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ADVANCED MANAGEMENT ACCOUNTING

LESSON 7:
BASIC COST CONCEPTS

Learning Objectives Replacement Cost


After studying this chapter you should be able to Replacement cost is the cost of replacement in the current
market.
• Explain different cost accounting terms.
• Understand basic cost concepts.
Committed Cost
Committed cost is a fixed cost, which results from decisions of
Cost Center: for the purpose of costing, it is desirable to divide pior period. The amount of committed cost is fixed by
the organization into sub-units. Cost center is the smallest decisions, which are made in the past, and is not subject to
organizational sub- units for which separate cost collection is managerial control in the present on short run basis. Examples
attempted. It can be a location, person or item of equipment. A of committed cost are depreciation, insurance, rent etc.
cost center is primarily of two types: (a) personal cost center (b)
impersonal cost center, which consists of a location or item of Historical Cost
equipment. Whether it is personal or impersonal, cost center Historical cost are post mortem costs, which are collected after
represents organizational span for which separate cost determi- they have been incurred. These costs, report past events and the
nation is attempted for decision-needs of management. time lag between event and its reporting makes the information
out of date and irrelevant for decision-making.
From functional point of view, cost center may be of two types:
(a) production cost centers i.e.; cost centers where production is Behavior wise Classification
done, for example, milling, turning and assembling and (b) This classification is very important for accounting and control.
service cost center i.e.; cost center which render services to Based on behavioral patterns, overhead can be divided into the
production centers, i.e.; boiler plant, repair shop, and crane etc. following categories:
Formation of appropriate cost center is very important for cost a. Fixed cost: fixed cost represents indirect cost, which remains
control purposes. Important considerations for formation of constant in total within current budget period regardless of
cost center are : (i) organization of the factory, (ii) Condition changes in volume of activity. This concept of fixed cost
prevalent for incurrence cost, (iii) Management’s decision-needs remains valid within certain output and turnover limits.
Fixed overhead does not vary in total. The incidence of fixed
Different Types of Cost overhead on unit cost decreases, as production increases and
Cost varies with purpose and the same cost data cannot serve all
vice-versa. Examples of fixed overhead are: rent of building,
purposes equally well. The word cost is used in such a wide
depreciation of plan and machinery, pay and allowances of
variety of ways that it is advisable to use it with an adjective or
managers, secretary and accountants, canteen expenses, audit
phrase, which will convey the meaning, intended. Certain types
fees etc. Fixed overheads have been called ‘period cost’ or
of cost are briefly discussed below: -
‘stand-by cost’ because these costs will be incurred even when
Profit Center no production activity take place.
A profit center is a segment of activity or area of responsibility
Y
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. Total fixed cost
The mangers hold responsibility for both revenues and
expenses. The main objective of profit center’s manager is to
Fixed cost per unit
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 X
Out-of-pocket cost is that cost which involves the cash outflow b. Variable cost represents that part of indirect cost, which
due to a particular management decision. Depreciation on assets varies with change in volume of activity. It varies in total but
is an item of cost, which will not form part of out of pocket its incidence on unit cost remains constant. The examples of
cost, because it does not entail cash outflow. variable overhead are: indirect material cost, indirect labour
cost, power and fuel, internal transport, lubricants, tools and
Sunk Cost spares.
CIMA defines it is as the past cost not taken into account in
c. Semi-variable cost: it is that part of overhead that is partly
decision making.
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 Cost Unit

