Elements of Cost

Objectives:
▪ Define cost and cost object

▪ Cost classification for:

● Inventory valuation
● Cost behavior
● Planning and control
● Decision making
Cost and Cost object
Cost is the expenditure incurred in the normal course of business in bringing the product
or service to its present location and saleable condition.
A cost object is anything for which you can assign a cost, for example, a product, a job
order or a department/division.

Assigning costs to cost objects is important to enable managers to:

1. Track profitability of a product line or among different product lines.
2. Evaluate the performance of managers in terms of their spending and
management of cost effectiveness.
3. Provide information for pricing decisions to ensure whether the product is being
sold within the profit margin or if it is too costly to produce as compared to market
price and should be discontinued.
4. Control spending among departments by comparing budgets to actual results
and ensuring that spending does not exceed the set threshold.
5. Decide whether to add or drop a product line; whether to make or buy a product
or outsource a service.

Cost classification for Inventory Valuation

Cost classification is the process of arranging cost items into groups according to their
degree of similarity and the purpose of the cost.

Product Cost vs Period Cost

Product costs are all manufacturing costs incurred, that are a necessary and integral part
in the production process of converting raw materials into a finished product.
Examples of Product costs are:
1. Direct materials – cost of materials used in production (input) that can be
reasonably traceable to the final product

2. Direct labour – any salary/wages cost of employees who directly worked at any
stage in producing/assembling the finished product

3. Factory (manufacturing) overheads – all manufacturing costs that are not direct
material or direct labour
Product costs are inventoriable costs, which means they are attached to and recorded
as inventory. Product costs are reported as Inventory on the Statement of Financial
Position for all unsold units of the finished product.
When the finished product is eventually sold, these costs are expensed as Cost of
Goods Sold on the Income Statement.
This is in accordance with the Matching Principle of matching revenue with the cost
incurred to generate it in the same period.

In a merchandising company, product costs are simply the purchase cost of goods
bought. Therefore, product costs relate to all companies that have inventory.

Period costs are all costs that are not product costs, that is, costs not involved in the
manufacturing process. They are not attached to inventory and are expensed when
incurred. These costs are matched with the revenue of a specific time period rather than
included as part of the cost of a saleable product or service. They relate to selling and
administrative expenses incurred in the period.

For example, ABC Ltd employs janitors for the administration offices and for the factory
plant. Is this janitorial cost a product or period cost?
The wages of the janitor who cleans the factory is a product cost because the factory is
where production of the goods takes place and product costs are all costs incurred in the
factory during the production process.
The wages of the janitor who cleans the administrative office is a period cost because no
production takes place in the administrative office so it will be expensed when incurred.
Exercise: Classify the production manager’s salary and the accounting manager’s salary
as either period or product costs.
The production manager’s salary 🡪 Product cost

The accounting manager’s salary 🡪 Period cost

Direct Cost vs Indirect Cost

Direct costs are costs that are reasonably traceable directly to a cost object. If the output
doubles then the behaviour expected is that the direct cost will also double. They include
direct materials, direct labour and other direct expenses.

Indirect costs are costs that are not reasonably traceable directly to a cost object. These
are factory (manufacturing) overheads that are incurred and usually for producing more
than one type of product at the same time, therefore, indirect costs are a common cost.

For example, assume that ABC Ltd produces and sells bicycles; the cost of the tires
assembled on the bicycles is a direct cost because the tires can be easily traced and
identified on the bicycle. Also, assume that the factory building is rented, that cost is not
easily traceable to any one unit of bicycle produced and therefore is an indirect cost.
Another example, assume a company produces two types of products. Product A uses
wood and Product B uses steel and there is one factory manager who receives a
monthly salary to oversee the production of these items. Identify any direct and indirect
costs in this example.
The wood and the steel for the respective products 🡪 Direct costs

The factory manager’s salary 🡪 Indirect costs

Direct costs and indirect costs combined results in total manufacturing costs.

Prime Cost is the total of all direct costs i.e. direct material, direct labour and any other
direct costs of production. These can be viewed as the main (therefore prime) costs
included in the production of the finished good.

