CHAPTER 2COST CLASSIFICATION

2.1. Cost objectives

2.2.Cost for stock valuation

2.3. Cost for decision making

2.4. Cost for control

2.1. Cost objectives

1.1 Categories

There are three board categories of cost objectives:

Costs for stock vlution- cost of manufacturing an article Costs for decision making – make or buy a component Costs for control – costs of operating a department compared with budget.

1.2. Terminology

Cost object – any activity for which a separate measurment of costs is desired: a unit of product; the rendering of a service; a department.

Cost unit – a unit of a product or service in relation to which costs are calculated: kilowatt hours;

tonnes for coal mining; barrels of beer for brewery. Cost centre – a location, function or item of equipment in respect of which costs are calculated

and related to cost unit for control purposes (production centre, qualiy control) . Profit centre – a business segment in respect of which revenues are received and expenditures

caused.

2.2. Costs for stock valuation

2.2.1. Asset/expenses

For stock valuation and profit measures must distinguish between

asset (unexpired cost)------balance sheet expense (expired cost)-----P&L a/c.

Expense by nature from Financial accounting, classified in operating , financial and extraordinary activities, are regrouped by function for cost calculation.

Expenses inccorporated in different costs are only operating expenses and from financial expenses only the interest payable for long term lones. All other expenses are considered as non-incorporated expenses.

2.2.2. Period/product

Period cost – expensed in the period in which they are incurred therefore not assigned to product for stock valuation purposes.

Product costs – identified with goods purchased or manufactured for resale.

2.2.3. Functional classification

Total cost= Production cost + Non-Production cost

Non-Production = Selling, Distribution + Administration

2.2.4. Direct/indirect

All costs fall into one of these categories:

Direct costs are items of costs that are specifically traced to, or caused by, that cost object; can be separately identified in units of product or service.

Indirect costs are elements of costs that are associated with, or caused by, two or more cost objects jointly but that are not directly traced to each of them individually.

Total cost = Direct cost + Indirect cost

Production cost = Direct production cost + Indirect production cost

Direct production costs: direct materials; direct labour; other direct expenses.

Indirect production cost: indirect materials; indirect labour; depreciation expenses; energy cost; other expenses, that may be direct for cost centre or indirect and in this case must be apportioned.

Non –production costs are generally indirect costs, but a part of them may be direct(sales commission).

2.2.5. Elements of costs

Direct materials + Direct labour + other direct expenses = Prime cost

Prime cost + Indirect production cost(production overhead) = Production cost(for stock valuation)

Direct labour + Production overheads = Conversion cost

Conversion cost + Direct material cost = Production cost

Production cost + Non-production costs = Total cost or Cost of sales(for profit calculation)

2.3. Costs for decision making

2.3.1. Cost behaviour

Costs can be classified according to how they behave (are affected) as the level of production increases as:

Fixed Variable Semi-variable/mixed.

Fixed costs do not change regardless of the level of output(eg factory rent; depreciation; office expenses). Fixed costs per unit decrease as production increase and increase as production declines. Fixed costs falls under the category of non-controllable cost from the management.

Variable costs are those which vary in total in direct proportion to the volume of output. These costs per unit remain relatvly constant with changes in production.(direct materials; direct labour; indirect materials).

There are three types of variable costs in actual practice:

i) A 100% variable expenses. For all production the variable expenditure per unit of production is constant.

ii) The expenses per unit of production are lower at lower ranges of output but gradually increase as production goes up.

iii) The expenses per unit of production are more at lower ranges of output but gradually decrease with increase in production.

Semi-variable costs are in the nature of hybrid costs; prtly fixed and partly variable (telephone expenses; power and lighiting; repairs of buildings). Semi-variable costs must be devided into fixed and variable parts.

2.3.2. Determination of degree of variability of expenses

The following methods may be employed :

i) Method of least squares;ii) High or low points method;iii) By means of equations.

In all methods steps are the following:

1. Variable cost per unit calculation (Vuc);2. Total variable cost for a specific level of activity (TV);3. Fixed cost calculation (FC)=total semi-variable cost (TC)-TV;

i)Method of least squares.

All methods are illustrated with the help of the following example:

1 OUTPUT 50 100 150 200 250

2 Material, labour cost 200 400 600 800 1000

3 Depreciation 300 300 300 300 300

4 Other costs 200 300 400 500 600

TOTAL COST 700 1000 1300 1600 1900

Unit cost 14 10 8.66 8 7.6

SOLUTION

Vuc = total xy/totalx2,, where : x: deviation of output from the mean;

Y: deviation of expenses from the mean

.

ii)High or low points method.

Vuc = (cost at high point- cost at low point)/( output at high point – output at low point)

Solution

Iii)By means of equations.

The equation for a straight line is : Y= ax+ b where: x: output; a: Vuc; b: FC.

If the number of pairs of values of x and y are given, the fixed cost (b) and the variable cost per unit (a) can be calculated.

Solution

The necesity for classifying the overhead cost into fixed and variable arises from the following:

fixation of selling price; framing the budget; effective cost control; helps management decisions; marginal costing and break-even chart; method of absorption of overheads.

2.4. Costs for control

May be classified in the following categories:

budgeted costs (predetermined costs); compared against actual costs; controllable costs are those costs that may be changed by a managerial decision. For the level

of these costs some managers are responsabile; non-controllable costs are those costs that cannot be influenced by managers at a specific level

of hierarchy(external costs).