APPLIED MANAGEMENT ACCOUNTING AND FINANCE – Module 1 MAF 401

CHARTERED ACCOUNTANTS ACADEMY

MANAGEMENT ACCOUNTING AND FINANCE DEPARTMENT

CERTIFICATE OF THEORY IN ACCOUNTING

STUDY UNIT 4 – COST CLASSIFICATION

Contents
1. Introduction .......................................................................................................................... 2
2. Objective of Cost Classification ............................................................................................. 2
3. Study material ....................................................................................................................... 2
4. Competence Framework expectation ................................................................................... 3
5. Examination possibilities....................................................................................................... 3
6. Assumed Knowledge ............................................................................................................. 3
7. Integration............................................................................................................................. 3
8. Course Notes ......................................................................................................................... 3
8.1 Costing ................................................................................................................................ 3
8.2 Cost Behaviour .................................................................................................................... 4
8.3 Product costing and accounting basis................................................................................. 4
8.4 High-Low Method ............................................................................................................... 6

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APPLIED MANAGEMENT ACCOUNTING AND FINANCE – Module 1 MAF 401

1. Introduction

Introduction

This unit provides guidance on the principles behind costs.

2. Objective of Cost Classification

After studying this unit, you should be able to:

Define and illustrate a cost.

Explain and distinguish the following costs:

• Variable costs;

• Fixed costs;

• Semi variable and semi fixed; and

• Direct and indirect costs.

Apply and describe the different methods of estimating costs.

What is the high-low method and linear regression and when do we use it?

3. Study material
Management and Cost Accounting 8th Edition by Colin Drury.
CAA Applied Management Accounting and Finance MAR 402 Module 1.

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APPLIED MANAGEMENT ACCOUNTING AND FINANCE – Module 1 MAF 401

4. Competence Framework expectation

5. Examination possibilities
Highly examinable in a costing question.

6. Assumed Knowledge
The following is assumed knowledge which you should already have at CTA level.

1. Identifying costs and cost centers.

7. Integration
This topic can be integrated with the following topics/ subject areas

Inventory Costing
Relevant Costing and Constraint Optimization
Strategy and Risk Management
Enterprise Risk Management
8. Course Notes

8.1 Costing
It is the process of determining the costs of products, services or activities. Cost accounting
is used to determine the cost of products, jobs or services (whatever the organisation
happens to be involved in). Such costs must be built up using a process known as cost
accumulation.

Costs/Expenses for Management Accounting

A cost is a sacrifice of a resource (economic benefit) be it immediate, or future. The cost can
be an asset/expense. Expense is a cost that is charged against revenue in that operating
period. Operating profit is the excess of operating revenues over operating costs of the same
period.

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APPLIED MANAGEMENT ACCOUNTING AND FINANCE – Module 1 MAF 401

Note: a cost is not equivalent to an expense, cost accounting focuses on costs not
expenses.

Costs can be two types

Outlay cost- this is a cost that will result in past, present or future cash flow.
Opportunity cost- a cost of lost benefit (opportunity) of not using that resource
elsewhere.

8.2 Cost Behaviour

Variable cost: costs that vary with the level of output. They include direct materials, labour
and sales commission.

Fixed cost: Includes all costs that do not vary with activity for an accounting period. Fixed costs
are, at any time, the inevitable costs that must be paid regardless of the level of output and
of the resources used. A Fixed Cost is therefore not an Opportunity Cost.

Step fixed costs: A type of expense that is constant over a low level shift in activity, but which
changes incrementally when the activity shifts substantially. For example, a manufacturing
business would need to buy new production machinery to step production activity up another
level.

Mixed Cost (Semi-variable): A cost with both fixed and variable elements. Wage costs for
employees who are paid a monthly salary plus commissions are a good example of mixed
costs.

8.3 Product costing and accounting basis

These are the aggregated of costs that are associated with a unit of product. Such Costs may
or may not include an element of overheads depending upon the type of costing system
(marginal or absorption costing). Product costs are related to goods produced or purchased
for resale and are initially identifiable as part of inventory. These product or inventory costs
become expenses in the form of cost of goods sold only when the inventory is sold. Product
cost is associated with units of output. The costs of inputs in forming the product are direct
material, direct labour and factory overhead.

Direct cost: is a cost that can be traced in full to the product, service or department that is
being costed.

Indirect cost or overhead: is a cost that is incurred in the course of making a product, providing
a service or running a department, but which cannot be traced directly and in full to the
product, service or department.

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APPLIED MANAGEMENT ACCOUNTING AND FINANCE – Module 1 MAF 401

Absorption (Full) costing is a means of incorporating a fair share of these costs into the cost
of each unit of product manufactured or each service provided.

Variable (Marginal costing): costing which only includes variable manufacturing costs (i.e. unit
costs represents the additional cost of producing one additional unit).

Decision-making costs
Relevant and Irrelevant costs: are those future costs and revenues that will be changed a by
a decision, whereas irrelevant costs will not be changed by a decision.

