Cost Concepts

XIMB 2016 September

Dr. Manaswee K Samal
Learning Objectives
Relation between cost concepts, cost
objects and cost drivers
Difference between direct and indirect
cost
Cost behaviour
Inventoriable cost and period cost
Different cost for different purposes
Judgment and cost
What is cost?

COST is a resource that is sacrificed to attain

an objective.

Cost of a building?
Cost of manufacturing inventory?
Cost of advertisement?
Concept to practice
What is the cost of attaining your degree from
XIMB?
All explicit costs or implicit costs?
Which components are out of pocket costs?

What is the cost of equity capital used by TCS in

its business?
Do you think this cost is charged to the income
statement?

How do you choose a car to buy if you are a cost

conscious person?
Cost Object

Cost is determined for something called Cost

Object.
Examples of Cost Objects
Examples:
Product: Rafale fighter jet
Service: Inspection of Banks
Project: R&D project for Ebola vaccine
Customer: Dealer of LG Electronics
Department: Accounting department
Process: Grinding department cost per
hour
Discussion
Five different types of cost objects in XIMB
Cost driver

What are the cost drivers in the following

cases?
Tyre cost used for manufacturing of Ciaz car
Fuel cost for a transport company
Insurance cost of vehicles of a transport
company (assume same type of vehicles)

Understanding cost driver is necessary for

understanding competitive cost advantage.
Types of cost drivers
Activity based cost drivers (subject of
discussion)

Volume based cost drivers (subject of

discussion)

Structural cost drivers

Executional cost drivers

Volume based cost drivers
Many costs are volume based.
Examples: Direct material, Direct labour paid on
piece rate basis

Total volume based cost: nonlinear relation with

cost driver- due to increasing marginal
productivity, then law of diminishing productivity
sets in as you reach capacity limit

A linear approximation of the total cost curve

within a small range will be a straight line
relevant range
Structural cost drivers
Strategic in nature

Involve plans of long term effect around

scale, experience, technology and
complexity
Scale- how much to invest: 6 /9 million ton plant?
Experience- prior experience in its current and
planned products and services
Technology- huge cost saving
Complexity: How many products, what markets?
Executional cost drivers

Factors the firm can manage in the short-term

operational decisions to reduce cost
Workforce involvement
Process design: faster movement of the
product
Supplier relationship: Quality, timeliness, cost
What is relevant range?

A band of normal activity level where the activity

level has relation with the cost in question.

Ex: Fixed cost is fixed in relation to a range of

output and a given time span.

Variable cost may not rise proportionately

beyond a range.

Ex.- may be due to discount on material

purchase.
Cost Behaviour
Fixed Cost
Fixed how long?: may have cost drivers in a long run
Ex.- Testing cost (equipment and staff cost) may be pruned
down in accordance with production level in the long run.
Variable Cost
Semi-variable Cost
Peculiarities:
A cost could be variable in relation to one variable whereas
it could be fixed for another.
Not inherently fixed or variable
Many costs are semi-variable in nature
Impact of business process
Concept to practice
Give an example of a variable cost for your
programme in relation to number of students
from XIMBs point of view

Give an example of a fixed cost for your

programme in relation to number of students
Direct and Indirect cost

Direct cost:
Traceable to the cost object

Indirect cost:
Cannot be traced, need to be allocated (find the
driver and allocate)
Factor affecting direct and indirect cost classification:
Materiality of cost

Information gathering technology

Design of operations

Cost object chosen

Different types of costs

Cost object: Baleno car manufactured by Suzuki

(With some assumptions, of course)

Direct and variable: Cost of steering wheels

Direct and fixed: Salary of supervisor
Indirect and variable: Power of the plant
Indirect and fixed: Lease rent of plant
Concept of Total cost & Unit
cost
Unit cost is an average.
Total cost is difficult to interpret: so unitize
But unit cost is misleading in some cases:

Level of prod. Unit cost SPU

8000 units Rs.102 Rs.110
9000 units Rs. 98 Rs.105
Present level
10000 units Rs. 95 --------
X offers Rs.70 per unit for 1000 units.
Will you accept this order?
PERIOD COSTS AND INVENTORIABLE
COSTS

Inventoriable cost/ product cost: Cost which is

regarded as asset when incurred, but becomes a
part of cost of goods sold when the product is
sold. For Honda, all manufacturing cost is
inventoriable cost. (Raw material to WIP to
Finished goods)

Period costs (non-product cost): All costs in

income statement except cost of goods sold
So, in a mfg. sector unit, all non-manufacturing
costs are period costs. (Ex. Distribution cost, R&D
costs, Marketing costs, customer-service costs,
etc.)
Many meanings of product cost
Pricing and product-mix decisions:
Cost incurred in all business functions of the
value chain (R& D cost to Customer service
cost)
Contracting with Government agencies: Scope
of the contract defines
Preparing Financial Statements: Production
cost

Popular slogan: Different costs for

different purposes..
COST MEASUREMENT AND JUDGMENT

When is overtime premium on direct labour

considered as indirect cost?
Overtime premium: generally considered as
overhead. The reason is that it is not prudent
to burden the last batch of work simply
because it is a work during the overtime
period. It is only a scheduling. As opposed to
this, if overtime is due to a rush job, it is a
direct cost of that job.

