Cost Basics Basics

1 Introduction to Cost Basics

Costs are the backbone of financial decision-making, influencing everything from pricing
strategies to profitability. In these notes, we'll explore essential concepts like fixed and variable
costs, marginal analysis, and opportunity costs. By understanding these fundamentals, you'll
gain insights to optimize resource allocation and drive financial success. Let's dive in and
unravel the essentials of costs together!

Cost
Cost is the amount of resource given up in exchange of some goods or services. It can be
expressed as a QUANTITATIVE as well as a QUALITATIVE

Costing
Costing is defined as "the technique and process of ascertaining costs

Cost Accounting
Cost Accounting is defined as "the process of accounting for cost which begins with the
recording of income and expenditure or the bases on which they are calculated and ends with
the preparation of periodical statements and reports for ascertaining and con- trolling costs.

Cost Objects
Cost object is anything for which a separate measurement of cost is required. Cost object may
be a product, a service, a project, a customer, a brand category, an activity, a department or a
programme etc.

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Cost Units
It is a unit of product, service or time (or combination of these) in relation to which costs may be
ascertained or expressed

Examples of Cost Units

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Cost Driver
A Cost driver is a factor or variable which effect level of cost. Generally, it is an activity which is
responsible for cost incurrence. Level of activity or volume of production is the example of a
cost driver. An activity may be an event, task, or unit of work etc

Cost Cards
A cost card is used to show the breakdown of the costs of producing output based on the
classification of each cost. A cost card can be produced for one unit or a planned level of
production.

The following costs are brought together and recorded on a cost card:

Direct Materials

Direct Labour

Direct Expenses

Prime Cost (Total Direct Costs)

Variable Production Overheads

Fixed production Overheads

Non-Production Overheads.

The terms used in the above bullet points are explained in the rest of this module.

Classification Of Costs
It means the grouping of costs according to their common characteristics. The important ways of
classification of costs are:

(I) By Nature or Element

(II) By Functions

(III) By Variability or Behaviour

(IV) By Controllability

(V) By Normality

(VI) By Costs for Managerial Decision Making

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(I) Classification By Element

To classify by element you need to decide if a cost is a material cost, a labour cost or a cost
relating to something else - an expense.

Materials : All costs of materials purchased for production or non- production activities.
For example, raw materials, components, cleaning materials, maintenance materials
and stationery.

Labour : All staff costs relating to employees on the payroll of the organization.

Expenses : All other costs which are not materials or labour. This includes all bought-in
services, for example, rent, telephone, sub- contractors and costs such as the
depreciation of equipment

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(II) Classification By Function

Production Cost

Production costs are costs that relate to the manufacture of a product or provision of a
service. These costs are found in the cost of sales section of the statement of profit or loss.

Production costs, such as direct materials, direct labour, direct expenses and production
overheads, are included in the valuation of inventory.

Non-Production Cost

Non-production costs are costs that are not directly associated with the production of the
businesses output.

Non-production costs, such as administrative costs, selling costs and finance costs, are
charged to the statement of profit or loss as expenses for the period in which they are
incurred. Non-production costs are not included in the valuation of inventory.

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Production costs, or manufacturing costs, are the costs incurred in manufacturing finished
products, up to the time that the manufacture of the goods is completed,

Manufacturing costs include:

The material cost of the raw materials and components, purchased from suppliers and used in
the production of the goods that are manufactured the labour cost of all employees working for
the manufacturing function, such as machine operators, supervisors, factory supervisors and
the factory manager,

Other expenses of the factory, such as rental costs for the factory building, energy costs and the
cost of depreciation of factory machinery.

Non-production costs are any items of cost that are not manufacturing costs.

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Example Cost Basics

Facts: A company uses three categories of functional cost in its cost accounting system.
These are manufacturing costs, administration costs and sales and distribution costs.

Identify the functional cost category for each of the following costs:

(1) Salary of the chief accountant

(2) Telephone charges

(3) Cost of office cleaning services

(4) Cost of warehouse staff

Solution:
(1) Chief accountant's salary. Accounting department costs are an administration cost,
and the salary of the chief accountant is treated in full as an administration costs.

(2) Telephone charges. These are usually treated as administration costs, unless the
charges can be traced directly to telephones in the manufacturing department or the
sales and distribution department. When charges can be traced directly to telephones
in the manufacturing department, they should be recorded as manufacturing costs.

(3) Office cleaning services. These are usually treated as administration costs, unless
the charges can be traced directly to offices used by the sales and distribution staff, or
the production staff.

