Why Cost Management?

Cost management systems not only provide reliable financial reporting, but they also
track costs to provide information for management decision-making.

The most important function of cost management is to help management focus on

factors that make the firm successful.
The management accountant can provide information about the sources of the firm’s
competitive advantage, such as the cost, productivity, or efficiency advantage the firm
has relative to competitors.
In determining whether a firm is achieving its goals and objectives, two aspects of
operations are important: effectiveness and efficiency.
• An effective operation is one that achieves or exceeds the goals set for the
operation. Maximizing shareholder value is the primary goal.
• An efficient operation is one that makes effective use of its resources in carrying
out the operation
 Cost vs. Expense
Costs are resources given up to achieve an objective.

Expenses are costs that have been charged against revenue in a specific accounting
period.

“Cost” is an economic concept, while “expense” is an accounting concept. A cost

need not be an expense, but every expense was a cost before it became an expense.
 Cost Object
A cost object is a term used primarily in cost accounting to describe something to which costs
are assigned. Common examples of cost objects are: product lines, geographic territories,
customers, departments or anything else for which management would like to quantify cost.

Costing System
Product costing involves accumulating, classifying and assigning direct materials, direct
labor, and factory overhead costs to products, jobs, or services. In developing a costing system,
management accountants need to make choices in three categories of costing methods:
1. The cost measurement method to use in allocating costs to units manufactured
(standard, normal, extended normal, or actual costing).
2. The cost accumulation method to use (job costing or process costing).
3. The method to be used to allocate overhead (volume-based or activity-based).
 Cost terms
Implicit Cost
Some costs do not reach the income statement. Implicit costs such as opportunity
costs never become expenses in the accounting records, but they are costs
nonetheless because they represent resources given up to achieve an objective.

Direct costs can be traced directly to a specific cost object.

Indirect costs are costs that cannot be identified with a specific cost object. In
manufacturing, overhead is an indirect cost.

A cost pool is a group of indirect costs that are grouped together for allocation using
the same cost allocation base. Cost pools can range from very broad, such as all
 Costs Based on Production Level
Costs can be based on their behavior as the level of activity changes. An activity is
an event, task, or unit of work with a specified purpose.
• Variable costs
• Fixed costs
• Mixed costs
Managers might require information in order to answer questions such as:
1. How will cost and revenue change if activity is increased?
2. What will be the impact on profits if Selling price is reduced by 10%?
Activity or volume may be measured in terms of units of production or sales, hours
worked, or any other appropriate measure of the activity of an organization.
 Variable Costs
Costs such as material and labor that are incurred only when a product is made.
• The per unit variable cost remains unchanged as production increases or
decreases.
• Total variable cost increases as production increases and decreases as production
decreases.
 Fixed Costs
Fixed costs do not change within the relevant range of production.
• As long as the production volume remains within the relevant range, the total
amount of these costs does not change with a change in production volume.
• The cost per unit decreases as production increases and increases as production
decreases.
Over a long enough period, all costs will behave like variable costs.
 Mixed Costs
Mixed costs have both a fixed and a variable component.
• A semi-variable cost is a small fixed amount plus a variable amount. It has a
basic fixed amount that must be paid regardless of the amount of activity (or
even in the event of no activity) and added to that fixed amount is an amount
that varies with activity.

• A semi-fixed cost stays fixed for a given range then jumps to the next highest
level where it is fixed for a while, and then jumps again. A semi-fixed cost, also
called a step cost or a step variable cost,
 Total Costs
Y = F + VX

Y = total costs
F = total fixed costs
V = variable cost per unit
X = total units produced

Variable cost remains constant per unit whereas fixed cost remains constant in
total.
 Product vs. Period Costs
In addition to the classification of costs based on their behavior as production changes, costs can
also be classified according to their purpose.

