COSTS CONCEPTS AND CLASSIFICATION

INTRODUCTION TO COST

In order to fulfill the main objectives of cost accounting, (which include, cost ascertainment, cost analysis and cost control) it is of paramount importance to understand the concept of cost and its appropriate classifications. The purpose of this chapter is to explain the concept of cost and different cost classifications.

Cost is the amount of expenditure, actual (incurred) or notional (attributable), relating to a specific thing or activity (CIMA).

It represents amount of resources that are usually foregone in pursuing an objective or given up in exchange of some goods and services. There sources given up are generally in terms of money or, if not in terms of money, they are always expressed in monetary terms.

It can also be defined as an exchange price, a foregoing, a sacrifice made to secure some benefit. The sacrifice may be measured or represented by the decrease in assets (if payment is made) or increase in liabilities if it involves acquisition of goods and services on credit).

Basically, when a cost is incurred, it could be in the form of deferred cost(asset)or expired cost (expense). Deferred costs are unexpired costs .Capitalized costs, which provide benefits in future periods and known as assets and hence appear in the balance sheet. They actually represent the monetary values of unutilized resources 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 losses which are income statement items.

An expense is an expired cost which has benefited the organization and no longer has any service potential of providing more benefits to the organization.

Loss is a lost cost. It represents the cost that has expired (incurred) but has not yielded any benefit to organization. In financial accounting, it is used to denote a situation where expenses exceed revenues for the accounting period.

4. 1 COST UNIT

The Institute of Cost and Management Accountants, London has defined a cost unit as “a unit of quantity of product, or service or time (or combination of these), in relation to which costs may be ascertained or expressed.” In summary, it can be considered as a unit of measurement of cost or a quantification for which costs are expressed e.g. a litre, km, kg and a ream of paper. Thus a cost unit is any convenient measure of activity giving a feel of what the firm is producing.

The following table gives examples of cost units (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

This represents an individual part of a business whose manager has personal responsibility for its performance. Many organizations are structured into a hierarchy of responsibility centres which could be cost centre, revenue centres, profit centres and investment centres.

4.3 COST CENTRE

The  Chartered Institute of Management Accountants. London, defines the cost centre as “a location, person or item of equipment (or group of these) for which costs may be ascertained and used for the purposes of cost control.”

It may also be taken as a production or service location, function, activity or item of equipment whose costs can be charged or related. It is basically an organizational segment or area of activity considered to accumulate costs. Cost centres could include departments, processes, machine centres and offices.

From the functional point of view, the cost centres may take the following g forms:

  • Production cost centre
  • Service cost centre

Production-cum-service cost, Centre

Production cost centre: These include departments that are directly engaged in manufacturing activity and contribute to the content and form of finished product. Typical examples include Cutting, assembly, and finishing departments.

Service cost centres: These are cost centres that provide services or assistance to other departments, These contribute to the production process an indirect manner and do not shape the finished goods. Examples include human resource, maintenance, power plant, quality control departments.

Service-cum-production cost centres: Also known as mixed cost centres, these are basically service cost centres but sometimes they may undertake some productive work also. Typical example is tools department producing dies and Nuts as well as servicing tools.

4.4  Revenue centre

This is a segment of the organization which is primarily responsible generating sales revenue. A revenue centre manager docs not control over cost, investment in assets, but usually has control over some of (he expenses of the marketing department. The performance of a revenue centre evaluated by comparing the actual revenue with the budgeted revenue. The marketing managers of a product line or an individual sales representative are examples of revenue centres.

4.5 Profit centre

This is part of the organization for which both the revenue and the costs incurred and revenue earned are identified. The main purpose of die profit centre is to earn profit. The performance of the profit centre is assessed in terms of whether the centre has achieved its budgeted profit. A division of the company which produces and markets the products may be called profit centre.

4.6 Investment Centre

This is a profit centre with additional responsibility for capital investment and possibly for financing and whose performance is measured in terms of return on investment or return on capital employed Investment centre manager formulates the credit policy which has direct influence on debt collection, and the inventory policy which determines the investment in inventory. He has control over revenues, expenses and the amounts invested in the centre’s assets.

