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CHAPTER 01

COST ANALYSIS AND COST DETERMINATION

Learning outcomes

After com!eting t"is c"ater #ou $i!! %e a%!e to&

define key costing terms

understand the framework of conventional cost ascertainment

1'0 Intro(uction

Cost accounting is a management information system which analyses past, present and future

data to provide a bank of data for the management accountant to use.

Management accounting is the application of the principles of accounting and financial

management to create, protect, preserve and increase value so as to deliver that to the

stakeholders of profit and not for profit enterprises, both public and private.

1'1 A Cost

In the Oxford ictionary !cost" means !the price paid for something". #ut in the managementterminology, !cost" refers to expenditure and not to price. $he Institute of Cost and

Management %ccountants, &ondon, has defined cost as !the amount of expenditure incurred

on or attributable to a given thing or activity".

Cost ' (uantity used x price

1') Cost units

Costs are always related to some ob)ect or function or service. *or example, the cost of a car,

a haircut, a ton of coal. +uch units are known as cost units and can be formally defined as !%

unit of product or service in relation to which costs are ascertained".

E*am!e+,

In(ustr# Cost o%-ect

%utomobile Cars produced

%pparel Items produced

+and Cubes

Mobile phone Mobile phones

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ospital -atients treated

+chool university +tudents enrolled

-assenger transport -assengers travelled

1'. Cost Centres

Cost centre is a production or service location, function, activity or item of e(uipment for

which costs are accumulated. In other words a cost centre is a collecting place for costs. $he

costs will be collected in these cost centres until the costs are related to the units.

E*am!es+,

T#e of cost centre E*am!es

+ervice location Canteen

*unction +ales, marketing

%ctivity -ackaging, (uality control

Item of e(uipment /ashing plant, photocopier machine

1'/ Cost C!assification

Cost classification is

$he arrangement of items in logical groups having regard to their nature or purpose

$he costs can be classified in different nature. $he same cost item may be classified in

different ways depending on the cost classification method. $he method of cost classification

and level of detail re(uired will depend on the purpose of cost classification, thus purpose of

cost classification can be,

Cost planning

ecision making

+tock valuation

Cost control

-roduct -ricing

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1' Different Cost C!assification Met"o(s

0. %ccording to the elements

1. Costs classification according to the purpose

2. Cost classification according to the functions

3. Cost classification according to the behaviour

1''1 Accor(ing to t"e e!ements

Cost elements are the constituent parts of costs according to the factors upon which

expenditure is incurred, material, labour, and expenses. In other words, this is how the total

cost is composed of. If you consider a cost ob)ect such as a bottled water product the

following cost elements can be identified.

P!astic %ott!e an( t"e !i(

/ater %ll these items can be categori4ed as material

&abel

+alary of the machine operator

+alary of the (uality controller

+alary of the lab supervisor %ll these items can be categori4ed as labour

+alary of the deliverymen

+alary of the accountant

*actory rent

5lectricity

%dvertising %ll these items can be categori4ed as expenses

$ransport cost

-lant depreciation

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1'') Costs c!assification accor(ing to t"e urose

/hen costs are classified having regard to their purpose, they are grouped according to the

reason for which they have been incurred. %ccordingly, the costs can be classified as6

1'')'1 Direct costs

Costs may be classified in numerous ways, but a fundamental and important method of

classification is into direct and indirect costs. irect costs 7comprising direct material costs,

direct wages cost and direct expenses8 are those costs which can be directly identified with a

)ob, batch, product or service.

$he total of direct costs is known as prime cost,

Direct materia! (irect !a%our (irect e*enses 2 rime cost

1'')') In(irect costs

%ll material, labour and expense costs which cannot be identified as direct costs are termed

indirect costs. $he three elements of indirect costs6 indirect materials, indirect labour and

indirect expenses are collectively known as overheads. $ypical examples of indirect costs in

the production area are the following.

I9I:5C$ M%$5:I%&+; &ubricating oil, stationery, consumable materials,

maintenance materials, spare parts for machinery

I9I:5C$ &%#O

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1'' . Cost c!assification accor(ing to t"e functions

ere the Classification is under four ma)or functions of business;

7a8 -roduction cost;?It is also known as manufacturing factory cost incurred@ in

converting raw material into finished product.