(4) Warehouse staff. These are manufacturing costs when the warehouse is used to
store raw materials and components. They are sales and distribution costs when the
warehouse is used to store finished goods. If the warehouse stores raw materials and
finished goods, the wages costs should be apportioned between production costs and
sales and distribution costs.

In a manufacturing business, it is important to separate production costs from non- production

costs. This is because at the end of any financial period, there will be some closing inventory of:

Finished goods that have been produced during the financial period but not yet sold
(finished goods inventory), and

Partly-finished production, for which production is not yet compete (work-in- progress or
WIP, sometimes called work-in-process).

The costs of finished goods inventory and partly-finished production (work-in- progress or WIP)
consist of their production costs.

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Total production costs during a period must therefore be divided or shared between:

Goods produced and sold in the period

Goods produced but not yet sold (finished goods)

Partly-produced goods in the period (work in progress).

Non-production costs must never be included in the cost of inventory.

(III) Classification By Nature

Direct costs

Direct costs are costs which can be directly identified with a specific cost unit or cost centre.
There are three main types of direct cost - direct material, direct labour and direct expenses.
The direct costs associated with a shirt (cost unit) manufactured by a clothing company would
be:
Direct materials - cloth for making shirts

Direct labour - the wages of the workers stitching the cloth to make the shirts

Direct expenses - the royalties paid to a designer.

The total of direct costs is known as the prime cost.

Indirect costs

Indirect costs are costs which cannot be directly identified with a specific cost unit or cost
centre. The indirect costs associated with a shirt (cost unit) manufactured by a clothing company
would be:

Indirect materials - these include materials that cannot be traced to an individual item for
example cleaning fluids for cleaning the machinery

Indirect labour - the cost of a supervisor who supervises the shirt makers

Indirect expenses - the cost of renting the factory where the shirts are manufactured.

The total of indirect costs is known as overheads.

Direct and indirect cost?

It is important to realise that a particular cost may sometimes be a direct cost and sometimes
an indirect cost. It depends on the cost object we are trying to cost.

For example, the salary of the machining department supervisor is a direct cost of that
department or cost centre because it can be specifically identified with the department.
However, it is an indirect cost of each of the cost units processed in the machining department
because it cannot be specifically identified with any particular cost unit

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Direct materials

Direct materials are materials that are used directly in the manufacture of a product or the
provision of a service. For example:

The direct materials in the manufacture of a pair of shoes might include leather and rubber
heels

The direct materials in the manufacture of an office chair include wheels, a stand, a seat
(with seat cushion), back rest, arm rests and fabric.

The direct materials in a restaurant meal are the major items of food (and drink).

Direct materials may consist of either or both:

Raw materials, such as glass, metals and chemicals

Components purchased from an external supplier: for example the direct materials of a car
manufacturer include components purchased from other suppliers, such as windows,
wheels and tyres.

Services might also incur some direct materials costs. For example, with catering and restaurant
services the direct materials include the major items of food (and drink

Indirect material costs

Indirect materials are any materials that are used or consumed that cannot be attributed in full
to the item being costed. Indirect materials are treated as an overhead cost, and may be
classified as production overheads, administration overheads or sales and distribution
overheads.

Indirect materials in production include cleaning materials and any materials used by
production departments or staff who are not engaged directly in making a product. In a
restaurant, indirect materials will include the cost of salt, pepper and spices that are used by the
kitchen staff for most meals, but which cannot be attributed to any specific meal.

Direct labour

Direct labour is labour time that can be attributed directly to the item that is being costed. In
costing a small item of manufactured output, direct labour time might be quite short, say just a
few minutes per unit produced. In costing a large item such as the cost of operating a
warehouse, direct labour costs include the labour cost of all employees who spend all their
working time on warehouse activities.

As a general rule, labour costs are direct costs for work done by direct labour employees. Direct
labour employees are employees whose time is spent directly on the item being costed. For
example in a manufacturing company, direct labour employees will include:

Machinists working in the machining department

Assembly workers in the assembly department

Workers in the spray painting shop

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The time of these workers can be attributed directly to the production of the finished output
from the manufacturing process. On the other hand some workers in a factory are not direct
labour, because they do not work directly in the production of the output from the factory:
Inspection staff and supervisors are examples of labour that is not direct labour when costing
the output from a factory.

Non-manufacturing businesses also have direct labour employees. These are the employees
directly involved in producing the output of the business or providing a service that is sold to
customers. For example:

Bricklayers are direct labour employees of a house-building firm

Waiters and chefs are direct labour employees of a restaurant

Miners are direct labour workers in a mining company

Teachers are direct labour employees in a school.