Cost objective

 Any  activity for which a separate measurement of costs is desired. It addresses  the purpose for which cost information is required. Since managers undertake many management functions and other related functions, they always need readily information to help them in effecting them. There are three major objectives as to why cost information desired and these include:

  1. Cost information needed for stock valuation and profit measurement.

Such information is mainly provided by cost accounting and normally used in measuring or valuing what has been produced by the firm. It is a unit cost that can be used in determining the cost of goods produced and sold (cost of sales).  Cost of sales and other operating costs help in measuring the profitability of the firm.

  1. Lost information needed for decision making :Decision-making activity is every manager’s concern. It is of paramount importance for every manager to effectively undertake viable decisions that can add value to the business. Information to help in achieving this must be provided by both cost and management accounting system in place.
  2. Cost information needed to facilitate She cost control process: As earlier mentioned costs must always be controlled in order to improve efficiency and hence profits. Standard or target cost and actual data should be provided  and compared so as measure the level of efficiency and any possibilities by management to take action.

It is important to note that information meant for a Specific purpose cannot at all be used in fulfilling other purposes because managers carry out different activities and therefore such activities or functions require different composition of costs. For example information processed for stock valuation and profit measurement cannot be used in making decision because of the presence of fixed production and past (sunk) costs that are not relevant to decision- making.

Likewise, information meant for cost control or decision making cannot be applied in stock valuation because some of the production costs will be left out such as depreciation costs. Fixed production costs and others like opportunity costs will be incorporated in the valuation, all these will lead to inaccurate valuation of the produced items. It is the task of management accountant to ensure that the relevant cost information is processed and applied in the appropriate manner.

 4.7 OTHER COST CONCEPTS/TERMS

Sunk cost: A sunk cost is the cost that has already been incurred It is a cost that has been irreversibly incurred or committed prior to a decision point and which cannot therefore be considered relevant to subsequent decisions. Sunk cost may also be termed irrecoverable costs, Since they are caused by the decision made in the past, they cannot be changed or avoided by the decision that is made in the future. Examples of sunk costs are the book values of existing assets, such as plant & machinery, inventory, investment in securities among others. Except the possible gains or losses on sales of any of such assets, the book value is not relevant for decisions regarding whether to use them or dispose them off.

Standard Costs: Standard costs are those costs which are planned or predetermined cost estimates for a unit of output in order to provide a basis for comparison with actual costs.

They actually represent the desired level of performance or the costs that should be incurred in undertaking a productive activity.

Imputed cost or Notional cost: This is a surrogate of opportunity cost. CIMA Official Terminology defines notional cost/imputed cost as a cost used in product evaluation, decision making and performance measurement to represent the cost of resources which have no conventional actual cost.

Such costs are not actually incurred in some transaction and do not enter to traditional accounting system. Interests on internally generated funds, rental value of company owned property and salaries of owner’s partnership examples of imputed/notional costs.

Differential Cost: Differential cost is the difference in total costs between any two alternatives. Differential costs are equal to the additional variable expenses incurred in respect of the additional output, plus the increase in fixed costs, if any. Differential costs are also known as incremental costs, although technically an incremental cost should refer only to an increase in cost from one alternative to another; decrease in cost should be 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 costs which differ between alternatives. Such costs are affected and changed by a decision. On the contrary, irrelevant costs are those costs which remain the same and not affected by the decision whatever alternative is chosen.

Opportunity Cost: This represents the value of the benefit sacrificed when one course of action is chosen, in preference to an alternative. The opportunity cost is represented by the foregone potential benefit from the best rejected course of action.

Committed Costs. Costs arising from prior decisions, which cannot, in the short run, be changed.

Out-of-Pocket Costs: While imputed costs do not involve cash outlays, out-of-pocket costs signify the cash cost incurred on an activity. Non-cash costs such as depreciation are not included in out-of-pocket costs.

Conversion Costs: These represent costs that are incurred in transforming or changing a raw material into semi-finished or finished goods. Best examples of conversion costs include wages paid to factory staff, factory electricity costs etc.