Product costs, or inventoriable costs, are those costs that go directly into the production
process, without which the product could not be made. Product costs are “attached” to each unit
and are carried on the balance sheet as inventory during production (as work-in-process
inventory) and when production is completed (as finished goods inventory) until the unit is sold.
The main types of product costs are: 1) direct materials, 2) direct labor, and 3) manufacturing
overhead (both fixed and variable).

Direct material
Direct labor
Manufacturing OH
Indirect labor
Indirect material
 Product vs. Period Costs
Direct material: Direct materials are the raw materials that are directly used in
producing the finished product.
Direct labor: Direct labor costs are the costs of labor that can be directly traced to
the production of a product.
Manufacturing OH: Manufacturing overhead costs are the company’s costs related
to the production process that are not direct material or direct labor but are necessary
costs of production. Examples are indirect labor, indirect materials, rework costs,
electricity and other utilities, depreciation of plant equipment, and factory rent.
• Indirect labor: A common example is labor cost for employees of the
manufacturing equipment maintenance department
• Indirect material: Examples are glue, screws, nails, and other materials such as
machine oils, lubricants, and miscellaneous supplies
 Groupings of Product Costs
The five main types of product costs can be further combined to create different cost
classifications.
• Prime costs = DM + DL
• Manufacturing costs = Prime costs + Manufacturing OH applied
• Conversion costs = Manufacturing OH + DL
Conversion costs are the costs required to convert the direct materials into the final
product. Direct labor is both a prime cost and a conversion cost.
 Period Costs
Period costs, as compared to product costs, are costs for activities other than
production of the product. Period costs can be variable, fixed or mixed, but they are
not included in the calculation of cost of goods sold or cost of goods manufactured.
The more commonly used examples of period costs include selling, administration,
and accounting.

• For financial reporting they are expensed.

• For internal decision making that may be allocated to production departments –
will do this later in the section.
 Other Cost Terms
• Explicit- Explicit costs are also called out-of-pocket costs. Explicit costs involve
payment of cash and include wages and salaries, office supplies.
• Implicit- An implicit cost, also called an imputed cost, is a cost that does not
involve any specific cash payment and is not recorded in the accounting records.
Implicit costs are also called economic costs. Implicit costs do not become
expenses.
• Opportunity cost- An opportunity cost is a type of implicit cost
• Carrying costs- Carrying costs are the costs the company incurs when it holds
inventory.
• Sunk costs- Sunk costs are costs that have already been incurred and cannot be
recovered. Sunk costs are irrelevant in any decision-making process
• Committed costs- Committed costs are costs for the company’s infrastructure. They
are costs required to establish and maintain the readiness to do business
• Discretionary costs- Discretionary costs, sometimes called flexible costs, are costs
that may or may not be incurred by either engaging in an activity or not engaging in
it, at the discretion of the manager bearing the cost.
 Other Cost Terms
Marginal costs- Marginal costs are the additional costs necessary to produce one
more unit.
Incremental/ differential costs- incremental cost refers to the additional cost
related to the decision to increase output. The cost of each alternative.
Both concepts are associated with a change in cost, but marginal cost refers to both
an increase and a decrease in output. When considering incremental cost, you take
into account only the total costs that change from your decision to produce extra
units, while the marginal concept focuses on the impact of a single unit of
production on costs and revenues.
Incremental revenue is focused on sales generated by multiple units, while marginal
revenue is calculated by analyzing the profits from the sale of one additional unit.
 Other Cost Terms
• Engineered costs: Engineered costs are a type of cost that can be directly
attributed to the design, engineering, and development of a product or process.
These costs are often seen in manufacturing industries, including expenses
related to materials, labor, and equipment needed to design and produce a
product.
• Avoidable costs: Any costs that can be eliminated is referred to as an avoidable
cost.
• Conversion Cost: is the sum of direct labor and manufacturing overhead costs
incurred to turn raw materials into a finished product.
• Cost allocation: the process of identifying and assigning costs to activities,
people, projects or any other cost objects.
• Irrelevant costs: Costs that will not be affected by a decision.
• Indirect costs: Costs that cannot be identified with a given cost object, is known
as overheads.
 Other Cost Terms
• Responsibility accounting: Tracing cost and revenues to a responsibility center.
• Responsibility Centre: A unit or entity within an organization, that is responsible for all
the activities and tasks structured for that unit, such as cost center, investment center,
revenue center, and profit center. It may be a product line, a geographical area, or any
other meaningful unit. For eg. Under the cost center, the manager is held responsible
only for the costs, including a production department, maintenance department, human
resource department, etc.
• Avoidable costs: Any costs that can be eliminated is referred to as an avoidable cost.
• Conversion Cost: is the sum of direct labor and manufacturing overhead costs incurred
to turn raw materials into a finished product.
• Cost allocation: the process of identifying and assigning costs to activities, people,
projects or any other cost objects.
• Irrelevant costs: Costs that will not be affected by a decision.
• Indirect costs: Costs that cannot be identified with a given cost object, is known as
overheads.
 Other Cost Terms
Cost Centers: Responsible only for the incurrence of costs (any revenue it may earn
is immaterial).
Revenue Centers: Responsible only for generating revenues and is not measured by
its expenses.
Profit Centers: Responsible for both the incurrence of costs and generating
revenue.
Investment Centers: Responsible not only for the incurrence of costs and
generating revenues, but also for providing a return on an investment

