Admas University Cost II Chapter II

2. COST TERMINOLOGY AND CLASSIFICATION

2.1 General
Cost is usually defined as a resource sacrificed or forgone to achieve a
specific objective. The resources may be either tangible substances
(materials or machinery) or services (wages, power, rent or time spent).
Conventionally, monetary amounts that must be paid to acquire goods
and services are considered as cost.

The term ‘cost’ is meaningless without a suffix or a prefix, e.g. material

cost, labor cost; fixed cost, process cost, etc. the suffix or prefix explains
its nature and limitations.

To guide their decision making, managers want to know how mach a

certain thing (such as a new product, a machine, a service, or a process)
costs. We call this ‘thing’ a cost object. A cost object means anything for
which a separate measurement of cost is desired.
Examples of cost objects
Cost object Illustration
Product A ten-speed bicycle
Service An airline flight from Addis to Nairobi
Project An airplane assembled by Boeing for EAL
Customer All products purchased by a customer
Brand category All soft drinks with ‘Pepsi’ in their name
Activity A test to determine the quality level of a
television set
Department A department within a government
environmental agency that studies air
emission standards
Program An athletic program of a university

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2.1.1 Basic Cost Concepts

Concept of objectivity
 Cost exercises must be in harmony with objectives
 Gives directions to activities of:
o Cost finding
o Cost recording
o Cost analyzing and
o Cost reporting
Concept of time span
 All assumptions for various exercises remain valid for related time
span
 Time span should be sufficiently long to record the associated cost,
labor hours, output and other factors required for analysis.
Concept of relevant range of activity
 Refers to the span of volume for which the cost behavior is likely to
remain valid
 Various cost exercises work on certain assumptions regarding cost
behavior patterns, which remain valid only within the relevant range
of activities.
Concept of materiality
 Materiality is assessed by considering the nature of activities,
competitor’s practices of managerial policies.
 Certain decisions may be helpful, but benefits may not be material
enough on its implementation.
Concept of relevant cost and benefit
 For evaluating alternative courses of action, only relevant costs and
benefits relating to those alternatives should be considered.

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Admas University Cost II Chapter II

2.2 Classification of Costs

Cost classification is the process of grouping costs as per their common
characteristics viz. nature of expenses, function, variability,
controllability, normality, time, direct and indirect costs and decision
making.
Cost classification is a must for identifying costs with cost centers or cost
units for the determination and control of cost.
By nature of expense
 Here costs are divided under three heads, i.e. material, labor, and
overhead. Each element can be further sub-divided into direct and
indirect.
By function
 Here costs are divided into manufacturing cost, administration cost,
selling cost, distribution cost, research and development.
By variability or behavior
 Here costs are classified into fixed, variable and semi variable/semi
fixed depending upon their behavior in relation to change in the
volume of output.
o Fixed costs
 These costs do not tend change with the change in the volume
of output
 Examples are rent, insurance of factory building, salary of
works manager, depreciation etc
 Can be controlled by top management only
 Fixed cost per unit increases when volume of production
decreases and vice versa.
o Variable costs
 These costs tend to change directly with the volume of
production

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Admas University Cost II Chapter II

 Examples are direct material, direct wages/labor, and other

direct costs.
By controllability
 These costs are controllable and uncontrollable
o Controllable costs are:
 Those costs which can be influenced by the action of a
specified person of an organization
 Costs which responsible managers are able to control
 Examples are direct material costs, direct labor and other
direct overheads
o Uncontrollable costs are:
 Costs which remain unaffected by the action of a specified
person of an organization
 Examples are fixed costs and all allocated and apportioned
expenses
By normality
 Here costs are classified as normal and abnormal costs
o Normal cost
 Cost normally incurred at a particular level of output in the
conditions in which that level of output is generally achieved
o Abnormal cost
 Cost which is not normally incurred at a particular level of
output in the conditions in which that level of output is
generally achieved
Based on time
 Here costs are allocated as historical cost and predetermined cost
o Historical cost
 A ‘postmortem’ cost ascertained after incurrence
 Determined on the basis of actual cost incurred

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Admas University Cost II Chapter II

