Financial and Managerial

Accounting (MBA 521)

Chapter Four
Cost Accounting Basics
Instructor: Habtamu B. Abera [PhD]
Learning Objective
• By the end of this chapter, you should be able to:
LO-1 Importance of Cost Information
LO-2 Cost Classifications
LO-3 Cost Accounting Methods/systems
LO-1 Importance of Cost Information
• What is cost?
• Is there a difference between Cost and Expense:
– Yes No How?

• Definition:
• Cost is an amount that has to be paid or given up in
order to get something.
• Cost is different from an expense in that cost is some
thing of value we do expect a benefit out of it in the
future while expense is the expired portion of the cost
or an amount we paid for the value we enjoyed.
LO-1 Importance of Cost Information
• Managers’ Use of Cost Information
• Managers use information about operating costs to plan, perform,
evaluate, and communicate the results of operating activities.
• Service organizations
– In monitoring profitability and making decisions about:
• bidding on future business,
• lowering or negotiating their fees /prices/, or
• dropping one of their services
• Retail businesses
– To make decisions about
• reducing selling prices for clearance sales,
• lowering selling prices for bulk sales or
• dropping a product line.
• Manufacturing firms
– To make decisions about
• dropping a product line,
• outsourcing the manufacture of a part to another company,
• bidding on a special order, or
• negotiating a selling price, etc.
Activity

• Indicate whether each of the following activities takes place

during the planning (PL), performing (PE), evaluating (E),
or communicating (C)
A. Changing regular price to clearance price
B. Reporting results to appropriate personnel
C. Preparing budgets of operating costs
D. Comparing estimated and actual costs to determine variances
LO-1 Explain how managers classify costs and how they use
these cost classifications
• Cost Information and Organizations
• All organizations use cost information to determine profits and
selling prices and to value inventories. Ultimately a company
is profitable only when its revenues from sales or services
rendered exceed all its costs.
• Service organizations
– Need information about the costs of providing services, which
include the costs of labor and related overhead.
• Retail businesses
– Need information about the costs of purchasing products for
resale. These costs include adjustments for freight-in costs,
purchase returns and allowances, and purchase discounts.
• Manufacturing firms
– Need information about the costs of manufacturing products.
Product costs include the costs of direct materials, direct labor,
and overhead.
Cost of sales /Cost of Goods Sold/
• Cost of sales, cost of revenue, or cost of services
are referred to all the direct costs associated
with services rendered to the customer for the
business provides companies.
• It includes all the direct costs involved in running
or performing services.
• The typical expenses included in the category
of direct costs are the cost of material, cost of
labor or cost of salaries in a service industry, and
all other costs which can be linked directly in the
manufacturing of products or rendering of
services.
 Cost of Goods Sold

Merchandiser Manufacturer
Beginning merchandise inventory Beginning finished goods inventory

Plus purchases (Net) Plus: cost of goods manufactured

Merchandise available for sale

Finished goods available for sale
Less ending merchandise inventory
Less: ending finished goods inventory
Cost of good sold
Cost of good sold
 Activity
• ABC Plc provided the following information as of Aug. 31, 2020
– Beginning merchandise inventory……. Br. 230,000
– Ending merchandise inventory …… 15% of the beginning balance
– Purchases during the period ……… Br. 160,000
– Purchase Returns ………………………. 5% of the purchases during the year
– Purchase Discounts ………………….. Br. 4,500
• Compute the cost of goods sold
LO-2 Cost Classification

• Cost behavior— the way costs respond to changes in

volume or activity * is a factor in almost every decision
managers make.
• The knowledge of cost behavior patters enables
managers:
– to identify cost similarities and differences so comparisons of
alternatives are possible.
– to determine the impact of their actions on operating income
and resource optimization.
LO-1 Explain how …

• Cost Objects:
A Cost Object is any activity for which a separate
measurement of costs is desired or needed.

