TOPIC 1B:Cost Concepts &
Cost Classification
1
Learning Outcomes;
✔ By the end of this topic you should be
able to.
L.O.1: Distinguish between cost and
expenses
L.O.2:Distinguish between, Cost object, a
cost Centre and a cost unit .
L.O.3:Classify cost using; Element of cost,
Degree of traceability, By Function and
according to Behaviour of costs.
L.O.1: Distinguish between cost
and expenses;
What is Cost?
✔ Cost is the amount of expenditure
incurred on or attributable to a specified
thing or activity.
✔ Mathematically, cost is
the product of the quantity of a given res
ource used and the price per unit of the
quantity of resource.
✔ Costs are usually ascertained in respect
of cost units or cost objectives.
✔ Costs are incurred to produce future benefits. In
a profit making firm, future benefits usually
mean revenues.
✔ As costs are used up in the production of
revenues, they are said to expire. Expired costs
are called expenses.
✔ In each period, expenses are deducted from
revenues on the income statement to determine
the period’s profit. A loss is a cost that expires
without producing any revenue benefit.
✔ For example, the cost of uninsured inventory
destroyed by a flood would be classified as a
loss on the income statement.
✔ It is important to distinguish cost from
expense. An expense is a cost charged
against revenue in an accounting period;
hence, expenses are deducted from
revenue in that accounting period.
✔ We incur costs whenever we give up
(sacrifice) resources, regardless of
whether we account for it as an asset or
an expense.
✔ (We may even incur costs that the
financial accounting system never
records as an asset or expense.
L.O.2:Distinguish between a Cost object
,a Cost Centre and a cost unit;
Cost Object;
What is a Cost object?
✔ Cost object is anything for which a
separate measurement of cost is
required.
✔ In simple words, a cost object is
indicating something to which costs are
assigned.
✔ A cost object may be a product, a
service, a process, a project, a territory
area, a department, a customer, a brand
category, an activity,or a programme etc.
Cost object…
✔ A Cost Object is used when allocating direct and indirect
costs. Each cost should allocate to the cost object and
they are further classified into direct cost or indirect
cost.
✔ The central point of budgetary planning is the
identification and costing of cost objects that help to
prepare the master budget.
✔ It can be defined at a narrow level or broad level. At a
narrow level, cost object may be considered as a cost
unit. It may be considered as a cost centre at the
broader level.
✔ For example, the selling and marketing department is a
cost object for the cost of the sales staff salaries,
commission to sales staff and the advertisement cost,
etc.
✔ If any costs are allocated to customers, then the
customer is considered as a cost object. For example,
transportation costs associated with specific customers.
Cost object ,cost centre & Cost
Unit
Examples of cost objects;
Cost Centre;
Cost Centre;
What is a Cost Centre?
✔ A cost centre is a location, a person, an item of
equipment (or a group of these in relation to
which cost are ascertained and further related
to cost units.
✔ A cost centre According to the terminology of
CIMA (London), “It is a location, person or item
of equipment or group of these, for which cost
may be ascertained and used for the purpose of
controlling the cost.
✔ For example, the factory, canteen, maintenance
section, the foreman, managing director, the
plant, the pool of computers etc.
✔ Cost centers are broadly classified into:1.
Production cost centers2. service cost centers.
Production cost centers Vs Service
Cost centres;
1. Production cost centers;
✔ The production cost centre is a collection of
Costs/expenses where the production activity of
business carried on. For examples, assembly
department, finishing department, and molding
department, etc.
2.service cost centers.
✔ A service cost centre is a collection of
Costs/expenses which provides auxiliary services to
the production department or other service
departments.
✔ This is not engaged in the production process but
provides services to production, other service
departments.
✔ For example, Research & Development department,
quality control, welfare services department, Pollution
Control Department, and laboratory, etc.
Cost Unit;
What is a Cost Unit?
✔ A cost unit is a quantitative unit of a product or
service in relation to which costs are
ascertained.
✔ It is a unit of product, service or time (or
combination of these) in relation to which costs
may be ascertained or expressed.
