After completing the chapter, you should be able to:

Explain the concept of a direct cost and an indirect cost;

Explain why the concept of cost needs to be defined, in order to be meaningful;
Distinguish between the historical cost of an asset and the economic value of an asset to
an organization;
Prepare cost statements for allocation and apportionment of overheads, including
reciprocal service departments;
Calculate direct, variable and full costs of products, services and activities using overhead
absorption rates to trace indirect costs to cost units;
Apply cost information in pricing decisions

Explain how costs behave as product, service or activity levels increase or decrease;
Distinguish between fixed, variable and semi-variable costs;
Explain step costs and the importance of timescales in their treatment as either variable
or fixed;
Calculate the fixed and variable elements of a semi-variable cost.
Most organizations will have a costing system which is used to gather the
cost information for the organization together.

An organizations costing system is the foundation of the internal

financial information system for managers. It provides the information
that management needs to plan and control the organizations activities and
to make decisions about the future.
Examples of the type of information provided by a costing system and the uses to
which it might be put include the following:

1. Actual Unit Cost for the latest period: could be used for cost control by
comparing with a predetermined unit cost. Could also be used as the basis for
decisions about pricing and production levels.

For example, a manager cannot make a decision about the price to be charged to a
customer without information which tells the manager how much it costs to produce
and distribute the product to the customer.

2. Actual costs of operating a department for the latest period: could be

used for cost control by comparing with a predetermined budget for the department.
Could also be used as the basis for decisions such as outsourcing.

For example, a manager might be considering the closure of the packing

department and instead outsourcing the packing operations to another organization.
In order to make this decision the manager need to know, among other things, the
actual cost of operating the packing department.
3. The forecast costs to be incurred at different levels of activity: Could be
used for planning, for decision making and as part of cost control by comparing the
actual costs with the forecasts.

For example, a manager cannot make a well-informed decision about the

appropriate production level for the forthcoming period unless information is available
about the costs that will be incurred at various possible output levels.

This is by no means an exhaustive list of the information that is provided by a

costing system. However, it should serve to demonstrate that organizations need
costing systems that will provide the basic information that management requires
for planning, control and decision making.
Cost is a sacrifice of resources. An amount that has to be paid or Given up in
order to get something
In business, cost is usually a monetary valuation of (1) effort, (2) material, (3)
resources, (4) time and utilities consumed, (5) risks incurred, and (6) opportunity
forgone in production and delivery of a good or service.

All expenses are costs, but not all costs (such as those incurred in acquisition of an
income-generating asset) are expenses.
Refer to Bangladesh Cost Accounting Standard, it is a
measurement, in monetary terms, of the amount of resource
utilized for the production of goods or rendering of services.
Resources could be:
1. Money
2. Efforts
3. Materials
4. Time and utilities consumed
5. Assumed Risks
6. Opportunities forgone in production and delivery of goods and
service
There are many different types of cost and that each of its usefulness and limitations
in different circumstances. Some definitions of cost that need to know:
The term historical cost is normally used when we consider the purchase of an asset.
This applies to both non-current assets, such as buildings or vehicles, or current
assets such as inventory.

Historical cost is the original cost paid for the asset at the time of acquisition.
The CIMA Terminology defines a cost unit as a unit of product or service in relation to
which costs are ascertained.

This means that a cost unit can be anything for which it is possible to ascertain the cost. The
cost unit selected in each situation will depend on a number of factors, including the purpose of
the cost ascertainment exercise and the amount of information available.

Some examples from the CIMA Terminology are as follows:

Industry Sector Cost unit

Brick-making 1,000 bricks
Electricity Kilowatt-hour (KwH)
Professional services Chargeable hour
Education Enrolled student

Activity Cost unit

Credit control Account maintained
Selling Customer call

A cost unit can be anything which is measurable and useful for cost control purposes. For
example, with brick-making, 1,000 bricks are suggested as a cost unit. It would be possible to
determine the cost per brick but perhaps in this case a larger measure is considered more
suitable and useful for control purposes
The cost units for services are usually intangible and they are often composite cost
units, that is, they are often made up of two parts. For example, if we are
attempting to monitor and control the costs of a delivery service we might measure
the cost per ton delivered. However, ton delivered would not be particularly useful
cost unit because it would not be valid to compare the cost per ton delivered from
Dhaka to Chittagong with the cost per ton delivered from Dhaka to Comilla. The
former journey is much longer and it will almost certainly cost more to deliver a ton
over the longer distance.

Composite cost units assist in overcoming this problem. We could perhaps use a ton-
mile instead. This means that we could record and monitor the cost of carrying
one ton for one mile. The cost per ton-mile would be a comparable measure
whatever the length of journey and this is therefore a valid and useful cost unit for
control purposes.
Other example of composite cost units might be as follows:

Business Cost Unit

Hotel Bed night
Bus Company Passenger mile
Hospital In-patient day
A cost center is a production or service location, a function, an activity or an
item of equipment for which costs are accumulated. (A cost center is one
type of responsibility center).