 Helps in predicting future costs of different alternative actions

and selecting the best line of action
o Pre-determined cost
 Prepared in advance before the actual operation takes place
based upon specification, historical cost figures and other
factors affecting cost.
 It is a future cost which may be estimated or standard
 Estimated cost
o Prepared in advance for quoting price before the
acceptance of sales order
o Helps in comparing with actual performance
 Standard cost
o When pre-determined cost is found scientifically, it
becomes standard cost
o It consists of:
 Setting standards for each element of cost
 Comparing standard cost with actual cost
 Finding out the reasons for variance
 Fixing responsibility and taking remedial action to
avoid its recurrence in the future
Direct and indirect costs
 Direct costs
o Incurred for specific cost unit, process or department and can
be directly identified with and allocated to that cost object.
Also called product cost.
 Indirect cost
o Incurred for a number of cost units or cost centers and
apportioned among them on some suitable basis
o Incurred for a period of time to render benefit within that
period. Hence, called period costs.

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Admas University Cost II Chapter II

o Cannot be identified with a particular cost unit

Decision making
 Here costs are classified as relevant costs and irrelevant costs
 Relevant costs
o Those costs which are relevant for decision making
o Examples are marginal costs, incremental or differential cost,
opportunity cost, etc)
 Marginal cost- It is the total variable costs or additional costs
of producing one additional unit.
o Incremental or differential cost
 Incremental costs and incremental revenue arising out of a
decision to change the level of activity
 Considers both fixed and variable costs
o Opportunity cost
 The benefit or contribution forgone due to not availing an
alternative course of action
 Calculated only for the purpose of comparison
o Out-of-pocket-cost
 Cost associated with activity which involves actual cash
outlay
 Examples are wages, material cost, insurance etc
o Imputed costs
 Hypothetical or notional costs which do not involve any cash
outlay
 Calculated for the purpose of decision making
o Replacement cost
 The current market cost at which an asset or material can be
replaced with an identical one
 Relevant cost for decision making
 Irrelevant costs

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Admas University Cost II Chapter II

o Those costs which have no bearing on decision making

o Sunk costs
 Historical costs incurred or sunk in the past and are not
relevant to the specific decision being considered
o Committed costs
 Costs committed by the management are irrelevant for
decision making
o Absorbed fixed costs
 Fixed costs which do not change with changes in the volume
of output are irrelevant for decision making
2.3 Costs and Cost Drivers
The continuous cost reduction efforts of competitors create a never
ending need for organizations to reduce their own costs. Cost reduction
efforts frequently focus on two key areas:
 Doing only value added activities, that is, those activities that
customers perceive as adding value to the products or services they
purchase
 Efficiently managing the use of the cost drivers in those value added
activities
 A cost driver also called a cost generator or cost determinant is any
factor that affects total costs. That is, a change in the level of the cost
driver will cause a change in the level of the total cost of a related
cost object.

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Examples of cost drivers of business functions in the value chain

Business Function Cost Driver

Research and development Number of research projects

Personnel hours on a project
Technical complexity of projects

Design of products, services, Number of products in design

and processes Number of parts per product

Number of engineering hours

Production Number of units produced

Direct labor costs
Number of setups
Number of engineering change orders

Marketing Number of advertisements run

Number of sales personnel
Sales dollars

Distribution Number of items distributed

Number of customers
Weight of items distributed

Customer service Number of service calls

Number of products serviced
Hours spent servicing products
 Some cost divers are financial measures found in accounting
systems while others non-financial variables

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Cost management is the set of actions that managers take to satisfy

customers while continuously reducing and controlling costs.

2.4 Cost Accumulation and Application to Cost Objectives

A costing system typically accounts for costs in two basic stages:

Stage 1 It accumulates costs by some natural (often self-descriptive)

classification such as materials, labor, fuel, advertising, or shipping.

Stage 2 It assigns costs to cost objects Cost accumulation is the

collection of cost data in some organized way through an accounting
system.

Cost assignment/application is a general term that encompasses:

 Tracing accumulated costs to cost objects
 Allocating accumulated costs to cost objects
Costs traced to a cost object are direct costs, and costs that are allocated
to a cost object are indirect costs.

