Cost classification
and cost assignment
Lecture 2_2.10.2024
Agenda
Cost classifications
Mutual relation between cost classifications
Indirect cost assignment method
Direct v. indirect costs
• direct costs
• can be traced easily and accurately to a cost object
• indirect costs
• cannot be traced to cost objects
• estimate must be made of the
• resources consumed by cost objects using cost allocations (alokace n.)
• Cost allocation = the process of assigning costs
when a direct measure does not exist for the
quantity of resources consumed by a particular
cost object
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Direct v. indirect costs
depends on
what is identified as the
cost object
= any activity for which a separate
measurement of cost is required
e.g. cost of making 1 piece of product
e.g. cost of providing 1 hour of a service
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What are the possible unit costs in
following industries?
• Automobile?
• Construction of building?
• Chemicals?
• Transport?
• Restaurant?
• Education?
• Hospitals?
Manufacturing vs. Nonmanufacturing costs
Manufacturing cost
• Direct materials
• Direct labour
• Manufacturing overhead
• Indirect materials
• Indirect labour
• Manintenance and repairs on production
equipment
• Heat and light, property taxes, depreciation,
insurance on manufacturing facilitites
• Also environmental costs can be differentiated:
• Waste Disposal
• Pollution Control
• Environmental Compliance
• Energy Costs
Nonmanufacturing
• Selling costs
• Administrative costs
Prime cost v. Overheads
̶ answer to question how are costs controlled?
̶ prime costs / per-unit costs
̶ occur with each unit of product/hour of service
̶ controlled per unit through technical and economic standards (calculations/standars)
̶ Overheads opposite to prime cost
Manufacturing, administration and marketing
̶ controlled through budgets
̶ Conversion costs
̶ Costs of converting raw materials into finished goods
Links of cost categories
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Direct materials xxx
Direct labour xxx
Prime cost xxx
Manufacturing overhead xxx
Total manufacturing cost xxx
Non-manufacturing overheads xxx
Total cost xxx
Cost collection system
normally accounts for costs in two broad stages:
1. Accumulates costs by classifying them into certain categories
(e.g. labour, materials and overheads).
2. Assigns costs to cost objects
Traditional cost systems accumulate
product costs as follows:
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Product and Period Cost
Product costs
• are attached to the
products
and included in the
stock (inventory
valuation).
Period costs
• are not attached to
the product
and not included in
the inventory
valuation.
Treatment
of Product and Period Cost
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Treatment
of Product and Period Cost
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Example
• production 1000 units
at manufacturing cost 10 CZK per unit
• 800 units sold at selling price 20 CZK
• admin expenses 3,000 CZK
• selling expenses 2,000 CZK
• What is the bottom-line?
Solution:
Profit and loss account
Sales ............................................. 16,000 CZK
Cost of goods sold (COGS) .............. -8,000 CZK
Period costs ..................................... -5,000 CZK
Profit / loss = 3,000 CZK
Balance sheet
2,000 CZK in a closing balance of inventory = products in warehouse/store(room)
Do product cost always
equal to all manafacturing cost?
• YES
Absorption costing (also
known as full costing)
• traces all manufacturing costs
to products
• non-manufacturing overheads
as a period cost.
• NO
Variable costing (also
known as direct or marginal
costing)
• traces all variable costs to
products
• fixed manufacturing overheads
and non-manufacturing
overheads as a period cost12
Some arguments in support of variable costing
• Variable costing provides more useful information for decision-making.
• Variable costing removes from profit the effect of stock changes.
• Variable costing avoids fixed overheads being capitalized
in unsaleable stocks.
Some arguments in support of absorption costing
• Absorption Costing does not understate the importance of fixed costs.
• Absorption costing avoids fictitious losses being reported
(e.g. stocks accumulated for seasonal sales).
The debate just for internal reporting!
• External reporting (IFRS, US GAAP) insist on full costing!
Absorption v. variable costing
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Product costs
= all manufacturing costs
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Full costs (for inventory valuation)
• production 1000 units
at manufacturing cost 10 CZK per unit
involving variable cost 6 CZK per unit
• 800 units sold at selling price 20 CZK
• admin expenses 3,000 CZK
• selling expenses 2,000 CZK
Solution:
Profit and loss account
Sales ............................................. 16,000 CZK
Cost of goods sold (COGS) .............. -8,000 CZK
Period costs ..................................... -5,000 CZK
Profit / loss = 3,000 CZK
Balance sheet
2,000 CZK in a closing balance of inventory = products in warehouse/store(room)
NOT all manufacturing costs
are product costs
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Variable costs (for inventory valuation)
• production 1000 units
at manufacturing cost 10 CZK per unit
involving variable cost 6 CZK per unit
• 800 units sold at selling price 20 CZK
• admin expenses 3,000 CZK
• selling expenses 2,000 CZK
Solution:
Profit and loss account
Sales ............................................. 16,000 CZK
Cost of goods sold (COGS) .............. -4,800 CZK
Period costs ..................................... -9,000 CZK (incl.-4.000 CZK fixed manufact.)
