Cost Concept

Expenses: relate to value offered where it has not yet been determined whether the
expenses will be applied effectively.
As soon as the expenses are applied effectively,
we can speak of cost.

Value Offered

Wastage is the difference

If the expenses are not applied effectively, the between the total
expenses are wastage (loss).
expenditure and the
effective expenditure
Example
In a manufacturing environment certain materials are used in the production process, and it will
be an expense to purchase the material. If under normal circumstances 80% of the material is
used successfully and 20% is discarded, this discarded portion cannot be regarded as wastage as
it is part of the normal manufacturing process. Should more than the normal 20% be discarded
this additional portion will be an avoidable wastage and considered to be a loss.
Wastage is a loss but that all losses cannot be regarded as wastage. Wastage is thus all expenses
that were not necessary for producing a product or delivering a service.
Wastage may have different causes, for example,
1. ineffective administration,
2. working methods,
3. marketing, and distribution of expensive production resources.
 What is Cost
Costs are expenses which are economically unavoidable and technically essential to
produce a product or service.
1. The basic materials required to manufacture a product, like metal for car parts. (Y/N) ?
2. The potential benefits lost when one option is chosen over another. (Y/N)
3. Wages paid to workers for their time and skills used in producing a product or service (Y/N)
4. Past expenses that have already been incurred and cannot be recovered (Y/N)
5. Indirect costs related to production, such as factory rent, utilities, and maintenance.(Y/N)
6. While important for selling the product, these are not technically essential to production (Y/N)
7. The reduction in value of assets (e.g., machinery) over time as they are used in production.(Y/N)
8. Expenses related to developing new products or improving existing ones.(Y/N)
 Item Description
The basic materials required
Raw Materials to manufacture a product, like
metal for car parts.
Wages paid to workers for
their time and skills used in
Labor
producing a product or
Table 1: Examples of Costs service.
Indirect costs related to
production, such as factory
Manufacturing Overhead
rent, utilities, and
maintenance.
The reduction in value of
assets (e.g., machinery) over
Depreciation
time as they are used in
production.
Expenses related to
Research and Development developing new products or
improving existing ones.
 Item Description
The potential benefits lost when one
Opportunity Costs option is chosen over another. Not a
direct cost.

Past expenses that have already been

Table 2: Items Not Reflecting Costs Sunk Costs incurred and cannot be recovered.

Anticipated earnings; these are

Expected Future Profits speculative and not incurred during
production.

While important for selling the product,

Marketing and Advertising these are not technically essential to
production.

Costs related to financing and

Interest on Investments investments, not directly tied to the
production process.
However, in certain instances it is not so easy to determine the costs of products or services.
For example if management requests a 100-page computer printout regarding a specific
aspect, how will the cost of the printout be determined?
In border term

Cost is a monetary measure of the resources given or expensed to

acquire goods or services that benefit the enterprise at present or in
the future.
Cost Object
The cost object is any product, activity (service) or project requiring the costs to be measured.
A cost object is not the actual costs: it is the products, services, departments, divisions or any
other activity or object which requires to the cost to be determined.
Deferred Vs Expensed Cost
 Cost Classifications
All the costs that are allocated to a cost object can be classified in a variety of ways.
1. Manufacturing costs :Manufacturing costs is the sum of all the costs incurred in the
manufacturing process, direct materials, direct labour and manufacturing overhead.
2. Commercial costs: Commercial costs are all non-manufacturing costs that support the
effective functioning of the business as a whole and can be divided into:
◦ marketing costs are part of commercial costs and include all the costs associated
with the promotion of the product, the acquisition of orders, the administration of
the marketing function and the delivery of finished goods; and
◦ Administrative costs relate to executive, organizational and clerical costs of an
enterprise, which exclude the costs, related to the manufacturing and marketing
functions
Cost classification by Timing
Period costs are the costs associated with a given accounting period rather than a given
product.
◦ marketing and administrative costs are normally costs incurred to generate income in a given period
but it is not relative to the sale of given units.
Product costs, on the other hand, are costs associated with the products that are manufactured. Since
this type of cost is coupled with the product it is sometimes treated as an asset and sometimes as an
expense, depending on whether the product with which the cost is associated has already been sold.
If still on hand it will be an asset (for example, cost of finished goods on hand) and will thus be shown as
an asset in the Statement of Financial Position. Once the product is sold the cost becomes an expense
and is transferred to the cost of goods sold and brought into account against the income generated by
the sale of the product in the Statement of Profit or Loss.
Difference between COFG and COGS
Cost of Finished Goods (COFG): This refers to the total cost incurred to manufacture products that
are completed and ready for sale.
◦ direct materials,
◦ direct labor, and manufacturing overhead allocated to the products up to the point they are finished.