Indirect labour costs

Indirect labour costs consist mainly of the cost of indirect labour employees. Indirect labour
employees are individuals who do not work directly on the items that are produced or the
services that are provided.

In a manufacturing environment, indirect labour employees include staff in the stores and
materials handling department (for example, fork lift truck drivers), supervisors, and repairs
and maintenance engineers.

All employees in administration departments and marketing departments (sales and

distribution staff) - including management - are normally indirect employees.

Illustration

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Question

Office & Administration Overheads

Indirect cost related to office & administration which includes indirect material, indirect labor &
indirect expenses related to office

E.g. stores used in office, accountant's salary, depreciation of office furniture

Selling & Distribution Overheads

Indirect cost related to selling & distribution which includes indirect material, indirect labor &
indirect expenses related to sales & distribution

E.g. materials used in sales dept, sales manager's salary, depreciation of delivery truck

Production Overheads

Factory overhead is the costs incurred during the manufacturing process, not including the
costs of direct labor, direct expenses and direct materials.

Simply indirect cost related to production department which includes indirect material, indirect
labor & indirect expenses related to production

E.g. Production supervisor's salary, rent of factory premises

Overheads

POH
FOH O&A OH S&D OH
MOH
WOH

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Full cost

The full cost of a unit of product (or the full cost of a unit of service) is a cost that includes both
direct costs and some overheads. The full cost of a unit of product might be analysed as follows:

Notes

Prime cost plus a share of production overheads are the full production cost or 'fully
absorbed production cost of the cost unit.

In cost accounting systems, it is common practice to include production overheads in

unit costs and measure the full production cost per unit. However, administration
and selling and distribution overhead costs are not usually included in the cost of
each unit. Instead, they are treated in total as an expense for the period ('period
costs').

(IV) Classification By Variability or Behaviour

Based on this classification, costs are classified into three groups viz., fixed, variable and semi-
variable.

(a) Fixed costs- These are the costs which are incurred for a period, and which, within certain
output and turnover limits, tend to be unaffected by fluctuations in the levels of activity
(output or turnover). They do not tend to increase or decrease with the changes in output. For
example, rent, insurance of factory building etc., remain the same for different levels of
production.

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A fixed cost is a cost which is incurred for an accounting period, and which, within certain
activity levels remains constant.

Note that the total cost remains constant over a given level of activity but that the cost per
unit falls as the level of activity increases.

Examples of fixed costs:

1. Rent
2. Business rates
3. Executive salaries.

Here are some examples of fixed cost items.

The rental cost of a building, which is $40,000 per month. The rental cost is fixed for a given
period: $40,000 per month, or $480,000 per year.

The salary costs of a worker who is paid $11,000 per month. The fixed cost is $11,000 per
month or $132,000 per year.

Example Fixed Cost

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b) Variable Costs- These costs tend to vary with the volume of activity. Any increase in the
activity results in an increase in the variable cost and vice- versa. For example, cost of direct
material, cost of direct labour, etc.

Note that as total costs increase with activity levels, the cost per unit of variable costs
remains constant.

Examples of variable costs include direct costs such as raw materials and direct labour

Example Variable Cost

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Question

C) Mixed Cost

A mixed cost, also called a semi-fixed cost or a semi-variable cost, is a cost that is partly fixed
and partly variable

Stepped fixed cost

A stepped fixed cost is a cost which:

Has a fixed cost behaviour pattern within a limited range of activity, and

Goes up or down in steps when the volume of activity rises above or falls below certain
levels.

On a cost behaviour graph, step fixed costs look like steps rising from left to right.

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Illustration

A company might pay its supervisors a salary of $4,000 each month. When production is less
than 3,500 hours each month, only one supervisor is needed: when production is between
3,501 and 7,000 hours each month, two supervisors are needed. When output is over 7,000
hours each month, three supervisors are needed.

These supervision costs are therefore fixed costs within a certain range of output, but go up or
down in steps as the output level rises above or falls below certain levels

Example Stepped Cost

Semi-Variable Costs

Semi-variable costs contain both fixed and variable cost elements and are therefore partly
affected by changes in the level of activity.

Semi-variable costs can be shown graphically as follows:

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Examples of semi-variable costs:

Electricity bills (fixed standing charge plus variable cost per unit of electricity consumed)

Telephone bills (fixed line rental plus variable cost per call).

