 600 x 22.000 = 13,200.00 4,400.00
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Perpetual Average Cost
Date Purchased Sold Balance
Beg. Inv. 800 x 22.00 = 17,600 $ 17,600.00
1-Sep 600 x 22.000 = 13,200.00 4,400.00
3-Sep 300 x 24.00 = 7,200 11,600.00
10-Sep 300 x 23.200 = 6,960.00 4,640.00
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Perpetual Average Cost
Date Purchased Sold Balance
Beg. Inv. 800 x 22.00 = 17,600 $ 17,600.00
1-Sep 600 x 22.000 = 13,200.00 4,400.00
3-Sep 300 x 24.00 = 7,200 11,600.00
10-Sep 300 x 23.200 = 6,960.00 4,640.00
15-Sep 250 x 25.00 = 6,250 10,890.00
21-Sep 200 x 27.00 = 5,400 16,290.00
29-Sep 400 x 28.00 = 11,200 27,490.00
30-Sep 450 x 26.181 = 11,781.45 15,708.55
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Perpetual Average Cost
Date Purchased Sold Balance
Beg. Inv. 800 x 22.00 = 17,600 $ 17,600.00
1-Sep 600 x 22.000 = 13,200.00 4,400.00
3-Sep 300 x 24.00 = 7,200 11,600.00
10-Sep 300 x 23.200 = 6,960.00 4,640.00
15-Sep 250 x 25.00 = 6,250 10,890.00
21-Sep 200 x 27.00 = 5,400 16,290.00
29-Sep 400 x 28.00 = 11,200 27,490.00
30-Sep 450 x 26.181 = 11,781.45 15,708.55
Cost of Goods Sold in September
Sale Date Units Cost/Unit Total
Sum
1-Sep 600 22.000 $ 13,200.00
10-Sep 300 23.200 6,960.00
30-Sep 450 26.181 11,781.45
Total 1,350 31,941.45
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Weighted-Average Periodic System
Let’s use the same information to assign costs to ending
inventory and cost of goods sold using the periodic
system.
Ending Inventory
(600 units)
Beginning Inventory
Available
(800 units) for Sale
(1,950 units)
Goods Sold
(1,350)
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Value of inventory under AVCO
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Important point
In the time of rising prices, value of closing inventory is
always higher than value calculated under AVCO and in the
time of falling prices vice versa.
If closing inventory is higher then it will reduce cost of goods
sold and ultimately profit will be higher.
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Cost behaviour
• the way in which costs change as the volume of
activity changes.
• Management might want information about
estimated costs, or about what costs should have
been.
An understanding of cost behaviour is necessary
in order to:
• forecast or plan what costs ought to be; and
• compare actual costs that were incurred with
what the costs should have been.
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Fixed costs
• Fixed costs are items of cost that remain the
same in total during a time period, no matter
how many units are produced, and regardless of
the volume or scale of activity.
Examples
• The rental cost of a building is Rs.40,000 per
month. The rental cost is fixed for a given period:
Rs.40,000 per month, or Rs.480,000 per year.
• The salary costs of a worker who is paid Rs.
11,000 per month. The fixed cost is Rs.11,000 per
month or Rs.132,000 per year.
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Variable costs
• are costs that increase, usually by the same amount,
for each additional unit of product that is made or each
additional unit of service that is provided.
• The variable cost of a cost unit is also called the
marginal cost of the unit.
• The variable cost per unit is often the same amount for
each additional unit of output or unit of activity.
• This means that total variable costs increase in direct
proportion to the total volume of output or activity.
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Total Variable and Fixed Costs
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Variable and Fixed Costs Per Unit
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Total Costs
To get total costs you need to add variable
costs and fixed costs
Total Cost
Fixed costs
The Slope is the
variable cost per
unit
Number of units
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Examples of variable cost items.