7b8%dministration cost; ? %dministration cost is incurred for over all planning,

organi4ing and control of the enterprise

7c8+elling cost; ? +elling costs are also known as selling expenses and sellingoverheads which comprise of all the expanses of selling department

including product promotion and advertising.

7d8istribution cost; ? It is cost of se(uence of operations which begin with making

the packed product available for dispatch and ends with

making the reconditioned, returned empty package,

If you consider the previous example the cost ob)ect being a bottled water product the

following cost elements can be categori4ed into their respective functions.

-lastic bottle and the lid

/ater

&abel

+alary of the machine operator

+alary of the (uality controller %ll these items can be categori4ed as

+alary of the lab supervisor production costs

*actory rent

5lectricity

-lant depreciation

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+alary of the deliverymen %ll these items can be

%dvertising categori4ed as selling and

$ransport cost distribution costs %ll these functional costs

Interest cost paid this item can be can be categori4ed as

Categori4ed as finance non production costs.

costs

1''/ Cost c!assification accor(ing to t"e %e"a3ior

#ased on nature or behavior, cost is classified into fixed, variable and semi variable costs.

4i*e( cost+ ,A% cost which tends to be unaffected by variations in volume of outputB. It is

sometimes referred to as period costs.

$otal cost

&evel of activity

5g;?+alary of managing director, rent of single factory, depreciation of single machine

7straight line8

5aria%!e costs+ ,A% cost which tends to vary directly with volume of output.

5.g.6?raw material cost, direct labour cost, sales commission

$otal cost

&evel of activity

Semi, 3aria%!e costs+

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% semi?variable cost is a !cost containing both fixed and variable components and which is

thus partly affected by fluctuations in the level of activity.

5g; 5lectricity bill, tax and gas+emi variable cost ' fixed cost > variable cost

$otal cost $C

*C

&evel of activity

%s per cost behaviour, fixed cost remains constant to a particular level of output where as

variables cost has tendency to change proportionately.

E*am!e

$he following information is given with regard to =D -lc per year.

&E:

:ent for the factory 2FF,FFF

Insurance of the factory 0FF,FFF

-lant depreciation GH,FFF

$he cost accountant of the company has obtained the following other information with regard

to one unit of product =.

irect materials used 1 Egs at &E:. 1H per Eg

irect labour 2 hours at &E:. 1F per hour

esigner fee &E:.0HF

*ind out the total cost of making

0. O unit 1. H,FFF units 2. 0F,FFF units

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irect materials consumed

irect wages

irect expenses

-rime cost

*actory overhead

*actory cost

?

?

?

?

?

?

?

?

?

?

? ?

Office and %dministration overhead

Cost of production

+elling and istribution overhead

$otal cost

? ?

?

?

?

?

? ?

E*am!e+,

Sat#am Pro(ucts P!c' supplies you with the following information relating to product !="

for the month of January 1F00.

:aw materials consumed &E:. KF,FFF

irect wages &E:.. 2K,FFF

9o. of machine hours worked HFF

Machine our :ate &E:. 1F

Office overhead 1FL on works cost

+elling overhead &E:.1 per unit sold

9o. Of units manufactured H,FFF

9o. Of units sold 3,FFF &E:. 2H per unit

ou are re(uired to prepare a cost sheet in respect of the above showing cost and profit per

unit.

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1'8 Cost estimation

Cost estimation? $he determination of cost behaviour according to the level of activity.

Cost estimation is widely used in planning and decision making. $here are several methods

that are commonly used to determine the relationship between cost and activity level.

1'8'1 Hig" 9!o$ met"o(

In high low method the highest and the lowest activity levels are selected in order to identify

the variable cost which is then used to ascertain the fixed cost. $he given below are steps of

high low method.

0. +elect the highest and the lowest values from the independent variable that is from the

activity level and their respective costs.

1. Calculate the change in the activity level and the change in the cost to calculate the

variable cost per unit.

ariable cost per unit ' Change in the total cost

Change in the activity level

variable cost per unit x 9umber of units

E*am!e+

T"e num%er of atients Tota! cost :L;R .

cost

irect

&abour >

cost

irect

5xpenses >

ariable

-roduction

Overhead cost

/'1'1 Contri%ution

It is known as the difference between the selling price of particular goods or services and its

variable cost.