✔ We may for instance, determine the cost per ton
of steel, per ton-kilometre of a transport service
or cost per machine hour. Sometime, a single
order or a contract constitutes a cost unit. A
batch which consists of a group of identical
items and maintains its identity through one or
more stages of production may also be
considered as a cost unit.
;
✔ Cost units are usually the units of
physical measurement like number,
weight, area, volume, length, time and
value.
✔ A few typical examples of cost units are
given below:.
Examples of Cost Units;
L.O.3:Classification of Costs
✔ Classification of costs entail the grouping of
costs according to their common
characteristics.
✔ We have four main approaches that can be
adopted when classifying costs. These include;
a) Classification of costs based on the element of
the cost.
b) Classification of costs based on the degree of
traceability(Direct & Indirect cost
classification).
c) Classification of costs based on the function of
the cost.
d) Classification of costs based on the behaviour
of the cost.
a) Classification of costs based on the
element of the cost
✔ This is the most basic method of classifying
costs. Under this method Costs can be
classified based on the element of the cost.
✔ There are three basic elements of cost.
These are materials, labour and other
facilities or resources other than materials
and labour.
✔ Thus when classified according to elements,
there are the following classes of cost:
1.Materials cost.
2.Labour cost
3.Other expenses/Costs.
;
Classification of cost according to element of cost;
;
1. Material Cost;
✔ These are the costs of materials or
commodity other than fixed assets,
introduced into product or consumed in the
operations of an organization. In other
words, they are the cost of materials input
into the production of goods and services.
✔ For example, the cost of: raw materials;
component parts ,work in progress, primary
packing materials; lubricating oil;
consumable tools; stationary and cleaning
materials etc.
;
2. Labour Cost;
✔ These are the cost of employee remuneratio
n. In other words, payments made to and on
behalf of
employees for offering services in the produ
ction function.
3.Other Expenses;
✔ These are costs other than material costs a
nd labour costs.
✔ For example, the cost of:
Hiring special equipment and maintaining su
ch equipment, Royalty payments,
Copyrights and patent payments,utilities
such as rent,water and electricity
Cost Sheet format (When costs are classified based on
element of cost)
Cost Sheet
Material Cost XXXX
Labour Cost XXXX
Other Expenses XXXX
TOTAL COST XXXX
b) Classification of costs based on the
degree of traceability(Direct & Indirect cost
classification);
✔ Under this costs are classified according to
the degree of the traceability with costs
being broadly classified as Direct or Indirect
costs. This classification of costs extends
the basic classification of costs as per
element. Under this method we have six sub
categories of costs;
✔ Direct material cost
✔ Direct labour cost
✔ Direct expenses
✔ Indirect material cost
✔ Indirect labour cost
✔ Indirect expenses
Classification of cost according to Degree of
traceability (Direct & Indirect cost classification);
1.Direct Costs;
✔ These are costs that can be directly
identified and charged to a cost unit
without apportioning.
Direct costs comprise of:
✔ Direct material cost
✔ Direct labour cost
✔ Direct expenses
;
i)Direct Material Cost;
✔ These are the costs of material that can
be physically identified with a specific
cost object.
✔ They are the cost of materials entering
into and becoming constituent elements
of a product or saleable service. Direct
material costs are allocated to cost units.
;
✔ Materials which are present in the
finishedproduct(cost unit/cost object) or
can be economically identified in the
product are called direct materials.For
example, clothin dress making;
materials purchased for a specific job
etc.
✔ However, in some cases a material may be
direct but it is treated as indirect, because it
is used in small quantities, it is not
economically feasible to identify that
quantity and those materials which are used
for purposes ancillary to the business..
;
ii)Direct Labour Cost;
✔ These are the costs for employees‟
efforts and skill that can be directly
associated and allocated to a specific
cost object.
✔ Such wages are allocated directly to cost
object. Examples of direct labour cost
are:Wages of production operatives who
are involved in transforming raw
materials into finished goods.
;
iii. Direct Expenses;
✔ These are costs other than material cost,
labour cost which can be identified with and
charged or allocated to a specific cost
object.
✔ In other words they are costs other than
material cost and labour cost which are
incurred for a specific product or saleable
service.