4.8 Classification of costs

The achievement of cost and management accounting requires that costs should be ascertained, classified and grouped. Costs classification refers to the process of grouping costs according to their common characteristics. The classification of costs is essential for management because it is only after such grouping management may effects its functions. There are many objectives of cost classifications depending on the requirement of management. However, the following objective are considered very useful and significant:

  1. Determining product costs for stock valuation and profit measurement
  2. Planning
  3. Decision making and
  4. Control.

The principal bases on which costs are classified are:

  1. Natural classification of costs.
  2. Cost behavior
  3. Degree of traceability to the product,
  4. Degree of association with the product
  5.  Relationship with accounting period
  6. Functional classification of costs
  7.  Costs for decision making and planning                                    
  8. Costs for control
  9. Normality classification.

Natural Classification of Costs

The term ”natural classification” refers to the basic physical characteristics of the cost. In a manufacturing concern, the following costs are the best examples

  1. Direct Material: This relates to the cost of materials which are conveniently and economically traced to specific units of outputs. Examples of direct material include among others, crude oil, raw cotton in textiles and sugar cane. In this case the cost of the material is either conversion cost or the cost of the item to be converted into finished product. For example in the making of sugar, cane sugar is an item which is transformed into final product(sugar) and transformation process requires costs like diesel and water which constitute conversion costs.
  2. Direct labor cost: This refers to wages and salaries paid to workers who are directly involved in the manufacture of products or providing services, e.g. payments made to machine operators and assemblers.
  3. Direct expenses: These include any expenditure other than direct material and direct labor incurred on a specific product or job. Such expenses can be identified with a product or job and are charged directly to the product as part of the prime cost. Some of the examples of direct expense in the manufacturing concern include:

– Cost of transport and conveyance to the site of the job or operations.

– Cost of hiring special plant or machinery

– Cost of electricity in a factory which produces a single product

– Inward carriage and freight charges on special materials.

The total of the above three elements of costs i.e. direct materials, direct labor and direct expenses, are prime cost.

  1. Factory  overhead:  Also known as manufacturing overheads, includes indirect material, indirect labor and indirect expenses. All these costs have a common characteristic of not being directly identified with a specific product or job.

Indirect materials in this case refer to production supplies and other materials that cannot conveniently or economically be charged or traced to specific unit of output 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.

Indirect labor cost refers to the wages and salaries paid to the workers who are not directly involved in the production process but do facilitate the entire production exercise. Such costs cannot be associated with or easily traced to specific products via physical observation. Some examples of indirect labor cost are wages paid to shop clerks, foremen, factory cleaners, material handlers, plant guards and general helpers. The Institute of cost &Management Accountants (UK) define indirect expenses as the “expenses that cannot be allocated but which can be apportioned to or absorbed by cost centers or cost units.” They are incurred for the benefit of more than one product, job or activity and must be apportioned by appropriate bases to the various functions. Expenses of this type include items such as light, heat, maintenance, depreciation, insurance, taxes, and hire of machinery among others.

The aggregate of all indirect costs amounts to overhead costs. Likewise the total of prime cost and factory overhead cost is known as ‘Factory cost’.

Direct labour cost and factory overheads together are known as conversion costs because they are the costs of converting raw materials into finished products.

(v)Selling, distribution and administrative overheads: Selling and distribution overheads represent costs incurred to create and stimulate demand for the product and to secure orders, they are nonmanufacturing costs which are incurred when the product is in a saleable condition. They cover the cost of making sales and delivering or dispatching product examples include advertising, salesmen salaries and commissions, packing, storage, transportation and sales administrative costs. Administrative overhead include costs of planning and controlling the general policies and operations of a business enterprise. Examples includes of board of directors, the chairman’s salary, and the rent of general offices and costs of general accounting among others.  All selling, distribution and administrative overheads form operating expenses which are discharged in the income statements to reduce gross profit.

    The Elements of Cost Can thus be Illustrated Below;

The Elements of Cost illustration
The Elements of Cost

The above  diagram best illustrates the  Elements of costs

BEHAVIORAL CLASSIFICATION

The basis of classification here is the behavioral pattern of costs. The consideration is how the costs respond, i.e. change with a given change in the volume of production. Whereas some costs vary with the change in quantity of output or level of activity, others do not. Accordingly, there are four categories of costs that can explain the behavior: fixed, variable, semi-variable and semi-fixed.