.
 Cost driver & Cost pool
A cost driver is anything (it can be an activity, an event or a volume of something)
that causes costs to be incurred each time the driver occurs. Examples of cost drivers
in a volume-based overhead allocation system are machine hours and direct labor
hours. Examples of cost drivers in an activity-based overhead allocation system are
set-ups, moving, number of parts, casting, packaging or handling.

Cost pools are the amount of money spent on an 'activity’. Cost pools are used in
activity-based costing to accurately determine where the money is spent rather than
splitting the overhead costs equally over all departments.
 Framework of Cost sheet
A cost sheet is a statement that shows the various components of total cost for a product and shows
previous data for comparison. You can deduce the ideal selling price of a product based on the cost
sheet.

Importance and objectives of cost sheet

1. Determining cost: The main objective of the cost sheet is to obtain an accurate product cost. It
gives you both the total cost and cost per unit of a product.
2. Fixing selling price: In order to fix the selling price of a product, you need to create a cost sheet
so you can see the details of its production cost.
3. Cost comparison: It helps the management compare the current cost of a product with a
previous per unit cost for the same product. Comparing the costs helps management take
corrective measures if costs have increased.
4. Cost control: Using an estimated cost sheet aids in monitoring labour, material and overhead
costs at each step of production.
5. Decision-making: Some of the most important decisions management makes are based on the
cost sheet. Whenever a business needs to produce or buy a component, or quote prices for its
goods on a tender, managers refer to the cost sheet.
 Cost of Goods Sold
Beginning finished goods inventory
+ Purchases (for a reseller) or cost of goods manufactured (for a
manufacturer)
− Ending finished goods inventory
= Cost of Goods Sold
 Cost of Finished Goods Manufactured
The COGM represents the cost of the units completed and transferred out of work-
in-process during the period.
COGM is an internal number, and it is not reported on either the balance sheet or the
income statement. COGM represents the cost of producing the units that were
completed during the period.

