ACOF 014

Introduction to Costing
Semester 2 2008/ 2009

TOPIC 1: Introduction & Cost Classification

Topic Outline:
1. Learning Objectives
2. Differences between Financial, Management & Cost Accounting
3. Role of Costing
4. Key Concepts in Costing
5. Classification of Costs
5.1. Costs for stock valuation
5.2. Costs for decision-making
5.3. Costs for control

1. Learning Objectives
After studying this topic, students should be able to:
 Differentiate between management accounting, cost accounting and financial accounting
 Describe and explain briefly the key concepts in cost accounting
 Identify the roles of costing within an organisation
 Describe the cost objectives and the classification of costs therein

2. Differences between Financial, Management & Cost Accounting

In relation to… Financial Accounting Management Accounting
USERS/AUDIENCE  concerned with the provision of  concerned with the provision of
information to external parties outside the information to people within the
organisation organisation to help them make better
 i.e. for external reporting such as to decisions
owners, investors, creditors, bankers,
regulators (stock exchange, tax)
PURPOSE  financial reporting  internal decision-making
TYPE OF  financial measurements  financial and non-financial information
INFORMATION  financial statements  various internal reports
 backward-looking; past information  future-oriented
REPORT  issued periodically  issued as needed; can be quarterly,
FREQUENCY monthly, weekly, daily, even hourly
PRECISION/  accurate, objective, reliable, auditable  subjective, relevant, involves
NATURE OF estimation/approximations, flexible
INFORMATION
SCOPE/SEGMENT  highly aggregated; summarised  may be more detailed; less summarised
 whole of organisation  may focus on smaller parts of
organisation as well (e.g. individual
products, activities, departments)
LEGAL  subject to public & regulator scrutiny  no restrictions, upon request/necessity
REQUIREMENTS/  must comply with MASB, Securities  optional, and not subject to regulations
RESTRICTIONS Commission, Company Act rules &  not required by law
regulations
Exhibit 1.1 Comparison between Financial Accounting and Management Accounting

Cost Accounting
~ is concerned with the cost accumulation for stock valuation to meet the requirements of external
reporting (Drury)
~ "The establishment of budgets, standard costs and actual costs of operations, processes,
activities or products; and the analysis of variances, profitability, or the social use of funds" (Lucey)

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3. Role of Costing
 Foundation of the internal financial information system
 Management needs a variety of information to plan, to control, and to make decisions.

a) Cost accounting and control

 To ensure that operations, departments, processes and costs are under control – organisation as
a whole are working efficiently towards agreed objectives
 Costing system provides a sound basis of information for financial control – monitors the results
of all activities.
 E.g. budgeting and standard costing

b) Cost accounting and decision making

 Decision making – making a choice between alternatives
 Financial implications (information provided by the costing system) of the various alternatives is
essentially a critical factor in making such decision

c) Cost accounting and planning

 Calculation of costs that will be incurred in the future and also the analysis of past costs will
assist managers in planning

4. Several Key Concepts in Costing

 Cost
 The amount of expenditure (actual or notional) incurred on, or attributable to, a specified
thing or activity. i.e. cost = quantity x price

 Cost units
 Costs are always related to some object or function or service
 A unit of product or service in relation to which costs are ascertained
 May be units of production (e.g. tonnes of cement, typewriters) or units of service (e.g.
consultation hours, number of invoices processed, kilowatt-hours)
 E.g. cost of making one unit of table (cost/unit), cost of producing ten tonnes of iron ore
(cost/tonne)

 Direct costs
 Costs which can be directly identified with a job, batch, product or service
 Consists of direct materials, direct labour and direct expenses
 Do not have to be spread between various categories – the whole cost can be attributed
directly to a production unit or saleable service
 Total of direct costs is known as prime cost.

 Indirect costs
 All material, labour and expense costs that cannot be identified as direct costs are termed
indirect costs.
 The three elements of indirect costs: indirect materials, indirect labour and indirect expenses
are collectively known as overheads.
 In practice, overheads are usually separated in categories such as Production Overheads,
Administrative Overheads and Selling Overheads

 Cost Centre
 A production or service location, function, activity or item of equipment for which costs are
accumulated
 Responsibility centre where managers are accountable for the expenses that are under their
control
 Normally consists of departments, but in some instances they consist of smaller segments
such as groups of machines within a department

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 Cost allocation
 To assign a whole item of cost, or of revenue, to a single cost unit, centre, account or time
period
 Applies to direct costs as well as indirect costs

