ADVANCED MANAGEMENT ACCOUNTING
LESSON 7:
BASIC COST CONCEPTS
Learning Objectives
After studying this chapter you should be able to
• Explain different cost accounting terms.
• Understand basic cost concepts.
Cost Center: for the purpose of costing, it is desirable to divide
the organization into sub-units. Cost center is the smallest
organizational sub- units for which separate cost collection is
attempted. It can be a location, person or item of equipment. A
cost center is primarily of two types: (a) personal cost center (b)
impersonal cost center, which consists of a location or item of
equipment. Whether it is personal or impersonal, cost center
represents organizational span for which separate cost determi-
nation is attempted for decision-needs of management.
From functional point of view, cost center may be of two types:
(a) production cost centers i.e.; cost centers where production is
done, for example, milling, turning and assembling and (b)
service cost center i.e.; cost center which render services to
production centers, i.e.; boiler plant, repair shop, and crane etc.
Formation of appropriate cost center is very important for cost
control purposes. Important considerations for formation of
cost center are : (i) organization of the factory, (ii) Condition
prevalent for incurrence cost, (iii) Management’s decision-needs
Different Types of Cost
Cost varies with purpose and the same cost data cannot serve all
purposes equally well. The word cost is used in such a wide
variety of ways that it is advisable to use it with an adjective or
phrase, which will convey the meaning, intended. Certain types
of cost are briefly discussed below: -
Profit Center
A profit center is a segment of activity or area of responsibility
for which both revenues and costs are accumulated. In general
terms, most responsibility centers are viewed as profit centers-
taking the difference between revenues and expenses as profit.
The mangers hold responsibility for both revenues and
expenses. The main objective of profit center’s manager is to
maximize the center ‘s profit. CIMA defines profit center as a
part of business accountable for costs and revenues. It may be
called a business center, business unit, or strategic business unit.
Out of Pocket Cost
Out-of-pocket cost is that cost which involves the cash outflow
due to a particular management decision. Depreciation on assets
is an item of cost, which will not form part of out of pocket
cost, because it does not entail cash outflow.
Sunk Cost
CIMA defines it is as the past cost not taken into account in
decision making.
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Replacement Cost
Replacement cost is the cost of replacement in the current
market.
Committed Cost
Committed cost is a fixed cost, which results from decisions of
pior period. The amount of committed cost is fixed by
decisions, which are made in the past, and is not subject to
managerial control in the present on short run basis. Examples
of committed cost are depreciation, insurance, rent etc.
Historical Cost
Historical cost are post mortem costs, which are collected after
they have been incurred. These costs, report past events and the
time lag between event and its reporting makes the information
out of date and irrelevant for decision-making.
Behavior wise Classification
This classification is very important for accounting and control.
Based on behavioral patterns, overhead can be divided into the
following categories:
a. Fixed cost: fixed cost represents indirect cost, which remains
constant in total within current budget period regardless of
changes in volume of activity. This concept of fixed cost
remains valid within certain output and turnover limits.
Fixed overhead does not vary in total. The incidence of fixed
overhead on unit cost decreases, as production increases and
vice-versa. Examples of fixed overhead are: rent of building,
depreciation of plan and machinery, pay and allowances of
managers, secretary and accountants, canteen expenses, audit
fees etc. Fixed overheads have been called ‘period cost’ or
‘stand-by cost’ because these costs will be incurred even when
no production activity take place.
Y
Total fixed cost
Fixed cost per unit
X
b. Variable cost represents that part of indirect cost, which
varies with change in volume of activity. It varies in total but
its incidence on unit cost remains constant. The examples of
variable overhead are: indirect material cost, indirect labour
cost, power and fuel, internal transport, lubricants, tools and
spares.
c. Semi-variable cost: it is that part of overhead that is partly
fixed and partly variable. These overheads show mixed
relationship, when plotted against volume. Semi-variable
overheads may remain fixed within certain activity level, but
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 once that level is exceeded, they vary without having direct
relationship with volume change. Semi variable costs do not
fluctuates in direct proportion to volume. An example of
the semi variable overhead cost is the earning of an
employee, who is paid a salary of Rs 500 per month (fixed0
plus a bonus of Rs 0.50 for each init completed (variable0. if
he increases his output from 1000 units to 1500 units, his
earnings will increase from Rs 1000 to Rs 1250. an increase of
505 in volume brought about only 25% increase in cost.