A cost center is used as a collecting place for costs. The cost of operating the cost
center is determined for the period, and then this total cost is related to the cost
units which have passed through the cost center. For instance, an example of a
production cost center could be the machine shop in a factory. The production cost
for the machine shop might be Tk. 100,000 for the period. If 1,000 cost units have
passed through this cost center we might say that the production cost relating to
the machine shop was Tk. 100 for each unit.

A cost center could also be a service location, a function, an activity or an

item of equipment. Examples of these might be as follows:

Type of cost center Examples

Service Location Stores, canteen
Function Sales representative
Activity Quality Control
Item of Equipment Packing Machine
A cost center is a location where all costs relating to certain activities and
functions etc. are stored.

Types of Cost Center

Cost center can come in all different shapes and sizes and are not limited
exclusively to direct costs and production. The four main types of cost center are:

Function
Activity
Service location
Equipment
A cost object is anything for which costs can be ascertained.

The CIMA Terminology contains the following description: For example a product,
service, center, activity, customer or distribution channel in relation to which costs are
ascertained.
Costs can be classified in many different ways. It is necessary to be able to classify al
costs, that is, to be able to arrange them into logical groups, in order to devise an
efficient system to collect and analyze the costs. The classification selected
and the level of detail used in the classification grouping will depend on the purpose
of the classification exercise.

The CIMA Terminology defines classification as the arrangement of items in logical

groups by nature, purpose or responsibility.

There are three main ways in which costs can be classified:

Nature
Purpose
Behavior
LABOR MATERIAL EXPENSES DIRECT INDIRECT FIXED VARIABLE
SEMI-VARIABLE
Classifying costs according to their nature means grouping costs according to
whether they are materials, labor or expense cost

Raw materials that become an integral part of the product and that can be
conveniently traced directly to it. The cost of having the materials brought to
the organization is known as carriage inwards.

Example: A radio installed in an automobile

Those labor costs that can be easily traced to individual units of product.
Labor costs are those incurred in the form of wages and salaries,
together with related employment costs.

Example: Wages paid to automobile assembly workers

Expenses costs are external costs such as rent, business rates, electricity, gas,
postages, telephones and similar items which will be documented by invoices from
suppliers.

Manufacturing costs cannot be traced directly to specific units produced.

Examples: Indirect materials and indirect labor

Materials used to support the Wages paid to employees who are

production process. not directly involved in
production work.
Examples: Lubricants and Examples: Maintenance workers,
cleaning supplies used in the janitors and security guards.
automobile assembly plant.
Manufacturing overhead includes all manufacturing costs except direct materials and
direct labor. These costs cannot be easily traced to specific units produced (also called
indirect manufacturing cost, factory overhead, and factory burden).

Manufacturing overhead includes indirect materials that are part of the finished
product, but that cannot be easily traced to it and indirect labor costs that cannot be
physically or conveniently traced to the creation of products.

Other examples of manufacturing overhead include: maintenance and repairs on

production equipment, heat and light, property taxes, depreciation and insurance on
manufacturing facilities, and salaries for supervisors, janitors, and security guards.
 Administrative
Selling Costs
Costs

Costs necessary to get the All executive,

order and deliver the organizational, and clerical
product. costs.
A manufacturing company incurs many other costs in addition to manufacturing costs.

For financial reporting purposes, most of these other costs are typically classified as
selling costs and administrative costs. These costs are also called selling, general and
administrative costs, or SG&A. Selling and administrative costs are incurred in both
manufacturing and merchandising firms.

Selling costs include all costs necessary to secure customer orders and get the finished
product into the hands of the customer. These costs are also referred to as order-
getting and order-filling costs.

Administrative costs include all executive, organizational, and clerical costs associated
with the general management of an organization that are not classified as production
or marketing costs.
Which of the following costs would be considered a period
rather than a product cost in a manufacturing company?
(There may be more than one correct answer.)

A. Manufacturing equipment depreciation.

B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production facility.
E. Sales commissions.
Which of the following costs would be considered
a period rather than a product cost in a
manufacturing company? (There may be more
than one correct answer.)

A. Manufacturing equipment depreciation.

B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production facility.
E. Sales commissions.
When costs are classified having regard to their purpose, they are grouped according
to the reason for which they have been incurred. The broadest classification of this
type is to divide costs into direct costs and indirect costs.

Direct costs:
Costs that, for a reasonable cost, can
be directly traced to the product.