Direct cots are costs that are related to a particular cost object and that
can be traced to that cost object in an economically feasible (cost-
effective) way.

Indirect costs are costs that are related to a particular cost object but
can not be traced to it in an economically feasible (cost effective) way.
Indirect costs are allocated to the cost object using a cost allocation
method.

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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.
Several factors affect the classification of a cost as direct and indirect
 The materiality of the cost in question
 Available information gathering technology
 Design of operations
 Contractual arrangements

2.5. COST VOLUME PROFIT RELATIONSHIPS

Cost volume profit (CVP) analysis examines the behavior of total
revenues, total costs, and operating income as changes occur in the
output level, selling price, variable costs, or fixed costs.

2.5.1 Variable Costs and Fixed Costs

A key to understanding cost behavior is distinguishing variable and fixed
costs. Costs are classified as variable or fixed depending upon how mach
they change as the level of a particular cost driver changes.
A variable cost is a cost that changes in direct proportion to changes in
cost driver. In contrast, a fixed cost is not immediately affected by
changes in the cost driver. Suppose units of production are a cost driver
of interest. A 10% increase in units of production would produce a 10%
increase in variable costs. However, the fixed costs would remain
unchanged.

Notice that the variable costs do not change per unit but the total costs
change in direct proportion to the cost driver activity. A fixed cost does
not change in total but becomes progressively smaller on a per unit basis
as the volume increases. The variable or fixed characteristics of a cost
relates to its dollar amount and not to its per unit amount.

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If cost driver activity level increases or decreases

Type of cost Total cost Cost per unit
Fixed costs No change Decrease or increase
Variable costs Increase or decrease No change

When analyzing costs two rules of thumb are useful:

 Think of fixed costs as a total. Total fixed costs remain unchanged
regardless of changes in cost-driver activity.
 Think of variable costs on a per-unit basis. The per unit variable
cost remains unchanged regardless of changes in cost driver
activity.

Major assumptions
The definitions of variable costs and fixed costs have important
underlying assumptions:
 Costs are defined as variable or fixed with respect to a specific cost
object.
 The time span must be specified.
 Total costs are linear. That is when plotted on ordinary graph; a total
variable cost or a total fixed cost relationship to the cost driver will
appear as unbroken straight line.
 There is only one cost driver. The influences of other possible cost
drivers on total costs are held constant or deemed to be insignificant.
 Variations in the level of the cost driver are within the relevant range.

Purpose of Distinguishing Between Variable Costs and Fixed Costs

The purpose of distinguishing between variable costs and fixed costs as
ranked by managers are:
 Pricing
 Budgeting

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 Profitability analysis of existing and new products

 Cost volume profit analysis
 Variance analysis

2.5.2 Cost Volume Profit Analysis

CVP analysis is a technique used to study the interrelationship between
costs, sales and net profit. It shows the net effect that fluctuation in cost,
price and volume has on profit. The higher the volume of output, the
lower will be the unit cost of production and vice versa as the fixed
overhead cost in total cost does not change with the volume of output.
The concept of CVP is relevant to virtually all decision making areas. It is
an important tool of short term planning and forecasting of business
activities and is useful in taking short run decisions and formulating
business policies.
Managers of non profit organizations also benefit from CVP analysis
because knowledge of how costs fluctuate as volume changes helps them
in determining how to control cost. Example how costs behave in a
hospital with volume of patients.
Basic questions of interest to management decision making areas
answered by this analysis are:
 What should be the volume for a desired profit?
 What changes in selling price affect profit position?
 What should the optimum product mix of the company be?
 How does variation of cost affect profit? Etc

Assumptions Underlying CVP Analysis

 Fixed costs and variable costs can be ascertained with reasonable

accuracy, total fixed costs remain fixed and variable costs per unit
remain constant.

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 Efficiency and productivity remain the same.

 Selling prices remain constant at all sales volumes.
 The volume of production equals the volume of sales.
 There is a constant sales mix at all levels of sales in multi-product
situation or there is only one product.
 Volume is the only relevant factor which affects cost and revenue.
 Factor prices like wage rates, material prices, etc. remain constant at
all sales volumes.