 Cost apportionment
 To spread revenues or costs over two or more cost units, centres, accounts or time periods.
This may also be referred to as ‘indirect allocation’.
 The choice of an appropriate basis is a matter of judgement to suit the particular
circumstances of the organisation and wherever possible there should be a cost-cause
relationship
 The process of apportionment is an essential part of the build-up of overheads, because
many indirect costs apply to numerous cost centres rather than just to one

5. Classification of Costs
 Costs Objectives
 Any activity for which a separate measurement of costs is desired
 In other words, if the users of accounting information want to know the cost of something, this
something is called a cost objective.
 E.g. Cost of a product, the cost of rendering a service to a bank or hospital patient

 Cost objectives are divided into 3 broad categories:

a) Costs for stock valuation
b) Costs for planning and decision making
c) Costs for control

 E.g.
 Cost of operating an existing machine is a cost objective that may be required for a
comparison with the costs of operating a replacement machine. – costs for decision making
 Cost of operating a department is a cost objective that may be required for a comparison with
the budgeted costs – costs for control

Cost Objective Possible methods of cost classifications

1. Costs for stock valuation  Period and product costs
 Elements of manufacturing costs
 Job and process costs

2. Costs for planning decision-making  Cost behaviour

 Relevant and irrelevant costs
 Avoidable and unavoidable costs
 Sunk costs
 Opportunity costs
 Marginal and incremental costs

3. Costs for control  Controllable and uncontrollable costs

Exhibit 1.2 Cost objectives and possible cost classifications

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5.1. Classification of Costs for Stock Valuation and Profit Measurement

 Unexpired vs Expired costs

 Unexpired costs:
 Resources that have been acquired and that are expected to contribute to future revenue
 They are recorded as assets in the balance sheet
 Expired costs:
 Unexpired costs that have been consumed in the generation of revenue and have no
future revenue-producing potential
 They are recorded as expense in the profit and loss account
 Example – stock (asset); becomes cost of goods sold (expense); matched against sales
(revenue)

a) Period and product costs

 For stock valuation, only manufacturing costs should be included in the calculation of product
costs
 Therefore, they have product costs and period costs:
 Product costs – costs that are identified with goods purchased or produced for resale. Stock
valuation for finished goods, or for work-in-progress. (Manufacturing costs)

 Prime cost – direct costs of the product – direct materials + direct labour + direct expenses
 Direct materials – all those materials that can be physically identified with a specific
product. E.g. Wood – direct materials in producing a desk.
 Direct labour – those labour costs that can be specifically traced to or identified with a
particular product. E.g. – wages of operatives who assemble parts into the finished
products (desk)
 Direct expense – expenses incurred specifically for a particular product. E.g. royalties
paid per unit for a copyright design

 Manufacturing overhead – all manufacturing costs other than direct labour, direct
materials and direct expenses
 Indirect materials – Those materials that cannot be directly traced to a particular unit
of product. E.g. varnish
 Indirect labour – Those labour costs that cannot be physically identified with a
particular product. E.g. salaries of factory supervisors
 Indirect expense – expenses that cannot be traced to the item being manufactured.
E.g. rent and rates of the factory

 Period costs – costs that are not included in the stock valuation. Treated as expense in the
period in which they are incurred (Non-manufacturing costs)
 Financial expenses: bank charges, interest on loan, discounts allowed
 Selling and distribution: salesmen’s salaries, commission
 Administrative: salaries of office staff

b) Job and Process Cost

 Job costing
 Refers to accounting system that determine the cost of individual orders (jobs)
 It is suitable in a production environment where each new order is different from the earlier
or succeeding order
 E.g.
 Shoe manufacturing where each order differs from the following due to different
specifications being required
 Vehicle repair shops, where each vehicle repair requires different parts replacement and
labour hours
 Garment manufacturing, where orders received could vary significantly from one
another

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  Process costing
 Helps to determine the cost per unit of product produced in an environment where identical
products are produced for all customers.
 E.g.
 Electronic assembly line where all products produced are identical
 Biscuit manufacturing where although there may be more than one product line, each
line is a separate, continuos process producing identical products

5.2. Classification of Costs for Planning & Decision-Making

 Cost accounting is concerned with the calculation of actual product costs for stock valuation and
profit measurement, whereas management accounting is concerned with the provision of
information to help people within the organisation make good decisions.

a) Cost behaviour

1. Fixed costs
 Remain constant over wide ranges of activity for a specified time period
 E.g. depreciation of the factory machine, supervisors’ salaries, rent
 Graph:

Total fixed cost (RM)

Activity level

 Unit fixed costs decrease proportionally with the level of activity.

