Basic concepts

Sadiq Farooq
Who are stakeholders
These are individuals and businesses which have some interest in our
business
Stakeholders: internal and external
They can be classified into External and internal.
External stakeholders include:
Shareholders
Banks
Government
Regulatory authorities
Stock Exchange
Etc
Internal stakeholders include:
Managers
Directors
Department Heads
How the information needs of various
stakeholders are fulfilled.
• The needs of External stakeholders are met from financial accounting
information and reports.
• The annual report of the company is meant for the present
shareholders, Banks and other stakeholders mentioned in the
previous slide.
Now internal stakeholders and their needs.
These are managers, department Heads and Directors. There role is to
plan for the future of the company.
It is their responsibility to increase the profitable sale of the company.
They have to make budgets of sales of various products. They need
information for profit planning etc
• Since these are internal, there are no compulsory accounting
standards for management accounting.
• There are some established ways of doing things which have now
become common in companies.
Now lets talk about accounting
What is accounting…
Accounting is an art of:
oRecording (Journal) business transactions
oClassifying these transactions into (Ledger)
oSummarizing them into (Trial Balance)
oReporting (P & L and Statement of Financial Position)
oAnalysis and interpretation of financial information.
Now what is cost accounting.
• These internal people need to determine the price at which they should
sell the product profitably. For this purpose, they need information
generated by cost accounting.

• Now what is cost accounting?

• It is infact accounting for Costs.
• Now what are costs?
• These are infact expenditures incurred
• Now another question?
• Incurred for what??
• These are expenditures incurred for a producing an article or a service
Accounting or financial accounting Vs cost
accounting…
• We can say that financial accounting is for external purpose only
• Cost accounting is for internal purpose only.
Continued…
• So in cost and management accounting, we learn what information to
collect, how to measure it and how to accumulate it.
• Now why a managements needs that information…the following are
the decisions
• Price
• Make or buy
• Continue or shut down
• Whether a Machine to buy now or buying it sometime in future.
• Therefore to understand cost and management accounting, we need
to understand the various classifications of costs:
• Our first classification is the following:
• Production vs Non production costs.*
• Now lets look at it.
Production vs Non production Costs
These can be classified as follows:
Production costs: Materials and labour used and expenses incurred to
make things and get them ready for use
Non production costs include the following:
Selling and Distribution Costs: These are costs incurred both to
persuade people to buy them and to get the finished items to the point
where people can buy them.
Financing costs: this is the cost of capital or loan of the business.

Administration costs: these include all other costs.

Now we are looking at further
classifications of Production
costs.
How do we calculate profit in a factory
• Sales XXXX
• - Production costs of sales -XXXX

• Gross profit xxxxx

• Less: Non production costs - xxxx

Profit XXXX
Direct vs indirect costs
We can broadly classify production costs into direct and indirect costs
Direct costs are those costs which can be economically and
conveniently traced in full to the cost unit.
These are
1)Direct materials: these are the costs of the main materials which we
can identify into the final product.
• Also the cost of the components bought and added to the products
• For example cloth for making shirt (the final product). We can trace in
full how much cloth was used into making 1 shirt and we know what
was the price per meter of that cloth
• Any packing material which is used to pack the final product.
2) Direct labour: These are the costs of that labour which has directly worked upon
producing the product. For example wages paid to the workers to stitching the cloth to
make the shirt.
• We know how much time the worker took to make a shirt and we also know how much
he or she was paid for it.
3) Direct Expenses: these are expenses other than direct material and Direct labour which
can be traced in full to the product.
• Examples are costs of special tools, Royalty paid to the designer of the shirt or dress. We
know how much per unit was the cost of these direct expenses.
• Sometimes a special machine or tool is needed for a particular order which might be
bought or rented. So this cost of purchasing or rent paid is also treated a Direct Expense
• Therefore we treat them as Direct costs.
• The total of the 3 direct costs are called total Direct cost and also called Prime costs
Now lets look at indirect costs:
These are the costs which cannot be economically traced in full to the
cost unit. These are as follows
1) Indirect materials: Cost of the thread used to stitch the shirt or the
cheap buttons are indirect materials. Cost of oil for lubricating the
stitching machinery is also indirect material or cost of fuel
2) Indirect labour: these do not themselves produce the product. They
have either supervisory or assistant role.
3) Indirect expenses: these are the other expenses which cannot be
economically traced with the product. For example: Rent, Electricity,
Gas bills of the factory premises are indirect expenses. We cannot trace
and measure exactly how much rent into each and every unit of a
product.
• The total of indirect costs are Called Overheads
Now lets do some practice
Which one of the following is the best description of a direct costs?
A: a costs which is directly shared by one or more cost centers
B: A costs which can be directly traced to cost unit.
C: A cost which is paid in cash
D: Any factory cost.
Another question..
Which one of the following is most likely to be treated as an indirect
cost by a computer manufacturer?
A Production line workers
B Microchips
C Plastic housing for computer bodies
D factory supervisors wages
Another question.
Which one of the following is most likely to be treated as an indirect
costs by a car manufacturer?