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relationship with volume change. Semi variable costs do not After the cost of various cost centers has been ascertained, the
fluctuates in direct proportion to volume. An example of need arises to express the cost of output. Cost unit is defined
the semi variable overhead cost is the earning of an as unit of quantity of output in relation to which costs are
employee, who is paid a salary of Rs 500 per month (fixed0 ascertained or expressed. While cost center is the organizational
plus a bonus of Rs 0.50 for each init completed (variable0. if sub-unit for cost collection, cost unit is the unit of output for
he increases his output from 1000 units to 1500 units, his which a separate cost is ascertained.
earnings will increase from Rs 1000 to Rs 1250. an increase of More than one cost unit may be employed within a specified
505 in volume brought about only 25% increase in cost. company. If cost unit is to reflect the efficiency being achieved, it
Differential cost- differential cost are defined as the may be necessary to consider quantity, quality or other character-
difference in total cost between any two acceptable istics. This in itself will mean selection of mare than one cost
alternatives. Key emphasis in differential costing is on change unit. A transport contractor may decide to relate his cost to
in total costs associated with alternative decision. Incremental weight carried. This a cost unit, but it is not a logical cost unit,
cost is the increase in cost from one alternative to another. since it does not consider the distance factor, which considerably
Decremental cost is the decrease in cost due to alternative influence cost. Therefore, an appropriate and accurate cost unit
under consideration. Differential cost is a term broader than would be ton-mile, which associates weight with distance
incremental cost or decremental cost. The term differential covered. A few typical examples of cost units are given below:
costing encompasses both the terms incremental costing and Industry Cost unit basis Industry Cost unit basis
decremental costing.
Automobile number sugar tonne
Opportunity Cost Bricks 1000Nos. Steel tonne
CIMA has defined is as “the value of a benefit sacrificed in
Chemical litre, gallon, Kg Power Kwatt Hr.
favour of an alternative course of action.” If accepting an
alternative requires use of facilities or resources, which are used Cement Tonne Transport Tonne-Km
for some other purpose, there arises an opportunity cost. The Passenger-KM
opportunity cost is measured by the profit, which would have Gas Cubic metre Construction contract
been earned, if the resources or facilities had been used for
Suppose there is a factory X. it produces electric meters. It is
second best alternative. It is not easy to measure opportunity
important for the company to know the cost of one meter for
cost in all cases, but the relevance of opportunity cost in
obvious reason of cost control and price fixation etc. in this case
decision-making cannot be disputed.
cost of one meter is a “unit cost”. Since cost is being collected
Joint cost: are those costs, which are common to the processing by number, ‘cost unit’ is number.
of joint products or by products up to the point of separation.
For determining cost, factory will have to be divided into
In other words, joint costs represent pre-separation cost of
production and service department A B C may be production
joint products or by-products. After the point of separation,
department and D and E may be service department. In these
the products can be separately identified and post separation
cases ABC will be production cost centers and D and E will be
costs can be readily attributed to individual products. Costs
service centers. Then, total cost will be distributed among the
common to joint products or by-products before the point of
total number of meters produced. This will give the cost of
separation of their identity, present a problem of allocation.
one meter. In this situation A B C D and E were the cost
These pre-separation costs should be appropriately apportioned
centers. Cost of one meter is the unit cost. Number is the cost
for correct determination of products and managerial analysis
unit. Therefore, unit cost is very important objective. Cost unit
for decision-making. Joint costs are incurred as lump sum for
is he media to express it. Cost centers are the organizations sub-
the combination an not separately for the individual products.
divisions necessary for cost collection and cost ascertainment.
In dairy farming, the cost of milk for the preparation of cream,
butter, skimmed milk, etc. will be the joint cost. The term joint Conversion Costs
cost is used to refer to lump sum costs incurred in the simulta- Conversion Costs are all manufacturing costs other than direct
neous production of multiple products that cannot be material costs. These costs represent all manufacturing costs
produced separately. Joint costs present following difficulties for incurred to convert direct materials into finished goods. Some
accountants: companies use conversion cots to simplify their accounting.
1. Determing how it should be apportioned among the They have only two classifications of costs: direct material costs
individual members of the product-group. and conversion costs. For these companies, all conversion costs
are indirect manufacturing costs. An example is costing system
2. If joint cost is not properly apportioned among the joint
in computer integrated manufacturing (CIM) plants. CIM
products, it will lead to incorrect inventory valuation.
plants have very few workers. The workers role is to monitor
3. Incorrect apportionment of joint cost will lead to wrong the manufacturing process and maintain the equipment that
income measurements relating to individual joint products. produces multiple products. Costing system in CIM plants do
This situation may be tolerable for product pricing in some not have a direct manufacturing labour cost category because
situation, but it is disastrous for managerial analysis and direct manufacturing labour costs are small and because it is
control. difficult to trace these costs to products.