Avoidable and unavoidable costs: Avoidable costs are those costs that can be saved by not
adopting a given alternative, whereas unavoidable costs cannot be saved.
Avoidable/unavoidable costs are alternative terms sometimes used to describe
relevant/irrelevant costs.

Sunk costs are the costs of resources already acquired and are unaffected by the choice
between the various alternatives (e.g. depreciation). Sunk are irrelevant for decision-making.

Opportunity cost: a cost that measures the best opportunity that is lost or sacrificed when the
choice between the various alternative courses of action is taken.

Management control
Discretionary: costs which can be avoided by management. Such costs are not permanent.
Advertising, research and development cost, salaries of low-level managers are examples of
discretionary costs because these costs may be avoided or reduced in the short run if so
desired by the managements.
Committed costs is a cost or obligation that a business entity has already made and cannot
recover or cannot get out of. Costs, like rent for example. These costs are not easily changed
and are often fixed.

Engineered costs: costs having a clear relationship to output. Direct materials cost is an
example.

Period costs: These are costs that tend to be unaffected by changes in level of activity during
a given period of time. A period cost is associated with a time period rather than
manufacturing activity and these costs are deducted as expenses during the current period
without having been previously classified as product costs. Selling and distribution costs are
period costs and are deducted from the revenue without their being regarded as part of the
inventory cost.

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APPLIED MANAGEMENT ACCOUNTING AND FINANCE – Module 1 MAF 401

Cost Estimations: Costs must be separated between fixed and variable components and
various methods can be used to derive a linear cost equation:

y = a + bx y = total cost (dependent

variable) x = activity measure
(independent variable) a = fixed cost per
period
b = variable cost per unit of activity (gradient) Techniques
to derive a linear equation:
• High/low method
• Scatter graph;
• and linear regression analysis
8.4 High-Low Method
- Considers the highest and lowest points based on activity level, cost:

Example 1
Highlow (Pvt) Ltd wants to determine the cost-volume relation between its factory overhead
cost and number of units produced. Use the high-low method to split its factory overhead
(FOH) costs into fixed and variable components and create a cost volume formula. The volume
and the corresponding total cost information of the factory for past eight months are given
below:

Month Units FOH

1 1,520 $36,375
2 1,250 $38,000

3 1,750 $41,750

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APPLIED MANAGEMENT ACCOUNTING AND FINANCE – Module 1 MAF 401

4 2,100 $48,100
5 3,000 $59,000
6 2,750 $56,800
Solution:
Highest activity: x2 =3,000; y2 =59,000
Lowest activity: x1 = 1,250; y1 = $38,000
Variable Cost per Unit = ($59,000 − $38,000) ÷ (3,000 − 1,250) = $12 per unit Total Fixed Cost
= $59,000 − ($12 × 3,000) = $38,000 − ($12 × 1,250) = $23,000
Cost Volume Formula: y = $23,000 + 12x
Evaluation of the method
Quick and simple, but
Only two observations used:
How representative of population?
Especially being extreme values?
Maybe a starting point (quick estimate)

Example 2
The following behavior pattern has been observed for costs at different production levels:

Volume Price level index Cost $

100 000 100 100 000
90 000 120 110 000
120 000 125 148 000
130 000 140 175 000
Required
(i) Predict the cost at a volume of 150 000 units with a price index of 150, using the
highlow method; (3)
(ii) Indicate whether the high-low method will give the best cost estimate, and to suggest
an alternative method that can be used. (1)
(4)

EXAMPLE 2- SOLUTION

(i) Volume Adjusted cost

100 000 150 000 (100 000 x 150)

100

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APPLIED MANAGEMENT ACCOUNTING AND FINANCE – Module 1 MAF 401

130 000 187 500 (175 000 x 150)

140
= 187 500 – 150 000 (1)
130 000 – 100 000

= $1.25 variable cost/unit (½)

Therefore, fixed costs = $150 000 - (100 000 x 1.25) or 187 500 (130 000 x 1.25)

= $25 000 fixed costs (½)

y = 25 000 + 1.25x
= 25 000 + (1.25 x 150 000) (1)
= $212 500
(3)
The principles are: The low level is given by the price level index of 100; costs are adjusted to
the required price index, in this case 150. The high-low is then applied.

Alternative:
Adjusted Cost = 175 000 = $125 000 (½)
1.4

= $0.833 variable cost/u (½)

Total Fixed Cost = 125 000 - (130 000 x 0.833) or 100 000 - (100 000 x 0.833)
= $16 710 or $16 710 (½) y =
16 710 + 0.833 x
= 16 710 + 0.833 (150 000)
= $141 660 (1)
Value at price index of 150 = $141 660 x 1.5 = $212 490.

(ii) The high-low method will not give the best estimate. (1)
A more accurate estimate would be obtained by adjusting all four years to common price levels
and carrying out simple linear regression analysis. (½)

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