SECTION 2

Concepts of Cost Accounting

Learning Outcomes of This Section
• Define the concepts of cost accounting.
• Analyze cost behavior.
• Identify the inventoriable costs and product cost flows.
Costs and Costs Terminology
• The term cost is a frequently used word that reflects a monetary measure of the
resources sacrificed or forgone to achieve a specific objective, such as acquiring a
good or service.
• An actual cost is a cost incurred (historical cost).
• A budgeted cost is a predicted or forecasted cost.
• The expense is defined as a decrease in owners’ equity caused by selling goods
or providing services.
• We use the word cost to refer to an item that still has service potential and is an
asset. But we use the word expense after the organization has used the asset’s
service potential!
Costs and Costs Terminology
• A cost object is an item or activity for which we measure costs. If the
users of accounting information want to know the cost of something,
this something is called a cost object.
Costs and Costs Terminology
• A cost driver (also called a cost generator or cost determinant) is any factor that affects
total costs.
• A change in the level of the cost driver will cause a change in the level of the total cost
of a related cost object.
Costs and Costs Terminology
• Some cost drivers are financial measures found in accounting systems (such as
direct manufacturing labour costs and sales), while others are non-financial
variables (such as the number of parts per product and the number of service
calls).
• Changes in a particular cost driver do not automatically lead to changes in
overall costs.
• Consider the number of items distributed as a driver of distribution labour costs.
Suppose that management reduces the number of items distributed by 25%.
• This reduction does not automatically translate to a reduction in distribution
labour costs. Managers must take steps to reduce distribution labour costs,
perhaps by shifting workers out of distribution into other business functions
needing additional labour or by laying off some distribution employees..
Costs and Costs Terminology
• Costing is defined as the process of accumulating, classifying, and assigning
direct materials, direct labor, and factory overhead costs to products or services.
• A costing system typically accounts for costs in two basic stages:
➢Cost accumulation: The collection of cost data in some organized way
by means of an accounting system.
➢Cost assignment: Both tracing accumulated costs that have a direct
relationship to a cost object and allocating accumulated costs that have
an indirect relationship to a cost object.
Costs and Costs Terminology
• In some organisations, cost accumulation and cost assignment occur
simultaneously.
• Consider the purchase by Airbus of 100 business-class seats to be
installed in an A330-200 aeroplane to be sold to British Airways (BA).
• This transaction could be coded to a general ledger account such as
materials (the cost accumulation stage) and simultaneously coded to
three separate cost objects (the cost assignment stage): a department
(assembly), a product (A330-200 product line), a customer (BA).
Costs and Costs Terminology

• Alternatively, cost accumulation could occur first, followed by cost

assignment.
• For example, the 100-seat purchase by Airbus could first be coded to
the materials account, then subsequently assigned to a department,
then reassigned to a product, and finally reassigned to a customer.
• Advances in information-gathering technology (such as barcoding) are
facilitating the simultaneous assignment of costs to more than one
cost object at the time costs are incurred.
 Direct and Indirect Costs
Costs Assigned to Cost Objects