E.g. - the cost of a product,

- the cost of rendering a service to a bank customer or
hospital patient,
- the cost of operating a particular department or sales
territory.
Classification Bases and types of costs
Cost Traceability
• Direct and Indirect Costs
– Direct Costs: Refer those costs which are easily traceable to a
particular cost object.
• E.g. Direct Material and Direct labor costs (in a
manufacturing enterprise)
– Indirect Costs: Refer those costs which are assigned to a
particular cost object.
• E.g. Indirect Material, Indirect labor and other factory
costs (manufacturing overhead or factory overhead costs)
Note:
The sum of direct material and direct labor costs is called prime
cost while the sum of direct labor and other factor costs
(manufacturing overhead costs) is called conversion costs.
Cost Traceability
• Prime Costs: are the primary costs of production;
they are the sum of the direct materials costs and
direct labor costs.
• Conversion Costs: are the costs of converting direct
materials into a finished product; they are the sum
of direct labor costs and overhead.
• Note:
• Cost tracing is the assigning of direct costs to the
chosen cost object.
• Cost allocation is the assigning of indirect costs to
the chosen cost object.
• Cost assignment encompasses both cost tracing and
cost allocation.
Relationship of Direct and Indirect costs to
a cost object
 Factors affecting direct/Indirect cost
classifications
• The materiality of the cost in question: the
higher the cost in question, the more likely
the economic feasibility of tracing that cost
to a particular cost object.
• Availability of information-gathering
technology: Improvements in this area are
enabling an increasing percentage of costs
to be classified as direct.
• Design of operations: Facility design can
impact on cost classification.
 Exercise
• Which of the following should be classified as indirect labor?
– (a) machine operators in a factory producing furniture;
– (b) lawyers in a legal firm;
– (c) maintenance workers in a power sub station
– (d) lorry drivers in a road transport company.
– (e) sales person at supermarket

• Which of the following holds true about total manufacturing

cost?
– A. Prime cost + conversion cost
– B. Direct Material + Direct Labor + Manufacturing Overhead
– C. Direct Material + Manufacturing Overhead
– D. Direct labor + Manufacturing Overhead + Prime Cost
– E. Prime Cost + Direct Labor + Conversion Cost
Cost Behavior (reaction to change in
volume of activity)
• Variable Cost: variable costs
vary in direct proportion to the
volume of activity.
Consequently, total variable
costs are linear and unit
variable cost is constant.

• Fixed Costs: remain

constant over wide ranges of
activity for a specified time
period. They are not affected
by changes in activity
Major Assumptions
• The definitions of variable costs and fixed costs
have important underlying assumptions:
a) Costs are defined as variable or fixed with respect
to a specific cost object.
b) The time span must be specified
c) Total costs are linear
d) There is only one cost driver
e) Variations in the level of the cost driver are
within a relevant range.
Exercise
• Fixed costs are conventionally deemed to be:
– (a) constant per unit of output;
– (b) constant in total when production volume
changes;
– (c) outside the control of management;
– (d) those unaffected by inflation.
• Mixed Cost: A mixed cost, also called semi-variable
cost, has both a variable and a fixed component. On a per-
unit basis, a mixed cost does not fluctuate proportionately
with changes in activity nor does it remain constant with
changes in activity.
• E.g. Electricity Bill or land line telephone bill

Total Cost

Variable
component
Birr -------------------------------
Fixed Component

Quantity

Total Cost = (Variable cost rate x Units Produced) + Fixed Costs

• Step-fixed costs: also known as semi-fixed costs are
costs that remain fixed within specified activity levels for
a given amount of time but which eventually increase or
decrease by a constant amount at critical activity levels.
Total
FC

Activity Level
Relevant range: is a range of the cost driver in which a specific
relationship between cost and the level of activity or volume
is valid.
 Exercises
• Variable costs are costs that:
– (a) vary in total directly and proportionately with changes in the
activity level.
– (b) remain the same per unit at every activity level.
– (c) Neither of the above.
– (d) Both (a) and (b) above.

