2.

Cost Concepts, Classifications, and Estimation

• Key Topics:
o Definition of Cost
o Cost Objects
o Direct vs. Indirect Costs
o Product vs. Period Costs
o Costs for the Purpose of Short-term Decision Making (Fixed, Variable, Semi-
variable, Step Costs)
o Relevant vs. Irrelevant Costs
o Avoidable and Unavoidable Costs
o Sunk Costs
o Opportunity Costs
o Controllable and Uncontrollable Costs
o Cost Estimation & Methods

1. What is Cost?

• Cost is the monetary value of resources sacrificed to achieve a specific

objective.
• It includes efforts, materials, time, utilities, risks, and opportunities forgone in
producing goods or services.

• Purpose of Cost Information:

o Decision-making: Helps managers make informed decisions about

pricing, production, and resource allocation.

o Control functions: Assists in monitoring and controlling costs to ensure

efficiency.

o Profit measurement and inventory valuation: Used to calculate profits

and value inventory for financial reporting.

2. Cost Objects

• A cost object is anything for which a separate measurement of costs is desired.

• It can be a product, service, process, department, customer, project, or any

activity that requires cost tracking. (e.g.: a product, service, process, department,
a contract, a project or customer)

• Cost object can be defined according to the requirement of the user as well.
Activity 2.1:
• Identify three possible examples of cost objects for each of the following:
o Garment Factory
o University
o Furniture Manufacturer
o Hospital

• Examples:

o Garment Factory: Cost objects could include a specific product line (e.g.,
shirts), a production process (e.g., cutting), or a department (e.g.,
stitching).

o University: Cost objects could include a specific course, a department

(e.g., Accounting), or a research project.

o Furniture Manufacturer: Cost objects could include a specific product

(e.g., chairs), a production line, or a customer order.

o Hospital: Cost objects could include a specific department (e.g.,

Cardiology), a patient, or a medical procedure.

3. Classification of Costs

❖ Based on Traceability:

Direct Costs: Costs that can be specifically and exclusively identified with a cost
object.

o Examples: Direct materials (e.g., wood for furniture), direct labor (e.g.,
wages of workers assembling products), and direct other costs (e.g.,
specific tools used for a product).

Indirect Costs: Costs that cannot be specifically identified with a cost object.

o Examples: Manufacturing overheads (e.g., factory rent, utilities),

administrative costs, and selling & distribution costs.

❖ Based on Function:

Manufacturing Costs: Costs incurred in the production of goods.

o Examples: Direct materials, direct labor, and manufacturing overheads.

Non-Manufacturing Costs: Costs not directly related to production.

o Examples: Administrative costs, selling costs, and distribution costs.
4. Direct vs. Indirect Costs

• Direct Costs:

o Direct Materials: Raw materials that are directly used in the production
of goods.
▪ Example: Wood used in making furniture.

o Direct Labor: Wages of workers directly involved in the production

process.
▪ Example: Wages of carpenters in a furniture factory.

o Direct Other Costs: Other costs directly traceable to the product.

▪ Example: Specific tools or machinery used for a particular product.

• Indirect Costs:

o Manufacturing Overheads: Indirect materials, indirect labor, and other

indirect expenses related to production.
▪ Example: Factory rent, utilities, and maintenance costs.

o Non-Manufacturing Overheads: Costs not related to production, such as

administrative and selling costs.
▪ Example: Salaries of office staff, advertising expenses.

5. Product vs. Period Costs

For profit measurement and inventory/stock valuation purposes (i.e. the

valuation of completed unsold products and partly completed products or services) -
classify costs as either product costs or period costs.
• Product Costs:
o Costs identified with goods purchased or produced for resale.
o Costs attached to the product and included in inventory valuation.
o Examples: Direct materials, direct labor, and manufacturing overheads.
o Treatment: Recorded as an asset (inventory) until the product is sold.
When sold, these costs are expensed as cost of goods sold (COGS).
 • Period Costs:

o Costs expensed in the period they are incurred, regardless of production

levels.
o Examples: Administrative costs, selling costs, and distribution costs.
o Treatment: Expensed in the income statement in the period they are
incurred.

6. Costs for the Purpose of Short-term Decision Making

• Variable Costs: Costs that vary in direct proportion to the volume of activity.
o Example: Raw materials used in production. If production doubles, the
cost of raw materials will also double.