Direct Costs Indirect Costs

Direct Material Costs Direct Labour Costs

Indirect Material Indirect Labour Indirect

Costs Costs Expenses
Direct Costs
• Direct costs are costs that are related to the particular cost object
and that can be traced to it in an economically feasible (cost-
effective) way.
• Direct costs are the costs that are directly identified with a cost
object.
• Direct costs can be traced easily and accurately to a cost object.
• Cost tracing is the assigning of direct costs to the chosen cost
object.
• For example, Take a tennis racket as a cost object. The cost of the
carbon fibre used to make that racket is a direct cost, because the
amount of material used in making the racket can easily be traced
to the racket.
Direct Costs
• Direct material costs represent those material costs that can be
specifically and exclusively identified with a particular cost object.
• In manufacturing organizations, where the cost object is a product,
physical observation can be used to measure the quantity consumed
by each individual product.
• The cost of direct materials can be directly charged to products.
• Direct materials become part of a physical product.
• For example, wood used in the manufacture of different types of
furniture can be directly identified with each specific type of furniture
such as chairs, tables and bookcases.
Direct Costs
• Direct labour costs are those labour costs that can be specifically
and exclusively identified with a particular cost object.
• Physical observation can be used to measure the quantity of labour
used to produce a specific product or provide a service.
• The direct labour cost in producing a product includes the cost of
converting the raw materials into a product, such as the costs of the
machine operatives engaged in the production process in the
manufacture of televisions.
 Indirect Costs
• Indirect costs are costs that are related to the particular cost object but cannot
be traced to it in an economically feasible (cost-effective) way.
• Indirect costs are the costs that are not directly identified with a cost object.
• Indirect costs are costs that are not directly responsible to a cost object.
• Indirect costs cannot be traced to cost objects. Instead,
an estimate must be made of the resources consumed by cost objects using
cost allocations.
• Cost allocation is the assigning of indirect costs to the chosen cost object.
• For example, Take a tennis racket as a cost object. The cost of lighting in the
factory, where the racket was made, is an indirect cost of the racket, because
although lighting helped in the making of the racket (the workers needed to see),
it is not cost effective to try to determine exactly how much lighting cost was
used for a specific racket.
Indirect Costs
• In a manufacturing organization, where products are the cost object,
the wages of all employees, whose time cannot be identified with a
specific product, represent indirect labour costs.
• The cost of materials used to repair machinery cannot be identified
with a specific product and can therefore be classified as indirect
material costs.
• Examples of indirect expenses in manufacturing, where products are
the cost objectives, include lighting and heating expenses and
property taxes.
 Indirect Costs
• The term Overheads is widely used instead of indirect costs.
• In a manufacturing organization, overhead costs are categorized as manufacturing, administration or
marketing (or selling) overheads.
• Manufacturing overheads include all the costs of manufacturing apart from direct labour and material
costs.
• Administrative overheads consist of all costs associated with the general administration of the
organization. Examples of administrative overheads include top executive salaries, general accounting,
secretarial, and research and development costs.
• Marketing (selling) costs are costs that are necessary to market and distribute a product or service.
Examples of marketing costs include advertising, sales personnel salaries/commissions, warehousing
and delivery transportation costs.
Direct and Indirect Costs
Factors Affecting Direct/Indirect Cost Classifications
• The materiality of the cost in question: The higher the cost in question, the more
likely the economic feasibility of tracing that cost to a particular cost object.
• Available information-gathering technology: Improvements in information
technology are enabling an increasing percentage of costs to be classified as direct.
• The choice of the cost object: A cost can be treated as direct for one cost object
but indirect in respect of another.
• Design of operations: Facility design can impact on cost classification.
 Product Costs and Period Costs

It is necessary to classify costs as either product costs or period costs

(period expenses) for profit measurement and inventory/stock valuation

Product Costs Period Costs (Period

• Those costs that are identified with goods
purchased or produced for resale. Expenses)
• In a manufacturing organization, product • Those costs that are not specifically
related to manufacturing or purchasing a
costs are costs that are attached to the product or providing a service that
product and that are included in the generates revenues.
inventory valuation for finished goods or • Period costs are not included in the
for partly completed goods (work in inventory valuation and as a result are
progress), until they are sold. treated as expenses in the period in which
• When the product is sold, product costs they are incurred.
are then recorded as expenses (as cost • Non-manufacturing costs are regarded as
of goods sold) and matched against sales period costs.
for calculating profit.
• All manufacturing costs are regarded as
product costs.
Product Costs and Period Costs
Depreciation Insurance, Energy
Indirect Indirect Expenses of Tax and Rent and Fuel
(Raw) Labor Fixed Assets Expenses of Costs
Material Cost Used in Fixed Assets Used in
Cost Production Used in Production
Production

Direct Direct Manufacturing

(Raw) Labor Overhead
Material Cost Cost
Cost

Manufacturing Cost
Product Costs and Period Costs
Advertising
Public Expenses
General
Relation
Office Rent Sales
Salaries of Expenses
Expenses commission
Top s/salaries
Executives

Shipping
Marketing or Expenses
Administrative
Overhead Cost Selling
(Administrative Overhead Cost
Expenses) ( Marketing or
Selling
Expenses)
Sales
Travel
Expenses

Non-Manufacturing Cost
(Non-Manufacturing Expenses)
Prime Cost and Conversion cost

Prime cost consists of all direct

manufacturing costs (it is the sum of
direct material and direct labour costs)

