02 - Cost Identification and Behaviour Flashcards
What are the learning outcomes for the Cost Identification and Behaviour chapter?
- Explain the concept of a direct cost and an indirect cost.
- Explain why the concept of “cost” needs to be defined, in order to be meaningful.
- Explain how costs behave as product, service or activity levels increase or decrease.
- Distinguish between fixed, variable and semi-variable costs.
- Explain step costs and the importance of timescales in their treatment as either variable or fixed.
- Calculate the fixed and variable elements of a semi-variable cost.
What must you know from the Cost Identification and Behaviour chapter?
- The need for costing systems.
- Costing terminology such as cost units, composite units, cost centres and cost objects.
- Classification of costs by nature and purpose.
- The uses to which information about the elements of cost can be put.
- Cost behaviour—fixed, stepped fixed, variable and semi-variable costs.
- How to analyse semi-variable costs using the high-low method and the scattergraph approach.
Why do organisations need costing systems?
Managers need information.
An organisation’s costing system is part of the internal financial information available to managers.
It forms the foundation of the system and provides the information that management needs to plan and control the organisation’s activities and to make decisions about the future.
What is the definition of ‘cost’?
Noun
The word ‘cost’ can be used as a noun e.g. when we are referring to the cost of an item.
Verb
Alternatively, it can be used as a verb, for example, we can say that we are attempting to cost an activity when we are undertaking the tasks necessary to determine the costs of carrying out the activity.
What is a ‘cost’ unit?
A cost unit is a unit of product or service in relation to which costs are ascertained.
A cost unit can be anything which is measurable and useful for cost control purposes.
Costing can be done on both tangible and intangible items:
- Tangible items are those which can be seen and touched
- Intangible items can neither be seen nor touched and do not have physical substance. However, they can be measured, for example, a chargeable hour of accounting service.
Other info
- A cost unit can be anything for which it is possible to ascertain the cost.
- The cost unit selected in each situation will depend on a number of factors, including the purpose of the cost ascertainment exercise and the amount of information available.
- Cost units can be developed for all kinds of organisations, whether manufacturing, commercial or public-service based.
What are composite cost units?
The cost units for services are usually intangible and they are often composite cost units, that is, they are often made up of two parts.
Examples
- Delivery - Tonne-mile
- Hotel - Bed-night
- Bus company - Passenger-mile
- Hospital - In-patient day
What are cost centres?
A cost centre is a production or service location, a function, an activity or an item of equipment for which costs are accumulated.
A cost centre is used as a ‘collecting place’ for costs.
The cost of operating the cost centre is determined for the period and then this total cost is related to the cost units which have passed through the cost centre.
A cost centre could also be a service location, a function, an activity or an item of equipment.
Examples
- Service location - Stores, Canteens
- Function - Sales representatives
- Activity - Quality control
- Item of equipment - Packing Machine
What is a cost object?
A cost object can be a product, service, center, activity, customer or distribution channel in relation to which costs are ascertained.
Why do costs need to be classified?
Costs can be classified in many different ways.
To devise an efficient system to collect and analyse costs, all costs must be classified, that is, arranged into logical groups.
The classifications selected and the level of detail used in the classification groupings will depend on the purpose of the classification exercise.
Definition
Classification is defined as the arrangement of items in logical groups by nature, purpose or responsibility.
How would you classify costs by their nature?
Material
Material costs include the cost of obtaining materials and receiving them within the organisation
The cost of having the materials brought to the organisation is known as carriage inwards.
Labour costs
Labour costs are those costs incurred in the form of wages and salaries, together with related employment costs.
These costs are documented internally, the amount of wages and salary costs being determined by reference to agree rates of pay and attendance time and output measures, depending on the method of remuneration being used.
Expense costs
Expense costs are external costs such as rent, business rates, electricity, gas, postage, telephones and similar items which will be documented by invoices from suppliers.
How would you classify costs by their purpose?
When costs are classified by purpose, they are grouped according to the reason for which they have been incurred.
Broadest classification - direct vs. indirect
It is important for you to realise that a particular cost may sometimes be a direct cost and sometimes an indirect cost. It depends on the cost object we are trying to cos
Direct
A direct cost is one that can be clearly identified with the cost object we are trying to cost.
Indirect
Other costs incurred would be classified as indirect costs. They cannot be directly attributed to a particular cost unit, although it is clear that they have been incurred in the production of the table.
What are the elements of cost?
The elements of cost are the constituent components which together make up the total cost of a cost object.
The outline cost statement for a single cost unit shown below illustrates how the total or full cost for a unit might be built up. Notice in particular that a number of subtotals can be highlighted before the total cost figure is determined.
The usefulness of each of these subtotals depends on the management action that is to be taken based on each of the totals.
What is the prime cost?
The prime cost is the total direct cost.
How can profit be related?
It can be related to cost or selling price.
The important thing in an assessment question is that you should establish whether profit is to be calculated as a percentage of cost or as a percentage of selling price.
What is cost behaviour in management accounting terms?
Many factors affect the level of costs incurred; for instance, inflation will cause costs to increase over a period of time.
However, in management accounting, when we talk about cost behaviour we are referring to the way in which costs are affected by fluctuations in the level of activity.
The level of activity can be measured in many different ways. For example, we can record the number of units produced, miles travelled, hours worked, meals served, percentage of capacity utilised and so on.
Why is it important to understand cost behaviour?
An understanding of cost behaviour patterns is essential for many management tasks, particularly in the areas of
- planning,
- decision-making
- and control.
It would be impossible for managers to forecast and control costs without at least a basic knowledge of the way in which costs behave in relation to the level of activity.
