AN INTRODUCTION TO COST TERMS AND CONCEPTS

1. AN INTRODUCTION TO COST TERMS AND CONCEPTS Akuntansi Manajemen _ Fakultas Pertanian_Universitas Wiraraja Reference : “MANAGEMENT ACCOUNTING FOR BUSINESS DECISIONS : 2nd edition” The Thomson Learning, Italy, 2001. by Collin Drury

2. Direct cost and Indirect Cost • If the users of accounting information want to know the cost of something, this “something” is called a cost object. • Direct costs are those cost that can be specifically and exclusively identified with a particular cost object. In Contrast, Indirect costs cannot be identified specifically and exclusively with a given cost object. • Assume that our cost object is product, or to be more specific a particular desk that is manufactured by an organization. In this situation the wood that is used to manufacture the desk and can thus be classified as direct cost. In contrast, the salary of factory or the rent of factory cannot be specifically and exclusively traced to a particular desk and these costs are therefore classified as indirect. • If the cost object is the cost of using different distribution channels, then the rental of warehouse and the salaries of storekeepers will be regarded as direct for each distribution channel. Also consider a supervisor’s salary in a maintenance department or a manufacturing company. If the cost object is maintenance department, then the salary is a direct cost. What about if the cost object is product ?

3. CATEGORIES OF MANUFACTURING COSTS • In manufacturing organizations, products frequently the cost object. • Traditional cost accounting systems accumulate product costs as follows : Direct materials XXX • Direct labor XXX • Prime cost XXX • Manufacturing overhead XXX • Total Manufacturing costs XXX • Direct materials consist of all those material can be identified with the specific product. For example, wood that is used to manufactured a desk can easily be identified as part of the product, and can thus be classified as direct materials. Alternatively, materials used for the repair of a machine that is used for the manufacture of many different desks are classified as indirect materials.

4. Direct Labor consist of those labor costs that can be specifically traced to or identified with a particular product. Example direct labor costs include the wages of operatives who assemble parts into the finished products, or machine operatives engaged in the production process. By contrast, the salaries of factory supervisors or the wages paid to the staff in the stores department cannot be specifically identified with the product, and thus form part of indirect labors. The wages of all employees who do not work on the product itself but who assists in the manufacturing operation are thus classified as part of the indirect labor costs. As with indirect materials, indirect labor is classified as part of the manufacturing overhead costs. • Prime costs refers to the direct costs of the product and consists of direct labor costs plus direct material costs plus any direct expenses. The cost of hiring a machine for producing specific products is an example of a direct expense.

5. Manufacturing overhead consist of all costs other than direct labor, direct materials, and direct expenses. It therefore includes all indirect manufacturing labor and material costs plus indirect manufacturing expenses. Examples of indirect manufacturing expenses in a multi-product company include rent of the factory and depreciation of machinery.

6. PERIOD AND PRODUCT COSTS • External financial accounting rules in most countries requires that for inventory valuation, only manufacturing costs should be include in the calculation of product costs (published by accounting standard committee). Accountants therefore classify costs as product costs and period costs. • Product costs are those costs that are identified with good purchase or produce for resale. Period costs are those costs that are not include in the inventory valuation and as a result are treated as expenses in the period in which they are incurred. • Companies operating in merchandising sector, such as retailing or wholesaling organizations, purchase goods for resale without changing their basic form. The cost of goods purchased is regarded as a product costs and all other costs such as administration and selling and distribution expenses are considered to be period costs. In figure 1 you will see that both product and period costs are eventually classified as expenses. The major difference as the point of time at which they are so classified.

7. Why are non-manufacturing costs treated as period costs and not included in the inventory valuation? There are two reasons. First, inventories are asset (unsold production) and asset represent resources that have been acquired that are expected to contribute to future revenue. Manufacturing costs incurred in making a product can be expected to generated future revenues to cover the costs of production. There is no guarantee, however, that non-manufacturing costs will generate future revenue, because they do not represent value added to any specific product. Therefore they are not included in inventory valuation. Second, many non manufacturing costs (e.g. distribution costs) are not incurred when the product is being stored. Hence it is inappropriate to include such costs within the inventory valuation. • Figure 1. Treatment of period and product costs Sold Record as an asset (inventory) in the balance sheet and becomes an expenses in the profit and loss account when the product is sold Product code Manufacturing Costs Unsold period code Non-Manufacturing Costs Record as an expenses in the profit and loss account In current accounting period

8. COST BEHAVIOUR • Short term variable costs vary in direct proportion to the volume activity; that is, doubling the level of activity will double the total variable cost. Consequently, total variable costs are linear and unit variable cost is constant. Example of short term variable manufacturing costs include piecework labor, direct materials, and energy to operate the machines. Example of non-manufacturing variable costs include sales commission, which fluctuate with sales value, and petrol, which fluctuates with the number of miles traveled. • Fixed costs remain constant over wide ranges of activity for a specified time period. Example of fixed costs include depreciation of the factory building, supervisor salaries, and leasing charges for cars used by the sales force. • The distinguished feature of semi-fixed or step-fixed costs is that within a given time period they are fixed within specified activity levels, but they eventually increase or decrease by a constant amount at various critical activity levels. Ex. 1). If price levels increase then some fixed costs such as management salaries will increase 2). Within short term period, such as one year, labor costs can change in response to changes in demand.