+ince it is assumed that the variable cost per unit and the selling price per unit are constant in

marginal costing, contribution received by a unit is constant at any level of activity.

? profit &oss

Or

$otal Contribution ' $otal +ales = -rofit olume :atio

%ccordingly,

$otal -rofit ' $otal Contribution $otal *ixed Cost

E*am!e+,

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%#C produces product !=" of which selling price per unit is &E:. 0FF' and the variable

cost per unit is &E:. KF'. $he fixed cost per month is &E:. 1FF,FFFand the monthly sales

(uantity is 0F,FFF units.

ou are re(uired to calculate,

0. Contribution of a unit of product !="

1. $otal contribution received from the product ! =" for a month.

/'1') Imortance of t"e Contri%ution

Contribution is important to the management as it is provided the re(uired information to the

managerial decision making.

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Opening stock of finished goods =xx

7to variable production cost8

-roduction cost

irect material cost =xx

irect labour cost =xx

irect expenses =xx

-rimary cost =xx

-roduction overhead cost xxx =xx

Closing stock of finished goods 7xxx87to variable production cost8

=xx

5stablishment S %dministration cost =xx

+elling S istribution xxx 7xxx8

Contribution xxx

*ixed cost

-roduction 7xxx8

5stablishment S administration 7xxx8

+elling S distribution 7xxx8 7xxx8

-rofit &oss xxx

T"is can %e summariGe( as fo!!o$s'

&E:.

+ales value xxx

ariable cost 7xxx8

Contribution xxx

*ixed cost 7xxx8

-rofit &oss xxx

/') A%sortion Costing

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In *inancial %ccounting, revenue statement is prepared using absorption costing

method.

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E*am!e+,

-R: -lc produced 0F,FFF units in July 1F0F and which were sold by &E:.. 0FF' per unit.

Other relevant information for the month is as follows.

&E:.

irect material cost 1HF,FFF

irect labour cost 0FF,FFF

irect expenses GH,FFF

-roduction overhead cost ariable HF,FFF

*ixed KF,FFF

%dministration overheads cost ariable 3F,FFF

*ixed 3F,FFF

+elling overhead cost ariable HF,FFF

*ixed NH,FFF

ou are re(uired to prepare profit statements based on marginal and absorption costing

methods.

Practice =uestions

01 $arget -rofit8 x +ales price per unit intarget profit 7:s sales8 Contribution per unit.

6'1' Dra$ing a %asic %rea?e3en c"art'

6'1''1 Tra(itiona! %rea?e3en c"art'

% basic breakeven chart records costs and revenues on the vertical axis and the level of

activity on the hori4ontal axis. &ines are drawn on the chart to represent costs and sales

revenue. $he breakeven point can be read off where the sales revenue line cuts the total cost

line.

/e shall use our basic example to demonstrate how to draw a breakeven chart. $he data is;

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+elling price &E:.HF per unit

ariable cost &E:. 2F per unit

*ixed costs &E:.1F,FFF per month

*orecast sales 0,GFF units per month

raw the basic breakeven chart

6'1'') T"e contri%ution %rea?e3en c"art'

% contribution breakeven chart is based on the same principles but it shows the variable cost

line instead of the fixed cost line. $he same lines for total cost and sales revenue are shown so

the breakeven point and profit can be read off in the same way as with a conventional chart.

owever, it is also possible to read the contribution for any level of activity

6'1''. T"e rofit,3o!ume c"art

%nother form of breakeven chart is the profit?volume chart. $his chart plots a single linedepicting the profit or loss at each level of activity. $he breakeven point is where this line cuts

the hori4ontal axis. $he vertical axis shows profits and losses and the hori4ontal axis is drawn

at 4ero profit or loss.

T"e a(3antage of t"e rofit,3o!ume c"art'

$he main advantage of the profit? volume chart is that it is capable of depicting clearly the

effect on profit and breakeven point of any changes in the variables.

