MODULE 2 - COST CLASSIFICATION

Relevant Costs Overview

• Relevant costs are future cash flows directly resulting from a decision.
• Decision-making should hinge on future incremental cash flows.

Relevant Costs Definition

• Relevant costs include future costs, which are unaffected by past decisions (sunk costs).
• Committed costs represent future outflows that will occur regardless of current decisions.
• Only cash flows are relevant; non-cash costs like depreciation are ignored.
• Incremental costs are additional expenses incurred due to a specific decision or action.

Avoidable Costs

• Avoidable costs are costs that do not need to be incurred if a specific activity ceases.
• Relevant in decisions about discontinuing products where only variable and specific costs would be avoided.

Differential Costs and Opportunity Costs

• Differential costs represent the cost difference between alternative choices.
• Opportunity costs reflect the benefits missed when choosing one alternative over another.

Controllable and Uncontrollable Costs

• Controllable costs can be influenced by a manager in the short term.
• Committed fixed costs (like rents) are usually unavoidable and thus uncontrollable.

Sunk Costs

• Sunk costs are past expenditures irrelevant to current decision-making.
• Managers should focus on future costs, disregarding sunk costs when evaluating alternatives.

Fixed and Variable Costs

• Variable costs are generally relevant as they fluctuate with production volume.
• Fixed costs often remain constant and are typically considered non-relevant unless they can change based on specific decisions.

Non-Relevant Variable Costs

• Some variable costs could qualify as sunk costs, making them non-relevant.

Attributable Fixed Costs

• Attributable fixed costs may change based on decision-making, unlike general overheads which are unaffected.

Absorbed Overhead

• Notional accounting costs, like absorbed overheads, should be disregarded in decision-making; focus on incremental overheads instead.

Relevant Cost of Materials

• The relevant cost for additional materials includes current purchase costs or replacement costs.
• Materials already in inventory may be considered based on resale value or alternative use value.

Relevant Cost of Labour

• Relevant cost of labour varies based on whether it must be hired externally or if spare capacity exists.
• Contribution lost from not utilizing existing capacity must be factored in when resources are scarce.

Relevant Cost of an Asset

• The relevant cost of an asset, or its deprival value, is assessed based on potential future revenues or alternative scrap value.
• This value is essential for determining a firm's minimum acceptable return when deprived of the asset.

Key Module Points

• Focus on future cash flows and avoid incorporating sunk costs in decision-making.
• Understand the distinction between relevant and non-relevant costs, including variable and fixed classifications.

Quick Revision Questions

• Questions test understanding of concepts like sunk costs, relevant costs of materials, and opportunity costs related to decision-making scenarios.### Cost Behaviour Principles
• As activity levels increase, costs generally rise.
• Higher production levels lead to increased costs; for example, producing 2000 units costs more than producing 1000.
• Key accounting challenge: analyze cost drivers and predict cost variations with activity changes.
• Focus on volume of production for measuring costs.

Costs Analysis Types

• Costs classified into variable, fixed, and step-fixed.
• Variable Costs: Change with activity level, e.g., fuel and oil costs per kilometer, repair costs linked to mileage.
• Fixed Costs: Remain unchanged within certain activity levels; examples include depreciation and routine maintenance.
• Step-Fixed Costs: Fixed within specific activity ranges but increase once certain thresholds are exceeded, such as tire replacement costs after a set distance traveled.

Fixed and Variable Costs

• Fixed Costs: Do not vary with output; include rent and straight-line depreciation.
• Variable Costs: Adjust according to production volume; examples include direct material costs and sales commissions.
• Semi-Variable Costs: Contain both fixed and variable components, e.g., utility bills or sales staff salaries.

Cost Behaviour Patterns

• Fixed costs remain stable, variable costs change proportionately with output.
• Curvilinear Costs: Total variable costs may exhibit non-linear behaviour under specific circumstances, leading to increasing or decreasing variable costs.

Semi-Variable Costs

• Include both fixed (e.g., basic salary, rent) and variable costs (e.g., commission on sales).
• Examples comprise electricity bills and running costs of vehicles.