Neither cost of goods sold nor cost of goods manufactured includes indirect selling
and administrative costs such as sales, marketing and distribution, as those are period
costs.
 Cost of Finished Goods Manufactured
Direct Materials Used in the period
+ Direct Labor Used
+ Manufacturing Overhead Applied
= Total Manufacturing Costs
+ Beginning Work-in-Process Inventory
− Ending Work-in-Process Inventory
= Cost of Goods Manufactured
 Cost behavior patterns
There are four basic cost behavior patterns: fixed, variable, mixed (semivariable), and step.
• Fixed costs remain constant (in total) over some relevant range of output. Depreciation,
insurance, property taxes, and administrative salaries are examples of fixed costs. Recall
that so-called fixed costs are fixed in the short run but not necessarily in the long run.
Average FCs per unit decrease as the activity level increases
• Variable costs vary (in total) directly with changes in volume of production or sales. In
particular, total variable costs change as total volume changes.
• Mixed costs have both fixed and variable characteristics. A mixed cost contains a fixed
portion of cost incurred even when the facility is idle, and a variable portion that
increases directly with volume. Electricity is an example of a mixed cost.
• A step cost remains constant at a certain fixed amount over a range of output (or sales).
Then, at certain points, the step costs increase to higher amounts. For instance, the local
McDonald’s restaurant has one supervisor until sales exceed 100 meals during the lunch
hour. If sales regularly exceed 100 meals during that hour, the company adds a second
supervisor.
 Cost behavior patterns
There are four basic cost behavior patterns: fixed, variable, mixed (semivariable),
and step.
Cost behavior patterns
 Cost behavior patterns
Many costs do not vary in a strictly linear relationship with volume. Rather, costs
may vary in a curvilinear pattern—a 10% increase in volume may yield an 8%
change in total variable costs at lower output levels and an 11% change in total
variable costs at higher output levels.
Management is interested in a cost behavior within the company’s relevant range
(the range in which the company is expected to operate). For project managers who
work within a budget, cost behavior is an important and useful tool for Budget
creation, analysis of cost-volume-profit, cost control.
 Cost estimation methods
Cost Estimation is the process of determining how a particular cost behaves. It has a
cost driver (cause of the cost) which is likely to influence the cost. Some methods
used by cost analyst to estimate costs are:
1. Visual fit method: Plotting the recent observation of cost at various activity
levels. This method is appropriated by subtly plotting the cost in various stages
of activity on a graph and drawing the best-fit line across the points. The slope
of the line becomes the variable cost per unit, whereas the line crossing the y-
axis becomes the fixed cost.
2. High-Low method: The high and low level of activity are chosen together with
their associated costs to compute fixed cost components. This method considers
the lowest and highest stages of an activity to estimate the variable and fixed
costs, simultaneously ignoring the median data.
 Cost estimation methods
3. Least Squares Regression: This type of cost estimation analyses previous data
using a mathematical approximation to decide the fixed and variable units of a
cost and gives forth an equation that can be used to estimate future costs or
expenses.
Y= a +bX
where
Y- dependant variable
X – Independent variable
b- slope of regression line
a- intercept of the line.
4. Multiple regression: It is a statistical method that estimates a linear relationship
between on dependent variable with two or more independent variable.
 Management decision making
In order to make the right decisions, you need sufficient data.
Qualitative decision-making is a process of making decisions based on subjective
information, such as personal experiences, observations, and interpretations, rather than
objective data. The benefits of qualitative decision-making are many. Qualitative
decision-making allows for a more in-depth understanding of a problem or issue.

The triple bottom line is a business concept that states firms should commit to
measuring their social and environmental impact—in addition to their financial
performance—rather than solely focusing on generating profit, or the standard “bottom
line.” A firm’s success most heavily depends on its financial performance, or the profit
it generates for shareholders. Strategic planning initiatives and key business decisions
are generally carefully designed to maximize profits while reducing costs and
mitigating risk.
 Tripple bottom line
The triple bottom line is a business concept that states firms should commit to
measuring their social and environmental impact—in addition to their financial
performance—rather than solely focusing on generating profit, or the standard
“bottom line.”
• A firm’s success most heavily depends on its financial performance, or the profit
it generates for shareholders. Strategic planning initiatives and key business
decisions are generally carefully designed to maximize profits while reducing
costs and mitigating risk.

