Introduction to Cost Terms

What is the cost of producing one unit or providing services? What should be the sales-mix to achieve a target net income? What is the break-even point?

Is it cheaper to buy products from outside vendors or to do manufacturing in-house?

Is it worthwhile to invest more resources in design and manufacturing if it reduces costs in marketing and customer service or increase revenue?

Cost and Cost Terminology

Cost is a resource sacrificed or forgone to achieve a specific objective.
Actual cost- cost incurred, a historical cost Budgeted cost- predicted/forecasted cost, future cost

When a manager thinks of cost, he invariably thinks of it in the context of finding the cost of a particular thing. A cost object/cost unit is a particular thing for which a separate measurement of costs is desired. Product Service Bank: customer Hospital: patient Project E & P company: a well, lease, block

Direct and Indirect Costs

Direct Costs Related to particular cost object and can be traced in an economically feasible (cost-effective) way to the cost object Example: Paper on which India Today magazine is printed Indirect Costs Related to particular cost object but cannot be traced in a cost effective way to the cost object Example: Lease cost for India Today Group Building, housing the senior editors of its Magazines Money Today, Business Today, Fortune, Care Today

COST OBJECT

India Today magazine

A costing system typically accounts for costs in two basic stages: Cost accumulation: collection of cost data Cost assignment: cost tracing and cost allocation Cost tracing: assignment of direct costs to a particular cost object Cost allocation: assignment of indirect costs to a particular cost object

Why to assign costs to cost objects? Costs assigned to a department facilitate decisions about department efficiency. Costs assigned to products help in pricing various products and in analyzing how profitable different products are Costs assigned to customers help in understanding profit earned from different customers and in making decisions about how to allocate resources to support different customers

Factors affecting Direct/Indirect Cost Classifications

Materiality of the cost in question

Smaller the amount of cost, less likely that it is economically feasible to trace that cost to a particular cost object Shoe manufacturing company economically feasible to trace the cost of leather used in each pair of shoe cost of thread used in each pair is likely to be classified as indirect cost Not cost effective to trace nominal amount of thread to each pair

Available information gathering technology

Design of operations
whether facility is used exclusively for a specific cost object Toyota Vs General Motors

Variable Cost
Changes in total in proportion to changes in the related level of total activity or output e.g. Tata Motors buys a steering wheel at Rs.400 for each of its Nano car No. of cars assembled 1 10 100 1,000 10,000 Cost of steering Total cost of steering wheel per car (Rs.) wheel (Rs.) 400 400 400 4,000 400 40,000 400 4,00,000 400 40,00,000

Variable Cost

Total steering wheel cost Steering wheel cost per car

Steering wheel cost

No. of cars assembled

Fixed Cost
Remains unchanged in total for a given time period, despite wide changes in the related level of total activity or volume e.g. Tata Motors incurs Rs. 1 cr. in leasing cost for its Nano car plant No. of cars assembled 1 10 100 1,000 10,000 Total Leasing Cost (Rs.) 1,00,00,000 1,00,00,000 1,00,00,000 1,00,00,000 1,00,00,000 Leasing cost per car (Rs.) 1,00,00,000 10,00,000 1,00,000 10,000 1,000

Fixed Cost
Total Leasing Cost

Leasing Cost

Leasing cost per car

No. of cars assembled

Why are some costs variable and other costs fixed? Tata buys steering wheels only when they are needed The leased plant facility is acquired and put in place well before Tata uses it Suppose that Tata puts in place the leased plant facility capable of assembling 10,00,000 cars per year If the demand is only for 7,00,000 cars, there will be idle capacity But Tata has to pay for the unused plant capacity, because the cost of supervision cannot be reduced in the short run Unlike VC, FC of resources cannot be quickly and easily changed to match the resources needed or used Unlike VC that go away automatically if the resources are not used, reducing FC requires active intervention on the part of managers

Fixed Cost and Variable Cost

Do not assume that individual cost items are inherently variable or fixed Costs are defined as variable or fixed with respect to a specific activity and for a given time period.

Relationships of Types of Costs

Direct Costs
Cost Object: Tata Indica Cost Object: Tata Indica Tires used in assembly Salary of supervisor on Tata Indica assembly of a car line Cost Object: Tata Indica Power costs of the plant. Power usage is metered only to the plant where multiple cars are assembled Cost Object: Tata Indica Lease rent of plant, where multiple cars are assembled

Variable Costs

Fixed Costs

Indirect Costs

Skoda Octavia, plant of NUMML, a joint venture of GM and Toyota, assembles 2 types of cars (Corolla and Geo Prism). Separate assembly lines are used for each type of car. Answer D or I; V or F for each of the following items. If in doubt, select on the basis of whether the total costs will change substantially if there is a large change in the number of cars assembled. 1.Cost of tires used on Geo Prism 2.Salary of PRO for NUMML plant 3.Annual awards dinner for Corolla suppliers 4.Salary of engineer who monitors design changes on Geo Prism 5.Freight costs of Corolla engines shipped from Japan to California 6.Electricity costs for NUMML plant, single bill covers entire plant 7.Wages paid to temporary assembly-line workers hired in periods of high production, paid on hourly basis 8.Annual fire-insurance policy cost for NUMML plant

Cost Behavior Patterns Example

Hero Bicycles buys a handlebar at Rs.52 for each of its bicycles. What is the total handlebar cost when 1,000 bicycles are assembled? 1,000 units Rs.52 = Rs.52,000

What is the total handlebar cost when 3,500 bicycles are assembled? 3,500 units Rs.52 = Rs.1,82,000
When considering how VC behave, always focus on total variable costs

Cost Behavior Patterns Example

Hero Bicycles incurred Rs.94,500 in a given year for the leasing of its plant. This is an example of fixed costs with respect to the number of bicycles assembled.

