BBA Study Material to Cost Accounting notes Cost Concepts For Decision Making

Abandonment Cost-

The abandonment cost is the cost incurred in closing down a department or a division  or in withdrawing a product or ceasing to operate in a particular sales territory etc. the abandonment costs are the cost of retiring altogether a plant from service. Abandonment arises when there is a complete cessation of activities and creates a problem as to the disposal of assets.

Urgent Cost-

the urgent costs are those which must be incurred in order to continue operation of the firm. For example, cost of material and labour must be incurred if production is to taken place.

Postponable Cost-

The postponable cost is that cost which can be shifted to the future with little or no effect on the efficiency of current operations. These costs can be postponed at least for some time e.g., maintenance relating to building and machinery.

Specific and Common Fixed Costs-

The specific fixed cost refers to those cost which can be easily identified with a department, process, product or territory. It follows that such costs which are not identified with a department, process, product or territory would be common fixed cost. This classification of cost is important for the purpose of decision making. For example, if there is a proposal to discontinue a product, specific fixed cost of the product shall be relevant where as common fixed cost of this product be irrelevant.  Similarly, if there is a proposal to discontinue a territory, the entire specific fixed cost of that territory shall be relevant for above decision.

Committed Fixed Costs-

The committed fixed cost is a cost that is primarily associated with maintaining the organisation’s   legal and physical existence over which management has little discretion. The committed cost is fixed costs which result from decisions of prior period. The amount of committed cost is fixed by decisions which are made in the past and not subject to managerial control in the short-run.  Since committed cost does not fluctuate with volume and remains unchanged until action is taken to increase or reduce available capacity. Committed cost does not present any problem in cost behavior analysis. Examples of committed cost are depreciation, insurance premium, rent, etc.

Discretionary Fixed Costs-

The discretionary fixed cost refers to those costs which are influenced by the managerial decisions. These costs will vary depending on the intentions of management. Examples:

  • Management may decide to pay bonus over and above the minimum bonus.
  • Instead of engaging the services of employees, it may be decided to outsource the services.
  • Replacement lf labour oriented machine with automatic machine.

Engineered Costs-

The engineered cost relates to the inputs like material, labour and expenses. Etc., which are directly connected with the product. The quality or material usage or labour hours can be determined for each product or activity. An item of engineered cost is a type of input that has a definite physical relationship with output. In most of the production processes it is possible to develop standards for both direct materials and direct labour and these standards reflect the relationship between input and output. Engineered costs can be established with the help of (a) engineering analysis and (b) analysis of historical costs and can be controlled by the management by scheduling production volume, taking proper care of machinery and assigning workers to various jobs.

Managed costs-

the managed cost is a cost that stems from current operations but which must continue to be incurred into the future , its sum level determined by management, to ensure the continued existence of the enterprise . The managed costs are those which have no direct relationship with the product.  The cost on advertisement, research and development, tool room, drawings and design, etc., cannot be easily associated with the product. The control system starts with budget is made on a monthly basis and variations are ascertained. Managed costs produce an output which benefits the firm in the same manner as engineered costs do but it is difficult to find an exact relationship between the amounts of managed costs incurred (input) and its output.

Capacity Costs-

The capacity costs are normally fixed costs. A definite relationship between capacity cost and the output of product emerge only in the long-run. The cost and incurred by a company for providing production, administration and selling and distribution capabilities in order to enable it to   perform its functions are termed as capacity costs. Capacity costs include the costs of plant, machinery and building for production, warehouse , and vehicles for distribution and key personnel for administration . Capacity costs are in the nature of long – term costs and are incurred as a result of planning decisions.

Programmed Costs-

The programmed cost is a cost that is subject to both the management discretion and management control but which has little immediate relevance to current operation although it is generally incurred to ensure long-term survival. Programmed costs are subject both to management discretion and management control, but which are unrelated to current activities. Advertisement, research and development, sales promotions are good examples and it appears that these costs results from special policy decisions of management.

 

Bba Study Material to Cost Accounting Cost Concepts for Decision Making short notes of Classification of Costs by Nature of Production Process

Classification of Costs by Nature of Production Process

Depending on the nature of production

process, the cost can be classified into the following:

Batch Cost-

It is the aggregate cost related to cost units which consist of a group of similar articles which maintain its identity through one or more stages of production.

 

Process Cost-

When the production process is such that goods are produced from a sequence of continuous or repetitive operations or processes, the cost incurred during a period is considered as process cost. The process cost per unit is derived by dividing the process cost by number of units produced in the process during the period. Accounts are maintained for cost of a process for a period. The average cost per unit produced during the period is process cost per unit.