Identifying Cost Behaviours

The behavioural characteristics of costs are used when planning or forecasting costs at
different levels of production or activity. When producing a forecast it may be necessary to
identify the type of behaviour a cost is exhibiting. It is useful to remember the following:

Fixed costs are constant in total

Variable costs are constant per unit

Semi-variable costs are neither constant in total nor constant per unit.

Stepped fixed costs will be constant in total within a certain range

Illustration

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The High Low Method used for separating a Semi-Variable Cost

The total cost of a semi-variable cost is:

Total costs = Total fixed costs + (Variable cost per unit × Activity level)

To be able to predict costs at different activity levels it is necessary to separate the fixed cost
element from the variable cost element. The high low method can be used to approximate the
variable cost per unit and the total fixed cost.

The High Low Method

Step 1

Select the highest and lowest activity levels, and their associated costs.

Step 2

Calculate the variable cost (VC) per unit:

Cost at high level of activity - cost at low level of activity

VC per unit =
High level of activity - low level of activity

Step 3

Calculate the fixed cost by substitution, using either the high or low activity level:

Fixed cost = Total cost at activity level - (Variable cost per unit × Activity level)

Step 4

Use the total fixed cost and the variable cost per unit values from steps 2 and 3 to calculate the
estimated cost at different activity levels:

Total costs = Total fixed costs + (Variable cost per unit × Activity level)

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Illustration High Low Method

Question

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Illustration High Low Method with changing variable cost

Cost Equations
Cost equations are derived from historical cost data. Once a cost equation has been
established, for example distinguishing the fixed and variable costs using the high low method,
it can be used to estimate future costs. Cost equations are assumed to have a linear function
and therefore the equation of a straight line can be applied: y = a + bx

Where:

'a' is the intercept, i.e. the point at which the line y = a + bx cuts the y axis (the value of y
when x = 0).

'b' is the gradient/slope of the line y = a + bx (the change in y when x increases by one unit).

'x' = independent variable.

'y' = dependent variable (its value depends on the value of 'x').

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This formula can be related to the results of the high low calculation as follows:

'a' is the fixed cost per period (the intercept)

'b' is the variable cost per unit (the gradient)

'x' is the activity level (the independent variable)

'y' is the total cost = fixed cost + variable cost (dependent on the activity level)

Suppose a cost has a cost equation of y = $5,000 + 10x, this can be shown graphically as
follows:

Illustration Cost Equations

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Question

Example High Low Method

Solution:

(continued)

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(continued)

(IV) Classification By Controllability

Costs here may be classified into controllable and uncontrollable costs.

Controllable Costs: Cost that can be controlled, typically by a cost, profit or investment
centre manager is called controllable cost. Controllable costs incurred in a particular
responsibility centre can be influenced by the action of the manager heading that
responsibility centre. For example, direct costs comprising direct labour, direct material,
direct expenses and some of the overheads are generally controllable by the shop floor
supervisor or the factory manager.

Uncontrollable Costs - Costs which cannot be influenced by the action of a specified

member of an undertaking are known as uncontrollable costs. For example,
expenditure incurred by say, the tool room is controllable by the foreman in-charge of
that section but the share of the tool-room expenditure which is apportioned to a
machine shop is not controlled by the machine shop foreman.

Distinction between Controllable Cost and Uncontrollable Cost:

The distinction between controllable and uncontrollable costs is not very prominent and is
sometimes left to individual judgement. In fact, no cost is uncontrollable; it is only in
relation to a particular individual that we may specify a particular cost to be either
controllable or uncontrollable.

(V) Classification By Normality

According to this basis, cost may be categorized as follows:

Normal Cost It is the cost which is normally incurred at a given level of output under the
conditions in which that level of output is normally attained.

Abnormal Cost It is the cost which is not normally incurred at a given level of output in
the conditions in which that level of output is normally attained. It is charged to Costing
Profit and loss Account

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(VI) Classification by Costs used in Managerial Decision Making

According to this basis, cost may be categorized as follows:

Standard Cost

A standard cost is described as a predetermined cost, an estimated future cost, an expected

cost, a budgeted unit cost, a forecast cost, or as the “should be” cost. Standard costs are often
an integral part of a manufacturer's annual profit plan and operating budgets.

Marginal Cost

The amount at any given volume of output by which aggregate costs increases if the volume of
output is increased or decreased by one unit.

Differential Cost (Incremental and decremental costs)

It represents the change (increase or decrease) in total cost (variable as well as fixed) due to
change in activity level, technology, process or method of production, etc

Imputed Costs

These costs are notional costs which do not involve any cash outlay. Interest on capital, the
payment for which is not actually made, is an example of imputed cost. These costs are similar
to opportunity costs.