Direct labor:
Direct materials:
Work directly traceable to
Materials directly
transforming materials
traceable to the product
into the finished product
A Direct Cost is one that can be clearly identified with the cost object we
are trying to cost.

For example, suppose that a furniture maker is determining the cost of a wooden
table. The manufacturer of the table has involved the use of timber, screws and metal
drawer handles. These items are classified as direct materials. The wages paid to the
machine operator, assembler and finisher in actually making the table would be
classified as direct labor costs. The designer of the table may be entitled to a royalty
payment for each table made, and this would be classified as a direct expense.
 Indirect costs:
Costs that cannot reasonably
be directly traced to the product.

Manufacturing overhead:
All production costs except
direct materials and direct labor.

Indirect materials Other indirect costs

Other costs incurred would be classified as indirect costs.

They cannot be directly attributed to a particular cost unit, although it is

clear that they have been incurred in the production of the table. These
indirect costs are often referred to as overheads.

Examples of indirect production costs are as follows:

Cost incurred Cost classification

Lubricating oils and cleaning materials indirect material
Salaries of supervisory labor indirect labor
Factory rent and power indirect expense
State whether each of the following costs would be a direct cost or an indirect
cost of the quality control activity which is undertaken in a companys factory.

The salary of the quality control supervisor

The rent of the factory
The depreciation of the quality testing machine
The cost of the samples destroyed during testing
The insurance of the factory
Spotless Ltd is an office cleaning business which employs a team of
part time cleaners who are paid an hourly wage. The business provides
cleaning services for a number of clients, ranging from small offices
attached to high street shops to large open plan offices in high rise
buildings.

In determine the cost of providing a cleaning service to a

particular client, which of the following costs would be a direct cost of
cleaning that clients office and which would be an indirect
cost?

The wages paid to the cleaner who is sent to the clients premises
The cost of carpet shampoo used by the cleaner
The salaries of spotless Ltd.s accounts clerks
Rent of the premises where spotless Ltd.s stores its cleaning
materials and equipment
Traveling expenses paid to the cleaner to reach the clients premises
Advertising expenses incurred in attracting more clients to spotless
Ltd.s business
1-31

Product costs include direct Period costs are not included in

materials, direct labor, and product costs. They are expensed
manufacturing overhead. on the income statement.

Cost of
Inventory Goods Sold Expense

Sale

Balance Income Income

Sheet Statement Statement
Product costs include all the costs that are involved in acquiring or making
a product.

In the case of manufactured goods, it includes direct materials, direct labor, and
manufacturing overhead.

Consistent with the matching principle, product costs are recognized as

expenses when the products are sold. This can result in a delay of one or more
periods between the time in which the cost is incurred and when it appears as an
expense on the income statement.

Product costs are also known as inventoriable costs.

Period costs include all selling and administrative costs.

These costs are expensed on the income statement in the period incurred.

All selling and administrative costs are typically considered to be period costs.

The usual rules of accrual accounting apply to period costs.

For example, administrative salary costs are incurred when they are earned by the
employees and not necessarily when they are paid to employees.
Manufacturing costs are often classified as follows:
The outline cost statement for a single cost unit shows how the total or full cost for
a unit might be built up.
$ $
Direct Material 15
Direct labor 5
Direct expenses 2
Prime cost or total direct cost 22
Production Overhead:
Indirect Material 4
Indirect labor 6
Indirect expenses 6
16
Total production/factory cost 38
Selling, distribution and administration overhead 2
Total (full) cost 40
Profit 10
Selling price 50

Note that the costing is split by both nature and purpose. The direct costs are shown
first, split by nature.
Prime cost is the total of the direct costs.

Indirect costs (or overheads) are shown next, again split by nature.

This now gives the total production (or factory) cost.

Once the non-production costs (those costs which are incurred after production of the
goods) are added, the total (or full) cost can be ascertained.

Suppose that the cost analysis has been provided by the management
accountant to help us to decide on the selling price to be charged for a
luxury wall-mounted hairdryer: the type that is fixed to the wall for customers
use in hotel bedrooms.

Now look at the costs that might be incurred in manufacturing and selling a hairdryer,
and how each cost would be classified in terms of the above analysis of the elements
of cost.
Direct Materials. This is the material that actually becomes part of the finished
hairdryer. It would include the plastic for the case and the packaging materials. If we
make another batch of hairdryers then we will need to purchase another batch of
these and other direct materials.

Direct Labor. This is the labor cost incurred directly as a result of making one
hairdryer. If we make another batch of hairdryers then we will need to pay more
direct labor cost.

Direct expenses. These are expenses caused directly as a result of making one
more batch of hairdryers. For example, the company might be required to pay the
designer of the hairdryer a royalty of $2 for each hairdryer produced.

