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BY GHANENDRA FAGO
Cost concepts, Cost Classification and
Estimation
Cost Concepts
Cost refers the amount of expenses spent to generate product or services.
Cost refers expenditure that may be actual or nominal expenses incurred to generate output.
Cost is the value of economic resources used as result of producing or doing the things.
Cost has many meaning but in management cost refers the expenditure not the price.
As a manager we use cost information for taking decisions and making plans, programs and policies and strategies.
Cost according to elements of cost
Direct material Direct laborDirect expenses Overheads
Cost According to function- Manufacturing Vs. Non-manufacturing costs
Manufacturing Costs Manufacturing costs involves the cost of raw
material, labour and use of equipment to finished goods
Composed up of the following elements. Direct material Direct labour Overheads
Elements of Manufacturing Cost
Materials LabourOverheads- indirect material labors and
factory expenses
Non manufacturing Cost
Cost other than manufacturing cost that are incurred for sale
Non-manufacturing costs are: Selling expenses /marketing expenses Promotion, or Advertisement costs, Administrative costs
Cost according to behavior
Variable costMixed costFixed cost
Variable costs
Variable costs are based on activity. The variable costs should be zero at zero activity. They change directly with changes in activity level
in a responsibility center. If output is doubled, variable expenses is to be
doubled, if output increases by 15% the variable expenses
also increase by 15%, if output is zero, the variable cost also zero.
Variable costs are usually characterized by:
Unit cost remains constant.
Total costs that increase as activity increases.
Total costs that decrease as activity decreases.
Total costs changes proportionality with changes in output.
Variable cost
Units of products 0
cost
Variable cost per unit
Variable cost
Fixed Cost
Fixed cost is also called period cost or capacity cost.
It does not change in short term period or within a relevant range.
They accrue primarily with the passage time.Fixed costs are caused by holding of assets
and other factors of production in a state of readiness to produce.
Characteristics of fixed cost
Unit cost increase as activities/outputs decrease.
Costs that remain constant even activities are decreased or decreased
Cost per unit that increases as activity decreases and vice versa
Total costs that remain constant.
Fixed cost curve
Fixed cost
Units of products 0
cost
Committed fixed cost
Committed cost arises from the ownership, facilities or possession of assets.
Committed cost can not be changed by a simple decision.
Major decisions to change. For example: property tax, Loan installments depreciation, insurance etc.
Discretionary fixed Cost
Arises from management decision Controllable costsCan be easily changed by decisions Examples:
Advertisement,Training costsmarketing expenses, promotional expenses etc.
Step fixed costs
Remains constant over fixed range of activities but jumps to different amount for the activities levels outside the range
Semi–Variable Expenses/ Mixed costs
Semi–variable expenses also changes with changes in output or activity but not in proportion to changes in activity or output
Semi variable expenses have some of the characteristics of both fixed and variable costs.
Semi variable expenses are caused by combined effect of passage of time, activity or output and management discretion decisions.
Methods of Cost Segregation
Engineering analysisAccounting analysisHigh Low point methodsLeast Square Regression Analysis
Engineering Analysis
Systematic review of costs for product and services
Measuring cost behaviors according to what cost should be, not by what have been
Mixed Cost Function = Rs4,000 + Rs.600 X Per Day
Accounting analysis
This is a simple method Segregates cost into fixed and variables
based on certain cost driver.
Example: The Directorium Manufacturing Company produced and sold 80,000 units at Rs. 50 each. The cost for 1976 were as follows:
Particular Fixed Cost Variable Cost
Direct materials - Rs.200,000
Direct labour - 160,000
Manufacturing overhead Rs.440,000 20,000
Selling and admi. expenses 280,000 100,000
Mixed cost function = Rs.720,000 + Rs.6 X units of production
High Low Point method
Under this method, semi variable cost can be segregated into variable and fixed cost based on the two extreme levels of activities using the following formulas.
Variable rate (b) = [Cost at high point- Cost at low Point]/
[High point –Low point]Fixed cost (a) = Total cost – Variable rate Level of
activitiesTherefore, the cost volume formula:Total cost = Fixed cost + (Variable rate levels of
activities)
Advantages and Disadvantages
Advantages:It is easy and less time consuming.Cost behavior is restricted to the relevant
ranges.It will be more suitable when there are two
levels of activities to estimate cost.Disadvantages Use of only two extreme conditions may not
be representative of normal conditionsIt may give the unreliable estimate of fixed
cost (a) and variable rate (b).It does not specify the fixed cost below and
above the two levels of activities.
Least Square Analysis
One of the best and widely used methods in cost estimation, A statistical procedure for estimating mathematically the
average relationship between the dependent variable (y) and independent variable (a).
