Management Accounting

CHAPTER 2. COST BEHAVIOUR.

2.1. Classification of costs
2.1.1. Manufacturing and non-manufacturing costs
2.1.2. Fixed, variable, semi-variable and semi-fixed costs
2.1.3. Direct and indirect costs
2.2. Cost cycle analysis
2.3. Costs elements of production cost
2.4. Costs and revenues structure: Profit and loss account
2.5. Bibliography
2.6. Review questions (chapter 2)
Exercises 04, 05 and 06.

Learning Objectives
After studying this chapter, you should be able to:
 Distinguish between Manufacturing and Non-Manufacturing, Fixed and Variable,
Direct and Indirect costs
 Develop basic profit and loss account with cost information.

Basic Vocabulary for chapter 2

Raw material
Labour
Overhead
Finished products
Work in progress
Labour hours
Machine hours

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2.1. Classification of costs

To answer the first question, we will have to briefly review the specific types of costs. We will
see three classifications:

2.1.1. Manufacturing and non-manufacturing costs

The first classification distinguishes production (or manufacture) costs from period costs
(also referred to as non-manufacture costs). This classification is important because the first
category shows us how to determine the cost of the product, whereas the second does not
play a part in the calculation of the cost of the product and is only used to determine the result
in the profit and loss account.
1.1. Manufacturing cost: This cost is generated when transforming the raw material into a
finished product. It also designates the “industrial cost” of the product which fundamentally
consists of:
 Raw materials cost,
 Labour cost
 Indirect production costs or overhead cost (we will use overhead).
1.2. Non-manufacturing: This essentially is made up of the costs of sales and distribution
along with the administrative and financial costs, i.e. the costs that are not directly linked to
the production process.
The costs of distribution or sales are the costs incurred when the manufactured product
must be transported from the company to the consumer e.g., costs for advertising, transport,
commissions, and so forth.
Administration costs are those that originate in the administrative area. For example the
telephone bill, admin wages, etc.

2.1.2. Fixed, variable, semi-fixed and semi-variable costs

The second basic classification we are looking at divides costs into fixed costs (costs that
remain the same regardless of the number of units produced) and variable costs (costs that
vary depending on the number of units produced). Between these two extremes we may find
another two types of cost: semi-fixed and semi-variable costs. Thus, according to the
established general classification costs consist of: (AECA, 1996):
1. Fixed costs
2. Semi-fixed costs (variable for specific levels of activity)
3. Semi-variable costs (mixed cost: fixed and variable components)
4. Variable costs
1. Fixed costs: “Fixed costs are those costs that, generally, do not have a direct relation with
the activity level. That is to say, the level of activity and the variations produced by this level of
activity do not have an impact on them. It is fundamental to specify that these costs remain
constant despite changes in the units of output, at least within a specific range of activity.
Thus, for a determined interval of activity these costs remain invariable. However, an increase
or decrease in the interval of activity may imply a change in the structure of fixed costs”.

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Fixed costs can be represented as follows:

Total Fixed costs

cost

Activity level
2. Semi-fixed Costs: “This type of costs is characterized by the fact that they remain constant
within a range of production. Nevertheless, some changes in the volume of production may
produce an increase in these costs, which will in turn remain constant for that range until the
following activity level is reached”.
Semi-fixed costs can be represented as follows:

Total
Cost

X1 X2 X3
Activity level
3. Semi-variable Costs: This includes all those concepts that cannot be conclusively classified
as fixed or variable, given that they contain both fixed and variable elements within the
accounting cycle.
“Semi-variable costs can be defined as costs that vary according to output volume, but their
variations are not directly proportional to the changes in activity level, i.e., it is a cost with a
positive coefficient of relative correlation to the activity of production that is always less than
one.
Semi-variable costs can be represented as following:

Total
Cost

X1 X2 X3
Activity level
4. Variable costs: these include those company costs for which there are direct correlations
between their amounts and volume. These are costs that vary directly with changes in the
level of activity they refer to (production, sale, labour hours, machine-hours).
Variable costs can be represented as follows

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Total
cost

Activity level

2.1.3. Direct and Indirect costs.

The third and last of the three classifications separates costs into direct and indirect costs.
3.1. Direct costs: Direct costs are those that are fully associated with a specific product,
department or activity. For example, if a company manufactures drinks and cookies, the cost
of the bottles is a direct cost of the drinks (cookies can not be inside a bottle). In the same
manner, it follows to say that the wage of the Sales Director’s secretary is a direct cost of the
Sales Department.
3.2. Indirect costs: However, indirect costs are those that cannot be associated to a specific
product, department or activity. Taking our previous example, if we consider the consumption
of electricity we can see that this has just as much to do with the manufacture of drinks as it
does with cookies. Further examples of this may be depreciation costs, the cost of indirect
materials, indirect labour costs, repair and maintenance costs, rent or supplies (water, gas,
electricity, etc.)
Do the questionnaire (questions 1, 2 and 3)
Do exercises 04 + 05 + 06

