CHAPTER 2 - Cost Classification

CHAPTER 2: COST CLASSIFICATION

Contents 1.

Introduction to cost classification................................................................................................2

2.

Classification according to nature................................................................................................4

3.

2.1

Cost object.............................................................................................................................4

2.2

Direct costs............................................................................................................................4

2.3

Indirect costs.........................................................................................................................6

Classification according to behaviour...........................................................................................7 3.1

Variable costs........................................................................................................................8

3.2

Fixed costs...........................................................................................................................10

3.3

Mixed costs.........................................................................................................................13

3.4

Step costs............................................................................................................................15

4.

Classification according to function............................................................................................16

5.

Classification according to time..................................................................................................17

6.

Classification of costs for decision making.................................................................................18

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Learning Outcomes: After completing this chapter, the person should demonstrate an: (a) Understand the basis of and when to apply the basis to classify costs, (b) Understanding the principles of and applying the classification of costs according to nature, (c) Understand the principles of and applying the classification of costs according to behaviour, (d) Understanding the principles of and applying the classification of costs according to function, (e) Understanding the principles of and applying the classification of costs according to time.

1. Introduction to cost classification The classification of costs must serve the primary functions of management, viz. planning, control, and decision-making. It is therefore, important that costs are classified in such a manner that provides management with useful information to assist management in making informed decisions when fulfilling the responsibilities.

Classification of costs can be made according to the following basis. (a) Classification according to elements: Costs can be classified according to the elements based on the production process of an organisation. There are three elements of costing, viz. material (input), labour (input and process), and expenses (process). The total cost of production/services can be divided into the three elements to find out the contribution of each element in the total costs of production or service rendered. When costs are allocated according to the elements of the production process or process involves in rendered the services, then the information provided by the system enables management to focus on planning the processes as well as evaluating the efficiency and cost effectiveness of the processes.

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(b) Classification according to nature: As per this classification, costs can be classified into direct and indirect. Direct costs are the costs which are identifiable with the product unit or cost centre (cost object) while indirect costs are not easily identifiable with the product unit or cost centre, hence they are to be allocated, apportioned, and then absorb in the production units. All elements of costs like material, labour, and expenses can be classified into direct and indirect. When cost are allocated according to nature, then management is interested in tracking and allocating costs to an activity, product or services. This type of information assist management in determining the cost of the product/service more effectively. (c) Classification according to behaviour: Costs can also be classified according to their behaviour in relation to the level of production output or level of operating activity – the total cost incurred may change in relationship to the level of production output/activity.

When the costs a re classified according to behaviour, then the focus of management is to control the costs by controlling the level of activities or production output. This type of information is important to management when they are setting prices and allocating resources to improve profitability as well as preparing the production plans. (d) Classification according to functions: Costs can also be classified according to the functions/activities performed in an organisation – the costs can be allocated based on the departments/units of the organisation. When costs are classified according to functions, then the focus of management is on planning and control of costs within the organisation. This type of information is used when preparing budgets and monitoring the performance of the departments/units in the organisation. (e) Classification according to time: Costs can also be classified according to time – provides an indication as to the period to which the costs relate – for example, historical costs versus budgeted costs. When costs are classified according to time, then it allows management with planning, control and decision making in terms of allocating resources and reporting on performance.

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2. Classification according to nature The objective of classifying costs according to nature is to enable management to track costs to a product, service, or activity. The allows management to measure the cost of the product, service, or activity more accurately. The costing system allows costs to track information easily to the product, service, or activity and provides information that can be used to measure that cost of the product, service, or activity for planning, control, and decision-making.

2.1 Cost object The cost object is defined as the item that needs to be measured and can be represented by the product, service, or activity. By clearly defining the cost object, it allows the costs to be tracked easily to determine the cost of the product, service, or activity. The ease with which the costs can be tracked to the cost objective will determine the classification of the cost between (i) direct costs – costs which can be tracked easily to the cost objective, and (ii) indirect costs – cost which cannot be traced easily to the cost object, and is generally, allocated to the cost object using an appropriate allocation method/basis.

2.2 Direct costs Direct costs represent the costs that can be easily tracked to the cost object. For example, if the cost object is defined as the product, then all cost which can be tracked without any difficulty to the product will be classified as direct costs – these costs can consist of both variable and fixed costs. Similarly, the cost object is defined as a department, then all the costs associated with the activities of the department and can be tracked easily to the department will be classified as directly costs. It is generally, concluded that direct costs are only represented by variable costs. However, this is only true if the cost object is defined as the product or the service rendered.

