Module objectives:
After going through this module, you will be able to:
- Define and explain the various basis of cost classification
- Understand the various cost and responsibility centres used in various organisation
- Explain the concept of cost behaviour
- Perform calculations to distinguish between variable costs and fixed costs using the High and Low method.
1. Cost classification
Cost claassification can be referred to the grouping of cost into various groups based on certain criteria/features or behaviour of cost. The cost of a product can be classified into various groups according to nature, behaviour, functions, among others.
1.1. Classification by nature
The total cost of making a product or providing a service consists of the following:
(a) Cost of materials
(b) Cost of the wages and salaries (labour costs)
(c) Cost of other expenses
(i) Rent and rates
(ii) Electricity and gas bills
(iii) Depreciation
- Direct costs and indirect costs
A direct cost is a cost that can be traced in full to the product, service, or department that is being costed.
An indirect cost (or overhead) is a cost that is incurred in the course of making a product, providing a service or running a department, but which cannot be traced directly and in full to the product, service or department.
Materials, labour costs and other expenses can be classified as either direct costs or indirect costs
- Direct material costs are the costs of materials that are known to have been used in making and selling a product (or even providing a service). Example
| Materials = | Direct materials | + | Indirect materials |
| + | + | + | |
| Labour = | Direct labour | + | Indirect labour |
| + | + | + | |
| Expenses = | Direct expenses | + | Indirect expenses |
| Total cost = | Direct cost | + | Overhead |
- Direct labour costs are the specific costs of the workforce used to make a product or provide a service. Direct labour costs are established by measuring the time taken for a job, or the time taken in ‘direct production work’
- Other direct expenses are those expenses that have been incurred in full as a direct consequence of making a product, or providing a service, or running a department.
Examples of indirect costs include supervisors’ wages, cleaning materials and buildings insurance
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Analysis of total cost
Full cost of sales
In costing a small product made by a manufacturing organisation, direct costs are usually restricted to some of the production costs. A commonly found build-up of costs is therefore as follows.
$
Production costs
Direct materials A
Direct wages B
Direct expenses C
Prime cost A+B+C
Production overheads D
Full factory cost A+B+C+D
Administration costs E
Selling and distribution costs F
Full cost of sales A+B+C+D+E+F
Production overhead
Production (or factory) overhead includes all indirect material costs, indirect wages and indirect expenses incurred in the factory from receipt of the order until its completion.
Production overhead includes the following.
- Indirect materials which cannot be traced in the finished product. Consumable stores, e.g. material used in negligible amounts
- Indirect wages, meaning all wages not charged directly to a product. Wages of non-productive personnel in the production department, e.g. foremen
- Indirect expenses (other than material and labour) not charged directly to production.
(i) Rent, rates and insurance of a factory
(ii) Depreciation, fuel, power, maintenance of plant, machinery and buildings
Administration overhead
Administration overhead is all indirect material costs, wages and expenses incurred in the direction, control and administration of an undertaking.
Examples of administration overhead are as follows.
- Depreciation of office buildings and equipment.
- Office salaries, including salaries of directors, secretaries and accountants.
- Rent, rates, insurance, lighting, cleaning, telephone charges and so on.
Selling overhead
Selling overhead is all indirect materials costs, wages and expenses incurred in promoting sales and retaining customers.
Examples of selling overhead are as follows.
- Printing and stationery, such as catalogues and price lists.
- Salaries and commission of salesmen, representatives and sales department staff.
- Advertising and sales promotion, market research.
- Rent, rates and insurance of sales offices and showrooms, bad debts and so on
Distribution overhead
Distribution overhead is all indirect material costs, wages and expenses incurred in making the packed product ready for dispatch and delivering it to the customer.
Examples of distribution overhead are as follows.
- Cost of packing cases.
- Wages of packers, drivers and despatch clerks.
- Insurance charges, rent, rates, depreciation of warehouses and so on.
1.2. Classification by function
Classification by function involves classifying costs as production/manufacturing costs, administration costs or marketing/selling and distribution costs.
In a ‘traditional’ costing system for a manufacturing organisation, costs are classified as follows:
- Production or manufacturing costs. These are costs associated with the factory.
- Administration costs. These are costs associated with general office departments.
- Marketing, or selling and distribution costs. These are costs associated with sales, marketing, and warehousing and transport departments.
1.3. Classification by behaviour
This refers to the classification of cost according to how the costs react/vary with output levels. It means, based on the activity level or the outputs produced, costs can be classified as fixed or variable.
