COST UNITS, COST CLASSIFICATION

AND PROFIT REPORTING

LESSON 3
 INTRODUCTION TO COSTS
Lets suppose you have a pen which you bought
from a retailer for 50 ngwee. Why does the retailer
charge you 50 ngwee? What does the 50 ngwee
stand for?
From the retailer’s point of view the cost can be
split into two.
Price paid by the retailer to wholesaler X
Retailers mark-up Y
Total 50
 COST UNITS
• A cost unit is a unit of product or service to which costs can be related.
• One factor that may cause things to slightly complicated is that a cost unit is not
always a single item. It might be a batch of 1000 if this is how the individual items
are made. In fact, a cost per 1000 is sometimes the most meaningful information.
• Examples of cost units include the following.
(a) room(in a hotel)
(b) Batch of 1,000 shoes
(c) Patient night
• A possible cost unit for a hospital might be a patient. This however, is not
particularly useful for control purposes as different patients will spend different
amount of time in hospital. The patient per night cost is much more useful.
Notice that this is made up of two parts, the patient and the night. These two
parts cost units are called composite cost units and are mostly used in service
industry.
 COST UNITS
• Cost information is needed to aid price setting, decision making,
planning and budgeting, control and reporting.
• Managers need to know what resources are used and what costs
are incurred in the production of a cost unit. This information may
be used in a number of ways-such as the situations described
below:
(a) Setting a selling price that covers the cost of manufacture and
makes a profit
(b) Planning and budgeting future activities relies on knowing
production quantities and costs so that we know what resources
we will need, for which we will need to know the cost.
(c) Decision making: for example whether to sell product A or B,
which will depend upon how much profit each product makes,
for which we need to know the cost.
 COST UNITS
(d) Control of resources and cost of production is possible if
we know what quantities and costs ought to be. If costs are
higher, or if more time is needed to make the cost units than
was expected, then this would need investigation so that any
problems can be ironed out.
(e) Reporting the results of the business relies on knowing
the costs incurred and the value of inventory of the
manufactured goods.
• Cost classification is the grouping of costs under common
characteristics. Examples include direct or indirect, fixed or
variable.
 PRODUCTION COSTS
The cost of production is made up of direct
materials, direct labour, direct expense and
production overheads. (refer to page 40)
A cost card is the made of the various
components that make the cost of one unit of
the product.
 PRODUCTION COSTS
Example
BMX makes 20,000 braces per year. Each brace
requires ½ hour of labour at$5 per hour and are
bought in components, costing $1.25, $2 and 40c.
Each respectively. The packaging for the brace costs
$16 per 100 boxes. The business incurs fixed
production costs of $4000 per annum, and the cost of
selling, administration and distribution works out at
50c per item sold. Calculate the production cost and
the total cost of a brace and record this on a cost card.
 DIRECT AND INDIRECT COSTS
• Costs can be divided into three elements, materials,
labour and expenses.
• Costs can be classified as direct or indirect.
• Direct costs can be traced specifically to a cost unit.
 Direct materials- which form part of the end product.
 Direct labour – involved directly in making the product
 Direct expenses- it is rare for expenses to be directly
traceable to the product.
• The sum of the direct costs is known as the prime cost.
 DIRECT AND INDIRECT COSTS
• The factory will also have indirect costs or factory overheads which are not
directly traceable to the product but will still be part of the cost of making it.
 Indirect materials- such as lubricants for machinery.
 Indirect labour- such as supervisors and maintenance workers
 Indirect expenses- it is rare for expenses to be directly traceable to a product.
• There are also non-manufacturing overheads in a manufacturing business.
These are not included in the production cost of goods or for inventory
valuation purposes. An appropriate proportion of these overheads is included
on the cost card so that n appropriate can be set.
Examples include
 The accountant’s salary ( a non manufacturing labour cost)
 The office rates ( non-manufacturing expenses)
 COST BEHAVIOUR
• Cost behaviour patterns demonstrate the way in
which costs are affected by changes in the level
of activity.
• Instead of categorising materials, labour and
expenses costs into direct and indirect costs, it
can sometimes be very useful to use a different
system, one that is based on cost behaviour.
• Cost behaviour is the way costs change as the
level of activity changes.
 LEVEL OF ACTIVITY
• The level of activity refers to the amount of work
done, or the volume of production.
• 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; it will usually cost
more to make five telephone calls than to make one
call and so on. However, this system identifies
several types of costs which respond differently to a
change in activity level.
 VARIABLE COSTS
A variable cost is a cost which tends to vary in
total directly with the volume of output. The
variable cost per unit is the same amount for
each unit produced whereas total variable cost
increases as the volume of output increases.
 VARIABLE COSTS