Conversion cost is the sum of direct labour and

manufacturing overhead costs. It represents the cost of
converting raw materials into finished products.
Treatment of Period Costs and Product Costs
Exercise
Cost Behaviour
• A knowledge of how costs and revenues will vary with different levels of activity or volume is
essential for decision-making.
• Management accounting systems record the cost of resources acquired and track their
subsequent use. Tracing these costs allows managers to understand how these costs behave.
• Cost behavior is defined as the functional relationship between changes in activity or volume
and changes in cost.
• Activity or volume may be measured in terms of units of production or sales, hours worked,
miles travelled, patients seen, students enrolled or any other appropriate measure of the
activity of an organization.
• Variable costs and fixed costs are two basic types of cost behaviour pattern.
Variable Cost and Fixed Cost
• A variable cost is a cost that changes in total in proportion to changes in the
related level of total activity or volume.
• Examples of variable costs in a manufacturing organization include direct
materials, energy to operate the machines and sales commissions.
• Examples of variable costs in a merchandising company, such as a
supermarket, include the purchase costs of all items that are sold.
• In a hospital, variable costs include the cost of drugs and meals which may
be assumed to fluctuate with the number of patient days.
• Total variable costs are linear and unit variable cost is constant.
Variable Cost and Fixed Cost
• Consider the example of a bicycle manufacturer who purchases
component parts. Assume that the cost of purchasing two wheels for a
particular bicycle is £10 per bicycle.
Variable Cost and Fixed Cost
• A fixed cost is a cost that does not change in total despite changes in
the related level of total activity or volume.
• Total fixed costs remain constant over wide ranges of activity for a
specified time period. They are not affected by changes in activity.
• Examples of fixed costs include depreciation of equipment, property
taxes, insurance costs, supervisory salaries and leasing charges for
cars used by the sales force.
• Total fixed costs are constant for all units of activity, unit fixed costs
decrease proportionally with the level of activity.
Variable Cost and Fixed Cost
• For example, a vehicle company may incur £20 million in a given year
for the leasing and insurance of its plant. Both are examples of fixed
costs: costs that are unchanged in total over a designated range of
the cost driver during a given time span.
• Fixed costs become progressively smaller on a per-unit basis as the
cost driver increases.
• For example, if the company assembles 10,000 vehicles at this plant
in a year, the fixed cost for leasing and insurance per vehicle is
£2,000 (£20 million ÷ 10,000). In contrast, if 50,000 vehicles are
assembled, the fixed cost per vehicle becomes £400 (£20 million ÷
50,000).
Variable Cost and Fixed Cost

£2,000

£20 million

£400
10,000 50,000
Variable Cost and Fixed Cost
• Do not assume that individual cost items are inherently variable or
fixed. For example, consider labour costs.
• An example of purely variable labour costs is the case where workers
are paid on a piece-work basis. Some textile workers are paid on a
per-shirt-sewn basis.
• Often, labour costs are appropriately classified as fixed where
employment conditions restrict an organisation’s flexibility to assign
workers to any area that has extra labour requirements.
Major Assumptions for Variable and Fixed Cost
1. Costs are defined as variable or fixed with respect to a specific cost object.
2. The time span must be specified. Consider the €20 million rent and insurance that a vehicle company
pays for its plant. This amount may be fixed for one year. Beyond that time, the rent and insurance
may be renegotiated to be, say, €22 million for a subsequent year.
3. There is only one cost driver. The influences of other possible cost drivers on total costs are held
constant or deemed to be insignificant.
4. Variations in the level of the cost driver are within a relevant range.
A relevant range is the range of the cost driver in which a specific relationship between cost and the
level of activity or volume is valid. A fixed cost is fixed only in relation to a given relevant range
(usually wide) of the cost driver and a given time span (usually a particular budget period).
Semi-fixed Cost (Step-fixed Cost)

• Semi-fixed cost (or step-fixed cost) can be defined as a cost which

shows the characteristics of fixed costs initially and it jumps to a
higher point when the quantity increases and shows against the
characteristics of fixed cost until production amount changes. Costs
that increase with activity as a step function.
• The distinguishing feature of step-fixed costs is that within a given
time period they are fixed within specified activity levels, but they are
eventually subject to step increases or decreases by a constant
amount at various critical activity levels.
Semi-fixed Cost (Step-fixed Cost)
• For example, consider the Swedish-based Trans-Europe Transport Company
(TETC), which operates two refrigerated vehicles that carry agricultural
produce to market.
• Each vehicle has an annual fixed cost of €40,000 and a variable cost of €12
per kilometre of hauling.
• TETC has chosen kilometres of hauling to be the cost driver.
• The maximum annual usage of each vehicle is 120,000 kilometres.
• Suppose that in the current year (2016) the predicted combined total hauling
of the two vehicles is 170,000 kilometres.
Semi-fixed Cost (Step-fixed Cost)