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Illustrative example 1: The company incurred the following costs to produce a product: (a) material costs of CU 34.50 per unit, (b) labour cost of R 9.80 per unit, and (c) variable overhead costs of R 4,75 per unit, fixed overhead costs of R 56,000 for the production cycle.

Required: classify the cost according to nature as direct costs if the cost object is defined as the product.

Suggested solution: Cost Material cost

Classification The material costs are directly associated with the production of the product and can be tracked to the product – if the product is not produced then the costs will not be incurred. Therefore, the material costs are direct costs.

Labour cost

The labour costs are directly associated with the production of the product and can be tracked to the product – if the product is not produced then the costs will not be incurred. Therefore, the labour costs are direct costs.

Variable overhead costs

The variable production overhead costs are directly associated with the production of the product and can be tracked to the product – if the product is not produced then the costs will not be incurred. Therefore, the variable overhead costs are direct costs.

Fixed overhead costs

Although the fixed production overhead costs are directly associated with the production of the product, it cannot be tracked easily to the individual product produced – the fixed costs are allocated to the product.

Therefore, the fixed overhead costs are not direct costs.

Illustrative example 2: Page 5 of 19

The company incurred rental expenses for its factory of R 50,000 for the month which is included in it production overhead costs.

Required: determine whether the rental expenses should be classified as a direct costs.

Suggested solution: Cost object Product

Classification If the cost object is defined as the product, then the rental cost cannot be tracked easily to each individual product.

Therefore, the rental expense should be not be treated as a direct cost even though it is incurred in the production of the products – the rental expense is allocated to the cost of the product.

Production

If the cost object is defined as the production department (the

department

total cost of the department must be measured), then the rental expense can be tracked easily to the department.

Therefore, the rental expense will be classified as a direct cost.

Conclusion: the cost will be classified as a direct cost based on the definition of the cost object (what management intend to measure).

2.3 Indirect costs Indirect costs represent the costs that cannot be tracked easily to the cost object. These costs are allocated to the cost object using an appropriate basis of allocation. Generally, it stated that fixed costs are indirect because the assumption is that the cost object is defined as the product – fixed costs cannot be tracked easily to the individual product cost. For example, the fixed rental cost for a factory plant will be treated as an indirect cost which will be allocated to the product cost based on the number of units produced for the period.

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Illustrative example 3: The company the following incurred labour costs in the production of a product. Viz. (i) labour cost which is charged for each unit produced, and (ii) the production manager’s salary which is fixed for the month.

Required: determine whether the labour costs above should be classified as direct of indirect costs if the cost object is defined as the product.

Suggested solution: Cost

Classification

Labour cost based on output

The labour cost based on the units produced can be tracked easily to the product, therefore, it should be classified as a direct cost – the cost will not be incurred if no units are produced.

Production manager’s fixed

The manager’s salary cannot be tracked to the

monthly salary

individual unit produced as it is associated with the entire production process.

Therefore the manager’s

salary will be classified as an indirect cost.

NB: costs are classified as direct costs based on the ease with which the costs can be tracked to the cost object and not whether the cost a classified as variable or fixed cost (classification according to behaviour).

3. Classification according to behaviour Costs are classified according to behaviour when a pattern is established between the cost and the level of activity, units produced, or services rendered. There is a relationship between the total cost incurred and the changes in the level of activities.

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3.1 Variable costs Generally, the total variable costs changes in direct relationship the level of output – when the level of activity or output increases then the total variable costs will also increase. The is a direct relationship between the rate of change in the total variable cost and the total level of activity or output – the graph of the costs to output is represented by a 45% line passing through zero.

The following are the characteristics of variable costs: (a) Total variable costs changes: the total variable cost changes in relation to changes in the level of activity or output – an increase in output will results in a corresponding increase in the total cost.

Illustrative example 4: The company incurred raw material costs of CU 90,000, CU 70,000 and CU 120,000 to produce 45,000, 35,000 and 60,000 units respectively.

Required: determine whether material costs display the characteristic of a variable cost based on the behaviour of its total cost.

Suggested solution: Situation A

Situation

Situation C

B the variable cost per unit will remain unchanged irrespective (b) Cost per unit remains fixed: Material CU 70,000 CU 120,000 of changes inCU the90,000 level of activity or output – assumption is that the unit cost will not be cost affect be other factors such as (i) negotiating better prices, (ii) discounts received for Output 45,000 bulk purchases, etc.