Differential cost- differential cost are defined as the
difference in total cost between any two acceptable
alternatives. Key emphasis in differential costing is on change
in total costs associated with alternative decision. Incremental
cost is the increase in cost from one alternative to another.
Decremental cost is the decrease in cost due to alternative
under consideration. Differential cost is a term broader than
incremental cost or decremental cost. The term differential
costing encompasses both the terms incremental costing and
decremental costing.
Opportunity Cost
CIMA has defined is as “the value of a benefit sacrificed in
favour of an alternative course of action.” If accepting an
alternative requires use of facilities or resources, which are used
for some other purpose, there arises an opportunity cost. The
opportunity cost is measured by the profit, which would have
been earned, if the resources or facilities had been used for
second best alternative. It is not easy to measure opportunity
cost in all cases, but the relevance of opportunity cost in
decision-making cannot be disputed.
Joint cost: are those costs, which are common to the processing
of joint products or by products up to the point of separation.
In other words, joint costs represent pre-separation cost of
joint products or by-products. After the point of separation,
the products can be separately identified and post separation
costs can be readily attributed to individual products. Costs
common to joint products or by-products before the point of
separation of their identity, present a problem of allocation.
These pre-separation costs should be appropriately apportioned
for correct determination of products and managerial analysis
for decision-making. Joint costs are incurred as lump sum for
the combination an not separately for the individual products.
In dairy farming, the cost of milk for the preparation of cream,
butter, skimmed milk, etc. will be the joint cost. The term joint
cost is used to refer to lump sum costs incurred in the simulta-
neous production of multiple products that cannot be
produced separately. Joint costs present following difficulties for
accountants:
1. Determing how it should be apportioned among the
individual members of the product-group.
2. If joint cost is not properly apportioned among the joint
products, it will lead to incorrect inventory valuation.
3. Incorrect apportionment of joint cost will lead to wrong
income measurements relating to individual joint products.
This situation may be tolerable for product pricing in some
situation, but it is disastrous for managerial analysis and
control.
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Cost Unit
ADVANCED MANAGEMENT ACCOUNTING
After the cost of various cost centers has been ascertained, the
need arises to express the cost of output. Cost unit is defined
as unit of quantity of output in relation to which costs are
ascertained or expressed. While cost center is the organizational
sub-unit for cost collection, cost unit is the unit of output for
which a separate cost is ascertained.
More than one cost unit may be employed within a specified
company. If cost unit is to reflect the efficiency being achieved, it
may be necessary to consider quantity, quality or other character-
istics. This in itself will mean selection of mare than one cost
unit. A transport contractor may decide to relate his cost to
weight carried. This a cost unit, but it is not a logical cost unit,
since it does not consider the distance factor, which considerably
influence cost. Therefore, an appropriate and accurate cost unit
would be ton-mile, which associates weight with distance
covered. A few typical examples of cost units are given below:
Industry Cost unit basis Industry Cost unit basis
Automobile number sugar tonne
Bricks 1000Nos. Steel tonne
Chemical litre, gallon, Kg Power Kwatt Hr.
Cement Tonne Transport Tonne-Km
Passenger-KM
Gas Cubic metre Construction contract
Suppose there is a factory X. it produces electric meters. It is
important for the company to know the cost of one meter for
obvious reason of cost control and price fixation etc. in this case
cost of one meter is a “unit cost”. Since cost is being collected
by number, ‘cost unit’ is number.
For determining cost, factory will have to be divided into
production and service department A B C may be production
department and D and E may be service department. In these
cases ABC will be production cost centers and D and E will be
service centers. Then, total cost will be distributed among the
total number of meters produced. This will give the cost of
one meter. In this situation A B C D and E were the cost
centers. Cost of one meter is the unit cost. Number is the cost
unit. Therefore, unit cost is very important objective. Cost unit
is he media to express it. Cost centers are the organizations sub-
divisions necessary for cost collection and cost ascertainment.
