Ch-3 Cost Behavior

8/12/2019 Ch-3 Cost Behavior

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Cost Behavior


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OBJECTIVE OF STUDY

Meaning of Cost Behavior Fixed cost Variable cost Mixed cost

Meaning of Costing

Difference between Costing and Cost AccountingDifference Between Costing and Pricing.Methods of CostingTechnique of CostingClassification of Cost


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COST BEHAVIOR

When we talk about cost behavior, we aren't referring to "good" or "bad" behavior.Cost behavior is nothing more than the sensitivity of costs to changes in production or sales volume. The range of output or sales over which costbehavior patterns remain unchanged is called the relevant range.

FIXED COSTS: Fixed costs are constant in total over the relevant range . Fixedcosts per unit often shows the inverse relationship between fixed costs and increases inproduction. As production increases, total fixed costs stay the same within the relevantrange, but since we are dividing a constant numerator [total fixed costs] by aprogressively larger denominator [total production or sales], the resulting costs perunit become smaller and smaller. Fixed costs include things like rent, insurancepremiums, management salary, depreciation and property taxes .

E.g., Straight-line depreciation is an example of a fixed cost. It does not matter whetherthe machine is used to produce 1,000 units or 1,00,000 units in a month, thedepreciation expense is the same because it is based on the number of years themachine will be in service.


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VARIABLE COSTS: Variable costs vary in total with volume, but are constantper unit within the relevant range. Total variable costs for a given situation areequal to the number of units multiplied by the variable cost per unit. Variable costsinclude things like labor and materials. Some overhead [indirect costs] such as

indirect labor, supplies and some utilities are also variable.

E.g., If it takes one yard of fabric at a cost of $5 per yard to make one chair, the totalmaterials cost for one chair is $5. The total cost for 10 chairs is $50 (10 chairs $5 perchair) and the total cost for 100 chairs is $500 (100 chairs $5 per chair).


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The graphs for the fixed cost per unit and variable cost per unit look exactlyopposite the total fixed costs and total variable costs graphs. Although total

fixed costs are constant, the fixed cost per unit changes with the number ofunits. The variable cost per unit is constant.

RELATIONSHIP BETWEEN FIXED COST PER UNIT AND VARIABLE COAT PER UNIT


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MIXED COSTS: Some costs, called mixed costs, have characteristics of bothfixed and variable costs.

For example, a company pays a fee of $1,000 for the first 800 local phone calls in a

month and $0.10 per local call made above 800. During March, a company made2,000 local calls. Its phone bill will be $1,120 ($1,000 +(1,200 $0.10)).


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Meaning of costing

Costing is a technique and process of ascertaining costs . This techniqueconsist of principle and rules which govern the procedure of ascertaining thecost of product/ service. The process of costing includes routines ofascertaining cost by historical costing, standard costing or marginal costing.

DIFFERENCE BETWEEN COSTING AND COST ACCOUNTING

Basis ofdistinction

Costing Cost Accounting

Nature It is technique and process ofascertaining cost.

It is regarded as a specializedbranch of Accounting

Scope The costing techniques includeprinciples and rules whichgovern the procedure of

ascertaining the cost ofproduct/ services

It involves classification,accumulation, assignmentand control of cost

Process The process of costing includesroutines of ascertaining cost byhistorical costing, standardcosting or marginal costing.

It involves establishment ofbudgets, standard costs oractual cost of operation,classification, recording andappropriate allocation of cost.


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DIFFERENCE BETWEEN COSTING AND PRICING

The word costing refers the cost incurred to manufacture the productand pricing is cost of selling the same product in the market .example : if we manufacture a toy which costs 200/- and the same toy we are going to sell in the market is 500/-.this is called pricing.

Pricing is based on the data produced in the costing process, the value customer place on the product and the competition in themarket.

costing is exclusive of profit margin. Whereas pricing is inclusive ofprofit margin.