Idle time due to breakdown, scheduling

problems, lack of order, etc. are overheads.
 Some more ways of cost
classification
Elemental classification of cost: Material, Labour,
Other Expenses

Functional Classification:
R&D cost
Design cost
Production- Expenses till goods are ready for despatch
Administration- Directing the organisation
Selling (to create demand and secure orders) Ex. Bad
debts, market research, price lists, catalogues,etc.
Distribution-(from point of production till consumption)
Ex.- Warehouse expenses, carriage outward,
depreciation of delivery vans, etc.
Financing costs: costs for raising and using capital
Commercial cost is cost beyond manufacture, i.e.,
Admin. and S&D cost.
Continued

Controllability:
From responsibility point of view:
controllable / uncontrollable

Normality: normal/abnormal

Planning & control: Budgeted Cost &

Standard Cost
Relevant cost
What is pertinent for decision on hand?

Out of pocket costs: cash outflow involved

Differential costs: Change in total cost due to

change in level of activity or method of
production. Could be incremental or
decremental.

Opportunity cost: Benefit forgone from not

choosing the next best alternative available.
Cont..
Irrelevant cost: not relevant for decision
making
Example: Sunk costs: Sunk cost is the cost
of abandoned plant less salvage value. Not
relevant for decision making.

Imputed (Notional cost): Actually not

incurred (interest on own capital, rent on
owned building, etc.) Taken into account in
capital budgeting decisions.

Replacement cost: Cost of replacing at

current market price.
Cont..
Avoidable and unavoidable cost: Cost
that can be avoided by eliminating a
product or department is avoidable and
that which cannot be, is unavoidable.

Example: Rent of factory is unavoidable if a

product is discontinued.
Some more cost concepts:
Future costs: cost to be incurred in future
Programmed cost: Cost incurred as per policy of top
management. Ex.- Donation to charity.
Joint cost: cost of joint or by-products incurred before
separation, which cannot be traced to particular
products.
Conversion cost: cost of converting raw material to
finished goods = Production cost minus direct material.
Discretionary cost: not essential for decision on
hand. Ex.- Training expenses of workers, R&D cost,
Advertisement costs, etc. (Be careful, managers play
around these costs)
Committed cost: Costs incurred due to past decisions
and are not within control in the short run at present.
Ex.- Depreciation on Plant, Rent, etc.
Definitions
COST UNITS
Unit of output in production or service in relation to
which cost may be ascertained or expressed.
Examples of cost units: Motor car in MUL, Passenger
km. for a transport operator, Cubic meter for gas,
1000 no. of capsules in pharmaceutical industry,
etc.

COST CENTRES
Smallest segment of activity or area of responsibility
for which cost is accumulated. A department might
have many cost centers. Examples of cost centres:
location, a person, a machine, etc.
P-1
X had placed an order for purchase of a special machine from
Y. As per contract, X had given an advance of Rs.15,000 to Y
which is to be adjusted against the contract price. Y has incurred
Rs.70,000 as on date on fabrication of the machine. X backs out
of the contract at this stage. Y finds another customer Z with lot
of difficulty who needs the machine with some modifications and
is prepared to pay Rs.40,000 for the machine. Y estimates that
the modification would cost as under:

Unused components procured for this machine costing Rs.7000

will fetch Rs.3,000 in the local market if not used for the
machine.

Additional labour required for this job needs to be diverted

from another contract where they would have earned profit of
Rs.30,000.

For the old machine, Y had entered into a contract with Bob for
designing of the machine for a fee of Rs.5,000. If his service is
not used, Bob will get Rs.2,000.
General head office overheads of Rs. 7,000 will be allocated to
this contract. Should Y accept Zs offer?
P-2

A machine was purchased in 2012-13 at a cost of

Rs.40,000. Its estimated useful life is 8 years and
salvage value is nil. SLM is followed for
depreciation. It has been unused for the last eight
months as there is no demand for the products for
which this machine was used. A customer places
one order that would use this machine for next
four months. Estimated net disposal value of the
machine at present is Rs.20,000. If the order is
accepted, the machine can be disposed for
Rs.15,000 after four months. The net book value
of the machine is Rs.25,000. Current regular
maintenance expense for the machine is Rs.400
per month. If the machine is used, this cost
would be Rs.500 per month. Estimate the
machine related cost for the new order?
P-3
X Ltd. has been approached by a customer who would
like a special job to be done for him and is willing to pay
Rs.40,000 for it.
Material B is used regularly by X Ltd. and if stocks are
required for this job, they would need to be replaced to
meet other production demand.
Materials C and D are in stocks as a result of previous
excess purchase and they have restricted use. No other
use could be found for material C but material D could
be used in another job as substitute for 300 units of
material E which currently costs Rs. 5 per unit (of which
the company has no units in stock at the moment).
What are the relevant costs of material, in deciding
whether or not to accept the contract? Assume all
other expenses on this contract to be specially incurred
besides the relevant cost of material is Rs. 15,000.
P-3 continued

The job would require the following materials:

Material Total Units Book value Realisable Replacement

units in stock of units in value cost
required stock Rs./unit Rs./unit
Rs./unit

A 1000 0 0 0 6

B 1000 600 2 2.5 5

C 1000 700 3 2.5 4

D 200 200 4 6 9
Questions, please

THANK
YOU