Incentive to Overproduce

Criticisms of Absorption Costing
Systems: Incentive to
Overproduce Part 1
Week 11
REVISION QUESTIONS ON LAST MATERIAL
1. If the opening balance is 5000 pounds, the cash payments are 2000 pounds and
the cash receipts are 4000 pounds, how much is the closing balance? And what
kind of balance do we have?
REVISION QUESTIONS ON LAST MATERIAL
1. If the opening balance is 5000 pounds, the cash payments are 2000 pounds and
the cash receipts are 4000 pounds, how much is the closing balance? And what
kind of balance do we have?
5000+4000-2000=7000
(positive balance)
REVISION QUESTIONS ON LAST MATERIAL
2. Which of the following is a cash outflow?
Customers payments
Loan provided by the bank
Income tax
Income from rent
REVISION QUESTIONS ON LAST MATERIAL
2. Which of the following is a cash outflow?
Customers payments
Loan provided by the bank
Income tax
Income from rent
-> INCOME TAX, because for the first one we receive payments from the customers,
for the second one we receive money from the bank and for the last one, we receive
money from renting a place such as via AirBnB.
REVISION EXERCISE ON CASH BUDGET

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REVISION EXERCISE ON CASH BUDGET

Learning Outcomes
 To introduce the concept of cost
 To identify what is a cost unit and a cost centre
 To identify the various costs classifications along with examples
Introduction to cost
• Cost represents the amount sacrificed to achieve a particular business objective (Atrill and
McLaney, 2007)
• Management accounting is concerned with providing the management of a business with
financial recommendations, based on costing information, so as to enable daily decisions
and long-term plans to be made.
• Management accounting uses information from previous transactions in order to help in
financial decision making, planning and control for future purposes.
• The management of a company needs to know the accurate costs of individual goods or
services, together with the aggregate costs of running the company. This information can
be found from the costing records.
• The use of costing information to make decisions is quite important in order for the
businesses to maximize their profits and for the public sector organizations to provide value
for money services.
(Cox and Fardon, 2007)
Cost units and cost centres
• Before the study of costing starts, the two following terms need to be understood: cost units
and cost centres.
• Cost units are units of output to which costs can be charged. A cost unit can be either a unit
of production from a factory (e.g. car, an item of furniture) or a unit of service (e.g. a
transaction on a bank statement, a swimming pool attendance).
• Within a business, especially in the service industry, there may be several cost units that
can be used. For example, in a hotel the cost units in the restaurant are the meals, while for
the rooms, the cost units are the guest nights.
• Cost centres are sections of a business to which costs can be charged. For example, in a
manufacturing business a cost centre is a department of a factory, a specific stage in the
production process or even the entire factory. In a college, the cost centres are the teaching
departments or specific sections of departments, such as the college administrative office.
(Cox and Fardon, 2007)
Cost classifications
• There are several classifications of cost.
• The first one is the cost classifications between direct and indirect costs. In the following
slide, we can see this particular difference:
Direct and Indirect Cost
Next…
Understand the
classification of
manufacturing cost and
elaborate more on the
various types of direct and
indirect costs.
Classification of Manufacturing cost
Direct Material
• Can you think of any more examples?
Other examples…
Direct Labor
Manufacturing Overheads
Non-Manufacturing Overheads
• We also have the non-manufacturing overhead costs, which are not part of the
manufacturing process, but part of other functions, such as selling and distribution,
administration, finance.
Next…
Distinguish between
product costs and
period costs (based on
the time of cost
occurrence) and give
examples of each.
Before we start:
Let’s watch about Period Costs
–https://youtu.be/5RcNPp1_stU
Fixed Cost
Product Cost Vs Period Cost
Product costs: direct materials, direct labor,
manufacturing overheads.
• Product costs are recognized as expenses when the
products are sold.
Period costs: non-manufacturing overheads (selling
costs, administrative costs, finance costs).
• Period costs are expensed on the income statement
in the period incurred.
Product Cost Vs Period Cost
Product Cost Vs Period Cost

The table below highlights some of the differences between product costs and period costs:
Next…
Understand cost
behavior patterns
including variable costs,
fixed costs, and mixed
costs.
Cost Classifications for Predicting Cost Behavior
Cost behavior refers to how a cost
will react to changes in the level of
activity. The most common
classifications are:
Variable costs
Fixed costs
Semi-fixed (semi-variable)
costs
Variable Cost
The Variable Cost varies with the volume of activity. In a manufacturing business, for example,
this would include the cost of raw materials used. In the below figure, there is a graphical
depiction of the variable cost. When there are zero units of production, the variable cost is zero
and then it increases in a straight line as activity increases.
Can you think of any examples of Variable Cost?
The Activity Base (or Cost Driver) for the
Variable Cost
Fixed Cost
The Fixed Cost remains the same when changes happen to the volume of activity. In the below
figure, there is a graphical depiction of the fixed cost. In all levels of production (including zero),
the fixed cost is the same.
Can you think of any examples of Fixed Cost?
Fixed Cost – example
Types of Fixed Cost
Two types of fixed costs are commonly recognized:
1. Discretionary fixed costs and
2. Committed fixed costs
Semi-fixed (semi-variable) Cost
• In some cases, a particular cost has an element of both fixed and variable cost. These can be
described as semi-fixed (semi-variable) costs.
• For example, the electricity cost for the hairdressing business. Some of this will be for lighting,
and this part is mainly fixed and the other part, such as the power of hairdryers, will vary with
the volume of activity.
• An example of how this type of cost looks in a figure is found below:
Can you think of any more examples of Semi-fixed (semi-variable) Cost?
Quick Check
Which of the following costs would be variable
with respect to the number of cones sold at a
Baskins & Robbins shop? (There may be more
than one correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.
Next…
Understand cost
classifications used in
making decisions:
differential costs,
opportunity costs, and
sunk costs.
Differential Cost (and Revenue)
Differential costs (or incremental costs) is a difference in cost between any two
alternatives. Differential costs can be either fixed or variable. A difference in
revenue between two alternatives is called differential revenue.
Opportunity Cost
Opportunity cost is the potential benefit that is given up when one alternative is selected over
another. These costs are not usually entered into the accounting records of an organization, but
must be explicitly considered in all decisions.
Sunk Cost
• A sunk cost is a cost that has already been incurred and that cannot be changed by any
decision made now or in the future.
• All sunk costs are considered fixed costs, however not all fixed costs are considered as sunk
costs. For example, equipment which is a fixed cost can be resold or returned at a determined
price. Therefore, it is not a sunk cost.
• Example 1: Suppose you bought a ticket to a concert for £200. On the night of the concert, you
remember that you have an important assignment due on the same night. You must make a
decision: go to the concert or finish your assignment. The £200 paid for the ticket is a sunk cost
and should not affect your decision.
• Example 2: Suppose you had bought gold for £400 an ounce, but now it is selling for £250 an
ounce. Should you wait for the gold to reach £400 an ounce before selling it?
You may say “YES” even though the initial purchase of £400 is a sunk cost.
Thank you
Any Questions?