Cost Classification

FIA MA1 Notes September 2019 to August 2020

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Introduction to cost classification

This chapter looks at how coding systems can be devised and used in accounting systems.

The nature and types of cost classification

Costs can be classified in a number of different ways:

• By their behaviour. Do they increase as an organisation gets busier or do they tend to stay the same? This is important when it comes to budgeting as it is essential to be able to predict how costs are likely to change.
• By their location. Where in the organisation are they incurred? For example, costs incurred in the factory are relevant to working out the cost of production. However, costs incurred in storing and delivering finished goods are not relevant to production.
• By their function. For example costs related to research and development, marketing, training, manufacturing.
• By the person responsible for their control. All costs need to be controlled and there should be a clearly identified person who is responsible for the control of each cost. For example, the managers of a branch might be held responsible for the costs incurred there.
• By their type. For example, material, labour, other production expenses, such as the cost of running machinery.
• By their traceability. Are they direct or indirect? Direct costs are closely related and traceable to each item produced. Indirect costs are not so easy to relate and trace to each unit of production.

Variable, fixed, semi-variable and stepped fixed costs

These terms relate to how costs behave as the activity level of an organisation changes.

Variable costs: these are directly proportional to the level of activity.

If the number of units produced doubles, then variable production costs will double also. An example would be the cost of material used to produce units.

If the number of units sold increases by 20% then variable selling and distribution costs would increase by 20% also.

On a graph, variable costs would look like:

Fixed costs: constant over a wide range of activity

An example would be the factory rent. It does no matter how many units are made, the rent is fixed.

On a graph, fixed costs would appear as:

Note that the cost per unit will decrease as the activity level decreases. For example, say that the rent was $10,000 and 1,000 units were made. Then you could argue that it takes $10 rent to make a unit ($10,000/1,000).

If, however, 10,000 units were made, the rental cost per unit would be only $1 ($10,000/10,000). Higher production volumes are making better use of the fixed resource.

Semi-variable costs have a fixed element and a variable element.

An example would be a telephone bill. Usually there is a fixed cost for the line rental then each minute of telephone calls causes an additional cost.

On a graph, fixed costs would appear as:

Stepped fixed costs: constant over a range of activity then a sudden increase, then constant  again

An example would be the salary of supervisors. One supervisor for up to six workers, two for up to 12 workers, etc.

On a graph, stepped fixed costs would appear as:

The classification of labour and material costs

There are three types of production expenses:

• Material
• Labour
• Expenses (often known as overheads)

Each can be direct or indirect

Businesses also have non-production overheads. These are costs which have nothing to do with production such as the accounting department, advertising, distribution, head office costs.