CHAPTER TWO

COST CLASSIFICATION

Cost classification

 

Cost classification may be defined as ‘the arrangement of cost items in a logical sequence having regard to their nature and purpose to be fulfilled’.  Costs are classified according to the cost objectives.  Cost objective is the activity for which a separate measure of cost is desired. They include, cost stock valuation, cost for decision-making and cost for control purposes. The table below shows a summary of cost classifications given cost objectives:

	Cost objective		Possible classification
1.	Stock valuation	•	Manufacturing and non-manufacturing costs
		•	Period and product costs
		•	Direct and indirect costs
2.	Decision making	•	Cost behavior: Variable, fixed, semi variable,
		•	Relevance: opportunity, sunk cost, historical cost, standard costs
3.	Control purposes	•	Controllable and non-controllable
		•	Avoidable and non-avoidable

 

Manufacturing costs

These are the costs incurred to produce a product. Remember that a product refers to both goods and services. The elements of manufacturing costs are: direct material costs, direct labour costs; and overhead costs. The elements make up the total cost of a product, as shown below:

Note; direct expenses are expenses incurred for a particular job, project or service e.g. royalties, franchise, hire of special equipment, materials, labour, etc. they are traceable to that specific job.

MANUFACTURING AND NON-MANUFACTURING COSTS

These costs are discussed further in the following sections.

a)Material costs

Material refers to all the physical inputs into the production process. They do not only refer to purely unprocessed materials or natural resources but refers to any material input in the manufacturing process. Finished goods for one company can be raw materials for another for instance, packed wheat flour is a finished good for the milling industry but a raw material to the banking industry.

Raw materials can be classified as direct or indirect

 Direct materials are those materials that can be easily traced to a product without any extra cost or inconvenience. Examples include leather and sole for a shoe making industry.

Direct expenses are expenses incurred for a particular job, project or service e.g.

• Royalties
• Franchise
• Hire of special equipment

Indirect materials are materials that become an integral part of the finished product but may be traceable into the product only at great cost or inconvenience. Examples include glue and thread for a shoe making industry.

An analysis of the various materials input into a production process is as follows

• Raw material
• Components and subassemblies
• Consumable materials
• Maintenance materials

(b) Labour

 

Labour is the physical and mental human input in a production process. Labour costs can be divided into direct labour costs and indirect labour costs.

Direct labour cost refers to wages paid to workers who are directly involved in the production of each item produced. Such labour cost can be physically traced to the creation of product without undue cost. The cost can be readily identified with specific product or unit. For instance, wages paid to factory supervisors, forklift truck drivers, factory store room clerks, etc.

Indirect labor costs refer to the wages paid to workers whose efforts cannot be readily identified with specific product units or batches e.g. laborers paid to maintain all the premises utilized for production of goods and services.

(c) Overhead costs

They are also called indirect production costs. They include all costs of manufacturing except direct materials and direct labour. They are incurred for the benefit of all products thus the amount of overhead allocated can only be an estimate. They include indirect materials, indirect labour and other indirect expenses that cannot be traced directly to a product. They are at times referred to as factory burden, factory overheads or manufacturing expense.

Functional classification

Non-manufacturing costs are costs incurred by all activities that support the production of goods and services. They are administration costs, selling costs and distribution costs. These are explained as follows:

• Production costs: these are costs incurred in the manufacturing process. They include material costs, labour costs and overhead costs as discussed above.
• Administrations cost: Is the sum of costs associated with the overall management of the enterprise, which cannot be readily identified with one of the major functional areas e.g. salary of the factory manager would be seen as a production cost but the salary of the personnel officer will be viewed as administrative cost since the personnel function does work for all other functions of the enterprise.
• Selling Cost: this is the sum of costs associated with the securing of orders from customers. Included in this area will be items such as the salaries paid to the salesmen and expenditure on advertising.
• Distribution costs: these are costs associated with warehousing the products and their delivery to customers. They are incurred in getting the finished product to customers for instance, depreciation of the distribution van.
• Finance costs: These are costs incurred to secure funds to finance the organization’s activities. These include interests on loans and overdrafts, dividends to shareholders, interests on debentures etc.
• Research and development costs: These are costs that are incurred to invent new products or to modify the existing ones, as well as costs incurred to acquire more information on such products.

Classification according to behavior

Cost behavior means how costs will respond or react to changes in the activity level. I.e. as we increase output or sales, are the costs rising, dropping or remaining the same. Cost Behavior can be used to produce various classifications of costs such as:

Variable costs

These are costs that increase or decrease, in total, in direct proportion to changes in the total level of activity or number of units produced i.e. that portion of the cost of an activity that change with the level of output. Examples of variable costs include wages paid to casual employees paid on an hourly basis and fuel cost based on mileage.

     

Variable Cost per Unit = total variable cost/activity level

 

With variable costs, the cost level is zero when production is zero. The cost increases in proportion to the increase in the activity level because variable cost per unit of activity level is constant, thus the variable cost function is represented by a straight line from the origin. The gradient of the function indicates the variable cost per unit.

For a cost to be variable, there should be an activity base which drives it. This activity base is a measure of effort that operates as a casual factor in the incurrence of variable costs. Thus to control these costs, cost accountants should be well acquainted with the various cost drivers (activity bases) within the organization.

Semi variable costs

These are costs with both a fixed and variable cost component. The fixed component is that portion which is constant irrespective of the level of activity. They are variable within certain activity levels but are fixed within other activity levels, as shown below: examples include salesmen salaries (salary plus commission, telephone charges, water bills, etc.

 

 

To illustrate unit variable cost

Fixed Costs

These are costs that do not change with the level of output. They are also called autonomous costs, as they remain the same irrespective of the activity level as shown below.

To illustrate total fixed costs

 

The classification of cost into fixed and variable costs would only hold within a relevant range beyond which all costs are variable. The relevant range is the activity limits within which the cost behavior can be predicted

Semi Fixed Costs or stepped costs

These are costs which are constant within a certain production band but eventually increase at some critical point by a constant amount to another fixed level once the output band changes. This is a clear illustration of how fixed costs behave in the long run. For instance, managers’ salaries are increased from time to time. Each time there is an increase, the costs increase by the amount added at that critical point.

Curvilinear

 

Curvilinear cost functions exist where costs do not vary in direct proportion to the level of activity thus giving a nonlinear function.

                          (i)     Convex cost function

Convex direct costs are said to occur where each and extra unit of output causes a less than proportionate increase in cost. This is especially the case where economies of scale are in operation. For instance, the more you buy, the more quantity discounts you secure. Though there is an increase in total material cost, the unit material cost continues to decrease for each and every additional material unit purchased. The cost function will appear as follows:

 

To illustrate convex cost function

(ii) Concave cost function

Concave cost functions exist where an increase in activity level causes a more than proportionate increase in costs. For instance, where the rate of variability increases between two points e.g. wages paid under a bonus scheme. The cost function will be as shown on the opposite page;

 

To illustrate concave cost function

Assuming that bonus is awarded at an increasing rate on the following basis

	Output		Bonus per unit
	0 to 100		500
	101 to 200		1000
	201 to 300		1500
Note that the labour cost is increasing at a more than proportionate increase in output. When the relationship is plotted on a graph, a concave cost function will be derived.

 

DIRECT COSTS AND INDIRECT COSTS

Direct costs are costs that can be traced specifically and identified to the end product of the production process without any extra cost or inconvenience. Direct costs consist of costs that can be directly attributed to a specific output, product or level of activity. Direct costs include direct raw materials and direct labour also called prime costs in aggregate.

PRIME COST = Direct Material Cost + Direct Labour Cost + Direct expenses

Indirect costs are costs that will not be directly attributable to a specific product. They are regarded as overheads. Identification of overheads to specific products is done through cost allocation and apportionment. They include supervisors’ salaries, rent, electricity, depreciation of building etc.

In order to trace a cost, it must first be possible, i.e. practical, to measure the service or supply and then determine the related cost. Note that it is not the nature of the cost but its traceability that determines whether the cost is direct or indirect.

 

Classification according to controllability

 

Controllable cost: Refers to the cost, which can be influenced by the actions of a person in whom authority for such control is vested. Cost is said to be controllable at a particular level of management if that level has the power to authorize its incurrence. In other words, controllable costs are costs that are reasonably subject to regulations by the manager with whose responsibility those costs are being identified. For instance, a decision to hire more personnel to an organization at affordable rates can be controlled.

Non controllable cost: is a cost which cannot be influenced by a person in whom authority for such control is vested. They are costs, which cannot be adjusted without affecting the long-term objective of the firm. For example if the trade union demands an increase in wages, the increment is a non-controllable cost. Similarly, the depreciation of a building is a noncontrollable cost to a manager as he does not have authority over depreciation.

Classification according to normality

Normal costs: these are costs that are expected to be incurred given a specific level of production. They may also be referred to as standard costs.

Abnormal costs: abnormal costs are costs above the normal costs given a specific level of activity. For instance, abnormal costs may be incurred in production where the prices of materials have significantly and adversely varied from the standard.

 

Classification for decision making

 

In decision making, only controllable costs are relevant because they can be changed by the

Decision maker. There is little or nothing that the decision maker can do about the non-controllable costs thus they are irrelevant in decision making.

 

Classification according to time

Historical costs: these are costs that were incurred at a given time in the past. They are irrelevant for decision making. An example is acquisition cost of an asset.

Predetermined costs: these are estimated costs that have been estimated for purposes of decision making. An example of such costs include overheads which are absorbed on a given predetermined overhead absorption rate. They are not always accurate.

Classification based on identification with inventory

 

Under this classification, costs are classified according to the function they perform in an organization. Costs can functionally be classified as:

• Product costs: are all the costs incurred in production of units during a time period

e.g. raw material costs, direct labour costs and production overheads. Such costs are capitalized and expensed (charged to the profit and loss account) only when the manufacturer sells inventory. These costs may be carried from one period to the other.

• Period costs: these are costs mainly incurred in the ordinary running of the business enterprise. They include costs like electricity bill paid, salaries and allowances and rent payments. They are referred to as period costs since they are expensed in the period they are incurred.
• Sunk costs: these are costs, which have already been incurred. They cannot be changed by any decision made after incurrence. Such costs are irrelevant for decision making. For example, cost of a delivery van already acquired by the organization shall be irrelevant as it cannot be changed by any course of action taken by management.
• Marginal cost: is the additional cost of producing an extra unit of output.
• Opportunity cost: is defined as the cost of the next best foregone alternative or the potential benefit that is lost by taking one course of action and giving up the other. For instance, by deciding to take on a leave and forego wages, the opportunity cost of the decision shall be the foregone wages.
• Differential cost/incremental cost: these are costs that differ among alternatives. They are costs relevant for decision making. They may be either variable or fixed. For instance, if taking up a different business apartment amounts to an extra Shs.2, 000 rent expense, the differential (incremental) cost of the decision shall be the Sh.2, 000.

(e) Imputed cost

Is an expense not incurred directly, but actually borne. For example, a person who owns a home debt-free has an imputed rent expense equal to the amount of interest that could be earned on the proceeds from the sale of the home if the home were sold.

                    (f)     Replacement cost

The amount it would cost to replace an asset at current prices. If the cost of replacing an asset in its current physical condition is lower than the cost of replacing the asset so as to obtain the level of services enjoyed when the asset was bought, then the asset is in poor condition and the firm would probably not want to replace it

(g) Standard cost

A management tool used to estimate the overall cost of production, assuming normal operations.

(h) Budgeted cost

This is the cost estimated to be incurred and used for budgeting purposes. It is a cost included in the budget representing cost expected.  Most of the times, budgeted cost will be derived from standard cost.

QUESTIONS

1. Identify and give examples of each of the three basic cost elements involved in the manufacture of a product.
2. Product costs are sometimes called inventorable costs. Why?
3. It is possible for costs such as salaries and depreciation to end up as assets on the balance sheet.

Explain

1. Classify the following costs as either fixed or variable
2. Depreciation on a straight line basis   ii. Wages paid to casual workers – on piece rate basis   iii. Salary paid to stores manager
3. Are fixed costs always fixed?

SOLUTIONS

1. a) Basic cost elements:
2. materials such as leather and sole used to make a shoe
3. Labour such as the cobblers
4. Product costs are inventorable costs because they are costs incurred to manufacture inventory units. Inventory is normally valued based on the production cost.
5. It is possible, when such costs are treated as product costs and then there exists inventory at the end of the period (ending inventory) then such costs will indirectly appear in the balance sheet
6. Classification of costs
7. Fixed cost
8. Variable cost
9. Fixed cost
10. e) Fixed costs are only fixed in the short run and within the relevant range. Beyond the relevant range, they may assume a different behavior.

QUESTION ONE

Identify and give examples of each of the three basic cost elements involved in the manufacture of a product.                   (10 marks)

QUESTION TWO

Explain the difference between the following terms

1. Product cost and period cost ii. Sunk cost and relevant cost iii.  Fixed and variable cost
2. Avoidable and unavoidable costs
3. Controllable and uncontrollable costs
4. Direct and indirect costs

• Prime cost and Conversion cost                                                           (3 marks each)

QUESTION THREE

Discuss the behavioral classification of costs, explaining all the terms used therein   (20 marks)

Decision-making situations under short-term conditions require consideration of:

1. The cost classifications which the management accountant should use or ignore, and
2. Factors which may affect the behavior of costs and hence the accuracy of the cost analysis and the relevance of the decision making.

A company X may decide to make quantities of a component used in a manufacture of a product or buy the component from an outside supplier or out source.

Only relevant cash flows are used for decision making. These are future, incremental cash flows, which arise as a consequence of choosing a particular course of action

Future Costs

Any cost that was incurred in the past and cannot now be recovered in a cost and is, therefore, not relevant to decision making.  Only costs that will be incurred in the future if a particular course of action is taken are relevant.

Incremental Costs

Incremental costs are the additional costs incurred as a result of a decision and are, therefore, relevant.  Any costs will be incurred in the future regardless of whether or not the decision is taken (committed costs) are not relevant.

Cash Flow

It is assumed that a decision is taken to maximize ‘satisfaction’ of the person or organization in question. Although the time value of money affects the worth of cash flow from a project over a longer period, all short-run decisions are assumed to improve, ‘satisfaction’ if they increase net cash inflow. Depreciation is not, therefore, a relevant cost and it is only information pertaining to a cash flow, which is relevant to decision making.

In general, variable costs are relevant costs because they are only incurred if a decision to do something is taken, whereas fixed costs are irrelevant to decision because they will be incurred regardless of the course of action taken.  There is, however, a school of thought that argues that fixed costs are not always irrelevant.  They have put forward the idea of the attributed cost which is made up of the following:

(a) Short run visible costs

• Divisible fixed costs. A fixed cost is divisible if significant shifts in the level of activity will require increases in the total amount of that cost.
• Indivisible traceable costs. This is an indivisible fixed costs that can be traced directly to a product or function.

Finally, opportunity costs (the benefit forgone by choosing one option instead of the next best alternative) are relevant.  Historic costs are not.  One area in which the concept of relevant costs is needed is the make or buy situation.

A make or buy problem involves a decision by an organization about whether it should make a product with its own internal resources, or whether it should buy the product from an outside supplier.  If an organization has the choice of whether to manufacture a component internally or buy in from outside and it has no source resources that put a restriction on what it can do itself, the principal relevant costs are the differential costs between the two options.

Costs behavior and decision-making

Although it is easy to generalize and to state that, for example, variable costs are relevant to a decision and fixed costs are not a proper understanding of the behavior of costs is vital to ensure that the cost analysis is accurate.  Consider the simple example in part (a) of the answer.

Strategic planning is the process of setting or changing the long-term objectives or strategic target of an organization.  These would include such matters as the selection of products and markets, the required level of company profitability, the purchases and disposal of subsidiary companies or a major fixed asset and so on.  A notable characteristic of strategic planning is as follows:

1. It will generally be formulated in writing, and only after much discussion by committee (the board).
2. It will be (or should be) circulated to all interested parties within the organization and perhaps even to the press.
3. It will trigger the production not of direct action but of a series of lesser plan for sales, production, marketing, and so on.

Operational planning works out what specific tasks need to be carried out in order to achieve the strategic plan.  For example, a strategy may be to increase sales by 5% per annum for at least five years, and an operational plan to achieve this would be sales representatives’ weekly sales target.  (Note: we use the word ‘strategic’ and ‘operational’ in the sense implied in the well-known work of Robert Anthony).

Notable characteristic of operational planning are the speed of response to changing conditions and the use and understanding of non-financial information such as data about customer orders or raw material input.

 

 

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