cost

Cost refers the amount of expenses spent to generate product or services.

Cost refers expenditure that may be actual or nominal expenses incurred to generate output.
Cost is the value of economic resources used as result of producing or doing the things.
Cost has many meaning but in management cost refers the expenditure not the price.
As a manager we use cost information for taking decisions and making plans, programs and
policies and strategies.
Elements of cost
Cost of production/manufacturing consists of various expenses incurred on
production/manufacturing of goods or services. These are the elements of cost which can be
divided into three groups : Material, Labour and Expenses.

Expense Types
• Recurring expense: anticipated and occur at regular intervals.
• Purchasing food, paying rent
• Non-recurring expense: one-of-a-kind event that occurs at an irregular interval.
• Illness, accident, death
Sometimes we attempt to plan for large non-recurring costs by buying insurance. Paying
the periodic insurance premium turns this expense into a recurring cost.
Types of cost classifications
Costs are classified differently, depending on mngrs‘ needs (different costs for different
purposes).
Types of cost classifications
• Classification by behaviour
• Classification by traceability (assignment to a cost object)
• Classification by controllability
• Classification by relevance (avoidable x unavoidable)
• Classification by function
• Cost in financial statements
• Classification by manufacturing-cost system
• Classification by business function of the value chain
• Classification by aggregate or average
• Concept of incremental and marginal costs, …

Classification by behaviour: FIXED x VARIABLE

Fixed cost
does not change with changes in a cost driver (the volume of activity).
(i.e. straight-line depreciation on equipment)
Variable (marginal) cost
It changes in total in proportion to changes in a cost driver (the volume of activity)
(i.e. sales commissions computed as a percent of sales revenue)
When cost items are combined, total cost can be fixed, variable, or mixed (semi-fixed, semi-
variable).
(i.e. equipment rental: amount of service – fixed; amount of usage – variable.)
Usage: cost-volume-profit analyses, short-term decision making.
Classification by traceability: DIRECT x INDIRECT
Direct costs
when cost is traced to a cost object (product, process, department, customer) to which costs
are assigned in an economically feasible (cost-effective) way. Direct costs are incurred for the
benefit of one specific cost object (material and labour costs usually, when cost object is
product; when it is 1 department: salaries, equipment, materials, depreciation).
Indirect costs
they related to the particular cost object but cannot be traced to it in an economically feasible
(cost-effective) way, they are incurred for the benefit of more than one cost object. They are
allocated to the cost object using a cost allocation method. (2 or more departments, factory:
accounting, administration, rents, managers salaries, light and heat, internal audit, intranet,…).
Usage: cost assignment (cost tracing and cost allocation to the chosen cost object)

Factors affecting DIRECT/INDIRECT cost classifications

1. Materiality of the cost in question.(courier charges for delivering a package: direct cost; the cost of
the invoice paper for delivery service: indirect cost)
2. Available information-gathering technology.
3. Design of operations.
4. Contractual arrangements.
!!! One particular cost may be both direct and indirect!!!
(It depends on the choice of the cost object)

Classification by controllability:
CONTROLLABLE x NOT CONTROLLABLE
Whether a cost is controllable or not depends on the employee’s responsibilities; is referred to as
hierarchical levels in management of the company.
Example:
Senior manager controls costs of investment in land, buildings, and equipment.
Supervisor controls daily expenses such as supplies, maintenance, and overtime.
Usage: for assigning responsibility to and evaluating managers.

Classification by relevance:
SUNK COST x OUT-OF-POCKET COST x OPPORTUNITY COST
Sunk cost (unavoidable cost)
has already been incurred and cannot be avoided or changed. It is irrelevant to future making
financial decisions. (i.e. cost of a company’s office equipment previously purchased).
Out-of-pocket cost (avoidable cost)
requires a future outlay of cash and is relevant for decision making; cost that may be saved by not
adopting a given alternative. (future purchases of equipment).
Opportunity cost
is the potential benefit lost by choosing a specific action from two or more alternatives. It is not
recorded by the accounting system. (taking on the new contract will result in a lost profit contribution
of the present production – opportunity cost should be included when
negotiating for the new contract)

Classification by function:
PRODUCT COST x PERIOD COST
Product costs
are costs capitalized as inventory, which refer to expenditures necessary and integral to finished
products. They pertain to activities carried out to manufacture the product. They are assigned to
inventory in the balance sheet. (direct material + direct labour + overhead)
Period costs
are „expensed“ – refer to expenditures identified more with a time period than with finished products.
They pertain to activities that are not part of the manufacturing process. They are expensed in the
income statement. (selling and general administrative expenses)
Usage: interpreting a manufacturing statement.