The three direct costs are summed to derive the prime cost of $22. This is one
measure of cost but there are still other costs to be added: production overheads and
other overheads.
Production overheads are basically the same three costs as for direct cost, but they are
identified as indirect costs because they cannot be specifically identified with any particular
hairdryer or batch of hairdryers. Indirect costs must be shared out over all the cost objects
using a fair and equitable basis.

Indirect materials are those production materials that do not actually become part of the
finished product. This might include the cleaning materials and lubricating oils for the
machinery. The machine must be clean and lubricated in order to carry out production, but it
will probably not be necessary to spend more on these materials in order to manufacture a
further batch. This cost is therefore only indirectly related to the production of this batch.

Indirect labor is the production of labor cost which cannot be directly associated with the
production of any particular batch. It would include the salaries of supervisors who are
overseeing the production of hairdryers as well as all other products manufactured in the
factory.

Indirect expenses are all the other production overheads associated with running the factory,
including factory rent and rates, heating and lighting etc. These indirect costs must be shared
out over all of the batches produced in a period.

The share of indirect production costs is added to the prime cost to derive the total
production cost of $38. This is another measure of cost but there are still more costs to be
added: a share of the other overheads.
Selling and distribution overhead includes the sales force salaries and
commission, the cost of operating delivery vehicles and renting a storage warehouse,
etc. these are indirect costs which are not specifically attributable to a particular cost
unit.

Administrative overhead includes the rent on the administrative office building, the
depreciation of office equipment, postage and stationery costs, etc. These are also
indirect costs which are not specifically attributable to a particular cost unit.

In this example, the non-production overheads amount to $2 per unit; this is

added to the total production cost to give a total (full) cost of $40.

In this example, a profit of $ 10 has been added, suggesting a selling price of

$50.
When Accounting for costs it is imperative that you understand the ways in
which cost behave and what factors can affect cost. There are many
external factors which can affect costs such as inflation, exchange rates or
interest rates.

However cost behavior from the prospective of a management accountant relates to

how cost change depending on the level of production.
An understanding of cost behavior patterns is essential for many management tasks,
particularly in the areas of planning, decision making and control. It would be
impossible for managers to forecast and control costs without at least a basic
knowledge of the way in which costs behave in relation to the level of activity.

Now we are splitting costs by the way they behave as a result of changes in activity
levels. The main splits are:

Fixed
Variable
Semi-variable

It is important to be able to identify the cost behavior and also to be able to

represent the cost graphically.
Managers often need to be able to predict how costs will change in
response to changes in activity. The activity might be the output of goods
or services or it might be some measure of activity, internal to the company,
such as the number of purchase orders processed during a period.

Cost behavior refers to how a cost will react to changes in the level of
activity within the relevant range. The most commonly used
classifications of cost behavior are variable and fixed costs. The total of just
about any cost will change if there is a big enough change in activity. There is
some controversy concerning the proper definition of the relevant range.
Some refer to the relevant range as the range of activity within which the
company usually operates. We refer to the relevant range as the range of
activity within which the assumptions about variable and fixed costs are valid.
Either definition could be usedour choice was dictated by our desire to
highlight the notion that fixed costs can change if the level of activity
changes enough.
A variable cost is a cost that changes in relation to variations in an activity.

In a business, the "activity" is frequently production volume, with sales volume being
another likely triggering event. Thus, the materials used as the components in a
product are considered variable costs, because they vary directly with the number of
units of product produced.

It is extremely useful to understand the proportion of variable costs in a

business, since a high proportion means that a business can continue to function at a
relatively low revenue level. Conversely, a high proportion of fixed costs requires that a
business maintain a high revenue level in order to stay in business.

Direct materials: The most purely variable cost of all, these are the raw materials
that go into a product.

Piece rate labor: This is the amount paid to workers for every unit completed (note:
direct labor is frequently not a variable cost, since a minimum number of people are
needed to staff the production area; this makes it a fixed cost).
Production supplies: Things like machinery oil are consumed based on the amount
of machinery usage, so these costs vary with production volume.

Billable staff wages: If a company bills out the time of its employees, and those
employees are only paid if they work billable hours, then this is a variable cost.
However, if they are paid salaries (where they are paid no matter how many hours
they work), then this is a fixed cost.

Commissions: Salespeople are paid a commission only if they sell products or

services, so this is clearly a variable cost.

Credit card fees: Fees are only charged to a business if it accepts credit card
purchases from customers. Only the credit card fees that are a percentage of sales
(i.e., not the monthly fixed fee) should be considered variable.

Freight out: A business incurs a shipping cost only when it sells and ships out a
product. Thus, freight out can be considered a variable cost.

In most organizations, the bulk of all expenses are fixed costs, and represent the
overhead that an organization must incur to operate on a daily basis. There tend to
be far fewer variable costs.
 Your total texting bill is based on how many texts you send.
Total Texting Bill

Number of Texts Sent

A variable cost varies in direct proportion to changes in the level of activity.