The cost of buying raw material is Rs.500 per litre
regardless of purchase quantity. The variable cost is
Rs.500 per litre:
• the total cost of buying 1,000 litres is Rs.500,000
• the total cost of buying 2,000 litres would be Rs.
1,000,000.
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Semi-variable cost
• is a cost that is partly fixed and partly variable.
• A company uses a photocopier machine under a rental
agreement. The photocopier rental cost is Rs.4,000 per
month plus Rs.2 per copy produced.
The Total cost for making15,000 copies during a month?
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Stepped cost
• has a fixed cost behaviour pattern within a limited range of
activity, and
• goes up or down in steps when the volume of activity rises
above or falls below certain levels.
• Example
A company might pay its supervisors a salary of Rs. 20,000
each month.
• When production is less than 2,000 hours each month, only
one supervisor is needed:
• When production is between 2,001 and 4,000 hours each
month, two supervisors are needed.
• When output is over 4,000 hours each month, three
supervisors are needed.
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COST ESTIMATION
analysing fixed and variable costs
• y = a + bx
Where:
• y = total costs in a period
• x = the number of units of output or the volume of activity in the
period
• a = the fixed costs in the period
• b = the variable cost per unit of output or unit of activity.
There are two methods of constructing the total cost function equation:
• high/low analysis
• linear regression analysis.
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High/low analysis
Month Production (units) Total cost (Rs.)
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• Step 4: Construct total cost function
Total cost = a +bx = 20,000 + 3.5x
• Step 5: Calculate the expected cost .
Total cost for producing 9000 units in July
= 20,000 + 3.5 x 9,000
=51,500
High/low method with step in fixed costs
A company has identified that total fixed costs increase by 20% when
activity level equals or exceeds 7,500 units. The variable cost per unit is
constant over this range of activity.
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High/low method with step in variable
costs
• A company has identified that total fixed costs are constant over all levels of
activity but there is a 10% reduction in the variable cost per unit above 24,000
units of activity. This reduction applies to all units of activity, not just the
additional units above 24,000.
PERIOD
UNIITS AMOUNT
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• Step 1: Choose the pair which is on the same side as the
.
change.
• Step 2: Compare the different activity levels and associated
costs and calculate the
variable cost=356,000-320,000/30,000-25,000
=Rs. 7.2 per unit
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COST ESTIMATION:
LINEAR REGRESSION ANALYSIS
• Linear regression analysis is a statistical technique
for calculating a line of best fit from a set of data:
Y = a + bx
• It is an alternative to the high-low method.
• High-low analysis uses just two sets of data.
Regression analysis uses as many sets of data for
x and y as are available.
• Regression analysis provide a more reliable
estimate than high-low analysis for the values of
a and b.
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A company has recorded the following output levels
and associated costs in the last six months
Month Output “000” Total cost “million”
January 5.8 40.3
February 7.7 47.1
March 8.2 48.7
April 6.1 40.6
May 6.5 44.5
June 7.5 47.1
Required:
Construct the equation of a line of best fit for this data.
Calculate the cost of producing 90,000 units.
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• .
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Hammad Limited (HL) imports and supplies three products, Alpha, Gamma
and Beta. The opening balances and transactions for the month of June 2014
are as follows:
Qty- Value (Rs.) Qty. Invoice value (Rs.) Qty. Value (Rs.)
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Hammad Limited (HL) imports and supplies three products, Alpha, Gamma
and Beta. The opening balances and transactions for the month of June 2014
are as follows:
Units purchased during the
Opening balance Units Sold during the month
month
Items
Qty- Value (Rs.) Qty. Invoice value (Rs.) Qty. Value (Rs.)
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Hammad Limited (HL) imports and supplies three products, Alpha, Gamma
and Beta. The opening balances and transactions for the month of June 2014
are as follows:
Units purchased during the
Opening balance Units Sold during the month
month
Items
Qty- Value (Rs.) Qty. Invoice value (Rs.) Qty. Value (Rs.)
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