Conversion Costs
Conversion Costs are all manufacturing costs other than direct
material costs. These costs represent all manufacturing costs
incurred to convert direct materials into finished goods. Some
companies use conversion cots to simplify their accounting.
They have only two classifications of costs: direct material costs
and conversion costs. For these companies, all conversion costs
are indirect manufacturing costs. An example is costing system
in computer integrated manufacturing (CIM) plants. CIM
plants have very few workers. The workers role is to monitor
the manufacturing process and maintain the equipment that
produces multiple products. Costing system in CIM plants do
not have a direct manufacturing labour cost category because
direct manufacturing labour costs are small and because it is
difficult to trace these costs to products.
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 Standard Costing
ADVANCED MANAGEMENT ACCOUNTING
According to CIMA(London), “Standard costing is a control
technique which compares standard costs and revenues with
actual results to obtain variances which are used to stimulate
improved performance.” Use of standard costing isnot
confined to industries having repetitive processes and homoge-
neous products only. This technique has established the
advantages of its use in industries having non-repetitive
processes like manufacturing of automobile, turbines, boilers
and heavy electrical equipment.
Discretionary costs have two important features to consider
(1) they arise from periodic (usually annual) decision regarding
the maximum amount to be incurred and, (2) they have no
measurable cause and effect relationship between output and
resources used. Examples of discretionary costs include
advertising, executive training, R&D, health care and corporate-
staff department costs such as legal, human resources and
public relations. The most noteworthy aspect of discretionary
costs is that managers are seldom confident that the correct
amounts are being spent.
Marginal cost is the additional cost resulting from producing
and selling one additional cost unit. The marginal cost often
decreases as production increases up to a point because of
efficiencies created by larger amounts. At some point, however,
marginal costs begin to rise with increases in production because
facilities begin to be overcrowded or over used, resulting in
efficiencies.
Cost Drivers
A cost driver is a variable, such as the level of activity or volume
that casually affects costs over a given time span. That is, there is
a cause and effect relationship between a change in the given of
activity or volume and a change in the level of costs. For
example, if a product design costs change with the number of
parts in a product, the number of parts is a cost driver of
product-design costs. Similarly, miles driven are often a cost
driver of distribution costs. The cost driver of a variable cost is
the level of activity or volume whose change causes proportion-
ate in variable costs.
Cost Tracing and Cost Allocation
Direct cost of a cost object is related to the particular cost object
and can be traced to that cost in an economically feasible way.
For example, the cost of the cans or bottles is a direct cost of
Pepsi-colas. The cost of the cans or bottles can be easily traced
to or identified with the drink. The term cost tracing is used to
describe the assignment of direct costs to the particular cost
object.
Indirect cost of a cost object are related to the particular cost
object but cannot be traced to that cost object in an economically
feasible way. For example, the salaries of supervisors who
oversee production of many different soft drink products
bottled at a Pepsi plant is an indirect cost of Pepsi-colas.
Supervision costs are related to the cost object (Pepsi-cola)
because supervision is necessary for managing the production
and sale of Pepsi-colas. Supervision costs are indirect cost
because supervisors also oversee the production of other
products such as 7-up. Unlike the cost of cans or bottles, it is
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difficult to trace supervision costs to the Pepsi-cola line. The
term cost allocation is used to describe the assignment of
indirect costs to a particular cost object.
Uniform Costing
CIMA defines uniform costing as “a system, using common
concepts, principles and standard accounting practice, adopted
by different entities in the same industry to facilitate inter-firm
comparison.”
Basic Cost Concepts
These terms are based on certain cost concepts, which are
summarized below:
1. Concept of objectivity:-
It is this concept that gives direction to the activities related
to cost funding, cost analyzing and cost reporting. This
concept necessitates goal congruence, i.e; cost exercise has to
be in harmony with objectives. Cost treatments and cost
strategies are influenced by objectives, which may include
internal reporting for operational decisions, internal
reporting for non-repetitive decisions and external decisions
2. Concept Of Materiality
This concept that stresses accuracy must be tempered by
good judgment, if no distortion of product cost is likely to
result. For example, overhead may include some items of
direct cost, which may not be material as to justify tracing
them to specific unit of production. A particular decision
may be useful, but benefits may not be material enough to
implement it. Materiality is determined with reference to
nature of company’s activities, managerial policies and
competitors practices.