2.2. Cost cycle analysis

A company will have to carry out the following phases to calculate costs:
In the first place, the cost object must be determined. A cost object is "Everything that
requires an independent measurement of its cost” (AECA, 1996). That is to say, if the users of
the accounting information need to know a specific cost, this specific issue constitutes the cost
object. Examples of this can be: the cost of a product; the cost of a service; the cost of the
activity of a product; the cost of any factor applied to the production process; etc. Product is
the cost object most commonly used in a company although, evidently, it is by no means the
sole cost object of the company.
In second place, a company will identify all the costs involved in the calculations and will
proceed to their classification, that is to say, it will differentiate the types of costs. Although at
first glance this may seem simple, it really is not simple at all because a vast majority of costs
are semi-fixed or semi-variable.
In third place, all the phases of allocation, distribution and attachment of costs to their
cost object must be developed. In some cases it will be necessary to identify and classify cost
centres, processes, and activities, yet in other cases this may not be possible because it will be
dependent on the chosen cost model as well as on the type of company under study.
The allocation, distribution and attachment of costs can be represented as follows.

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Direct To allocate
costs

Indirect Cost
costs
objects

To distribute

To attach

2.3. Cost elements of production cost

To obtain a specific product or service the company has to undertake a series of costs.
Foremost are all those costs that are directly involved in determining the production cost as
follow:
1. Raw materials costs
2. Labour costs
3. Overhead or Indirect production costs.
1. Raw material or Direct Material: These are the goods the company transforms into a
finished product. For example, in a company that buys metal to make the bodywork for cars
there are two conditions that must be fulfilled so that this metal can be considered raw
material:
 It must be a part of the finished product
 Its consumption must be verified
The calculation of the cost of raw materials is obtained by multiplying the quantity consumed
by the price.

In some cases raw materials have several prices. That is to say, for example, I can buy 1100
kilos of steel on the first of January for 3 €/kilo, on the third of February I can buy 200 more
kilos for 2.5 €/kilo and on the tenth of May another 400 kilos for 2 €/kilo. So I will require the
use of a valuation method to determine the consumption.
There are many methods of valuation, but here we will discuss two of them:
•FIFO (First In First Out).
•Average Cost.

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2. Labour: It consists of the cost of wages and all other personnel-related charges (social
security, compensation, retirement plan contributions, grants, canteen, insurance for
death or disability, etc.) as follows:
• Direct labour is labour that is clearly related to a particular cost object. For
example, if the factory produces car bodywork, the direct labour will be the
operators that partake in transforming the metal sheets into the final product,
the car bodywork.
• Indirect labour is labour that lacks immediate causal relationship with the cost
object. As in our previous example (the factory that produces car bodywork) this
type of labour for example is represented by the workers from cleaning or
maintenance department of factory.
Cost of labour is extracted from the expense presented in external accounting and
takes into account all the costs surrounding a person such as salary (including the
payment of overtime), social security plans, pension premiums, attire, etc.
3. Indirect Production cost or Overhead: Incorporates all the non-raw materials and non-
labour costs that result from the production process. This may include consumption such as:
• Indirect materials: fuels, lubricants, detergents.
• Indirect labour costs: Workshop foremen; Foremen and supervisors; cleaning
personnel; personnel in charge of the transport of materials, workshop maintenance,
quality control and machine preparation.
• Other indirect costs: Maintenance; depreciation; insurance; rents; supply of utilities
like water, gas, electricity, etc.

2.4. Cost and revenue structure: Profit and Loss account

The profit and loss account is the tool that we are going to use the most in our analyses.
Using it as our basis, we may draft a single scheme with the revenues and costs for each of the
products, departments or activities and analyse them either individually or comparatively.
Basic diagram of internal Profit and loss account:
1. SALES REVENUE (1)……………….……………………………………….
2. COST OF SALES (2)…………………………………………………….…..
+ Direct raw material cost
+ Direct labour cost
+ Overhead cost .
COST OF PRODUCTION
+ Opening stock work in progress
- Closing stock work in progress
+ Opening stock finished products
- Closing stock finished products

GROSS PROFIT (1) - (2)………………………………………………………

3. PERIOD COSTS (3)………………………………………………………….
3.1- Selling Costs.
3.2- Admin Costs
RESULT (1) - (2) – (3)………………………………………………………….

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Where, the cost of production shall consist of the cost of raw materials, i.e., consumption
of raw materials or direct materials used in the production process, plus the cost of direct
labour, i.e. applied in the production process and, finally, plus the overhead costs.
The cost of marketing and sales include sales expenses, i.e. those expenses incurred once
the product has been manufactured and needs to be placed on the market for sale. This will
imply a number of expenses such as advertising, commissions to vendors and so forth.
Finally we have the financial and administrative costs. This includes the administrative
expenses incurred by the organization (management salaries, office phone expenses, etc...)
and financial costs, which are the expenses incurred by the company to obtain the external
resources it requires in order to develop business. This includes the cost of the interest that
must be paid on loans as well as the cost of extending credit to customers.