Capitalized Costs

These are costs which are initially recorded as assets and subsequently treated as expenses.
Example, installation expenses on the erection of a machine are added to the cost of a
machine.

Product Costs

These are the costs which are associated with the purchase and sale of goods (in the case of
merchandise inventory). In the production scenario, such costs are associated with the
acquisition and conversion of materials and all other manufacturing inputs into finished
product for sale. Hence, under marginal costing, variable manufacturing costs and under
absorption costing, total manufacturing costs (variable and fixed) constitute inventoriable or
product costs

Opportunity Cost

This cost refers to the value of sacrifice made or benefit of opportunity foregone in accepting
an alternative course of action. For example, a firm financing its expansion plan by withdrawing
money from its bank deposits. In such a case the loss of interest on the bank deposit is the
opportunity cost for carrying out the expansion plan next best alternative forgone relevant in
decision making

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Out-of-pocket Cost

It is that portion of total cost, which involves cash outflow. This cost concept is a short-run
concept and is used in decisions relating to fixation of selling price in recession, make or buy,
etc. Out-of- pocket costs can be avoided or saved if a particular proposal under consideration
is not accepted

Shut down Costs

Those costs, which continue to be, incurred even when a plant is temporarily shut-down e.g.
rent, rates, depreciation, etc. These costs cannot be eliminated with the closure of the plant. In
other words, all fixed costs, which cannot be avoided during the temporary closure of a plant,
will be known as shut down costs.

Sunk Costs

Historical costs incurred in the past are known as sunk costs. They play no role in decision
making in the current period. For example, in the case of a decision relating to the
replacement of a machine, the written down value of the existing machine is a sunk cost and
therefore, not considered not relevant in decision making

Discretionary Costs

Such costs are not tied to a clear cause and effect relationship between inputs and outputs.
They usually arise from periodic decisions regarding the maximum outlay to be incurred.
Examples include advertising, public relations, executive training etc.
This cost incur by only management decision. management can incur or avoid this cost.

Explicit Costs

These costs are also known as out-of-pocket costs and refer to costs involving immediate
payment of cash. salaries, wages, postage and telegram, printing and stationery, interest on
loan etc. are some examples of explicit costs involving immediate cash payment.

Period Costs

These are the costs, which are not assigned to the products but are charged as expenses
against the revenue of the period in which they are incurred. All non-manufacturing costs such
as general & administrative expenses, selling and distribution expenses are recognized as
period costs

Avoidable cost
It is an expense that will not be incurred if a particular activity is not performed. Avoidable
costs refer primarily to variable costs that can be removed from a business operation, unlike
most fixed costs, which must be paid regardless of the activity level of a company.

Unavoidable cost

It is a cost that is still incurred even if the activity is not performed. Some examples include
depreciation on equipment, property taxes, lease payments, interest expense, etc. These costs
are often considered fixed costs. The amount of the expense does not depend on production.

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Relevant Costs and Revenues

Not all information produced by an accounting system is relevant to the decisions made by
management. In particular, information produced mainly for financial reporting purposes and
then taken as the basis for management decisions will often need significant modification to be
useful to management. The principle here is that the figures presented to assist in management
decision-making are those that will be affected by the decision, i.e. they should be:

Future - costs and revenues that are going to be incurred sometime in the future. Costs and
revenues that have already been incurred are known as sunk costs and are not relevant to
the decision to be made.

Incremental - the extra cost or revenue that is created as a result of a decision taken.

Cash flows actual cash being spent or received not monetary items that are produced via
accounting convention e.g. book or carrying values, depreciation charges.

Differences between Management Accounting and Financial Accounting

The following illustration compares management accounting with financial accounting:

Illustration Management versus Financial Accounting

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Differences between Management Accounting and Cost Accounting

Cost and Management Accounting with Financial Management

Cost and Management Accounting is an application of Financial Management for decision
making purposes.

The relationship among Cost Accounting, Management Accounting, Financial Accounting and
Financial Management can be understood with the help of the following diagram

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Role & Functions of Cost and Management Accounting

The role of a cost and management accounting system is to:

Provide relevant information to management for decision making,

Assist management for planning, measurement, evaluation and controlling of business

activities,

Help in allocation of cost to products and inventories for both external and internal users

Product Cost
Product cost It is also called inventoriable cost. Product cost are cost for the production process
without which the product could not be made. Product cost include;

Direct material (DM)

Direct Labour

Manufacturing Overhead

Direct Material

These are raw materials that are directly used in production.

