MANAGEMENT AND COST

ACCOUNTING

CHAPTER II

DEFINITIONS IN COST ACCOUNTING

Cost Concept and Classification of Costs

• Cost is referred to as the value of resources sacrificed to acquire something such as products or services.

• However, they must put up with some costs to bring both economic and noneconomic benefits to a company to realize its activities. These benefits may be both current and future benefits. Thus, cost concept is divided into two separate parts; expired and unexpired costs. When the benefits are consumed, the costs, which are consumed to get these benefits, are called expenses. In this respect, expenses are expired costs. However, unexpired costs cannot be considered as expenses since they are the sources of future benefits. Accordingly, the unexpired costs can be evaluated as assets

• Cost Object is anything, such as goods, services, customers, etc., for which a separate cost is determined. For example, if a manager of a hospital wants to evaluate cost of a patient, the patient becomes the cost object. Contrary to some costs that can be directly allocated to the cost objects, some other costs which have not a direct relationship with the cost object can only be allocated indirectly

• A connection should be created between these indirect costs and the cost object so as to get accurate cost information regarding the cost object. Things that establish this link to obtain accurate cost information are called cost drivers. The term Cost Driver can be defined as any factor, change of which will change the total cost of a cost object. For example, assume that you are going to Mersin from Adana by your car. In this case, this travel is considered as a cost object. In addition, the consumption of fuel has a significant impact on the total cost of the cost object. Thus, fuel consumption cost should be calculated by considering the total distance travelled. If the fuel consumption cost per kilometre is constant, the total kilometres travelled will change the total cost of the journey.

• Relevant Range is a band in which a relationship exists between cost and the cost driver. It is also defined as an interval in which the total fixed cost and variable cost per unit are constant.

Relevant Range

Cost Accumulation and Cost Allocation

• In the determination of the cost of a product or service, on the other hand, any cost system needs two things: Cost Accumulation and Cost Allocation.

• Cost Accumulation is defined as the systematic collection of costs

through a cost system.

• Cost Allocation is the process of identification of costs with a cost object. In other words, it is the process of assigning or tracing costs to a cost object. Allocations of direct costs to a cost object always become easy for managers. However, it is not the case for indirect costs. Therefore, the term “cost allocation” generally refers to the allocation of costs having indirect characteristics to the cost object.

Direct Cost and Indirect Cost

The Direct Costs are the costs that are directly identified with a cost object. Their costs can easily be traced to a cost object in an economically feasible way. Therefore, there are two characteristics of direct costs:

• They are directly identified with a cost object.• They are directly and easily assigned to a cost object.

The Indirect Costs are those costs that are not directly identified with a cost object and their cost may not be conveniently and economically assigned to a cost object.

Production (Manufacturing) Cost

In a production process, while some costs are directly related to a cost object, others have indirect relationships. Accordingly, direct material, direct labour and factory overhead costs are the components of product or manufacturing costs. These costs components can be explained as follows:

Production (Manufacturing) Cost

• Direct Materials are the basic and main materials of a product. Their consumption can easily be weighted, measured and assigned to that particular product. More than one direct material may be used in the production of a product. Also, cost of those materials can be directly identified with and be conveniently allocated to this product. Therefore, their costs can be defined as Direct Material Costs. In a desk, for example, direct materials are wood and iron bars.

Production (Manufacturing) Cost

• Direct Labour refers all labour forces directly participated in a production process. In other words, direct labour is the employees who shape products (or render service) or use the machinery that shapes the products. Accordingly, Direct Labour Costs are the total cost of the workers participated in the production process of goods or services. However, workers who do not produce products but who help workers in production processes, such as forklift operators, carriers, securities, etc., are known as indirect labour. The cost of a carpenter can be given as an example of direct labour cost in production of a wooden table and a chair.

Production (Manufacturing) Cost

• Factory Overhead (FOH) may be defined as any costs that incur in the factory floor except direct material and direct labour. Consequently, factory overhead includes indirect materials, indirect labour and other indirect costs. Because of including many indirect costs with different characteristics, factory overhead costs are the costs that cannot be allocated easily and directly to products. The cost of glue, screws and nails can be given as examples of factory overhead costs for the production of wooden tables and chairs.