A metal for car body

B wages of production line workers
C lubricants for machinery
D Fabric for car sheets
Another question
Which one of the following would be classed as an indirect labour
• A coach driver in a transport company
• Machine operators in a milk bottling plant
• A maintenance assistant in a factory maintenance department
• Plumbers in a construction company
Now lets look at another cost
classification…
Cost classification by behaviour
• We can also make groups of Production costs on the basis of their
response to the change in quantity produced.. These are broadly 4
groups:
• Fixed costs (without Step changes)
• Fixed costs with Step changes.
• Total Variable costs
• Semi variable costs
Now lets look at time one by one…
Total fixed costs: these costs do not change with change in units
produced within a relevant range..
The examples of Factory rent and factory supervisor salaries

Output in units Rent in Rs

0 3000
100 3000
200 3000
300 3000
400 3000
500 3000
Graph of Total fixed costs

Important exam note: For the sake of exam, you must memorize that it is a always a line parallel to X axis
continued: same on a graph paper
Total fixed cost with step
Stepped Fixed costs is that category of costs which remains the same in
total within the relevant range but increases in step when activity level
changes outside the relevant range.
Examples: Factory rent, supervisor salaries etc.
Output in units Rent
0 1000
100 1000
101 2000
200 2000
201 3000
300 3000
 Now lets look at its Graph…

This graph shows a stepwise increase in the total cost. Relevant range in this graph is of 100 numbers of units. There are 3
relevant ranges in this diagram.
Total variable costs.
These costs change with change in units of production. (activity level)
Examples: cost of direct material, cost of direct labour etc,

Units of production (activity level) Costs of Material

0 0
100 1000
200 2000
300 3000
400 4000
Now lets see its graph…
Continued………
Semi variable costs:
• It is also known as Mixed and Semi Fixed costs. It is part fixed and part
variable. (Some amount has the behavior of Total fixed cost and some
amount has the behavior of Total variable costs)
• Example: utility bills- a fixed line rent plus charges of units consumed.
Units Total fixed Variable Total costs
produced cost costs
0 2000 0 2000
100 2000 1000 3000
200 2000 2000 4000
300 2000 3000 5000
400 2000 4000 6000
Now lets look at its Graph..
Continued: Total variable cost shown on a
graph paper
Now lets look at the 4 graphs of
total costs again
Now lets memorize the graphs of 4 total
costs..(first 2)
1) Total Fixed costs
(without Step)

2) Total Fixed costs (with Step) :

Last 2
3) Total variable costs:

4) Semi variable costs:

Now lets look at the per unit
aspect of these four costs..
(we have already understood the concepts of Fixed cost without step, Fixed costs
without step, Variable costs and Semi variable costs
Now we will be looking at the behavior of average or per unit costs of the above 4
total costs. )
Now lets look at some other elements of
these 4 costs.
Fixed cost per unit falls as the output increases and vice versa.
• (here we are dealing with Fixed cost per unit without Step)
Output in units Rent in Rs Rent per unit
0 3000 0
100 3000 30
200 3000 15
300 3000 10
400 3000 7.5
500 3000 6
Fixed cost per unit Graph…
Fixed cost per unit Graph…comparison with
graph of total fixed costs.

Graph of Total Fixed costs

Graph of Fixed cost per unit
Stepped Fixed cost per unit..
• When there will be a step in total fixed cost as shown in its graph,
there will also be a step in the graph of stepped fixed cost per unit
and then it will again start to fall.
Output in units Rent Rent per unit.
0 1000 0
100 1000 10
101 2000 19.8 or 20 Approx
200 2000 10
201 3000 14.9 or approx. 15
300 3000 10
Graph of Stepped Fixed cost per unit
variable costs per unit
The graph of this costs in a horizontal line parallel to X axis.
Lets look again at our data and add one more column to it..

Units of production Costs of Material Cost of material per

(activity level) 1 unit
100 1000 10
200 2000 10
300 3000 10
400 4000 10
Now lets look at its graph
Semi variable cost per unit.
The graph of this cost also falls like the graph of Fixed cost per unit as
the fixed cost included in the semi variable cost falls in per unit but
variable cost per unit remains the same. So the total cost per units falls.
Units Total fixed Fixed cost Variable Variable Semi Semi variable cost
produced cost per unit costs cost per variable per unit.
unit costs

0 2000 0 0 0 2000 0

100 2000 20 1000 10 3000 30

200 2000 10 2000 10 4000 20

300 2000 6.67 3000 10 5000 16.67

400 2000 5 4000 10 6000 15

Now recap of Cost behavior..
Recap of Fixed cost graphs: total and
Average/per unit
Graph of Total Fixed Cost Graph of Fixed cost per unit (Average Fixed Cost)
Graph of Total Fixed Cost
Recap of Stepped fixed cost graphs
Graphs of Semi variable costs:
Graphs of Variable costs:
Now questions of Cost behaviour
Now question time…
Which one of the above graphs illustrates the
costs described in questions below?
Question 1: A linear variable cost – when the vertical axis represents cost
incurred.

