COST CLASSIFICATIONS

Cost can be classified in accordance with the purpose for which the cost is needed. Some of
the possible classification includes:

Classification According to Element of Cost

The three basic elements of cost are:
 Material cost
 Labour cost
 Expenses e.g. rent, rate, depreciation, electricity bill etc
The addition of the three elements of cost gives total cost of production

Classification According to Traceability

All the elements of cost can be further classified as direct costs and indirect costs.

Direct Cost: These are costs that can be traced in full and directly to a product, service or
department that is being costed. The addition of all direct costs is called PRIME COST.
Example includes:
i. Direct Material Costs: These are the costs of materials that are known to have been
used in making a product or providing a service. All materials becoming part of a
product is a direct material unless those having a negligible cost. Examples of direct
material are as follows:
a) Component parts
b) Work in progress
c) Primary packing materials such as cartons, tin and boxes

ii. Direct Labour Costs: These are the specific costs of the workforce used to make a
product or provide a service. It is established by measuring the time taken for a job or
unit produced x rate per hour or per unit. Examples include:
a) Wages paid to direct labour
b) Shop clerks

iii. Other Direct Expenses: These are expenses that have been incurred in full as a
direct consequence of making a product or providing a service. Direct expenses are
any expenses which are incurred on a specific product other than direct material costs
and direct wages. Examples are:
a) The hire of tools or equipment for a particular job
b) Purchase of a particular equipment for a job

Indirect Costs: Indirect costs are also called overheads. Indirect costs are costs that are
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. Overhead
includes:
 Indirect material costs e.g. consumable stores and material used in negligible
amount
 Indirect labour costs e.g. wages of non productive personnel i.e. foreman, wages
paid to indirect worker,
  Indirect expenses e.g. insurance, maintenance of plant, machinery and building and
depreciation

Elements of Cost Traceability

Direct Cost Indirect cost
1 Material Direct Material Indirect Material
.
2 Labour Direct Labour Indirect Labour
.
3 Expenses Direct Expense Indirect Expenses
.
PRIME COST OVERHEADS

PRIME COST + OVERHEADS = TOTAL COST

Note the following:

All direct costs = PRIME COST

All indirect production costs = PRODUCTION OVERHEAD COST
This is demonstrated below:

A COST CARD
PRODUCTION COST N N
Direct materials xx
Direct labour xx
Direct expenses xx
PRIME COST xx
Indirect materials xx
Indirect labour xx
Indirect expenses xx
PRODUCTION OVERHEAD xx
Full Factory / Production Cost xx

Question
Classify the following labour costs as either direct or indirect cost
 The basic pay of direct workers
 The basic pay of an indirect worker
 Overtime premium
 Bonus payment
 Social insurance contribution
 Idle time of direct workers
 Work on installation of equipment

Classification by Function
This involves classifying costs as production/manufacturing costs, administration costs,
marketing costs, selling and distribution costs.
Production/Manufacturing costs: These are costs that are associated with the factory
production costs.

Administration costs: These are general office department costs

Marketing/Selling and distribution costs: these are costs associated with sales, marketing,
and warehousing and transport departments

Cost Card can be build up as follows:

Production Cost N N
Direct materials xx
Direct labour xx
Direct expenses xx
PRIME COST xx
Production Overhead xx
Full Factory / Production Cost xx
Administrative cost xx
Selling and distribution costs xx
Full Cost of Sales xx

Question
Within the costing system of a manufacturing company the following types of expenses are
incurred:
Reference No.
1 Cost of oils used to lubricate production machinery
2 Motor vehicle licenses for Lorries
3 Depreciation of factory plant and equipment
4 cost of chemicals used in the laboratory
5 Commission paid to sales representatives
6 Salary of the secretary to the finance director
7 Trade discount given to customers
8 Holiday pay of machine operatives
9 Salary of security guard in raw materials warehouse
10 Fees to advertising agency
11 Rent of finished goods warehouse
12 Salary of scientist in the laboratory
13 Insurance of the company’s premises
14 Salary of the supervisor working in the factory
15 Cost of typewriter ribbons in the general office
16 Protective clothing for machine operatives

