1. Cost concepts, Cost Classification and Estimation
By Ghanendra Fago

2. Cost Concepts
Cost refers the amount of expenses spent to generate product or services.
Cost refers expenditure that may be actual or nominal expenses incurred to generate output.
Cost is the value of economic resources used as result of producing or doing the things.
Cost has many meaning but in management cost refers the expenditure not the price.
As a manager we use cost information for taking decisions and making plans, programs and policies and strategies.

3. Cost according to elements of cost
Direct material Direct labor Direct expenses Overheads

4. Cost According to function- Manufacturing Vs. Non-manufacturing costs
Manufacturing costs involves the cost of raw material, labour and use of equipment to finished goods
Composed up of the following elements.
Direct material
Direct labour
Overheads

5. Elements of Manufacturing Cost
Materials
Labour
Overheads- indirect material labors and factory expenses

6. Non manufacturing Cost
Cost other than manufacturing cost that are incurred for sale
Non-manufacturing costs are:
Selling expenses /marketing expenses
Promotion, or Advertisement costs,
Administrative costs

7. Cost according to behavior
Variable cost
Mixed cost
Fixed cost

8. Variable costs Variable costs are based on activity.
The variable costs should be zero at zero activity.
They change directly with changes in activity level in a responsibility center.
If output is doubled, variable expenses is to be doubled,
if output increases by 15% the variable expenses also increase by 15%,
if output is zero, the variable cost also zero.

9. Variable costs are usually characterized by:
Unit cost remains constant.
Total costs that increase as activity increases.
Total costs that decrease as activity decreases.
Total costs changes proportionality with changes in output.

10. Variable cost cost Variable cost Variable cost per unit
Units of products
cost
Variable cost
Variable cost per unit

11. Fixed Cost Fixed cost is also called period cost or capacity cost.
It does not change in short term period or within a relevant range.
They accrue primarily with the passage time.
Fixed costs are caused by holding of assets and other factors of production in a state of readiness to produce.

12. Characteristics of fixed cost
Unit cost increase as activities/outputs decrease.
Costs that remain constant even activities are decreased or decreased
Cost per unit that increases as activity decreases and vice versa
Total costs that remain constant.

13. Fixed cost curve
Fixed cost
Units of products
cost

14. Committed cost can not be changed by a simple decision.
Committed fixed cost
Committed cost arises from the ownership, facilities or possession of assets.
Committed cost can not be changed by a simple decision.
Major decisions to change.
For example: property tax, Loan installments
depreciation, insurance etc.

15. Discretionary fixed Cost
Arises from management decision
Controllable costs
Can be easily changed by decisions
Examples:
Advertisement,
Training costs
marketing expenses,
promotional expenses etc.

16. Step fixed costs
Remains constant over fixed range of activities but jumps to different amount for the activities levels outside the range

17. Semi–Variable Expenses/ Mixed costs
Semi–variable expenses also changes with changes in output or activity but not in proportion to changes in activity or output
Semi variable expenses have some of the characteristics of both fixed and variable costs.
Semi variable expenses are caused by combined effect of passage of time, activity or output and management discretion decisions.

18. Methods of Cost Segregation
Engineering analysis
Accounting analysis
High Low point methods
Least Square Regression Analysis

19. Engineering Analysis
Systematic review of costs for product and services
Measuring cost behaviors according to what cost should be, not by what have been
Mixed Cost Function = Rs4,000 + Rs.600 X Per Day

20. Accounting analysis This is a simple method
Segregates cost into fixed and variables based on certain cost driver.

21. Mixed cost function = Rs.720,000 + Rs.6 X units of production
Example: The Directorium Manufacturing Company produced and sold 80,000 units at Rs. 50 each. The cost for 1976 were as follows:
Particular
Fixed Cost
Variable Cost
Direct materials -
Rs.200,000
Direct labour
160,000
Manufacturing overhead
Rs.440,000
20,000
Selling and admi. expenses
280,000
100,000
Mixed cost function = Rs.720,000 + Rs.6 X units of production

22. High Low Point method
Under this method, semi variable cost can be segregated into variable and fixed cost based on the two extreme levels of activities using the following formulas.
Variable rate (b) = [Cost at high point- Cost at low Point]/
[High point –Low point]
Fixed cost (a) = Total cost – Variable rate  Level of activities
Therefore, the cost volume formula:
Total cost = Fixed cost + (Variable rate  levels of activities)

23. Advantages and Disadvantages
It is easy and less time consuming.
Cost behavior is restricted to the relevant ranges.
It will be more suitable when there are two levels of activities to estimate cost.
Disadvantages
Use of only two extreme conditions may not be representative of normal conditions
It may give the unreliable estimate of fixed cost (a) and variable rate (b).
It does not specify the fixed cost below and above the two levels of activities.

