INTRODUCTION TO COST
Inorder to fulfill the main objectives of cost accounting, (which include, costascertainment, cost analysis and cost control) it is of paramount importance tounderstand the concept of cost and its appropriate classifications. The purposeof this chapter is to explain the concept of cost and different costclassifications.
Costis the amount of expenditure, actual (incurred) or notional (attributable),relating to a specific thing or activity (CIMA).
Itrepresents amount of resources that are usually foregone in pursuing anobjective or given up in exchange of some goods and services. There sourcesgiven up are generally in terms of money or, if not in terms of money, they arealways expressed in monetary terms.
Itcan also be defined as an exchange price, a foregoing, a sacrifice made tosecure some benefit. The sacrifice may be measured or represented by thedecrease in assets (if payment is made) or increase in liabilities if itinvolves acquisition of goods and services on credit).
Basically,when a cost is incurred, it could be in the form of deferred cost(asset)orexpired cost (expense). Deferred costs are unexpired costs .Capitalized costs,which provide benefits in future periods and known as assets and hence appearin the balance sheet. They actually represent the monetary values of unutilizedresources that can generate revenue in future periods and include prepayments,inventor, book value of non-current assets such as plant& machinery,buildings, motor vehicles and others. When these deferred costs are used up,they become expired costs which could be in form of either expenses or losseswhich are income statement items.
Anexpense is an expired costwhich has benefited the organization and no longer has any service potential ofproviding more benefits to the organization.
Loss is a lost cost. It represents the cost thathas expired (incurred) but has not yielded any benefit to organization. Infinancial accounting, it is used to denote a situation where expenses exceedrevenues for the accounting period.
4. 1 COST UNIT
The Institute of Cost and Management Accountants, Londonhas defined a cost unit as “a unit of quantity of product, or service ortime (or combination of these), in relation to which costs may be ascertainedor expressed.” In summary, it can be considered as a unit of measurementof cost or a quantification for which costs are expressed e.g. a litre, km, kgand a ream of paper. Thus a cost unit is any convenient measure of activitygiving a feel of what the firm is producing.
The following table gives examples of costunits (i.e. a unit of cost activity):
Table 1
| Industry | Cost Unit |
| Transport | Tonne kilometer, Passenger kilometer |
| Paper | Ream |
| Power | Kilowatt hour |
| Timber | Cubic foot |
| Building | House or square foot of an area |
| Cement | Tonne |
| Sugar | Tonne/kilograms |
| Hospital | Per bed/out-patient visit |
| Gas | Cubic meter |
4.2 RESPONSIBILITY CENTRE
Thisrepresents an individual part of a business whose manager has personalresponsibility for its performance. Many organizations are structured into ahierarchy of responsibility centres which could be cost centre, revenuecentres, profit centres and investment centres.
4.3 COST CENTRE
The Chartered Institute of ManagementAccountants. London, defines the cost centre as “a location, person oritem of equipment (or group of these) for which costs may be ascertained andused for the purposes of cost control.”
Itmay also be taken as a production or service location, function, activity oritem of equipment whose costs can be charged or related. It is basically anorganizational segment or area of activity considered to accumulate costs. Costcentres could include departments, processes, machine centres and offices.
Fromthe functional point of view, the cost centres may take the following g forms:
- Production cost centre
- Servicecost centre
Production-cum-servicecost, Centre
Production cost centre: Theseinclude departments that are directly engaged in manufacturing activity andcontribute to the content and form of finished product. Typical examplesinclude Cutting, assembly, and finishing departments.
Service cost centres: Theseare cost centres that provide services or assistance to other departments,These contribute to the production process an indirect manner and do not shapethe finished goods. Examples include human resource, maintenance, power plant,quality control departments.
Service-cum-production cost centres: Alsoknown as mixed cost centres, these are basically service cost centres butsometimes they may undertake some productive work also. Typical example istools department producing dies and Nuts as well as servicing tools.
4.4 Revenue centre
Thisis a segment of the organization which is primarily responsible generatingsales revenue. A revenue centre manager docs not control over cost, investmentin assets, but usually has control over some of (he expenses of the marketingdepartment. The performance of a revenue centre evaluated by comparing theactual revenue with the budgeted revenue. The marketing managers of a productline or an individual sales representative are examples of revenue centres.
4.5 Profit centre
Thisis part of the organization for which both the revenue and the costs incurredand revenue earned are identified. The main purpose of die profit centre is toearn profit. The performance of the profit centre is assessed in terms ofwhether the centre has achieved its budgeted profit. A division of the companywhich produces and markets the products may be called profit centre.
4.6 Investment Centre
Thisis a profit centre with additional responsibility for capital investment andpossibly for financing and whose performance is measured in terms of return oninvestment or return on capital employed Investment centre manager formulatesthe credit policy which has direct influence on debt collection, and theinventory policy which determines the investment in inventory. He has control overrevenues, expenses and the amounts invested in the centre’s assets.
Cost objective
Any activity for which a separate measurement of costs is desired. Itaddresses the purpose for which costinformation is required. Since managers undertake many management functions andother related functions, they always need readily information to help them ineffecting them. There are three major objectives as to why cost informationdesired and these include:
- Cost informationneeded for stock valuation and profit measurement.
Such information is mainly provided by costaccounting and normally used in measuring or valuing what has been produced bythe firm. It is a unit cost that can be used in determining the cost of goodsproduced and sold (cost of sales). Costof sales and other operating costs help in measuring the profitability of thefirm.