• The second component of the triple bottom line highlights a business’s societal
impact, or its commitment to people. It’s important to make the distinction
between a firm’s shareholders and stakeholders.
• The final component of the triple bottom line is concerned with making a
positive impact on the planet.
 Practice Question
A fixed cost that would be considered a direct cost is
A. A cost accountant’s salary when the cost objective is a unit of product.
B. Board of directors’ fees when the cost objective is the Marketing
Department.
C. The rental cost of a warehouse to store inventory when the cost objective is
the Purchasing Department.
D. A production supervisor’s salary when the cost objective is the Production
Department.
 Answer
Answer: D
A direct cost is one that can be specifically associated with a single cost objective in
an economically feasible way. Thus, a production supervisor’s salary can be directly
associated with the department (s)he supervises.
 Practice Question
An entity has the following cost components for 100,000 units of product for the
year:
Direct materials $200,000
Direct labor 100,000
Manufacturing overhead 200,000
Selling and administrative expense 150,000
All costs are variable except for $100,000 of manufacturing overhead and $100,000
of selling and administrative expenses. The total costs to produce and sell 110,000
units for the year are
 Answer
Direct materials unit costs are strictly variable at $2 ($200,000 ÷ 100,000 units).
Similarly, direct labor has a variable unit cost of $1 ($100,000 ÷ 100,000 units). The
$200,000 of manufacturing overhead for 100,000 units is 50% variable. The variable
unit cost is $1. Selling costs are $100,000 fixed and $50,000 variable for production
of 100,000 units, and the variable unit selling expenses is $0.50 ($50,000 ÷ 100,000
units). The total unit variable cost is therefore $4.50 ($2 + $1 + $1 + $0.50). Fixed
costs are $200,000. At a production level of 110,000 units, variable costs are
$495,000 (110,000 units × $4.50). Thus, total costs are $695,000 ($495,000 +
$200,000).
 Practice Question
A painting contractor maintains a job-order cost system. Job costs are accumulated
by tracking the actual cost of paint and other materials used on each job, as well as
the actual cost of wages earned by the painters on each job. In addition, overhead is
applied to each job by using a predetermined rate based on the actual painters’
wages. A painter earned $168 today by working on Job 08-45. In computing prime
cost and conversion cost for Job 08-45, how would the wages earned today by the
painter be classified?
A. As a component of both prime and conversion cost.
B. As a component of neither prime cost nor conversion cost.
C. As a component of conversion cost but not as a component of prime cost.
D. As a component of prime cost but not as a component of conversion cost.
 Answer
Answer: A
Manufacturing costs are often grouped into the following classifications: prime cost,
which equals direct materials plus direct labor (i.e., those costs directly attributable
to a product), and conversion cost, which equals direct labor plus manufacturing
overhead (i.e., the costs of converting raw materials into the finished product). The
wages earned by a painter working for a painting contractor are thus properly
classified as both a prime cost and a conversion cost.
 Practice Question
Which one of the following is true regarding a relevant range?
A. Total variable costs will not change.
B. Actual fixed costs usually fall outside the relevant range.
C. The relevant range cannot be changed after being established.
D. Total fixed costs will not change.
 Answer
Answer: D
The relevant range is the range of activity over which unit variable costs and total
fixed costs are constant. The incremental cost of one additional unit of production
will be equal to the variable cost.
 Practice Question
The difference between variable costs and fixed costs is
A. Variable costs per unit change in varying increments, while fixed costs per
unit change in equal increments.
B. Variable costs per unit are fixed over the relevant range and fixed costs per
unit are variable.
C. Variable costs per unit fluctuate and fixed costs per unit remain constant.
D. Total variable costs are variable over the relevant range and fixed in the
long term, while fixed costs never change.
 Answer
Answer: B
Fixed costs remain unchanged within the relevant range for a given period despite
fluctuations in activity, but per unit fixed costs do change as the level of activity
changes. Thus, fixed costs are fixed in total but vary per unit as activity changes.
Total variable costs vary directly with activity. They are fixed per unit, but vary in
total.
 Practice Question
A company reported the following cost information for the last fiscal year when it
produced 100,000 units.
Direct labor $100,000
Direct materials 200,000
Manufacturing overhead 200,000
Selling and administrative expenses 150,000
All costs are variable except for $100,000 of manufacturing overhead and $100,000
of selling and administrative expenses. Using flexible budgeting, what are the total
costs associated with producing and selling 110,000 units?
 Answer
Direct materials unit costs are strictly variable at $2 ($200,000 ÷ 100,000 units).
Similarly, direct labor has a variable unit cost of $1 ($100,000 ÷ 100,000 units). The
manufacturing overhead costs are $100,000 fixed and $100,000 variable, and the
variable manufacturing cost per unit is $1 ($100,000 ÷ 100,000 units). Selling costs
are $100,000 fixed and $50,000 variable for production of 100,000 units, and the
variable unit selling expenses is $.50 ($50,000 ÷ 100,000 units). The total unit
variable cost is therefore $4.50 ($2 + $1 + $1 + $.50). Fixed costs are $200,000. At a
production level of 110,000 units, variable costs are $495,000 (110,000 units ×
$4.50). Hence, total costs are $695,000 ($495,000 + $200,000).
 Practice Question
Jackson Co. has the following information for the first 4 months of this year:
Machine Cleaning
Hours Expense
January 2,100 $ 900
February 2,600 1,200
March 1,600 800
April 2,000 1,000