Profit / loss = 2,200 CZK
Balance sheet
1,200 CZK in a closing balance of inventory = products in warehouse/store(room)
Variable v. Fixed Cost
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Variable costs:
(a) total: (b) unit
Variable v. Fixed Cost
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Fixed costs:
(a) total: (b) unit
Classification by cost
behaviour
• Important to predict costs and revenues at different activity levels for many
decisions.
• Variable costs
• Fixed costs
• Semi-fixed costs are fixed within specified activity levels, but they
eventually increase or decrease by some constant amount at critical activity
levels.
• Semi-variable costs (=mixed cost) include
both a fixed and a variable component (e.g. telephone charges).
• the classification of costs depends on the time period involved.
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Semi-variable (=mixed) costs
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Semi-variable cost
How to separate var. and fix.c.?
high-low method
regression analysis
(ordinary least square method)
inspection of accounts
Fixed Costs
more detailed classification:
sunk fixed costs (=unavoidable)
costs of resources already acquired
(e.g. depreciation)
connected with establishing the production capacity
avoidable fixed costs
incured when the produciton capacity is running
(e.g. wages of supervisors, servicemen, heating, lighting)
fixed, but can be avoided if production stops completely
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Semi-fixed Costs
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Microeconomic foundations
Total revenues/costs
Shape of the total cost function (initial
steep rise, levels off, followed by a further
steep rise)
The total revenue
(line initially rises steeply, then levels off and
declines)
Curvilinear graph results in
two break-even points.
Unit variable costs
Curvilinear variable cost function
1.Output levels between 0 and Q1
= Increasing returns to scale
2.Output levels between Q1 and Q2
= Constant returns to scale
3.Output levels beyond Q2 =
Decreasing returns to scale
Relevant v. irrelevant costs and revenues
relevant = future costs and revenues that will be
changed by a decision
irrelevant costs and revenues will not be changed
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Convert or not convert?
Avoidable vs. Unavoidable/sunk costs
more detailed classification:
sunk costs (=unavoidable)
costs of resources already acquired
(e.g. depreciation)
connected with establishing the production capacity
avoidable costs
incured when the produciton capacity is running
(e.g. wages of supervisors, servicemen, heating, lighting)
fixed, but can be avoided if production stops completely
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Opportunity costs
Opportunity costs
measures the opportunity that is lost or sacrificed when the choice of
one course of action requires that an alternative course of action is
given up.
Incremental v. Marginal
costs/revenues
Incremental (přírůstkové)
= additional costs/revenues from the production of a group of
additional units.
Marginal (marginální/mezní)
= additional costs/revenues from the production of one additional
unit of output
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Case to solve in
pairs
• Explain and identify sunk and
opportunity costs
• State the decision ?rs Johnson
should make according the
information given, supporting
your conclusion with a financial
statement
Opportunity cost
• 550 £ *12-5.000 £ (rent) =1.600 £
Sunk cost
• 5.000 £
Potential profit calculation
• Net sales 100.000 £
• Costs - 82.000 £
• Opportunity costs -16.000 £
• Net profit 16.400 £
Mutual relations between
cost categories
Prime v. direct cost
Direct
Indirect
Prime cost
Overheads
Can you provide me some direct
overhead example?
Prime v. variable
Variable
Fixed
Prime
Overheads
Can you provide me some variable
Direct v. variable
Variable
Fixed
Direct
Indirect
Variable
Fixed
What about some indirect variable
Cost assignment methods
Indirect cost assignment
Cost assignment methods
Example
Furniture Inc.
3 types of products
• wardrobes
• tables
• drawers
annual costs
$ 2,791,160
How to assign cost
to 1 unit of each product?
Furniture s.r.o.
Direct Costs
Indirect Costs
Indirect cost allocation
Plant-wide overhead rate (1/6)
Indirect cost allocation
Plant-wide overhead rate (2/6)
Indirect cost allocation (3/6)
Plant-wide overhead rate (4/6)
Plant-wide overhead rate (6/6)
In practice: Multidimensional
cost information systems
Cost accounting system of a real large firm generates
usually more cost dimensions simultaneously,
at least for:
1.inventory valuation for internal and external profit measurement
2.managers’ decision-making based on relevant information
3.planning, control and performance measurement
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Thank you for your
Attention!
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