Operation cost-

It is the cost of a specific operation involved in a production process or business activity. When there are distinctly separate operations involved in a process, cost for each operation is found out for effective control mechanism.

Operating cost –

It is the cost incurred in conducting a business activity. Operating costs refer to the cost of undertakings which do not manufacture any product but which provide services.

Contract cost –

It is the cost of contract with some terms and condition of adjustment agreed upon between the contractee and the contractor. Contract cost usually implied to major long-term contracts as distinct from short-term job costs. Escalation clause is sometimes provided in the contract in order to take care of anticipated change in material price, labour costs etc.

Joint costs-

These are the common costs of facilities or services employed in the output of two or more simultaneously produced or otherwise closely related operations, commodities or services. When a production process is such that from a set of same input, two or more distinguish-ably different products are produced together, products of greater importance are termed as joint products and products of minor importance are termed as by- products and the costs incurred prior to the point of separation of the products are termed as joint costs. For example, in a petroleum refinery industry, petrol, diesel oil, kerosene oil, naphtha, tar etc. are produced jointly in the refinery process. A by-product cost is the cost assigned to the by-products.

Bba study Material to Cost Accounting Cost Concept for Decision Making short not of Classification of Costs by Behaviour

Classification of Costs by Behaviour

Depending on the variability behavior, costs can be classified into.

Variable Cost-

The variable cost is a cost that tends to vary in accordance with level of activity within the relevant range and within a given period of time. The prime product costs i.e., direct material, direct labour and direct expenses tend to vary in direct proportion to the level of activity. An increase in the volume means a proportionate increase in the total variable costs and a decrease in volume will lead to a proportionate decline in the total variable costs. There is a linear relationship between volume and variable costs. They are constant per unit. Variable costs have an explicit physical relationship with a selected measure of activity and exists an optimum cause and effect relationship between the input and output. Therefore, variable costs are also known as engineered cost. All variable costs are not engineered costs. Some of the variable components which are termed as ‘discretionary  variable costs’ and such costs will  vary with fluctuations in the levels of activity merely because of the policy of the management. The variable element of research and development or advertisement costs, which are discretionary by nature, may increase with increased activity and management may decide to spend more in periods of increased activity.

Fixed Costs-

The fixed cost is a cost that tends to be unaffected by changes in the level of activity during a given period of time. The fixed costs remain constant in total regardless of changes in volume up to a certain level of output. They are not affected by change in the volume of production. There is an inverse relationship between volume and fixed cost per unit. Fixed costs tend to remain constant for all levels of activity within a certain range. It follows that some fixed costs will continue to be incurred even when the activity comes down to nil. Some fixed costs are liable to change from one period to another. For example salaries bill may go up because of annual increments or due to change in the pay rates and due to pay structure.

Semi-variable Cost or Semi-fixed Cost-

Many costs fall between these two extremes. They are called as ‘semi-variable costs ‘ or semi-fixed costs.’ They are neither perfectly variable nor absolutely fixed in relation to changes in volume. They change in the same direction as volume, but not in direct proportion thereto. An example is found in telephone charges. The rental element is a fixed cost whereas charges for calls made are a variable cost. The distinction between fixed and variable costs is important in forecasting the effect or short-run changes in volume upon costs and profits. This distinction has also given rise to the concepts of marginal costing, direct costing, and flexible budgeting. Costs which have neither a linear or curvilinear relationship with output but they move in steps with fluctuations in activity levels. These are called ‘stepped-up costs’. Basically these are fixed costs up to a certain level of activity specified but they change as soon as new range is reached such costs are semi-variable in the long- term but fixed in the short-term. Certain variable costs tend to vary during specific periods for a reason not related to fluctuations is activity level. For example increased maintenance cost during period of low production, increased costs on air-conditioning in summer. A cost which fluctuates with volume of production but after stage of production has reached the fluctuations in cost is disproportionate. It changes either of retarded or accelerated rates.

Bba Study Material to Cost Accounting Cost Concepts for Decision Making Short Notes of ImpoBba study material cost accounting, cost concepts for decision making short notes of rtance of Behavior wise Cost Classification

Importance of Behavior wise Cost Classification

Cost Control

The importance of separating variable from fixed costs stems from the different behavior patterns of each, which have a significant bearing on their control. Variable costs are controlled in relation to level of activity whilst fixed costs must be controlled in relation to time.