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METHODS OF COSTING Various methods of ascertaining costs are available to suit the business need. But thebasic principles are the same in every method. The choice of a particular method ofcosting depends on the nature of business of the concern.

There are two basic methods of costing(a) SPECIFIC ORDER COSTING- : Specific order costing is the category of basic costingmethod applicable where the work consist of separate job, batches or contract eachof which is authorized by specific order or contract. Job costing, batch costing,contract costing are included in this category.

(b) CONTINUOUS OPERATION OR PROCESS COSTING-: This category of basiccosting methods applicable where standardized goods and services results from asequence of repetitive and continuous operations or process to which cost ischarged before being averaged over unit produced during the period.

JOB COSTING: Under this method, cost is accumulated and collected for each job, work order or project separately. The system of costing is used where production is nothighly repetitive and in addition consists of distinct jobs so that the material and laborcosts can be identified by order number. This method is followed by these concerns when work is carried on by the customers request A job card is prepared for each job for costaccumulation. This method is applicable to printers, machine tool manufactures,foundries and general engineering workshops.


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CONTRACT COSTING: Contract costing does not in principle differ from job costing. A contract is a big job whereas a job is a small contract . The term is usually applied where large-scale contracts are carried out. In case of builders, civil engineeringcontractors, constructional and mechanical engineering firm,this system of

costing is used . A separate account is kept for each contract.BATCH COSTING : This extension of job costing. A batch is a group of identicalproducts . Under batch costing a batch of similar products is treated as a separate unitfor the purpose of ascertaining cost. The total costs of a batch is divided by the totalnumber of units in a batch to arrive at the costs per unit. This method is used in

biscuit manufacture, garments manufacturer and spare parts and componentmanufacture.

PROCESS COSTING: This method is suitable where production is continuous,manufacturing is carried on by distinct and well defined process, the finishedproduct of one process becomes raw material of subsequent process, different

product with or without by-product are produced simultaneously at the sameprocess and product produced during a process are exactly identical . As finishedproduct obtained at end of each process, it will be necessary to ascertain not only thecost of each process, but also cost per unit at each process. A separate account is openedfor each process to which all expenditure incurred are charged. This is also known as Average processing or continuous processing. This method is used in textileindustries , chemical industries, tanneries, paper manufacture, soapmanufacturing etc


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ONE OPERATION ( UNIT OR OUTPUT ) COSTING : This method is suitable forindustries where manufacture is continuous and unit are identical. This methodis applicable in industries like mines, quarries, oil drilling, breweries, cement work, brick work etc . In all theses industries there is standard unit of cost say, a barrelof beer in breweries, a tonne of coal in collieries, a thousand of brick in brick work etc.

SERVICE COSTING: This is suitable for industries which render services asdistinct from those which manufacture goods . This is applied in transport, powersupply companies, municipal service, hospitals , hotel etc. This method is used toascertain cost per service rendered. There is usually a compound unit in suchundertaking tonne-kilometer(transport), kilowatt-hour(power supply), patientday(hospital).

FARM COSTING : It help in calculation of total cost and per unit cost of variousactivities covered under farming. Farming activities include agriculture, animalhusbandry, horticulture, poultry farming, pisciculture, dairy, sericulture, nurseries etc.

OPERATION COSTING: Operation costing is a further refinement of process costing.The system is employed in the industries of the following types:The industry in which mass or repetitive production is carried out

The industry in which articles or components have to be stocked in semi-finished stageto facilitate the execution of special orders, or for the convenience of issue for later

operations


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The procedure of costing is broadly the same as process costing except that inthis case, cost unit is an operation instead of a process . For example, themanufacturing of handles for bicycles involves a number of operations such as those ofcutting steel sheets into proper strips, molding , machining and finally polishing. Thecost to complete these operations may be found out separately.

