Unit 5 Cost Management Concepts

5.1 Cost Management Terminologies

Financial Accounting- reports mainly to external users, through financial statements, made
according to GAAP and has a historical focus.
Management Accounting- reports mainly to internal users, by producing reports that
improve organizations (planning, controlling and decision making) and is future oriented.
Cost Accounting- supports both financial and management accounting, reports for both
internal and external users and provides information about cost of resources acquired and
used by the entity.

Cost (management accounting) - measurement in monetary terms of the amounts of

resources used for a specific purpose.
Cost (financial accounting)- the sacrifice measured by the price paid to acquire goods or
service, to generate future cash flow. (raw material purchased to sell finished goods)
Expenses- are costs that have been charged against revenue in a specific accounting period
and does not expect to generate a future benefit.

Cost Object- an object that costs can be attached to, they are allocated to help management
in decision making (ex- product, department, branch, process)
Cost Driver- the basis/how to assign costs to cost object OR measure of activity and must
have direct cause and effect relationship between the quantity produced and total costs (ex-
labor hours, machine hours)

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 1. Classification of costs
Cost can be classified as Manufacturing (factory) VS Non-Manufacturing (office)
1) Direct Materials- tangible inputs that can be traced/chased to a product (ex- bricks in
a building). It includes purchase price and all other costs to bringing the raw material
to the factory line to begin production.

2) Direct Labor- costs of human labor than can be traced/chased to a product (ex-
worker in construction who actually touch the raw material)

3) Manufacturing Overhead- consists of all costs that are not direct material or direct
labor. They include:

a. Indirect Materials- tangible inputs that cannot be traced/chased to a product

(ex- oil for machines in the production line)
b. Indirect Labor- costs of human labor than cannot be traced/chased to a
product (ex- supervisor salary, janitor salary)
c. Factory Operating Costs- all costs of the factory or plant to keep it running
(ex- rent, depreciation, tax)

Prime Costs (main costs)- those costs directly related to a product (DM + DL)
Conversion Costs- the costs of converting raw materials to finished goods (DL + MOH)

1) Selling (marketing) Expenses- costs incurred to getting the product from the factory
to the consumer. (ex- sales commission, advertising, product shipment)
2) Administrative Expenses- costs incurred by the company not related to producing or
marketing the product (ex- executive salaries, depreciation on office)

Costs can also be classified to Product VS Period Costs

This is a very crucial capitalization as it determines to capitalize the costs as COGS or
Expensed
1) Product Costs (inventoriable costs)- capitalized as part of finished goods and
become part of COGS, these costs include DM and DL
2) Period Costs- expensed as incurred and are excluded from COGS, as they are caused
by the passage of time and will occur if production was zero.

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Costs can be classified by Direct VS Indirect Costs, based on the costs object.
1) Direct Costs- the ones that can be associated with a specific costs object in an
economically feasible way (traced to the product) DM + DL

2) Indirect Costs- the ones that cannot be associated with a specific costs object in an
economically feasible way and must be allocated MOH (indirect material and
labor).

Indirect Costs are usually allocated using Cost Pool, which is an account where similar costs
elements are accumulated. It is better to have same cost pool for same cost driver. MOH
items are commonly accumulated before being allocated as they are untraceable.
Common Costs- it is a type of indirect costs, where it is incurred for the benefit of more than
one cost object. They must be allocated in a systematic and rational basis. Ex- rent on HQ, is
direct costs on the building as whole but common costs on departments as they share the
building.

Absorption Costing Variable Costing (no GAAP)

Product Cost
(included in COGS)
Period Cost
(NOT included in COGS)
(GAAP) External Internal
Variable Manufacturing Cost (DM & DL & MOH (variable))
Fixed Manufacturing Costs
(MOH (fixed))
Fixed Manufacturing Costs
(MOH (fixed))
Fixed and Variable Selling & Administrative Expenses

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5.2 Cost Behavior and Relevant Range

Relevant Range- is the limit in which per unit variable costs remains constant and fixed
costs are not changing in the short run.

Variable Costs- it is the direct function of the production volume. Increase when production
increase. DM, DL and MOH (variable).

1) Variable Cost per Unit- remains constant in the short run

despite the level of production.

2) Total Variable Cost- vary directly and proportionally with the

change in production

Fixed Costs- remain constant, despite the production (ex- rent, insurance, tax). MOH (fixed).

1) Fixed Cost per Unit- changes indirectly with the

production level.