Decision Making

From decision making point of view it is important to know whether or not a particular cost will vary as a result of a given decision.

Marginal Costing

The marginal costing technique is based on separate treatment of fixed and variable costs. For this purpose all costs should be segregated into fixed costs and variable costs.

Flexible Budgeting

A flexible budget takes into account the changes in costs with the changes in activity levels. Flexible budgets cannot be prepared unless the impact of fluctuating activities on variable cost and fixed costs are shown separately.

CVP Analysis

Separation of cost into fixed costs and variable costs is important for cost-volume – profit analysis and break even analysis.

Direct Costing

The direct costing is a system of costing in which the product is charged only with those costs which vary with volume. Variable or direct costs such as direct materials, direct labour and variable manufacturing expenses are charged to the product cost. For computation of direct cost, all costs should be classified into variable costs and fixed costs.

Bba Study Material Cost Concept for Decision Making Diagrammatic Presentation of Cost Behavior

Diagrammatic Presentation of Cost Behavior

The behavior of costs as discussed above can be represented in the form of diagrams as shown in figure:

Bba Study Material to Cost Accounting  Cost Concept for Decision Making Short Notes  Method of Segregation of semi-Variable costs

 Method of Segregation of semi-Variable costs

The variability of costs can be determined by experience and thorough examination of cost behavior of cost items. But in many cases problem arises in separation of semi-variable or semi-fixed expenses into variable and fixed components. The following methods are used in separation of such costs into fixed costs and variable cost:

Bba study material short notes of industrial engineering method 

Industrial Engineering Method

This method is used to collect cost information that is not available in an organisation’s records and is particularly relevant when an organization is just beginning a new activity. Every productive process involves employing a particular mix of materials, labour and capital equipment in order to yield physical output. When the relationship between the input and output is established by an engineer or technical expert e.g., 2 kgs. Of materials+ 3 hours of labour =1 unit of output. The material and labour costs can be estimated by imputing material prices and wages rates to physical input needs. It is important to note that these costs are estimates because of possible uncertainty with regard to wastage in material usage and changes in labour efficiency in production process. The engineering method is particularly useful when applied to material and labour costs which represent a large proportion of the total output cost. If the relationship between material and labour inputs and outputs remain static over time, then these cost estimates can be used in the future without significant adjustment. When costing new products, the engineering method is the only approach that can be used due to lack of historic data. How there are three main disadvantages of the engineering method.

  • It is expensive as work measurement involves detailed analysis of the physical movement required in each task, in order to produce one unit of output.
  • There are other costs incurred in the production process e.g., machine maintenance and supervision which cannot be associated with specific units of output, but may be direct costs of the department. The engineering method cannot be applied to these costs, whose equations will have to be derived from an analysis of past data or from subjective evaluation.
  • Different mixes of materials and skills may be used to produce the same unit of output, leading to several conflicting cost estimates.

Although the engineering method is usually associated with production, work study techniques are applied to other areas, such as selling and administrative function of the organization.

Account Inspection Method

This method is a fast and inexpensive way of estimating costs as it simply involves examining each account and subjectively classifying the account’s total cost into either fixed or variable elements.  This requires that the management accounting inspect each item of expenditure within the ledgers at a given level of output to determine whether a cost is fixed, variable or semi-variable.

Illustration 1

Limitations- this technique has the following limitations:

  • It depends heavily on the initial decision to classify an account as fixed or variable.
  • It fails to recognize that semi-variable costs exist.
  • It relies on a single observation of the account to determine the cost equation rather than using an average based on several observations of each account.
  • It assumes that transactions have been correctly charged to one account or another.

The account inspection method should be used only when a crude approximation of cost behavior is sufficient for making decisions.

Bba study material cost accounting, cost concepts for decision making short notes of scatter graph method

Scatter graph Method

In this method, it involves plotting several observed levels of cost and their associated levels of activity on a scatter graph and then applying statistical analysis to fit the best line through these points.

Illustration 2

Output(units) 1,000 2,000 3,000 4,000 5,000 6,000  

Cost(Rs.) 10,500 12,500 13,800 15,100 15,900 17,200

The point at which the line of best fit touch the ordinate indicates fixed component of the cost i.e., Rs. 9,500 in this case. the slope of the line indicates the degree of variability of costs.

The scatter graph as shown in figure can be drawn with the help of the above data:

The line of best fit is relatively simple to apply and it does attempt to use all the information in the relevant range of production to arrive at the estimated cost function. However, it remains rather crude and does not adequately handle data points which are far away from the main body of points (called out liners). Another problem with this method is that each accountant using the same cost of equation may draw different total cost lines by eye, to describe the relationship between cost and activity. Despite these short coming, the method may be sufficient for the small company that does not possess the expertise to use complicated statistical technique.

