Cost Concepts and Cost Classification

Accounting concept that requires the numbers on the financial statements be based on actual
expenses from business transactions incurred during the period. In other words, all accounting
information must be measured on a cash or cash-equivalent basis.
Cost accounting is an accounting process that measures and analyzes the costs associated with
products, production, and projects, so that correct amounts are reported on a company's financial
statements. Cost accounting aids in decision-making processes by allowing a company to
calculate, evaluate, and monitor its costs.

Below are some of the types of costs used in cost accounting:

Direct Costs
Direct costs are related to producing a good or service. A direct cost includes materials, labor,
expense, or distribution cost associated with producing a product. It can be easily traced to a
product, department or project. For example, Ford Motor Company (F) manufactures cars and
trucks. A plant worker spends eight hours building a car. The direct costs associated with the car
are the wages paid to the worker and the parts used to build the car.

Indirect Costs
Indirect costs, on the other hand, are expenses unrelated to producing a good or service. An
indirect cost cannot be easily traced to a product, department, activity or project. For example,
with Ford Motor Company (F), the direct costs associated with each vehicle include tires and
steel. However, the electricity used to power the plant is considered an indirect cost because the
electricity is used for all the products made in the plant. No one product can be traced back to the
electric bill.

What Are The Different Types Of Costs In Cost Accounting?

Fixed Costs
Fixed costs do not vary with the number of goods or services a company produces over the short
term. For example, suppose a company leases a machine for production for two years. The
company has to pay $2,000 per month to cover the cost of the lease, no matter how many
products that machine is used to make. The lease payment is considered a fixed cost as it remains
unchanged.

Variable Costs
Variable costs fluctuate as the level of production output changes, contrary to a fixed cost. This
type of cost varies depending on the number of products a company produces. A variable cost
increases as the production volume increases, and it falls as the production volume decreases.
For example, a toy manufacturer must package its toys before shipping products out to stores.
This is considered a type of variable cost because, as the manufacturer produces more toys, its
packaging costs increase. However, if the toy manufacturer's production level is decreasing, the
variable cost associated with the packaging decreases. For more on how fixed and variable costs
affect the profit of a company, please read "How Do Fixed Costs and Variable Costs Affect
Gross Profit?"

Operating Costs
Operating costs are expenses associated with day-to-day business activities but are not traced
back to one product. Operating costs can be variable or fixed. Examples of operating costs,
which are more commonly called operating expenses, include rent and utilities for a
manufacturing plant. Operating costs are day-to-day expenses, but are classified separately from
indirect costs – i.e., costs tied to actual production. Investors can calculate a company's operating
expense ratio, which shows how efficient a company is in using their costs to generate sales.

Opportunity Cost
Opportunity cost is the benefit given up when one decision is made over another. In other words,
an opportunity cost represents an alternative given up when a decision is made. This cost is,
therefore, most relevant for two mutually exclusive events. In investing, it's the difference in
return between a chosen investment and one that is passed up. For companies, opportunity costs
do not show up in the financial statements but are useful in planning by management.
For example, if a company decides to buy a new piece of manufacturing equipment rather than
lease it. The opportunity cost would be the difference between the cost of the cash outlay for the
equipment and the improved productivity versus how much money could have been saved had
the money been used to pay down debt.

Sunk Costs
Sunk costs are historical costs that have already been incurred and will not make any difference
in the current decisions by management. Sunk costs are those costs that a company has
committed to and are unavoidable or unrecoverable costs. Sunk costs (past costs) are excluded
from future business decisions because the costs will be the same regardless of the outcome of a
decision.

Controllable Costs
Controllable costs are expenses managers has control over and have the power to increase or
decrease. For example, deciding on how supplies are ordered or the payroll for a manufacturing
company would be controllable, but not necessarily avoidable.

Chapter 3
Absorption Costing vs. Variable Costing: An Overview
Absorption costing includes all costs, including fixed costs, related to production, while variable
costing only includes the variable costs directly incurred in production. Companies that use
variable costing keep fixed-cost operating expenses separate from production costs.

Some of the direct costs associated with manufacturing a product include wages for workers
physically manufacturing a product, the raw materials used in producing a product, and overhead
costs involved in manufacturing the product, such as batteries to run machinery.

The fixed costs that differentiate variable and absorption costing are primarily overhead
expenses, such as salaries and building leases, that do not change with changes in production
levels. A company has to pay its office rent and utility bills every month regardless of whether it
produces 1,000 products or no products at all, for example.