Cost Estimation Techniques

• Account-Classification Method: Organizes costs as fixed, variable, or semi-variable based on historical data; relies heavily on managerial judgment.
• High-Low Method: Assesses cost behaviour using the highest and lowest activity levels; calculates variable and fixed costs.
• Scatter Graph Method: Uses historical data points to visually estimate cost relationships.

High-Low Method Steps

• Identify periods of highest and lowest activity.
• Calculate the total costs and units for identified periods.
• Determine variable costs per unit and fixed costs accordingly.

Practical Example Using High-Low Method

• Given data from DG Co., estimated variable cost calculated as $1 per unit.
• Fixed costs determined to be $80,000.
• Forecast total costs for an output of 85,000 units as $165,000.

Step-Fixed Costs and Examples

• Fixed costs may rise after specific output levels; for instance, added supervisory costs occur once production exceeds certain thresholds.
• Examples include increased rental expenses or employee salaries as output rises.

Addressing Variable Cost Changes

• External factors, such as wage negotiations, can alter variable costs, which should be taken into account when forecasting.

Cost Behaviour Assumptions

• Costs generally assumed linear within normal ranges of activity.
• Departmental costs typically considered mixed, displaying both fixed and variable characteristics.
• Assumptions guide estimations but should remain flexible for real-world variations in cost behaviour.### Cost Classification and Analysis
• Costs are classified into fixed, variable, and semi-variable costs based on their behavior regarding changes in activity levels.
• Fixed Costs: Incurred regardless of activity level; remain constant within a relevant range.
• Variable Costs: Change directly with the level of production; the variable cost per unit remains constant.
• Step-Fixed Costs: Fixed within certain activity levels but increase in steps beyond those levels.
• Semi-Variable (Mixed) Costs: Contain both fixed and variable components and are influenced by activity changes.

Cost Elements

• Total cost of a product or service is composed of:
  • Materials: Directly attributable to production.
  • Labour: Can include both fixed salaries and variable wages based on output.
  • Other Expenses: Indirect costs related to production.
• Costs can also be categorized as direct (identifiable with a specific product) or indirect (not directly traceable to a single product).

Cost Behaviour Insights

• Cost behaviour indicates that costs typically rise with increased activity; producing more output leads to higher total costs.
• Curvilinear costs indicate a non-linear relationship between total variable costs and activity levels; this relationship is visually represented with curved lines in graphs.

High-Low Method Application

• The high-low method is used to separate fixed and variable components of semi-variable costs by identifying costs at the highest and lowest levels of activity.
• Example calculations involve identifying the variable cost per unit by comparing total costs at different activity levels (i.e., using activity data of valuations recorded).

Cost Estimation Models

• Cost estimation must capture the model for total costs, represented as TC = Fixed Costs + Variable Costs,
• Different variations of this model exist, such as:
  • Option A: TC = 42,000+42,000 + 42,000+95V
  • Option B: TC = 46,500+46,500 + 46,500+85V
  • Option C: TC = 46,500−46,500 - 46,500−85V
  • Option D: TC = 51,500−51,500 - 51,500−95V

Relevant Costs in Decision Making

• Relevant costs are crucial for decision-making and include opportunity costs (the benefit lost by choosing one option over another).
• Sunk costs are past expenditures that should not affect future decisions due to their irrelevance.

Practical Examples of Cost Calculations

• Cost for producing a specific quantity can be determined through direct calculation; for instance, if the total cost of 20,000 units is $40,000, the variable cost per unit can be derived accordingly.
• A production worker's compensation may involve a combination of fixed salary and variable pay per unit produced, categorizing it as a semi-variable cost.

Graphical Representations

• Different graphs illustrate how costs behave:
  • Linear relationships depict variable costs (Graph 1).
  • Fixed costs remain constant in various activity levels (Graph 2).
  • Step-fixed costs increase in discrete increments (Graph 3).

Key Concept Review

• Understanding and analyzing cost components and their behavior is essential for effective management accounting and financial decision-making.