ICAB Accounting Notes: Management Chapter 2 – Direct & Indirect Costs and Inventory Valuation
Preparing for the ICAB exam can feel overwhelming, especially when it comes to cost accounting. Chapter 2 of Management Accounting focuses on two critical building blocks: direct and indirect costs and inventory valuation methods. These topics form the foundation for calculating unit costs, understanding profitability, and answering ICAB exam-style questions with confidence.
What is a Cost Unit?
A cost unit is the specific product, job, batch, or service for which costs are measured.
- A car repair is the cost unit for a garage.
- A batch of shirts is the cost unit for a textile company.
- A legal case may be the cost unit for a law firm.
Direct Costs
Direct costs are traceable expenses directly linked to a cost unit. They form part of the prime cost.
1. Direct Material Cost
Materials that become part of the final product.
- Example: component parts, cartons, packaging boxes.
Exam Tip: Negligible items like glue or screws may be treated as indirect.
2. Direct Labour Cost
- Assembly line workers in a car factory.
- Inspectors testing specific products.
3. Direct Expenses
- Hiring equipment for a particular contract.
- Special design or blueprint fees.
Indirect Costs (Overheads)
Indirect costs cannot be traced to one cost unit directly. They must be allocated or apportioned.
- Factory rent
- Depreciation of machinery
- Supervisor salaries
- Utilities
Common Misconceptions
- Direct ≠ Always Large – automation can make indirect higher.
- Indirect ≠ Unimportant – overheads support production.
- Direct ≠ Always Variable – salaried machine operators.
- Indirect Can Be Variable – like power costs.
ICAB Practice Question: Direct vs Indirect Costs
| Cost Item | Direct / Indirect | Reason |
|---|---|---|
| Salary of the accountant | Indirect | Not linked to specific job |
| Heating of garage | Indirect | Shared across all jobs |
| Engine oil used in repair | Direct | Traceable to job |
| Smear of grease | Indirect | Negligible item |
| Overtime premium to mechanic | Direct | Extra wages for job |
| Idle time payment | Indirect | Inefficiency cost |
| Supervisor wages | Indirect | Oversees multiple jobs |
Inventory Valuation
Inventory valuation directly impacts profit. It affects production cost, gross profit, and financial reporting.
FIFO (First In, First Out)
Oldest materials issued first. Closing stock reflects recent purchases.
- Advantage: Matches physical flow, easier for managers.
- Disadvantage: In inflation, profits overstated.
LIFO (Last In, First Out)
Latest purchases issued first. Closing stock = older batches.
- Advantage: Reflects current cost of issues.
- Disadvantage: Not IFRS compliant, undervalues stock in inflation.
Weighted Average Methods
Cumulative Weighted Average
Recalculate average after each new purchase. Smooths price fluctuations.
Periodic Weighted Average
Average calculated at period-end:
Average Price = (Opening Inventory + Purchases) ÷ (Opening Units + Purchased Units)
Impact on Profitability
| Method | Closing Inventory | Cost of Issues | Profit Impact |
|---|---|---|---|
| FIFO | Highest | Lowest | Higher profit |
| LIFO | Lowest | Highest | Lower profit |
| Weighted Average | Middle | Middle | Balanced profit |
ICAB Exam-Oriented Guidance
- Practice FIFO/LIFO/Weighted problems.
- Revise cost unit examples with industries.
- Be ready to explain profit variations.
Conclusion
Chapter 2 builds skills in cost classification and inventory valuation. For ICAB exam success:
- Classify costs confidently.
- Practice numerical problems extensively.
- Explain impacts of valuation methods on profitability.
Cost & Management Accounting MCQs
-
1. Which of the following is a direct cost?
a) Factory rent
b) Material used in a product
c) Advertising expense
d) Supervisor wages
Answer: b) Material used in a product -
2. Under FIFO, closing inventory is valued at:
a) Earliest purchase prices
b) Latest purchase prices
c) Weighted average price
d) Market price
Answer: b) Latest purchase prices -
3. Idle time wages are:
a) Direct cost
b) Indirect cost
c) Direct material
d) Fixed overhead
Answer: b) Indirect cost
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