• Identify the following as (Fixed), (Variable) or (Mixed) costs.

– 1. Direct materials
– 2. Electricity
– 3. Factory building rent
– 4. Manager’s Salary
– 5. Operating Supplies
 Exercises
• Assume Ethiotelecom offers you a plan that is classified
as a mixed cost. The cost for the 1,600 minutes in a month
is Br. 80 but for any additional minute you will be charged
Br. 0.35. If you use 1,200 minutes this month, your cost will
be:
– (a) Br. 80.00 (c) more than Br. 100.00
– (b) Br. 100.00 (d) between Br. 80.00 and Br. 200.00

• Assume all the information given above as is and if you

use 2,200 minutes this month, what will be your cost?
– (a) Br. 290.00 (c) more than Br. 180.00
– (b) Br. 135.00 (d) None
Exercises
• Classify each of the following as being usually fixed (F),
variable (V), semi-fixed (SF) or semi-variable (SV):
– (i) direct labor;
– (ii) depreciation of machinery;
– (iii) factory rental;
– (iv) supplies and other indirect materials;
– (v) advertising;
– (vi) maintenance of machinery;
– (vii) factory manager’s salary;
– (viii) supervisory personnel;
Value-adding Attributes
• A Value-adding cost:
– is the cost of an activity that increases the market value of a
product or service.

• A Nonvalue adding cost:

– is the cost of an activity that adds cost to a product or service
but doesn’t increase its market value.

• Managers examine the value-adding attribute of their

company’s operating activities and , wherever possible, reduce
or eliminate activities that do not directly add value to the
company’s products or services.
Example
• Think of a medium size bicycle assembly plant in your mind
and classify the following costs as value adding or non-value
adding.
a) Depreciation of office computer
b) Labor to assemble bicycle
c) Labor to inspect bicycle
d) Internal auditor’s salary
e) Lubricant for wheels
f) Tire for the wheels

• Answer:
– Value adding: b, c, e, and f
– Non-value adding: a and d
 Cost Classification for Financial Reporting
• For purposes of preparing financial statements,
managers classify costs as product costs or
period costs.
• Product costs: also called inventoriable costs, are
costs assigned to inventory. They include direct
materials, direct labor, and overhead. These cost
appear on the income statement as cost of goods
sold and on the balance sheet as inventory.
• Period costs, also called non-inventoriable costs,
are costs of resources used during the accounting
period that are not assigned to products. They
appear as operating expenses on the income
statement.
 Example
• Assume you are the accountant of Mars Co. that is engaged in
producing safety products for factory workers, and identified the
following costs. Classify them as product and period cost
a) depreciation of machinery;
b) factory rental;
c) direct labor;
d) factory manager’s salary;
e) supervisory personnel;
f) supplies and other indirect materials;
g) advertising;
h) maintenance of machinery;
LO-3 Cost Accounting Systems
• Job Order Cost System
– Output consists of special or custom-made
products.
– Provides a separate record for the cost of each
quantity of these special or custom-made
products.
• Process Cost System
– Accumulates costs for each department or process
in the factory.
 Job Order Cost System

Direct Materials
Direct Labor Work in Process Finished Goods
Factory Overhead Account Account

Job Cost Sheets

 Process Cost System

Work in Process
Work in Process Finished
Dept. 2
Dept. 1 Goods

Direct Direct Direct Direct

Materials Labor Materials Labor

Factory Factory
Overhead Overhead
 Standard Cost System
• May be used with either a job order or a process cost
system.
• Uses predetermined standard costs to furnish a
measurement that helps management make decisions
regarding the efficiency of operation.
• Standard costs are costs that would be incurred under
efficient operating conditions and are forecast before
the manufacturing process begins.
Financial and Managerial
Accounting (MBA 521)

End of Chapter Four