FIXED COSTS. These are unaffected by variations in the volume of activity or output. These costs remain constant over a relevant range of output, while fixed cost per unit varies with the output. They accrue or incurred with the passage of time and not with the production of the product or job (i.e. are time-based costs). Some typical examples include rent, insurance, taxes and supervisor’s salary. Fixed costs can again be divided into two categories i.e. committed fixed costs and discretionary fixed costs.

Committed fixed costs represent costs which cannot be reduced as these relate to the long term policies and planning of the organization. Charges, like depreciation, rent, insurance, tax on property are committed to the period. Discretionary fixed costs consist of costs which may be reduced partially or dropped wholly according 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.

behavior pattern of fixed costs
behavior pattern of fixed costs

Variable costs:- These represent costs that vary in direct proportion to changes in volume of output or level of activity. The total amount of variable costs tends to change in respect to changes in production volume, but the variable cost per unit stays at the same level under the same manufacturing environment and production methods. Examples of such costs include direct material, direct labor and direct expenses. Variable overheads like factor supplies, indirect materials, sales commission, and office supplies are some of the examples of variable costs.

The behavior of variable costs is illustrated below

 behavior of variable costs
behavior of variable costs

The graph s above  illustrates  Variable cost behavior

Semi-variable costs: These are known as mixed cost, and there are neither wholly variable nor wholly fixed in nature. They are made up of fixed and variable elements. The fixed part of semi variable cost represent minimum fees for making a particular item or service available.

The behavior of variable costs is illustrated in figure  below

The behavior of variable costs is illustrated in figure
variable cost

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.

Figure: Step/ semi-fixed costs






Step/ semi-fixed costs

If the firm plans to operate in the range Ox, it will pay fixed costs op. should it change to a different range.

Degree of traceability to the product

This classification of costs is based on the ability of attaching or tracing costs to specific products. As consequence we have direct cost and indirect costs.

Direct costs are those costs which are easily traceable or identifiable with a product whose sum represents prime cost. Examples include direct material .direct labor and direct expenses.

Indirect costs are costs which cannot be identified with or traced to a single product because they are incurred for several products. Examples of indirect costs are: indirect materials, salary of factory supervisors, rent, rates and depreciation. Indirect costs are often apportioned to different cost centers are cost units since they benefit several products.

Association with the product

This classification is based on whether the cost constitutes either the costs of the product or costs which relate to period. This is essential in matching expenses against revenues in the relevant period. Such a grouping helps management in income measurement for the preparation of financial statements. The categories of costs under this include product and period costs.

Product costs: These are the costs that constitute or make the cost of a product and constitute inventory values. These are basically manufacturing or production costs that make the cost of sales after the products have been sold. In the manufacturing concern, it is composed of direct materials; direct labor, direct expenses and manufacturing overheads. period costs: These costs are not identified with product or job and are deducted as expenses during the period in which they are incurred. These costs represent non- operating items and are related to the passage of time and not to the production and sales of the period. If the period costs benefit only one accounting period, they are called revenue expenditure. If they benefit two or more accounting periods, they are treated as assets until they are charged as expenditure for the relevant years. In summary, product costs and period costs are treated in manufacturing firms as manufacturing costs and non- manufacturing costs respectively.

Functional classification of costs

Costs under this grouping are based on the managerial functions which are performed in a given period. This classification refers to how the cost was used and implies 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 all production costs incurred in the making of the products and to bring them to a saleable condition, including direct material direct labor and indirect manufacturing overheads. Manufacturing costs in this case represent a total of conversion costs and the cost of the raw materials to be converted into finished product.

Selling and administrative charges may be treated as expenses incurred or charged to prepaid expense accounts such as prepaid insurance. Functional classification is important because it provides an opportunity to management o evaluate the efficiency of departments performing different functions in the organization.