For example, if you dont have a texting plan on your cell phone, text messaging
costs .5 Tk. per text. Your total texting bill increases with the number of texts you
send.
1-
46

The cost per text sent is constant at .5 taka per text.

Cost Per Text Sent

Number of Texts
Sent
1-47

Your monthly contract fee for your cell phone is fixed for the number of monthly
minutes in your contract. The monthly contract fee does not change based on the
number of calls you make.
Monthly Cell Phone
Contract Fee

Number of Minutes Used

Within Monthly Plan

A fixed cost is constant within the relevant range. In other words, fixed costs do not change
for changes in activity that fall within the relevant range. For example, your monthly
contract fee for your cell phone is a fixed amount for a certain number of minutes. The
monthly contract fee does not change based on the number of calls you make.

Of course, if you go over your allotted monthly minutes, you have exceeded the relevant range
for your monthly contract and will be charged above and beyond your monthly contract fee.
1-48

Within the monthly contract allotment, the average fixed cost per cell phone call
made decreases as more calls are made.

Monthly Cell Phone

Contract Fee
Number of Minutes Used
Within Monthly Plan

However, when expressed on a per unit basis, a fixed cost is inversely related to
activitythe per unit cost decreases when activity rises and increases when activity
falls. For example, the average fixed cost per cell phone call made decreases as
more calls are made in the month.
 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.
Which of the following costs would be variable with respect to the
number of cones sold at a Baskins & Robbins shop? (There may be
more than one correct answer.)

A. The cost of lighting the store.

B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.
Which of the following costs would be variable with respect to
the number of cones sold at a Baskins & Robbins shop? (There
may be more than one correct answer.)

A. The cost of lighting the store.

B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.
A semi-variable cost is a cost that contains both fixed and variable cost
elements. The fixed element of the cost will be incurred repeatedly over
time, while the variable element will only be incurred as a function of activity
volume.

Thus, a base-level cost will be always be incurred, irrespective of volume, as well as

an additional cost that is based only on volume. This concept is used to project
financial performance at different activity levels.

A semi-variable cost is also referred to as a semi-fixed or mixed cost.

The CIMA Terminology defines it as a cost containing both fixed and variable
components and thus partly affected by a chance in the level of activity.

Examples of semi-variable costs are gas and electricity. Both of these expenditures
consist of a fixed amount payable for the period regardless of the level of use, with a
further variable amount which is related to the consumption of gas and electricity.
A production line may require $10,000 of labor to staff it at a minimal level
per day, but once a certain production volume is exceeded, the production
staff must work overtime. Thus, the basic $10,000 daily cost will be
incurred at all volume levels, and is therefore the fixed element of the semi-
variable cost, while overtime varies with production volume, and so is the
variable element of the cost.

In the billing structure for a cell phone, there is a flat-rate monthly charge,
plus an overage charge for any bandwidth used that exceeds the cap
allowed under the flat rate. Thus, the flat rate is the fixed element of the
cost, and the excess bandwidth charge is the variable element of the cost.

Within the compensation of a salesperson, there is usually a salaried

component (fixed cost) and a commission (variable cost)
As the level of usage of a semi-variable cost item increases, the fixed component of
the cost will not change, while the variable component will increase. The formula for
this relationship is:

For example, if a company owns a production line, the total cost of that equipment in
a month is a semi-variable cost. The depreciation associated with the asset is a fixed
cost, since it does not vary from period to period, while the utilities expense will vary
depending upon the amount of time during which the production line is operational.
The fixed cost of the production line is $10,000 per month, while the variable cost of
utilities is $150 per hour. If the production line runs for 160 hours per month, then the
semi-variable cost calculation is:

From the perspective of a company manager, it is generally safer to increase the

variable portion of a semi-variable cost and decrease the fixed portion. Doing so
lowers the revenue level at which a business can break even, which is useful if the
business suffers from highly variable sales levels.
 A semi-variable cost is also known as a mixed cost and a semi-fixed cost.

Example: if a company owns a building, the total cost of that building in a year is a
mixed cost. The depreciation associated with the asset is a fixed cost, since it does
not vary from year to year, while the utilities expense will vary depending upon the
company's usage of the building. The fixed cost of the building is $100,000 per year,
while the variable cost of utilities is $250 per occupant. If the building contains 100
occupants, then the mixed cost calculation is:

$125,000 Total cost = $100,000 Fixed cost + ($250/occupant x 100 occupants)

Example: a company has a broadband contract with the local cable company, which it
pays $500 per month for the first 500 megabytes of usage per month, after which the
price increases by $1 per megabyte used. The following table shows the mixed cost
nature of the situation, where there is a baseline fixed cost, and above which the cost
increases at the same pace as usage:

Megabytes Variable Cost Fixed Cost Total Cost

500 $0 $500 $500
600 100 500 600
700 200 500 700
800 300 500 800
900 400 500 900
Mixed costs are common in a corporation, since many departments involve a certain
amount of baseline fixed costs in order to support any activities at all, and also incur
variable costs to provide varying quantities of services above the baseline level of
support. Thus, the cost structure of an entire department can be said to be a mixed
cost. This is also a key concern when developing budgets, since some mixed costs
will vary only partially with expected activity levels, and so must be properly
accounted for in the budget.