2.5. Bibliography
Asociación Española de Contabilidad y Administración de Empresas - AECA (1996): Costes
Indirectos de Producción: Localización, imputación y control. Documento nº 7 de la
serie de Principios de Contabilidad de Gestión.
Drury, C. (2015): Management and Cost Accounting, 9th Edition, International Thomson
Business Press, 2015, London.

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2.6. REVIEW QUESTIONS CHAPTER 2 COST BEHAVIOUR.

1. A key point for guidance in decision-making is good knowledge of the fixed and variable
components of cost. To check, indicate which of the following statements are true.
a / If the volume of activity increases 50%, the amount of fixed costs increases 50%.
b / If the volume of activity decreases a third, the variable unitary cost must remain constant.
c / A company pays €2 per kg of material X for the first 10,000 Kg to buy in a year. If you
exceed this amount, the supplier gives you a discount of 50 cents per kilo. The cost of material
X is therefore a fixed cost plus a variable cost when calculating the cost of producing one unit
of output.
d / If you decide to rent a lorry for €2,000 a year for 10,000 km and 50 cents for each
additional Km, lorry rental will be a semi-variable cost for the user.
2. Classify the following cost items into manufacturing costs and non-manufacturing costs
(mark an X in one of the columns on the right)
Non-
Manufacturing
manufacturing
costs
costs
Grapes for making wine: €5,000
Winery operator salaries €8,000
Rental for the building where the wine is made: €2,000
Administrative costs paid for external consulting: €10,000

3. Within manufacturing costs distinguish between: Materials, Labour and Indirect Costs of
Production (mark an X in the column on the right):
Indirect
Materials Labour Costs of
production
Cost of the wood used to make a table
Cost of the salary of the person who works making
the table
Cost of the rent for the factory facilities
Depreciation costs
Phone bill

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EXERCISE 04:
Classify the following concepts among production costs, distribution costs and administrative-
management costs

Admin/
Cost Total Production Distribution
Management
Raw Material consumption 6,100
Salaries of admin/management 6,800
personnel
Office material consumption 600
Sales Commissions 7,200
Gas (heating for the factory) 3,400
Outsourcing of production activities 12,200
Publicity 14,200
Financial costs 3,400
Oil for the machinery of the factory 100
Salaries of the factory operators 18,500
Salaries of foremen 11,200
Other factory costs 1,600
Rents of the factory building 82,400
Depreciation of the machinery of the 4,300
factory
Total costs 172,000

EXERCISE 05:
In the next table, determine the type of cost represented by each concept. Please take into
account its relation to the level of activity (fixed or variable) and to the product (direct or
indirect)

Fixed Variable Direct Indirect

Concept
cost cost cost cost

Raw Material consumption

Salary of product packaging operators
Salary of the factory foremen
Rent paid for the office facilities
Sales Commissions
Salary paid to General Manager
Depreciation of single-product machinery

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EXERCISE 06:
Look at the following company data for the end of the final economic exercise 200X:

Several production supplies purchased 15,000

Costs of carrying raw material for production process 4,000

Accrued Wages – direct labour 320,000

Cost of preparation of machines - labour 10,000

Accrued Wages – indirect labour cost 40,000

Accrued Wages – administrative 30,000

Accrued Wages– selling 55,000

Accrued Wages - management 25,000

Premium for overtime - production 12,000

Depreciation of the machinery 65,000

Raw materials purchased 200,000

Depreciation of the factory facilities 10,000

Depreciation of the office facilities 2,000

Accident insurance – factory 3,000

Fire insurance – factory 5,000

Fire Insurance – office 3,000

Sales commissions 20,000

Raw material Transport expenses 25,000

Supplies used for machinery maintenance 500

Sales Transport expenses 2,500

Other consumptions – administrative 500

Question: Indicate whether each of the above cost concepts are production or non-production
costs and fixed or variable

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1) Grouping and classification of costs Fixed Variable Fixed Variable Fixed
Several production supplies purchased 15,000
Costs of carrying raw material for production process 4,000
Accrued Wages – direct labour 320,000
Cost of preparation of machines - labour 10,000
Accrued Wages – indirect labour cost 40,000
Accrued Wages– administrative 30,000
Accrued Wages – selling 55,000
Accrued wages - management 25,000
Premiums for overtime - production 12,000
Depreciation of the machinery 65,000
Raw materials purchased 200,000
Depreciation of the factory facilities 10,000
Depreciation of the offices facilities 2,000
Accident insurance – factory 3,000
Fire insurance – factory 5,000
Fire Insurance – office 3,000
Sales commissions 20,000
Raw material transport expenses 25,000
Supplies used for machinery maintenance 500
Sales transport expenses 2,500
Other consumptions – admin 500
Total costs 847,500

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