3. Concept of time span
All assumptions relating to different cost exercises remain
valid only during related time span. The statement that cost
is fixed is based on a time span under consideration. No
costs will remain fixed for all the time. Time span selected by
a company should be long enough to permit the procedures
to record the associated cost, output, labor hours and other
factors needed in the analysis. If time span is too short, leads
and lags in recording the cost data may be quite troublesome.
If cost resulting to a particular time span activity is recorded
to another time span activity, cost results may turn out to be
quite erroneous.
4. Concept of relevant range of activity:
Relevant range of activity represents the span of volume
over which the cost behavior is expected to remain valid.
Different cost exercises are based on certain assumptions
relating to cost behavior patterns, which are valid only within
the relevant range of activity. A fixed cost is fixed only in
relation to the relevant range of activity during the period.
The relevant range of activity may be different between firms
and for individual firm also, it may change from time to
time.
5. Concept of relevant cost and benefit for operating decisions:
This concept is vital for decision –making purposes. In
evaluating alternative courses of action, management should
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 consider only relevant cost and relevant benefit relating to Fixed costs: Costs which remain constant in total, regardless

ADVANCED MANAGEMENT ACCOUNTING

alternatives under consideration. of changes in the level of activity. Unit fixed costs vary
a. Relevant costs and benefits for operating decisions: in depending on activity level.
operating decisions, concentration is on best use of Product costs: Costs involved in the purchase or manufacture
existing capacity. Incremental analysis based on differential of goods—direct material, direct labor, and manufacturing
cost and differential revenue is based directly on the overhead
concept of relevant cost and benefit. The term Period costs: Costs which are expensed in the period incurred,
opportunity cost also springs from the thought i.e, selling and administrative costs
underlying this concept.
Although much of the discussion in the text relates to these
b. Relevance of normal and abnormal cost. The term cost classifications and their application in a manufacturing
normal cost and abnormal cost, normal working environment; nevertheless, these cost concepts have similar
conditions and abnormal working conditions are application to many service organizations such as restaurants,
frequently used in cost accounting discussions. Normal banks, etc.
cost and abnormal cost cannot be treated alike. Similarly,
In this field trip assignment, would you please visit a business
cost accounting strategy for normal conditions will not
establishment—fast food restaurant, coffee house, etc. (if you
hold good for abnormal conditions. The term normal
wish, you may use your place of employment) and do the
stands for anything, which is in agreement with what is
following:
representative, usual, or regular. The term abnormal
stands for anything, which is different from what is 1. Name of selected business:
normal, ordinary or expected. Different cost accounting 2. Type of business, i.e., manufacturer, merchandiser, service,
treatments are laid down for normal cost and abnormal etc.
cost. Different cost accounting strategies exist for normal 3. Identify three fixed and three variable costs of the business.
circumstances and abnormal circumstances.
4. Identify three product costs and three period costs.
The Following Question-answer format 5. Identify at least five practices by which the company practices
Summarizes the Chapters Learning Total Quality Management.
Objectives
Notes
1. Explain how cost drivers affect cost behavior?
A cost driver is an output measure of a resource or activity.
When the use of a resource or the performance of an activity
changes, the level of the cost driver or output measure will
also change, causing changes in costs.
2. How do managers decide on a cost object?
A cost object is anything for which a separate measurement
of costs is needed. Examples include product, service,
project, customer, brand category, activity and department.
3. How do managers decide whether a cost is a direct or indirect
cost?
A direct cost is any cost that is related to a particular cost
object and can be traced to that cost object in an economically
feasible way. Indirect costs are related to the particular cost
object but cannot be traced to it in an economically feasible
way. The sane cost can be direct for one cost object and
indirect for other cost objects.
4. How should costs be estimated?
In general, focus on total, not unit costs. When making total
cost estimates, think of variable costs as an amount per unit
and fixed costs as total amount, the unit cost of a cost
object should be interpreted cautiously when it includes a
fixed cost component.
Assignment Material
Some important cost classifications considered in Chapter 2 of
the text are the following:
Variable costs: Costs which vary, in total, in direct proportion
to changes in the level of activity. Unit variable costs remain the
same

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