Lecture 1 – Role of Management Accounting, Cost Concepts
COST DEFINITONS AND CLASSIFICATIONS
The Cost Object (Or Cost Objective)
The item that the firm is costing is called the “cost object” or “cost objective”.
It may be:
o a whole process,
o a department,
o or a product (a motor car)/service (a hair cut)/job (laying Mr Smith’s new carpet).
Costing principles are identical whether we are referring to a product, a service, or a job.
A “cost driver” (or activity measure/activity level) is something which causes a cost to vary (increase or
decrease), and which is measurable and able to be linked to the product, service or job which the firm is costing.
There are three possible scenarios regarding cost drivers:
o Relatively easy to choose the cost driver. (e.g. considering only items over which you have control)
o More than one cost driver exists, and firms have to choose one.
can choose whichever one they want to!
No method is mandated therefore firms will make a decision frequently on cost-benefit
o There is no obvious cost driver.
Various Definitions of Cost
The full costs of a manufacturer are associated with the functional activities of the firm listed below (called the
value chain because all of these functions “add value” to the product):
1. Research and development )
2. Design )
3. Production (Manufacturing/Factory)
4. Marketing )
5. Distribution )
6. Customer service )
o This unit focuses on item (3)
Production (Manufacturing/Factory) Costs
There are only three possible manufacturing costs, defined in AASB102 (10). In summary they are:
o Direct materials (DM),
o Direct labour (DL), and
o Indirect costs (Manufacturing (factory) overhead (OH).)
DM + DL is called PRIME COST
DL + OH is called CONVERSION COST (this term is used in the accounting standards)
Product Costs for Valuing Inventory
A cost may be a production cost (DM, DL or OH), but whether it is also a product cost depends on whether the
firm is using absorption costing or variable costing.
A cost is a product cost if the cost is included for valuing inventory in the accounts.
o Product costs are also called inventoriable costs, because these costs are recorded as assets (inventory)
and only expensed when the goods to which they relate are sold.
Non-inventoriable costs are called period costs. (Not treated as assets. Expensed immediately to Profit and
Loss account in the period in which they are incurred.)
Under ABSORPTION COSTING:
All manufacturing costs are product costs
All non-manufacturing costs are period costs.
Under VARIABLE COSTING:
Only variable manufacturing costs are product costs
All fixed manufacturing costs, and all non-manufacturing costs are period costs. Fixed, Variable and Mixed Costs
Definitions of Cost Behaviour
Whether a cost is fixed or variable depends on how the total of the cost “behaves” in relation to the activity
level of the cost driver.
o Sales costs tend to vary with sales volume.
o Admin costs tend to vary with volume of either production or sales.
o Manufacturing costs are the focus of the remainder of this section.
A FIXED manufacturing cost is one which in total does not change (remains the same) relative to changes in
activity level of the cost driver. As activity level increases (e.g. as we produce more units, or as we use more DL
o total fixed costs remain constant
o fixed cost per unit decreases.
o This does not mean that a fixed cost never changes.
The amount of cost may change (ie the amount may increase or decrease) but this has
nothing to do with the number of units provided (activity level)
A VARIABLE manufacturing cost is one which in total varies in proportion to the activity level of the cost driver
(It does not just “vary” with activity level – it varies “in proportion to” the activity level.) As activity level
increases (e.g. as we produce more units, or as we use more DL hours etc):
o total variable costs increase proportionately
o variable cost per unit remains constant.
o If the variable costs varies in proportion, when producing 2 units, double the cost of producing just
Simplifying Assumptions for Management Accounting Purposes
For some variable costs (in particular materials), it is likely that as production volume increases the firm may buy
in bulk, resulting in a discounted price per unit. In reality the graph of the cost behaviour is a curve, not a
straight line, but this refinement is ignored for management accounting purposes.
Fixed costs in practice tend to be a particular dollar amount for a range of activity, and then increase for a
higher range of activity, and so on. For example, if production is suddenly doubled, the firm may need to lease
an extra room, and lighting cost would increase from $500 to, say, $1,000.
o All exercises in this unit will be restricted to one range of activity, called the "relevant range".
There are some costs that are not either fixed or variable as defined. When that occurs, firms will
“approximate” them to whatever cost behaviour is the closest.
Total Costs and Costs Per Unit
Determining whether a particular problem requires you to use total costs or per unit costs, however, is often
confusing. This difficulty arises because:
(1) The way to use costs depends what you are using the costs for (“different costs for different purposes”),
(2) Because of the different cost behaviour of fixed and variable costs.
Firms need to be able to answer the following types of questions:
(1) How much do you expect the total cost of produ