- Lost informationneeded for decision making :Decision-making activity is every manager’sconcern. It is of paramount importance for every manager to effectivelyundertake viable decisions that can add value to the business. Information tohelp in achieving this must be provided by both cost and management accountingsystem in place.
- Cost informationneeded to facilitate She cost control process: As earliermentioned costs must always be controlled in order to improve efficiency andhence profits. Standard or target cost and actual data should be provided and compared so as measure the level ofefficiency and any possibilities by management to take action.
Itis important to note that information meant for a Specific purpose cannot atall be used in fulfilling other purposes because managers carry out differentactivities and therefore such activities or functions require differentcomposition of costs. For example information processed for stock valuation andprofit measurement cannot be used in making decision because of the presence offixed production and past (sunk) costs that are not relevant to decision-making.
Likewise,information meant for cost control or decision making cannot be applied instock valuation because some of the production costs will be left out such asdepreciation costs. Fixed production costs and others like opportunity costswill be incorporated in the valuation, all these will lead to inaccurate valuationof the produced items. It is the task of management accountant to ensure thatthe relevant cost information is processed and applied in the appropriatemanner.
4.7 OTHER COST CONCEPTS/TERMS
Sunk cost: Asunk cost is the cost that has already been incurred It is a cost that has beenirreversibly incurred or committed prior to a decision point and which cannottherefore be considered relevant to subsequent decisions. Sunk cost may also betermed irrecoverable costs, Since they are caused by the decision made in thepast, they cannot be changed or avoided by the decision that is made in thefuture. Examples of sunk costs are the book values of existing assets, such asplant & machinery, inventory, investment in securities among others. Exceptthe possible gains or losses on sales of any of such assets, the book value isnot relevant for decisions regarding whether to use them or dispose them off.
Standard Costs:Standard costs are those costs which are planned or predetermined costestimates for a unit of output in order to provide a basis for comparison withactual costs.
Theyactually represent the desired level of performance or the costs that should beincurred in undertaking a productive activity.
Imputed cost orNotional cost: This is a surrogate of opportunity cost. CIMA Official Terminology definesnotional cost/imputed cost as a cost used in product evaluation, decisionmaking and performance measurement to represent the cost of resources whichhave no conventional actual cost.
Suchcosts are not actually incurred in some transaction and do not enter totraditional accounting system. Interests on internally generated funds, rentalvalue of company owned property and salaries of owner’s partnership examples ofimputed/notional costs.
Differential Cost: Differential cost is the difference in totalcosts between any two alternatives. Differential costs are equal to theadditional variable expenses incurred in respect of the additional output, plusthe increase in fixed costs, if any. Differential costs are also known asincremental costs, although technically an incremental cost should refer onlyto an increase in cost from one alternative to another; decrease in cost shouldbe referred to as decreamental cost. Differential cost is a broader term,encompassing both cost increases (incremental costs) and cost decreases(decremental costs) between alternatives.
Relevant Costs: “Relevant costs are those future costswhich differ between alternatives. Such costs are affected and changed by adecision. On the contrary, irrelevant costs are those costs which remain thesame and not affected by the decision whatever alternative is chosen.
Opportunity Cost: This represents the value of the benefitsacrificed when one course of action is chosen, in preference to analternative. The opportunity cost is represented by the foregone potentialbenefit from the best rejected course of action.
Committed Costs. Costs arising from prior decisions, whichcannot, in the short run, be changed.
Out-of-PocketCosts: Whileimputed costs do not involve cash outlays, out-of-pocket costs signify the cashcost incurred on an activity. Non-cash costs such as depreciation are notincluded in out-of-pocket costs.
Conversion Costs: These represent costs that are incurred intransforming or changing a raw material into semi-finished or finished goods.Best examples of conversion costs include wages paid to factory staff, factoryelectricity costs etc.
4.8 Classification of costs
Theachievement of cost and management accounting requires that costs should beascertained, classified and grouped. Costs classification refers to the processof grouping costs according to their common characteristics. The classificationof costs is essential for management because it is only after such groupingmanagement may effects its functions. There are many objectives of costclassifications depending on the requirement of management. However, the following objective areconsidered very useful and significant:
- Determining product costs for stock valuationand profit measurement
- Planning
- Decision making and
- Control.
Theprincipal bases on which costs are classified are:
- Natural classification of costs.
- Cost behavior
- Degree of traceability to the product,
- Degree of association with the product
- Relationship with accounting period
- Functional classification of costs
- Costsfor decision making and planning
- Costs for control
- Normality classification.
Natural Classification of Costs
Theterm ”natural classification” refers to the basic physicalcharacteristics of the cost. In a manufacturing concern, the following costsare the best examples
- Direct Material: This relates to the cost of materials which areconveniently and economically traced to specific units of outputs. Examples ofdirect material include among others, crude oil, raw cotton in textiles andsugar cane. In this case the cost of the material is either conversion cost orthe cost of the item to be converted into finished product. For example in themaking of sugar, cane sugar is an item which is transformed into finalproduct(sugar) and transformation process requires costs like diesel and waterwhich constitute conversion costs.
- Direct labor cost: This refers to wages and salaries paid to workers who aredirectly involved in the manufacture of products or providing services, e.g.payments made to machine operators and assemblers.
- Direct expenses: These include anyexpenditure other than direct material and direct labor incurred on a specificproduct or job. Such expenses can be identified with a product or job and arecharged directly to the product as part of the prime cost. Some of the examplesof direct expense in the manufacturing concern include:
– Cost of transport and conveyance to thesite of the job or operations.