Conversion cost is the combination of direct labour cost and factory overheads. It
represents the cost of converting raw materials into finished goods.
Cost classification by Behavior
Cost behavior is the way in which costs responds to changes in the volume of output or
activity. Cost behavior can be:
1. Fixed costs - cost that remains constant in total amount over a relevant range
of business activity for a particular period of time. Examples of these are factory
rent, factory depreciation or factory manager’s salary.

The relevant range can be described as the range of activity the entity expects
to operate within, which is decided by the management. This is the range of
output or production in which the entity’s cost assumptions are true. If they move
outside the relevant range, their cost assumptions are no longer valid.
Example, ABC Ltd manufactured chairs in a factory that was rented for $100,000.
If 50 chairs were produced the total rental expense is $100,000; if 100 chairs
were produced the total rental expense is still $100,000. On the other hand, the
rental expense per unit of production (per chair) is as follows:
For 50 chairs – $100,000 ÷ 50 chairs = $2,000 per chair
For 100 chairs – $100,000 ÷ 100 chairs = $1,000 per chair
For 200 chairs – $100,000 ÷ 200 chairs = $500 per chair

This shows that the fixed cost per unit decreases with increases in activity or
units produced but the Total Fixed Cost remains the same.

Consider the graphs below to illustrate these behaviours.

2. Variable costs – is a cost that changes in total amount proportionately
with some measure based on changes in the level of activity, with activity
being the number of units produced or the number of labour hours worked.
Typically, direct material cost and direct labour cost are variable costs.
For example, ABC Ltd produces bicycles and the direct labour cost to
assemble a bicycle is $10 per hour. Assume they produced 100 bicycles
with each unit requiring one hour to assemble, then the total direct labour
cost is as follows:
Direct labour cost p/hr = $10
Time to assemble one unit = 1 hour
Number of units produced = 100 bicycles
Total labour hours worked = 1hr x 100units = 100hrs
Therefore, total direct labour = 100hrs x $10 p/hr = $1000
In the example above, the total direct labour cost changed based on the
level of activity (i.e. units produced and number of hours worked on each
product line) as can be seen in the graph below where the straight line (or
linear graph) shows a steady or consistent increase in total cost as more
activity or units produced, occurs, however the variable cost per unit of
$10 p/hr remained constant (the same) as shown in the second graph.
3. Mixed costs – costs that must contain both a variable element and a fixed
element. They are also called semi-variable cost. An example of a mixed cost is
telephone expenses – there is usually a fixed service charge for each month plus
usage charges per call for all calls made for the month. Also, transportation
vehicle rental expenses – there is a fixed rental charge per day plus an additional
variable charge per mile (e.g. U-Haul).

In the two examples above, the fixed charge is the cost of having the service
available and the variable charge is the cost of actually using the service.
Cost $ Line 1

Line 2

Line 3

Output

The diagram above shows three illustrations of the behaviour of mixed costs:
a. Line 1 – this comprises a fixed charge plus a variable cost per activity
level. Notice the graph line starts at the axis and then increases in
linear manner, this is because even if there is no activity the fixed cost
is still incurred.

b. Line 2 – this comprises a fixed cost up to certain activity level and then
a variable cost thereafter.

c. Line 3 – this comprises a variable cost up to a certain activity level and

then a fixed cost thereafter.

4. Step costs – costs that remain fixed or constant over a limited range of activity
but once the limit is breached they will increase or decrease to another constant
amount and another limited range of activity.

For example, assume a Tour Guide Service pays a tour guide $300 per hiking
tour they conduct and each guide is responsible for ten (10) customers per hiking
tour. If the company books seven (7) customers for a tour then the labour cost
will be $300 but if the company books thirteen (13) customers then another tour
guide will have to be hired to accommodate the additional three (3) customers
over the limit of ten (10) customers and the labour costs will now increase a step
by another $300 to $600. Therefore an additional tour guide will have to be hired
for every group of ten (10) customers.

Another example, a manufacturing company employs a factory supervisor who

receives a fixed salary of $20,000 per month and manages twenty-five (25)
factory workers. If the company decides to increase production and hire fifteen
(15) more factory workers then another factory supervisor will have to be
employed to manage the extra workers and the company will incur an additional
$20,000 salary cost. Therefore for every group of twenty-five (25) factory workers
an additional factory supervisor will have to be employed.