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Ch. 2: #
Management Accounting
Oxford Fajar Sdn. Bhd. (008974-T) 2011
CHAPTER Cost terms,
Concepts and
Classifications
2
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Oxford Fajar Sdn. Bhd. (008974-T) 2011
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
Explain cost terms such as cost, cost object, cost
unit and cost centre.
Classify costs according to their traceability,
behaviour, function, external financial reporting,
controllability and relevance in making business
decisions.
Allocate manufacturing overhead costs to products.
Compute cost of goods manufactured and sold.
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COST CONCEPTS
Cost is a resource sacrificed or foregone to
achieve a specific objective.
Cost is usually expressed as the monetary
amount that must be paid in exchange for
acquired goods and services.

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COST
Actual vs. Budgeted Cost:
Actual costa cost that has occurred
Budgeted costa predicted or planned cost

Cost vs. Expenses:
Costssacrificed resource to achieve a specific
objective
Expenses are expired costs

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COST OBJECT
Cost objectanything of interest for which a cost is
desired
Any item such as products, customers,
departments, projects, activities, and so on, for
which costs are measured and assigned.
A cost object can be any unit of analysis including
product, product line, customer, department,
division, geographical area, or country
Example: A car is a cost object if we are
determining the cost to produce a car.

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COST UNIT
A cost unit is a quantitative unit of either a
product or service in relation to which costs can
be computed.
The cost per unit is the amount of total cost
divided by the total output.
Example: For a delivery company, an
appropriate cost unit is the cost per kilometer of
delivery; for a universitycost per student
enrolled; for electricity generator company
cost per kilowatt of electricity
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COST CENTRE
A cost centre is a part of the organization which is
responsible only for the amount of costs incurred in
that particular centre.
Examples of cost centres are divisions which
provide services such as maintenance and
computing services.
Although these service centres do not manufacture
products, they provide essential services like
repairs and maintenance.
When providing the services, they have to be
accountable for costs incurred.
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COST CLASSIFICATION
By Traceability
By Behaviour
By Function
For Financial reporting
For Performance evaluation
For Decision-making
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COST CLASSIFICATION BY
TRACEABILITY
Direct and Indirect Costs:
Direct costs
can be conveniently and economically traced
(tracked) to a cost object
can be specifically identified with a cost object
examples: Cost of wood used in making
dining table, cost of flour in roti canai
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COST CLASSIFICATION BY
TRACEABILITY (cont.)
Direct and Indirect Costs:
Indirect costs
cannot be conveniently or economically traced
(tracked) to a cost object
acquired or used by more than one cost object
due to the difficulty to trace, indirect costs need
to allocated to a cost object
examples: Costs of screws to make dining table,
costs of cooks salary in making roti canai

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COST ALLOCATION
Cost allocation is the process of sharing the indirect
costs among the cost objects.
It is a process of giving some portion of indirect
costs to the cost object.
Indirect
costs
e.g. rental
of factory
Cost object
e.g. product line:
dining table
Cost allocation
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COST CLASSIFICATION BY
BEHAVIOUR
Cost behaviour refers to the way in which costs
change with the changes in the levels of activity
or volume of production.
Three behaviour of costs:
Variable Costs
Fixed Costs
Semi-variable Costs
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COST BEHAVIOUR
Variable costs: Changes in total in proportion to
changes in the related level of activity or volume
Fixed costs: Remain unchanged in total
regardless of changes in the related level of
activity or volume
Semi-variable Costs: Have both variable and
fixed behaviourthus, also called mixed costs



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VARIABLE COST
Total variable cost varies in direct proportion to
volume.
Since total variable cost varies directly and
proportionately with volume, variable cost per
unit is constant.
Variable cost per unit is constant but total
variable cost is not constant.

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VARIABLE COST (cont.)
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FIXED COST
Total fixed costs remain constant with volume
but with more units, the same fixed cost is
spread over more and more units, reducing the
cost per unit.
Hence, total fixed costs remain constant but
fixed cost per unit reduces as production
increases, i.e. fixed cost per unit will vary at
different levels of activity.

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FIXED COST (cont.)
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RELEVANT RANGE
Costs are fixed or variable only with respect to a
specific activity or a given time period.
This specific activity is called relevant range.
Assumptions of cost behaviour only applies over
the activity within the relevant range.
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SEPARATING FIXED AND
VARIABLE COSTS
Three methods to separate fixed from variable
costs:
High-low method
Scattergraph method
Least-squares Regression Method
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HIGH-LOW METHOD

Identify the highest and lowest volume or points.
Compute difference in cost at these highest and
lowest volumes
Divide by changes in volume to determine the
variable cost per unit
Calculate the total variable costs at that specific
volume
Deduct total variable from total cost to determine
total fixed costs
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SCATTERGRAPH METHOD

Plot on the graph the different costs at various
levels of activity
The best fit line is drawn approximately, use
judgment so that an equal number of points fall
above and below the line
The line of best fit is called the regression line
The y-intercept of the regression line shows total
fixed costs while the slope of line is the variable
cost per unit
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SCATTERGRAPH METHOD (cont.)

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LEAST-SQUARES REGRESSION
METHOD
Similar to scattergraph method but uses
mathematical formulae rather than visual inspection
to fit the regression line
Differences or deviations of observed data points to
the regression line are measured vertically
Vertical distance is the difference between the
actual cost and the cost predicted by the line or
cost function called regression errors
Regression line is computed as that which
minimizes the sum of the squared errors

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LEAST-SQUARES REGRESSION
METHOD
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COST CLASSIFICATION BY
FUNCTION
Two functions: Manufacturing and Non-
manufacturing
Manufacturing costs:
Direct Materials
Direct Labour
Factory/Manufacturing Overhead
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COST CLASSIFICATION BY
FUNCTION
Non-manufacturing costs:
Selling expenses
Administrative expenses
Marketing expenses

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MANUFACTURING: DIRECT
MATERIALS
Materials that are directly traceable to the goods
or services being produced.
Examples:
Flour in roti canai
Steel in an automobile
Wood in dining table
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MANUFACTURING: DIRECT
LABOUR
Labour that is directly traceable to the goods or
services being produced.
Examples: Wages paid to workers who only
manufacture the dining tables
(note dining table is the cost object)
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MANUFACTURING: FACTORY
OVERHEAD
Factory overhead are indirect manufacturing
costs
Examples include:
Depreciation on building and equipment
Maintenance
Supplies
Supervision (salary of plant manager)
Factory utilities
Property taxes
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CLASSIFICATION FOR FINANCIAL
REPORTING
Product vs Period Costs:
Product Costs
Reported as asset inventory but later as
expenses when the inventory is sold
Sum of the three elements of manufacturing cost:
Direct materials cost
Direct labour cost
Factory overhead cost
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Product vs Period Costs:
Period Costs:
Period/Non-inventoriable cost
Non-manufacturing costs such as selling,
administrative and marketing expenses
The whole amount shown as expenses in the
income statement
CLASSIFICATION FOR FINANCIAL
REPORTING (cont.)
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PRODUCT VS PERIOD COSTS
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Manufacturing Cost
Product Cost

Non-Manufacturing Cost
Period Cost
Direct
Material
Direct
Labour
Factory
Overhead
Conversion Costs
Prime Costs
Selling Exp Adm Exp Mkting Exp
Total Costs
Manufacturing and Non-
Manufacturing Costs
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COST CLASSIFICATION FOR
PERFORMANCE EVALUATION
Controllable or uncontrollable costs:
Controllability refers to whether manager can
control and consequently, be held accountable
Controllable costs are within the influence of the
manager and hence, included for performance
evaluation
Uncontrollable costs are beyond the influence of
the manager and hence, excluded for
performance evaluation
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COSTS CLASSIFICATION FOR
DECISION-MAKING
Relevant vs irrelevant costs:
Relevant costs are relevant and are therefore
included or considered for decision-making.
Relevant costs are affected by the choice of
alternatives in the decision-making process and
are costs that will incur in future.
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COSTS CLASSIFICATION FOR
DECISION-MAKING
Non-relevant costs are costs that have incurred
or remain unaffected by the decision.
Non-relevant costs are historical or past costs
and will not change with the decision thus, are
not relevant for decision-making.

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Avoidable and unavoidable costs:
Avoidable costs are future costs which can be
changed.
Unavoidable costs are past costs which cannot
be changed or costs which will continue in the
future, thus are irrelevant.
COSTS CLASSIFICATION FOR
DECISION-MAKING (cont.)
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COSTS CLASSIFICATION FOR
DECISION-MAKING (cont.)
Avoidable costs are relevant costs because
these costs are future costs which have not
been incurred. Examples of avoidable costs are
variable or incremental costs and opportunity
costs.