Whichever costing method a company selects to use for accounting purposes, there are
advantages and disadvantages.

Absorption Costing
Absorption costing, also known as full costing, entails allocating fixed overhead costs across all
units produced for the period, resulting in a per-unit cost, unlike variable costing, which
combines all fixed overhead costs into one expense, reporting them as a single line item on a
balance sheet to be taken against net income. In contrast, absorption costing will result in two
categories of fixed overhead costs: those attributable to the cost of goods sold and those
attributable to inventory.
One of the big advantages of absorption costing is that it is the method required for a company to
be in compliance with generally accepted accounting principles (GAAP). Even if a company
decides to use variable costing in-house, it is required by law to use absorption costing in any
external financial statements it publishes. Absorption costing is also the method that a company
is required to use for calculating and filing its taxes.

Some might argue that since a company has to use absorption costing anyway, it might as well
make that its sole approach, as opposed to taking on the additional burden of keeping variable
costing books.

Absorption costing also provides a more accurate accounting of net profitability, especially when
a company doesn't sell all of its products in the same accounting period in which they are
manufactured. Every expense is allocated to products manufactured whether or not they are sold.

Variable Costing
Variable costing can make it more difficult to determine ideal pricing for its goods and services
since it does not directly consider all of the costs the company has to cover to be profitable.
However, by looking only at the costs directly associated with production, variable costing
makes it easier for a company to compare the potential profitability of manufacturing one
product over another.
However, absorption costing is not as helpful as variable costing for comparing the profitability
of different product lines. Variable costing, on the other hand, enables a company to run a cost-
volume-profit analysis. This analysis is designed to reveal the break-even point in production by
determining how many products a company must manufacture and sell to reach the point of
profitability.

KEY TAKEAWAYS

Absorption costing includes all costs, including fixed costs, related to production, while variable
costing only includes the variable costs directly incurred in production.

Absorption costing, also known as full costing, entails allocating fixed overhead costs across all
units produced for the period, resulting in a per-unit cost.

Variable costing can make it more difficult to determine ideal pricing for its goods and services
since it does not directly consider all of the costs.

Variable Costing Statement (direct, Marginal costing for internal reporting purpose).

Particulars Amount Rs. Amount Rs.

Sales revenue(SP× Unit sold) ×××
Less: Variable MFG cost of Goods sold:
Direct material @Rs.× Production unit) ×××
Direct labor @Rs.× Production unit) ×××
Direct expenses @Rs.× Production unit) ×××
Variable Manufacturing overhead @Rs× Production unit ×××
Variable manufacturing cost of goods sold ×××
Add: Opening stock @ Rs.× unit of opening ×××
Less: Closing Stock @ Rs.× Unit of closing (×××)
Variable manufacturing cost of goods sold ×××
Contribution margin ×××
Less: Non-manufacturing variable cost:
Office and administrative overhead @Rs. ×××
Selling and distribution overheads @Rs. ××× ×××
Net contribution Margin ×××
Less: Fixed cost:
Fixed factory/manufacturing overheads ×××
Fixed office and administrative overheads ×××
Fixed selling and distribution overhands ××× ×××
Net income ………………………………………………. ×××
Reconciled Profit under Variable costing
Particulars Rs.
Net profit as per absorption costing: ×××
Add: Fixed manufacturing overhead of opening stock (FCOR× ×××
O/S) ×××
(×××)
Less: fixed manufacturing overhead of closing stock (FCOR×
C/S)
Profit as per variable costing ×××

Income statement under absorption costing

Particulars Amount Rs. Amount Rs.
Sales revenue(SP× Unit sold) ×××
Less: Variable MFG cost of Goods sold:
Direct material @Rs.× Production unit) ×××
Direct labor @Rs.× Production unit) ×××
Direct expenses @Rs.× Production unit) ×××
Variable Manufacturing overhead @Rs× Production unit ×××
Fixed manufacturing overheads @Rs× Production unit ×××
Variable manufacturing cost of goods sold ×××
Add: Opening stock @ Rs.× unit of opening ×××
Less: Closing Stock @ Rs.× Unit of closing (×××)
Variable manufacturing cost of goods sold ×××
Gross profit margin before adjustment
Add/Less: over/ Under absorption of fixed MFG cost ± ×××
Less: Non-manufacturing variable cost: ×××
Office and administrative overhead @Rs. ×××
Selling and distribution overheads @Rs. ×××
Fixed factory/manufacturing overheads ×××
Fixed office and administrative overheads ×××
Fixed selling and distribution overhands ×××
Net income ………………………………………………. ×××