35,000

60,000

Illustrative example 4 - continue: The company incurred raw material costs of CU 90,000, CU 70,000 and CU 120,000 to produce 45,000, 35,000 and 60,000 units respectively.

Required: determine whether material costs display the characteristic of a variable cost based on the behaviour of the rate of change in the cost per unit.

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Suggested solution: Situation A

Situation

Situation C

B Material

CU 90,000

CU 70,000

CU 120,000

cost

level of the units produced the

Output Cost

Irrespective of the changes in the

per

45,000

35,000

60,000 material cost per unit remained

CU 2.00

CU 2.00

CU 2.00

unit

fixed – the change in the level of output did not affect the cost per unit.

(c) Direct relation in the rate of change in cost to output: there is a direct relationship between the rate of change in the total variable costs and the level of activity or output – the rate of change is the same and the direction of the change is in the same direction (if the level of activity increases by 30%, then the total variable costs will also change by 30%).

Illustrative example 4 - continue: The company incurred raw material costs of CU 90,000, CU 70,000 and CU 120,000 to produce 45,000, 35,000 and 60,000 units respectively.

Required: determine whether material costs display the characteristic of a variable cost based on the behaviour of the rates of changes in the total costs and output.

Suggested solution: Situation A

Situation

Situation C

B Material

CU 90,000

CU 70,000

CU 120,000

cost

costs and the output are exactly

Output Rate

The rate of change in the total

45,000 of

35,000

60,000 the same (same values and

-28.6%

71.4%

direction), therefore there is a

change – Page 9 of 19

total cost Rate

of

direct relationship between the -28.6%

71.4%

total cost and the level of output.

change – output

3.2 Fixed costs Fixed costs remain unchanged for a specific level of output – costs will not change if the output does not exceed the maximum output range. However, if the level of activity or output exceeds the maximum level, then the costs may change – for example, if a company hires four offices but only used three of the offices, then the rental cost will remain the same. However, if the company intends to rent an additional office, then the rental cost will increase accordingly.

The following are characteristics of fixed costs: (a) Total costs are fixed at all levels of output: the total cost remains unchanged as the level of activity or output changes within a specified range – total cost remains fixed for a given range of output.

Illustrative example 5: The company increased production overhead costs of CU 90,000 per period to produce 45,000, 35,000 and 60,000 units respectively.

Required: determine whether the production overhead costs display the characteristics of a fixed cost based on the behaviour of the total costs.

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Suggested solution: Situation A Overhead

CU 90,000

Situation

Situation

B

C

CU 90,000

CU 90,000

cost

Irrespective of the changes in the level of the units produced the

Output

45,000

35,000

60,000 total overhead costs remained fixed – the change in the level of output did not affect the total cost for the range of outputs.

(b) Average cost per unit varies as the level of output changes: the average cost per unit changes as the level of activity or output changes – as the level of activity or output increases the average cost per unit will decrease. This represents the economies of scale when utilising resources – also referred to as the economic principle of marginal utility.

Illustrative example 5 - continue: The company increased production overhead costs of CU 90,000 per period to produce 45,000, 35,000 and 60,000 units respectively.

Required: determine whether the production overhead costs display the characteristics of a fixed cost based on the behaviour of the average cost per unit.

Suggested solution: Situation A Overhead

CU 90,000

Situation

Situation

B

C

CU 90,000

CU 90,000

cost

As the level of output changes the average

production

overhead

Output

45,000

35,000

60,000

costs changes – when the output

Average

CU 2.00

CU 2.57

CU 1.50

increases

cost

per

the

average

cost

decreases and vice versa.

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unit

(c) Inverse relationship between the average cost per unit and the level of output: the rate of change in the average cost per unit has an inverse relation with the changes in the level of activity of output – the rate of change is not the same and the movement of the change is in opposite directions.

Illustrative example 5 - continue: The company increased production overhead costs of CU 90,000 per period to produce 45,000, 35,000 and 60,000 units respectively.

Required: determine whether the production overhead costs display the characteristics of a fixed cost based on the behaviour of the average cost per unit.

