PM 521 Project Cost

Accounting and Finance

American University of Ras Al
Khaimah
School of Engineering
Dr. Ahmed Al sharif

Week 2:
Project Cost Accounting
and Finance

Cost Classification
Cost-Volume-Profit Analysis

What Does Cost Mean?

There is no single definition of cost

Costs are developed and used for some

specific purpose
The way the cost is to be used will
define the way it should be computed
Management accountants have used
different systems, or classifications, to
develop cost information

Methods of costing
It refers to the techniques and processes
employed in the ascertainment of costs
Choice of the method depends upon the
type and nature of manufacturing activity
Types: Broadly,
Job costing or job order costing
Process Costing

Methods of costing - Types

Job Order Costing Applies where work
is undertaken to customers special
requirements.
Contract Costing or Terminal Costing:
It is same as Job order costing; however,
job is small and contract is big contract.
Contract is of long duration and may
continue for more than a financial year.
Batch costing: Cost of a batch or group

Methods of costing Types..

Process Costing Applies to a context
where there is a continuous process. Costs are
accumulated for each process. And then total
cost of a process is divided by the number of
units produced to arrive at cost per unit.
Operations Costing: Involves cost
ascertainment for each operation.
Operating or services costing: It is applied
to services; cost units are passenger

Methods of costing Types..

Multiple or composite costing
Application of more than one method of
costing in respect of the same product.
Used in industries where a number of
components are separately
manufactured and then assembled into a
final product.
Single, output or unit costing: Applied
to a context where output produced are
identical, the cost per unit is found by

Techniques of costing Types..

Standard costing Standard cost is
predetermined as target of performance
and actual performance is measured
against the standard.
Budgetary control: By comparing
actual with planned / budgeted
performance

Techniques of costing Types..

Total Absorption costing Both fixed
and variable costs are charged to products.
Uniform Costing: It is not a technique but
a situation wherein several undertakings
use the same costing principle and
practices.

Element of cost
Cost object
Cost
Cost unit
Cost center
Profit center
Cost driver

Cost object
It is an activity or item or operation for
which a separate measurement of costs is
desired
A cost object is anything for which a
separate
measurement of costs is desired.
A product, a product line, an
organizational unit

Cost
It is the amount of expenditure
incurred on a specific cost object
Total cost = quantity used * cost per
unit (unit cost)

Cost unit
It is a quantitative unit of product or
service in which costs are ascertained,
e.g. cost per table made, cost per
meter of cloth

Cost Centre
Cost center is a location, person, or item of
equipment (or group of these) for which costs
may be ascertained and used for the purpose of
control
It refers to a section of the business to which
costs can be charged.
E.g. the rent, rates and maintenance of
buildings; the wages and salaries of store
keepers

Profit centre
It is location or function where
managers are accountable for sales
revenues and expenses
E.g. division of a company that is
responsible for the sales of products

Cost Drivers
A cost driver is a measure of activity or
volume level; increases in a cost driver
cause variable/total costs to increase.
The relevant range is the span of
activity levels for which the cost
behavior patterns hold.

Cost Classification
The different bases of cost classification are:
(1) By time (Historical, Pre-determined).
(2) By nature or elements (Material, Labour and Overhead).
(3) By degree of traceability to the product (Direct, Indirect).
(4) Association with the product (Product, Period).
(5) By Changes in activity or volume (Fixed, Variable, Semi-variable).
(6) By function (Manufacturing, Administrative, Selling, Research and
development, Preproduction).
(7) Relationship with accounting period (Capital, Revenue).
(8) Controllability (Controllable, Non-controllable).
(9) Cost for analytical and decision-making purposes (Opportunity, Sunk,
Differential, Joint, Common, Imputed, Out-of-pocket Marginal, Uniform,

By Time
(a) Historical Costs: These costs are ascertained
after they are incurred. Such costs are available
only when the production of a particular thing has
already been done. They are objective in nature
and can be verified with reference to actual
operations.
(b) Pre-determined Costs: These costs are
calculated before they are incurred on the basis of
a specification of all factors affecting cost. Such
costs may be:
(i) Estimated costs: Costs are estimated

 (ii) Standard costs: This is a particular

concept and technique. This method involves:
(a) setting up predetermined standards for each
element of cost and each product;
(b) comparison of actual with standard to find
variation;
(c) pin-pointing the causes of such variances and
taking remedial action.