Reconciled profit under absorption costing

Particulars Rs.
Net profit as per variable costing: ×××
Add: Fixed manufacturing overhead of closing stock (FCOR× ×××
C/S) ×××
(×××)
Less: fixed manufacturing overhead of opening stock (FCOR×
O/S)
Profit as per absorption costing ×××
Closing stock= Opening stock +production –Sales
Fixed cost overhead rate (FCOR) = fixed manufacturing OH/ Normal capacity
If production unit is higher than sales it should be appears (Closing stock)
If sales unit is higher than production unit it should be appears (Opening stock)

Numerical problems:
Qn. 1. (Paints Manufacturing Company provides you following information for the year ending 
December 31"2017. 
Normal capacity 25,000 units
Opening inventory 3,000 units
Production 28,000 units
Sales 29,000 units

Direct material Rs.l0 per unit

Direct labor Rs.12 per unit
Variable manufacturing overhead Rs. 5 per unit
Variable selling and administrative overhead Rs. 3 per unit
Selling price Rs. 40 per unit

Fixed manufacturing overhead Rs.75000

Fixed selling and administrative overhead Rs.25000
Required: prepare the income statement under variable costing method and reconcile the
statement under absorption costing.

Qn.2. A manufacturing company with normal capacity of 50,000 units supplied you with the
following particulars for the year ending December 30.

Production 55,000 units

Sales 60,000 units
Closing stock 5,000 units
Fixed selling and administrative cost Rs. 90,000
Unit variable manufacturing cost Rs. 6
Unit fixed manufacturing overhead Rs. 3
Unit variable selling and administrative cost Rs.2
Unit selling price Rs.15
Required: (a) variable costing income statement (b) Reconciled profit under absorption costing.

Ans: 180,000 and 165,000

Qn.3. A manufacturing company has reported is income statement under absorption costing
techniques as under
Particulars Amount $ Amount ($)
Sales revenue $45×10,000units) 450,000
Less: cost of goods sold:
Opening inventory (2000×$27) 54,000
 Variable cost (9000×$23) 207,000
Fixed cost (9000×$4) 36,000
Closing inventory (1000×$27) (27,000) 270,000
Gross margin before adjustment 180,000
Less: fixed cost under absorption (4000)
Gross margin 176000
Less other cost 50,000
Net income before tax 126,000
Required: income statement under internal reporting technique.
Ans: Net income $ 130,000
QN.4. prepare variable costing income statement by reporting standard and actual manufacturing
cost of goods sold. On the basis of the following details and also shows the reconciled profit
under absorption costing.
Normal capacity …………………….200,000 units per year
Standard variable manufacturing expenses ………Rs. 20 per unit
Fixed manufacturing overhead ……………………Rs. 300,000
Variable selling expenses………………………….Rs. 2 per unit
Fixed selling expenses …………………………….Rs. 100,000
Unit sales price…………………………………….Rs. 25
The operating results for the year ending December of the last year are as follows:
Sales ……………………………………………….1,50,000 units
Production ………………………………………….1,80,000 units

Ans: Rs. 50,000 and 95,000

QN.5. A Garment factory manufactures a single product. The normal level of operation is 40,000
units. Data for the last financial year were as follows:
Production Unit 30,000
Sales Unit 35,000
Closing stock Nil
Fixed Manufacturing overhead Rs.200,000
Fixed selling overhead Rs.105,000
Selling price per unit Rs. 25
Variable Cost Per Unit:
Direct material Rs. 5
Direct Labor Rs. 4
Other direct expenses Rs.2
Selling overhead 4% of selling price
Required: income statement under absorption costing
Ans: Net income: Rs. 125000
A Company manufactures a single product; the operating data for period is given below
Production Units = 1500 units Fixed Manufacturing Cost =
Rs.8000
Sales Units = 1800 units Fixed Selling Overhead = Rs.12000
Closing Stock = 200 units Variable Factory Overhead = Rs.5
per unit
 Direct Material = Rs.7 per unit Variable Selling Overhead = Rs.3
per unit
Direct Labour = Rs.4 per unit Selling Price per Unit = Rs.50
Required: Income Statement under Variable Costing and Absorption Costing