Cost Behavior Patterns Example

What is the leasing (fixed) cost per bicycle when Hero Bicycles assembles 1,000 bicycles? Rs.94,500 1,000 = Rs.94.50 What is the leasing (fixed) cost per bicycle when Hero Bicycles assembles 3,500 bicycles? Rs.94,500 3,500 = Rs.27 Do not be misled by the change in FC per unit. When considering FC, always focus on total fixed costs

Cost Drivers
The cost driver of variable costs is the level of activity or volume whose change causes the variable costs to change proportionately. The number of bicycles assembled is a cost driver of the cost of handlebars. Costs that are fixed in the short run have no cost driver in the short run but may have a cost driver in the long run

Total Costs and Unit Costs Example

What is the unit cost (leasing and handlebars) when Hero Bicycles assembles 1,000 bicycles? Total fixed cost Rs.94,500 + Total variable cost Rs.52,000 = Rs.1,46,500 Rs.1,46,500 1,000 = Rs.146.50

Assume that Hero Bicycles management uses a unit cost of Rs.146.50 (leasing and handlebars). Management is budgeting costs for different levels of production. What is their budgeted cost for an estimated production of 800 bicycles? 800 Rs.146.50 = Rs.1,17,200
What is their budgeted cost for an estimated production of 3,500 bicycles? 3,500 Rs.146.50 = Rs.5,12,750

Use Unit Costs Cautiously

What should the budgeted cost be for an estimated production of 800 bicycles?

Total fixed cost Rs.94,500 Total variable cost (Rs.52 800) 41,600 Total Rs.1,36,100 Rs.1,36,100 800 = Rs.170.13
Using a cost of Rs.146.50 per unit would underestimate actual total costs if output is below 1,000 units.

Use Unit Costs Cautiously

What should the budgeted cost be for an estimated production of 3,500 bicycles? Total fixed cost Rs.94,500 Total variable cost (Rs.52 3,500) 1,82,000 Total Rs.2,76,500 Rs.2,76,500 3,500 = Rs.79.00

Elements of Cost Material Cost

Direct Material Cost Indirect Material Cost -Factory -Office -Selling & Dist.

Labour Cost
Direct Labour Cost Indirect Labour Cost -Factory -Office -Selling & Dist.

Other Expenses
Direct Indirect Expenses Expenses -Factory -Office -Selling & Dist.

Elements of Cost
Direct Material Cost Direct Labour Cost, e.g., wages to workers, foremen Direct Expenses, e.g., costs of special designs, drawings, layouts Production Overheads
-Indirect Materials: consumables, materials used in small quantity -Indirect Wages: salary of gate keeper -Indirect Expenses: rent, rates, insurance of factory premises

Administration Overheads
-Indirect Materials: stationery, brooms, duster, etc. -Indirect Wages: salary of office staff -Indirect Expenses: rent, rates, insurance of office premises

Selling and Distribution Overheads

-Indirect Materials: stationery, catalogues, price lists, promotional material -Indirect Wages: salary and commission of sales force -Indirect Expenses: rent, rates, insurance of godown

Cost Sheet
Opening stock of raw materials Add: Purchase of raw materials Less: Closing stock of raw materials Cost of raw materials consumed Add: Direct wages Add: Direct expenses Prime Cost Add: Factory Overheads Add: Opening stock of work-in-progress Less: Closing stock of work-in-progress Cost of Production Add: Opening stock of finished goods Less: Closing stock of finished goods Cost of Goods Sold x x x
x x x x x x x x x x x

Statement of Profit/Loss
Sales Less: Cost of Goods Sold Gross profit Less: Administrative overheads Less: Selling and Distribution Overheads Less: R & D Cost Operating Income/Net Profit x x x x x x x

Consider the following account balances for Candico Company: beginning of 2006 end of 2006 Direct materials inventory Rs.22,000 Rs.26,000 Work-in-process inventory 21,000 20,000 Finished goods inventory 18,000 23,000 Purchases of direct materials 75,000 Direct manufacturing labour 25,000 Indirect manufacturing labour 15,000 Plant insurance 9,000 Depreciation on Plant building and equipment 11,000 Repairs and maintenance of plant 4,000 Marketing, distribution and customer-service costs 93,000 General and administrative costs 29,000 Prepare a schedule of cost of goods manufactured for 2006 Prepare a schedule of cost of goods sold for 2006 Revenues in 2006 were Rs.3,00,000. Prepare the income statement for 2006

Opening stock of Direct materials Add: Purchase of direct materials Costs of direct materials available for use Less: closing stock of Direct materials Direct materials used Direct manufacturing labour costs Prime Cost Add: Indirect Manufacturing costs Plant insurance 9,000 Plant depreciation 11,000 Indirect labour 15,000 Plant repairs & maintenance 4,000 Manufacturing costs incurred during 2006 Add: opening stock of work-in-progress Less: closing stock of work-in-progress Cost of Goods Manufactured

22,000 75,000 97,000 26,000 71,000 25,000 96,000

39,000 1,35,000 21,000 1,56,000 20,000 1,36,000

Cost of Goods Manufactured Add: opening stock of finished goods Less: closing stock of finished goods Cost of Goods Sold

1,36,000 18,000 1,54,000 23,000 1,31,000

Revenue Less: Cost of goods sold Gross margin Less: Marketing, distribution and customer-service costs 93,000 General and administrative costs 29,000 Operating Income

3,00,000 1,31,000 1,69,000

1,22,000 47,000