Suggested solution: Situation A Overhead

CU 90,000

Situation

Situation

B

C

CU 90,000

CU 90,000

cost

The rate of change in the average production overhead cost per unit

Output

45,000

35,000

60,000

changes inversely to the change in

Average

CU 2.00

CU 2.57

CU 1.50

the level of output – change in not

cost

per

the same in value nor in the same

unit Rate

direction. Unlike, the variable cost of

28.5%

-41.6%

there

is

not

proportionate

change –

relationship between the average

average

cost and the level of output.

cost Rate

of

change

-

-28.6%

71.4%

output Page 12 of 19

3.3 Mixed costs Mixed costs, also referred to as semi-variable or semi-fixed depending on the dominant cost component, have the characteristics of both variable and fixed costs. Thus, mixed costs have a fixed cost and variable cost components for a specific range of activity or output.

Illustrative example 6: The company incurred the following production overhead costs CU 180,000, CU 300,000 and CU 340,000 to produce 20,000, 50,000 and 60,000 units respectively.

Required: determine how the production overhead costs should be classified based on its behaviour in relation to the level of output.

Suggested solution: Overhead

Situation A

Situation B

Situation C

CU 180,000

CU 300,000

CU 340,000

costs

The total cost changes as the level of output changes – indicating that the cost has a variable cost component.

Output

20,000

50,000

60,000

Average

CU 9.00

CU 6.00

CU 5.67

cost unit

per

The average cost per unit changes as the level of output changes with the given range – indicating that the cost has a fixed cost component

Conclusion: the production overhead costs have both a variable and fixed cost components indicating that the cost may be a mixed cost.

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The final classification of the cost as a mixed cost can only be made if the cost components can be verified to consist of fixed and variable costs. This can be verified by applying mathematical calculations as the Hi-low method, regression analysis, simultaneous equations, or using computer mathematical models. At this stage the hi-low methods will be applied to separate the costs between the fixed and variable cost components. The hilow method applies differential mathematics (differences between the cost and and outputs between the sets of highest and lowest output level) to determine the average cost per unit which is treated as a variable cost per unit, after which through deduction the fixed cost can be calculated.

Illustrative example 6 - continue: The company incurred the following production overhead costs CU 180,000, CU 300,000 and CU 340,000 to produce 20,000, 50,000 and 60,000 units respectively.

Required: determine how the production overhead costs should be classified based on its behaviour in relation to the level of output.

Suggested solution: Overhead

Situation A

Situation C

Difference

CU 180,000

CU 340,000

CU 160,000

20,000

60,000

40,000

costs Output Average cost

CU 4.00 per

satisfies the characteristics of

unit Total

This component of the cost variable costs – total cost

CU 80,000

CU 240,000

varies, cost per unit is fixed,

variable

and

cost

relationship rate of change in

there

is

a

direct

total cost and output Total fixed

CU 100,000

CU 100,000

This component of the cost Page 14 of 19

cost

satisfies the characteristics of a fixed cost – total cost is fixed, the average cost per unit changes, and there is an inverse relationship between the rate of change in cost and output

Conclusion: the production overhead costs have both a variable and fixed cost components indicating that the cost is a mixed cost.

3.4 Step costs Step costs consists only of fixed cost components, but the fixed cost changes as the ranges of output changes – there is a fixed cost for the specific level of activity or output and changes when it passes the maximum level into the next specified range.

4. Classification according to function Costs can also be classified according to the functions/activities.

This type of cost

classification assists management plan and control activities in the organisation – assist in allocating resources to core and support competencies and functions which will ensure that effective decisions can be made about the business model of the organisation. Classifying costs according to function assist management to evaluate the effectiveness of the structure of the organisation to achieve the strategic goals.

There are two major functions in an organisation, viz (i) manufacturing – costs are classified as manufacturing costs if they are directly associated with the production process or the Page 15 of 19

process of rendering services, and (ii) non-manufacturing – costs are classified and nonmanufacturing costs if they are not associated with the production process or the process of rendering services, but are necessary cost to carry out the operating activities of the organisation.

The costs can be classification according to the following functions: (a) Production costs: production costs represent all the costs incurred for production of products or the rendering of services. These costs cost consists of the three major elements of costs, viz. material, labour, and overhead expenses. Production costs are important to determine the cost of producing the product or rendering services, as well as setting competitive selling prices. (b) Administrative costs:

administrative

costs represent the

costs incurred for

administration of the business activities and is treated as a non-production cost. These costs include expenses such as office salaries, printing and stationery, office telephone, office rent, office insurance etc. Administrative costs assist management in determining the cost of implementing control over the operations of the organisation as well as determining the effect they have on the profitability of the organisation. (c) Selling and distribution costs: selling costs represent all costs incurred for procuring an order while all costs incurred for execution of order are distribution costs. Market research expenses, advertising, sales staff salary, sales promotion expenses are some of the examples of selling costs. Transportation expenses incurred on sales; warehouse rent etc are examples of distribution costs. (d) Research and development costs: in the modern days, research and development has become one of the important functions of a business organization because it ensures the organisation remain competitive and agile in the market. Expenditure incurred for this function can be classified as research and development costs.