Costs for decision making

For purpose of decision making, costs can be classified as relevant and irrelevant costs ,Relevant costs. Are future costs that differ between alternatives. T hey  influence the decisions to be made by managers and possess the following attributes:

  1. They are normally future costs
  2. They are incremental costs (additional costs) or avoidable costs.

Irrelevant Cost: Represents costs that are not pertinent to the decision. Such costs do not affect or influence future decisions and examples of costs that can be analyzed under this classification include among others opportunity cots, out-of-pocket costs, sunk costs, imputed costs and differential costs among others.

 4.9  COSTS FOR CONTROL

This tries to classify costs according to whether or not is influenced by the action of 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 of a specified member of the undertaking”. It is a cost over which a manager has direct and complete decision authority. Some examples of controllable costs are material costs, labor costs, power costs, lubricants, among others.

Uncontrollable costs: These are costs that cannot be influenced by the action of a specified member of an undertaking. Such costs are beyond the control of the person in charge of the undertaking e.g. rent, insurance and road license.

Normality cost classification

Costs may be classified according to whether they are normally incurred at a given level of output in the conditions in which that level of output is normally attained. In this case costs may be grouped as either normal cost or .-abnormal costs.

Normal costs are costs that are usually incurred under normal operating conditions and are always expected to be incurred in the process of providing goods and services. While costs that are not expected to be incurred and hence not budgeted for are abnormal costs e.g. costs associated with power cuts and strikes

It is therefore important to note that managers can only benefit from information in carrying out their activities or management functions if the appropriate grouping of costs is done.

COST SHEET

This analyses costs according to the elements involved. The preparation of cost sheet is one of the most important and primary function of cost accounting. The statement discloses the following:

1. Prime cost                            2. Works or factory cost

3. Cost of production                 4. Total cost

  The structure 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 the following 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:

  1. Prime cost
  2. Work cost
  3. Cost of production

Note: It is important to note that items or broad categories of expenses have not been included in the cost sheet because they are either purely financial charges or purely financial incomes such as interest received and dividends Other items that cannot appear in the cost sheet may include among others rent receivable, transfer fee received, discount /commission received and all appropriation of profit items and abnormal gains and losses.

4.10   COST ACCOUNTING SYSTEM

The cost Accounting System: According to Meigs & Meigs et al (1996:895), a cost accounting system consists of the: techniques, personnel, forms and accounting rec used to develop timely information regarding the cost of providing products or service consumers. Cost accounting systems are most widely used by manufacturing company .However, cost accounting concepts are certainly applicable to a wide range of service      industries, -e.g. banks, accounting firms, hospitals and government authorities, all use accounting systems to ascertain the cost of performing their respective functions. The cost accounting system is the link between planning and control in the decision-making cycle. Part of the output (feedback) is transferred to the input so that the cycle is continuous and interacting.

4.11   COST AND PROFIT ANALYSIS

Methods of  classifying cost.

(A)       Classification by function- Under this arrangement costs are classified according      functions they perform within the business; for example, as manufacturing, selling, administrative, or financial costs.

(B)       Classification by Object of Expenditure – This involves classifying costs accounting the     goods or services they purchase; for example, as wages, rent, or advertising.

(C)       Research and development costs:

(i)         Research costs are the costs of searching for new or improved product

(ii)        Development costs are the costs incurred between the decisions to produce or                                   improved product 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 the customer.

(g)        Direct cost and overheads.

(h)        Standard cost: the target or predetermined cost at which a business should derived from an estimate and is compared with actual results, thus providing efficiency and a basis for cost control.

(I)        Variable Cost: That part of cost which varies with the volume of production activity).

(j)         Fixed Cost: that part of cost which does not vary with the level of activity  production, and is considered as a time period charge.

(k)        Semi-variable (semi-fixed or mixed) costs are partly variable and partly fixed

(l)         Conversion Cost: The cost of producing goods excluding the direct mate usually taken as the aggregate of direct wages and production overheads.

(m)       Incremental or differential cost: the additional cost arising only because project is undertaken. Incremental costs include both variable costs and fixed costs arising from undertaking the particular project.

(n)        Opportunity cost: the cost of using resources in a particular venture express forgoing the 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, who will wish to know whether particular cost item is controllable by means of management action.

