2/24/20201LO1: Cost terms, concepts andclassificationDr Fidelis AkangaLearning outcomesBy the end of this unit Explain the difference between fixed andvariable costs, and direct and indirect costsExplain the different types of costs and theirbehaviour Explain why some costs and revenues are notrelevant for short term decision-making; Describe the three purposes for which costinformation is required2/24/20202Why cost information is required Inventory valuation for internal and external profitmeasurement. Provide relevant information to help managers make betterdecisions. Provide information for planning, control and performancemeasurement. Therefore, a database should be maintained so that relevantcost information can be extracted to meet each of thesepurposes.Why it is necessary to understand themeaning of different cost terms The term ‘cost’ reflects a monetary measure of the resourcessacrificed to achieve a specific objective. There is no one generally accepted definition of the term ‘cost’.– The word cost is always used with a preceding adjective to specifythe type of cost being considered. An understanding of what cost means is required.– To understand how accounting systems calculate costs (productsand services) and communicate accounting information.2/24/20203Definitions• A cost object is any activity for which a separatemeasurement of cost is required e.g. the cost of producing aproduct or rendering a service. A unit of product ( e.g. a cake) A unit of service ( service of a car)• A cost collection system normally accounts for costs in twobroad stages:– It accumulates costs by classifying them into certaincategories, and then– It assigns costs to cost objectsDefinitionsCost Unit – A cost unit is a basic measure of aproduct or service for which costs aredetermined. Examples include:• Tonne of steel produced• Meal served• Passenger per kilometre2/24/20204Definitions Cost Centres – In order to control costs it isnecessary to trace them to the area responsible forthe costs. These areas are known as Cost Centres.A Cost Centre can be a location, person orequipment. The Cost Centre acts as a collecting place forcosts e.g. a manufacturing department, a machine,an operating theatre in a hospital.Cost Classification2/24/20205Cost Classification according to natureDirectMaterialsDirectLabourManufacturingOverheadCost Classification according to natureDirect costs can be specifically and exclusivelyidentified with a given cost object.: The wood that is used to manufacture of a desk; Spare parts that are used in a car repair; The wages of operatives whose time can betraced to the specific desk or car.2/24/20206Cost Classification according to natureIndirect costs cannot be specifically and exclusivelyidentified with a given cost object Utility bills of the factory/garage. Depreciation of tools The salaries of the factory/garage supervisors Rent of the factory/garage.Cost Classification according to nature Manufacturing overheads are costs that cannot be traceddirectly to specific units produced.Examples: Indirect labour and indirect materials Wages paid to employeeswho are not directly involvedin production work.Examples: maintenanceworkers, cleaners andsecurity guards. Materials used to support theproduction process.Examples: lubricants andcleaning supplies used in the carassembly plant. 2/24/20207Cost Classification according tobehaviour Fixed costs – Cost that does not change within certain outputand sales revenue limits and is not affected by the increase ordecreases in the level of production or activity. Examplesinclude the rent of factory, salary of manager. However, per unitfixed costs decreases proportionally with the level of activityCost Classification according tobehaviour Variable costs – Is a cost that increases or decreases as thelevel of activity increases or decreases. For example your totallong distance telephone bill is based on how many minutes youtalk. However, per unit variable cost becomes constant.2/24/20208Cost Classification according tobehaviour Semi Variable costs ( mixed costs) – these are cost that arepart fixed and part variable and there are therefore partlyaffected by changes in the level of activity.Cost Classification according tobehaviour Stepped fixed costs – Sometimes costs may increase beyondthe relevant range. For example if production increases theremay be need to rent extra factory. The rent cost will thenincrease to new higher levels. This is called stepped fixedcosts.2/24/20209Cost Classification according tofunctionCost Classification according tofunction2/24/202010Cost Classification according tofunction Product and period costsProduct costs (manufacturing costs) arethose that are attached to the products andincluded in the stock (inventory valuation). Period costs (non manufacturing costs) arenot attached to the product and included inthe inventory valuationCost Classification according tofunction2/24/202011Cost Classification according todecision making1. Relevant Cost and Irrelevant Cost– Relevant costs and revenues are thosefuture costs and revenues that will bechanged by a decision, whereasirrelevant costs and revenues will not bechanged by a decision.Cost Classification according todecision makingAvoidable and unavoidable costsAvoidable costs are those costs that can besaved by not adopting a given alternative,whereas unavoidable costs cannot be saved.Avoidable/unavoidable costs are alternativeterms sometimes used to describerelevant/irrelevant costs.2/24/202012Cost Classification according todecision makingSunk CostSunk costs are the costs of resources alreadyacquired and are unaffected by the choicebetween the various alternatives (e.g.depreciation). Sunk costs are irrelevant for decision-making.Cost Classification according todecision makingOpportunity Costs• Cost that measures the opportunity that islost or sacrificed when the choice of onecourse of action requires that an alternativecourse of action be given up.2/24/202013Cost Classification according todecision makingMarginal and incremental costs/revenuesIncremental costs and revenues are theadditional costs/revenues from the productionor sale of a group of additional units.Marginal cost/revenue represents theadditional cost/revenue of one additional unitof output.2/24/202014Reading List Drury, C. (2018), Management & CostAccounting, 10th Edition. Chapter 2.