Production Cost

Production cost per unit is the sum of the following cost elements:

Cost of a product = DM+DL+FOH

Example 1: In a carpenter workshop, for instance, wooden chairs with iron bars are produced. On average, 100 chairs are produced in a month and the required additional data can be given as below:

SOLUTION

Example 2: Assuming that the chairs are completed within 15 days. Cost of a single chair can be calculated as: (in this case rent, depreciation and electricity costs are divided by 2 because they are monthly costs but chairs are completed in 15 days.)

Variable, Fixed and Mixed Costs

Other Related Concepts• The Raw Materials are those that have not yet been converted into

work-in-process or finished goods. A comparison of the terms raw material and direct material concepts always become a complex issue, especially for students. The raw materials are physical items that will be entered (but not yet entered) into production process for the purpose of transforming into work in process or finished goods. However, direct materials are items that have entered into production process. Thus, the cost of direct materials is also expressed as the cost of raw materials used in the production process.

• Work-in-Process is referred to as the units that are undergone production process, but not yet fully completed. In other words, they are partially completed products that are in the process of conversion into final products.

• Finished Goods are the end products ready for sale. These products have been completed and inventoried to be sold to customers.

• Product Cost is referred to as the total cost of direct material, direct labour and the factory overhead. Accordingly, product costs are the costs that are included in the production of a product. These costs are recorded as an expense (cost of goods sold) in the income statement when the products are sold.

• • A Period Cost can be defined as the cost concerned

with the period in which manufacturing activities are realized. The period costs are non-manufacturing costs such as marketing and sales, finance and administrative costs.

• Direct costs of a product are referred to as Prime Costs which include direct materials, direct labour and other direct costs (such as electricity cost that can be directly allocated to a cost object). Such costs may be fixed or variable. The important point here is that whether the cost can directly be allocated to the cost object or not. For example, although depreciation is a fixed cost, it could be a direct cost as well. If the cost object is the department itself in which the machinery is operating, the machine depreciation can be directly allocated to that department. Thus, a fixed cost may be a direct cost depending on the cost object.

• Conversion Costs are those costs that are used to convert raw materials into finished goods. They are the sum of direct labour and factory overhead costs in a production process.

Cost Segregation

• Some manufacturing companies segregate costs into two or three parts. These are called two-fold or three-fold segregations. A two-fold segregation is used if the direct labour cost is unimportant and, for example, is less than 3% of the total production cost. In this case, the terms prime and conversion cost are used in cost accounting. On the other hand, if all cost elements (DM, DL and FOH) have significant importance in the system, then, the three cost elements are used and this is known as three-fold segregation.

• Average Cost is a cost which is computed by dividing total cost by the number of quantity manufactured.

• Unit Cost is the production cost of one unit. Sometimes it is referred to as a cost obtained by dividing total cost by the number of units. In this case, it is equal to average cost particularly in mass production.

Some Cost Terms Regarding Management Functions

• Management accounting also requires you to know some concepts regarding both costing and decision-making processes. These generally refer to managerial functions of a company.

• Relevant Costs and Revenues are costs and revenues that are expected to incur in the future. These are always under the influence of a decision. Moreover, they differ between alternatives. However, irrelevant costs and revenues are those that have no relationships with a decision to be made, so they cannot be changed by the decision. For instance, assume that a housewife has an opportunity to talk her friends by her mobile phone. The fixed cost of the mobile phone can be expressed as an irrelevant cost. Because it is a monthly charge and it depends on possessing a mobile phone. Conversely, the variable cost amount of the mobile phone depends on the time spent during the talks. Therefore, the variable cost is classified as a relevant cost.

• Opportunity Cost is the prospective benefit forgone when one alternative is chosen among others. They are not considered in accounting records because they are not actually spent. However, they must be taken into account when a decision is made.

• Differential Costs are those that show the commutative property (changing characteristics) among alternatives. There are two types of differential costs. The first one is incremental cost which represents costs increasing from one alternative to another. The second one is decremental cost that represents costs decreasing from one alternative to another.

• Sunk Costs are the costs that cannot be affected or changed by any current or future decision. In this respect, these costs cannot be classified as a differential cost. These costs should also be ignored when making a decision since they are unavoidable. For example, assume that we bought a brand new car for ¨20,000 five years ago, and now we want to change it with a new and more technologic one for ¨30,000. In this case, the amount paid five years ago refers to as sunk cost.

• Controllable Costs are those, which can be changed by the decisions of managers. In contrast, Non-controllable Costs cannot be affected by the regulations of managers. For example, the cost of direct material and direct labour can be given as an example of controllable costs. However, depreciation and insurance costs are the examples of non-controllable costs.