MULTIPLE COSTING : It represents the application of more than one method ofcosting in respect of the same product. This is suitable to industries where anumber of components parts are separately produced and then assembled intofinal product. In such industries each component defer to another as to price,material used and process of manufacture undergone. So it is necessary to ascertaincost of each component. For this purpose process costing will be applied. To ascertaincost of final product batch costing may be applied. This method is applicable incycle, automobile, engines, radio, typewriter, aeroplanes.

DEPARTMENTAL COSTING : The ascertainment of the cost of output of eachdepartment separately is the objective of departmental costing. In case where a factoryis divided into a number of departments, this method is adopted.


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Job Costing Batch Costing Contract Costing

SPECIFIC ORDERCOSTING

Process costing Operation costing Multiple costing Service costing

Farm costing

CONTINOUSOPERATION OR

PROCESS COSTING

It is to be noted that basically there are only two methods of costing viz. job costing andprocess costing. Job costing is employed in cases where expenses are traceable to specific jobs or orders, e.g., house building, ship building etc. In case where it is impossible to tracethe prime cost of the items for a particular order because of the reason that their identitygets lost while manufacturing operations, process costing is used. For example, in a refinery

where several tons of oil is being produced at the same time, the prime cost of a specificorder of 10 tons cannot be traced. The cost can be found out only by finding out the cost perton of total oil produced and then multiplying it by ten. It may, therefore, be concludedthat the methods of batch contract and contract costing are only the variants of job costing whereas the methods of unit, operation and Service costing are the variants of processcosting.


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TECHNIQUE OF COSTINGIn each of the costing methods, various techniques may be used to ascertain cost,depending on the management requirement. These techniques may be grouped as

follows : A. ABSORPTION COSTING : It refers to the ascertainment of costs after theyhave been actually incurred . As per this system, fixed as well as variable costs areallotted to cost units and total overheads are absorbed by actual activity level. Absorption costing is termed as total costing, since total costs are ultimatelyallotted to cost units. It is also termed as historical or traditional costing.

However, since costs are ascertained after they have been incurred, and substantialtime-gap exists between occurrence of expenditure and reporting off costinformation, it does not help to exercise cost control.

B. MARGINAL COSTING : It refers to a principle whereby variable costs arecharged to cost units and the fixed costs attributable to the relevant period is

written off in full against the contribution for that period. Contribution is thedifference between sales and variable or marginal cost of sales. Marginal costing isalso known as direct or variable costing. It is a valuable aid to management intaking important policy decisions, such as product pricing, choosing product mix,decision to make or to buy, etc.


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C. STANDARD COSTING: It refers to the technique which uses standards for costsand revenues for the purpose of control through variance analysis. Standards areestablished for each cost element on a scientific basis for immediate future period,and actuals are compared against the standard. Variances from standards are

analysed, reasons established and corrective action taken to stop recurrence ofinefficient operation. Thus, standard costing is extremely helpful for costcontrol . Absorption costing system and marginal or direct costing system can beused in conjunction with standard costing system.

D. DIFFERENTIAL COSTING: It is defined as a technique used in the

preparation of adhoc information in which only costs and incomedifferences between alternative courses of action are taken intoconsideration . It considers only the additional costs and additional revenuesarising out of the decision regarding addition of a project.

E. UNIFORM COSTING : It refers to the use by several undertakings of the same

costing system i.e. the same basic methods, principles and techniques. This is not adistinct method of costing. The system is applied by a number of units of the sameundertaking or several undertakings within the same industry with a view topromote operating efficiency by comparing inter-unit or interfirm performancedata. Trade associations and multinational companies often use this system.


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TECHNIQUEOF COSTING

Absorption

costing

Marginal

costing

Standardcosting

DifferentialCosting

Uniform

costing


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CLASSIFICATION OF COST

Cost classification is the process of grouping costs according to their commoncharacteristics. A suitable cost classification is of vital importance in order to

identify the cost with cost centre or cost units .

The Important ways of classification are

By Nature or Element.By FunctionBy degree of Traceability to the productBy changes in the Activity or VolumeBy controllabilityBy NormalityBy relationship with Accounting PeriodBy Time

According to Planning and ControlBy Association with product.For Managerial Decisions.


