Cost
Classification
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Cost Classification
Cost accounting is used for:
For the preparation of financial
1. Preparing statements (e.g.,
statements, costs are often classified
budgets, costing)
as:
2. Cost data collection
1. Production
3. Applying costs to inventory,
2. Non-production costs
products and services
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Cost Classification
Fixed Costs Variable Costs
Production Costs Non Production Costs
Direct Costs Indirect Costs
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Fixed vs Variable Cost
Fixed Cost Variable Cost
Variable costs change with output—
Fixed costs remain the same no matter
rising as a business makes more stuff or
how much the business produces.
provides more services.
• Rent payments or property tax
• Raw goods and inputs
• Salaries for people who run the
• Wages for employees involved in
company (e.g., executives,
production, like assembly-line
administrative staff)
workers
• Insurance premiums
• Shipping and delivery costs
• Loan payments
• Sales commissions
• Equipment depreciation
• Employee bonuses
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Cost Classification
Direct Costs
Traceable in the unit of output
Indirect Costs / Overhead
Are not traceable in the unit of
output
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Production Costs
• Production Costs:
- are costs identified with goods produced for resale.
- are all the costs involved in the manufacture of goods
(costs incurred inside the factory)
▪ For example:
- Direct material
- Direct labor
- Direct expenses
- Production overheads
• variable production overheads
• fixed production overhead
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Direct Material Costs
• Direct Material are the costs of materials that are known to have been used in making and selling a
product (or even providing a service).
• Direct material costs are charged to the product as part of the prime cost. Examples of direct material
are as follows:
(a) Component parts, specially purchased for a particular job, order or process
(b) Part-finished work which is transferred from department 1 to department 2 becomes finished
work of department 1 and a direct material cost in department 2
(c) Primary packing materials like cartons and boxes
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Direct Labour Costs
• 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’.
• Direct wages costs are charged to the product as part of the prime cost. Examples of groups of
labor receiving payment as direct wages are as follows:
1. Workers engaged in altering the condition or composition of the product
2. Inspectors, analysts and testers specifically required for such production
3. Foremen, shop clerks and anyone else whose wages are specifically identified
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Other Direct Expenses
• 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.
• Direct expenses are charged to the product as part of the prime cost. Examples of direct expenses are
as follows.
1. The hire of tools or equipment for a particular job
2. Maintenance costs of tools, fixtures and so on
Direct expenses are also referred to as chargeable expenses
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Production Overheads
Production overheads 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:
(a) Indirect materials which cannot be traced in the finished product. Consumable stores, e.g.,
material used in negligible amounts
(b) Indirect labor cost - wages, meaning all wages not charged directly to a product. Wages of non-
productive personnel in the production department, e.g., foremen
(i) Rent, rates and insurance of a factory
(c) Indirect expenses (other than material and
labor) not charged directly to production. (ii) Depreciation, fuel, power, maintenance of plant,
machinery and buildings
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Analysis of Total Cost
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
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Non-Production Costs
Non-Production Costs:
- are not directly associated with production of
manufactured goods (costs incurred outside the
factory).
- are taken directly to the income statement as
expenses in the period in which they are incurred.
Such costs consist of:
• administrative costs
• selling and distribution expenses
• finance costs
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Non Production Costs - Administrative Costs
These include all the costs involved in running the general administration department of an
organization.
Examples of administrative costs include:
• Depreciation of office buildings and equipment.
• Office salaries, including salaries of directors, secretaries and accountants.
• Rent, rates, insurance, lighting, cleaning, telephone charges and others.
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Non Production Costs - Selling Costs
Selling costs include all costs incurred in promoting sales and retaining customers.
Examples of selling costs are:
• Salaries and commission of salesmen and sales department staff.
• Advertising and sales promotion, market research.
• Rent, rates and insurance of sales offices and showroom.
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Non Production Costs - Distribution Costs
Distribution costs include all costs incurred in making the packed product ready for dispatch and
delivering it to the customer.
Examples of distribution overhead are:
• Delivery costs
• Wages of packers, drivers and dispatch clerks.
• Insurance charges, rent, rates and depreciation of warehouse.
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Non Production Costs - Finance Costs
Finance costs include all the costs that are incurred to finance an organization, for e.g., loan
interest.
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Production costs are the costs which are incurred by the
sequence of operations beginning with the supply of raw
materials and ending with the completion of the product
ready for warehousing as a finished goods item.
Packaging costs are production costs where they relate to
'primary ‘packing (boxes, wrappers and so on).
Functional Administration costs are the costs of managing an
organization; that is, planning and controlling its
Costs operations, but only insofar as such administration costs
are not related to the production, sales, distribution or
research and development functions.
Selling costs, sometimes known as marketing costs, are
the costs of creating demand for products and securing
firm orders from customers.
Distribution costs are the costs of the sequence of
operations with the receipt of finished goods from the
production department and making them ready for
dispatch and ending with the reconditioning for reuse of
empty containers.
Functional Research costs are the costs of searching for new or
improved products, whereas development costs are the
Costs costs incurred between the decision to produce a new or
improved product and the commencement of full
manufacture of the product.
Financing costs are costs incurred to finance the
business, such as loan interest
• Once costs have been classified, a coding
system can be applied to make it easier to
manage the cost data, both in manual
systems and in computerized systems.
Cost Codes • Coding is the way in which the classification
system that we have been looking at is
applied.
Step 1 Costs are classified.
Step 2 Costs are coded.
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Cost Codes
Each individual cost should be identifiable by its code. This is possible by building up the individual
characteristics of the cost into the code.
The characteristics which are normally identified are as follows:
The cost centre
The nature of the to which the cost
cost (materials, should be
The department
labour, The type of cost allocated or cost
which the
overhead), which (direct, indirect unit which should
particular cost
is known as a and so on) be charged,
centre is in
subjective which is known
classification as an objective
classification
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Features of a Good Coding System
An efficient and effective coding system, whether manual or computerised, should incorporate the
following features:
The code must be easy Each item should have a The coding system must If there is conflict The code should be
to use and unique code. allow for expansion. between the ease of flexible so that small
communicate. using the code by the changes in a cost's
people involved and its classification can be
manipulation on a incorporated without
computer, the human major changes to the
interest should coding system itself.
dominate.
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Features of a Good Coding System
The coding system should be brief, to save
clerical time in writing out codes and to
The coding system should provide a
save storage space in computer memory The likelihood of errors going undetected
comprehensive system, whereby every
and on computer files. At the same time, should be minimised.
recorded item can be suitably coded.
codes must be long enough to allow for the
suitable coding of all items.
There should be a readily available index or Code numbers should be issued from a
reference book of codes. J. Existing codes single central point. Different people should
should be reviewed regularly and out of not be allowed to add new codes to the
date codes removed. existing list independently.
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The code should be either entirely numeric or entirely alphabetic. In
a computerised system, numeric characters are preferable. The use
of dots, dashes, colons and so on should be avoided.
Codes should be uniform (that is, have the same length and the
same structure) to assist in the detection of missing characters and
to facilitate processing.
Features of a The coding system should avoid problems such as confusion
good Coding between I and 1, O and 0 (zero), S and 5 and so on.
system The coding system should, if possible, be significant (in other words,
the actual code should signify something about the item being
coded).
If the code consists of alphabetic characters, it should be derived
from the item's description or name (that is, mnemonics should be
used).
Types of Code
1. Composite codes
2. Sequence (or progressive) codes
3. Group classification codes
4. Faceted codes
5. Significant digit codes
6. Hierarchical codes
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1. Composite Codes
'For example, in costing, the first three digits in the composite code 211 might indicate the nature of the expenditure
(subjective classification) and the last three digits 392 might indicate the cost centre or cost unit to be charged
(objective classification).’
So, the digits 211 might refer to:
2 Materials 1 Raw materials 1 Timber
This would indicate to anyone familiar with the coding system that the expenditure was incurred on timber.
The digits 392 might refer to:
3 Direct cost 9 Factory alpha 2 Assembly department
This would indicate that the expenditure was to be charged as a direct material cost to the assembly department in
factory alpha.
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2. Sequence (or Progressive) Codes
Numbers are given to items in ordinary numerical sequence, so that there is no obvious connection between an
item and its code.
For example:
000042 4 cm nails
000043 Office stapler
000044 Hand wrench
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3. Group Classification Codes
These are an improvement on simple sequences codes, in that a digit (often the first one) indicates
the classification of an item.
For example:
4NNNNN Nails
5NNNNN Screws
6NNNNN Bolts
(Note. 'N' stands for another digit; 'NNNNN' indicates there are five further digits in the code.)
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4. Faceted Codes
These are a refinement of group classification codes, in that each digit of the code gives information
about an item.
For example: The first digit: 1 Nails 2 Screws 3 Bolts
The second digit: 1 Steel 2 Brass 3 Copper
The third digit: 1 50mm 2 60mm 3 75mm
A 60 mm steel screw would have a code of 212
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5. Significant Digit Codes
These incorporate some digit(s) which is/are part of the description of the item being coded.
For example:
5000 Screws
5060 60 mm screws
5050 50 mm screws
5075 75 mm screws
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6. Hierarchical Codes
This is a type of faceted code where each digit represents a classification, and each digit further to
the right represents a smaller subset than those to the left.
For example:
3 = Screws
32 = Round headed screws
31 = Flat headed screws
322 = Steel (round headed) screws
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The Advantages of a Coding System
A code is usually briefer than
a description, thereby saving A code is more precise than
Coding facilitates data
clerical time in a manual a description and therefore
processing.
system and storage space in reduces ambiguity.
a computerised system.
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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.
Once costs have been traced to cost centres, they can be further analysed in order to
establish a cost per cost unit. Alternatively, some items of cost may be charged
directly to a cost unit, for example direct materials and direct labour costs.
1. Patient episode (in a hospital)
Examples of cost units include the 2. Room (in a hotel)
following.
3. Barrel (in the brewing industry)
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Cost Objects
If the users of management
A cost object is any activity for
information wish to know the
which a separate Examples include the
cost of something, this
measurement of costs is following:
something is called a cost
desired.
object.
The cost of operating a
The cost of a product The cost of a service
department
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Responsibility Centres
A responsibility centre is a department or Cost centres, revenue centres, profit centres and
organisational function whose performance is investment centres are known as responsibility
the direct responsibility of a specific manager. centres.
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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.
Overhead costs e.g., rent, rates,
A project (e.g., the installation of a new
A department A machine, or group of machines electricity (which may then be
computer system)
allocated to departments or projects)
Cost centres are an essential 'building block' of a costing system. They are the starting point for the following.
(c) The comparison of actual costs and budgeted
(a) The classification of actual costs incurred (b) The preparation of budgets of planned costs
costs (management control)
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Profit Centres
Profit centres are like cost centres but are accountable for both costs and revenues.
Profit centre managers should normally have control over how revenue is raised and how costs are incurred.
Often, several cost centres will comprise one profit centre. The profit centre manager will be able to make
decisions about both purchasing and selling and will be expected to do both as profitably as possible.
A profit centre manager will want information regarding both revenues and costs. They will be judged on the
profit margin achieved by their division.
In practice, it may be that there are fixed costs which they cannot control, so they should be judged on
contribution, which is revenue fewer variable costs. In this case they will want information about which
products yield the highest contribution.
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Revenue Centres
A revenue centre manager is not accountable
Revenue centres are like cost centres and Revenue centre managers should normally for costs. They will be aiming purely to
profit centres but are accountable for have control over how revenues are raised. maximise sales revenue. They will want
revenues only. information on markets and new products,
and they will look closely at pricing and the
sales performance of competitors – in addition
to monitoring revenue figures.
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Investment Centres
So, the investment centre
manager will want the
An investment centre is a They will have to make
same information as the
profit centre with decisions regarding the
profit centre manager and
additional responsibilities purchase or lease of non-
in addition they will
for capital investment and current assets and the
require quite detailed
possibly for financing, and investment of cash
appraisals of possible
whose performance is surpluses. Most of these
investments and
measured by its return on decisions involve large
information regarding the
investment. sums of money.
results of investments
already undertaken.
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