Classification by financial statements:

CAPITALIZED COST x NONCAPITALIZED COST
Capitalized costs
are first recorded as an assets (capitalized) when they are incurred. These costs are presumed to
provide future benefits to the company. (costs to acquiring new computer)
Non-capitalized costs
are recorded as expenses of the accounting period when they are incurred. (salaries paid to marketing
personnel, monthly rent paid for administrative offices)
Usage: interpreting a financial statement.

Classification in manufacturing activities

PRIME x CONVERSION COSTS
Prime costs (= direct material + direct labour costs) – expenditures directly associated with the
manufacture of finished products.
Conversion costs (= direct labour + manufacturing overhead) – expenditures incurred in the process of
converting raw materials in to finished products.
Classification by AGGREGATE x AVERAGE cost
Accounting systems typically report both total-cost (aggregate) and unit-cost (average) numbers.
Unit cost is computed by dividing some total cost by some number of units. ( €980,000 of
manufacturing costs were incurred to produce 10,000 units of finished products: Unit cost =€98).
Usage: assignment of total costs for the income statement and balance sheet (8,000 units are sold;
2,000 units remain in ending inventory)

Concept of INCREMENTAL x MARGINAL cost

Incremental (differential) costs are the difference between the costs of each alternative action that
is being considered. They result from a group of additional units of outputs.
( We have to options: 1. no increase in the production; 2. increase by 20 %. If „2.“ is chosen,
there are totally added (incremental, differential )
cost €150,000).
Marginal costs represent the additional cost of one extra unit of output.
Usage: in business comparing two alternatives and their impact in total. Marginal costs are mostly
used for explanation of the economic phenomena by theoretical economists.
Elements Of Costs
Cost can be broadly classified into variable cost and overhead cost.
Variable cost varies with the volume of production while overhead cost is fixed, irrespective of
the production volume.
Variable cost can be further classified into direct material cost, direct labour cost, and direct
expenses. The overhead cost can be classified into factory overhead, administration
overhead, selling overhead, and distribution overhead.
Direct material costs are those costs of materials that are used to produce the product.
Direct labour cost is the amount of wages paid to the direct labour involved in the production
activities.
Direct expenses are those expenses that vary in relation to the production volume, other than
the direct material costs and direct labour costs.
Overhead cost is the aggregate of indirect material costs, indirect labour costs and indirect
expenses. Administration overhead includes all the costs that are incurred in administering the
business.
Selling overhead is the total expense that is incurred in the promotional activities and the
expenses relating to sales force. Distribution overhead is the total cost of shipping the items
from the factory site to the customer sites.
The selling price of a product is derived as shown below:
(a) Direct material costs + Direct labour costs + Direct expenses = Prime cost
(b) Prime cost + Factory overhead = Factory cost
(c) Factory cost + Office and administrative overhead = Costs of production
(d) Cost of production + Opening finished stock – Closing finished stock = Cost of goods sold
(e) Cost of goods sold + Selling and distribution overhead = Cost of sales
(f) Cost of sales + Profit = Sales
(g) Sales/Quantity sold = Selling price per unit
In the above calculations, if the opening finished stock is equal to the closing finished stock,
then the cost of production is equal to the cost of goods sold.
1..8 Other Costs/Revenues
The following are the costs/revenues other than the costs which are presented in the
previous section:
 Marginal cost
 Marginal revenue
 Sunk cost
 Opportunity cost
1. Marginal Cost
Marginal cost of a product is the cost of producing an additional unit of that product. Let the
cost of producing 20 units of a product be Rs. 10,000, and the cost of producing 21 units of
the same product be Rs. 10,045. Then the marginal cost of producing the 21st unit is Rs. 45.
2. Marginal Revenue
Marginal revenue of a product is the incremental revenue of selling an additional unit of that
product. Let, the revenue of selling 20 units of a product be Rs. 15,000 and the revenue of
selling 21 units of the same product be Rs. 15,085. Then, the marginal revenue of selling the
21st unit is Rs. 85.
3. Sunk Cost (past)
This is known as the past cost of an equipment/asset. Let us assume that an equipment has
been purchased for Rs. 1,00,000 about three years back. If it is considered for replacement,
then its present value is not Rs. 1,00,000. Instead, its present market value should be taken
as the present value of the equipment for further analysis.
So, the purchase value of the equipment in the past is known as its sunk cost. The sunk cost
should not be considered for any analysis done from now onwards.
Opportunity Cost (future)
In practice, if an alternative (X ) is selected from a set of competing alternatives (X,Y ), then the
corresponding investment in the selected alternative is not available for any other purpose. If
the same money is invested in some other alternative (Y ), it may fetch some return. Since the
money is invested in the selected alternative (X ), one has
to forego the return from the other alternative (Y ).
The amount that is foregone by not investing in the other alternative (Y ) is known as the
opportunity cost of the selected alternative (X ). So the opportunity cost of an alternative is the
return that will be foregone by not investing the same money in another alternative.
 Estimating cost
• Rough: gut level, inaccurate
• Semi-detailed: based on historical records, reasonably sophisticated and accurate
• Detailed: based on detailed specifications and cost models, very accurate

