INTRODUCTION
Cost Classification
This chapter covers:
• Cost Accounting
• Cost
• Cost Unit
• Cost Center
• Cost Object
• Cost Classification
• Analysis of Cost Behaviours
• High Low Method
Cost Accounting
“Cost accounting involves applying a set of principles, method and
techniques to determine and analyze costs within the separate
units of a business”.
This involves:
The establishment of budgets, standards costs and actual costs of
operations, processes, activities or products and the analysis of
variances, profitability or the social use of funds.
Cost:
“All expenses carryout to make or purchase one unit of a product is called a cost of
that unit”. For example, A marker is of $5 from a shop. Here $5 is the cost for the
customer.
Cost Per Unit:
“Cost of one unit of product is called cost per unit”.
Cost Unit:
“A unit of product or service to which cost is attached”. For example, a notebook is of
$10. Here notebook is cost unit.
Examples:
Cost Unit Costs.
Brick $5 per unit
Shirt $60 per unit
Pack of 10 markers $40 per pack
Cost Center:
“A cost center is a physical location, where cost of a function, activity or item of
equipment are accumulated and analyzed”.
Examples:
• Production,
• Administration,
• Marketing, etc.
Cost is allocate to cost centers and then analyzed and charges to cost units.
Cost Object:
“A cost object is any activity or item for which a separate measurement of cost is
desired”. It could be a cost unit or cost center.
Cost Classification:
Cost classification is making logical groups of cost to help in analysis and control.
Here we have some classifications:
Cost Classification
1. By Nature
2. By Function
3. Product and Period cost
4. Controllable and Uncontrollable cost
5. By Behaviour
1. By Nature:
Nature wise there are three elements of cost:
• Material costs
• Labour costs
• Expenses
We further split into direct and indirect costs.
1. By Nature:
Direct cost: “A cost that can be directly identifiable with a specific
cost unit or cost center is called direct costs”.
Examples: Material used in production, Worker paid for making a
product, etc.
1. By Nature:
Indirect costs: “A cost that cannot be directly identifiable with a
specific cost unit or cost center is called indirect cost”. It is jointly
incurred and must be shared out on an equitable basis.
Examples: Salaries, Rent of the building, etc.
Material:
• Directly and easily associated/ related with a product.
• Traceable to a specific cost unit or cost center
• Form major part of the product.
Examples: For a chair Direct Indirect
Wood Nail
Iron Glue
Foam Paint
Fabric Polish
Spring
Labour:
• Directly and easily associated/ related with a product.
• Traceable to a specific cost unit or cost center.
• Directly involved in making a product.
Examples:
Direct Indirect
Machine Operator’s wage Supervisor’s salaries.
Accountants in firm, etc. General Manager’s salary.
Expense:
• Directly and easily associated/ related with a product.
• Traceable with a specific cost unit or cost center.
• Incurred to bring raw material from point of purchase to company
premises.
Examples:
Direct Indirect
Transportation costs. Bills
Royalty Rent, etc.
Sum of all All Indirect
direct cost is
called Prime
Cost costs are
accumulated
under one
cost. Direct costs Indirect costs head,
Direct Material Indirect Material Overheads.
Direct Labour Indirect Labour
Direct Expense Indirect Expense
Overheads
Production Overheads Non-Production Overheads
Examples: Examples:
Machine oil Sales Manager’s salary
Glue Auditor’s Fee
Supervisors Salary, etc. Advertisement, etc.
Formulae:
Prime Cost = Direct Material + Direct Labour + Direct Expense.
Production Cost = Prime cost + Production Overheads.
Total Cost = Production Cost + Non-Production Overheads.
Conversion Cost = Direct Labour + Direct Expense + Production
Overheads.
2. By Function:
Function: “All activities and operations of the company are called
functions”. In this classification, we classify cost as per activity,
operation, product, individual segment, division, department, etc.
2. By Function:
Examples:
• Production cost: (Materials, Labour and expenses incurred, etc)
• Selling cost: (Advertisement, Discounts to customers, sales staff salaries,
wages & commission, Showroom rents & Bills, after sales services, etc)
• Distribution cost: (Fuel, drivers wages, Insurance, Vehicle maintenance,
secondary packing, Road Tax, Chalans, License fee, etc)
• Administration Costs: (Offices expenses, Accounts Dept expenses, Bills,
Salaries, Audit fee, Canteen Expenses, Legal fee, stationary, etc)
2. By Function:
Uses:
• Cost control
• Stock Valuation
• Financial Statements, etc.
Example 1: A company has 2 departments- one produces cakes and the other
produced tablecloths. The following expenses have been incurred in this month:
a. 1 kg chocolate chips
b. Hours of cake decorator’s time
c. Rent of the factory
d. 300 meters of purple cotton
e. 2 sewing machine operators working 40 hours each
f. Cardboard cake boxes
g. Electricity bill for the whole factory
Classify the cost as Direct or Indirect Cost.
Example: The following data is given of a wooden furniture manufacturer:
$
Wood 5,000
Glue used in manufacturing 250
Leather skin for chairs 6,000
Designing costs (specific customer’s request) 350
Machine hire charges 25,000
Other factory overheads 2,200
Selling overheads 1,400
Admin overheads 1,200
Find the prime cost, the production cost and the total cost.
3. Product & Period Costs:
Product Costs: “Costs incurred on making a product is called
product cost”.
Examples:
• Materials
• Labour
• Expenses.
3. Product & Period Costs:
Period Costs: “A cost that does not change, which remains fix. It
relates with the passage of time rather than the output of
individual product or service is called period cost”.