Main Objectives of CVP Analysis

 Profit planning
 Set up of flexible budgets which show costs at various levels of
activities
 Evaluation of performance for control purpose
 Formulating pricing policies by projecting the effect that various price
structures have on cost and profits.
 Assisting in ascertainment of the amount of overhead costs that could
be charged to product costs at different levels of operation.
 Assisting in short run tactical decisions like shift working, acceptance
of special order, choice of sales mixes etc.

Limitations of CVP Analysis

 All costs cannot be easily and accurately segregated into fixed and
variable components.
 Total fixed costs do not remain fixed beyond certain ranges of activity
levels.
 When a firm sells more than one product:
o The sales mix changes continuously due to changes in demand

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o It becomes difficult to forecast accurately the volume of sales mix

which would yield maximum profit
 Some times changes in opening and closing stock may be significant.
 If selling prices and factor prices (material, wage rates) change, then
the CVP relationship is affected.

2.5.3 CVP Analysis: Single Product Case

2.5.3.1 Breakeven Point

The breakeven point is the level of sales at which revenue equals
expenses and net income is zero.

 Finding the breakeven point is often just the first step in a planning
decision.
 Managers usually concentrate on how the decision will affect sales,
costs, and net income.
 One direct use of the breakeven point is to assess possible risks. By
comparing the planned sales with the breakeven point, managers can
determine a margin of safety.
 Margin of Safety = Planned unit sales – Breakeven unit sales
 The margin of safety shows how far sales can fall below the planned
level before losses occur.

There are two techniques for computing a breakeven point: contribution

margin and equation techniques.

Contribution Margin Technique

Every unit sold generates a contribution margin or marginal income,
which is the unit sales price minus the variable cost per unit.

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Illustration: assume the following for Fine Shoe Shop:

Birr %
Unit Selling Price 100 100
Unit Variable Costs 80 80
Unit Contribution Margin 20 20

Fixed Costs
Rent 5,000
Wages 10,000
Other fixed expenses 5,000
Total fixed costs per month 20,000
The contribution margin per unit has represents the amount each unit
sold contributes towards fixed cost and net income. When is the
breakeven point reached? When enough units are sold to generate a total
contribution margin (total number of units sold X contribution margin
per unit) equal to the total fixed costs.

Or BEP = FC/UCM
Where:
BEP = breakeven point
FC = total fixed costs
UCM = unit contribution margin
For Fine Shoe the total number units that must be sold to breakeven
would be:
FC/UCM = 20,000/20 = 1,000 units or pairs of shoes
The sales revenue at breakeven point is:
BEP Units X SP = 1,000 X 100 = Br. 100,000

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Each unit (pair of shoes in our example) sold generates extra revenue of
100 and extra cost of 80. Fixed costs are unaffected.
If zero units were sold, a loss equal to the fixed cost of 20,000 would be
incurred. Each unit sold reduces the loss by 20 until sales reach the
breakeven point of 1,000 units. After that each unit adds (or contributes)
20 to profit.

Equation Technique
This is the most general form of analysis that can be adopted to any
conceivable cost-volume-profit situation.
Any income statement can be expressed in equation form or as a
mathematical model as follows:
Sales – Variable Expenses – Fixed Costs = Net Income
Unit number unit number fixed
Sales * of - variable * of - expenses = Net income
Price units cost sold

At the breakeven point net income is zero.

Sales- Variable Expenses- Fixed Expenses = 0
Let N be the number of units to breakeven. For Fine Shoe:
100N – 80N – 20,000 = 0
20N – 20,000 = 0
20N = 20,000
N = 20,000/20 = 1,000 units.
To find dollar sales multiplication of 1,000 units by selling price of Br.
100 yields breakeven Birr sales of 100,000.