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BY NATURE OR ELEMENT: According to this classification, the costs are divided into three categories

Materials CostLabor Cost

Expense Cost

BY FUNCTION According to this classification cost are divided in the light of different aspect of basicmanagerial activities involved in the operation of business.(a) PRODUCTION OR MANUFACTURING COST : Manufacturing costs are those costs

which are incurred in the course of manufacture. It includes cost of raw material, cost oflabour, other direct cost and factory indirect cost. Example of production ormanufacturing costs may be power, lighting, heating, rent, depreciation etc.(b) OFFICE AND ADMINISTRATION COST: These costs are incurred for the generaladministration of the enterprise. It includes office costs as well as administration cost.For example, salary of office staff, rent of office building, electricity charges, audit fee,printing and stationeries etc.(c) SELLING AND DISTRIBUTION COST: It includes both selling cost as well asdistribution cost. Selling costs are those costs which are incurred in connection with theselling of goods and services Distribution costs are those costs which are incurred ondespatch of finished goods to the consumers. Example of selling and distribution costsare: sales men salary, packing charges, carriage, out ward, advertisement, ware housecharges etc.


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BY DEGREE OF TRACEABILITY: According to this , total cost is divided intoDIRECT COST: Direct cost are those cost which are incurred for and may beconveniently identified with a particular cost centre or cost unit. Material used and

labor employed are example of direct costs.INDIRECT COST : Indirect cost are those which are incurred for the benefit of anumber of cost centre or cost unit and cannot be conveniently identified with aparticular cost centre or cost unit. Example of indirect cost are rent, managementsalaries etc.

BY CHANGE IN ACTIVITY OR VOLUME: According to this classification, costs are classified according to their behavior inrelation to change in the level of activity or volume of production.FIXED COST:Fixed costs are those costs which remain fixed irrespective of the changein volume of out put. As production increases cost per unit of the fixed cost decreasesand as production decreases fixed costs are, rent of the factory building depreciation,salary of the office manager etc VARIABLE COST: Variable costs are those costs which vary in direct proportion to the volume of out put. As production increases total cost increases but also per unitremains constant. As production decreases total cost decreases and cost per unit alsodecreases. Example of variable costs are, cost of raw materials labor etc.


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SEMI VARIABLE COST:These costs are partly fixed and partly variable. Examples of variable costs are telephone rent. It includes partly fixed charge up to a certain leveland then varies according to the calls.

BY CONTROLLABILITY : Under this, cost are classified according to whether ornot they are influenced by the action of a given member of the undertaking.CONTROLLABLE COST: Controllable cost are those which can be influenced by theaction of a specified member of an undertaking that is which are at least partly within the control of management. Example , all direct materials, direct labor arecontrollable by lower level management.

UNCONTROLLABLE COST: Uncontrollable cost are those which cannot beinfluenced by the action of a specified member of an undertaking, that is which arenot under the control of management. Example, rent of building, managerial salariesetc.

BY NORMALITY : under this , cost are classified asNORMAL COST: It is the cost which is normally incurred at a given level of out put.These costs are part of cost production. ABNORMAL COST: It is the cost which is not normally incurred at a given level ofout put. These costs are not charged to the cost of production. It is transferred to thecosting profit and loss account.


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BY RELATIONSHIP WITH ACCOUNTING PERIODCAPITAL EXPENDITURE: The cost which is incurred in purchasing an asset eitherto earn income or increase the earning capacity of the business is called capital

expenditure. Such cost is incurred one point of time but benefit are spread overnumber of accounting years. Example, Cost of rolling machine in steel plant.REVENUE EXPENDITURE: If any expenditure is incurred to maintain earningcapacity of the concern such as cost of maintaining an asset or running a businessis called revenue expenditure. Example, Cost of material, labour cost, salaries,depreciation, selling and distribution charges.