The best way to deal with mixed costs in a budget is to use a formula in place of a
single number for a mixed cost, with the cost automatically varying based on a
designated activity level (such as sales). This approach is more complicated, but
yields budget figures that are more likely to match actual results.
A step cost is a cost that does not change steadily with changes in activity
volume, but rather at discrete points. The concept is used when making
investment decisions and deciding whether to accept additional customer orders.

A step cost is a fixed cost within certain boundaries, outside of which it will
change.

When stated on a graph, step costs appear to be incurred in a stair step pattern,
with no change over a certain volume range, then a sudden increase, then
no change over the next (and higher) volume range, then another sudden
increase, and so on. The same pattern applies in reverse when the volume of
activity declines.

Relevant
Total fixed cost $

Range 3
Relevant
Relevant Range 2
Range 1

Activity Level
A facility cost will remain steady until additional floor space is constructed,
at which point the cost will increase to a new and higher level as the entity
incurs new costs to maintain the additional floor space, to heat and air
condition it, insure it, and so forth.

a company can produce 10,000 widgets during one eight-hour shift. If the
company receives additional customer orders for more widgets, then it
must add another shift, which requires the services of an additional shift
supervisor. Thus, the cost of the shift supervisor is a step cost that occurs
when the company reaches a production requirement of 10,001 widgets.
This new level of step cost will continue until yet another shift must be
added, at which point the company will incur another step cost for the shift
supervisor for the night shift.

Step costing is extremely important to be aware of when a company is

about to reach a new and higher activity level where it must incur a large
incremental step cost. In some cases, incurring the extra amount of a step
cost may eliminate profits that management had been expecting with an
increase in volume. If the increase in volume is relatively minor, but still
calls for incurring a step cost, it is possible that profits will actually decline;
a close examination of this issue may result in a business turning away
sales in order to maintain its profitability.
Conversely, a company should be aware of step costs when its activity level
declines, so that it can reduce costs in an appropriate manner to maintain
profitability. This may require an examination of the costs of terminating
staff, selling off equipment, or tearing down structures.

The point at which a step cost will be incurred can be delayed by

implementing production efficiencies, which increase the number of units
that can be produced with the existing production configuration. Another
option is to offer overtime to employees, so that the company can produce
more units without hiring additional full-time staff.
 Every decision involves a choice between at least two
alternatives.

Only those costs and benefits

that differ between alternatives
are relevant to the decision.
All other costs and benefits can
and should be ignored.
Differential cost is the difference between the cost of two alternative decisions, or of a
change in output levels.

The concept is used when there are multiple possible options to pursue, and a choice must be
made to select one option and drop the others. The concept can be particularly useful in step
costing situations, where producing one additional unit of output may require a substantial
additional cost. Here are two examples:
Example of alternative decisions. If you have a decision to run a fully automated operation
that produces 100,000 widgets per year at a cost of $1,200,000, or of using direct labor to
manually produce the same number of widgets for $1,400,000, then the differential cost
between the two alternatives is $200,000.

Example of change in output. A work center can produce 10,000 widgets for $29,000 or
15,000 widgets for $40,000. The differential cost of the additional 5,000 widgets is $11,000.
In essence, you can line up the revenues and expenses from one decision next to similar
information for the alternative decision, and the difference between all line items in the two
columns is the differential cost.

A differential cost can be a variable cost, a fixed cost, or a mix of the two there is no
differentiation between these types of costs, since the emphasis is on the gross difference
between the costs of the alternatives or change in output.

Since a differential cost is only used for management decision making, there is no accounting
entry for it. There is also no accounting standard that mandates how the cost is to be
calculated.
An avoidable cost is a cost that can be eliminated by not engaging in or no longer
performing an activity. For example, if you choose to close a production line, then the cost
of the building in which it is housed is now an avoidable cost, because you can sell the building.
The avoidable cost concept is crucial when engaging in cost reduction activities.

Over the long term, all costs are avoidable. For example, a 30-year lease is avoidable if
the decision-making period is more than 30 years. In the short term, legally-mandated or
government-mandated costs, such as leases or environmental cleanup obligations, are not
avoidable costs.