Fixed costs and variable costs
A different way of analysing and classifying costs is into fixed costs and variable costs.
Many items of expenditure are part-fixed and part-variable and hence are termed semi-fixed or semi-variable costs.
A fixed cost is a cost which is incurred for a particular period of time and which, within certain activity levels, is unaffected by changes in the level of activity.
A variable cost is a cost which tends to vary with the level of activity.
Examples of fixed and variable costs
(a) Direct material costs are variable costs because they rise as more units of a product are manufactured.
(b) Sales commission is often a fixed percentage of sales turnovers, and so is a variable cost that varies with the level of sales.
(c) Telephone call charges are likely to increase if the volume of business expands, but there is also a fixed element of line rental, and so they are a semi-fixed or semi-variable overhead cost.
(d) The rental cost of business premises is a constant amount, at least within a stated time period, and so it is a fixed cost.
1.4 Classification by Production and non-production costs
Production costs are all the costs involved in the manufacture of goods. In the case of manufactured goods, these costs consist of direct material, direct labour and manufacturing overhead.
Non-production costs are taken directly to the profit and loss account as expenses in the period in which they are incurred; such costs consist of selling and administrative expenses.
- Other cost classifications
Avoidable costs are specific costs of an activity or business which would be avoided if the activity or business did not exist.
Unavoidable costs are costs which would be incurred whether or not an activity or sector existed.
A controllable cost is a cost which can be influenced by management decisions and actions.
An uncontrollable cost is any cost that cannot be affected by management within a given time span.
Discretionary costs are costs which are likely to arise from decisions made during the budgeting process.
They are likely to be fixed amounts of money over fixed periods of time.
Examples of discretionary costs are as follows:
- Advertising
- Training
- Research and Development
- Cost units, cost objects and responsibility centres
Cost centres
Cost centres are collecting places for costs before they are further analysed. Costs are further analysed into cost units once they have been traced to cost centres.
When costs are incurred, they are generally allocated to a cost centre.
Cost centres may include the following:
- A department
- A machine, or group of machines
- A project (e.g. the installation of a new computer system)
- Overhead costs e.g. rent, rates, electricity (which may then be allocated to departments or projects)
Cost centres are an essential ‘building block’ of a costing system. They are the starting point for the following.
(a) The classification of actual costs incurred.
(b) The preparation of budgets of planned costs.
(c) The comparison of actual costs and budgeted costs (management control).
Cost units
A cost unit is a unit of product or service to which costs can be related. The cost unit is the basic control unit for costing purposes.
Examples of cost units include the following.
- Patient episode (in a hospital)
- Room (in a hotel)
- Barrel (in the brewing industry)
Cost objects
A cost object is any activity for which a separate measurement of costs is desired.
If the users of management information wish to know the cost of something, this something is called a cost object.
Examples include the following.
- The cost of a product
- The cost of operating a department
- The cost of a service
Profit centres
Profit centres are similar to cost centres but are accountable for costs and revenues
Revenue centres
Revenue centres are similar to cost centres and profit centres but are accountable for revenues only.
Revenue centre managers should normally have control over how revenues are raised.
Investment centres
An investment centre is a profit centre with additional responsibilities for capital investment and possibly for financing, and whose performance is measured by its return on investment.
Responsibility centres
A responsibility centre is a department or organisational function whose performance is the direct responsibility of a specific manager.
Cost centres, revenue centres, profit centres and investment centres are also known as responsibility centres
Cost Behaviour
Cost behaviour and decision-making
Cost behaviour is the way in which costs are affected by changes in the volume of output.
Management decisions will often be based on how costs and revenues vary at different activity levels.
Examples of such decisions are as follows:
- What should the planned activity level be for the next period?
- Should the selling price be reduced in order to sell more units?
- Should a particular component be manufactured internally or bought in?
- Should a contract be undertaken?
Cost behaviour and budgeting
Knowledge of cost behaviour is obviously essential for the tasks of budgeting, decision making and control accounting
Cost behaviour and levels of activity
There are many factors which may influence costs. The major influence is volume of output, or the level of activity. The level of activity may refer to one of the following.
- Number of units produced
- Number of invoices issued
- Value of items sold
- Number of units of electricity consumed
- Number of items sold
Cost behaviour principles
The basic principle of cost behaviour is that as the level of activity rises, costs will usually rise. It will cost more to produce 2,000 units of output than it will cost to produce 1,000 units.