• This graphic shows how annual fixed costs behave at different levels of kilometres of hauling.
• Up to 120,000 kilometres, TETC can operate with one vehicle; from 120,001 to 240,000 kilometres, it can operate with two vehicles;
and from 240,001 to 360,000, it can operate with three vehicles.
• The bracketed section from 120,001 to 240,000 is the range at which TETC expects the €80,000 fixed costs to be valid given the
predicted 170,000-kilometre usage for the year.
Semi-variable Cost (Mixed Cost)
• Semi-variable costs (or mixed cost): This cost can be defined as a
cost that includes both fixed and variable cost.
• For xample, Assume that a bicycle company incurs a fixed cost of
TL10,000 to generate a television advertisement, and then a variable
cost of TL500 each time the advertisement is aired on television.
• The graphic illustrates the total television advertising cost is a mixed
cost because the part is fixed and partly varies with the number of
times the advertisement is aired on television.
Semi-variable cost (Mixed cost)
(TL)
Meaning of Unit Cost
• A unit cost (also called an average cost) is calculated by dividing
some amount of total cost by the related number of units.
• The units might be expressed in various ways. Examples are hours
worked, packages delivered or cars assembled.
• Suppose that €980,000 of manufacturing costs were incurred to
produce 10,000 units of a finished good. Then the unit cost would be
€98:
Meaning of Unit Cost
• Unit costs are averages. they must be interpreted with caution. For decision
making, it is best to think in terms of total costs rather than unit costs.
• For example, assume that the president of the Jazz Society at the University is
deciding whether to hire a music group for a forthcoming party. The group charges
a fixed fee of €1,000.
• The president may intuitively calculate a unit cost for the group when thinking about
an admission price.
• Given the fixed fee of €1,000, the unit cost is €10 (1,000/100) if 100 people attend,
the unit cost is €2 (1,000/500) if 500 attend, and the unit cost is €1(1,000/1,000) if
1,000 attend.
Meaning of Unit Cost
• Consider the €1,000 fixed fee that we assumed was to be paid to the music group.
This is just one way the music group could be paid. Possible payment schedules that
might be considered include:
➢ Schedule 1: Only €1,000 fixed fee
➢ Schedule 2: €1 per person attending + €500 fixed fee
➢ Schedule 3: Only €2 per person attending

Under schedules 2 and 3, the euro amount of the payment to

the music group is not known until after the event.
Meaning of Unit Cost

y = a + bx -> Cost Function

y: Total Cost
a: Total Fixed Cost
b: Unit Variable Cost
x: Activity or Volume
Meaning of Unit Cost
Manufacturing, Merchandising and Service Organizations

• According to the fields of activity, the enterprises are classified under

three headings: Manufacturing Organizations, Merchandising
Organizations and Service Organizations.
• Manufacturing organizations purchase raw materials from suppliers
and convert these materials into tangible products or finished goods
through the use of labour and capital inputs (e.g. plant and machinery).
• Examples of manufacturing organizations are automotive
companies, toy manufacturer companies, shoemaker companies,
leather manufacturer companies, and furniture companies.
 Manufacturing, Merchandising and Service
Organizations
• There are three important inventory items in manufacturing organizations:
➢ Raw material inventory: Direct and indirect raw materials in stock and awaiting use in the
manufacturing process (for example, computer chips and components needed to manufacture
cellular phones.)
➢ Work-in-process inventory (Work-in-progress inventory): Consisting of partially complete
products awaiting completion (for example, cellular phones at various stages of completion in
the manufacturing process.)
➢ Finished goods inventory: Consisting of fully completed products that have not yet been
sold (for example, cellular phones).
Manufacturing, Merchandising and Service
Organizations
• Merchandising organizations purchase tangible products and then
sell them without changing their basic form.
• Examples of merchandising organizations are supermarkets, retail
departmental stores and wholesalers.
• Merchandising organizations hold only one type of inventory, which
is the original products they purchase, called merchandise inventory
or finished goods inventory.
Manufacturing, Merchandising and Service
Organizations
• Service organizations provide tasks or services.
• Examples of service organizations are law firms, accounting firms, advertising
agencies, insurance companies, and travel agencies.
• A major feature of service organizations is that they provide perishable
services that cannot be stored for future use.
• Service organizations do not have finished goods inventory but some service
organizations do have work in process. For example, a firm of lawyers may have
clients whose work is partially complete at the end of the accounting period.
Inventoriable Costs
• For manufacturing organizations, all manufacturing costs are
inventoriable costs.
• For merchandising organizations, inventoriable costs are the costs
of purchasing the goods that are resold in the same form. These costs
comprise the costs of the goods themselves plus any incoming freight,
insurance and handling costs for those goods.
• In service organizations, there are no inventoriable costs, there are
only service costs.
Product Cost Flows

2
3

3
4

1. Raw materials purchases are recorded in the ‘Raw Materials’ inventory account.
2. When raw materials are used in production, their costs are transferred to the ‘Work in
Process’ inventory account as direct materials.
3. Direct labor cost and manufacturing overhead cost are added directly to ‘Work in
Process’.
4. After the ‘Work in Process’ inventory is completed, they are transferred to the
‘Finished Goods’ inventory account.
5. When finished goods are sold for revenue, they are transferred to the cost of goods
sold.