Bba study material cost accounting, cost concepts for decision making short notes of high and low method

High and Low Method

Under this method, the highest and lowest volumes of output and the relevant cost figures are taken into consideration. The difference of cost between volumes, i.e., incremental cost for incremental output will be arrived at. The incremental cost will be further divided by the incremental  output. This will give the variable cost per unit. Total variable cost for any level of output can be determined easily. Now, the total cost of the volume of output less the total variable cost at that level of output gives the fixed cost which will remain for all levels of activity.

Illustration 3

The following are the Maintenance Costs Incurred in a Machine shop Per six months with corresponding Machine hours:

Illustration 4

The Standard Departmental overhead rate is Rs. 15 Per hour. Based on the following details provided to you, work out the activity level at which the overhead rate has been fixed.

Activity level (hours) 6,000 8,000 10,000
Overheads allowance (Rs.) 1,20,000 1,44,000 1,68,000
 
Solution 

Bba study material cost accounting, cost concepts for decision making short notes of Simple Regression Analysis

Simple Regression Analysis

After having established the fact that two variables are closely related we may be interested in estimating the value of one variable given the value of another regression is the measure of the average relationship between two or more variables in terms of the original units of the data. Several costs such as electricity charges, maintenance etc. varies with the volume of output though not in the same proportion. Thus when such expenses are to be estimated in a simple regression analysis, volume is taking as an independent variable and expenses as the dependent variable. This method is also known as ‘method of least squares’. In regression analysis one variable is taken as dependent while the other as independent, thus making it possible to study the cause and effect relationship. It should be noted that the presence of association does not imply causation, but the existence of causation always implies association. Statistical evidence can only establish the presence or absence of association between variables whether causation exists or not depends purely on reasoning. The closer the relationship between two variables, the greater the confidence that may be placed in the estimates. Variable may have either linear or non-linear relationship.

Two variables are said to have linear relationship when change in the ‘independent variable’ by one unit leads to constant absolute change in the ‘dependent variable’. When two variables have linear relationship, the regression line can be used to find out the values of dependent variable. When we plot the variables on scatter diagram,’ line of best fit ‘which pass through the plotted points, this line is called ‘regression line’. This regression line is based on equation called ‘regression equation’ which gives best estimate of one variable when the other is exactly known or given. These methods may be adopted to the analysis of costs to segregate the variable and fixed elements and determine their variability or relationship to volume changes.

Y= a + bx

Where,

y = total cost                           x = no. of units

a =fixed cost                           b = variable cost per unit

Illustration 5

From the data given in the following table, determine the fixed and variable components of the cost of Maintenance expenses.

Bba study material cost accounting, cost concepts for decision making short notes of multiple regression analysis

Multiple Regression Analysis

In the simple regression technique so far described, there is an assumed relationship between one dependent variable(y) and one independent variable (x). multiple regression analysis, in contrast, involves three or more variables. There is still a dependent variable (y), but now there are two or more independent variables. Knowing how to solve a multiple regression problem, awareness of its broad outline is necessary.

  • As with linear regression, the total function for ‘y’ is derived from an analysis of historical data.
  • The function for ‘y’ is described by the following formula:

Y = a + bx1 + cx2 + dx3 +……+ exn

Where,

X1,  x2, x3….xn          =  The various factors which affect the value of ‘y’

                    a      = Fixed constant value

b, c, d etc.         = The marginal change in the value of ‘y’ caused by each particular factor

  • The function for ‘y’ will, therefore, be impossible to draw on a two-dimensional graph, because there are three or more variables in the equation.
  • The aim of multiple regression analysis is to improve predictions of the value of ’y’ by recognizing that several different explaining factors might be involved , when the correlation between ‘y’ and any single independent variable is not high.

The disadvantage of multiple regression analysis is its relative complexity, and a computer programme would be needed to derive estimates of the ‘y’ function. However, provided that past estimates are a reliable guide to estimating for the future  (i.e., if the use of historical data to predict the future is valid) multiple regression analysis should prove more of reality. It should provide better information and its users will have more confidence in its predictions.

Illustration 6

On analysis, the electricity costs per month in ABC Ltd. vary with the number of working days in the month, the average daily temperature outside the building during the month and the number of employees. Using multiple regression analysis, a formula for estimating these costs per month has been derived as follows:


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