By accounting period
Costs can be capital and revenue.
Capital expenditure provides
benefit to future period and is
classified as an asset.
Revenue expenditure benefits
only the current period and is
treated as an expense.

By Degree Of Traceability
Direct Costs: The direct costs are those
which can be easily traceable to a product
or costing unit or cost center or some
specific activity, e.g. cost of wood for
making furniture. It is also called traceable
cost.
Indirect Costs : The indirect costs are
difficult to trace to a single product or it is
uneconomic to do so. They are common to

Direct and Indirect.

Costs may be direct or indirect with respect to a
particular division or department. For example, all the
costs incurred in the Power House are indirect as far
as the main product is concerned but as regards the
Power House itself, the fuel cost or supervisory
salaries are direct. It is necessary to know the
purpose for which cost is being ascertained and
whether it is being associated with a product,
department or some activity.
Direct cost can be allocated directly to costing unit or
cost center. Whereas Indirect costs have to be
apportioned to different products, if appropriate

By Function
Manufacturing costs: all costs
incurred inside the factory
associated with transforming raw
materials into a finished product
Nonmanufacturing Costs: an
organizations other costs

Manufacturing Costs
Direct manufacturing costs are
traced or assigned to the products that
created those costs and include the
cost of material and the cost of labor
that is paid based on the amount of
work done
Indirect manufacturing costs
include costs of equipment, as well as
the wages and benefits paid to
production supervisors and workers

Indirect Manufacturing
Costs
More difficult to trace to products
because these costs have a cause-andeffect relationship with capacity rather
than with individual units of production
Assigning to a product involves
allocating what is deemed to be a fair
share of the indirect cost to that product
Generally allocated based on the
products use of the various capacity

Nonmanufacturing Costs (1 of
2)

Distribution costs involve

delivering finished products to
customers
Examples are freight and the salaries of
shipping and delivery personnel

Selling costs include sales

personnel salaries and commissions
and other sales office expenses
Marketing costs include

Nonmanufacturing Costs
After-sales costs involve dealing with customers
after the sale and include warranty repairs and the
cost of maintaining help and complaint lines
Research and development costs include
expenditures for designing and bringing new
products to the market
General and administrative costs include
expenses, such as the chief executive officers
salary and legal and accounting office costs, that
do not fall into any of the above categories

By Elements of costs - Materials

Material cost : cost of commodities supplied to
an undertaking
Direct materials cost: those costs which are
incurred for and conveniently identified with a
particular cost unit, process or department.
Ex: cost of raw material

Indirect materials cost: those costs which

cannot be conveniently identified with a particular
cost unit, process or department.
Ex: cost of material that are inexpensive but may or
may not physically become part of the finished goods

Elements of costs Labour cost

Labour cost : cost of remuneration
(wages, salaries, commissions, bonuses,
etc etc) of the employees of an undertaking
- Direct labour cost: wages paid to workers
directly engaged in the production process.
Eg: Wages of machine operator

- Indirect labour cost: those wages which

cannot be conveniently identified with a
particular cost unit, process or department

Elements of costs Expenses

Expenses: The cost of services provided for an
undertaken
- Direct Expenses: those expenses which can be
identified with and allocated to cost centers or units.
Eg: Royalty paid, depreciation of a plant used
- Indirect Expenses: All indirect costs other than
indirect materials and labor. They cannot be
directly identified with a particular job, process or
work order and are common to cost units or cost
centers

Elements of costs Price cost

Direct Material +
Direct labour +
Direct Expenses

Elements of costs Overheads

Indirect Material +
Indirect labour +
Indirect expenses
Overheads are divided into
a. Production overheads
b. Office and administration overheads
c. Selling and distribution overheads

Elements of costs Production

Overheads
Indirect Material such as coal, oil grease,
stationary in factory office
Indirect labour such as work managers
salary, salary of factory office staff, salary
of inspector and supervisors, watchman,
sweeper
Indirect Expenses such as factory rent,
depreciation of plant, repairs and