The Birr breakeven sales can also be computed without finding the unit
breakeven point by using the relationship of variable costs as a
percentage of sales.
Variable cost ratio or percentage = Unit VC/Unit SP

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= 80/100
=.8 or 80%

Let S = sales in Birr needed to breakeven. Then,

S – 0.8S – 20,000 = 0
0.2S = 20,000
S = 20,000/.2
S = 100,000

On the basis of the foregoing discussion, we can derive the following

shortcut formulas:
BEP in units = Fixed Costs/Contribution Margin per Unit
BEP in Dollars = Fixed Costs/Contribution Margin Ratio

Changes in Fixed Expenses

Changes in fixed expenses cause changes in the breakeven point. For
example if the wages are reduced by Br. 2,500, the breakeven point in
units and Birr would be:
Fixed costs are now Br. 17,500 instead of 20,000
Thus:
BEP in units = Fixed Expenses/Unit Contribution Margin
= 17,500/20
BEP = 875 units
BEP in Birr = Fixed Expenses/Contribution Margin Ratio
BEP in Birr = 17500/0.2 = Br. 87,500

Changes in Contribution Margin per Unit

Changes in variable costs also cause the breakeven point to shift.
Companies can reduce their breakeven points by increasing their

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contribution margin per unit of product through either increase in sales

prices or decrease in unit variable costs or both.

For example assume that the rent expense for Fine Shoe is still Br. 5,000
but if:
1. The owner is paid 1 Br of rent per unit sold in addition to the fixed
sales
2. The selling price falls from Br. 100 to Br. 95 per unit
Required:
 Find the breakeven point under each of the circumstances
1. The variable cost per unit is now Br. 81 instead of Br. 80
Birr %
Selling price 100 100
Variable costs 81 81
Contribution margin 19 19
BEP in units = FC/UCM
= 20,000/19 = 1,053 units
BEP in Birr = FC/CM ratio
= 20,000/0.19 = 105,300
2. If the selling price falls from Br. 100 to 95 per unit:
Birr %
Selling price 95 100
Variable costs 80 84.2
Contribution margin 15 15.8
BEP in units = FC/UCM
= 20,000/15 = 1,333 units
BEP in Birr = FC/CM ratio
= 20,000/0.158 = 126,635 Birr

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Target Net Profit

Managers can also use CVP analysis to determine the total sales, in units
and Birr, needed to reach a target profit. Assume that Fine Shoe plans to
earn a minimum net income of Br 5,000 per month. How many units or
pairs of shoes need to be sold to meet this target?
Target sales volume in units:
= fixed costs + target net income/contribution margin per unit
= 20,000 + 5,000/20
=1,250 pairs of shoes
The BEP in Birr can be easily obtained either by multiplying the target
sales volume by the unit selling price or dividing the target net income
plus fixed costs by the contribution margin ratio.

Multiple Changes in Key Factors

So far we have seen in one CVP factor at a time. In the real world,
managers often must make decisions about the probable effects of
multiple factor changes. Suppose if Fine Shoe is considering a change in
its working hours and this result in saving of Br. 4,000 in fixed costs and
a decline in sales by 250 units.

Assume two different levels of sales volume:

 From 2,000 pairs of shoes to 1,750 pairs of shoes
 From 3,500 pairs of shoes to 2,250 pairs of shoes
One approach to determine the effect of the change is to construct and
solve equations for conditions that prevail under each alternative.

Decline from Decline from

2,000 to 1,750 3,500 to 3,250
Pairs Pairs
Units 2,000 1,750 3,500 3,250

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Sales 200,000 175,000 350,000 325,000

Variable costs 160,000 140,000 280,000 260,000
Contribution Margin 40,000 35,000 70,000 65,000
Fixed costs 20,000 16,000 20,000 16,000
Net income 20,000 19,000 50,000 49,000
Change in net income (1,000) (1,000)

A second approach, an incremental approach, is quicker and simpler.

Simplicity is important because it keeps analysis from being cluttered by
irrelevant and potentially confusing data.

The issue here is decline of sales by 10,000 units irrespective of the

current level of activity and the essence of the decision is whether
prospective savings in fixed costs exceed prospective loss in total
contribution margin dollars.
Birr
Lost total contribution margin 250*20 5,000
Savings in fixed cost 4,000
Prospective decline in net income 1,000

The change in working hours results in decrease of net income by Br.

1,000 and not a sound a financial decision.

2.5.4 CVP Analysis: Effects of Sales Mix

The sales mix is the relative combination of quantities of products or

services that constitutes total revenues. If the mix changes, overall
revenue targets may still be achieved but the effects on operating income
depend on how original proportions of lower or higher contribution
margin products have shifted.