It includes all the observed data and attempts to find the line of best fit in estimation of variable and fixed cost.
Under this method, the following least square formula can be used to estimate cost.Y = a + bxWhere, a = Estimated fixed cost i.e. constant
b = Variable rate i.e. slope of regression lineY = Dependent variable i.e. estimated total
costX = Independent variable i.e. Level of activity
or units of products, hours etc
Least Square Formula
22 XXN
YXXYNb
22
2
XXN
XYXYX
XbYa
activitiesoflevelsX
rateaibleb
tfixeda
Where
var
cos
Regression Statistics
Least square regression method is used to estimate variable and fixed cost.
However, it doses not explain the accuracy and the reliability of the regression result.
To explain the accuracy and reliability of the regression result, Correlation coefficient (r) and Coefficient of Determination (r2)
Correlation Coefficient (r)
Goodness of fit regressions line can be measured by assessing correlation coefficient. The correlation coefficient can be computed as follows:
Correlation coefficient (r) =
Explanation: The correlation coefficient measures the degree of
correlation between y and x. Therefore, it should be between +1 and –1. If not, it means, it is unclear about the results. Then, coefficient of determinant should be computed to find the meaningful result using the following formula.
2222 YYNXXN
YXXYN
Coefficient of Determination (r2)
r2 = [ ]2
Explanation:It means that ….% of the goodness of fit in
regression line. Therefore, higher the degree, more the confidence in cost estimation. In other words, …. % means the total variation of total cost is due to change in levels of activities and remaining in due to other factors other than the independent variable.
2222 YYNXXN
YXXYN
Data for total power costs and machine hours are given below:Power Costs (000 omitted) Machine Hours (000 omitted)
Rs.7683488675
9884679586
Rs.62 70 hours
1. Required:a) Separate the power costs into the fixed and variable
components using the method of least squares. b. Estimate the power costs when 6.5 machine hours are used.c. Compute the coefficient of determination.d. Does the regression equation need to be improved?e. t-value, e) Standard error of coefficient (Sb)
Classification of cost according to decision making
Relevant Cost and Irrelevant Cost Avoidable and Unavoidable Costs Out of pocket costs, Opportunity, Sunk costs Period Cost and Product Cost Direct Vs. Indirect cost Controllable and Uncontrollable Cost Incremental Cost/Differential Cost Committed fixed cost and Discretionary fixed
Cost
Relevant cost
Costs and expenses which are directly influenced by decision are relevant costs.
All future cost are relevant cost. They are pertinent and valid costs.
Relevant costs include all variable costs and additional fixed costs which are incurred because of the decision being taken
Irrelevant Cost
In other hand, costs that cannot be changed are called irrelevant costs. Irrelevant costs include the existing fixed costs which are going to exist even after the decisions are taken. Such costs do not affect the decision
Controllable and Uncontrollable Cost
Controllable and uncontrollable cost depends on the point of reference.
Uncontrollable cost at lower level may be controllable at top level, uncontrollable in short term may be controllable in the long run. etc.
A cost is a called controllable at particular level if the level has power to authorize the cost.
If it has not, it is called uncontrollable cost.
Avoidable VS Unavoidable Costs
Avoidable costs can be saved simply by not doing the alternative courses of action.
They are relevant in decision makingUnavoidable costs are irrelevant cost because they
can not be avoided or eliminated by taking decisions or alternatives.
If the revenue generated by avoidable cost is high, we have to take decisions
Direct Cost and Indirect Cost
Direct costs are directly traceable or identifiable to a particular job or department or product and are controllable.
Indirect costs are uncontrollable and no-traceable costs.
Cost may be direct but the same may be indirect depends on the situation.
Incremental Cost/Differential Cost
Cost difference between two alternativesIf differential costs are increased, it is called
incremental cost and decreased, and called decremental cost
Incremental cost refers the only the increased cost from one alternative to another.
Differential cost or incremental cost can also be used to analyses alternatives for decision-making purpose
Period Cost
Period costs are not manufacturing cost. However, they are incurred and paid based on the period
They are deductible from revenue.Example: Rent, salaries, telephone etc.
Product Costs
Product costs are manufacturing costs They are incurred for the manufacturing of goodsThey include direct material, direct labour, and
manufacturing overheads. Example: direct material, labour cost,
manufacturing overhead etc.
Out of pocket expenses
Expenses incurred for activities for raw materials, labour overheads etc.
Opportunity Cost
Not recordable in the books of account but are considered in every decisions of managers.
It is the amount of benefit that is sacrificed when one alternative is selected.
Sunk costs
Costs are the cost incurred a result of past decisions.
Cost can not be changed by taking operating decision
Sunk costs are irrelevant from decision making.Sunk costs are depreciation of assets, lease rent
etc.