Elements of costs Office and administration overheads

Indirect Material such as stationary used in

administration office, postage, etc
Indirect labour such as salary of office staff,
Directors, watchman, sweeper
Indirect Expenses such as office rent,
insurance of office building, office lighting and
power, telephone, depreciation of office
furniture, office a/c, sundry office expenses

Elements of costs Selling & distribution

overheads

Selling cost: cost of seeking to create and stimulate

demand and of securing orders such as ads, samples and
free gifts, salaries of salesmen
Distribution cost: cost of making packed product
available for dispatch and returning of empty packages
for reuse
Indirect Material such as stationary used in sales office,
packing mat, cost of samples, price list, oil for delivery
vans
Indirect labour such as salary of sales staff, salary of of
MD, Directors, watchman, sweeper

The various elements of cost

By Changes in activity or volume

(Cost behavior)
Costs can be classified according to
how they behave with respect of
changes in activity levels into:

Variable
Fixed
Semi-variable

 Variable Cost:
Variable costs are those costs that vary
directly and proportionately with the output
e.g. direct materials, direct labour. It should be
kept in mind that the variable cost per unit is
constant but the total cost changes
corresponding to the levels of output. It is
usually expressed in terms of units, not in
terms of time.

 Fixed Costs: The cost which is incurred for

a period, and which, within certain output
and turnover limits, tends to be unaffected
by fluctuations in the levels of activity
(output or turnover).
These costs are incurred so that physical and
human facilities necessary for business
operations, can be provided. These costs
arise due to contractual obligations and
management decisions. They usually arise
with the passage of time and not with
production and are expressed in terms of

 Semi-fixed (Semi-Variable) costs: Such

costs contain fixed and variable elements.
Because of the variable element, they
fluctuate with volume and because of the
fixed element; they do not change in direct
proportion to output.
Semi-fixed costs change in the same
direction as that of the output but not in the
same proportion.

 As an example of a semi-fixed cost, a

company must pay a certain amount to
maintain minimum operations for a
production line, in the form of
machinery depreciation, staffing, and
facility rent. If the volume of
production exceeds a certain amount,
then the company must hire additional
staff or pay overtime, which is the

By Product
Product Costs: Product costs are those which are
traceable to the product and included in inventory
values.
In a manufacturing it comprises the cost of direct
materials, direct labour and manufacturing overheads.
Product cost is a full factory cost.
Product costs are used for valuing inventories which are
shown in the balance sheet as asset till they are sold

Period Costs: Period costs are incurred on the basis of

time such as rent, salaries, etc., include many selling and
administrative costs essential to keep the business
running.
Though they are necessary to generate revenue, they are
not associated with production, therefore, they cannot be
assigned to a product.

Cost classified for analytical and

decision Making
Analytical and decision making
according to relevance to decisionmaking are:

- Costs relevant to decisionmaking

- Costs irrelevant to decision-

(A) Relevant cost :

Marginal cost
Marginal cost is the incremental cost of producing the next unit.
When costs are linear and the level of activity is within the
relevant range, marginal cost is the same as variable cost per unit.
Marginal Cost is relevant for decision-making, as this cost will be
incurred in future for additional units of production.

Relevant cost : Differential cost

Differential Cost: The difference in total
cost between alternatives, calculated to
assist decision making". Differential cost is
the increase or decrease in total costs
resulting out of change in the level of
activity or pattern or method of production.
Differential costs is useful in planning and
decision making and helps to choose the
best alternative. It helps management to
know the additional profit that would be

Relevant cost : Opportunity cost

Opportunity costs are the benefits of an alternative one gives up when
that alternative is not chosen. It is the value of sacrifice made
or benefit of opportunity foregone in accepting an
alternative course of action.
Example: Capital is invested in plant and machinery. It cannot
be now invested in shares or debentures. The loss of interest
and dividend that would be earned is the opportunity cost.
Opportunity costs are not recorded in the books. It is
important in decision making and comparing alternatives.
Opportunity costs are sometimes difficult to measure because they are associated
with something that did not occur.
Opportunity costs are always relevant in decision making.