Estimating Models
 Introduction to Breakeven Analysis
• Breakeven Analysis in the context of Production planning addresses the decision of
whether to make or buy a product.
• Making the product involves two cost elements:
– Fixed costs such as machine renting cost and operation expenses
– Variable costs such as raw material cost
• Buying the product involves only one cost element, the selling price. However, the
price may either be constant or variable based on the quantity.
s = selling price per unit
v = variable cost per unit
FC = fixed cost per period
Q = volume of production
The total sales revenue (S) of the firm is given by the following formula
S=sQ
The total cost of the firm for a given production volume is given as
TC = Total variable cost + Fixed cost
= v Q + FC

Profit and Loss Terms

• Breakeven: total revenue = total costs …., Just getting by
• Profit region: total revenue > total costs …., Putting money in the bank
• Loss region: total revenue < total costs …., Going into debt
 The intersection point of the total sales revenue line and the total cost line is called the break-
even point.
 The corresponding volume of production on the X-axis is known as the break-even sales
quantity.
 At the intersection point, the total cost is equal to the total revenue. This point is also called
the no-loss or no-gain situation.
 For any production quantity which is less than the break-even quantity, the total cost is more
than the total revenue.
 Hence, the firm will be making loss.

loss
For any production quantity which is more than the break-even quantity, the total revenue will
be more than the total cost. Hence, the firm will be making profit.
Profit = Sales – (Fixed cost + Variable costs)
= s Q – (FC + v Q)
The formulae to find the break-even quantity and break-even sales quantity

The contribution is the difference between the sales and the variable costs. The margin of
safety (M.S.) is the sales over and above the break-even sales. The formulae to compute
these values are
Contribution = Sales – Variable costs
Contribution/unit = Selling price/unit – Variable cost/unit
M.S. = Actual sales – Break-even sales
M.S. as a per cent of sales = (M.S./Sales) 100
Example
A firm manufactures a product that sells for $12 per unit. Variable cost per unit is $8 and fixed
cost per period is $1200. Capacity per period is 1000 units.
a) Graph the revenue and cost functions.
b) Find the number of units sold and the revenue amount ($) at break-even point.

Solution
Given: X is the number of units
P = 12
VC = 8X
FC = 1200

a) The revenue function

The revenue function is a linear function described by TR = 12*X in this example.
In order to graph the revenue function, we need to find at least two points that lie on TR = 12*X.
If zero units are produced, X = 0 and TR = 12*0 = 0. Thus we have one point (0,0).
At capacity, 1000 units are produced. Thus, when X = 1000, TR = 12(1000) = 12000. This gives
us another point on the graph (1000, 12000).
We plot the points (0,0) and (1000, 12000) on the graph of “x” versus revenue ($) and join the
points with a straight line. This is the revenue function.

The cost function

The revenue function is also a linear function described by TC = 8X + 1200.
In order to graph the cost function, again, we need to find at least two points that lie on :
TC = 8X + 1200.
We can use the same x values as before (x = 0, and x = 1000).
When X = 1000, TC = 8(1000) + 1200.
TC = 8000 + 1200
TC = 9200
When X = 0, TC = 8(0) + 1200
TC = 0 + 1200
TC = 1200
We plot the points (1000, 9200) and (0, 1200) on the same graph of “x” versus revenue ($) and
join the points with a straight line. This is the cost function.
The break-even point is the point of intersection for the revenue and cost functions.
Note: It is also useful to graph a function representing the fixed costs. Since the fixed cost is
always 1200 no matter how many units are produced, a horizontal line (FC = 1200) represents
the fixed costs function.
b) The number of units sold and the revenue amount ($) at break-even point can be found from
the graph above or algebraically.
Algebraically:
At break-even point, TR = TC
Thus, 12X = 8X + 1200.
Solving this equation for “X” will give us the number of units sold at break-even point.
12X – 8X = 1200
4X = 1200
X = 1200/4
X = 300
Thus, break-even point is reached when 300 units are sold.
The revenue ($) at break-even point can be found using our formula TR = 12*X and now we
know that X = 300.
TR = 12(300)
TR = 3600
Thus, at break-even point, the revenue is $3600.