1. Lecturer:
Dr. Kamilah Ahmad
25 February 2014
Topic 2: Type of Costs in
Production

2. Chapter Learning Outcomes
 Acknowledge the basic types of production cost in
production environment
 Differentiate costs behavior

3. Introduction
 All types of organizations incur costs.
 The kind of costs incurred and the way in which these
costs are classified depend on the type of organization.
 Will focus the cost characteristics of manufacturing
firms since their basic activities include most activities
found in other types of organizations.

4. General cost classification
Manufacturing costs Non-Manufacturing
costs
Direct materials Selling costs
Direct labor Administrative costs
Manufacturing overhead
Manufacturing operations purchase raw materials
and converts these materials into finished goods
through the process of production.

5. 1. Direct Raw Material
Basic materials that are used to process new products.
Indirect materials are usually used in small amounts and do
not physically become part of the finished product.
2. Direct Labor
The cost of employees that can be directly traceable to a
manufactured product
3. Manufacturing overhead
include all manufacturing costs other than the costs of direct
materials and direct labor.

6. Production Cost Flow
Direct Material
Overhead
Direct Labor Manufacturing
Process
Material
Inventory
Finished Good
Inventory
WIP
Inventory
Cost of
Good Sold
Sold
Finished
unfinished
Unused
Balance
Sheet
Income
Statement
AKR @2013

7. Product cost vs. Period cost
Product
Cost
(Manufacturi
ng costs)
Direct
Materials
Eg: flour, sugar, oils
Prime Cost
Direct Labor Wages
Factory
Overhead
Factory utilities,
depreciation of
machines, machines
maintenance
Conversion
cost
Period Cost
(non-
manufacturin
g costs)
Selling
expenses
Advertising, fees,
sales commissions
Administrative
expenses
Salaries, rent, office
utilities

8. example

9. Manufacturing vs non-manufacturing costs

10. Cost behavior
To predict how a certain cost will behave in response to a
change of productivity

11. Variable , Fixed and Mixed Costs
A VC is a cost that varies in direct
proportion to changes in the level
of activity(units produced, hours
Worked, miles driven)
A FC is a cost that remains constant
regardless of changes in the level
of activity within relevant range
(range of activity)
Is expressed on a per-unit basis.
The per-unit variable cost remains
unchanged regardless of changes
in the cost-driver.
Think of fixed costs
on a total-cost basis.
Total fixed costs remain constant
regardless of changes in the
cost-driver.
Mixed costs contain elements of both
fixed- and variable-cost behavior.

12. Mixed-Cost Behavior Patterns
Mixed costs contain elements of both fixed and variable costs.
The fixed-cost element is unchanged over a range of cost-driver
activity levels.
The variable-cost element of the mixed cost varies proportionately
with cost-driver activity within the relevant range.

13. Cost Drivers
Cost drivers are measures of activities that require
the use of resources and thereby cause costs.

14. Measurement of Cost Behavior
Cost Driver
• an activity which influences a cost.
Relevant Range
• range over which we can assume that
the cost behavior is linear
Variable Costs
• vary in proportion to changes in their
cost driver
Fixed Costs
• are not affected by changes in the
cost driver
$
Volume
$
Volume
$
Volume

15. Linear-Cost Behavior
Costs are assumed to be fixed or variable within the
relevant range of activity

16. Variations in Cost Behaviour
Step Costs
• change abruptly at intervals of
activity because the resources and
their costs come in indivisible
chunks. e.g supervisory salaries
Mixed Costs
• contain both variable and fixed cost
elements
• e.g. maintenance costs
Volume
$
Volume
$

17. Step-Cost Behavior Patterns
Expenses that are constant for a given level of activity,
but increase or decrease once a threshold is crossed.
these types of expenses will be represented
by a stairstep pattern.
For example, a coffee shop might be able to serve
30 customers an hour with one employee. If the
shop receives anywhere from zero to 30 customers
per hour, it will only need to pay the cost of having
one employee. If the shop begins receiving 31 or
more customers per hour, it must hire a second
employee, increasing its costs of doing business.

18. Step-Cost Behavior Patterns
Fixed cost that increases to a new level in step
with the significant changes in activity or usage.

19. Mixed-Cost Behavior Patterns

20. 1. Product or service attributes
2. Capacity decisions
3. Technology
4. Policies to create incentives to control costs
Management’s Influence on Cost
Behavior
3 types of cost that relate to management’s
influence on cost behavior
• Capacity costs
• Committed costs
• Discretionary Fixed Costs

21. Capacity Decisions
Fixed costs incurred to provide facilities that increase
a firm's ability to produce such as those relating to
space, equipment, and factory buildings. They
include rents, depreciation, property taxes, &
insurance.
What are capacity costs?
Capacity costs generally do not vary with production
levels and can be reduced or avoided only by shutting
down business locations or outsourcing.