5xample; ? % company manufactures a single product that incurs fixed costs of &E:. 2F,FFF

per annum. %nnual sales are budgeted to be GF,FFF units at a sales price of &E:. 2F per unit.

ariable costs are &E:.1N.HF per unit.

7a8 raw a profit? volume graph, and use it to determine the breakeven

point.

$he company is now considering improving the (uality of the product and increasing the selling

price to &E:. 2H' per unit. +ales volume will be unaffected, but fixed costs will increase to

&E:. 3H,FFF' per annum and variable costs to &E:.22' per unit.

7b8raw, on the graph as for part 7a8, a second profit? volume graph and comment on the results.

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6'1'6 T"e !imitations of %rea?e3en :or C5P< ana!#sis

$he limitations of the practical applicability of breakeven analysis and breakeven charts stemmostly from the assumptions that underlie the analysis

a8 Costs are assumed to behave in a linear fashion.

b8 +ales revenues are assumed to be constant for each unit sold.

c8 $here is assumed to be no change in stocks.

d8 It is assumed that activity is the only factor affecting costs, and factors such as

inflation are ignored.

e8 %part from the unrealistic situation described above of a constant product mix, the

charts can only be applied to a single product or service.

f8 $he analysis seems to suggest that as long as the activity level is above the

breakeven point, then a profit will be achieved.

6'1'7 Assumtions %e"in( t"e Brea?, e3en Ana!#sis

0. %ll costs can be classified as fixed and variable.

1. ariable costs vary proportionately with the production and the fixed cost will remain

constant to a certain level of activity.

2. ariable cost per unit and selling price per unit remain unchanged with in the level of

activity concerned. ence, contribution per unit also will not be changed.

3. +tocks are valued at variable cost.

H. $he technology, production efficiency and production methods, etc, remain

unchanged at every level of activity.

6'1'8 4actors affecting to increase t"e rofit 3o!ume ratio

0. Increase in selling price per unit.

1. ecrease in variable cost per unit.

2. $he speed of increasing the selling price per unit is greater than the speed of

increasing the variable cost per unit.

6'1'@ A(3antages of rofit %rea? 9e3en ana!#sis

0. $he profit or loss in relation to the given capacity level can be easily determined and

the relative profitability of each product is shown by the profit volume ratio.

1. $he break? even point and the margin of safety provide a hint about the business risk

and it helps to promote sales and production.

2. +ince revenue and cost are depicted graphically even managers who have not enough

knowledge about the costing can easily understand.

/'

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Eg+ +ales Managers

-roduction managers

6'1'10 sing costs for (ecision,ma?ing

Most management decisions involve a change in the level, method or mix of activities in

order to maximi4e profits. $he only costs that should be considered in decision? making are

those that will be altered as a result of the decision. $hose costs that will be affected by the

decision may be referred to as relevant costs, while others are non? relevant and should be

ignored in the analysis.

It is often the case that variable costs are relevant whereas fixed costs are not, unless the

decision affects the cost structure of the organi4ation. $hus, information for decision? making

should always be based on marginal costing principles, since marginal costing focuses on the

variable costs and is not concerned with arbitrary apportionment of fixed costs that will beincurred anyway.

6') S"ort, term (ecision , ma?ing

Re!e3ant cost

Cost that should be used in decision making is called as relevant cost. %ccordingly, relevantcost can be described as the cost that is specially incurred so as to take some management

decisions.

ence, two costs can be identified in short term decision making.

0. Incremental cost

1. Opportunity cost

Incrementa! cost

It is the cost which is incremental as to the relevant management decision. $hough, more

fre(uently the incremental cost includes variable costs, the fixed cost may also be included.

Oortunit# cost

$he income lost 7foregone8 by not using a resource which can be used in the best available

alternative method.

E*am!e+ , /ua!itati3e factors in Decision Ma?ing

0. %vailability of money

1. Inflation

2. 5mployees

3. Customers

H. Competitors

K. +uppliers

G. *easibility

N. -olitical pressure

P. &egal constraints

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1. Contribution per unit is computed for each product.

2. Compute the re(uired (uantity from limiting factor for each product.

3. Compute the contribution per limiting factor.

H. -lan the production based on the se(uential order of highest contribution per limitingfactor.

K. Maximum production should be the maximum demand for the relevant product.

E*am!e+