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Standard Costing difficult to trace supervision costs to the Pepsi-cola line. The
ADVANCED MANAGEMENT ACCOUNTING

According to CIMA(London), “Standard costing is a control term cost allocation is used to describe the assignment of
technique which compares standard costs and revenues with indirect costs to a particular cost object.
actual results to obtain variances which are used to stimulate
Uniform Costing
improved performance.” Use of standard costing isnot
CIMA defines uniform costing as “a system, using common
confined to industries having repetitive processes and homoge-
concepts, principles and standard accounting practice, adopted
neous products only. This technique has established the
by different entities in the same industry to facilitate inter-firm
advantages of its use in industries having non-repetitive
comparison.”
processes like manufacturing of automobile, turbines, boilers
and heavy electrical equipment. Basic Cost Concepts
These terms are based on certain cost concepts, which are
Discretionary costs have two important features to consider
summarized below:
(1) they arise from periodic (usually annual) decision regarding
the maximum amount to be incurred and, (2) they have no 1. Concept of objectivity:-
measurable cause and effect relationship between output and It is this concept that gives direction to the activities related
resources used. Examples of discretionary costs include to cost funding, cost analyzing and cost reporting. This
advertising, executive training, R&D, health care and corporate- concept necessitates goal congruence, i.e; cost exercise has to
staff department costs such as legal, human resources and be in harmony with objectives. Cost treatments and cost
public relations. The most noteworthy aspect of discretionary strategies are influenced by objectives, which may include
costs is that managers are seldom confident that the correct internal reporting for operational decisions, internal
amounts are being spent. reporting for non-repetitive decisions and external decisions
Marginal cost is the additional cost resulting from producing 2. Concept Of Materiality
and selling one additional cost unit. The marginal cost often This concept that stresses accuracy must be tempered by
decreases as production increases up to a point because of good judgment, if no distortion of product cost is likely to
efficiencies created by larger amounts. At some point, however, result. For example, overhead may include some items of
marginal costs begin to rise with increases in production because direct cost, which may not be material as to justify tracing
facilities begin to be overcrowded or over used, resulting in them to specific unit of production. A particular decision
efficiencies. may be useful, but benefits may not be material enough to
Cost Drivers implement it. Materiality is determined with reference to
A cost driver is a variable, such as the level of activity or volume nature of company’s activities, managerial policies and
that casually affects costs over a given time span. That is, there is competitors practices.
a cause and effect relationship between a change in the given of 3. Concept of time span
activity or volume and a change in the level of costs. For All assumptions relating to different cost exercises remain
example, if a product design costs change with the number of valid only during related time span. The statement that cost
parts in a product, the number of parts is a cost driver of is fixed is based on a time span under consideration. No
product-design costs. Similarly, miles driven are often a cost costs will remain fixed for all the time. Time span selected by
driver of distribution costs. The cost driver of a variable cost is a company should be long enough to permit the procedures
the level of activity or volume whose change causes proportion- to record the associated cost, output, labor hours and other
ate in variable costs. factors needed in the analysis. If time span is too short, leads
Cost Tracing and Cost Allocation and lags in recording the cost data may be quite troublesome.
Direct cost of a cost object is related to the particular cost object If cost resulting to a particular time span activity is recorded
and can be traced to that cost in an economically feasible way. to another time span activity, cost results may turn out to be
For example, the cost of the cans or bottles is a direct cost of quite erroneous.
Pepsi-colas. The cost of the cans or bottles can be easily traced 4. Concept of relevant range of activity:
to or identified with the drink. The term cost tracing is used to
Relevant range of activity represents the span of volume
describe the assignment of direct costs to the particular cost
over which the cost behavior is expected to remain valid.
object.
Different cost exercises are based on certain assumptions
Indirect cost of a cost object are related to the particular cost relating to cost behavior patterns, which are valid only within
object but cannot be traced to that cost object in an economically the relevant range of activity. A fixed cost is fixed only in
feasible way. For example, the salaries of supervisors who relation to the relevant range of activity during the period.
oversee production of many different soft drink products The relevant range of activity may be different between firms
bottled at a Pepsi plant is an indirect cost of Pepsi-colas. and for individual firm also, it may change from time to
Supervision costs are related to the cost object (Pepsi-cola) time.
because supervision is necessary for managing the production
5. Concept of relevant cost and benefit for operating decisions:
and sale of Pepsi-colas. Supervision costs are indirect cost
because supervisors also oversee the production of other This concept is vital for decision –making purposes. In
products such as 7-up. Unlike the cost of cans or bottles, it is 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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