A.        The AICPA has defined cost as “an exchange price, a forgoing, a sacrifice a benefit”.           The measurement of cost for any objective is dependent upon be served. Cost data          may be collected, presented and analyzed to serve major purposes:

C.         Classification by controllability– Costs are also categorized according to whether or not they can be influenced by managers of a particular segment of the entity within a specified period of time.

D.        Classification by Traceability – Costs are classified according to whether or not they           can be traced to and directly identified with a finished unit of production. The distinction’ may be described as that between direct and indirect costs.

E.         Classification by product or period:

1.         Product Costs are costs which are inventorial (i.e. which are assumed to       “attach” or “cling” to physical units).  These .costs become an expense when the goods to which the costs attach are sold. Most manufacturing costs, including depreciation on factory equipment and other manufacturing- overhead are product costs.

2.         Period   costs  are  costs which  do  not attach to  physical  units,  and  are  not inventoried. Period costs are charged to expense primarily as a function of time.

F.         Classification by behavior – Cost are classified as fixed or viable according to their response to changes in levels of activity.

4.12   FURTHER COST CLASSIFICATIONS

Thus, as the BPP text noted, a cost accountant is mainly concerned with the following cost concepts.

(1)        Functional Cost(a)      Production costs – i e. costs which are incurred by the sequence of operations beginning         with the supply of raw materials, and ending with the completion of the product ready for warehousing as a fun shed goods item; packaging costs are production costs where they       relate to “primacy” packing (e.g. boxes, wrappers, and so on).

(b)        Administration   Costs: The costs of managing an organization,   i.e.   Planning and controlling its operations, but only 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 of creating demand for products and securing firm orders from customers.

Distribution costs: the costs of the sequence of operations beginning with the receipt of finished goods from the production department and making them ready for dispatch and ending with the reconditioning for re-use of returned empty containers.

            Sub- Classifications of Fixed Costs

(1)        Committed costs – represent long- range commitments which are per. These costs remain even when the production volume is zero. Committed include depreciation of building and long-term lease payments.

(2)        Programmed Costs (managed or discretionary costs) – Represent annual appropriations. These costs are often unrelated to volume. Examples, advertising       costs and research and development costs.

(3)        Variable Costs- are those costs that tend to remain uniform per unit, but Vary in total in direct proportion to changes in the level of activity.

The total variable cost (TVC) has a direct relationship with volume. The total cost increases or decreases with the volume of production and/or sales.

The average variable cost (AVC) is assumed not to change with a change in volume (although, actually, an increase in volume often results in a decrease in average cost per unit due to economies of scale.

FIXED AND VARIABLE COST

  1. Fixed and variable costs refer to total cost behavior, not unit cost behavior.

2.         The total fixed cost does not change with an increase in volume (within the relevant range).

3.         The average fixed cost relates inversely with volume (see diagram). The Average Fixed Cost decreases when volume is increased and it increases when volume decreases. Because the fixed costs remain constant, any volume change has the effect of spreading the fixed costs over a lesser or greater unit volume.

(d)        The fixed and variable elements of mixed costs can be determined through mathematical models such as the scatter diagram, the high-low method and regression analysis.

2.         Step Costs – Costs that are approximately fixed over a small range of output, but are variable over a large range. For example, supervision costs may be fixed over a given production volume. However, additional work shifts or work crews may be added to increase production. This will require additional supervisors, thus the go up in a lump sum or “Stair step” patterns.

“Stair Step” Patterns.

"Stair Step" Patterns.
“Stair Step” Patterns.

III.       Breakeven and Cost-Volume-Profit Analysis

A.        Definitions:

1.       Break-even point .The point where sales less fixed and variable costs result in zero     profit.The terms 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   objectives of the enterprise.

B.         Break-even and cost-volume-profit analyses are concerned with the effect upon operating income or net income of various decisions regarding sales and costs. Break-even analysis indicates the number of units that must be produced at a particular cost so that neither a profit nor a loss results. The break-even point is that level of activity where total expenses equal total revenue. Cost-volume-profit analysis is broader in scope.

