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Chapter 1

Cost Accounting, Cost Classification and Cost Behaviour

WHAT IS COST ACCOUNTING?


Who can provide the answers to the following questions? What was the cost of goods produced or services provided last quarter? What was the cost of operating a department last month? What revenues were earned last quarter?

WHAT IS COST ACCOUNTING?


Cost accounting is concerned with providing information to assist the following. Establishing stock valuations, profits and balance sheet items Planning Control Decision making

THE ORGANISATION
An organisation, whether it is a manufacturing company, a provider of services (such as a bank or a hotel) or a public sector organisation (such as a hospital), may be divided into a number of different functions within which there are a number of departments.

THE ORGANISATION, COST CENTRES AND COST UNITS

Cost centres
In general, for cost accounting purposes, departments are termed cost centres The product produced by an organisation is termed the cost unit.

Cost centres (Examples)


A department A machine, or group of machines; A project (eg the installation of a new computer system); A new product (to enable the costs of development and production to be identified).

Cost unit

A cost unit is a unit of product or service to which costs can be related The cost unit is the basic control unit for costing purposes

Different organisations use different cost units

COST CLASSIFICATION

Classification involves arranging costs into groupings of similar items in order to make stock valuation, profit measurement, planning, decision making and control easier.

COST CLASSIFICATION FOR STOCK VALUATION AND PROFIT MEASUREMENT

The total cost of a cost unit is made up of the following: Materials Labour Other expenses (such as rent and rates, interest charges and so on)

Direct and Indirect cost

A direct cost is a cost that can be traced in full to the product, service, or department that is being costed. An indirect cost or overhead is a cost that is incurred in the course of making a product, providing a service or running a department, but which cannot be traced directly and in full to the product, service or department. Examples might be the cost of supervisors wages, cleaning materials and buildings insurance.

Prime Cost
Total direct cost is often referred to as prime cost.

Direct materials

Direct materials costs are the costs of materials that are known to have been used in making and selling a product (or providing a service).

Examples: Component parts or other materials specially purchased for a

particular job, order or process. Part-finished work which is transferred from department 1 to department 2 becomes finished work of department 1 and a direct material cost in department 2. Primary packing materials like cartons and boxes.

Direct labour

Direct labour costs are the specific costs of the workforce used to make a product or provide a service. Direct labour costs are established by measuring the time taken for a job, or the time taken in direct production work. Direct wages are all wages paid for labour (either as basic hours or as overtime) expended on work on the product itself.

Examples: (a) Workers engaged in altering the condition, conformation or composition of the product. (b) Inspectors, analysts and testers specifically required for such production.

Direct expenses

Direct expenses are any expenses which are incurred on a specific product other than direct material cost and direct wages.

Example: The cost of special designs, drawings or layouts The hire of tools or equipment for a particular job Maintenance costs of tools, jigs, fixtures and so on

Overheads

Overheads include all indirect material cost, indirect wages and indirect expenses incurred by a business.

Production Overheads (Examples)

Indirect materials which cannot be traced in the finished product.

Consumable stores, eg material used in negligible amounts

Indirect wages, meaning all wages not charged directly to a product.

Salaries and wages of non-productive personnel in the production department, eg foremen

Indirect expenses (other than material and labour) not charged directly to production.

Rent, rates and insurance of a factory Depreciation, fuel, power, repairs and maintenance of plant, machinery and factory buildings

Admin Overheads (examples)


Depreciation of office equipment. Office salaries, including salaries of secretaries and accountants. Rent, rates, insurance, lighting, cleaning and heating of general offices, telephone and postal charges, bank charges, legal charges, audit fees.

S & D Overheads (examples)

Printing and stationery, such as catalogues and price lists. Cost of packing cases. Salaries and commission of sales representatives and sales department staff and wages of packers, drivers and despatch clerks. Advertising and sales promotion, market research. Rent, rates and insurance of sales offices and showrooms, bad debts and collection charges, cash discounts allowed, after sales service. Freight and insurance charges, rent, rates, insurance and depreciation of warehouses, depreciation and running expenses of delivery vehicles.

Product costs

Product costs are costs identified with a finished product. Such costs are initially identified as part of the value of stock. They become expenses (in the form of cost of goods sold) only when the stock is sold.

Period costs
Period costs are costs that are deducted as expenses during the current period without ever being included in the value of stock held. Selling and administrative expenses

COST CLASSIFICATION FOR DECISION MAKING

A fixed cost is a cost which is incurred for a particular period of time and which, within certain activity levels, is unaffected by changes in the level of activity.
A variable cost is a cost which tends to vary with the level of activity.

COST CLASSIFICATION FOR DECISION MAKING- Examples


Direct Material Cost Sales Commission Telephone Bills Rental cost of Business Premises

COST CLASSIFICATION FOR CONTROL


A Controllable cost is a cost which can be influenced by management decisions and actions. An Uncontrollable cost is any cost that cannot be affected by management within a given time span.

COST BEHAVIOUR AND LEVELS OF ACTIVITY

Fixed Cost

Step Cost

Variable Cost

Semi-Variable Cost

Cost Behavior
Fixed Cost Variable Cost

High-low method
a)

(b) (c)

Records of costs in previous periods are reviewed and the costs of the following two periods are selected. The period with the highest volume of activity The period with the lowest volume of activity The difference between the total cost of these two periods will be the variable cost of the difference in activity levels (since the same fixed cost is included in each total cost). The variable cost per unit may be calculated from this (difference in total costs difference in activity levels), and the fixed cost may then be determined by substitution.

Scattergraph method