Lecture 1

An Introduction to Cost Terms and Purposes

Compiled by
Dr/Mohamed Shaaban

Source: 1) Cost Accounting for Managerial emphasis by

Charles Horngren et.al.2012
2) Cost accounting principles by Hassan abdrahman 2021
3) Lecture notes in Cost accounting by Gamal Ali et.al.2024

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Education. All rights reserved.
Definition of Cost accounting & its Purpose
“Cost accounting is the field of accounting that measures,records, and reports information about
costs.” Is the process of identifying, summarizing and interpreting the cost information in order
to help top management in planning, controlling and Making decisions

The users of Cost Accounting information are only theTOP Management

Standard cost Sheet (planning cost)

Source :Hassan abd Rahman 2021 Cost accounting

principles
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Objectives of Cost Accounting:
1. A basis for pricing contracts and Bids.
2. Cost measurement : Determining the cost of product manufactured
3. Cost control: by comparing the standard (planned)cost with the actual one for purpose of discovering gap.
4. Elimination of waste and improvement of performance(detecting idle time, overtime, spoilt product).
5. Cost management & reduction: by determining a target costs to reduce actual cost to achieve desirable profit
6. A Basis for managerial decision making (add/drop, Make/buy, continue/replace).
7. Profit planning & price determination.A measure of economic performance.
5. CVP (Cost volume profit analysis – Breakeven point). Break-even point is a cornerstone of management decision making
and perhaps the most famous product of cost accounting. The break-even point is a mathematical calculation arrived it
where profit or loss for a business is zero. This point is important because it determines a minimum threshold for activity
level and provides a quantity at which a business’s experiences greater profitability as the activity increases. This allows a
business’s management to know when to take on additional business at reduced prices.
6. Providing data for inventory valuation& income determination for manufacturing companies.
7. Accumulating costs to evaluate operating efficiency as it helps management in exercising effective control on cost
elements which are raw materials, work in progress and finished goods.

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Distinction between Cost & Financial Accounting
Financial Accounting Cost Accounting
1. Scope of objectives Preparing the financial statements measuring, analyzing, and reporting
(balance sheet, income statement, cash the information relating to the costs.
flow statement)

2. Users of information External parties such as investors and Internal users such as managerial
creditors levels.
3. Time span of events Depends on past data/ events. Depends on past, current, and future
data/ events.
4. The reporting standard Generally Accepted Accounting Relevant information to decisions
Principles (GAAP). making (Relevance).

5. Report scope Pertains to business as a whole. Pertains to subunits of the business,

such as: divisions, centers,
departments
6. Details of the reports Highly aggregated (condensed). Very detailed.

7. Reporting obligations Mandatory by law. Optional reports according to the

managerial needs for cost information.
8. Frequency of Reports Quarterly and annually. As frequently as needed.

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Differentiate between Cost, expenses, losses:
Cost:
• Is the value of assets given up to acquire anotherasset
• Is a sacrifice of resources
Example:
-If we pay cash to purchase supplies then it is cost
Expenses:
• Is the value of asset given up to generate revenue
• We use the term expenses for external reporting purposes.
Example:
- If we pay wages to employee who works to generate revenue, the wages are expenses
Losses/Spoilage:
If the value of assets given up for nothing in return.

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Basic Cost Terminology
• Cost—sacrificed resource to achieve a specific objective
• Actual cost—a cost that has occurred
• Standard/Budgeted cost—a predicted-planned cost
• Cost object—anything of interest for which a cost is assigned or allocated.
• Target cost- the desirable cost to be achieved
• Cost accumulation (pooling)—a collection of cost data in an organized manner
• Costing- the method used to assign or allocate cost on the cost object this
includes:
• Tracing accumulated costs with a direct relationship to the cost object
• Allocating accumulated costs with an indirect relationship to a cost object

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Cost Classification /1-Direct and Indirect Costs
• Direct costs can be conveniently and economically traced (tracked) to
a cost object.
• Indirect costs cannot be conveniently or economically traced (tracked)
to a cost object. Instead of being traced, these costs are allocated to a
cost object in a rational and systematic manner.

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Cost Examples
• Direct Costs
• Parts
• Assembly line wages
• Indirect Costs
• Electricity
• Rent
• Property taxes

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Classification criteria for direct and indirect costs:
Cost can be classified as “direct cost” if the following 3 criteria are met:
1. Easily traced to particular product or process.
o Example: The cost of the steel or tires can be easily traced to cars/
trucks.
o Example: The cost of wood can be easily traced to furniture.
2. Causal relationship between cost elements and the final product
o Example: individual workers record on their time sheets the hours
they spend working on particular product.
3. Materiality of cost: the cost elements is significant in value to the cost
of final product (if the cost element ≥ 5% of the cost of final product)
o Example: Wood is direct cost, and nails is indirect cost.