• Fixed Costs: Costs that remain constant over a wide range of activity.
o Example: Rent for a factory. The rent remains the same regardless of the
number of units produced.

• Semi-variable Costs: Costs that have both fixed and variable components.
o Example: Utility bills, which have a fixed base charge plus a variable
charge based on usage.

• Step Costs: Costs that remain fixed within a range of activity but increase in steps
when activity exceeds certain levels.
o Example: Supervisory salaries. If production increases beyond a certain
level, additional supervisors may need to be hired.

7. Relevant vs. Irrelevant Costs

• Relevant Costs: Future costs that will change as a result of a decision.

o Example: Incremental costs, such as additional materials or labor
required for a new order.

• Irrelevant Costs: Costs that will not be affected by a decision.

o Example: Sunk costs, such as the cost of machinery already purchased.

• Example:
A company has raw materials that cannot be used in production. A customer
offers to buy them for Rs. 12,000, but additional processing costs of Rs. 5,000 are
required. The relevant cost is Rs. 5,000, while the original cost of Rs. 20,000 is
irrelevant.
8. Avoidable vs. Unavoidable Costs

• Avoidable Costs: Costs that can be saved by not adopting a given alternative.
o Example: If a company decides to discontinue a product, the costs saved
(e.g., materials, labor) are avoidable.

• Unavoidable Costs: Costs that cannot be saved, regardless of the decision.

o Example: Fixed costs such as rent or salaries that must be paid even if
production stops.

• Example:
A company has a stock of materials that can be used in a new product. If the
materials are not used, they will be disposed of at a cost of Rs. 4,500. The
avoidable cost is the disposal cost, while the original cost of Rs. 32,000 is
unavoidable.

9. Sunk Costs

• Definition: Costs that have already been incurred and cannot be recovered.
o Example: A company has a rent agreement that cannot be canceled. The
rent paid is a sunk cost and should not influence future decisions.

• Key Point: Sunk costs are irrelevant for decision-making.

10. Opportunity Costs

The value of the next best alternative that is foregone when choosing one alternative
over another.

11. Incremental vs. Marginal Costs

• Incremental Costs: The difference in costs between two alternatives.

o Example: A university considering increasing student numbers by 20%
will incur additional costs for lecturers and facilities. The incremental cost
is the total additional cost.

• Marginal Costs: The additional cost of producing one more unit of output.
o Example: The cost of producing one additional chair in a furniture factory.

12. Controllable and Uncontrollable Costs

• Controllable Costs: Costs which can be influenced by the action of a a particular

member of an undertaking.
• Uncontrollable Costs: Cost which cannot be influenced by the action of a
particular member.
13. Cost Estimation Methods

General Principles;
• A regression equation identifies an estimated relationship between a dependent
variable (cost) and one or more independent variables (i.e. an activity measure or
a cost driver).

Methods;

1. Engineering Methods: Based on technological relationships between inputs and

outputs (e.g., time and motion studies).
• Method study, work sampling, and time and motion study are examples of
engineering methods.
• Almost exclusively for first time: new product or activity (no data is available,
better to use existing data).
• Advantages: Leads to a detailed analysis
• Disadvantages: Very expensive, Time consuming, Need more expertise

2. Inspection of Accounts Method: Classifying costs as fixed, variable, or semi-

variable by inspecting each item of expenditure.

3. Graphical/Scatter-graph Method: Plotting total costs against activity levels to

estimate the cost function.

4. High-Low Method: Using the highest and lowest activity levels to estimate
variable and fixed costs.

14. High-Low Method Example

• Data:
o Highest activity level: 10,000 units, Rs. 32,000
o Lowest activity level: 5,000 units, Rs. 22,000

• Calculation:
o Variable Cost per Unit = (Rs. 32,000 - Rs. 22,000) / (10,000 - 5,000) = Rs. 2 per unit
o Fixed Cost = Total Cost - (Variable Cost per Unit × Activity Level)
o Fixed Cost = Rs. 32,000 - (Rs. 2 × 10,000) = Rs. 12,000

15. Real-World Application

• Case Study: Irish Banking Bailout (2008)

The Irish government spent €41.7 billion to bail out banks. The opportunity cost
was the alternative uses of this money, such as infrastructure or healthcare.

• Questions:
1. What could the €41.7 billion have been spent on instead?
2. What would have happened to the Irish economy if the banks were not bailed
out?