AMC Lecture 2

2BUS0259 Lecture 2:
An Introduction to Cost Terms & Concepts Reading: Atrill Chapter 2 Drury Chapter 2
Outline:
Definition of a Cost Object; Cost Accumulation & Cost Assignment; Direct & Indirect Costs; Product & Period Costs; Variable, Fixed, Semi-Variable & Stepped Costs.
Cost Objects:
Accountants usually define cost as a resource sacrificed to achieve a specific objective, such as acquiring a good or service. To guide their decisions, managers often want to know how much a certain thing (such as a new product) costs. We call this thing a cost object, which is anything for which a separate measurement of costs is desired.
Cost Accumulation & Cost Assignment:

A costing system typically accounts for costs in 2 basic stages: 1. It accumulates costs by classifying them into certain categories such as labour, materials or advertising. 2. It then assigns these costs to cost objects.
Cost Terms & Concepts: I. Direct & Indirect Costs:

Costs that are assigned to cost objects can be divided into two categories: direct costs & indirect costs. Direct costs are those costs that can be specifically & exclusively identified with a particular cost object. In contrast, indirect costs cannot be identified specifically & exclusively with a given cost object.
Direct Costs: Direct Material Direct Labour

Cost --------------assignment
Cost tracing -------
Indirect Costs: Indirect Material Indirect Labour Rent, Electricity Etc.
Cost Objects: an example might be
A Desk
Cost --------allocation
Relationship of direct & indirect costs to a cost object
An Important Remark
The definition of direct and indirect costs depends on the purpose for which the cost will be used. For example, the electricity of a specific department is a direct cost within that department, however for each unit produced in that department that cost is an indirect cost.
Prime Cost & Manufacturing Overhead:

Prime cost refers to the direct costs of the product & consists of direct labour costs plus direct material costs plus any direct expenses such as the cost of hiring a machine for producing a specific product . Manufacturing overhead consists of all indirect manufacturing labour & materials costs plus indirect manufacturing expenses. Examples include rent of the factory & depreciation of machinery.
II. Product & Period Costs: Product costs are those costs associated with goods or services purchased, or produced, for sale to customers (in other words, these are the production costs). Period costs are those costs which are treated as expenses in the period in which they are incurred (in other words, these are the selling & administrative expenses).
III. Cost Behaviour: Variable, Fixed, Semi-Variable & Semi-Fixed Costs:

Variable costs are those costs which vary in --direct proportion to the volume of activity, that is, doubling the level of activity will double the total variable cost. Consequently, total variable costs are linear & unit variable cost is constant . The following example illustrates a variable cost where the variable cost per unit is 10.
Variable Costs:
Output (Number of units) Unit Cost (s) Total Cost (s)
100 10 1-----000
200 10 ------2 000
300 10 ------3 000
An Important Remark: However the variable costs ---------------------------------------------------------------do change in their total but the unit cost is fixed. ----------------------------------------------------------------
Graph of Total Variable Cost against Activity
Total Cost
Level of Activity
Graph of Unit Variable Cost against Activity
Unit Cost
Level of Activity
Examples of Variable Costs:

Materials used to manufacture a unit of output or to provide a type of service; Labour costs of manufacturing a unit of output or providing a type of service; Commission paid to a salesperson.
Fixed Costs: A Fixed cost is one which is not affected by changes in the level of activity, for a specified period of time. Total fixed costs are constant for all levels of activity whereas unit fixed costs decrease proportionally with the level of activity.
Fixed Costs:
Total Cost (s) Rent Output (Number of units) Unit Cost (s)
3 000
3 000
3 000
100 --30
200 --15
300 --10
Total fixed costs are constant for all levels whereas ---------------------------------------------------------------unit cost is decreasing as output increases, because ------------------------------------------------------------------------------------------------------------------------------the fixed cost is spread over more units.
Graph of Total Fixed Cost against Activity

Total Cost
Level of Activity
Graph of Unit Fixed Cost against Activity
Unit Cost
Level of Activity
Examples of Fixed Costs:

Advertising in the trade journals; Salaries & wages of administrative duties; Depreciation of building.
Semi-Variable Costs:
A Semi-Variable cost is one which varies, however not in a direct proportion, with changes in the level of activity, over a defined period of time. It includes both a fixed element that is fixed whatever the level of activity & a variable component that is directly related to the level of activity.
Semi-Variable Costs:
Activity (Number of units) Total Cost (s) 100 2 100 200 2 200 300 2 300
Total cost increases as activity increases but not in the same proportion
Graph of Total Semi-Variable Cost against Activity

Total Cost Variable -----------
Fixed -------Level of Activity
Examples of Semi-Variable Cost:

Office salaries where there is a core of longterm secretarial staff plus employment of temporary staff when activity levels rise; Maintenance charges where there is a fixed basic charge per year plus a variable element depending on the number of callouts per year.
Semi-Fixed or Stepped Costs:

The cost will take the shape of a step-cost whenever the cost is fixed over a fixed period of time but there is a revised increase in the cost to a higher level than the previous one in subsequent periods.
Example of a Stepped Cost:
Quarters of the year First Quarter Second Quarter Third Quarter Fourth Quarter
Cost of the Rent 1000 1200 1400 1600
Graph of Stepped Cost against Activity
1600 1400 1200 1000 800 600 400 200 0 1st Qtr 2nd Qtr 3rd Qtr 4th Qtr
Rent
Key Terms:
Cost Object; Direct Costs; Indirect Costs; Cost Tracing; Cost Allocation; Cost Assignment; Prime Cost; Manufacturing Overhead Product Costs; Period Costs; Variable Costs; Fixed Costs; Semi-variable Costs; Stepped Costs;
Seminar 2 Questions Q.1:

For each of the following cost items, explain how it could be classified under each of the following headings given in the following table: (a) raw materials to be used in production; (b) the cost of hiring a machine for producing a specific product; and (c) rent of a warehouse for one year to allow temporary expansion of output.
Item
Variable / Fixed
Direct / Indirect
Product / Period
Material Cost of Machine Rent
Q.2: Classify each of the following as being primarily a direct OR an indirect cost for each unit produced: (a) Wood used to manufacture a desk; (b) Materials used for the repair of a machine that is used for the manufacture of many different desks, (c) Factory insurance; (d) Salaries of factory supervisors; (e) The wages of operatives engaged in the production process; and (f) Canteen managers salary.
Item Wood Repair Insurance Supervisors salaries
Direct/Indirect
Operatives wages Canteen managers salary
Q.3:
(a) Identify the cost behaviour in each of the
following tables as: (i) fixed cost; or (ii) variable cost; or (iii) semi-variable cost. (b) Draw a graph for each table to illustrate the cost behaviour.
Cost X
Output Units Total Cost () Unit Cost () 100 200 300 400 500
600
600
600
600
600
1.50
1.20
Cost Y
300
600
900
1, 200
1, 500
Cost Z
660
720
780
840
900
6.60 3.60 2.60 2.10
1.80
Q.4:
Peter Bright is a well-known professional Management Accounting for Business Decisions speaker. The Essex Business Bureau wants Bright to be the sole speaker at an all-day seminar. Brights agent offers Essex the choice of three possible fee arrangements: Schedule 1: 8000 fee Schedule 2: 20 per person + 2000 fixed fee Schedule 3: 50 per person Each attendee will be charged a 200 fee for the all-day seminar.
Required:
1. What is Essexs fixed cost and variable cost for hiring Bright under each alternative schedule? 2. For each schedule, calculate the total cost and unit cost per seminar attendee if (a) 50 attend, (b) 200 attend, and (c) 500 attend. Comment on the results.
Q.5:
Oven Pies Ltd plans to buy a delivery van to distribute pies from the bakery to various neighbourhood shops. It will use the van for three years. The expected costs are as follows:
Items New van Trade-in price after 3 years Service costs (every 6 months) Spare parts, per 10 000 miles Four new tyres, every 15 000 miles Vehicle licence and insurance, per year Fuel per litre (consumption is 1 litre every 5 mile)
15 000 600 450 360 1 200 800 0.70
You are required to do the following 1. Prepare a table of costs for mileages of 5 000, 10 000, 15 000, 20 000 and 30 000 miles per annum, distinguishing variable costs from fixed costs. 2. Calculate the average cost per mile at each of the mileages set out in (1) above.

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2BUS0259 Lecture 2:

Cost Accumulation & Cost Assignment:

Cost Terms & Concepts: I. Direct & Indirect Costs:

Direct Costs: Direct Material Direct Labour

Cost tracing -------

Indirect Costs: Indirect Material Indirect Labour Rent, Electricity Etc.

Cost Objects: an example might be

Relationship of direct & indirect costs to a cost object

Prime Cost & Manufacturing Overhead:

III. Cost Behaviour: Variable, Fixed, Semi-Variable & Semi-Fixed Costs:

200 10 ------2 000

300 10 ------3 000

Graph of Total Variable Cost against Activity

Graph of Unit Variable Cost against Activity

Examples of Variable Costs:

Graph of Total Fixed Cost against Activity

Graph of Unit Fixed Cost against Activity

Examples of Fixed Costs:

Graph of Total Semi-Variable Cost against Activity

Fixed -------Level of Activity

Examples of Semi-Variable Cost:

Semi-Fixed or Stepped Costs:

Example of a Stepped Cost:

Cost of the Rent 1000 1200 1400 1600

Graph of Stepped Cost against Activity

Seminar 2 Questions Q.1:

Material Cost of Machine Rent

Item Wood Repair Insurance Supervisors salaries

Operatives wages Canteen managers salary

6.60 3.60 2.60 2.10

15 000 600 450 360 1 200 800 0.70

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