✔ Examples of direct expenses are:• the cost
of hiring a special equipment for a particular
production order.
✔ The sum of all direct costs is prime cost.
2.Indirect Cost;
✔ All costs that cannot be identified with and
allocated to a specific cost object.
✔ Such indirect costs have to be apportioned
to a number of cost centers and further
absorbed by cost units are described as
indirect cost.
✔ Another term for all indirect costs is
overhead costs.
Indirect costs comprise of:
✔ Indirect material cost
✔ Indirect labour cost
✔ Indirect expenses.
;
i)Indirect material cost;
✔ These are the cost of material items that cannot
be identified with a specific cost object i.e any
one product because they are used for the
benefit of all products rather than for any one
specific product.
✔ In other words, these are material costs which
cannot be allocated to cost objects but are
apportioned and absorbed by different cost
objects.
✔ For example; The cost of materials required for
operating and maintaining plant & equipment
such as. • lubricating oil• consumable tools• cost
of stationery• cost of cleaning materials• soap
and detergents• rugs and dusters• brooms and
brushes etc.
;
ii. Indirect labour cost;
✔ These include any labour costs that cannot
be directly associated or attributed to a
specific cost object.
✔ These are wages of employees who do not
work on the product itself but who assist in
the manufacturing process. Such costs
cannot be allocated to cost units; rather
they are apportioned to cost centers and
further related to cost units through
absorption.
✔ For example:• salaries of factory
supervisors• wages of the store dept.
employees• wages of cleaners etc..
;
iii.Indirect Expenses;
✔ These are expenses incurred in general
and cannot be associated with a specific
cost object.
✔ For example:
Selling and distribution expenses•
advertising• sales promotion etc.•
administrative expenses • stationery• audit
& consultancy fees• secretarial charges•
production expenses• rent• insurance•
electricity
;
✔ When you combine the classification
according to element and direct /
indirect cost, a cost build‐up can be
made as follows:
✔ The cost sheet given below indicated
how one would go about computing the
total cost by accumulating various costs.
✔ The computed total cost can then be
used in decisions such as setting the
price by adding a profit margin on the
total cost.We will go through this in detail
under the costing methods topic later on.
Cost Sheet format (When costs are classified based on degree
of traceability-Classifying costs as direct or indirect costs)
Cost Sheet
Direct Material Cost XXXX
Direct Labour Cost XXXX
Direct Expenses XXXX
Prime Cost (Total Direct Costs) XXXX
Indirect Material Cost XXXX
Indirect Labour Cost XXXX
Indirect Expenses XXXX
Total Indirect Costs (Total
Overhead costs) XXXX
TOTAL COST XXXX
c) Classification of costs based on the
Function of the cost.
✔ The classification of costs according to
the function of costs is the most detailed
method of classifying costs. This method
extends the classification of the indirect
costs into the various functional
departments within a business.
✔ All the indirect costs, that is, overhead
cost, can also be classified according to
function.
;
✔ Under this classification, costs are
divided according to the function for
which they have been incurred. It includes
the following:
(i) Direct Material Cost
(ii) Direct Labour Cost
(iii) Other Direct Expenses/Costs
(iv) Production/Manufacturing Overhead costs
(v) Administration Overhead costs
(vi) Selling & Distribution Overhead costs
(vii) Research and Development Overhead
costs
✔ The Direct Material Cost, Direct Labour
Cost and Direct Expenses are as
discussed under classification of costs
according to degree of traceability
discussed above.
✔ The indirect costs are then classified
according to the function for which they
were incurred for.
✔ This is illustrated by the figure provided
below.
Classification of cost according to Function of the
cost;
;
(4) Production/Manufacturing Overheads :
✔ It is also known as works/ factory/ manufacturing
overheads. It includes the indirect costs that are
incurred in the actual factory where products and
services are being produced/manufactured.
✔ Examples of production overheads include the
following;(a) Consumable stores and spares. (b)
Depreciation of plant and machinery, factory building
etc. (c) Lease rent of production assets. (d) Repair
and maintenance of plant and machinery, factory
building etc. (e) Indirect employees cost connected
with production activities. (f) Drawing and Designing
department cost. (g) Insurance of plant and
machinery, factory building, stock of raw material &
WIP etc. (h) Amortized cost of jigs, fixtures, tooling
etc. (i) Service department cost such as Tool Room,
Engineering & Maintenance, Pollution Control etc..