2) Total Fixed Costs- remains constant in the short run

despite the volume

Mixed (Semi-variable) Costs- these costs combine both fixed and variable elements, costs
remain constant in between that range (ex- electricity bill by bracket)
0 – 200 kw $1000
201 – 300 kw $1500

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There are 2 methods to estimate mixed costs:
1) Regression (scatter graph) Method- more complex but more accurate

2) Hight-Low Method- less accurate but quicker to calculate

$Cost at Highest Activity - $Cost at Lowest Activity

Hrs. Driver at Highest Activity - Hrs. Driver at Lowest Activity

Linear VS Non-Linear Cost

1) Linear Costs
They change at a constant rate/remain unchanged over the short run

2) Non-Linear Cost
The fixed cost per unit will never reach zero.

Another type of Non-Linear Cost is Step-Cost Function, which is constant over a small
range of output but increases by steps (discrete/individual amounts) as activity increases. The
greater the steps, it is probably Fixed Cost. If the steps were lower, it might be
Variable Cost

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Ex rent per month $10,000 but for 2 months is $9,000, salary of production workers operating
at one shift.

Relevant Range and Marginal Cost

Marginal Cost is the cost incurred by one unit against the activity level of a particular cost
driver.
Economically, its assumed that as production increases the Marginal Cost decreases, which
decreases the Total Variable Cost and the Variable Cost per Unit. On the other hand, under
the relevant range, even if production increases the Marginal Cost must remain constant.
Management Accountant have the idea that “all costs are variable in the long-run”.
Investments in modern technologies can result in lowering the Total Variable Cost and the
Variable Cost per Unit.

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5.3 Cost Classification

Same costs can be re-classified by separate ways depending on the perspective, to improve
decision making.

1) Controllable VS Non-Controllable
Controllable Costs- those that are directly influenced by a particular manager (ex-
advertising costs are decided by the branch manager)
Non-Controllable Costs- costs that a particular manager can not change
(Controllability is determined by the level of the organization, not the nature of the costs
itself)

2) Avoidable VS Committed
Avoidable Costs- costs that can be eliminated by not engaging in the activity or being more
efficient. (ex- choosing to advertise between the internet 0$ or agency $5000)
Committed Costs- arise from holding of PPE, long term in nature and can not be reduced by
decreasing the production. (ex- purchasing an asset by a capital lease, so the constant
payments are committed costs)

3) Incremental VS Differential
Incremental Costs- the additional costs from making a specific decision (ex- expanding HQ,
2 alternatives, $1.5 m, or $1.3 m)
Differential Costs- the difference between the two decisions (ex- expanding HQ, 2
alternatives, $1.5 m or $1.3 m, differential is $300k)

4) Engineered VS Discretionary
Engineered Costs- costs that have direct, observable, quantified cause and effect relation
between output and resources used. (ex- DM)
Discretionary Costs- costs that have no relation between output and resources used, the have
uncertainty in cause-and-effect relation. Not related to production. (ex- R & D cost)

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 5) Outlay VS Opportunity
Outlay Costs- require actual cash payment, explicit cost (ex- payment to get RM)
Opportunity Costs- the max benefit forgone by using scares resources for a specific purpose
and not for the next best alternative, implicit costs (ex- expanding to location A instead of B)
Economic Costs- Explicit Costs + Implicit Costs
Imputed Costs- the costs that should be considered when deciding even though no
transaction was made, type of opportunity cost (ex-lost profit from production as inventory
was low)

6) Relevant VS Sunk
Relevant Costs- future costs that will vary depending on the actions take (ex- increasing
production will require more DM)
Sunk Costs- either already paid OR irrevocably (permanently) committed to occur, since
they are unavoidable, they will not vary with the decision taken, not relevant for future
decisions.
Historical Costs- actual (explicit) price paid to acquire an asset; it is considered sunk costs
however management finds it useful for decision making

7) Joint VS Separable
Some manufacturing process involves single input, till a point
where multiple end products become separately identifiable
(split off point)

Joint Costs- costs incured before the split off point, they must
be allocated as the are non-traceable.
Separable Costs- costs incurred after the split off point, after
the end products are separated and identifiable.
By Product Costs- products that are relatively small in
quantity, produced simulatenously with the maifacturing
process, but have a great value.

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 8) Normal VS Abnormal Spoilage
Normal Spoilage- it is the spoilage that occurs under normal operating conditions,
uncontrollable in the short run. Treated as a product costs as it is expected to occur under
normal operating conditions
Abnormal Spoilage- the spoilage that is not expected to occur under normal, efficient
operating conditions. More controllable by management and consider as period costs as they
are unusual in nature.
Rework, Scrap and Waste
Rework- it is end products that do not meet the standards to be sold but can be sold with
additional effort. The decision to rework depends on the marginal revenue received and the
marginal cost to rework it.
Scrap- it raw materials left from production; it can be used for a purpose other than the one
which it was purchased for.
Waste- its raw material left over from production and has no further use, not saleable and
must be discarded.