Cost behaviour patterns
Fixed costs
A fixed cost is a cost which tends to be unaffected by increases or decreases in the volume of output.
Fixed costs are a period charge, in that they relate to a span of time; as the time span increases, so too will the fixed costs (which are sometimes referred to as period costs for this reason). It is important to understand that fixed costs always have a variable element, since an increase or decrease in production may also bring about an increase or decrease in fixed costs.
Examples of a fixed cost would be as follows.
- The salary of the managing director (per month or per annum)
- The rent of a single factory building (per month or per annum)
- Straight line depreciation of a single machine (per month or per annum)
Step costs
A step cost is a cost which is fixed in nature but only within certain levels of activity.
Consider the depreciation of a machine which may be fixed if production remains below 1,000 units per month. If production exceeds 1,000 units, a second machine may be required, and the cost of depreciation (on two machines) would go up a step.
Other examples of step costs are as follows:
(a) Rent is a step cost in situations where accommodation requirements increase as output levels get higher.
(b) Basic pay of employees is nowadays usually fixed, but as output rises, more employees (direct workers, supervisors, managers and so on) are required.
(c) Royalties.
Variable costs
A variable cost a cost which tends to vary directly with the volume of output. The variable cost per unit is the same amount for each unit produced.
Semi-variable costs (or semi-fixed costs or mixed costs)
A semi-variable/semi-fixed/mixed cost is a cost which contains both fixed and variable components and so is partly affected by changes in the level of activity.
Examples of these costs include the following:
(a)Electricity and gas bills
(i) Fixed cost = standing charge
(ii) Variable cost = charge per unit of electricity used
(b)Salesman’s salary
(i) Fixed cost = basic salary
(ii) Variable cost = commission on sales made
(c)Costs of running a car
(i) Fixed cost = road tax, insurance
(ii) Variable costs = petrol, oil, repairs (which vary with miles travelled)
Assumptions about cost behaviour
Assumptions about cost behaviour include the following:
(a) Within the normal or relevant range of output, costs are often assumed to be either fixed, variable or semi-variable (mixed).
(b) Departmental costs within an organisation are assumed to be mixed costs, with a fixed and a variable element.
(c) Departmental costs are assumed to rise in a straight line as the volume of activity increases. In other words, these costs are said to be linear.
The high-low method of determining fixed and variable elements of mixed costs relies on the assumption that mixed costs are linear. We shall now go on to look at this method of cost determination.
Determining the fixed and variable elements of semi-variable costs
Analysing costs
The fixed and variable elements of semi-variable costs can be determined by the high-low method.
It is generally assumed that costs are one of the following.
- Variable
- Semi-variable
- Fixed
Cost accountants tend to separate semi-variable costs into their variable and fixed elements. They therefore generally tend to treat costs as either fixed or variable
High-low method
Follow the steps below to estimate the fixed and variable elements of semi-variable costs.
Step 1
Review records of costs in previous periods.
- Select the period with the highest activity level.
- Select the period with the lowest activity level.
Step 2
Determine the following:
- Total cost at high activity level
- Total costs at low activity level
- Total units at high activity level
- Total units at low activity level
Step 3
Calculate the following:
Step 4
The fixed costs can be determined as follows. (Total cost at high activity level) – (total units at high activity level × variable cost per unit).
Example: The high-low method
DG Co has recorded the following total costs during the last five years.
Year Output volume Total cost
Units
$
20X0 65,000 145,000
20X1 80,000 162,000
20X2 90,000 170,000
20X3 60,000 140,000
20X4 75,000 160,000
Required
Calculate the total cost that should be expected in 20X5 if output is 85,000 units.
Solution
Step 1
- Period with highest activity = 20X2
- Period with lowest activity = 20X3
Step 2
- Total cost at high activity level = 170,000
- Total cost at low activity level = 140,000
- Total units at high activity level = 90,000
- Total units at low activity level = 60,000
Step 3
Variable cost per unit
(170000 – 140000) / (90000 – 60000) = $1 per unit
Step 4
Fixed costs = (total cost at high activity level) – (total units at high activity level × variable cost per unit) = 170,000 – (90,000 × 1) = 170,000 – 90,000 = $80,000
Therefore the costs in 20X5 for output of 85,000 units are as follows.
$
Variable costs = 85,000 × $1 85,000
Fixed costs 80,000
165,000
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