BY TIME: Cost can be classified as HISTORICAL COST : The cost which are ascertained after being incurred is calledHistorical cost. Such cost are available only when the production of a particularthing has already done. Such cost are only of historical value and not helpful forcost control purpose.PREDETERMINED COSTS : Such cost are estimated cost i.e, computed in advanceof production taking into consideration the previous periods, cost and factorsaffecting such costs. Perdetermined cost determined on scientific basis becomestandard cost. Such a cost when compared with actual will give reason of varianceand help the management to take remedial action.


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ACCORDING TO PLANNING AND CONTROL :Planning and control are two important function of management. Cost accountingprovide information to management which is helpful in discharge of two function. Basedon this , cost is classified asBUDGETED COST: Budgeted cost represent an estimate of expenditure for differentphases of business operation such as manufacturing, administration, sales, research anddevelopment etc. coordinated in well conceived framework for a period of time in future which subsequently become the written expression of managerial targets to be achieved. Various budget are prepared for various phases such as raw material budget, sales budget,production budget, cash budget, overhead budget etc

STANDARD COST: Budget cost are translated into actual performance throughinstrument of standard cost. Standard cost is the predetermined cost based on technicalestimate of material, labor, and overhead for a selected period of time and for aprescribed set of working condition.

BY ASSOCIATION WITH THE PRODUCT :

PRODUCT COST : Product cost are cost which are traceable to product and are includedin inventory control. Product cost are inventoriable cost and they become basis forproduct pricing and cost plus contracts. They comprises direct material, direct labor andproduction overhead in manufacturing concern.PERIOD COST: Period cost are incurred on the basis of time such as rent, salaries etc.these may relate to administration and selling cost essential to keep business running.

Though these are not associated with production and are necessary to generate revenue.


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FOR MANAGERIAL DECISIONS:

On this basis, costs may be classified into following costs

MARGINAL COST: Marginal cost is the total of variable costs i.e, prime cost plus variable overheads. It is based on the distinction between fixed and variable costs. Fixedcost are ignored and only variable costs are taken into consideration for determining thecost of product and value of work-in-progress and finished goods.OUT-OF-POCKET COST: This is that portion of the costs which involves payment tooutsiders i.e., give rise to cash expenditure as apposed to such cost as depreciation, which do not involves any cash expenditure.DIFFERENTIAL COST: The change in cost due to change in level of activity or patternsor method of production is called differential cost. If the change increases the cost, it will be called incremental cost. If there is decrease in costs resulting from decrease inoutput, the difference is known as decremental cost.SUNK COST: Sunk costs are historical or past costs. These are the costs which have beencreated by a decision that was made in the past and cannot be changed by any decisionthat will be made in the future. Investments in plant and machinery, buildings etc. areprime examples of such costs. Since sunk costs cannot be altered by decisions made atthe later stage, they are irrelevant for decision-making.


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SHUTDOWN COST: A manufacturer or an organization may have to suspend itsoperations for a period on account of some temporary difficulties, e.g., shortage of rawmaterial, non-availability of requisite labor etc. During this period, though no work is

done yet certain fixed costs, such as rent and insurance of buildings, depreciation,maintenance etc., for the entire plant will have to be incurred. Such costs of the idleplant are known as shutdown costs.NOTIONAL COST OR IMPUTED COST : Imputed cost and notional cost have samemeaning. These cost are notional in nature and do not cause any cash outlay. It isdefined as the value of benefit where no actual cost is incurred. Even though such

cost do not involve cash outlay, but they are taken into consideration while makingmanagerial decision. E.g, Rent charged on business premises owned by proprietor,interest on capital for which no interest is paid.OPPORTUNITY COST : It is the maximum possible alternative earning that might beearned if the productive capacity or service had been put to alternative use. Forexample, if owned building is proposed to be put for a project, the likely rent of the

building is the opportunity cost which should be taken into consideration whileevaluating profitability of project.


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Ch-3 Cost Behavior

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