The cost of finished goods is reported as an asset on the balance sheet under inventory until the
goods are sold. It represents the value of inventory that is ready for sale but has not yet been sold.
Cost of Goods Sold (COGS): COGS is the cost attributed to the production of goods that have been
sold during a specific period. It also includes direct materials, direct labor, and allocated overhead,
but only for the products that have actually been sold to customers.
Unlike the cost of finished goods, COGS is reported on the income statement. It is deducted from
revenue to calculate the gross profit. COGS directly affects the profitability and tax liability of a
business.
 AMOUNT
DESCRIPTION (USD)

Raw Materials $20,000

Table 1: Cost of Finished Goods
Example
Direct Labor $10,000

Manufacturing Overhead $5,000

Total Cost of Finished $35,000

Goods
 Amount
Description (USD)
Beginning Inventory $15,000
Table 2: Cost of Goods Sold Example Plus: Purchases $25,000
Plus: Production
$20,000
Costs
Less: Ending
$10,000
Inventory
Total Cost of
$50,000
Goods Sold
Classifying cost by their functions
Management decides what the cost of goods manufactured in a manufacturing enterprise
consist of. They do this by:
1. knowing which costs are product costs in such an enterprise; and
2. understanding the flow of costs through the accounts of a manufacturing enterprise.

Product manufacturing costs consist of the following three elements:

◦ Direct material
◦ Direct labour
◦ Manufacturing overheads.
Direct material consists of primary material and is easily traceable to the manufacturing of
goods or services rendered. It forms an integral part of the final product and usually consists of
a predetermined measurable quantity proportional to the volume of production usage.

Indirect material consists of secondary material which may or may not form part of the
end product and the quantity used is not directly related to the volume of production. It
cannot be conveniently linked directly to a cost object.
the concept direct labour refers to the cost of all essential labour physically expended on the
manufacturing of a product and can be conveniently traced to the manufacturing of goods or
services rendered.
Indirect labour can thus be defined as labour costs that cannot be conveniently linked directly
to a cost object.
Manufacturing overheads refer to all other costs (excluding direct material and direct
labour cost) expended in the manufacturing process. Examples of manufacturing
overheads are indirect material, indirect labour, depreciation and insurance costs of
production machinery and equipment.
The primary characteristic of manufacturing overheads is that they cannot be attributed
directly to a particular unit, but they are, in fact, incurred during the production process.
Two further sub classifications of production are: primary costs; and conversion costs.
Primary costs refer to the total of the direct material and direct labour costs. Initially in the
development of costing, the emphasis was on these two relatively easily determinable costs
only, while manufacturing overheads were (wrongly) treated as mere period costs.
The concept conversion cost is still commonly used today and has a bearing on the total of the
direct labour costs and manufacturing overheads. In this context the concept of conversion cost
refers to the cost that must be employed to convert raw materials to a finished product, which is
direct labour and manufacturing overheads
Classification by Behavior
Costs may be classified according to the way that they behave in relation to
changes in levels of activity. Cost behavior classifies costs as one of the
following:

• Variable cost
• Fixed cost
• Stepped fixed cost
• Semi-­variable cost.
Variable Cost
A variable cost is one the total of which changes in direct proportion to changes in activity level.
If production increases by ten percent, total variable costs will also increases by ten percent. It is
important to note that total amount of variable cost increases or decreases with activity level, but
per unit variable cost is a constant amount. Direct materials and direct labour are good examples
of variable costs.
 Variable Factory Overhead
Supplies
Fuel
Power
Small tools
Spoilage, Salvage, and Reclamation Costs
Receiving Costs
Royalties
Communication Costs
Overtime Premium
Hauling within Plant
 Fixed Cost
Annual Depreciation Number of Automobiles Produced Average Fixed Cost Per Unit

Rs. 100,000 100 Rs. 1,000

Rs. 100,000 1,000 Rs. 100

Rs. 100,000 10,000 Rs. 10

Stepped Fixed Costs
This is a type of fixed cost that is only fixed within certain levels of activity. Once the upper limit
of an activity level is reached then a new higher level of fixed cost becomes relevant.
• Examples of stepped fixed costs:
– warehousing costs (as more space is required, more warehouses must be purchased or rented)
– supervisors’ wages (as the number of employees increases, more supervisors are required).
Semi-variable Cost
Semi­-variable costs contain both fixed and variable cost elements and are
therefore partly affected by changes in the level of activity.
Examples of semi-­variable costs:
– Electricity bills (fixed standing charge plus variable cost per unit of electricity consumed)
– Telephone bills (fixed line rental plus variable cost per call)
Big T manufactures printed T-shirts. A selection of costs associated with the manufacturing process of the
T-shirts and the general operations of the company are provided below:
1. A single printed T-shirt uses one of the 7 standard colours of T-shirt to print on. Such a standard
colour T-shirt costs R25.
2. Each T-shirt is manually loaded into and out of the printing machine and at the same time a quality
check is performed on the T-shirt. Such an employee will earn a monthly salary of R12 000.
However, for any special orders that required the employee to come to work over a weekend, an
additional R2 per T-shirt is paid to the worker, over and above his/her normal monthly salary.
3. Each job order is also quality inspected by a factory supervisor who is paid a monthly salary of R25
000 per month regardless of the level of production.
4. Electricity consumption per printing machine averages at R150 per hour regardless of whether it is
active or id
5. The depreciation cost of the printing machine used to print on the T-shirts totals R25 000 per year.
6. The salary of the operations director is R225 000 per year.
7. Big T spends R200 000 per year on advertisement costs
8. Sales personal do not earn a salary but are paid R2.50 per T-shirt sold. Big T orders the 7 standard
colour T-shirts in bulk from its supplier in the East. Big
9. T stores these bulk orders of inventory in a storage facility at a fixed cost of R30 000 per month. At
times, this storage facility is insufficient in capacity, resulting in Big T renting out more storage space
at an additional R10 000 per month to mitigate this issue