Eg: cost of cotton for cloth manufacturing company, cost of wood for chair manufacturing
company

Direct Labour

Direct labor refers to the salaries and wages paid to workers directly involved in the
manufacture of a specific product or in performing a service.
Eg: carpenters in chair manufacturing company

Manufacturing overhead

It is an indirect cost that related with production process. It is also called factory overheads.
It includes:

Fixed manufacturing overheads.

Variable manufacturing overheads.

Direct cost

Direct cost are cost that can be traced directly to a specificcost object.
Eg:DM, DL.

Indirect cost

Indirect cost are cost that cannot be traced directly to a specificcost object. It is also known as
overheads.
Eg: indirect material, indirect labour etc.

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Grouping Of Product Cost

PRIME COST= DM+DL

CONVERSION COST=DL+MANUFACTURING OVERHEAD

MANUFACTURING COST=DM+DL+ MANUFACTURING OVERHEAD

Note:

Conversion cost is cost that helps to convert directmaterial into finished goods.

Period cost

It is also called non – manufacturing cost. Period cost are cost for all other activity except
production. It is expensed as incurred.
Eg: advertisement cost, selling and administrative cost

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Question

1. DM=500000DL=200000
Fixed Manufacturing overhead=50000
Variable Manufacturing overhead=20000

Calculate prime cost

DM+DL =500K+200K =700K

Calculate Indirect production cost

50k+20k =40k

Calculate conversion cost

DL+ MOH = 200K+70K =270K

2. DM=100K
DL=75K
FMOH=10K
VMOH=20K

Calculate prime cost

100k+75k =175k

Calculate conversion cost

75k+10k+20k =105k

Calculate manufacturing cost

100k+75k+10k+20k =205k

Calculate Manufacturing Overhead

10k+20k =30k

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3. DM=20/unit
DL=7/unit
MOH=1000
Production=1200

Calculate prime cost

DM=20*1200 =24000
DL=7*1200 =8400
Prime cost=24000+8400 =32400

Calculate conversion cost

=(1200*7)+1000 =8400+1000 =9400

Total cost of production

=32400+1000 =33400

4. DM=100K
DL=75K
FMOH=10K
VMOH=20K

Calculate Prime cost

100k+75k =175k

Calculate Conversion cost

75k+10k+20k =105k

Calculate Manufacturing cost

100k+75k+10k+20k =205k

Manufacturing Overhead
10k+20k =30k

5. DM=20/unit,
DL=7/unit,
MOH=1000
Production=1200

Calculate Prime Cost

DM=20*1200 =24000
DL=7*1200 =8400
Prime cost=24000+8400 =$32400

Calculate conversion cost

=(1200*7)+1000 =8400+1000 =9400

Total cost of production

32400+1000 =33400

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6. Selling price =25/unit

DM=2/unit
DL=3/unit
VMOH=1/unit
FMOH=150
VNMOH=2.5/units
FNMOH=200
Production =100unit

Product cost per unit

2+3+1+1.5 (FMOH per unit=150/100=1.5) =7.5

Calculate Period cost per unit

2.5+2 (FNMOH=200/100=2) =4.5

Calculate Prime cost per unit

DM+DL= 2+3 = 5

Calculate Conversion cost per unit

DL + Manufacturing = 3+1+1.5 = 5.5

Calculate Total Fixed Cost

150+200= 350

Calculate Variable Cost per unit

1+2.5 +2+3 = 8.5

Calculate Total Production Cost

100X 7.5 = 7500

Calculate Total Period Cost

VNMOH + FAMOH = 200+250
= 450

Calculate Total Cost

350+ (8.5×100)=350+850
=1200

7. DM=20/unit
DL=25/unit
VMOH=10/unit
FMOH=120K
Production =95k

Calculate Production cost per unit

20+25+10+1.26 (FMOH=120K/95=1.26)
=56.26

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Calculate Prime cost

20+25=45 /units
Calculate Variable cost per unit
=10+25+20 =55
Calculate Product cost per unit when production 75000?
=20+25+10+1.26 =56.26

Absorption Income Statement

It is the practice of charging all costs, both variable and fixed to operations, processes or
products. This differs from marginal costing where fixed costs are excluded

Q) Selling Price =20

Cost of good sold=10
Selling and administrative =50k
Interest=10k
Tax=10%
Sales unit=10k