(d)        The fixed and variable elements of mixed costs can be determined through mathematical models such as the scatter diagram, the high-low method and regression analysis. (We shall look at these later).

2.         Step Costs – Costs that are approximately fixed over a small range of output, but are variable over a large range. For example, supervision costs may be fixed over a given production volume. However, additional work shifts or work crews may be added to increase production. This will require additional supervisors, thus the go up in a lump sum or “Stair step” patterns.

III.       Break even and Cost-Volume-Profit Analysis

A.         Definitions:

1.    Break-even point – The point where sales 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-Profit Analysis – Management’s stud) of the relationships among cost, volume and profit.    This study is used in planning, controlling and evaluating the objectives of the enterprise.

B.    Break-even and cost-volume-profit analyses are concerned with the effect upon operating income or net income of various decisions regarding sales and costs.    Break-even analysis indicates the number of units that must he produced at a particular cost so that neither a profit nor a loss results.   The break-even point is that level of activity where total expenses equal total revenue.  Cost-volume-profit analysis is broader in scope.

4.13   Break-Even-Analysis

Break-even point is the sales point that neither yields profit nor loss; it is the point at which total revenue and total costs are the same. At this point, total contribution and total fixed cost are the same in short term this situation may be okay for the organization, but it should not be allowed to continue beyond business tint-period.

Contribution Margin

It is the contribution by each unit sold to the recovers- of fixed overhead I cost. It is arithmetically define as sales minus variable expenses. Additional contribution after the breakeven point will yield a profit, which the organization can utilize for its own development. Thus, margin of safety is defined as budgeted sales minus contribution margin.

Assumption Underlying Break-Even Analysis

  1. The behavior of total costs and total revenue has been reliably determined and is linear over relevant range.

2.         All costs can be divided into fixed and variable elements.

3.         Total fixed costs remain constant over the relevant volume range of cost-volume-profit

4.         Total variable cost is directly proportional to volume over the long range.

5.         Selling price is to remain constant.

6.         Prices of the factors of production are to be constant.

7.         There is no significant difference between the unit sold and unit produced.

8.         Sales are the only relevant factor affecting cost.

9.         The efficiency and productivity are to remain constant.

10.       The analysis covers a single product or assumed a constant product-mix

ILLUSTRATION  1

The following figures related 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 in prices, with variable costs carefully controlled to reflect pre-determine relationships and an unvarying figure for fixed

Calculate:

  1. The fixed cost
  2. The profit/volume ratio
  3. 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)       Pro fit-Volume-Ratio

Sales                                  N39.000               100%

Variable Cost                          27,300                70%

Contribution Margin              11,700                  30%

Fixed Costs                             7,500                   –       

NETPROFIT                           4,200                     –     

Note: Profit-Volume ratio     =N I1,700/N39;000     =30%

(C)Break-even-point

Sales – Variable cost – Fixed costs = 0

Ix =0.70 x-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 the selling price of which is N20.00    

The summarized profit and 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 understand by 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 to achieve an after tax profit of N165,000
  • Calculate the sales value required to achieve a net profit before tax 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 tax 20% higher than last year results.
  • Calculate the selling, price per unit that the company, must charge in the current year to cover a potential increase last year contribution margin ratio if the variable cost increases by 12%.
  • Determine the volume of sales in naira the company must achieve in the current year to maintain the same net profit of last year if the selling price 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/E point                                             =          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 required to 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 required in achieving 15% net profit before tax

Sales – variable costs = fixed cost/1 – target income rate

1x – 0.45         = N23 1,000/1 -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 to achieve 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 unit in 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 selling price                         =              N20

Variable cost                                    =              N9.00

Thus 12% increase                          =              1. 12 x N9. 00

Thus contribution margin ratio           =                        10 – 10. 08 x 100

                                                                            20

                                                       =               0.496 or 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 assumes that the organization deals in a single product line. However where there is more than one product line, the product sales mix must be constant over relevant production and sales range.

Where the situation holds, then the application of brake-even analysis will be possible.

Illustration 3

As the first management accountant employed by a manufacturer of power tools you have been asked to supply financial result by product line to help marketing decision-making.