Required:
Complete the following table by placing each expense in the correct cost classification
Cost Classification Reference Number
Selling and distribution costs 2 5 7 10 11
Production costs 1 3 8 9 14 16
Administration costs 6 13 15
Research and development costs 4 12
Each type of expenses should appear only once in your answer. You may use the reference
numbers in your answers.

Classification as Production and Non- Production Costs

For the preparation of financial statement, costs are often classified as production costs and
non-production costs.

Production Costs are costs identified with goods produced for resale. They include direct
materials, direct labour, direct expenses and production overhead costs

Non-Production Costs are costs deducted as expenses during the current period. They are
taken directly to the profit or loss account as expenses in the period in which they are
incurred. Examples include selling and distribution expenses

Example:
A business has the following costs for a period in which 100 units of a product are produced:
N
Material 1,200
Labour 2,000
Production overhead 1,000
Administrative overhead 1,400 (Non Production Cost)
5,600
If 80 units were sold @ N80 each, what are the gross profit, the value of closing inventory
and net profit?

Solution:
Production cost per unit: (1,200 + 2,000 + 1,000) / 100 units
= N4,200 / 100 = N42 per unit
N
Sales (80 units x N80) 6,400
Cost of sales (80 units x N42) (3,360)
Gross profit 3,040
Other expenses:
Admin overhead (1,400)
NET PROFIT 1,640

Value of closing inventory =

(100 units produced – 80 units sold) = 20 units unsold x N42 = N840

Classification according to behavior

This classification is made in line with the behavior of the costs. This includes:

Fixed Cost: A fixed cost is a cost which is incurred for a particular period of time or a range
and which is unaffected by changes in the level of activity within a certain level of activity. It
is a cost that does not vary with changes in activity level within a range of activity e.g. rent,
rates, straight line depreciation and salary etc.
Characteristics of Fixed Cost
 Fixed cost remain the same in total within a given range
 Fixed cost changes in unit
  Fixed cost reduces per unit as the level of activity increases
 Fixed cost is a period cost or a given range

N20,000 FC

0 5 10 15

Variable Cost: This is a cost which tends to change with the level of activity. Variable cost
varies in direct proportion with changes in activity level e.g. direct material cost, direct labour
cost and sales commission. Variable cost remains the same in unit and changes in total as
output increases.
VC
30,000

20,000

10,000

0 1 2 3

Characteristics
Variable cost remains the same per unit
Variable cost changes in total
Variable cost increases in total as the level of activity increases

Semi Variable Cost / Semi Fixed Cost / Mixed cost: This is a cost which contains both
element of fixed and variable costs for a given range of activities. Total cost increases as
output increases but the cost per unit declines as output increases. Examples of these costs
include:
Electricity bills
 Fixed cost = fixed and maintenance charges
 Variable cost = charges per unit of electricity consumed
Salesman’s salary
 Fixed cost = basic salary
 Variable cost = commission on sales made

Stepped Fixed Cost: This is a cost which is fixed for a given range of activity level but
which changes discretely for ranges of activity level beyond the given range. For instance,
rent of a room that contains 50 students will need to be expanded or the need to rent another
room to accommodate 80 students.
60,000

40,000

20,000

0 15 30 45

Classification as Controllable and Uncontrollable Costs

Controllable cost: a controllable cost is a cost which can be influenced by a given manager
within a given period of time and range. It is a cost that is reasonably subject to regulation by
a given responsibility center manager. All costs are controllable at some level of
management.

Uncontrollable costs: This is a cost that cannot be influenced by a given manager within a
given time span.