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Q) Selling Price=100
DM=30
DL=25
MOH=15
VNMOH=5
FNMOH=10K
Interest= 1k
Tax=20%
Production =1500
Sales=1000
Prepare income statement Absorption income statement

Absorption Income Statement

Sales (100*1000) = 100000

Cost of goods sold :
DM=30*1000 =30K
DL=25*1000 = 25K
MOH=15*1000=15K (70000)

Gross profit = 30000

(-) selling and administrative exp

VNMOH (5*1000) = (5000)
FNMOH = (10000)

Operating Profit = 15000

Interest = (1000)

EBT = 14000
Tax (14000*20/100) = (2800)

Net Income = 11200

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Q) Selling price=50
Production =20k
Sales=10k units
DM=10
DL=10
VMOH=5
FMOH=100000
FNMOH=20000
VNMOH=2
Tax =10%
Prepare income statement

Absorption Income Statement

Sales (50*10000) = 500000

Cost of goods sold :
DM=10*10000 =100K
DL=10*10000 = 100K
VMOH=5*10000=50K
FMOH=100000/20000 =5*10000= 50K (300000)

Gross profit = 200000

(-) selling and administrative exp \

VNMOH (2*10000) = (20000)
FNMOH = (20000)

Operating Profit = 160000

EBT = 160000
Tax (160000*10/100) = (16000)

Net Income = 144000

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Q) Selling price=30
Production =30k
Sales=20k units
DM=5
DL=1.5
VMOH=2.5
FMOH=90000
Selling & Administration exp = 200000
Prepare income statement
Absorption Income Statement

Sales (20*10000) = 600000

Cost of goods sold :
DM=5*20000 =100K
DL=1.5*20000 = 30K
VMOH=2.5*20000=50K
FMOH=90000/30000 =3*20000= 60K (240000)

Gross profit = 360000

(-) selling and administrative exp 200000

Operating Profit = 160000

Absorption Costing Income Statement and Variable Costing Income

statement

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2 C.2. Marginal Analysis COST BASICS

Absorption Costing (GAAP) vs. Variable Costing (Non-GAAP)

The calculation of operating income on the manufacturing company's income statement

normally looks as follows, using what is commonly called absorption costing:

Sales

- Cost of goods sold (COGS)*

= Gross profit

- Selling and administrative expenses (SG&A)

= Operating Income

For internal purposes, a company may also prepare an income statement using the variable
costing approach:

Sales

- Variable costs

= Contribution margin

- Fixed costs

= Operating income

Therefore, 2 Income statements for a Manufacturing Co.

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Q) DM Used = 300k
DL = 100k
VMOH = 50k
FMOH = 80k
Calculate Inventriable Cost under absorption costing.

Ans) DM Used = 300k

DL = 100k
VMOH = 50k
FMOH = 80k =530k

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Q) Prime Cost = 800k

VMOH = 100k
FMOH = 160k
V. Selling Cost = 80k
Calculate Inventriable Cost under absorption costing.

Ans) Prime Cost = 800k

VMOH = 100k
FMOH = 160k =1,060,000

Calculate Inventriable Cost under Variable Costing.

Ans) Prime Cost = 800k
VMOH = 100k = 900k

Contribution Margin Income Statement

It is defined as the ascertainment of marginal cost by differentiating between fixed and variable
costs. It is used to ascertain effect of changes in volume or type of output on profit.

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Q) Sales = 1 million
Variable Cost = 600,000
Fixed cost = 200,000
Interest = 50,000
Tax@20%
Prepare CM Income Statement

Sales 1,000,000
Variable Cost (600,000)

CM 400,000
Fixed Cost (200,000)

Operating Income 200,000

Interest (50,000)

EBT 150,000
Tax@20% (30,000)

Net Income 120,000

Q) Selling Price = 80
Variable Cost = 50
Fixed cost = 20,000
Sales Unit = 1000
Prepare CM Income Statement

Sales(80*1000) 80,000
Variable Cost (50*1000) (50,000)

CM 30,000
Fixed Cost (20,000)

Operating Income 10000

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Q) Sales = 20 Million
Variable Cost = 18 Million
Fixed cost = 4 Million
Prepare CM Income Statement

Sales 20 Million
Variable Cost (18 million)

CM 2 Million
Fixed Cost (4 Million)

Operating Loss (2 Million)

Q) Sales = 40 Million
Variable Cost = 36 Million
Fixed cost = 8 Million
Tax = 20%
Prepare CM Income Statement

Sales 40 Million
Variable Cost (36 million)

CM 4 Million
Fixed Cost (8 Million)

Operating Loss /EBIT (4 Million)