– Cost of hiring special plant or machinery
– Cost of electricity in a factory whichproduces a single product
– Inward carriage and freight charges onspecial materials.
Thetotal of the above three elements of costs i.e. direct materials, direct laborand direct expenses, are prime cost.
- Factory overhead: Alsoknown as manufacturing overheads, includes indirect material, indirect laborand indirect expenses. All these costs have a common characteristic of notbeing directly identified with a specific product or job.
Indirectmaterials in this case refer to production supplies and other materials thatcannot conveniently or economically be charged or traced to specific unit ofoutput because two or more units of outputs have benefited from such costs e.g.lubricants, vanish in a carpentry workshop, stationery, to mention but a few.
Indirectlabor cost refers to the wages and salaries paid to the workers who are notdirectly involved in the production process but do facilitate the entireproduction exercise. Such costs cannot be associated with or easily traced tospecific products via physical observation. Some examples of indirect laborcost are wages paid to shop clerks, foremen, factory cleaners, materialhandlers, plant guards and general helpers. The Institute of cost&Management Accountants (UK) define indirect expenses as the “expensesthat cannot be allocated but which can be apportioned to or absorbed by costcenters or cost units.” They are incurred for the benefit of more than oneproduct, job or activity and must be apportioned by appropriate bases to thevarious functions. Expenses of this type include items such as light, heat,maintenance, depreciation, insurance, taxes, and hire of machinery among others.
Theaggregate of all indirect costs amounts to overhead costs. Likewise the totalof prime cost and factory overhead cost is known as ‘Factory cost’.
Directlabour cost and factory overheads together are known as conversion costsbecause they are the costs of converting raw materials into finished products.
(v)Selling, distribution and administrativeoverheads: Selling and distribution overheads representcosts incurred to create and stimulate demand for the product and to secureorders, they are non–manufacturingcosts which are incurred when the product is in a saleable condition.They cover the cost of making sales and delivering or dispatching productexamples include advertising, salesmen salaries and commissions, packing,storage, transportation and sales administrative costs. Administrative overheadinclude costs of planning and controlling the general policies and operationsof a business enterprise. Examples includes of board of directors, thechairman’s salary, and the rent of general offices and costs of generalaccounting among others. All selling,distribution and administrative overheads form operating expenses which aredischarged in the income statements to reduce gross profit.
The Elements of Cost Can thus be Illustrated Below;
The above diagram best illustrates the Elements ofcosts
BEHAVIORAL CLASSIFICATION
Thebasis of classification here is the behavioral pattern of costs. Theconsideration is how the costs respond, i.e. change with a given change in thevolume of production. Whereas some costs vary with the change in quantity ofoutput or level of activity, others do not. Accordingly, there are four categories of costs that canexplain the behavior: fixed, variable, semi-variable and semi-fixed.
FIXED COSTS. These are unaffected by variations in thevolume of activity or output. These costs remain constant over a relevant rangeof output, while fixed cost per unit varies with the output. They accrue orincurred with the passage of time and not with the production of the product orjob (i.e. are time-based costs). Some typical examples include rent, insurance,taxes and supervisor’s salary. Fixed costs can again be divided into twocategories i.e. committed fixed costs and discretionary fixed costs.
Committedfixed costs represent costs which cannot be reduced as these relate to the longterm policies and planning of the organization. Charges, like depreciation,rent, insurance, tax on property are committed to the period. Discretionaryfixed costs consist of costs which may be reduced partially or dropped whollyaccording to the policy of the management and need of the situation. Expenses like advertisement, research,fees for consultancy and costs of training are the best examples.
The behavior pattern of fixed costs is illustrated in the figure below.
Variable costs:- Theserepresent costs that vary in direct proportion to changes in volume of outputor level of activity. The total amount of variable costs tends to change inrespect to changes in production volume, but the variable cost per unit staysat the same level under the same manufacturing environment and productionmethods. Examples of such costs include direct material, direct labor and directexpenses. Variable overheads like factor supplies, indirect materials, salescommission, and office supplies are some of the examples of variable costs.
Thebehavior of variable costs is illustrated below
The graph sabove illustrates Variable cost behavior
Semi-variable costs: Theseare known as mixed cost, and there are neither wholly variable nor wholly fixedin nature. They are made up of fixed and variable elements. The fixed part ofsemi variable cost represent minimum fees for making a particular item orservice available.
The behavior of variable costs is illustratedin figure below
Step costs: Semi-fixed costs: These are costs, which are constant according to levels of activity. Such costs change as the level of activity or output is adjusted. Some examples of such costs include transport costs based on number of tones, supervisory costs based on the number of workers, transport fares based on distance among others. The behavior of variable is illustrated in figure 2.5 below.
Step/ semi-fixed costs
Ifthe firm plans to operate in the range Ox, it will pay fixed costs op. shouldit change to a different range.
Degree oftraceability to the product
Thisclassification of costs is based on the ability of attaching or tracing coststo specific products. As consequence we have direct cost and indirect costs.
Directcosts are those costs which are easily traceable or identifiable with a productwhose sum represents prime cost. Examples include direct material .direct laborand direct expenses.
Indirectcosts are costs which cannot be identified with or traced to a single productbecause they are incurred for several products. Examples of indirect costs are:indirect materials, salary of factory supervisors, rent, rates anddepreciation. Indirect costs are often apportioned to different cost centersare cost units since they benefit several products.