9) Other Costs
Carrying Costs- the costs of storing or holding inventory. (ex- warehouse)
Transferred in Costs- costs incurred when transferring the WIP from one department to
other (ex- including holding and transportation costs)
Value-Adding Costs- costs of activity that can not be eliminated, if we do eliminate it the
quality, responsiveness, quantity maybe effected.
Stockout Costs- opportunity cost of missing a customer’s order (ex- lack of RM)

Manufacturing Capacity
1) Theoretical/Ideal Capacity- max capacity of operation assuming no holidays
2) Practical Capacity- max output efficiently produced, includes unavoidable delays
holidays, maintained, etc.
3) Normal Capacity- long-term average level of output, estimated demand over a period
of time, incudes seasonal, trend variations. Deviations will be offset in the subsequent
periods.

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5.4 Costing Techniques

1. Absorption VS Variable Costing

Absorption Costing (full costing)

Treats all manufacturing costs as product costs (DM, DL, MOH variable and fixed). This
technique is required for external financial reporting and income tax.
Gross Margin (Gross Profit) = Net Sales – Absorption COGS

Variable Costing (direct costing)

It treats MOH (variable) as product cost (DM, DL, MOH variable). The MOH fixed is
considered period cost, so it is expensed. This method is not allowed for external reporting;
however, it is very useful to internal decision making as it stops management from
manipulating income by over producing.
Contribution Margin = Net Sales – (Variable MOH & Selling and Administrative
Expenses)

NOTE
This leads to change in ending finished goods between both methods.

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 2. Actual VS Normal Costing

1) Actual Costing
It is recording the product cost based on actual DM, DL and MOH (fixed and variable). This
is the most accurate method of accumulating costs; however, it is the most volatile (changes)
and the least timely as it is known at the end of the period. After the end of production period,
all actual costs are totalled, and indirect costs are allocated. Since the per-unit costs fluctuate
dramatically, this can result in misleading financial statements. Its better to be used with Job
Order Costing.

2) Normal Costing
Under this method actual rate DM and DL are applied
however, MOH (variable and fixed) are applied using
budgeted rate. This compensates the fluctuation in unit
cost.
Sometimes there is a difference between the budgeted
MOH and actual MOH:
➢ Immaterial- allocated at COGS only
➢ Material- allocated to COGS, WIP, FG

3) Extended Normal Costing

It utilizes the normalized rates to DM, DL and MOH (variable and fixed)

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 3. Standard Costing
It is a system which alerts management when the
actual costs of production change significantly from
the budgeted (standard) costs. This method can be
used for job order and process costing systems as it
has a simple record keeping. The difference between
the actual and budgeted costs can be settled
allocating to COGS if immaterial. If the difference
is material, it must be allocated to COGS, WIP and
FG.

SUMMARY

Rate/Price Quantity
Actual Costing ACTUAL ACTUAL
Standard Costing STANDARD STANDARD
Normal Costing ACTUAL (DM, DL) ACTUAL
STANDARD (MOH)
Extended Normal Costing STANDARD ACTUAL

Flexible Budgeting- is comparing the quantity and costs of input that should have been
consumed with a specific level of production. It supports the static budget, which the
company determines the best resource utilization in the upcoming period.

Target Costing
It is the process of calculating the price of the product (selling price) by adding the desired
profit margin to the production cost.

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 4. Cost Accumulation System
There are 4 systems to accumulate costs of a product:

1) Job Order Costing

Used when producing products with individual characteristics or tailored (ex- custom-made
products)

2) Process Costing
Used when similar products are produced, mass production or continuous basis. Costs are
attached by departments (ex- assembly, machining). Costs are averaged as for all units as are
attached to streams, so we use FIFO or WA. Remaining units at the end of the period are
recognized by EUP.

3) Activity Based Costing (ABC)

Assigns the costs by activities and then to physical units. It is a response to inaccurate or
peanut butter costing, as under the traditional method indirect costs are significant because of
increase of technology.
Under volume based (traditional) single cost pool is applied for the entire factory, however
with the use of ABC, each production process has its own cost pool.

4) Life Cycle Costing

It illustrates the need to price the product over its entire lifespan to cover all the costs
incurred. Costs incurred before production including R&D and product design are upstream
costs and costs after production are downstream costs such as customer service and
warranty.

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