The following account was produced for the year ended 31stDecember 2008.

N’OOO                        N’OOO

Sales (300,0000 units)                                                                                     720

Cost of Sales:

Materials                                                                       300

Wages                                                                            180

Production Expenses                                                   120

Marketing cost                                                             60                                   660

                                                                                                                             60

A statistical analysis of the figures shows the following variable elements in the costs:

Materials                    90%                  Wages                                     80%                

Production Expenses      60%    Marketing Expenses                      50%

Below is given, as percentages, the proportion unit of the sales and the variable elements of the costs 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 showing contribution 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 Showing Contribution 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 margin ratio – 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 ratio calculated above. C has the highest contribution margin rate of 45% and therefore 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 16.25 respectively. It is necessary that effort be made to increase their sales through necessary advertisement and known market strategies

‘For Product B with contribution margin of 1.67, management will need to be decisive; the stage of the 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 maturity stage, then its already at decline, a new product should be introduced in place B now.

(a)        Break-even Units

Sales – variables costs – fixed costs = 0

Let x = units to be sold

Discouragement are being unfairly charged with uncontrollable cost. In any event, if management insists that both controllable and uncontrollable costs appear on the same report, these costs should not be mingled indiscriminately.

Time Period, Control and Responsibility

The influence of time product on determining whether a cost is controllable is a difficult problem. Too often managers are inclined to over simplify by assuming that variable costs are controllable and fixed costs are uncontrollable. Such thinking may lead to erroneous conclusions. For example, rent is uncontrollable by the assembly foreman. But it may be controllable by the Managing Director who has the responsibility of choosing plant facilities and 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 the objective of the firm. This is compared with the current position. It found satisfactory, the decision maker will search for a variety of possible outcomes, strategies or alternative courses of action; data would be gathered about the alternatives.

When the various data have been obtained, appropriate alternative courses of actions would be selected. That is choosing between alternative courses of action and selecting the alternative that meets the firm’s objective; the decision is then implemented. The implementation will attract a comparison 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 the decision.

(2)        To deliver all the available courses of action.

(3)       To evaluate these potential courses of action.

(4)        To select the most suitable course of action.

PRACTICE QUESTIONS

  1. Define a ‘cost’. How is it different from expense?
  2. What is the meaning of the term incremental cost? Does incremental cost mean the same thing as variable cost?
  3. Product cost is a general term that denotes different costs allocated to products for different purposes. Describe three purposes. Explain the composition of product cost for the purpose of external financial reporting along with its rationale.
  4. Explain whether you agree with each of the following statement:
  5. All direct costs are variable costs”.
  6. Variable costs are controllable and fixed costs are not”
  7. Sunk costs are irrelevant costs when providing decision making information”
  8.  “Unit   variable   cost   cannot   change   under   any   manufacturing environment or conditions”
  9. Classify each of the following costs using the following classifications:
  10. Direct materials (b)  Direct labor (c) Manufacturing overhead (d) Non-manufacturing expense.
  11. Managing director’s salary

ii.     Oil for a milling machine

iii.    Salary of the milling machine operator

iv.    Salary of the supervisor of assembly department for  products A,B,&C.

v.     Depreciation on the factory building    vi.    Income tax expense

vii.   Depreciation on direct materials warehouse    viii.    Depreciation on the administrative office building     ix. Rent on the finished goods warehouse

x.      Rent on the sales office   xi .Insurance on the track used for delivery of finished goods sold

xii.    Gasoline for the truck used for transfer of work in processor department to another

xiii.   Interest on borrowed money

xiv.   Insurance expense on managing directors official vehicle

xv.    Fuel expense purchase for machine use in the factory.

  • Costs may be classified in variety of ways according to their nature and the information needs of management” Explain and discuss the statement giving examples of classifications required for different purpose.
  • Explain the nature of product and period costs. How do they affect net income of the business enterprise?
  •  “The diverse uses of routinely recorded cost data give rise to a fundamental danger: information prepared for one purpose can be grossly misleading in another context”.

Required:

Using practical and relevant examples discuss the 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?