Association withthe product
Thisclassification is based on whether the cost constitutes either the costs of theproduct or costs which relate to period. This is essential in matching expensesagainst revenues in the relevant period. Such a grouping helps management inincome measurement for the preparation of financial statements. The categoriesof costs under this include product and period costs.
Product costs: Theseare the costs that constitute or make the cost of a product and constituteinventory values. These are basically manufacturing or production costs thatmake the cost of sales after the products have been sold. In the manufacturingconcern, it is composed of direct materials; direct labor, direct expenses andmanufacturing overheads. period costs:These costs are not identified with product or job and are deducted asexpenses during the period in which they are incurred. These costs representnon- operating items and are related to the passage of time and not to theproduction and sales of the period. If the period costs benefit only oneaccounting period, they are called revenue expenditure. If they benefit two ormore accounting periods, they are treated as assets until they are charged asexpenditure for the relevant years. In summary, product costs and period costsare treated in manufacturing firms as manufacturing costs and non-manufacturing costs respectively.
Functional classification of costs
Costsunder this grouping are based on the managerial functions which are performedin a given period. This classification refers to how the cost was used andimplies that the business performs many functions for which costs arc incurred.The costs of a typical organization may be divided into manufacturing,marketing, administrative and financing group. Manufacturing costs are allproduction costs incurred in the making of the products and to bring them to asaleable condition, including direct material direct labor and indirectmanufacturing overheads. Manufacturing costs in this case represent a total ofconversion costs and the cost of the raw materials to be converted intofinished product.
Sellingand administrative charges may be treated as expenses incurred or charged toprepaid expense accounts such as prepaid insurance. Functional classificationis important because it provides an opportunity to management o evaluate theefficiency of departments performing different functions in the organization.
Costs for decision making
Forpurpose of decision making, costs can be classified as relevant and irrelevantcosts ,Relevant costs. Arefuture costs that differ between alternatives. T hey influence the decisions to be made bymanagers and possess the following attributes:
- They are normally future costs
- They are incremental costs (additional costs)or avoidable costs.
Irrelevant Cost: Represents costs that are not pertinent tothe decision. Such costs do not affect or influence future decisions andexamples of costs that can be analyzed under this classification include amongothers opportunity cots, out-of-pocket costs, sunk costs, imputed costs and differentialcosts among others.
4.9 COSTS FOR CONTROL
Thistries to classify costs according to whether or not is influenced by the actionof a given manager of the undertaking. Possible classifications include Controllable and uncontrollable costs. Controllable costs: The CIMA (UK)defines controllable cost as “a cost which can be influenced by action ofa specified member of the undertaking”. It is a cost over which a managerhas direct and complete decision authority. Some examples of controllable costsare material costs, labor costs, power costs, lubricants, among others.
Uncontrollablecosts: Theseare costs that cannot be influenced by the action of a specified member of anundertaking. Such costs are beyond the control of the person in charge of theundertaking e.g. rent, insurance and road license.
Normality costclassification
Costsmay be classified according to whether they are normally incurred at a given level of output in the conditions inwhich that level of output is normally attained. In this case costs may begrouped as either normal cost or .-abnormal costs.
Normalcosts are costs that are usually incurred under normal operating conditions andare always expected to be incurred in the process of providing goods andservices. While costs that are not expected to be incurred and hence notbudgeted for are abnormal costs e.g. costs associated with power cuts andstrikes
Itis therefore important to note that managers can only benefit from informationin carrying out their activities or management functions if the appropriategrouping of costs is done.
COST SHEET
Thisanalyses costs according to the elements involved. The preparation of costsheet is one of the most important and primary function of cost accounting. Thestatement discloses the following:
1.Prime cost 2.Works or factory cost
3.Cost of production 4.Total cost
Thestructure of cost sheet can be illustrated below: COST SHEET (for the period…)
| NAIRA | Total cost (NAIRA) | |
| Opening stock of raw materials Purchases Carriage Inward Less Closing stock Direct Material Consumed Direct wages Direct Expenses Direct Labour Direct expenses Prime Cost Add Work or Factory Overhead Indirect materials Indirect wages Rent and rates(factor) Lighting and heating Power and fuel Repairs and maintenance Works or factory cost Add Office and administrative overheads; Rent and rate Salaries Lightning and heating Insurance Depreciation of office furniture Telephone and postage Bank charges Audit charges Cost of Production Add Selling and distribution overhead Lightning and heating Sales men salaries Travel expenses Depreciation and expenses of delivery van Debt collection expenses Postage Cost of Sales: Add (or deduct) Net profit (or loss) Sales |
PRACTICE QUESTIONS
The cost account of a manufacturing firm reveals thefollowing information for May 2014.
NAIRA
Material at the beginning 14, 000
Indirect wages 2, 000
Wages 16,000
Purchase during the year 20, 000
Defective material (scrap) 200
Overtime 400
Stores 800
Loose tools 200
Advertisement 1, 200
Trade discount 200
Raw material at the end 6, 000
Carriage inward 800
Depreciation 600
Insurance 1,200
Bank interest 2,000
Dividend 200
Inspection fee 400
Postage 1,600
Manager’s salary 4,000
Supervision expense 3,400
Cleaning charges 1,200
Collection charges 800
Research expense
Required: prepare a statement so as follow:
- Prime cost
- Work cost
- Cost of production
Note:It is important to note that items or broad categories ofexpenses have not been included in the cost sheet because they are eitherpurely financial charges or purely financial incomes such as interest receivedand dividends Other items that cannot appear in the cost sheet may includeamong others rent receivable, transfer fee received, discount /commissionreceived and all appropriation of profit items and abnormal gains and losses.
