Cost Classification and Behaviour
This chapter gives you the vocabulary of costing. Section 1 classifies costs in relation to output: the cost unit (and the wider idea of a cost object), direct costs and prime cost, production overheads, and non-production costs. Section 2 classifies costs by how they behave as activity changes: variable, fixed, stepped fixed and semi-variable costs.
It ends with your first calculation, the high-low method, which splits a semi-variable cost into its fixed and variable parts. Chapter 3 takes that further.
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 inventory valuation purposes.
Cost unit
A cost unit is a unit of product or service in relation to which costs may be ascertained.
The syllabus also uses a wider term, the cost object. A cost object is anything for which a separate measurement of cost is required – for example a product, a service, an activity, a customer or a department. A cost unit is the cost object used most often: one unit of the product or service the business provides.
The cost unit should be appropriate to the type of business, for example:
Suggest appropriate cost units for the following businesses:
Car manufacturer
Cigarette manufacturer
Builder
Audit company
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Types of expenses
$ | |
Production/manufacturing costs | X |
Administration costs | X |
Selling and distribution costs | X |
TOTAL EXPENSES | X |
Administration costs are the costs of running the business, such as the accounts department and the reception. Selling and distribution costs include advertising, sales staff and delivering goods to customers.
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.
The main direct costs are direct materials (the materials that go into each unit) and direct labour (the wages of the workers who make each unit). Any other cost that can be traced to a unit – for example a royalty paid for each unit made – is a direct expense.
Total direct costs = prime cost (direct materials + direct labour + direct expenses)
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.
Examples are the rent of the factory, the wages of the factory supervisor (indirect labour), electricity for the factory machines and depreciation of the machinery. None of these can be measured in each unit, so they are shared out over the units produced – how this is done is the subject of chapter 4.
Total production cost = prime cost + production overheads
A business makes wooden chairs. Each chair needs 2 square metres of wood costing $5 per square metre, and takes 3 hours to make. Workers are paid $4 per hour. Production overheads are $10,000 a year and the business expects to make 1,000 chairs a year.
Calculate the prime cost and the total production cost of one chair.
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Non-production costs
Other costs required to run the business.
These are the administration costs and the selling and distribution costs. They are costs of the business, but not of making the product, so they are not included in the cost of a unit.
Total costs = production costs + non-production costs
Mwangi Furniture, a manufacturer in Kenya, incurs the following costs. Classify each one as direct materials, direct labour, production overhead, administration cost or selling and distribution cost.
Wood used to make tables
Wages of the workers who assemble the tables
Rent of the factory
Salary of the factory supervisor
Electricity for the factory machines
Salaries of the accounts department
Running costs of the delivery vans
Commission paid to sales staff
Wages of the head-office receptionist
Depreciation of the factory machinery
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Classification for decisions
Costs can also be classified according to whether they affect a decision. A relevant cost is a future cash cost that will change as a result of the decision; an irrelevant cost – such as money already spent, or a cost that will be paid whatever is decided – does not affect it. This classification is explained in chapter 18, with make-or-buy decisions.
2 Cost behaviour
The lecture works the high-low method as the sixth example of the chapter; in these notes it is Example 5. The four types of cost behaviour, which the lecture draws by hand, are explained with graphs below.
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.
There are four types of cost behaviour.
(a) Variable cost
A variable cost is one whose total changes in proportion to the level of activity, while the cost per unit stays the same. Direct materials are an example: if materials cost $10 a unit, one unit costs $10, two units $20, and 1,000 units $10,000. If nothing is produced, nothing is spent.
(b) Fixed cost
A fixed cost is one whose total stays the same whatever the level of activity, so the cost per unit falls as more units are made. Factory rent of $10,000 a year is an example: it is $10 a unit if 1,000 units are made, but only $5 a unit if 2,000 are made and $2 a unit if 5,000 are made.
(c) Stepped fixed cost
A stepped fixed cost is fixed over a range of activity but jumps to a higher level when that range is exceeded. If one factory, rented for $10,000 a year, can make up to 10,000 units, a second factory is needed for more than 10,000 units and the rent jumps to $20,000. The graph looks like a staircase. A supervisor who can oversee a set number of workers is another example.
(d) Semi-variable (semi-fixed) cost
A semi-variable cost has a fixed part and a variable part. Factory electricity is an example: lighting the factory might cost $1,000 a year whatever is produced, and running the machines $1 for each unit made. There is only one electricity bill, so the total is $1,000 + $1 per unit – $1,000 at nil output, $3,000 at 2,000 units and $6,000 at 5,000 units.
Kumar Engineering in India has the following costs:
materials: $10 per unit
factory rent: $10,000 a year
electricity: $1,000 a year plus $1 per unit.
For each of the three costs, calculate the total cost and the cost per unit if 1,000, 2,000 and 5,000 units are made in a year.
The factory can make at most 10,000 units a year. A second factory, at the same rent, would be needed for any output above that. What would the total rent be for an output of 8,000 units, and of 12,000 units?
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Linear assumption
For this examination we will assume that total variable costs vary linearly with the level of production (or that the variable cost per unit remains constant). In practice this may not be the case, but we will not consider the effect of this until later examinations.
Behaviour of manufacturing costs
With the linear assumption all costs can be categorised as either fixed or variable. This fits together with previous definitions:
Direct costs
By their nature direct costs will be variable costs.
Indirect costs/overheads
Overheads can be fixed (factory rent), variable (electricity for the machines) or semi-variable (the whole electricity bill). Non-manufacturing costs can also be either: the accounts department’s salaries are fixed, while delivery costs rise with sales and are variable.
Fixed | Variable | |
Direct costs | X | √ |
Production overheads | √ | √ |
Non-manufacturing costs | √ | √ |
Semi-variable costs
It is necessary to determine the fixed and variable elements of semi-variable costs. A method known as ‘High-Low’ can be used to establish the fixed and variable elements. This technique is best illustrated by the use of an example.
The total costs of a business for differing levels of output are as follows:
Output | Total Costs |
(units) | ($’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.
Use your equation to estimate the total cost of producing 500 units.
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A better approximation of the fixed and variable elements can be obtained using Regression Analysis. This will be considered in the next 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 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
Cost Classification and Behaviour
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