MFA Accounting Chapter 2

Cost: a monetary measure of the resources sacrificed or forgone to achieve a specific objective, such
as acquiring a good or service.

➢ But: rarely used without a preceding adjective to specify the type of cost being considered.

cost object: if the users of accounting information want to know the cost of something, it is called
cost object.

MANUFACTURING, MERCHANDISING AND SERVICE ORGANIZATIONS

Different types of organisations classify different costs based on their activities:

manufacturing organizations

- Raw material inventories

- Work in progress inventory
- Finished goods inventory

Merchandising organisations

- Only finished goods inventory

Service organisations

- Services cannot be stored for future use.

- Still: firms can have work in progress “inventory”, when a service is not finished at the end of
the financial period.

DIRECT AND INDIRECT COSTS

Direct material costs represent those material costs that can be specifically and exclusively measured
and identified with a particular cost object.

Example: wood used in the manufacture of different types of furniture can be directly
identified with each specific type of furniture such as chairs, tables and bookcases.

Direct labour costs are those labour costs that can be specifically and exclusively identified with a
particular cost object.

Example: a personal trainer in a gym can be specifically identified with an individual client or
with a specific instance of service.

↔ Indirect costs cannot be identified specifically and exclusively with a given cost object.

Example: cost of materials used to repair machinery cannot be identified with a specific
product and can therefore be classified as indirect material costs.

- Widely used equivalent: overheads.

➢ Normally categorized by their functional area, such as manufacturing, administration
or marketing.

Manufacturing and non-manufacturing costs

Distinguishing between direct and indirect costs

- Depends on object and context.

- Example:
If the cost object is the cost of using different distribution channels, then the rental of
warehouses and the salaries of storekeepers will be regarded as direct for each distribution
channel. If, by the same token, the cost object is the product, both the warehouse rental and
the salaries of the storekeepers will be an indirect cost because these costs cannot be
specifically identified with the product.

cost allocation: the process of assigning costs when a direct measure does not exist for the quantity
of resources consumed by a particular cost object.

➢ only direct costs can be accurately assigned to cost objects.

PERIOD AND PRODUCT COSTS

Product costs: costs that are identified with goods purchased or produced for resale.

Period costs: costs that are not specifically related to manufacturing or purchasing a product or
providing a service that generates revenues.

➢ no attempt is made to attach period costs to products for inventory valuation

purposes.

In a manufacturing organization, all manufacturing costs are regarded as product costs and non-
manufacturing costs are regarded as period costs.

Treatment of period and product costs

*Calculation example on page 32. Example 2.1. I left it out here because it takes a lot of space.

COST BEHAVIOUR

Variable costs vary in direct proportion to the volume of activity.

➢ Doubling the level of activity will double the total variable cost.
➢ Total variable costs are linear and unit variable cost is constant.

Graphically

↔ Fixed costs remain constant over wide ranges of activity for a specified time period. They are not
affected by changes in activity.

semi-fixed or step-fixed costs: within a given time period costs are fixed within specified activity
levels, but they are eventually subject to step increases or decreases by a constant amount at various
critical activity levels.
semi-variable costs or mixed costs: include both a fixed and a variable component.

Example: land line. Fixed component (the line rental) plus a variable component (the number
of telephone calls made multiplied by the cost per call).

RELEVANT AND IRRELEVANT COSTS AND REVENUES

Relevant costs and revenues are those future costs and revenues that will be changed by a decision,
whereas irrelevant costs and revenues are those that will not be affected by the decision.

Also sometimes referred to as

Avoidable costs are those costs that may be saved by not adopting a given alternative, whereas
unavoidable costs cannot be saved. Only avoidable costs are relevant for decision-making purposes.

Sunk costs: costs that have been created by a decision made in the past and that cannot be changed
by any decision that will be made now or in the future.

- Irrelevant for decision-making

opportunity cost: the opportunity (or benefit) that is lost or sacrificed when the choice of one course
of action requires that an alternative course of action be given up.

- Cannot be recorded in the accounting system, but influence decision-making.

Incremental costs or differential costs: the difference between the costs of each alternative action
that is being considered.

Similar to marginal cost and marginal revenue:

The main difference is that marginal cost/revenue represents the additional cost/revenue of
one extra unit of output, whereas incremental cost/revenue represents the additional
cost/revenue resulting from a group of additional units of output.

THE COST AND MANAGEMENT ACCOUNTING INFORMATION SYSTEM

A cost and management accounting information system should generate information to meet the
following requirements:

1. to allocate costs between cost of goods sold and inventories for internal and external profit
measurement and inventory valuation.
2. to provide relevant information to help managers make better decisions.
3. to provide information for planning, control and performance measurement.
A database should be maintained with costs appropriately coded or classified, so that relevant
information can be extracted for meeting each of the above requirements.

Responsibility accounting: For cost control and performance measurement, costs and revenues must
be traced to the individuals who are responsible for incurring them.

A responsibility centre is an organization unit or part of a business for whose performance a

manager is held responsible. (similar to a department)

Summary on page 41.