In general, a variable cost is considered to be an avoidable cost, while a fixed cost is not
considered to be an avoidable cost. In the very short term, many costs are considered to be
fixed and therefore unavoidable.

From a risk management perspective, it is useful to periodically review the cost structure of a
business and try to shift as many costs as possible from the unavoidable to the avoidable
category, which gives management greater room to maneuver if the business suffers a revenue
shortfall and must cut back on its expenses. For example, a lease can be renewed with a
shorter term, so that management has the option to cancel the related expense within a shorter
period of time than had previously been the case. As noted in the example, the general
strategic approach to dealing with avoidable costs is to commit to shorter time periods for any
planned expenditures.
A sunk cost is a cost that an entity has incurred, and which it can no longer
recover by any means.

Sunk costs should not be considered when making the decision to continue investing
in an ongoing project, since you cannot recover the cost. However, many managers
continue investing in projects because of the sheer size of the amounts already
invested in the past. They do not want to "lose the investment" by curtailing a
project that is proving to not be profitable, so they continue pouring more cash into
it. Rationally, they should consider earlier investments to be sunk costs, and therefore
exclude them from consideration when deciding whether to continue with further
investments.

An accounting issue that encourages this adverse behavior is that capitalized costs
associated with a project must be written off to expense as soon as the decision is
made to cancel the project. When the amount to be written off is quite large, this
encourages managers to keep projects running.
Marketing study. A company spends $50,000 on a marketing study to see if
its new auburn widget will succeed in the marketplace. The study
concludes that the widget will not be profitable. At this point, the $50,000
is a sunk cost. The company should not continue with further investments
in the widget project, despite the size of the earlier investment.

Research and development. A company invests $2,000,000 over several

years to develop a left-handed smoke shifter. Once created, the market is
indifferent, and buys no units. The $2,000,000 development cost is a sunk
cost, and so should not be considered in any decision to continue or
terminate the product.

Training. A company spends $20,000 to train its sales staff in the use of
new tablet computers, which they will use to take customer orders. The
computers prove to be unreliable, and the sales manager wants to
discontinue their use. The training is a sunk cost, and so should not be
considered in any decision regarding the computers.

Hiring bonus. A company pays a new recruit $10,000 to joint the

organization. If the person proves to be unreliable, the $10,000 payment
should be considered a sunk cost when deciding whether the individual's
employment should be terminated.
An irrelevant cost is a cost that will not change as the result of a
management decision. However, the same cost may be relevant to a different
management decision. Consequently, it is important to formally define and document
those costs that should be excluded from consideration when reaching a decision.
For example, the salary of an investor relations officer may be an irrelevant cost if a
management decision relates to issuing a new product, since dealing with investors
has nothing to do with that particular decision. However, if the board of directors is
considering taking the company private, then it may no longer need an investor
relations officer; in the latter case, the salary of the investor relations officer is highly
relevant to the decision. As another example, the rent for a production building is
irrelevant to the decision to automate a production line, as long as the automated
equipment is still housed within the same facility.

Non-cash items, such as depreciation and amortization, are frequently

categorized as irrelevant costs for most types of management decisions,
since they do not impact cash flows.

Sunk costs, such as the purchased cost of a fixed asset that was incurred in
a prior period, are also usually considered irrelevant when making
decisions on a go-forward basis.
Consider the following costs:

100 units 200 units

Material $500 $1,000
Labor $1,000 $2,000
Rent $2,000 $2,000
Electricity $700 $900

Requirement: Identify if the costs are fixed, variable or semi-variable.

Solution:

To determine the type of cost, consider the cost behavior over a range of activity
levels.

Material would normally be a variable cost-the total cost is increasing as the number
of units increases. To check if it is a linear variable cost, divide the total cost by the
number of units and the unit cost should be the same for each level:

Material is $500 for 100 units, therefore $5 per unit, and $1,000 for 200 units,
therefore $5 per unit. This suggests that material is a variable cost.

Again if we look at labor cost, we see that labor is a variable cost of $10 per unit.

Rent is normally a fixed cost and the total rent cost is $2,000 for each level of
activity. This suggests that rent is a fixed cost.

For electricity the total cost is increasing as the number of units increase, but if we
work out the unit cost we can see that it varies at each level. Electricity is $700 for
100 units, therefore $7 per unit and $900 for 200 units, therefore $4.50 per unit.
This suggests that electricity is a semi-variable cost.
When managers have identified a semi-variable cost they will need to know how
much of it is fixed and how much is variable. Only when they have determined this
will they be able to estimate the cost to be incurred at relevant activity levels.

Note: Total cost=Total Fixed Cost+ Total variable cost

(Total variable cost=Variable cost per unit* Number of units)

Past records of costs and their associated activity levels are usually used to carry out
the analysis.