Jackson’s management expects machine hours for the month of May to be 1,400
hours. Using the high-low method, what is their expected total cost for the month of
May?
 Answer
The expected total cost, using the high-low method, can be found as follows:
First, calculate the variable cost per machine hour.

($1,200 – $800) ÷ (2,600 hours – 1,600 hours) = $0.40

Then, using the data from February (or March), calculate the expected fixed costs.

Total cost $1,200

Minus: Variable cost (2,600 hours × $0.40) (1,040)
Fixed cost $ 160
Finally, calculate the expected total cost.

Expected total cost = Expected fixed cost + Expected variable cost

= $160 + (1,400 hours × $.40 per hour)
= $160 + $560 = $720
 Practice Question
In a broad sense, cost accounting can best be defined within the accounting system
as
A. Internal reporting for use in management planning and control, and external
reporting to the extent its product-costing function satisfies external reporting
requirements.
B. Internal reporting for use in planning and controlling routine operations.
C. External reporting to government, various outside parties, and shareholders.
D. Internal and external reporting that may be used in making nonroutine
decisions and in developing plans and policies.
 Answer
Answer: A

Cost accounting is a combination of (1) management accounting in the sense that its
purpose can be to provide internal reports for use in planning and control and in
making nonroutine decisions, and (2) financial accounting because its product-
costing function satisfies external reporting requirements for reporting to
shareholders, government, and various outside parties.
 Practice Question
A manufacturing company estimates semi-variable costs by using the high-low
method with machine hours as the cost driver. Recent data are shown below.
Period
Semi-Variable Costs Machine Hours
1 € 100,000 22,000
2 120,000 30,000
3 96,000 23,600
If 29,000 machine hours were budgeted for the next period, estimated semi-variable
costs would total
 Answer
The difference in cost between the highest and lowest levels of activity for a group
of periods is divided by the difference in the cost drivers (activity level) at the two
levels. The highest level of activity is 30,000 machine hours, and the lowest level is
22,000 machine hours. Therefore, the variable rate for the variable portion is
calculated as follows: (€120,000 – €100,000) ÷ (30,000 – 22,000) = €2.50 per
machine hour. The fixed portion is then calculated as follows:
€120,000 = Fixed + 30,000 × €2.50
Fixed = €45,000
Now the answer can be calculated as follows:

Total costs = €45,000 + 29,000 × €2.50

= €45,000 + €72,500
= €117,500