5. Classification according to time

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Costs can also be classified according to time when drafting reports to assist management with planning (budgeting and forecasting), control (evaluating performance), and decisionmaking (developing strategic and operating plans). Costs can be classified according to time using the following bases: (a) Historical costs: historical costs represent the costs which are incurred in the past, i.e. in the past year or past month – and reflect the transactions of previous periods.

Historical costs are used by management to (i) evaluate performance, (ii) determine trends that can be used to predict the future, and (iii) monitor and evaluate performance and results against the plans of the organisation. (b) Predetermined Cost: predetermined costs represent the costs relating to the product or service that are computed in advance of production – used to determine the standard cost of a product or service based on the specification of all the factors affecting cost and cost data. Standard Cost is a predetermined calculation of how much cost should be under specific working conditions.

The main purpose of standard cost is to have

benchmarks for comparing the actual performance with the standards. On the other hand, estimated costs are predetermined costs based on past performance and adjusted to the anticipated changes. It can be used in any business situation or decision making which does not require accurate cost.

6. Classification of costs for decision making One of the important functions of cost accounting is to present information to the management for the purpose of decision making. For decision making certain types of costs are relevant. Classification of costs based on the criteria of decision making can be done in the following manner (a) Marginal Cost: marginal cost is the change in the aggregate costs due to change in the volume of output by one unit – this is important information when management is planning its production cycles or determining whether the output should be increased.

For example, suppose a manufacturing company produces 10,000 units and the Page 17 of 19

aggregate costs are CU 25,000, if 10,001 units are produced the aggregate costs may be CU 25,020 which means that the marginal cost is CU 20. Marginal cost is also termed as variable cost and hence per unit marginal cost is always same, i.e. per unit marginal cost is always fixed. (b) Differential costs: Differential costs are also known as incremental cost – the difference in total cost that will arise from the selection of one alternative to the other. Differential costing is used when management is comparing various alternative when making decisions. This type of analysis is useful for taking various decisions like change in the level of activity, adding or dropping a product, change in product mix, make or buy decisions, accepting an export offer and so on. (c) Opportunity costs: Opportunity cost is the value of benefit sacrificed in favour of an alternative course of action. Opportunity costs represents the maximum amount that could be obtained at any given point of time if a resource was sold or put to the most valuable alternative use that would be practicable.

Opportunity cost of goods or

services is measured in terms of revenue which could have been earned by employing that goods or services in some other alternative uses. (d) Relevant cost: The relevant cost is a cost which is relevant in various decisions of management – relevant costs are the future costs that influence the decision when considering several alternative courses of action. (e) Replacement cost: Replacement cost is the cost at which existing items of material or resource can be replaced - the cost of replacing existing resource at present or at a future date. (f) Abnormal costs: abnormal costs are unusual or a typical cost whose occurrence is usually not regular and is unexpected. This cost arises due to some abnormal situation of production. Abnormal cost arises due to idle time, may be due to some unexpected heavy breakdown of machinery. These costs are not taken into consideration while computing cost of production or for decision making. (g) Controllable costs: the objective of management involves costs cost control and cost reduction.

Hence it is essential to identify the controllable and uncontrollable costs.

Controllable costs are those which can be controlled or influenced by management’s action. For example, costs like telephone, printing stationery etc can be controlled while costs like salaries etc cannot be controlled at least in the short run. Generally, direct Page 18 of 19

costs are controllable while uncontrollable costs are beyond the control of an individual in a given period of time. (h) Shutdown cost: shutdown costs are the costs which are incurred if the operations are shut down and these costs will no longer be incurred if the operations are continued.

Examples of these costs are costs of sheltering the plant and machinery and construction of sheds for storing exposed property. Computation of shutdown costs is important for taking a decision of continuing or shutting down operations. (i) Capacity cost: capacity costs are normally fixed costs and are incurred by a company for providing production, administration and selling and distribution capabilities to perform various functions. Capacity costs include the costs of plant, machinery and building for production, warehouses and vehicles for distribution and key personnel for administration. (j) Urgent costs: urgent costs are costs which must be incurred to continue operations of the organisation.

For example, cost of material and labour must be incurred if

production is to take place.

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