Cost Classification and Behaviour
1 Cost classification
Cost classification is the arrangement of cost items into logical groups. For example: by their nature (materials, wages etc.); or function (administration, production etc.).
The eventual aim of costing is to determine the cost of producing a product/service; for profitability analysis, selling price determination and stock valuation purposes.
Cost unit
A cost unit is a unit of product or service in relation to which costs may be ascertained.
The cost unit should be appropriate to the type of business, for example:
Suggest appropriate cost units for the following businesses
Solution
Business Appropriate cost unit
Car manufacturer
Cigarette manufacturer
Builder
Audit company
Types of expenses
$ | |
Production/manufacturing costs | X |
Administration costs | X |
Selling and distribution costs | X |
TOTAL EXPENSES | X |
Only the production costs will be relevant in costing.
Direct costs
Direct costs are those costs which can be identified with and allocated to a particular cost unit.
TOTAL DIRECT COSTS = PRIME COST
Direct costs
Indirect production costs (overheads)
Indirect production costs (known as production overheads) are those costs which are incurred in the course of making a product/service but which cannot be identified with a particular cost unit.
Indirect production costs
TOTAL PRODUCTION COST = PRIME COST + PRODUCTION OVERHEADS
Non-production costs
Other costs required to run the business.
Non-manufacturing/production costs
TOTAL COSTS = PRODUCTION COSTS + NON-PRODUCTION COSTS
2 Cost behaviour
It is expected that costs will increase as production increases (i.e. as output increases) but the exact way in which costs behave with output may differ.
Types of behaviour
Variable cost
Fixed cost
Stepped fixed cost
Semi variable/fixed cost
Linear assumption
For this examination we will assume that total variable costs vary linearly with the level of production (or that the variable cost per unit remains constant). In practice this may not be the case, but we will not consider the effect of this until later examinations.
Behaviour of manufacturing costs
With the linear assumption all costs can be categorised as either fixed or variable. This fits together with previous definitions:
Direct costs
By their nature direct costs will be variable costs.
Indirect costs/overheads
Overheads can be fixed or variable
Fixed | Variable | |
Direct costs | X | √ |
Production overheads | √ | √ |
Non-manufacturing costs | √ | √ |
Semi-variable costs
It is necessary to determine the fixed and variable elements of semi-variable costs. A method known as ‘High-Low’ can be used to establish the fixed and variable elements. This technique is best illustrated by the use of an example.
The total costs of a business for differing levels of output are as follows:
Output | Total Costs |
(units) | ($’000) |
200 | 30 |
1,000 | 110 |
What are the fixed and variable elements of the total cost using the High-Low method?
Describe the relationship between the output and costs in the form of a linear equation.
A better approximation of the fixed and variable elements can be obtained using Regression Analysis. This will be considered in a later chapter of these notes.
Typical cost card for a cost unit
$/unit | |
Direct costs: | |
- Direct materials (2kg @ $1.50/kg) | 3.00 |
- Direct labour (3 hrs @ $4/hr) | 12.00 |
Prime cost | 15.00 |
Indirect costs | |
- Variable overheads | 2.00 |
- Fixed overheads | 3.00 |
Full product cost | 20.00 |
3 Responsibility centres
Cost centres:
Cost centres are areas where costs are collected e.g. individual departments or individual machines
Profit centres:
Profit centres are where both costs and revenues are collected. Many companies will have separate divisions and make the divisional manager responsible for the profit of that division.
Revenue centres:
Here, the manager is only responsible for the revenues of his division or department – not for the costs.
Investment centres:
This is like a profit centre except that the manager also has the responsibility for new capital investment (i.e. the purchase of new machines etc.). You will see in a later chapter that more thought needs to be given as to how to measure the performance of a manager of an investment centre.
4 The Just-in-time system
Under this approach, minimum inventories are held of Finished Goods, Work-in-Progress, and Raw Materials.
The conditions necessary for the business to be able to operate with minimum inventories include the following:
4.1 Finished Goods:
a short production period, so that goods can be produced to meet demand (‘demand-pull’ production)
good forecasting of demand
good quality production, so that all production is actually available to meet demand
4.2 Work-in-Progress:
a short production period. If the production is faster, then the level of WIP will automatically be lower.
the flexibility of the workforce to expand and contract production at short notice
4.3 Raw Materials:
the ability to receive raw materials from suppliers as they are needed for production (instead of being able to take from inventory). This requires the selection of suppliers who can deliver quickly and at short notice.
guaranteed quality of raw material supplies (so that there are no faulty items holding up production).
the flexibility of suppliers to deliver more or less at short notice.
tight contracts with suppliers, with penalty clauses, because of the reliance placed on suppliers for quality and delivery times.
A ‘just-in-time’ approach is a philosophy affecting the whole business. The benefits are not just cost savings from lower inventory-holding costs and less risk of obsolete inventory, but benefits in terms of better quality production (and therefore less wastage), greater efficiency, and better customer satisfaction.
Cost Classification and Behaviour
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