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BMW: Assigning Costs to a Cost Object

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 BMW manufacturing vehicle X5
Cost Elements Easily traced Causal Relationship Materiality Direct or Indirect

Steel ✓ ✓ ✓ Direct Cost

Nails ✗ ✓ ✗ Indirect Cost

Glue ✗ ✓ ✗ Indirect Cost

✓ ✓
Packing materials ✗ Indirect Cost

Glass ✓ ✓ ✓ Direct Cost

Tires ✓ ✓ ✓ Direct Cost

Wages of production workers ✓ ✓ ✓ Direct Cost

Salaries of Production Supervisors ✗ ✓ ✗ Indirect Cost

Utilities ✗ ✓ ✗ Indirect Cost

Rent ✗ ✓ ✗ Indirect Cost

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Depreciation ✗ ✓ ✗ Indirect Cost
 Cost Classification /2-Cost elements
The elements of cost are broadly classified into material, labor, and overhead. Each of them is further divided into direct and
indirect costs.
(1)Material cost: This is the cost of the basic substances that are used to produce an item. It can be further classified into
direct material and indirect material.
Direct material: Materials are substance which are directly involved in the manufacturing of a product and are
present in the finished product constitute direct material. For example, wood used to make furniture, or cloth
used to make a shirt.
(2) Labor cost: These are the human resources required to convert materials into finished goods. They can be further
classified into direct and indirect labor.
Direct labor: People who are involved actively during the manufacturing of products. For example, production
or manufacturing labor.
.
(3)Overhead costs: Costs incurred by a business, other than Direct material and direct labor costs, generally fall under this:
• Indirect material: Materials which are instrumental in the production of finished goods but cannot be
assigned to specific physical units. For example, a pair of scissors to cut the cloth for the shirt, or a saw to cut
the wood for furniture.
•Indirect labor: Employees who are not directly involved in the manufacturing process and whose labor cannot
be assigned to one particular product. For example, sales representatives and directors

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Overhead
Overhead costs can be classified into the following three categories:
▪ Factory overhead: This includes overhead cost incurred due to manufacturing,
production, or any other type of cost that is responsible for the
smooth functioning of a factory. For example, factory rent,
insurance, and utilities.
▪ Office and administrative overhead: These are expenses connected to the
management and administration of a business. For
example, office rent, printers, and stationery.
▪ Selling and distribution overhead: These are expenses related to marketing a
product, acquiring orders, and
dispatching goods and services.

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Cost Classification /3-Cost Behavior
• Variable costs—changes in total costs in proportion to changes in the
related level of activity or volume.
• Fixed costs—remain unchanged in total regardless of changes in the
related level of activity or volume.
• Costs are fixed or variable only with respect to a specific activity or a
given time period.

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Cont. Cost Classification /3-Cost Behavior
• Variable costs are constant on a per-unit basis. If a product takes 5
pounds of materials each, it stays the same per unit regardless if one,
ten, or a thousand units are produced.
• Fixed costs change inversely with the level of production. As more units
are produced, the same fixed cost is spread over more and more units,
reducing the cost per unit.

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Cost Behavior Summarized

Total Dollars Cost Per Unit

Change in Unchanged in
Variable Costs proportion with relation to output
output
More output = More cost
Change
Fixed Costs Unchanged in inversely with
relation to output output
More output = lower cost
per unit

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Cost Behavior Visualized

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Other Cost Concepts
• Cost driver (reason of cost)—a variable that causally affects costs over
a given time span, example working hrs. or Ibs (pounds) used of
material
• Relevant range—the band of normal activity level (or volume) in
which there is a specific relationship between the level of activity (or
volume) and a given cost
• For example, fixed costs are considered fixed only within the relevant range.

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Relevant Range Visualized

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Multiple Classification of Costs
• Costs may be classified as:
• Direct/Indirect, and
• Variable/Fixed
• These multiple classifications give rise to important cost
combinations:
• Direct and variable
• Indirect and variable
• Indirect and fixed

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Different Types of Firms
• Manufacturing-sector companies purchase materials and
components and convert them into finished products.
• Merchandising-sector companies purchase and then sell tangible
products without changing their basic form.
• Service-sector companies provide services (intangible products).

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Types of Manufacturing Inventories
• Direct materials—resources in-stock and available for use
• Work-in-process (or progress)—products started but not yet
completed, often abbreviated as WIP
• Finished goods—products completed and ready for sale

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Types of Product/Inventoriable Costs
• Also known as inventoriable costs
• Direct materials—acquisition costs of all materials that will become part of
the cost object.
• Direct labor—compensation of all manufacturing labor that can be traced to
the cost object.
• Indirect manufacturing—factory costs that are not traceable to the product in
an economically feasible way. Examples include lubricants, indirect
manufacturing labor, utilities, and supplies.

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Accounting Distinction Between Costs
• Inventoriable costs—product manufacturing costs. These costs are
capitalized as assets (inventory) until they are sold and transferred to
Cost of Goods Sold.
• Period costs—have no future value and are expensed in the period
incurred.(all selling and administrative overhead)

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