Total cost
$

Level of activity
 VARIABLE COSTS

Cost per
unit $

level of activity
 VARIABLE COSTS
A constant variable cost per unit implies that the purchase price per
unit of material purchased or cost per labour hour worked and so on
is constant, and that the rate of material usage/labour productivity is
also constant. In other words, constant rate and efficiency levels are
implied in variable costs.
The following are variable costs.
(a) The cost of raw materials, because the volume of raw materials
purchased relates to the volume used in production
(b) Direct labour costs. This is due to the ability to increase or
decrease the number of workers and therefore the total cost.
(c) Sales commission is variable in relation to the volume or value of
sales.
 VARIABLE COSTS
At this point it is important to stress that variable
cost is not just another name for a direct cost. The
distinctions that can be made are as follows.
(a) Costs are either variable or fixed, depending
upon whether they change in total when
volume of production changes
(b) Costs are either direct or indirect, depending
upon how easily they can be easily traced to a
specific unit of production.
 FIXED COSTS
A fixed cost is a cost which tends to be
unaffected in total by increases in the volume of
output. Fixed costs are a period charge, in that
they relate to a span of time; as the time span
increases, so too will the fixed costs.
 FIXED COSTS
Total
cost $

fixed cost

level of activity
 FIXED COSTS
The following are fixed costs:
(a) The salary of the managing director(per month or per
annum)
(b) The rent of a single factory building(per month or per
annum)
(c) Straight line depreciation of a single machine(per
month or per annum)
Because the total fixed cost remain the same for all levels
of activity, if you calculate the fixed cost per unit, this will
decrease as more units are produced.
 FIXED COSTS
Cost per
Unit

level of activity
 STEPPED FIXED COSTS
Stepped-fixed costs are fixed in nature within
certain levels of activity. Many items of costs are
fixed cost in nature within certain levels of
activity. For example, the depreciation of a
machine may be fixed if production remains
below 1000 units per month, but if production
exceeds 1,000 units, a second machine may be
required, and the cost of depreciation(on two
machines would go up) would go up a step.
 STEPPED FIXED COSTS

Total
cost $

level of activity
 STEPPED FIXED COSTS
Cost
per
unit $

level of activity
 STEPPED FIXED COSTS
Other examples of stepped fixed costs are as
follows:
(a) Rent, where accommodation requirements
increase as output levels get higher
(b) Supervisor salary. One supervisor may be able
to supervise a maximum of 10 employees.
When the number of employees increases
above a multiple of 10 an extra supervisor will
be required.
 MIXED COSTS
Mixed costs (semi-variable/semi-fixed costs) are
partly fixed and partly variable, and only partly
affected by changes in activity levels.
These are cost items which are part fixed and
part variable, and are therefore partly affected
by changes in the level of activity.
 MIXED COSTS

