Cambrige AS and A Level Accounting Notes (9706)/ ZIMSECĀ  Advanced Accounting Level Notes: Types of Costs: Period, Opportunity, Sunk and Relevant costs

  • In addition to looking at how costs behaviour in relation to the level of activity ( units produced)
  • It might also be useful to classify costs in other ways:
    1. Period versus product costs
    2. Relevant versus irrelevant costs
    3. Sunk costs
  • We will now examine the meaning of each in detail

Period costs versus Product costs

  • Accounting concepts dictate that revenue must be matched will all costs incurred in generating that revenue
  • This ensures that the profit figure for the period is accurate i.e. it is not overstated or understated
  • In order to be able to do this it is important to distinguish between period costs and product costs
  • Product costs-are those costs that are identified with goods purchased or produced for resale
  • Period costs can be attributed to goods bought or produced for sale
  • Total product costs thus the sum of all costs associated with the production of a specific quantity of a good or service
  • Product costs include direct costs such as cost of raw materials and associated overheads
  • Product costs must only be charged against revenue in the period in which the goods/service is sold
  • Knowing product costs is also important when calculating the value of inventories (finished goods and work in progress)
  • Period costs-are costs that can be identified with the accounting period in which they are incurred
  • Period costs are therefore to be charged against revenue in the period in which they occur
  • Examples of period costs include Selling and Distribution expenses as well as other administration expenses
  • Period costs are not included in calculating the value of inventory

Relevant versus irrelevant costs

  • When a decision has to be made it is important to distinguish between costs that are relevant and irrelevant to the decision being made in order to avoid distractions
  • Relevant costs and revenues are those future costs and revenues that will be changed by a decision while
  • Irrelevant costs and revenues are those that will not be affected by the decision
  • For example when deciding whether to make or buy a product:
  • Factory rentals are relevant costs since the business would not need to rent the factory if it decides to purchase the product instead of making it by itself
  • On the other hand delivery costs to customers are irrelevant costs since the business would need to deliver the product to customers regardless of whether they made it themselves or not

Sunk costs

  • These are the costs of resources that already have been acquired and will thus be unaffected by future decisions
  • They are costs that were created by past decisions and thus can no longer be altered by future decisions
  • For example if a business already has a delivery truck the cost of acquiring that truck is a sunk cost and should not affect the decision of whether to deliver products or ask customers to come and pick them up
  • All sunk costs are thus irrelevant costs however not all irrelevant costs are sunk costs
  • There are some irrelevant costs that are not sunk costs for example:
  • If a business has to decide whether to make product X or Y where both products use the same key component Z in equal amounts the cost of Z would be an irrelevant cost but not a sunk cost

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