Relevant cost : Out of Pocket Cost

Out of Pocket Cost: It involves payment to
outsiders i.e. gives rise to Cash Expenditure as
opposed to such costs as depreciation which
don't involve any cash expenditure.
Cash for the decision at hand avoided or
saved, if a particular proposal under
consideration is not accepted.
Such costs are relevant when make or buy
decision is to be made.

Relevant cost: Imputed Costs

Imputed Costs: Some costs are not incurred
and are useful while taking decision pertaining to
a particular situation. These costs are known as
imputed or notional costs and they do not enter
into traditional accounting systems (no payment
has been made).
Examples: Interest on internally generated funds
or notional rent etc.
Where
alternative
capital
investment
projects
are
being
evaluated,
it
is

Relevant cost: Replacement Costs

Replacement Costs: This is the cost of replacing
an asset at current market values e.g. when the
cost of replacing an asset is considered, it means
the cost of purchasing the asset at the current
market price is important and not the cost at
which it was purchased.
It is the cost of replacement at current market
price and is relevant for decision-making.

Relevant cost: Common Costs

Common Costs: Common costs are those costs
which are incurred for more than one product, job,
territory or any other specific costing object. They
are not easily related with individual products and
hence are generally apportioned.
The cost of services employed in the creation of
two or more outputs which is not allocable to
those outputs on a clearly justified basis.
It should be kept in mind that management
decisions influence the incurrence of common

Relevant cost: Discretionary costs

Discretionary costs are periodic costs
incurred for
activities that management may or may not
determine are worthwhile.
Can be cut for (short periods of time) with
minimal damage to long term goals
Discretionary costs are relevant for
decision making only if they vary across the

(B) Irrelevant Costs:

(Not useful for decision making): Sunk costs

Sunk costs are costs that were incurred or sunk

in the past.
Firm has obsolete stock of materials originally
purchased for $50,000 which can be sold as
scrap now for $18,000 or can be utilised in a
special job, the value of stock already
available $50,000 is a sunk cost and is not
relevant for decision-making.

Irrelevant Costs : Absorbed

Fixed Costs:
Fixed Costs do not change due to increase
or decrease in activity
Fixed Costs are absorbed in cost of
production at a normal rate, they are
irrelevant for managerial decision-making.
However if Fixed Costs are specific, they
become relevant.

Irrelevant Costs: Committed

Costs:
Cost in respect of which decision has already been taken,
and such decision cannot be altered.
e.g. entering into irrevocable agreements for Rent,
Technical Collaboration, etc.
should be contrasted with Discretionary Costs, which are
avoidable costs.
1) long term in nature.
2) cant be significantly reduced, even over short periods of
time without changing the long term goals of the company.

What Information is Relevant for Decision

Making?
Information is relevant if:
Differs across the alternatives, and
Is about the future.
Relevant information can be quantitative or
qualitative
Information is irrelevant if:
Does not vary with the option chosen or
action taken
Irrelevant information is NOT useful in decision

Product cost
Product cost are related to the goods purchased
or produced for resale
If the products are sold, the product cost will be
included in the cost of goods sold and recorded
as expenses in current period
If the products are unsold, the product costs will
be included in the closing stock and recorded as
assets in the balance sheet
64

Prime Costs
Direct
Materials

Direct
Labor

Prime
Costs

Prime cost is the combination of a manufactured product's

costs of direct materials anddirect labor. In other words,
prime cost refers to thedirect production costs.
Indirect manufacturing costs arenotpart of prime cost.

Conversion Costs
Conversion cost is the production cost of
converting raw materials into finished product
Manufacturing
Direct
Conversion
+ Overhead = Costs
Labor

Indirect
Labor

Indirect
Materials

Other

Cost accumulation
Prime cost = direct materials + direct labour
Production cost = Prime cost + factory overhead
OR
= Direct materials + Conversion cost
Total cost = Prime cost + Overheads (admin, selling, distribution
cost)

OR
= Production cost + period cost (administrative, selling,
distribution and finance cost)

After the break

Cost-Volume-Profit
Analysis

CVP Analysis and the Breakeven Point

CVP analysis looks at the relationship
between selling prices, sales volumes, costs,
and
The profits.
breakeven point (BEP) is where total revenue
equal total costs.
$

Total Revenue (TR)

BEP in
sales $

Total Costs (TC)

units
BEP in units

How is CVP Analysis Used?

