RESUME CHAPTER 2: AN INTRODUCTION TO

COST TERMS AND CONCEPTS

Management accounting information system is necessary in order to allocate costs,
provide information to managers, helping them with decisions, and provide information
for a better planning, control and performance measurement.
However, for a better application of management accounting, is necessary to
understand the term cost and its types.

COSTS AND COST OBJECT

Cost object its a product, service or a department of a company which cost
measurement its desired. The costs assigned to the costs objects are divided in
different sections and most of the times can vary depending on the nature of the firm,
which can be a manufacturing, merchandising or service organization.

TYPES OF COSTS
DIRECT AND INDIRECT COSTS
A cost will be distinguished as direct or indirect depending on the cost object and its
size.
Direct costs: usually very easy to trace and allocate to a cost object. It can be divided
in:

Direct materials: raw materials and other components used to create a product.
This definition can be only applied properly in manufacturing organizations,
where costs become part of a physical product. However, this term usually
cannot be applicable to merchandising (the term will be purchase cost of items
use for resale) and service organizations (materials or parts purchase to
provide a service).
Direct labour costs are the labour used to create a specific good or service.

Indirect costs or overheads: are difficult to trace, the only way to identify them is
through estimation by using cost allocations (process use to assign a common cost to
various cost objects).
Are costs that cannot be specifically identified with a particular product, service or
department. In the case of manufacturing organization are divided in manufacturing,
administrative and marketing overheads. Examples of indirect costs are property costs
or the costs of materials use to repair machinery.
PERIOD AND PRODUCT COSTS

A cost is going to be classify as period or product when there is a profit measurement

and inventory valuation. All firms organizations must consider both costs.
Period costs: not necessary part of the manufacturing process as they not represent
value added to any product and they cannot be assigned as an inventory cost.
Administrative or selling expenses are examples of period costs.
Product costs: identify with the manufacturing process, goods purchase or produced
for resale, are inventoriable costs.
Both costs are classified as expenses, however the main difference is the time at which
are classified. In the case of product costs, when the goods or services are sold costs
are released as expense. On the other hand period costs are recorded as expenses
when they are incurred.
COST BEHAVIOUR
For decision-making the level of activity of a company is essential. Level can be
measured in different units, like sales or hours worked among others, depending on the
subject of the activity.
Depending on how react costs to changes in activity, can be classify in:
Variable costs are the ones that vary in direct proportion to the volume of activity.
Total costs are linear and the unit is constant. Examples of variable costs are direct
materials in manufacturing organization or the purchase cost of items sold in a
merchandising company.
Fixed costs are the ones that are not affected by changes in activity. Total costs are
constant and the unit cost decrease proportionally with the level of activity. Examples of
fixed costs are depreciation of equipment or insurance costs.
Usually the main difference between variable and fixed costs is time. In the short-term
the costs can be both, fixed and variable, however in the long-run tend to become all
variable.
However, there are some specific cases of variable and fixed costs which are:
Semi-fixed costs are the ones that are fixed during a small level of activity and when
its above that level it change staying fixed again for a while at the higher step until the
activity move out of that step and so on. For example, if there is a continuous losses on
a company, staff that is considered as fixed (like supervisors) can be turn to variable.
Semi-variable costs are the ones composed by a mixture of fixed and variable
components. Photocopying costs is an example.
RELEVANT AND IRRELEVANT COSTS
Relevant costs are the future ones affected by decisions.
Irrelevant costs are not affected by decisions.

On an ordinary subject like a car, and relevant costs would be the petrol costs while the
insurance of the car would be irrelevant.
AVOIDABLE AND UNAVOIDABLE COSTS
They respond as an alternative name to relevant and irrelevant costs. In this case, for
the decision-making, avoidable costs are the important ones.
Avoidable costs are the costs that the may be saved by not adopting a given
alternative.
Unavoidable costs are the ones that cannot be saved.
SUNK COSTS
Irrelevant for decision-making as are created in the past and cannot be change by any
decision that will be made in the future. An example is the costs of materials that are
not used and will not be used in the future.
OPPORTUNITY COSTS
Is the cost of giving up to the alternative choice of the one choose. Usually are not
recorded in the accounting system since they dont involve cash outlays.
INCREMENTAL AND MARGINAL COSTS
Incremental costs (or differential costs) are the difference between the costs of each
alternative action, recording the additional cost resulting from a group of additional
units of output. It can include fixed and variable costs.
Marginal costs represent the additional cost of one extra unit of output.
The definition of both terms is the same; however, they are different when it comes to
measure the costs.