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Differential and non-differential costs:
Differential costs are costs that will differ in
amount at the different decision-making
alternatives.
Non-differential costs are the costs that do not
differ with the choice of alternatives.
COSTS CLASSIFICATION FOR
DECISION-MAKING (cont.)
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COSTS CLASSIFICATION FOR
DECISION-MAKING (cont.)
Only costs that will change by the decisions to
be made and are yet to be incurred are
relevant. Differential costs such as variable
costs are relevant.

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RELEVANT VS IRRELEVANT
COSTS
Opportunity and Sunk Costs:
Opportunity costs do not involve cash outlay
because they are valued as the forgone
benefits. Since opportunity costs will change by
the decisions to be made and are yet to incur,
opportunity costs are classified as relevant cost
for decision-making.
Sunk cost due to being historical or past cost is
irrelevant cost
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Summary on Cost Classification
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ALLOCATING MANUFACTURING
OVERHEAD COSTS TO PRODUCTS
Three reasons for allocating manufacturing
overhead costs to cost objects:
to determine the full manufacturing cost of the
cost object
to motivate the manager to manage costs
including manufacturing overhead
to plan, control and make decisions

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Allocation of manufacturing to cost object; uses
allocation base
Use predetermined overhead rate to enable the
allocation to be made during production period
rather than at end of period
Amount of applied overhead cost to product or
work in process is equal to the rate multiplied by
the actual activity or volume.
ALLOCATING MANUFACTURING
OVERHEAD COSTS TO PRODUCTS (cont.)
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OVER- OR UNDER-APPLIED
OVERHEAD
Overhead account has a credit balance when
overhead applied exceeds actual overhead. The
credit balance in the overhead account is the
amount of over-applied overhead.
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OVER- OR UNDER-APPLIED
OVERHEAD (cont.)
If overhead account has a debit balance, the
actual overhead exceeds the applied overhead.
This debit balance is the amount of under-
applied overhead.
Adjusting entry is needed to reflect overhead at
actual costs.
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INVENTORY OF
MANUFACTURING COMPANIES
Three inventories of a manufacturing business:
Direct materials inventory: Inputs in the process
of manufacturing finished products
Work in process inventory: Products not
completely finished and are therefore not ready
for sale
Finished goods inventory: Fully completed
products that remained unsold at the end of the
accounting period
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BALANCE SHEET OF
MANUFACTURING COMPANY
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COST OF GOOD SOLD
Cost of direct materials used = Beginning balance
Direct material inventory + Purchases Ending
balance Direct materials inventory.
Cost of goods manufactured = Beginning balance
Work in process inventory + Current manufacturing
cost incurred Ending balance Work in process
inventory.
Cost of goods sold = Beginning balance Finished
goods inventory + Cost of goods manufactured
Ending balance Finished goods inventory
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COST OF GOOD SOLD
Cost of direct materials used = Direct material
inventory at the beginning + Purchases Direct
materials inventory at the end.
Cost of goods manufactured = Work in process
inventory at the beginning + Current manufacturing
cost incurred Work in process inventory at the
end.
Cost of goods sold = Finished goods inventory at
the beginning + Cost of goods manufactured
Finished goods inventory at the end.
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COST OF GOODS SOLD (cont.)
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Beginning balance of work in process inventory 3000
Manufacturing costs for the period:
Direct material:
Beginning balance 1500
Add: Purchases 2000
Raw material available for use 3500
Deduct: Ending balance (1700)
Direct material used 1800
Direct labour costs 2500
Variable manufacturing overhead 800
Fixed manufacturing overhead 800
Total manufacturing costs for the period 5900
Total cost to account for 8900
Deduct ending balance work in process inventory (100)
Cost of goods manufactured 8800

SCHEDULE OF COST OF GOODS
MANUFACTURED
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Beginning balance of finished goods inventory

6000
Add: Cost of goods manufactured 8800
Goods available for sale 14800
Deduct: Ending balance of finished goods inventory (7800)
Cost of goods sold 7000
SCHEDULE OF COST OF
GOODS SOLD (cont.)

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