CVP analysis can determine, both in
units and in sales dollars:
the volume required to break even

the volume required to achieve target profit levels

the effects of discretionary expenditures
the selling price or costs required to achieve
target volume levels

Q2: CVP Calculations for a Single

Product

where F = total fixed costs

P = selling price per unit
V = variable cost per unit
P - V = contribution margin per unit

Q2: CVP Calculations for a Single Product

Units required to achieve target
pretax profit
Q

F Profit

P -V

where F = total fixed costs

P = selling price per unit
V = variable cost per unit
P - V = contribution margin per unit

To find the breakeven point in units, set Profit = 0.

Units required to achieve

target
Q
pretax profit

F Profit

P -V

Q2: CVP Calculations for a Single

Product
To analyze CVP in terms of total revenue
instead of units.

The contribution margin ratio can be written

in terms of total revenues (TR) and total
variable costs (TVC).

Sales $ required
to achieve target
pretax profit

F Profit

CMR

where F = total fixed costs

CMR = contribution margin ratio

Note that CMR

can also be
computed as

Total Revenue Total Variable Costs

CMR
Total Revenue

To find the breakeven point in sales $, set Profit = 0.

 Use the forecast information about volume

(12,000 bikes) to determine the contribution
margin ratio.

Breakeven Point
Managers often want to know the level of activity
required to break even.
We can calculate the breakeven point from any of the
preceding CVP formulas, setting profit to zero.
Depending on which formula we use, we calculate the
breakeven point in either number of units or in total
revenues.

Q2: Breakeven Point Calculations

Bills Briefcases makes high quality cases for laptops that
sell for $200. The variable costs per briefcase are $80, and
the total fixed costs are $360,000. Find the BEP in units
and in sales $ for this company.
BEP in units

BEP in sales $

F 0
$360,000

P V $200 / unit $80 / unit

$360,000

3,000 units
$120 / unit

F
$360,000
F 0

(P V ) / P ($200 $80) / $200

CMR
$360,000

$600,000
60%

Q2: CVP Graph

Draw a CVP graph for Bills Briefcases. What is
the pretax profit if Bill sells 4100 briefcases? If he
sells 2200 briefcases? Recall that P = $200, V =
Profit at 4100 units =
$80, and F = $360,000.TR
$120 x 4100 - $360,000.
$132,000

$1000s

TC

$600
$360

Profit at 2200 units = $120 x 2200 - $360,000.

More easily: 4100 units is 1100 units past BEP, so
profit = $120 x 1100 units; 2200 units is 800 units
before BEP, so loss = $120 x 800 units.

-$96,000

2200

3000

4100

units

Q2: CVP Calculations

How many briefcases does Bill need to sell to reach
a target pretax profit of $240,000? What level of
sales revenue is this? Recall that P = $200, V = $80,
Units F
needed
to reach
and
= $360,000.
F Profit $360,000 $240,000
target pretax profit

P V

$120 / unit

5,000 units
Sales $ required to
reach target pretax
profit

F $240,000
F

CMR
(P V ) / P

$600,000
$1,000,000
60%

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 After-tax profit is calculated by subtracting income tax

from pretax profit. The tax is usually calculated as a
percentage of pretax profit.

Income Tax
The Spotted Cow Creamery is a popular ice cream
emporium near a university in Munich, Germany.
Information for the most recent month (amounts in
euros) appears here.
Income statement:

CVP Calculations
How many briefcases does Bill need to sell to reach a
target after-tax profit of $319,200 if the tax rate is
30%? What level of sales revenue is this? Recall that P
= $200, V = $80, and F = $360,000.
First convert the target after-tax profit to its target pretax profit:
Pretax profit

After-tax profit $319,200

$456,000
(1 Tax rate)
(1 0.3)

Units needed to reach

$360,000 $456,000

6,800 units
target pretax profit
$120 / unit
Sales $ needed to
reach target pretax
profit

$360,000 $456,000
$1,360,000
60%

Using CVP to Determine Target Cost Levels

Suppose that Bills marketing department says that they
can sell 6,000 briefcases if the selling price is reduced to
$170. Bills target pretax profit is $210,000. Determine the
highest level that his variable costs can be so that he can
make his target. Recall that F = $360,000.

