Costs: Costs Are Different From Expenses

Costs
• Costs are different from expenses.

• Costs are resources sacrificed to achieve an objective.
• Expenses are the costs charged against revenue in a particular accounting
period.
• Hence, “cost” is an economic concept, while “expense” is a term that falls
within the domain of accounting.
Types of costs
Costs
Direct Costs Indirect Costs
Fixed Costs Variable Costs
Marginal Costs Opportunity Costs
Sunk Costs Differential Costs
Relevant Costs
Direct Cost
• Direct costs can be specifically and exclusively identified with

a given cost object.
• Direct cost is what a company pays for the production of
goods.
• When a company that produces soap - adding up everything it takes
to produce said soaps (material, employees etc)
Indirect Cost
• Indirect costs cannot be specifically and exclusively identified with
a given cost object.
• Indirect costs (i.e. overheads)are assigned to cost objects on the basis of
cost allocations.
• Indirect costs are costs that are important in terms of keeping the company
operating; however have nothing to do with the production of a good.
• Indirect costs may include utility, rent, and paying employees among other things.
• It can be safe to say that indirect costs have similarities to fixed costs in that it is an
important expense that is not directly related to the production of goods.
Fixed Cost
• Fixed costs remain constant over wide ranges of activity.
• Do not Change with the levels of organizational Activities (in a
range)
• We have to incur these or pay these costs even if things
fluctuate outside the organizational environment
• Rent, property tax, insurance and interest expense.
Fixed cost
(a) Total (b) Product
Variable Cost
• Variable costs vary in direct proportion with activity.
• “Change in the volume of production units"
• Costs may vary according to the amount of operations carried out in
an organization
• How much you will require to pay when you produce..
Variable costs
(a) Total (b) Product
Fixed Cost and Variable Cost in a Graph
Rs Amount Total Cost
Variable Cost
Fixed Cost
Level of Activity
Cost behaviour Relevant Range
Behavior of Cost (within the relevant range)
Cost In Total Per Unit
Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Average fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.
So the cost function ….
• Fixed cost = F
• Variable cost = V
• The total cost T = V + F
• If we write this as a formula
• At production level x
• The cost function is T(x) = F + V(x)
Marginal Cost
• The cost to produce one more additional unit of output
Cost
Level of Output
Start-up Normal Exceeding
Range Operations Capacity
Sunk cost
• Unrecoverable past expenditures.
• These should not normally be taken into account
when determining whether to continue a project or
abandon it, because they cannot be recovered either
way.
• It is a common instinct to count them, however.
Sunk Cost
• Sunk costs are costs that cannot be reversed or undone (The

Economist, 2008).
• Examples of sunk costs include advertising and research. (The
Economist, 2008)
• The economist (2008) says that sunk cost can be a barrier to entry.
• If it cannot recover the costs of advertising and research, said
company may be scared out of the marketplace.
Opportunity Cost
The potential benefit that is given up when

one alternative is selected over another.
• These costs are not usually entered into the accounting
records of an organization, but must be explicitly
considered in all decisions.
• Why ?
Differential Cost
• Differential costs (or incremental costs) is a difference in cost between any
two alternatives. A difference in revenue between two alternatives is
called differential revenue. Differential costs can be either fixed or
variable.
• First Job – Rs 250K – Cost 100K = 150K
• Second Job – Rs 175 – Cost 15K = 160K 10K
Differential Revenue = (75)

Differential Cost = 85 10K
Relevant Cost
• Relevant costs are costs that change with respect to a particular decision
and those that differ as between the alternatives being considered.
• Sunk costs are never relevant.
• Future costs may or may not be relevant.
• If the future costs are going to be incurred regardless of the decision that is made,
those costs are not relevant.
• Committed costs are future costs that are not relevant.
• Even if the future costs are not committed, if we anticipate incurring those costs
regardless of the decision that we make, those costs are not relevant.
Remember
• Contribution (C) per unit
= Unit Selling Price – Unit Variable Cost
• Operating Income/Profit
= Unit selling price – Variable cost – Fixed Cost
BE Point in Graph
Benefits and Uses:
• The evaluation to determine necessary levels of

service or production to avoid loss.
• Comparing different variables to determine best case

scenario.
Break-even analysis:
Break-even point
• John sells a product for $10 and it cost $5 to produce (UVC) and has
fixed cost (FC) of $25,000 per year
• How much will he need to sell to break-even?
• How much will he need to sell to make $1000 profit?

Break-even analysis:
Break-even point
• XYZ plc , revenue was Rs 750,000. They sold 100,000 units. The
total variable cost was Rs 500,000
• What is the fixed cost if it has to Break even?
• What is the profit if the fixed cost is Rs 150,000
• What is the Break even Revenue if the Fixed cost is 150,000?
• If the management is aiming at 250,000 profit how many units
must be sold?
Graphical analysis:
Dollars
70,000
(6000, 60000)
60,000 Total Cost
Line
50,000
40,000
30,000
Total Revenue Break-even point
20,000 Line
10,000
1000 2000 3000 4000 5000 6000
Quantity
Graphical analysis:
Cont.
Dollars
70,000
60,000 Total Cost
Line
50,000
40,000
30,000
20,000
Total Revenue
10,000 Line Break-even point
0
1000 2000 3000 4000 5000 6000
Try Q5-10Quantity
Limiting Factor
• When we emphasize on the marginal costing technique the product with
highest contribution per unit will be preferred.
• Most/Some of the sometimes an organization can sell all it produces but
production is limited due to scarcity of raw material, labour, electricity,
plant capacity or capital.
• These elements are called limiting factors (LF) or key factors (KF)
• They have the ability to place a limitation on production and also profit of
the firm.
Summary:
• Break-even analysis can be an effective tool in determining the

cost effectiveness of a product.
• Required quantities to avoid loss.
• Use as a comparison tool for making a decision.

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Costs

• Costs are different from expenses.

Direct Costs Indirect Costs

Fixed Costs Variable Costs

Marginal Costs Opportunity Costs

Sunk Costs Differential Costs

• Direct costs can be specifically and exclusively identified with

Rs Amount Total Cost

• Sunk costs are costs that cannot be reversed or undone (The

The potential benefit that is given up when

Differential Revenue = (75)

• The evaluation to determine necessary levels of

• Comparing different variables to determine best case

• How much will he need to sell to break-even?

• How much will he need to sell to make $1000 profit?

• Break-even analysis can be an effective tool in determining the

• Required quantities to avoid loss.

• Use as a comparison tool for making a decision.

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