24. Least Square Analysis
One of the best and widely used methods in cost estimation,
A statistical procedure for estimating mathematically the average relationship between the dependent variable (y) and independent variable (a).
It includes all the observed data and attempts to find the line of best fit in estimation of variable and fixed cost.
Under this method, the following least square formula can be used to estimate cost.
Y = a + bx
Where, a = Estimated fixed cost i.e. constant
b = Variable rate i.e. slope of regression line
Y = Dependent variable i.e. estimated total cost
X = Independent variable i.e. Level of activity or units of products, hours etc

25. Least Square Formula

26. Regression Statistics
Least square regression method is used to estimate variable and fixed cost.
However, it doses not explain the accuracy and the reliability of the regression result.
To explain the accuracy and reliability of the regression result, Correlation coefficient (r) and Coefficient of Determination (r2)

27. Correlation Coefficient (r)
Goodness of fit regressions line can be measured by assessing correlation coefficient. The correlation coefficient can be computed as follows:
Correlation coefficient (r) =
Explanation:
The correlation coefficient measures the degree of correlation between y and x. Therefore, it should be between +1 and –1. If not, it means, it is unclear about the results. Then, coefficient of determinant should be computed to find the meaningful result using the following formula.

28. Coefficient of Determination (r2)
Explanation:
It means that ….% of the goodness of fit in regression line. Therefore, higher the degree, more the confidence in cost estimation. In other words, …. % means the total variation of total cost is due to change in levels of activities and remaining in due to other factors other than the independent variable.

29. Machine Hours (000 omitted)
Data for total power costs and machine hours are given below:
Power Costs (000 omitted)
Machine Hours (000 omitted)
Rs.7 6 8 3 4 7 5 9
Rs.62
70 hours
Required:
a) Separate the power costs into the fixed and variable components using the method of least squares.
b. Estimate the power costs when 6.5 machine hours are used.
c. Compute the coefficient of determination.
d. Does the regression equation need to be improved?
e. t-value,
e) Standard error of coefficient (Sb)

30. Classification of cost according to decision making
Relevant Cost and Irrelevant Cost
Avoidable and Unavoidable Costs
Out of pocket costs, Opportunity, Sunk costs
Period Cost and Product Cost
Direct Vs. Indirect cost
Controllable and Uncontrollable Cost
Incremental Cost/Differential Cost
Committed fixed cost and Discretionary fixed Cost

31. Relevant cost
Costs and expenses which are directly influenced by decision are relevant costs.
All future cost are relevant cost. They are pertinent and valid costs.
Relevant costs include all variable costs and additional fixed costs which are incurred because of the decision being taken

32. Irrelevant Cost
In other hand, costs that cannot be changed are called irrelevant costs. Irrelevant costs include the existing fixed costs which are going to exist even after the decisions are taken. Such costs do not affect the decision

33. Controllable and Uncontrollable Cost
Controllable and uncontrollable cost depends on the point of reference.
Uncontrollable cost at lower level may be controllable at top level, uncontrollable in short term may be controllable in the long run. etc.
A cost is a called controllable at particular level if the level has power to authorize the cost.
If it has not, it is called uncontrollable cost.

34. Avoidable VS Unavoidable Costs
Avoidable costs can be saved simply by not doing the alternative courses of action.
They are relevant in decision making
Unavoidable costs are irrelevant cost because they can not be avoided or eliminated by taking decisions or alternatives.
If the revenue generated by avoidable cost is high, we have to take decisions

35. Direct Cost and Indirect Cost
Direct costs are directly traceable or identifiable to a particular job or department or product and are controllable.
Indirect costs are uncontrollable and no-traceable costs.
Cost may be direct but the same may be indirect depends on the situation.

36. Incremental Cost/Differential Cost
Cost difference between two alternatives
If differential costs are increased, it is called incremental cost and decreased, and called decremental cost
Incremental cost refers the only the increased cost from one alternative to another.
Differential cost or incremental cost can also be used to analyses alternatives for decision-making purpose

37. Period Cost
Period costs are not manufacturing cost. However, they are incurred and paid based on the period
They are deductible from revenue.
Example: Rent, salaries, telephone etc.

38. Product Costs Product costs are manufacturing costs
They are incurred for the manufacturing of goods
They include direct material, direct labour, and manufacturing overheads.
Example: direct material, labour cost, manufacturing overhead etc.

39. Out of pocket expenses
Expenses incurred for activities for raw materials, labour overheads etc.

40. Opportunity Cost
Not recordable in the books of account but are considered in every decisions of managers.
It is the amount of benefit that is sacrificed when one alternative is selected.

41. Sunk costs Costs are the cost incurred a result of past decisions.
Cost can not be changed by taking operating decision
Sunk costs are irrelevant from decision making.
Sunk costs are depreciation of assets, lease rent etc.