Use the CVP formula for units, but solve for V:

Q = 6,000 units

$360,000 $210,000

$170/unit V

$360,000 $210,000
$170/unit V
$95/unit
6,000 units
V $75/unit

If Bill can reduce his variable costs to $75/unit, he can meet his goal.

Uncertainties in Bills Decision

After this analysis, Bill needs to consider several issues
before deciding to lower his price to $170/unit.

How reliable are his marketing departments

estimates?
Is
a $5/unit decrease in variable costs feasible?
Will this decrease in variable costs affect product
quality?
If 6,000 briefcases is within his plants capacity but
lower than his current sales level, will the increased
production affect employee morale or productivity?

Using CVP to Compare Alternatives

CVP analysis can compare alternative cost structures or
selling prices.
high salary/low commission vs. lower salary/higher commission
for sales persons
highly automated production process with low variable costs per
unit vs. lower technology process with higher variable costs per
unit and lower fixed costs.
broad advertising campaign with higher selling prices vs. minimal
advertising and lower selling prices

The indifference point between alternatives is the level of

sales (in units or sales $) where the profits of the
alternatives are equal.

Using CVP to Compare Alternatives

Currently Bills salespersons have salaries totaling $80,000
(included in F of $360,000) and earn a 5% commission on each
unit ($10 per briefcase). He is considering an alternative
compensation arrangement where the salaries are decreased to
$35,000 and the commission is increased to 20% ($40 per
briefcase). Compute the BEP in units under the proposed
First Recall
compute
V under
plan:
alternative.
thatF Pand
= $200
and the
V =proposed
$80 currently.
F = $360,000 - $45,000 decrease in salaries
V = $80 + $30 increase in commission

= $315,000
= $110

Then compute Q under the proposed plan:

Units needed
$315,000
to breakeven Q F 0
3,500 units
$200 / unit - $110/unit
P V

Determining the Indifference Point

Compute the volume of sales, in units, for which Bill
is indifferent between the two alternatives.
The indifference point in units is the Q for which the profit equations of
the two alternatives are equal.
Contribution margin
unit
Totalper
fixed
costs

Current Plan
$120
$360,000

Proposed
Plan
$90
$315,000

Profit (current plan) = $120Q - $360,000

Profit (proposed plan) = $90Q - $315,000
$120Q - $360,000 = $90Q - $315,000
$30Q = $45,000

Q = 1,500 units

CVP Graphs of the Indifference Point

Draw a CVP graph for Bills that displays the costs
under both alternatives. Notice that the total revenue
line for both alternatives is the same, but the total cost
lines are different.
BEP for the
TR
TC-proposed plan
$1000s

current plan

TC-current plan
$600
BEP for the
proposed plan

$360
$315

indifference point between the plans

1500

3000

3500

units

Comparing Alternatives
The current plan breaks even before the proposed plan.
At 1500 units, the plans have the same total cost.
TR

$1000s

TC-proposed plan
TC-current plan

$600

Each unit sold

provides a larger
contribution to profits
under the current
plan.

$360
$315

1500

3000

3500

units

Uncertainties in Bills Decision

Hopefully Bill is currently selling more than
1500 briefcases, because profits are negative
under BOTH plans at this point.

The total costs of the current plan are less

than the those of the proposed plan at
sales levels past 1500 briefcases.
Therefore, it seems the current plan is
preferable to the proposed plan.
However, . . .

Uncertainties in Bills Decision

. . . this may not be true because the level of future
sales is always uncertain.

What if the briefcases were a new product line?

Estimates of sales levels may be highly uncertain.

The lower fixed costs of the proposed plan may be safer.

The plans may create different estimates of the

likelihood of various sales levels.
Salespersons may have an incentive to sell more units under the
proposed plan.

 Questions?