;
5.Selling Overheads and Distribution
overheads;
✔ These include all the indirect costs that are
incurred in relation to marketing related
activities.
✔ Selling overheads include the indirect costs
incurred in securing orders, e.g. sales
promotion cost.
✔ Distribution Overheads;
These are the costs incurred in making the
finished goods ready for dispatch and the
delivery of the product to customers, e.g. cost
of carriage outwards.
;
6.Administrative Overheads;
✔ These are the costs of formulating policy,
directing and controlling operations not related
directly to production, selling, distribution or
research and development.
7.Research and Development Overheads;
✔ These are the costs of seeking new ideas,
materials, methods of production and improved
products and the development and design of
such ideas so that they can be applied to formal
production.
NB: The total cost can be computed by
accumulation of the the costs as per the
functional classification as shown in the cost
sheet in the next slide.
Cost Sheet format (When costs are classified based on the
function of the cost)
Cost Sheet
Direct Material Cost XXXX
Direct Labour Cost XXXX
Direct Expenses XXXX
PRIME COST =(Total Direct Costs) XXXX
XXXX
FACTORY COST = (Prime cost
+Production/Manufacturing Overhead costs) XXXX
(i)
Add Research and Development Overhead costs
COST OF PRODUCTION XXXX
Add Selling & Distribution Overhead costs
XXXX
TOTAL COST XXXX
Add Profit Margin XXXX
SELLING PRICE XXXX
d) Classification of costs based on the
Behaviour of the cost.
✔ Costs can also be classified according to
the way the cost behaves in relation to
activity level.
In this regard, cost may be classified as:
i. Fixed cost
ii. Variable cost
iii. Mixed cost /Semi‐fixed/semi‐variable or
iv. Stepped fixed cost.
Examples of Activity levels for different
types of costs
It is important to note that the same cost may have more than one
activity level as illustrated in the examples given below.
Example of Costs Activity Levels
Direct material Cost Output produced
Output & No of Direct
Direct Labour Cost Labour Hrs
Rent cost Output produced
Telephone Cost Talk time(Minutes)
Water cost Litres of water
Electricty Kilowatt Hrs
Sales & Distribution
cost No of products sold
Transportation cost No of Trips made
i) Fixed costs;
✔ These are costs that do not vary with
changes in activity levels. These costs
remain constant within a relevant range
of activity but they usually change with
the passage of time.
✔ For example, rent and rates, the
managing directors salary etc..
✔ As illustrated by the graph below fixed
costs remain constant even as the
activity level changes within the relevant
range.
Graphical representation of fixed costs;
✔.
ii) Variable costs;
✔ These are costs which vary in direct
proportion with changes in activity
levels. This implies that variable cost per
unit of activity is constant at all the
activity levels.
✔ For example, the cost of raw materials,
direct wages and direct expenses such
as royalties.
✔ The graphical presentation of the
variable costs is as illustrated below;
Graphical representation of variable
costs;
iii) Mixed cost
/Semi‐fixed/semi‐variable costs;
✔ These are costs which contain fixed and
variable elements. That is, for a given
range of activity level ,the cost may
remain constant and beyond the relevant
ranges, costs may then vary in direct
proportion with changes in activity level.
✔ These costs are partly affected by
fluctuations in the levelof activity.
Examplesof mixed/semi
variable/semi-fixed costs are water,
telephone bills, gas and electricity etc.
Such costs are depicted graphically as
follows:
Graphical representation of
mixed/semi-variable/semi-fixed costs;
iv) Stepped fixed cost costs;
✔ These are costs which are fixed for a
given range of activity level but which
change discretely for ranges of activity
levels beyond the given ranges.
✔ A good example of this is rent cost for a
production facility which will remain
constant within a certain range of
production but increase beyond certain
production levels.
✔ This can be illustrated graphically as
shown in the next slide.
Graphical representation of
stepped-fixed costs;
Thank you!
Any
Questions?