22. Committed Fixed Costs
Committed fixed costs are those fixed costs that are
difficult to adjust and arise from the investment in
facilities, equipment, and a basic organizational structure
of a firm. Committed costs are generally long-term costs.
• Large, indivisible chunks of cost that the organization is
obligated to incur and usually would not consider avoiding
• Can only be changed by changing the basic philosophy,
scale or scope of the organization's operations.
mortgage, lease payments, property taxes,
Insurance, salaries of key personnel

23. Discretionary Fixed Costs
• Discretionary fixed costs are costs fixed at certain
levels only because management decided that these
levels of cost should be incurred to meet the
organization’s goals.
• Companies have more flexibility with these.
• Generally short-term costs and;
• Are determined each year, and are subject to change
whenever the company decides to do so.

24. These discretionary fixed costs have no obvious
relationship to levels of output activity but
are determined as part of the periodic planning
process.
Each planning period, management will determine
how much to spend on discretionary items.
These costs then become fixed until the next
planning period.
Discretionary Fixed Costs..cont..

25. Examples
Advertising
and promotion
Research and
development
Management
salaries

26. Technology Decisions
Choice of technology (e-commerce versus
in-store or mail-order sales) positions the
organization to meet its current goals and
to respond to changes in the environment.

27. Cost-Control Incentives
Managers use their
knowledge of cost
behavior to set
cost expectations.
Employees may
receive rewards that
are tied to meeting
these expectations.

28. Cost Functions
Planning and controlling the activities
of an organization require accurate
and useful estimates of future
fixed and variable costs.

29. Cost Functions
Understanding relationships between costs
And their cost drivers allows managers to:
Make better operating, marketing,
and production decisions
Plan and evaluate actions
Determine appropriate costs for
short-run and long-run decisions.

30. Cost Functions
The first step in estimating or predicting
costs is measuring cost behavior as a
function of appropriate cost drivers.
The second step is to use these cost
measures to estimate future costs at
expected levels of cost-driver activity.

31. Cost Function Equation
Let:
Y = Total cost
F = Fixed cost
V = Variable cost per unit
X = Cost-driver activity in number of units
Mixed-cost function:
Y = F + VX
Y = $10,000 + $5.00X
The mixed-cost function is called a linear-cost function.

32. Developing Cost Functions
A cost function’s estimates of costs
at actual levels of activity must reliably
conform with actually observed costs.
The cost function must be believable.

33. Choice of Cost Drivers: Activity
Analysis
Choosing a cost function starts
with choosing cost drivers.
Managers use activity analysis to
identify appropriate cost drivers.
Activity analysis directs management
accountants to the appropriate
cost drivers for each cost.

34. Choice of Cost Drivers: Activity Analysis
Northwestern Computers makes two
products: Mozart-Plus and Powerdrive
In the past, most of the support costs
were twice as much as labor costs.
Northwest has upgraded the production
function, which has increased support
costs and reduced labor cost.

35. Choice of Cost Drivers: Activity
Analysis
Using the old cost driver, labor cost, the
prediction of support costs would be:
Mozart-Plus Powerdrive
Labor cost $ 8.50 $130.00
Support cost:
2 × Direct labor
cost $17.00 $260.00

36. Choice of Cost Drivers: Activity
Analysis
Using the more appropriate cost driver,
the number of components added to products,
companies can predict support costs more accurately.
Mozart-Plus Powerdrive
Support cost at $20
per component
$20 × 5 components $100.00
$20 × 9 components $180.00
Difference in predicted
support cost $ 83.00 $ 80.00
higher lower
Managers will make better decisions with this more
accurate information.

37. Type of Costing Systems (traditional)
JOB COSTING
 Provide cost of each
quantity of product
manufactured
 Each qty of product is
called “JOB”
 Industry example: apparel,
Furniture, machine
components etcs
PROCESS COSTING
 Provide cost for each
manufacturing department
or process
 Product are
indistinguishable from
each other and
manufacture using
continuous production.
 Example: oil product,
foods, paper production
etcs

38. Type of Costing Systems and allocation of
costs
JOB COSTING or BATCH PROCESS COSTING
Traditional costing
approach
Activity Based Costing
Approach
preferred
Full absorption Related cost allocation
to product
MATERIAL – LABOR -OVERHEAD

39. Topic 2