Examples:
•Salaries
•Rent of building, etc.
3. Product & Period Costs:
Uses:
• Cost control
• Inventory valuation
• Absorption & Marginal costing, etc.
4. Controllable & Uncontrollable Costs:
Normally the costs incur within the organisation are controllable
whereas the costs charged from outside the organisation are
generally considered as uncontrollable costs for management.
4. Controllable & Uncontrollable Costs:
Examples:
Controllable:
• Material used for production
• Labour paid to production workers
Uncontrollable:
• Share in the rental cost of the building
• Share in the organisation’s bills.
Activity Level: “The amount/quantity of work done or the volume
of production is called activity level”.
Examples:
• No. of shirts produced.
• No. of labour hours worked.
• No. of machine hours worked, etc.
5. By Behaviour:
Some costs varies with the change in activity level and some of them remain
unchanged. In the cost behavior we will see the effect on costs with the
change in activity level. By behaviour we split it in four categories.
Variable cost
Fixed cost
Stepped fixed cost
Semi-variable/ Semi-fixed/ Mixed/ Total cost
Variable Cost:
“A cost that varies in total with the change in activity level but
remains constant in per unit is called variable costs”.
Examples:
• Material purchased.
• Worker paid per unit.
• Royalty paid per unit.
Variable Cost:
Charts:
In Total: In per unit:
$ $
0 Activity level 0 Activity level
Discounts in Variable costs:
There are two categories of discounts, one applies on all quantity purchase
called full discount and the other applies on excess quantity only called partial
discount.
Partial Discount Full Quantity Discount
In total In total
$ $
0 Activity level 0 Activity level
In per unit In per unit
$ $
0 Activity level 0 Activity level
Fixed Costs:
“A cost that remains fix in total with the change in activity level
(within a specific range) but changes in per unit is called fixed
cost”. Fixed cost does not depend on the activity level, it relates
with the passage of time
Fixed Costs:
Example:
• Rent
• Salaries
• Straight line depreciation, etc.
Charts:
In Total: In per unit:
$ $
0 Activity level 0 Activity level
Stepped Fixed Cost:
“A cost that fix for a certain level of activity, will increase and will
then remain fix again until another level of production is called
stepped fixed cost”.
Examples:
• Store rent
• Supervisor’s salaries
• Tyre replacement
Stepped Fixed Cost:
Charts:
In total In per unit
$ $
0 Activity level 0 Activity level
Semi-Variable Cost:
“A cost which has both elements fixed and variable is called semi-
variable cost”.
Examples:
• Bills
• Salesmen salaries plus commission
• Cost of running a car (Fixed: Road tax, insurance
Variable: Petrol, oil, repairs, etc.)
Semi-Variable Cost:
Charts:
In total In per unit
$ $
0 Activity level 0 Activity level
Example 3 A company has established the following information
for the costs and revenues at an activity level of 500 units:
Sales revenue $40,000
Direct Materials ($15,250)
Direct labour ($10,000)
Production overheads ($6,000)
Selling overheads ($5,000)
Profit/ (Loss) $3,750
40% of the selling costs and 60% of the production overheads are
fixed over all levels of activity.
What will be the total profit at an activity level of 700 units?
Solution:
Example: A cost is said to be semi-variable cost. What will happen to
cost per unit, if activity level increase by 10%?
a. It will increase but more than 10%
b. It will increase but less than 10%
c. It will decrease but more than 10%
d. It will decrease but less than 10%
Example: A cost is said to be Fixed cost. What will happen to cost per
unit, if activity level increase by 50%?
a. It will increase by 33.33%
b. It will decrease by 33.33%
c. It will increase by 100%
d. It will decrease by 100%
e. It will remain constant
HIGH-LOW METHOD
This a method used to determine fixed and variable elements from
mixed cost. It relies on the assumption that mixed costs are linear.
APPLYING HIGH LOW METHOD
This method consists of selecting the periods of highest and lowest
activity levels and comparing the changes in costs that result from two
levels.
HIGH-LOW METHOD
Application of the method requires the following steps:
1. Identify two different levels of activities: the highest and the lowest level of
activities and the corresponding costs.
2. Find the variable cost per unit by
Total costs at highest activity level – Total costs at lowest activity level
Units at highest activity level – Units at lowest activity level
HIGH-LOW METHOD
3. Compare the variable cost with the total costs at either the
lowest activity level or highest activity level to compute the total
fixed cost.
= Total costs at highest activity level – (Total units at highest level x
Variable cost per unit)
4. Form the equation
Total Cost = Total Fixed Cost + Total Variable cost
Total Cost = Total Fixed Cost + (Variable cost per unit x Number of
Units)
Y = a + bx
Y = a + bx
Where,
Y is the dependent variable i.e. the total cost for the period at
activity level of X
X is the independent variable, i.e. the activity level
a is the constant, i.e. the total fixed cost for the period
b is also a constant, i.e. the variable cost per unit of activity
ADVANTAGES AND DISADVANTAGES OF HIGH LOW
METHOD
Advantages
• It is easy to use and understandable
Disadvantages
• It relies on historical data assuming that level of activity is the only
factor affecting cost and historical cost can reliably predict
future cost.
• It uses only two level of activity highest and lowest, which means
that the result may be distorted because of random variation of
these values.
Example : The following data was collected for the period of
January to March last year:
Months Sales Units Total Cost($)
January 8,500 46,000
February 9,100 50,000
March 10,200 54,925
Estimate the total costs when output is 9,500 units using high – low
method.
Solution:
