Cost Classification and Cost Behavior

Cost Classification & Behavior

Classification by Function

A typical Manufacturing business will have five functions, production, administration, selling &
distribution, research & development and finance. Costs incurred on these functions will be classified
according and will be called:
• 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,
warehousing and transport departments.
• Research & Development costs. Costs spent on gaining new knowledge (research) and costs spent
on developing a prototype (development).
• Finance costs. Interest or associated costs.

Note:

For the purpose of inventory valuation, the cost of product should only include production
costs and therefore production costs are called product costs whereas as all other costs are
charged to income statement in the period they are incurred and hence are called period
costs.

Direct Cost: A direct cost is a cost that can be traced in full to the product, service or department that is being
costed.

Indirect Cost/Overhead: 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 to a
unit of product.

Material Direct Material Indirect Material

Labor Direct Labor Indirect Labor
Expense Direct Expense Indirect Expense
Production cost (Sum of above) Prime costs (sum of above) Production overheads (Sum of above)

Direct material is all material becoming part of the product (unless used in negligible amounts and/or having
negligible cost). E.g wood in chair, cement in a building etc.

Direct wages are all wages paid for labour (either as basic hours or as overtime) expended on work on the
product itself.

Direct expenses are any expenses which are incurred on a specific product other than direct material cost and
direct wages.

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 Cost Classification and Cost Behavior

Production Overheads include all indirect material costs, indirect wages and indirect expenses incurred in the
factory from receipt of the order until its completion.

Conversion costs include direct labor costs and production overheads (all production costs except direct
material).

Other Non-Production Costs

Administration overhead is all indirect material costs, wages and expenses incurred in the direction, control
and administration of an undertaking. E.g. Depreciation, Office Salaries, Rent, rates, insurance, lighting,
cleaning, telephone charges and so on.

Selling overhead is all indirect materials costs, wages and expenses incurred in promoting sales and retaining
customers. E.g.Salaries & commission of sales personnel, Sales promotion & advertising, Rent, rates
and insurance of sales offices and showrooms, bad debts and so on.

Distribution overhead is all indirect material costs, wages and expenses incurred in making the packed
product ready for despatch and delivering it to the customer. E.g. Wages of packers, drivers and
despatch clerks, Insurance charges, rent, rates, depreciation of warehouses and so on

Fixed and 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

o Direct material costs are variable costs because they rise as more units of a product
are manufactured.
o Sales commission is often a fixed percentage of sales turnover, and so is a variable
cost that varies with the level of sales.
o 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.
o The rental cost of business premises is a constant amount, at least within a stated
time period, and so it is a fixed cost.

Cost Units, Objects and Responsibility centres

i. 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.

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 Cost Classification and Cost Behavior

Cost centres may include the following.

• A department or function
• A machine, or group of machines
• A project (eg the installation of a new computer system)

ii. 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)

iii. A cost object is any activity for which a separate measurement of costs is desired.

Examples include the following.

• The cost of a product

• The cost of operating a department
• The cost of a service

iv. Profit centres are similar to 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. A profit centre manager will want information regarding both
revenues and costs. They will be judged on the profit margin achieved by their division.
v. 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. A revenue centre manager is not accountable for costs. They
will be aiming purely to maximise sales revenue.
vi. 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.
An investment centre manager will take the same decisions as a profit centre manager
but they also have additional responsibility for investment. So they will be judged
additionally on their handling of cash surpluses and they will seek to make only those
investments which yield a higher percentage than the company's notional cost of
capital.

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 Cost Classification and Cost Behavior

Cost Behaviour

Cost behaviour is the way in which costs are affected by changes in the volume of output.

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

i. Fixed Costs
A fixed cost is a cost which tends to be unaffected by increases or decreases in the volume of output.

A sketch graph of total fixed cost would look like this

Examples of a fixed cost would be as follows.

o The salary of the managing director (per month or per annum)
o The rent of a single factory building (per month or per annum)
o Straight line depreciation of a single machine (per month or per annum)

ii. Step Fixed Costs

A step cost is a cost which is fixed in nature but only within certain levels of activity.

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 Cost Classification and Cost Behavior

Examples of step fixed costs are as follows.

o Rent is a step cost in situations where accommodation requirements increase as output levels
get higher.
o Basic pay of employees is nowadays usually fixed, but as output rises, more employees (direct
workers, supervisors, managers and so on) are required.

iii. Variable Costs

A variable cost is 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.
Total Variable Cost Graph

A constant variable cost per unit implies that the price per unit of, say, material purchased is
constant, and that the rate of material usage is also constant.
o The most important variable cost is the cost of raw materials (where there is no discount
for bulk purchasing since bulk purchase discounts reduce the cost of purchases).
o Direct labour costs are, for very important reasons, classed as a variable cost even though
basic wages are usually fixed.
o Sales commission is variable in relation to the volume or value of sales.
iv. Semi Variable Costs
A Semi variable cost is cost which shows both the element of variable cost and fixed
cost. There will be a minimum fixed cost for certain level of activity and then will
increase as the level of activity increases.

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 Cost Classification and Cost Behavior

Cost Behaviour and Cost/unit

The following table relates to different levels of production of the zed. The variable cost of producing a zed is $5.
Fixed costs are $5,000.

What happens when activity levels rise can be summarised as follows.

• The variable cost per unit remains constant.
• The fixed cost per unit falls.
• The total cost per unit falls.

Quick Practice Questions

Q1.) Company B has the following Activity levels:

Units Total
Cost
12,000 $72,000
11,000 $69,000
14,000 $78,000

What would be the total cost at an activity level of 16,000? __________. (Answer: $84,000)

Q2.) CK Ltd. has the following cost pattern at different activity levels

Units Total Costs

50,000 $500,000
55,000 $535,000
45,000 $465,000
60,000 $620,000
65,000 ?

The fixed cost increases by $50,000 when activity level crosses 55,000 units.

What is the Total cost at an activity level of 65,000 units? _______. (Answer: $655,000)