4.10 COST ACCOUNTING SYSTEM
The cost AccountingSystem: According to Meigs & Meigs et al (1996:895), a cost accountingsystem consists of the: techniques, personnel, forms and accounting rec used todevelop timely information regarding the cost of providing products or service consumers. Cost accounting systems are mostwidely used by manufacturing company .However, cost accounting concepts arecertainly applicable to a wide range of service industries,-e.g. banks, accounting firms, hospitals and government authorities, all use accountingsystems to ascertain the cost of performing their respective functions. Thecost accounting system is the link between planning and control in thedecision-making cycle. Part of the output (feedback) is transferred to theinput so that the cycle is continuous and interacting.
4.11 COST AND PROFIT ANALYSIS
Methods of classifying cost.
(A) Classificationby function- Under this arrangement costs are classified according functions they perform within the business;for example, as manufacturing, selling, administrative,or financial costs.
(B) Classificationby Object of Expenditure – This involves classifying costs accounting the goods or services they purchase; forexample, as wages, rent, or advertising.
(C) Researchand development costs:
(i) Research costs are the costs ofsearching for new or improved product
(ii) Development costs are the costs incurredbetween the decisions to produce or improvedproduct and the commencement of fall, formal manufactured product.
Others are:
(D) Total costs: the sum of all items of expense (paid or not)incurred in distribution of a product, or in rendering a service to thecustomer.
(g) Direct cost and overheads.
(h) Standardcost: the target or predetermined cost at which a business should derivedfrom an estimate and is compared with actual results, thus providing efficiencyand a basis for cost control.
(I) VariableCost: That part of cost which varies with the volume of productionactivity).
(j) Fixed Cost: that part of cost which does not vary with the level ofactivity production, and is consideredas a time period charge.
(k) Semi-variable(semi-fixed or mixed) costs are partly variable and partly fixed
(l) ConversionCost: The cost of producing goods excluding the direct mate usually takenas the aggregate of direct wages and production overheads.
(m) Incrementalor differential cost: the additional cost arising only because project isundertaken. Incremental costs include both variable costs and fixed costs arising fromundertaking the particular project.
(n) Opportunitycost: the cost of using resources in a particular venture express forgoingthe benefit that could be derived from the best alternative use resources.
(o) Controllable and uncontrollable costs.One of the purposes of cost a provide control information to management, whowill wish to know whether particular cost item is controllable by means ofmanagement action.
A. The AICPA has defined cost as “anexchange price, a forgoing, a sacrifice a benefit”. The measurement of cost for anyobjective is dependent upon be served. Cost data may be collected, presented and analyzed to serve majorpurposes:
C. Classificationby controllability– Costs are also categorized according to whether or notthey can be influenced by managers of a particular segment of the entity withina specified period of time.
D. Classificationby Traceability – Costs are classified according to whether or not they can be traced to and directlyidentified with a finished unit of production. The distinction’ may be described as that between direct andindirect costs.
E. Classificationby product or period:
1. ProductCosts are costs which are inventorial (i.e. which are assumed to “attach” or “cling” tophysical units). These .costs become anexpense when the goods to which the costs attach are sold. Most manufacturingcosts, including depreciation on factory equipment and other manufacturing-overhead are product costs.
2. Period costs are costs which do notattach to physical units, and are not inventoried. Period costs are charged toexpense primarily as a function of time.
F. Classificationby behavior – Cost are classified as fixed or viable according to theirresponse to changes in levels of activity.
4.12 FURTHER COST CLASSIFICATIONS
Thus, as the BPP textnoted, a cost accountant is mainly concerned with the following cost concepts.
(1) FunctionalCost(a) Production costs – i e. costs which are incurred by the sequence ofoperations beginning with thesupply of raw materials, and ending with the completion of the product readyfor warehousing as a fun shed goods item; packaging costs are production costswhere they relate to“primacy” packing (e.g. boxes, wrappers, and so on).
(b) Administration Costs: The costs of managing anorganization, i.e. Planning and controlling its operations, butonly insofar as such administration costs are not related to the production,sales, distribution or R & D functions.
(c) Selling Costs, sometimes known as marketing costs, are the costs ofcreating demand for products and securing firm orders from customers.
Distributioncosts:the costs of the sequence of operations beginning with the receipt of finishedgoods from the production department and making them ready for dispatch andending with the reconditioning for re-use of returned empty containers.
Sub-Classifications of Fixed Costs
(1) Committed costs – represent long- rangecommitments which are per. These costs remain even when the production volumeis zero. Committed include depreciation of building and long-term lease payments.
(2) ProgrammedCosts (managed or discretionary costs) – Represent annual appropriations.These costs are often unrelated to volume. Examples, advertising costs and research and development costs.
(3) VariableCosts- are those costs that tend to remain uniform per unit, but Vary intotal in direct proportion to changes in the level of activity.
The total variable cost (TVC) has a direct relationship with volume. The total costincreases or decreases with the volume of production and/or sales.
The average variable cost (AVC) is assumed not to change with achange in volume (although, actually, an increase in volume often results in adecrease in average cost per unit due to economies of scale.
FIXED AND VARIABLE COST
- Fixed and variable costs refer to total cost behavior, not unitcost behavior.
2. The total fixed cost does not changewith an increase in volume (within the relevant range).
3. The average fixed cost relatesinversely with volume (see diagram). The Average Fixed Cost decreases whenvolume is increased and it increases when volume decreases. Because the fixedcosts remain constant, any volume change has the effect of spreading the fixedcosts over a lesser or greater unit volume.
(d) The fixed and variable elements of mixedcosts can be determined through mathematical models such as the scatterdiagram, the high-low method and regression analysis.
2. StepCosts – Costs that are approximately fixed over a small range ofoutput, but are variable over a large range. For example, supervision costs maybe fixed over a given production volume. However, additional work shifts orwork crews may be added to increase production. This will require additionalsupervisors, thus the go up in a lump sum or “Stair step” patterns.
“StairStep” Patterns.
III. Breakeven andCost-Volume-Profit Analysis
A. Definitions:
1. Break-even point .The point where sales lessfixed and variable costs result in zero profit.Theterms break-even point analysis and cost-volume-profit analysis are sometimes used interchangeably.
2. Cost-Volume-Profit Analysis –Management’s study of the relationships among cost, volume and profit. This study is used in planning,controlling and evaluating the objectivesof the enterprise.
B. Break-even and cost-volume-profitanalyses are concerned with the effect upon operating income or net income ofvarious decisions regarding sales and costs. Break-even analysis indicates thenumber of units that must be produced at a particular cost so that neither aprofit nor a loss results. The break-even point is that level of activity wheretotal expenses equal total revenue. Cost-volume-profit analysis isbroader in scope.
(d) The fixed and variable elements of mixedcosts can be determined through mathematical models such as the scatterdiagram, the high-low method and regression analysis. (We shall look at theselater).
2. Step Costs – Costs that areapproximately fixed over a small range of output, but are variable over a largerange. For example, supervision costs may be fixed over a given productionvolume. However, additional work shifts or work crews may be added to increaseproduction. This will require additional supervisors, thus the go up in a lump sumor “Stair step” patterns.
III. Break even andCost-Volume-Profit Analysis
A. Definitions:
1. Break-even point – The point wheresales less fixed and variable cost result in zero profit..The terms break-even point analysis and cost-volume-profit analysts are sometimes used interchangeably.
2 . Cost-Volume-ProfitAnalysis – Management’s stud) of the relationships among cost, volume andprofit. This study is used inplanning, controlling and evaluating the objectives of the enterprise.
B. Break-even and cost-volume-profit analyses areconcerned with the effect upon operating income or net income of variousdecisions regarding sales and costs. Break-even analysis indicates the number of units that must he producedat a particular cost so that neither a profit nor a loss results. The break-even point is that level ofactivity where total expenses equal total revenue. Cost-volume-profit analysis is broader inscope.
4.13 Break-Even-Analysis
Break-even point isthe sales point that neither yields profit nor loss; it is the point at whichtotal revenue and total costs are the same. At this point, total contributionand total fixed cost are the same in short term this situation may be okay forthe organization, but it should not be allowed to continue beyond businesstint-period.
Contribution Margin
It is thecontribution by each unit sold to the recovers- of fixed overhead I cost. It isarithmetically define as sales minus variable expenses. Additional contributionafter the breakeven point will yield a profit, which the organization canutilize for its own development. Thus, margin of safety is defined as budgetedsales minus contribution margin.
Assumption Underlying Break-EvenAnalysis
- The behavior of total costs and total revenue has been reliablydetermined and is linear over relevant range.
2. All costs can bedivided into fixed and variable elements.
3. Total fixed costsremain constant over the relevant volume range of cost-volume-profit
4. Total variablecost is directly proportional to volume over the long range.
5. Selling price isto remain constant.
6. Prices of the factors of production are to be constant.
7. There is no significant differencebetween the unit sold and unit produced.
8. Sales are the onlyrelevant factor affecting cost.
9. The efficiency andproductivity are to remain constant.
10. The analysis coversa single product or assumed a constant product-mix
ILLUSTRATION 1
The following figuresrelated to a company manufacturing a varied range of products
Year Total Sales Total Costs
N N
1 39,000 34,800
2 43,000 37,000
Required:
Assuming stability inprices, with variable costs carefully controlled to reflect pre-determine relationships and an unvarying figure forfixed
Calculate:
- The fixed cost
- The profit/volume ratio
- The break -even point
Solution to illustration 2
- To determine the fixed cost high-low method
Recall Y= a + bx. Where a = fixed cost: b = variable cost x activity levy.
YH – YL N37.600 – 34,800
b = XH -XL N43, 000 -39,000
= N2: 800/N4,000
= N0.70
Thus:fixed cost – Y – a + bx
= N34.800 – a + NO.7 (39,000)
= N34:800-N27.300-a
a =N7,500
(b) Profit-Volume-Ratio
Sales N39.000 100%
VariableCost 27,300 70%
ContributionMargin 11,700 30%
FixedCosts 7,500 –
NETPROFIT 4,200 –
Note: Profit-Volume ratio =NI1,700/N39;000 =30%
(C)Break-even-point
Sales –Variable cost – Fixed costs = 0
Ix =0.70x-N7,500 =0
0.3x N7:500
x =N7,500/0.3
= N25,000
Illustration 2
Warm-up Nigeria Ltd manufacture and sells a unique product theselling price of which is N20.00
The summarized profitand loss statement for the last year is as follows:
N N
Sales 800,000
Direct material 120,000
Direct wages 160,000
Variable production- overhead 80,000
Fixed production overhead 100,000
Administration overhead 71,000
Selling and distribution overhead 60,000 591,000
Net profit before tax 209,000
Less: Provision for taxation (40%) 82,000
Net profit after tax 127,000
Required:
- Calculate the break-even point for last year
- What do you understandby the terms profit volume ratio and margin of safety. Illustrate using last year result.