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Suppose Fine Shoe sells two types of products Shoes and Jackets and
the sales budget is as follows:

Shoes (S) Jackets (J) Total

Sales in units 2,000 500 2,500
Sales @ 100 and 500 200,000 250,000 450,000
Variable Costs @
80 & 425 160,000 212,500 372,500
Contribution margin 40,000 37,500 77,500
Fixed expenses 40,000
Net income 37,500
Ignoring income taxes, what is the breakeven point? The typical answer
assumes a constant sales mix of 4 units of shoes for every unit of
jackets.
Sales – Variable costs – Fixed costs = 0
[100 (4J) + 500(J)] – [80(4J) + 425(J)] – 40,000 = 0
400J + 500J – 320J – 425J – 40,000 = 0
155J = 40,000
J = 258
S = 4J = 258 * 4 = 1032
The breakeven point is 258 Jackets + 1032 Shoes = 1290 units.
This is the only breakeven point for sales mix of four shoes for every
jacket sold. Clearly, however, there are other breakeven points for other
sales mixes.
For instance if only jackets were sold fixed costs being the same:
BEP = 40,000/75 = 533 units.
If only shoes were sold
BEP = 40,000/20 = 2,000 units.

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Managers are interested in knowing how changes in the planned sales

mix affect net income. When the sales mix changes, the breakeven point
and the expected net income at various sales levels are altered. Suppose
the actual total sales were equal to the budget of 2,500 units but only
1,700 shoes were sold:
Shoes (S) Jackets (J) Total
Sales in units 1,700 800 2,500
Sales @ 100 and 500 170,000 400,000 570,000
Variable Costs @
80 & 425 136,000 340,000 476,000
Contribution margin 34,000 60,000 94,000
Fixed expenses 40,000
Net income 54,000

The change in sales mix resulted in actual net income of 54,000 rather
than the budgeted net income of 37,500 a favorable difference of 16,500.
The total units sold were equal to the budget but the proportion of sales
of the product bearing the higher contribution margin increased.

Managers prefer to generate the most profitable sales mix achievable.

2.5.5 Sensitivity Analysis and Uncertainty

Sensitivity analysis is a what- if technique that examines how a result
will change if the original predicted data are not achieved or if an
underlying assumption changes. In the context of CVP, sensitivity
analysis answers such questions as, what will operating income be if
output level decreases by 5% from the original prediction? What will
operating income be if variable costs per unit increase by 1o%? The
sensitivity to various possible outcomes broadens managers’ perspectives

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as to what might actually occur despite their well laid plans. The margin
of safety is an answer to the what if question.
Sensitivity analysis is one approach to recognizing uncertainty, which is
defined here as the possibility that an actual amount will deviate from an
expected amount.

2.5.6 CVP Analysis and Income Tax

In our earlier example, we have said that Fine Shoe has a target net
income of 5,000 per month if we convert this to a year we can assume
the yearly target profit is Br. 60,000.
Assume this net income is after tax and the tax rate is 30%. The only
change in the equation method of CVP analysis is to modify the target
operating income to allow for income taxes.

Revenue – Variable Costs – Fixed Costs = Operating Income

Introducing income tax effects:

Target net income = Operating income – (Operating income * Tax rate)
Target net income = (Operating income)-(1- Tax rate)
Operating income = Target net income/1 – Tax rate
So, taking income taxes into account, the equation method yields:
Revenues – Variable costs – Fixed costs = Target net income/1-Tax rate
Substituting numbers from Fine Shoe example,
100Q – 80Q – 20,000 = 5,000/1- 0.3
100Q – 80Q – 20,000 = 7,143
20Q = 27,143
Q = 1,357
ASSIGNMENTS
Introduction to Management Accounting 11th Edition
Fundamental Assignment Material
2-A1, 2-A2, 2-B2

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Exercises
2-23, 2-24, 2-25, 2-28, 2-31, 2-36, 2-37, 2-47
Cost Accounting Ninth Edition
Exercises
3-16, 3-18, 3-20
Problems
3-29, 3-37

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