Ma - 02

MANAGEMENT
ACCOUNTING
02
Introduction to Cost terms & Objects
• Cost
• Cost Objects, Activity & Cost collection system
• COST TERMS
• Direct & Indirect costs
• Period & Product costs
• Cost behavior in relation to volume of activity
• Relevant & Irrelevant Costs
• Avoidable & Unavoidable Costs
• Sunk Costs
• Opportunity Costs
• Incremental & Marginal Costs
INTRODUCTION
Cost is monetary measures of resources sacrificed to achieve a specific objective
i.e. Acquiring any goods or services, Payment of rent, Insurance expenses etc.
• Do emotions have a cost in Accounting?
COST OBJECTS
What is the cost of something? How to address this question?
• Any activity / item / head for which a separate cost measurement is required
• Examples: Cost per product, per student at IBA, Cost of dept. of Accounting,
Cost of main campus or city campus etc.
• Benefits: Determine profitability, assess mangers’ performances, price setting
INTRODUCTION continued….
Cost collection system
• Is Used to accumulate costs
• By classifying them into
a) Type of expense (Direct material, direct labor or indirect costs)
b) Cost behavior (Fixed, Variable or semi-variable costs) Service providers
Types of Inventory costs for various businesses Service providers

Manufacturers Merchandisers Such companies normally do not have
inventories but may have work in
• Raw material process for incomplete activities i.e.,
• Work in process especially in construction industry
• Finished goods • Finished goods
Check next slide
Direct and indirect costs
• Direct cost can be traced exclusively with a particular cost object.
Examples are Metal used to manufacture a car, Labor/ machine
hours used to manufacture that car.
Test yourself? 1) Construction

• How a company can trace direct costs? companies=
timber, steel,
• Can a service provider use raw material? concrete etc.
• What is the direct costs for IBA? 2) Catering services=
Ingredients to
prepare food
Direct and indirect costs
Indirect Cost is non-traceable cost so can not be traced with a particular cost object, so it can be
allocated / assigned to cost objects. Also known as Overheads.
Examples:
• Indirect material (Loose tools)
• Indirect labor (Supervision)
• Other Indirect manufacturing costs (Utilities, Rent etc.)
Test yourself?
• How do you know whether depreciation expense is an overhead cost or Administrative expense?
Direct materials + Direct labor = PRIME COST
Direct labor + Manufacturing overheads* = CONVERSION COST
*Any manufacturing cost other than Direct material & Direct labor
Product and Period Costs
Product cost (Inventoriable cost) is the cost: (D. Mat. + D. Lab. + Mnf. overheads)
• That is attached to a product
• Used for inventory valuation
• Will not be treated as an expense unless the product is being sold
• All manufacturing cost is regarded as product cost
In service organizations,
materials (if any), labor &
Period cost (non-inventoriable cost) is treated as expense overheads, assigned to cost
objects (customers) is
• When incurred in that period normally treated as product
• Not included in inventory valuation costs.
• Non-manufacturing cost is regarded as period cost All other costs are period
costs.
Comparison
Why we treat both Costs differently when eventually both will be used for
profit calculation?
Test Yourself
Variable & Fixed Cost - Cost behaviors
Variable cost
• Vary in direct proportion to the volume of Cost Behaviors:
activity
• Total variable costs is linear and unit variable
cost is constant • Impact of cost and revenue
due to change in activity
• Impact of decrease in
Fixed cost revenue per unit from $20
to $15
• Remains constant over wide ranges of activity
• At what point, break-even
for a specified time period point is achieved
Variable & Fixed Cost (Cost behaviors)
Semi-fixed / Step-fixed Costs remain fixed within a given time period within specified
activity level but eventually are subject to step increases/ decreases by a constant
amount at various critical activity levels
Semi-variable Costs / Mixed costs include both elements of Fixed and variable cost. (i.e.
fixed salary + commission)
Test yourself:
• Impact of monthly rentals on no. of students (in total & per student)
• Do you agree that variable costs are fixed per unit but changes in total
• What is semi-fixed cost
Relevant & Irrelevant costs & revenues
Relevant Costs and revenues are those future costs that can be changed by a decision &
those future costs/ revenues which a unchanged by a decision will be termed as Irrelevant
costs and revenues.
Test yourself?
Option 1 Option 2
• A company purchases raw material for $100 but is unable to sell that material
Do nothing Go aheadin its current
state
Material -100 -100
• The additional conversion cost will be $200 Conversion cost 0 -200
• A customer is willing to pay $250 for that material Revenues 0 250
Net profit / loss -100 -50
Should the company go ahead? Relevant cost= -200

Avoidable & Unavoidable Costs
Sometimes the above terms can be used instead of relevant &
Irrelevant costs.
Avoidable costs are costs that can be avoided by not adopting a

given alternative and whereas Unavoidable costs can not be saved.
Test Yourself?
• In the previous example what was the Avoidable cost?
Sunk Cost
Sunk Cost is:
• Any cost incurred due to any past decision
• Can not be changed by future decision
• It is irrelevant is decision making but
• Not all irrelevant costs are sunk cost
Example:
Two alternatives' decisions require identical material expenditures. The
direct material cost will be irrelevant, but material costs is not a sunk cost
because it will be incurred in future regardless of any alternative.
Opportunity cost
Opportunity cost measure the cost of opportunity that is lost or sacrificed
when choice of one course of action requires that an alternative course of
action is given up.
Additional points:
• It is not recorded in accounting system as no cost is incurred, so will only
be used in decision making
• Represent scarce resources as where resources are not scarce there will
be no sacrifice
Test yourself
• A student got a job offer @ Rs. 100,000 a month but decided to take a
gap year. What will be the opportunity cost.
• ABC Ltd. is manufacturing product A on machine X at full capacity.

Product A will generate a profit of $100. If company receive another order
to produce product B but ABC ltd. has to incur additional cost of $300 for
this product. For making B company has to stop product A.
What will be the total cost of & opportunity cost of “B”?
Incremental & Marginal Costs
Incremental costs also known as differential costs are the differences
between costs of each alternative course of action that is being
considered. In simple terms any extra cost when comparing
alternatives.
Marginal Costs are similar to Incremental cost but the only difference
is:
• MC represent cost of one extra unit of output
• Whereas IC represent cumulative extra cost of output
Test yourself
A university is considering 2 alternatives:
• Increase no. of students by 20%
• No increase
If 1st alternative is chosen, then it will require new permanent

Lecturers at a cost of $100,000 and more part-timers at a cost
of $10,000. What will be the incremental cost of option 1?

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MANAGEMENT

Types of Inventory costs for various businesses Service providers

Test yourself? 1) Construction

Net profit / loss -100 -50

Should the company go ahead? Relevant cost= -200

Avoidable costs are costs that can be avoided by not adopting a

• ABC Ltd. is manufacturing product A on machine X at full capacity.

If 1st alternative is chosen, then it will require new permanent

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