9. Over very short term periods such as one month, spending on direct labor and supervisory salaries will be fixed in relation to changes in activity. • Semi-variable costs. These include both a fixed and a variable component. The cost of maintenance is a semi-variable cost consisting of planned maintenance that is undertaken whatever the level of activity, and a variable element that is directly related to the level of activity. • A further semi-variable costs is where sales representatives are paid a fixed salary plus a commission on sales.

10. RELEVANT AND IRRELEVANT COSTS AND REVENUES • For decision-making, costs and revenue can be classified according to whether they relevant to a particular decision. • Relevant costs and revenues are those future costs and revenues that will be changed by the decision, whereas irrelevant costs and revenues are those that will not be affected by the decision. • For example, if one is faced with a choice of making a journey by car or public transport, the car tax and insurance costs are irrelevant, since they will remain the same whatever alternative is chosen. However, petrol costs for the car will differ depending on which alternative is chosen, and this costs will be relevant for decision-making. • Assume a company purchased raw materials a few years ago for $100 and that there appears to be no possibility of selling these materials or using them in future production apart from in connection with an enquiry from a former customer. This customer is prepared to purchased a product that will require the use of all these materials, but he is not prepared to pay more than $250 per unit. The additional costs of converting these materials into the required product are $200. Should the company accept the order for $250 ?

11. It appears that the cost of the order is $300, consisting of $100 material cost and $200 conversion costs, but this is incorrect because the $100 will remain the same whether the order is accepted or rejected. The material cost is therefore is irrelevant for the decision, but if order is accepted the conversion costs will change by $200, and this conversion cost is relevant cost. If we compare the revenue of $250 with the relevant costs for the order of $250, it means that the order should be accepted, assuming of course that no higher-priced orders can be obtained elsewhere.

12. AVOIDABLE AND UNAVOIDABLE COSTS • Sometimes the terms of avoidable and avoidable costs are use instead of relevant and irrelevant cost. Avoidable costs are those costs that may be saved by not adopting a given alternative, whereas unavoidable costs cannot be saved. Therefore, only avoidable costs are relevant for decision-making purposes. Consider the example that we used to illustrate relevant and irrelevant costs. The material costs of $100 are unavoidable and irrelevant, but the conversion costs of $200 are avoidable and hence relevant. The decision rule is to accept those alternatives that generate revenues in excess of the avoidable costs.

13. SUNK COSTS • These costs are the cost of resources already acquired where the total will be unaffected by the choice between various alternatives. They are costs that have been created by decision made in the past and cannot be changed by any decision that will be made in the future. • For example, if a machine was purchased four years ago for $100 000 with an expected life of five years and nil scrap value then the written down value will $20 000 if straight line depreciation is used. • Sunk cost are irrelevant for decision-making, but they are distinguished from irrelevant costs because not all irrelevant costs are sunk costs. For example, a comparison of two alternative production methods may result in identical direct material expenditure for both alternatives, so the direct materials is irrelevant because it will remain whichever alternative is chosen, but the material is sunk cost since it will be incurred in the future.

14. OPPORTUNITY COSTS • An opportunity costs is a 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. • Example : a company has an opportunity to obtain a contract for the production of a special component. This component requires will require 100 hours of processing on machine X. Machine X is working at full capacity on the production of product A, and the only way in which the contract can be fulfilled is by reducing the output of product A. This will result in a lost profit contribution of $200. The contract will also result in additional variable costs of $1000. If the company takes on the contract, it will sacrifice a profit contribution $200 from the lost output of product A. This represent an opportunity cost, and should be included as part of the cost when negotiating for the contract. The contract price should at least cover the additional costs of $1000 plus the $200 opportunity cost to ensure that the company will be better of in the short term by accepting the contract. • If no alternatives use of resources exist then the opportunity cost is zero, but if resources have an alternative use, and are scarce, then an opportunity cost does exist.

15. INCREMENTAL AND MARGINAL COSTS • Incremental (also called differential) costs and revenues are the difference between costs and revenues for the corresponding items under each alternative being considered. • For example, the incremental costs of increasing output from 1000 to 1100 units per week are the additional costs of producing an extra 100 units per week. Incremental costs may or may not included fixed costs. If fixed costs do not change as a result of a decision, the incremental costs will be zero. • Incremental costs and revenues are similar principle to the economist’s concept of marginal costs and marginal revenue. • The main difference is that marginal cost/revenue represent the additional cost/revenue of one extra unit of output whereas incremental cost/revenue represent the additional cost/revenue resulting from a group of additional units of output.

16. MAINTAINING A COST DATABASE • A costs and management accounting system should generate information to meet the following requirements : • 1. to allocate costs between cost of goods sold and inventories for internal and external profit measurement and inventory valuation. • 2. to provide relevant information to help managers make better decisions; • 3. to provide information for planning, control and performance measurement. • See review problems page 36…!!!