Cost concepts, Cost Classification and Estimation By Ghanendra Fago

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 labor Direct expenses Overheads

Cost According to function- Manufacturing Vs. Non-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 Labour Overheads- 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 cost Mixed cost Fixed 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 cost Variable cost Variable cost per unit Units of products cost Variable cost Variable cost per unit

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 cost

Committed cost can not be changed by a simple decision. 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 costs Can be easily changed by decisions Examples: Advertisement, Training costs marketing 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 analysis Accounting analysis High Low point methods Least 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.

Mixed cost function = Rs.720,000 + Rs.6 X units of production 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 activities Therefore, the cost volume formula: Total cost = Fixed cost + (Variable rate  levels of activities)

Advantages and Disadvantages 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 conditions It 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 + bx Where, a = Estimated fixed cost i.e. constant b = Variable rate i.e. slope of regression line Y = Dependent variable i.e. estimated total cost X = Independent variable i.e. Level of activity or units of products, hours etc

Least Square Formula

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.

Coefficient of Determination (r2) 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.

Machine Hours (000 omitted) Data for total power costs and machine hours are given below: Power Costs (000 omitted) Machine Hours (000 omitted) Rs.7 6 8 3 4 7 5 9 Rs.62 70 hours 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 making Unavoidable 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 alternatives If 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 goods They 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.