Tax @20% (800,000)

Net Loss (3.2 Million)

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Q) Selling Price = 100

DM=20
DL = 10
VMOH = 7.5
FMOH = 10,000
VNMOH = 12.5
FNMOH = 20,000
Production = 1200
Sales = 1000
Prepare CM Income Statement

Sales(100*1000) 100,000
Variable Cost
DM (20*1000) (20000)
DL (10*1000) (10000)
VMOH(7.5*1000) (7500)
VNMOH(12.5*1000) (12500)

CM 50,000
Fixed Cost
FMOH (10000)
FNMOH (20000)

Operating Income 20000

Q) Selling Price = 20
CM = 10
Fixed cost = 5000
Sales Unit = 1000
Calculate Operating Income

CM(10*1000) 10,000
FC (5000)

Operating Income 5000

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Q) Selling Price = 500

DM=150
DL = 130
VMOH = 50
FMOH = 50000
VNMOH = 20
FNMOH = 40,000
Production = 1050
Sales = 1000
Prepare CM Income Statement

Sales(500*1000) 500,000
Variable Cost
DM (150*1000) (150000)
DL (130*1000) (130000)
VMOH(7.5*1000) (50000)
VNMOH(20*1000) (20000)

CM 150,000
Fixed Cost
FMOH (50000)
FNMOH (40000)

Operating Income 60000

Q) Sales revenue = 250000

Production = 70000
Sales= 50000
Calculate selling price per unit

Note:
Sales revenue= sales * Selling price per unit
Selling price per unit = sales revenue / sales

Ans) Selling price per unit = 25000/50000 = 5

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Q) Selling price = 120

Sales unit = 100
Production = 110
Calculate sales revenue
Ans) Sales = selling price * sales unit = 120*100 =12000

Q) Sales Revenue = 800000

Selling price = 40
Calculate sales per unit
Ans) Sales per unit = 800000/40 = 20000

Q) Selling price = 400

DM = 120
DL = 80
VMOH = 20
FMOH = 30
VNMOH = 30
FNMOH = 50
Sales unit= 1000, Production unit = 2000
a) Calculate Product cost Product Cost per unit =
DM + DL + VMOH + FMOH = 120+80+20+30 =250

b) Calculate Prime cost

DM + DL = 120+80 = 200

c) Calculate Conversion cost

DL + Manufacturing cost =80+20+30 = 130

d) Calculate total production cost

Product cost per unit * production =250 * 2000 = 500000

e) Calculate Cost of Goods Sold

(DM + DL + VMOH + FMOH) * Sales = 250*1000 = 250000

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f) Calculate TFC
= (FMOH + FNMOH) * production = (30+50) * 2000 = 160000

g) Calculate VC per unit

DM + DL + VMOH + VNMOH = 120+80+20+30 =250

h) Prepare CM income statement

Sales(450*1000) 450,000
Variable Cost
DM (120*1000) (120000)
DL (80*1000) (80000)
VMOH(20*1000) (20000)
VNMOH(30*1000) (30000)

CM 200,000
Fixed Cost
FMOH (30*2000 (60000)
FNMOH(50*2000 (100000)

Operating Income 40000

Note:
Fixed Cost is multiplied with production

Q) Selling Price = 200

DM=60
DL = 30
VMOH = 20
FMOH = 10
VNMOH = 10
FNMOH = 20
Production = 1500
Sales = 1200
Prepare CM Income Statement

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Ans) Sales(200*1200) 240,000

Variable Cost
DM (60*1200) (72000)
DL (30*1200) (36000)
VMOH(20*1200) (24000)
VNMOH(10*1200) (12000)

CM 96000
Fixed Cost
FMOH (10*1500 (15000)
FNMOH(20*1500) (30000)

Operating Income 51000

Q)

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Q)

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Cost of Goods Sold and Cost of Goods Manufactured

To determine COGS, the calculation is:

Beginning finished goods inventory

+ Cost of goods manufactured

= Cost of goods available for sale

- Ending finished goods inventory

= Cost of Goods Sold (tentative)

COGM = Opening WIP + Manufacturing Cost - Closing WIP

COGS = Opening FG + COGM - Closing FG

To determine Cost of goods Manufactured, the calculation is:

Direct materials used

+ Direct labor incurred

+ Overhead applied

= Costs added to production

+ Beginning work-in-progress inventory

- Ending work-in-progress inventory

= Cost of goods manufactured

COGS on Trading Firm

COGS = Opening Inventory + Net Purchase

- Closing Inventory

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