- Determine the number of unit to sell in the current year toachieve an after tax profit of N165,000
- Calculate the sales value required to achieve a net profit beforetax of 15% of total revenue.
- Assuming no change in unit selling price and cost structure,calculate the percentage increase in sales volume required in the current year,to produce a produce a profit before tax20% higher than last year results.
- Calculate the selling, price per unit that the company, must chargein the current year to cover a potential increase last year contribution marginratio if the variable cost increases by 12%.
- Determine the volume of sales in naira the company must achieve inthe current year to maintain the same net profit of last year if the sellingprice remains at N20 and variable cost per unit increase by 12%.
Solution 2
N N
Sales 400,00 @ 20.00 800,000
Direct materials @ 3.00 120,000
Direct Wages @ 4.00 160,000
Variable production overhead @2.00 80,000
Marginal production cost @9.00 (360.000}
Contribution Margin 440,000
Fixed Overhead 100,000
Fixed Administrative 71,000
Fixed selling expenses 60.000
Total fixed cost (231,000)
Profit before tax 209,000
Tax t; 40% 82.000
Net profit after tax 127,000
(i) Break-even point for last year
Sales – variable cost – fixed costs – 0
N20xN9x-N235. 000-0
llx-N231; 000/11
x = 21,000 units
(ii) Pro fit-volume-ratio
Sales 300,000 100%
Variable cost 360.000 45%
Contribution margin 440.000 55%
Break-even value Naira = Fixed Cost
CMR
(a) B/Epoint = 231,000
0.55
= N420,000
(b) Margin of safety =budgeted sales B/E point
Margin of safety = N800, 000 – N420, 000
= N380, 000
(Or)
N20 (40,000-21) = N380.00
(iii) Sales unit requiredto achieve N 150.000 profit
Sales – Variable costs – fixed cost = Target Profit
1– tax rate
N20x– N9x – N231, 000 = N165, 000/1 – 0.4
N11x– 231, 000 = N275, 000
11x = N275, 000 + N231, 000
x = N506, 000/11
x = N46,000 units
Sales value requiredin achieving 15% net profit before tax
Sales – variable costs = fixed cost/1 – target income rate
1x – 0.45 = N231,000/1 -0.1 5
0.55x =N271,675
x = N271, 765/0.55
x = N 494.120(to the nearest units)
Check
Sales 494,120
Less Variable cost 189, 000
Contribution on margin 305, 120
Fixed cost 231,000
Profit before Tax 74,520
Tax @ 40% 29.648
Profit after tax 44.472
(v) Sales volume toachieve profit before tax of 20% higher than previous years
Sales – variable cost – fixed cost – N209, 000(1.2)
Ix – 0.45x -N23, 000 =N250,800
N250. 800 + N231. 000 = 0.55x
N481, 800/0.55 = N876, 000
Therefore % increase =N76,000/800,000 x 100 = 9.5%
(vi) Selling price unitin current year to cover expected 12% increases in variable cost.
Sales 1.00= 22.40
Variable cost 0.45= 10.08
Contribution margin 0.55= 12.32
i.e. N9 + 12% = 45%
Thus 100% = N10.08/0.45
= N22.40
(vii) Present sellingprice = N20
Variable cost = N9.00
Thus 12%increase = 1. 12 x N9. 00
Thuscontribution margin ratio = 10– 10. 08 x 100
20
= 0.496or 49.5%
Thus to achieve the present profit:
Fixed Cost + Net Profit
Contribution margin ratio
231,000+ 127.000 = 358.00
0.496 0. 496
= N721.780
Multi-Products Lines
Break-even analysis assumesthat the organization deals in a single product line. However where there ismore than one product line, the product sales mix must be constant overrelevant production and sales range.
Where the situationholds, then the application of brake-even analysis will be possible.
Illustration 3
As the firstmanagement accountant employed by a manufacturer of power tools you have beenasked to supply financial result by product line to help marketingdecision-making.
The following accountwas produced for the year ended 31stDecember 2008.
N’OOO N’OOO
Sales (300,0000units) 720
Cost of Sales:
Materials 300
Wages 180
ProductionExpenses 120
Marketing cost 60 660
60
A statisticalanalysis of the figures shows the following variable elements in the costs:
Materials 90% Wages 80%
ProductionExpenses 60% Marketing Expenses 50%
Below is given, aspercentages, the proportion unit of the sales and the variable elements of thecosts among the five products manufactured:
Product
| A | B | C | D | E |
| 10 | 30 | 20 | 30 | 10 |
| 30 | 15 | 15 | 20 | 20 |
| 40 | 20 | 10 | 20 | 10 |
| 30 | 10 | 10 | 30 | 2010 |
| 10 | 30 | 20 | 30 | 10 |
| 15 | 25 | 10 | 25 | 25 |
SALES TOTAL
Sales unit 100
Sales revenue 100
Materials 100
Production exps
Marketing c
Wages
Note:
(i) Prepare statement of the year showingcontribution by products
(ii)Comments on contributions
(iii)Determine the break even units by products
(iv)Determine the margin of safety in units.