A Graph 1
B Graph 2
C Graph 4
D Graph 5
Question 2: A fixed cost – when the vertical axis represents cost incurred.

A Graph 1
B Graph 2
C Graph 3
D Graph 6
Continued..
Question 3: A step fixed cost – when the vertical axis represents cost incurred.

A Graph 3
B Graph 4
C Graph 5
D Graph 6

Question 4: A semi-variable cost – when the vertical axis represents cost incurred.

A Graph 1
B Graph 2
C Graph 4
D Graph 5
Continued..
Variable costs are conventionally deemed to:

A be constant per unit of output

B vary per unit of output as production volume changes
C be constant in total when production volume changes
D vary, in total, from period to period when production is constant
Continued..
The following is a graph of cost against level of activity:
Continued..
To which one of the following costs does the graph correspond?

A Electricity bills made up of a standing charge and a variable charge

B Bonus payment to employees when production reaches a certain
level
C Salesman's commissions payable per unit up to a maximum amount
of commission
D Bulk discounts on purchases, the discount being given on all units
purchased
Continued..
A production worker is paid a salary of $650 per month, plus an extra 5
cents for each unit produced during the month. This labour cost is best
described as:

A A variable cost
B A fixed cost
C A step cost
D A semi-variable cost
Continued..
Continued..
Now lets have a look at our 2nd

First cost classification

Production vs Non production costs
Production vs Non production Costs
These can be classified as follows:
Production costs: Materials and labour used and expenses incurred to
make things and get them ready for use
Non production costs include the following:
Selling and Distribution Costs: These are costs incurred both to
persuade people to buy them and to get the finished items to the point
where people can buy them.
Financing costs: this is the cost of capital or loan of the business.

Administration costs: these include all other costs.

How to calculate the costs of a product or
service and show it on a cost card..
Item amount
Direct material A
Add: Direct Labour +B
Add: Direct Expenses +C
Total Direct Costs Or Prime Costs A+B+C
Add: ProductionOverheads (Ind Material + Ind Labour + Ind Exp) +D
Total production Costs A+B+C+D
Add: Non Production overheads +E
Total Cost A+B+C+D+E
ABC co make 20000 Braces per year. Each braces requires ½ hours of
labour at $5 per hour and 3 bought in components at costing $1.25, $2
and 40c each respectively.
The packaging for the brace costs $16 for 100 boxes. The business
incurs fixed production costs of $4000 per annum, and the cost of
selling, administration and distribution works out at 50c per item sold.
Calculate the production costs and the total cost of a Brace and record
this information on the cost card
Answer…
Brace- Unit cost card $
Direct materials – components (1.25+ 2.00 + 0.40 ) 3.65
box ($16/100) 0.16
Direct labour (1/2) hours at $5 per hour + 2.5
Prime costs 6.31
Production overheads ($4000/20000) units + 0.21
Production cost 6.51
Non manufacturing overheads + 0.5
Total costs 7.01
Question for practice
A product that a company requires 3kg of material A costing $6.20 kg and
4kg of material B costing $5.60 per kg. The product requires 2 hours labour
at $7.40 per hour. The product is sold in packs of 10 and the packaging for 10
units costs $22. Fixed production costs are $60000 per annum and selling,
distribution and administration costs are $24000 per annum. The company
makes 15000 units of the product each year.
Now answer the following questions:
• What is the prime cost of the product?
• What is the production cost of the product?
• What is the total cost of the product?
• Production costs of Product X have been classified in various ways.
$
Prime costs 50.8
Variable costs 54.44
Fixed overheads $15.20 per
DLH
Direct labour 2.6 hours per
unit at $12
per hour
Variable overheads $1.4 per DLH
Direct materials $19.6

• What is the total production cost per unit of product X?

Another three very important
concepts
Cost object, Cost unit and cost center
What is a cost object
• Cost object is anything for which costs can be ascertained.
Concepts of cost units and cost centers
What is Cost unit: it is a unit of a product or service in relation to which costs are
ascertained. It has two types: Cost unit of a product and Cost unit of a service. (cost
units are units of measurement of costs)
1) Cost unit of a product: These are single cost units eg Rs 15 per pen, Rs 80 per Kg,
Rs 110 per dozen etc
2) Cost unit of a service: These can be compound or made up of two parts, both
parts of cost units measuring something different. Examples are below:
Cost per bed per night (called bed-night)
Cost per room per night (room-night)
Cost per kg per km or mile ( kg-km)
Cost per pessenger per km/mile ( pessenger/km)
Brief repetition of concept of composite cost
unit
It is a compound cost unit which is made of two parts.

• Examples are
• For a hotel, it can be room-night
• For a Bus company, it can be Passenger-mile
• For a hospital, it can be Bed-night or Room-night
Cost centers
What are cost centers: Simple definition is “ a cost center is a collecting place
of costs: Detail definition is: a production or service location, function,
activity or item of equipment for which costs are accumulated (collected and
recorded)
There are broadly two types of cost centers
• Production costs centers: for example, Cutting department, Stitching and
packing department etc

• Service cost centers: these departments are not involved in production

such as Maintenance department, Engineering Department, canteen etc