In this subject, we have to know how to use two common methods of

separating the fixed and variable elements.

The High-Low method

The Line of best fit method
This method picks out the highest and lowest activity levels from the
available data and investigates the change in cost which has occurred
between them. The highest and lowest points are selected to try to use
the greatest possible range of data. This improves the accuracy of the
result.
A company has recorded the following data for a semi-variable cost:
Activity level Cost incurred
Month (units) ($)
January 1,800 36,600
February 2,450 41,150
March 2,100 38,700
April 2,000 38,000
May 1,750 36,250
June 1,950 37,650

The highest activity level occurred in February and the lowest in May.
Always select the highest and lowest activity level.

Since the amount of fixed cost incurred in each month is constant, the extra cost
resulting from the activity increase must be the variable cost.
Activity level Cost incurred
Month (units) ($)
February 2,450 41,150
May 1,750 36,250
Increase 700 4,900
The extra variable cost for 700 units is $4,900. We can now calculate the variable
cost per unit.

Variable cost per unit = (Change in costs/Change in units)

= ($4,900/700)= $7 per unit.

Substituting back in the data for February, we can determine the amount of fixed
cost:

February:
Total Cost= $41,150
Variable Cost= (2,450 units*$7) = $17,150
Therefore, Fixed Cost= $41,150-$17,150=$24,000
 The total cost for producing product X is given:

500 units 1,000 units

Total Cost $3,250 $4,000

Required: Calculate the variable cost per unit and the total fixed cost.
The following data relate to two activity levels of an out-patient department in a
hospital:

Number of simulations per period 4,500 5,750

Overheads $269,750 $289,125

Fixed overheads are not affected by the number of consultants per period. The
variable cost per consultation:

Is approximately $15.50
Is approximately $44.44
Is approximately $59.94
Cannot be calculated without more information
 The total cost for product A is given:

100 units 200 units

Total Cost $700 $900

Required: Estimate the total cost of producing 180 units.

The variable production cost per unit of product B is $2 and the fixed production
overhead for a period is $4,000. Calculate the total production cost of producing
3,000 units of B in a period.
The second method for separating fixed and variable elements of cost is the
scattergraph method. This method takes account of all available historical data and it
is simple to use. However, it is very prone to inaccuracies that arise due to subjectivity
and the likelihood of human error.
The scattergraph plot is also called the quick-and-dirty method.

The first step when using this method to analyze a mixed cost is to plot the data on
a scattergraph. The cost, which is known as the dependent variable, is plotted on the
Y axis. The activity, which is known as the independent variable, is plotted on the X
axis.

The second step is to examine the dots on the scattergraph to see if they are linear,
such that a straight line can be drawn that approximates the relation between cost
and activity. If the dots are not linear, do not analyze the data any further. Instead,
search for another independent variable that bears a stronger linear relationship with
the dependent variable.

The third step is to draw a straight line where, roughly speaking, an equal number
of points reside above and below the line. Make sure that the straight line goes
through at least one data point on the scattergraph.
Step 4:
Part I
The fourth step is to identify the Y intercept. This intercept represents the estimated
fixed cost portion of the mixed cost ($10,000 in this example).

Part II
The fifth step is to estimate the variable cost per unit of the activity by first selecting
one point on the scattergraph that intersects the straight line and then determining
the total cost and the total activity level at the chosen point.

Step 5
Part I
Subtract the fixed costs from the total costs to arrive at the total variable costs for the
chosen activity level.

PartII
Divide the total variable costs by the activity level at the chosen point. This is the
variable cost per unit of activity.

PartIII
Construct an equation that can be used to estimate total costs at any activity level.
 Plot the data points on a graph (total cost vs.
activity).
Y
20
Maintenance Cost

* *
1,000s of Dollars

* * * *
* * *
10 *

0 X
0 1 2 3 4
Patient-days in 1,000s
 Draw a line
through the
Y
data points
20
Maintenance Cost

* *
1,000s of Dollars

with about
* * * * an equal
* * * number of
10 * points above
and below
the line.
0 X
0 1 2 3 4
Patient-days in 1,000s
 Use one
data point to
Y Total maintenance cost = $11,000
estimate the
20
Maintenance Cost

* *
1,000s of Dollars

total
* * * * level of
* * * activity and
10 * the total
Intercept = Fixed cost: $10,000 cost.
0 X
0 1 2 3 4
Patient-days in 1,000s
Patient days = 800
 Make a quick estimate of variable cost per
unit and determine the cost equation.

Total maintenance at 800 patients $ 11,000

Less: Fixed cost 10,000
Estimated total variable cost for 800 patients $ 1,000

$1,000
Variable cost per unit = = $1.25/patient-day
800

Y = $10,000 + $1.25X

Total maintenance cost Number of patient days