Classification as relevant and Irrelevant Costs

Relevant Costs: Relevant costs are:
 Future cost
 Cash flow and
 Incremental cost

Relevant costs are costs that can be altered by a given decision. They are also avoidable cost
and opportunity cost

Irrelevant Costs: These are costs that will not be affected by a given decision. Irrespective
of what decision is taken, the cost will not be changed or altered. Examples are sunk cost,
unavoidable cost and fixed cost except for increment fixed cost and fixed costs that can be
saved.

Other classification of Cost

Sunk cost: This is a past cost which would not be altered if the activity to which they relate
did not exist

Unavoidable Cost: This is a cost that will be incurred if the activity to which they relate did
not exist. They are irrelevant for decision making i.e. fixed cost

Differential cost: This is the difference in total cost between two alternatives
Opportunity cost: this is the value of the benefit sacrificed when one source of action is
chosen in preference to an alternative. It is the value of the next best alternative forgone.

Replacement Cost: This is the estimated cost at which an identical item can be acquired. It is
used for items that would be replaced when used.

Conversion Costs: These are costs of transforming raw materials into finished goods. It is
the total of production cost less cost of raw materials i.e. direct wages and production
overhead costs or the total, of direct labour and production overhead

Committed Costs: These are costs that have been agreed to be paid. The service may have
been rendered but payment may be yet to be settled e.g. credit facilities granted

Marginal or Incremental Cost

This is the additional cost that a company must incur in order to get an additional work done.
Marginal costs are used for decision making i.e. they are relevant costs needed for decision
making. The marginal cost of a job consists of the following:
 All variable cost incurred because of the job
 Any additional fixed cost incurred solely because of the job

COMPARISON OF VARIABLE COSTS, DIRECT COSTS AND MARGINAL COSTS

This section examines whether direct cost is synonymous with variable cost or even marginal
cost. This issue raised is best answered with illustrating example below:

An order was received from a customer to produce 5,000 special units of a product by ABC
Ventures. The following information relate to the cost unit of product JUPEB:
N
Direct materials 9.00
Direct labour 10.00
Variable overhead 7.50
Depreciation 2.50
Rent 8.00
Miscellaneous fixed cost 5.00
Total cost per unit 42.00
In addition, a special device costing N2,500 is to be used for the order only.

Required:
a) Calculate the order in tabular form
i. The direct cost
ii. The variable cost
iii. The marginal cost

Solution
Direct Cost Variable Cost Marginal Cost
N N N
Direct materials 45,000 45,000 45,000
Direct labour 50,000 50,000 50,000
Variable overhead 37,500 37,500
Special device 2,500 . 2,500
 97,500 132,500 135,000

CONTRIBUTION DEFINED
Contribution can be defined as the difference between sales and variable cost. The more the
number of units sold, the greater the contribution towards the recovery of the fixed cost for
the period. After the recovery of the fixed cost, any additional contribution made above the
fixed cost is known as Profit.

Contribution is not the same thing as Profit

To an average person who is not familiar with accounting, any time he goes to the market and
buys an article say for N8 and sells it for N15, his “profit” as far as he is concern is N7. Such
notion of profit does not take into consideration the fact that transport fares are paid for and
possibly rent and electricity for the shop where such goods are sold. The N7 difference
between the N15 selling price and N8 variable cost is Contribution per unit rather than Profit
per unit. If 2,000 units of the articles are bought and sold during the period, Contribution =
2,000 units x N7 per unit = N14,000. If the total fixed cost for the same period is N10,000
then,
Profit = Contribution – Fixed cost
= N14,000 – N10,000 = N4,000

Relationship between Contribution and Profit

From the example above; the relationship between contribution and profit can be stated as:
Profit = Contribution – Fixed Cost
It can also be stated that:
Contribution = Profit + Fixed cost
This implies that contribution can be viewed from various angles. It can be said to be:
Contribution = Sales – Variable cost
Contribution = Profit + Fixed cost