 E.g. if the total of the fixed costs is RM5,000 for a month, the fixed costs per unit will be
as follows:

Units produced Fixed cost per unit (RM)

1 5,000
10 500
100 50
1,000 5

 Therefore, the graph should look like:

Unit fixed cost (RM)

Activity level

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2. Variable costs
 Vary in direct proportion to the volume of activity – doubling the level of activity will double the
total variable cost
 Total variable costs are linear and unit variable cost is constant

Total Variable Cost Unit Variable Cost

(RM) (RM)

5,000

4,000

3,000

2,000 10

1,000

100 200 300 400 500 100 200 300 400 500
Activity level Activity level
(units of output) (units of output)
 E.g. sales commissions, raw materials, petrol

3. Semi-fixed or step fixed costs

 Costs that are fixed within specified activity levels but they eventually increase or decrease by
a constant amount at various critical activity levels
 E.g. labor costs. If production capacity expands to some critical level, and therefore additional
workers will be employed, labor costs could be semi-fixed

Total fixed cost

(RM)

Level of activity

4. Semi-variable costs
 Include both a fixed and a variable component
 These are costs that change with production, but not in direct proportion to the volume.
 E.g. telephone charges which has a fixed charge for line rental of say RM68 per month and a
variable charge per minute for call charges of say RM0.30 per minute.

Total cost (RM)

104

Variable cost element

68

Fixed cost elements

120 Minutes
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b) Relevant and Irrelevant Costs and Revenues
--- past vs future
--- differ between alternatives

 For decision-making, costs and revenues can be classified according to whether they are
relevant to a particular decision
 Relevant costs and revenues are those future costs and revenues that will be changed by a
decision, whereas irrelevant costs and revenues are those that will not be affected by the
decision
 E.g. Petrol costs is relevant in deciding whether to have a journey by own car or public
transport. But the neither car insurance nor car tax costs are relevant.
 Sometimes, the terms avoidable and unavoidable costs might be replacing the terms relevant
and irrelevant costs.

c) Sunk costs
 The cost of resources already acquired where the total will be unaffected by the choice
between various alternatives
 They are the costs that have been created by the decision made in the past and that cannot
be changed by any decision that will be made in the future.
 E.g. Let say you want to conduct a project. You have two alternatives whether using the old
machine or replacing it with a new machine. The cost of purchasing the old machine is
therefore sunk cost. Whether you want to use it or you want to buy a new one, the cost has
already incurred
 Sunk costs are irrelevant for decision making.
 Distinguished from irrelevant costs because not all irrelevant costs are sunk costs

d) Opportunity costs
 Cost that measures the opportunity that is lost or sacrificed when the choice of one course of
action requires that an alternative course of action be given up.
 E.g. if an asset such as capital is used for one purpose, the opportunity cost is the value of the
next best purpose the asset could have been used for. Acquiring or renting? Let say, you
choose to acquire a building. A saving of RM150 per month of renting might be your
opportunity cost.

e) Incremental and marginal costs/revenues

 Incremental costs and revenues are the additional costs or revenues that arise from the
production or sale of a group of additional units.
 E.g. You want to set up a branch in Muadzam Shah. Therefore, you need the analysis on the
incremental costs and revenues by setting up such a new branch (including sales, advertising,
staff salaries, travelling, rentals etc)
 Marginal cost/revenue represents the additional cost/revenue of one extra unit of output. If let
say the cost of producing 1 unit of table is RM20, how about two units?

5.3. Classification of Costs for Control

 Costs and revenues must be traced to the individuals who are responsible for incurring them.
This is called responsibility accounting
 In an organisation, normally it has 3 responsibility centres:
 Cost centre – managers are accountable for the expenses that under their control. E.g.
advertising department, purchasing department
 Profit centre – managers are accountable for sales revenue and expenses. E.g. sales
department
 Investment centre – managers are normally accountable for sales revenue and expenses,
but in addition are responsible for some capital investment decisions.

a) Controllable and non-controllable costs and revenues

 Costs and revenues allocated to responsibility centers should be classified according to
whether or not they are controllable or non-controllable by the manager of the responsibility
center.

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 A controllable cost may be defined as a cost that is reasonably subject to regulation by the
manager with whose responsibility that cost is being identified