Total
cost $

variable part

fixed part

level of activity
 MIXED COSTS

Cost
per unit
$

level of activity
 MIXED COSTS
• Examples of these costs can include utility
bills, if there is a standing basic charge plus a
variable charge per unit of consumption. An
example of this is a telephone bill with a fixed
charge for line rental and a variable charge for
calls made.
 QUESTION
Are each of the following likely to be variable or fixed
costs?
(a) Charges for telephone calls made
(b) Charges for rental of telephone
(c) Annual salary of the chief accountant
(d) Managing director’s subscription to the institute
of directors
(e) Cost of materials used to pack 20 units of
product X into a box.
 FUNCTIONAL COSTS
Costs can also be analysed by their function. For
example, production, distribution and selling,
administration and financing costs.
When we are talking about functional costs we
are not talking about a different type of costs
from those we have met already, but about a way
of grouping costs together according to what
aspects of an organisation’s operations(what
function) cause them to be incurred.
 FUNCTIONAL COSTS
• A convenient set of functions is the following:
(a) Production costs: materials and labour used and expenses
incurred to make things and get them ready for sale.
(b) Distribution and selling costs: costs incurred to get the finished
goods to the point where people can buy them and to persuade
people to buy them.
(c) Administration costs: the materials and labour used and the
expenses incurred in coordinating the activities of the production
function and the distribution and selling function.
(d) Financing costs: the expenses when a business has to borrow to
purchase non-current assets or simply to operate on a day to day
basis.
 CALCULATING THE COST OF A PRODUCT OR
SERVICE
The cost of a product can be built up on a cost
card, which identifies:
• Direct costs
• Prime costs (sum of direct costs)
• Production overhead
• Production costs
• Non-production overhead
• Total production cost
 CALCULATING THE COST OF A PRODUCT OR
SERVICE
Example
Skeggy ltd makes 20,000 braces per year. Each brace
requires ½ hour of labour at $5 per hour and 3 bought
in components, costing $1,25, $2 and 40c each
respectively. The packaging for the brace costs $16 for
100 boxes. The business incurs fixed production costs
of $4,000 per annum, and the cost of selling,
administration and distribution works out at 50c per
item sold. Calculate the production cost and the total
cost of a brace and record this on a cost card.
 CALCULATING THE COST OF A PRODUCT OR
SERVICE
Solution:
Brace cost card
Direct materials-components(1.25+2.00+0.40) 3.65
- box ($16/100) 0.16
Direct Labour (1/2 h at $5 per hour) 2.50
Prime cost 6.31
Production overheads ($4,000/20,000units) 0.20
Production cost 6.51
Non- manufacturing overheads 0.50
Total cost 7.01
 PROFIT REPORTING
• Absorption costing and marginal costing are different ways of accounting
for costs. If there are changes in inventory levels during a period,
marginal costing and absorption costing will give different profit figures.
• Earlier on we mentioned that an important reason for finding the cost of
cost units produced was so that we could report the profit made and
value any closing inventory. For management accounting purposes there
are two ways of doing this, which differ in their treatment of fixed costs.
• Absorption costing: the cost of the product for inventory valuation is the
variable production cost plus the fixed production cost.
• Marginal costing: the cost of the product for inventory valuation is the
variable production cost only. Fixed production cost are treated as period
costs rather than a product cost, and are charged to the income
statement in full in the period in which they are incurred.
 PROFIT REPORTING
This will lead to different inventory values, and to a different
reported profit if inventory quantities rise or fall over the period in
question.
EXAMPLE
Robbers ltd makes one product, the cop. At 1 June, there were 40
cops in inventories held. Each cop requires 2 hours of labour and 1
kg of raw material. Labour is paid $8 per hour, and raw material
costs $12 per kg. Robbers incurs fixed production overheads of
$2,000 per month and the factory produces 1,000 cops each
month.
A cop sells for $35. sales in june were 1,000 cops, but in July, sales
fell to 900 cops.
 ABSORPTION COSTING
The absorption costing of a cop can be found by drawing up a unit
cost card. The variable costs are found by multiplying the quantity
used by the cost. The fixed cost is spread over the units produced.
Cop-unit cost card(absorption costing)
Variable Production cost
Direct materials 1kg at $12 per kg 12.00
Direct labour 2 hrs at $8 per hour 16.00
Total variable cost 28.00
Fixed production overhead $2000/1,000 2.00
Total production cost 30.00
 ABSORPTION COSTING
A profit statement can now be produced for June and July using
these costs.
June July
Sales 35,000 31,500
Opening inventory 1,200 1,200
Production(1000x$30) 30,000 30,000
31,200 31,200
Less:closing inv(40x$30) 1,200 (140x30) 4,200
Cost of sales 30,000 27,000
Gross profit 5,000 4,500
 MARGINAL COSTING
Cop-unit cost card (Marginal costing)
Variable production costs
Direct Material 1 kg at $12 per kg 12.00
Direct Labour 2hrs at $8 per hr 16.00
Total variable or marginal cost 28.00

The marginal costing profit statement is a little different. Firstly,

the fixed overheads are not included in the product cost, but are
brought in to the income statement in full. Secondly, a new sub
heading is needed in marginal costing called contribution.
Contribution is sales less variable or marginal costs
 MARGINAL COSTING
A profit statement can now be produced for June and July using these
costs.
June July
Sales 35,000 31,500
Opening inventory 1,120 1,120
Production(1000x$28) 28,000 28,000
29,120 29,120
Less:closing inv(40x$28) 1,120 (140x28) 3,920
Variable cost of sales 28,000 25,200
Contribution 7,000 6,300
Less fixed costs 2,000 2,000
Profit 5,000 4,300
 MARGINAL COSTING AND ABSORPTION
COSTING
Marginal costing and absorption costing are different.
(a) In marginal costing
(i) closing inventory is valued at marginal production cost.
(ii) fixed costs are charged in full against the profit of the period in which
they are incurred.
(b) In absorption costing
(i) closing inventory is valued at full production cost including a share of
the fixed production cost.
(ii) the effect of this is that cost of sales in a period will include some
fixed overhead incurred in a previous period(opening inventory values).
The cost of sales will also exclude some fixed overhead incurred in the
current period as this is carried forward in closing inventory values to be
charged to subsequent accounting periods.