(v)Determine the break-even value
Solution to Illustration 3
Statement ShowingContribution by Products
Product Lines A B C D E TOTAL
Sales unit (000) 8 9 6 9 3 30
Sales Revenue (000) 216,0 108.0 108.0 144.0 104.00 720.0
Variable Costs Materials 108.0 54,0 27.0 54.0 27.0 27.0
Wages 21.6 36.0 14.4 36.0 36.0 144
Product exp. 21.6 7.2 7.2 21.6 14.4 72
Marketing Expenses 3.0 9.0 6.0 9.0 3.0 3.0
Total marginal cost (154.2) (106.2) (54.6) (120.6) (80.4) 515.0
Contribution Margin 61.8 1.8 53.4 23.4 63.4 104.0
Fixed costs (Note 1) 144.00
60.00 Note 1
Fixed costs
(10% x 300) + (20% x 1 80) + (40% / 1200) +(30% x 60) – N144
(ii) Comments
Contribution marginratio – contribution/sales
A B C D E
61.8/216 1.8/108 53.4/108 23.4/144 63.4/144
28 61% 1.67 % 49.44% 16.25% 44.03%
Based on the ratiocalculated above. C has the highest contribution margin rate of 45% andtherefore the company should boost the sales and production of the product.This product is followed by B, A and D in that order of 44. 03, 28 61 and 16.25respectively. It is necessary that effort be made to increase their salesthrough necessary advertisement and known market strategies
‘For Product B withcontribution margin of 1.67, management will need to be decisive; the stage ofthe product in product life cycle must be determined If it is at growing stage,constant advertisement may be made to boost Us sales, if it is al maturitystage, then its already at decline, a new product should be introduced in placeB now.
(a) Break-even Units
Sales –variables costs – fixed costs = 0
Let x =units to be sold
Discouragement are being unfairly charged with uncontrollablecost. In any event, if management insists that both controllable anduncontrollable costs appear on the same report, these costs should not bemingled indiscriminately.
TimePeriod, Control and Responsibility
The influence of time product on determining whether a cost iscontrollable is a difficult problem. Too often managers are inclined to oversimplify by assuming that variable costs are controllable and fixed costs areuncontrollable. Such thinking may lead to erroneous conclusions. For example,rent is uncontrollable by the assembly foreman. But it may be controllable bythe Managing Director who has the responsibility of choosing plant facilitiesand deciding whether to own or rent.
4.14 THE DECISION MAKING, PLANNING AND CONTROL PROCESS
The first step is to identify the objective by specifying theobjective of the firm. This is compared with the current position. It foundsatisfactory, the decision maker will search for a variety of possibleoutcomes, strategies or alternative courses of action; data would be gatheredabout the alternatives.
When the various data have been obtained, appropriate alternativecourses of actions would be selected. That is choosing between alternativecourses of action and selecting the alternative that meets the firm’sobjective; the decision is then implemented. The implementation will attract acomparison with plan outcomes and actual outcomes through performance reports.The decision would now respond to deviations appropriately.
4.15 THE ROLE OF A DECISION MAKER
(1) Recognition of the necessity for thedecision.
(2) To deliver all the available courses ofaction.
(3) To evaluate these potential courses ofaction.
(4) To select the most suitable course ofaction.
PRACTICE QUESTIONS
- Define a ‘cost’. How is it different fromexpense?
- What is the meaning of the term incrementalcost? Does incremental cost mean the same thing as variable cost?
- Product cost is a general term that denotesdifferent costs allocated to products for different purposes. Describe threepurposes. Explain the composition of product cost for the purpose of externalfinancial reporting along with its rationale.
- Explain whether you agree with each of thefollowing statement:
- All direct costs are variable costs”.
- Variable costs are controllable and fixedcosts are not”
- Sunk costs are irrelevant costs whenproviding decision making information”
- “Unit variable cost cannot change under any manufacturing environment or conditions”
- Classify each of the following costs usingthe following classifications:
- Direct materials (b) Direct labor (c) Manufacturing overhead (d) Non-manufacturingexpense.
- Managing director’s salary
ii. Oil for amilling machine
iii. Salary ofthe milling machine operator
iv. Salary of thesupervisor of assembly department for productsA,B,&C.
v. Depreciationon the factory building vi. Income tax expense
vii. Depreciationon direct materials warehouse viii. Depreciation on the administrative officebuilding ix. Rent on the finishedgoods warehouse
x. Rent on thesales office xi .Insurance on the trackused for delivery of finished goods sold
xii. Gasoline forthe truck used for transfer of work in processor department to another
xiii. Interest onborrowed money
xiv. Insuranceexpense on managing directors official vehicle
xv. Fuel expensepurchase for machine use in the factory.
- Costs may be classified in variety of waysaccording to their nature and the information needs of management” Explainand discuss the statement giving examples of classifications required fordifferent purpose.
- Explain the nature of product and periodcosts. How do they affect net income of the business enterprise?
- “The diverse uses of routinely recordedcost data give rise to a fundamental danger: information prepared for onepurpose can be grossly misleading in another context”.
Required:
Using practical and relevant examples discussthe extent to which the above statement is valid and explain your conclusions.
- Explain the benefits of classifying costs to organizations or managers.
- Explain what is meant by ‘responsibility centre’ .What are the different types of responsibility center? What purpose do responsibility center serve?
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