7) A Company manufactures a single product; the operating data for period is given below
Production Units = 12000 units Fixed Manufacturing Cost = Rs.60000
Normal Output = 10000 units Fixed Selling Overhead = Rs.30000
Selling Price per Unit = Rs.90 Fixed office Overhead = Rs.100000
Direct Material = Rs.20 per unit Variable Selling Overhead = Rs.5 per unit
Direct Labour = Rs.10 per unit Variable Factory Overhead = Rs.25 per unit
Opening Stock = nil Closing Stock = 2000 units
Required: Income Statement under Variable Costing and Absorption Costing

8) A Company manufactures a single product; the operating data for period is given below
Production Units = 9000 units Fixed Manufacturing Cost = Rs.50000
Normal Output = 10000 units Fixed Selling Overhead = Rs.20000
Selling Price per Unit = Rs.80 Fixed Administrative Overhead = Rs.50000
Direct Material = Rs.10 per unit Variable Selling Overhead = Rs.4 per unit
Direct Labour = Rs.15 per unit Variable Factory Overhead = Rs.20 per unit
Opening Stock = 1000 units Closing Stock = 2000 units
Required: Income Statement under Variable Costing and Absorption Costing

The Variable Costing Income Statement of a Company is as follows

Normal Capacity in units 25000
Sales in units 28000
Sales Revenue in Rs. 840000
Less: Variable Cost of Sales: Rs.
Beginning Inventory 3000 units 54000
Direct Material Cost 27000 @ Rs.5 135000
Direct Labour Cost 27000 @ Rs.8 216000
Variable Manufacturing Overhead 27000 @ Rs.5 135000
Total Cost of Goods Available 540000
Less: Ending Inventory 2000 @ Rs.18 36000
Total Variable Cost of Sales 504000
Contribution Margin 336000
Less: Fixed Manufacturing Overhead 100000
Net Income before Tax 236000
Required: Income Statement under Absorption Costing and Reconciliation of Differences

The Absorption Costing Income Statement of a Company is as follows

Sales in units 10000
Sales Revenue 400000
Less: Cost of Goods Sold: Rs.
Beginning Inventory 2000 units @ Rs.25 50000
Direct Material Cost 9000 @ Rs.10 90000
Direct Labour Cost 9000 @ Rs.10 90000
Variable Manufacturing Overhead 9000 @ Rs.2 18000
Fixed Overhead 9000 @ Rs.3 27000
Total Cost of Goods Available 275000
Less: Ending Inventory 1000 @ Rs.25 25000
Cost of Goods Sold 250000
Contribution Margin before Adjustment 150000
Less: Fixed Cost under Absorption 3000
Contribution Margin after Adjustment 147000
Less: Other Expenses 47000
Net Income before Tax 100000
Required: Income Statement under Variable Costing and Reconciliation of Differences

A Manufacturing Company with Normal Capacity of 20000 units furnished you the following
information:
Beginning Inventory Units 3000
Units Produced during the year 18000
Units Sold during the year 20000
Fixed Factory Overhead at Normal Capacity Rs. 100000
Fixed Administrative Overhead Rs. 50000
Fixed Selling Overhead Rs. 20000
Unit Selling Price Rs. 30
Variable Cost per Unit: Rs.
Raw Material 10
Direct Labour 5
Direct Expenses 3
Required: Income Statement under Absorption Costing and reconcile profit without preparing
Variable Costing Statement.

A company had the following information for two years:

Variable Manufacturing cost per unit Rs.15
Selling price per unit Rs.25
Fixed manufacturing cost per unit Rs.5
Fixed selling and administrative expenses Rs.325000
Variable selling expenses 5% of Sales
Normal Output 150000 units
Production Volume: 2012 170000 units
2013 140000 units
Sales Volume 2012 140000 units
2013 160000 units
Required: Income statement for the two years under external and internal reporting system
Case
9. As the chief financial analyst of a company, you have been asked by the chief executive to
explain the differences between two income statements prepared for his consideration: one was
prepared by the controller and the other by the sales manager. Both used the same data from
operations.
Statements A (Rs.) Statements B (Rs.)
Sales (30000 units) 3000000 3000000
Less: COGS
Beginning Inventory - -
add: Production Cost 1800000 2700000
less: Ending Inventory 600000 900000
Total cost of goods sold 1200000 1800000
Gross Profit 1800000 1200000
Less: Other expenses 1500000 600000
Net profit 300000 600000

Variable cost of production is Rs.40

Required: Which statement was prepared using variable costing and which was absorption
costing. Explain

Garrison 7.1, 7.3, 7.5, 7.7, 7.11, 7.14, 7.18 Page no. 294