Cost Classification and Cost Behaviour

Question 1

Accounting =

Answer 1

A process of identifying, recording, processing, summarizing and reporting economic information to decision makers

Question 2

Financial accounting

Answer 2

Focuses on the specific needs of decision makers external to the organization, whereas

Question 3

Management accounting =

Answer 3

Focuses on the specific needs of decision makers internal to the organization

Question 4

The Nature of Accounting

Answer 4

• Accounting systems are therefore designed to meet the needs of the decisions makers who use the accounting information.
• Every business has some sort of accounting system.
• These accounting systems may be very complex or very simple, but the real value of any accounting system lies in the information that the system provides.

Question 5

The major distinction between financial and management accounting is…

Answer 5

The users of the information.

• Financial accounting serves external users.
• Management accounting serves internal users, such as top executives, management, and administrators within organizations.

Question 6

Differences Between Financial Accounts & Management Accounts

Answer 6

Question 7

Cost =

Answer 7

The amount of expenditure incurred on or attributable to a specified thing or activity.

Question 8

Cost Unit =

Answer 8

The unit of a product or service in relation to which costs are ascertained

Question 9

Why Are Costs Required?

Answer 9

Businesses require the cost of a:

1. Department
2. Cost centre
3. Product or service

Why?

1. Statutory requirement
2. Decision making
3. Planning and control
4. Performance measurement

Question 10

Classification of Costs

Answer 10

Costs can be grouped in a number of ways based on the purpose for which they are required.

Classifications include:

1. Prime Cost & Manufacturing Overhead
2. Product vs. Period costs
3. Direct vs. Indirect costs
4. Opportunity and sunk costs

Question 11

Prime Cost =

Answer 11

Prime cost refers to the direct costs of the product & consists of direct labour plus direct material plus any direct expenses such as the cost of hiring a machine for producing a specific product .

Question 12

Manufacturing Overhead =

Answer 12

Manufacturing overhead consists of all indirect manufacturing labour & material costs plus indirect manufacturing expenses such as rent of the factory & depreciation of machinery.

Question 13

Product =

Answer 13

Product costs are those costs associated with goods or services purchased, or produced, for sale to customers (in other words, these are the production costs).

Question 14

Period Costs

Answer 14

Period costs are those costs which are treated as expenses in the period in which they are incurred (in other words, these are the selling & administrative expenses).

Question 15

Costs that are assigned to cost objects can be divided into two categories: direct costs & indirect costs.

Answer 15

• Direct costs are those costs that can be specifically & exclusively identified with a particular cost object.
• Indirect costs cannot be identified specifically & exclusively with a given cost object.

Question 16

An Important remark about indirect and direct costs:

Answer 16

• The definition of direct and indirect costs depends on the purpose for which the cost will be used.

For example, the salary of a project manager is indirect cost to the company but a direct cost to the project.

Question 17

Opportunity Costs =

Answer 17

An opportunity cost is the benefit foregone for not taking the next best alternative

Example - A proposal to make a newly-developed product offers an NPV of £3m. An alternative is for the firm to sell the patent for £4m to another firm for it to make the product.

NPV £3m

Opportunity cost £4m

NPV (£1m)

Question 18

Sunk Costs =

Answer 18

Sunk costs are costs which arose as a result of past decisions and do not affect a decision currently under consideration

E.g. An oil company has incurred £2m conducting exploratory studies to identify the best sites for drilling. Is this a relevant cost to the current proposal to sink a well?

Question 19

Variable Costs =

Answer 19

• Variable costs are those costs which vary in direct proportion to the volume of activity. So, doubling the level of activity will double the total variable cost.
• Consequently, total variable costs are linear & unit variable cost is constant.
• The following example illustrates a variable cost where the variable cost per unit is £10

Question 20

Examples of Variable Costs:

Answer 20

• Materials used to manufacture a unit of output or to provide a type of service;
• Hourly paid / unit paid Labour costs of manufacturing a unit of output or providing a type of service;
• Commission paid to a salesperson.

Question 21

Fixed Costs

Answer 21

• A fixed cost is one that is not affected by changes in the level of activity, for a specified period of time and within a specified range of activity.
• Total fixed costs are constant for all levels of activity whereas unit fixed costs decrease proportionally with the level of activity.

Question 22

Graph of Total Fixed Cost against Activity

Answer 22

Question 23

Graph of Unit Fixed Cost against Activity

Answer 23

Question 24

Examples of Fixed Costs

Answer 24

• Advertising in the trade journals
• Salaries & wages of administrative duties
• Depreciation of building

Question 25

Semi-variable Costs

Answer 25

• It includes both a fixed element that is fixed whatever the level of activity & a variable component that is directly related to the level of activity.

E.g. A mobile phone contract has a fixed monthly payment for certain level of calls and texts & a variable cost element for extra calls and texts made beyond the free bundle

Question 26

Analysis of Mixed Costs

Answer 26

• Costs are rarely purely fixed or variable but semi variable
• Semi-variable costs can be analysed into their fixed and variable cost components using one of three methods:

1. The High Low
2. Scatter Graph
3. Least Squares

• The high low method is often used in management accounting to separate costs into their fixed and variable cost components

Question 27

Calcul of Semi-Variable Cost

Answer 27

Question 28

Graph of Total Mixed Cost against Activity

Answer 28

Question 29

Examples of Semi-Variable Cost

Answer 29

• Salesmen salaries where there is a basic fixed salary plus variable commission which is directly related to the volume of sales made by the salesman
• Maintenance charges where there is a fixed basic charge per year plus a variable element depending on the number of call-outs per year.

Question 30

Step Costs =

Answer 30

• The cost will take the shape of a step
• The cost is fixed over a fixed period of time but there is a revised increase in the cost to a higher level than the previous one in subsequent periods.

Question 31

Example of a Stepped Cost

Answer 31

Question 32

Graph of Stepped Cost against Activity

Answer 32