Cost Classification and Behaviour

1 Cost classification

Cost classification is the arrangement of cost items into logical groups — by their nature (materials, wages, and so on), by their function (production, administration, selling), by whether they can be traced to what is being costed, or by how they behave as activity changes.

The eventual aim of costing is to determine the cost of producing a product or delivering a service, for inventory valuation, profit reporting, cost management and decision-making — the four rationales set out in chapter 1. Which classification is useful depends on which of those four you are serving. Classification by function values inventory; classification by behaviour supports decisions; classification by cause supports cost management. The same cost appears in all three.

Part 1 of two recordings for this chapter. It teaches sections 1 and 3 — the cost unit, the types of expense, direct costs and production overheads. Three points before you play it.

Prime cost: at about 10 minutes the recording says the direct costs are “normally simply the materials and the labour”. That is true of most factories but it is not the full definition: prime cost is direct materials plus direct labour plus direct expenses. Section 3.2 and Example 2 carry the third element.

The cigarette carton: the recording first suggests a carton of 10 packets and then, a minute later, calls it a carton of 20 packets. Nothing turns on which — the whole point of that example is that there is no rule — but do not try to reconcile the two numbers.

Prior paper: the recording mentions “paper F3” when it reaches depreciation. That is an ACCA code; this lecture is a re-cut of an ACCA master. The CIMA equivalent is BA3 Fundamentals of Financial Accounting.

Coverage: it works four of Example 1's six parts and does not reach section 2 at all.

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1.1 Cost objects and cost units

Cost object and cost unit

A cost object is anything whose cost is being measured: a product, a service, an activity, a process, a project, a customer, a department, a channel — anything management wants a cost for.

A cost unit is the particular kind of cost object that is a unit of output: the unit in relation to which costs are ascertained and expressed.

Every cost unit is a cost object; not every cost object is a cost unit. The syllabus uses “cost object” because a modern organisation costs a great deal that is not a unit of output — an order, a customer relationship, a delivery route, a subscription. The older term “cost unit” is still correct and still used, and this chapter uses whichever is the more natural.

The cost unit must be appropriate to the type of business, and choosing it is a judgement rather than a rule. The test is: what does the organisation actually sell, and what unit does it make decisions about?

Choosing a cost unit

Suggest an appropriate cost unit for each of the following, and give your reason.

A car manufacturer
A cigarette manufacturer
A builder of houses
An audit firm
A hospital
A business selling software by monthly subscription

Choosing a cost unit

There is no single right answer to any of these. What is being marked is whether the unit chosen is one the organisation actually sells and makes decisions about.

Business	Cost unit	Why
Car manufacturer	One car	Thousands of identical units. Cost one and you have costed them all
Cigarette manufacturer	One pack, or one carton of packs	Cigarettes are not sold singly. The pack carries the packaging cost as well as the contents, and the carton is what is invoiced to the retailer. Choose the unit you sell
Builder	One house	But unlike the car maker, each house differs, so each is costed separately as a job. The unit is the same; the costing method is not
Audit firm	One chargeable hour	Every engagement differs in size, so the firm costs an hour of professional time and builds an engagement cost from the hours it takes
Hospital	A patient-day, or a treated case	A composite unit: two measures combined, because neither a patient nor a day alone describes what is consumed
Subscription software business	One subscriber-month	There is no physical unit at all. The cost object is a customer over a period, which is also the unit revenue is earned in

Composite cost units — patient-day, passenger-kilometre, tonne-kilometre, room-night — combine two measures because one alone would not capture what drives the cost. They are common wherever the output is a service.

A note on the recording: the lecture works the first four of these six and does so well. It predates parts (5) and (6), which were added to serve the syllabus's requirement that costing concepts be applied to different types of organisation and to digital cost objects.

2 Costing in different types of organisation

Almost every illustration in a costing textbook is a factory, and the whole of this chapter's vocabulary — materials, labour, production overhead, prime cost — comes from manufacturing. The syllabus requires the concepts to be applied more widely than that.

	What is costed	What makes it different
Manufacturing	A physical unit of output	Materials are a large, traceable, largely variable cost. There is inventory of finished output to value, so the absorption of production overhead matters (chapter 3)
Service	A composite unit, an engagement, or an hour	Output cannot be stored, so there is no finished-goods inventory to value. Materials are small; labour and overhead dominate; a high proportion of cost is indirect and fixed
Not-for-profit and public sector	A service, a programme, or a client served	There is no profit to measure, so costing supports value for money — economy, efficiency and effectiveness — and the allocation of a fixed budget between competing calls on it
Digital	A subscriber, a transaction, an active user, an API call	Development cost is large and incurred once; the cost of serving one more unit is close to nil. Almost everything is fixed, so a “cost per unit” depends almost entirely on volume

2.1 Why services are harder to cost

Four characteristics of a service make its costing different, and they are worth naming:

Intangibility — there is no physical thing to attach a cost to, so the cost unit has to be defined before anything can be costed at all.
Simultaneity — the service is produced and consumed at the same moment, so there is no work in progress to measure and no output to inspect before delivery.
Perishability — an unsold hour, seat or room is gone. It cannot be held in inventory, which is why service organisations are so sensitive to capacity utilisation.
Heterogeneity — no two deliveries of the service are identical, so an average cost conceals more variation than it does in a factory.

The practical consequence is that the interesting question in a service organisation is rarely “what does a unit cost?” but “what drives our overhead, and who consumes it?” — which is why activity based costing (chapter 4) is at least as useful in services as in manufacturing, and why chapter 7 treats digital cost objects separately.

3 Cost elements and cost structure

3.1 Types of expense

	$
Production / manufacturing costs	X
Administration costs	X
Selling and distribution costs	X
TOTAL EXPENSES	X

Only the production costs are relevant to costing a unit of output for inventory valuation. The others are period costs: they are charged in full against the profit of the period in which they arise, and are never carried forward in the value of inventory.

3.2 Direct costs and prime cost

Direct cost

A direct cost is a cost which can be identified with, and allocated to, a particular cost unit.

The test is measurement, not size. A cost is direct if you can look at one unit and say how much of that cost is in it.

The three direct cost elements are direct materials, direct labour and direct expenses. Their total is the prime cost.

Prime cost = Direct materials + Direct labour + Direct expenses

Direct costs

A business manufactures desks. Give an example of each of the three direct cost elements, and calculate the prime cost of one desk from the following:

Wood	2 square metres at $5.00 a square metre
Assembly labour	3 hours at $10.00 an hour
Royalty payable to the designer	$1.50 for each desk made

Direct costs

Element	Example	$
Direct materials	The wood in the desk — 2 m² × $5.00	10.00
Direct labour	The wages of the workers who assemble it — 3 hrs × $10.00	30.00
Direct expenses	A royalty paid for every desk made	1.50
PRIME COST		41.50

Direct expenses are the element candidates forget. They are costs other than materials and labour that are still traceable to one unit or one job — a royalty per unit, the hire of a machine for a single job, the cost of a subcontractor engaged for one contract.

Note that the wages of a worker who maintains the machines are not direct labour, even though they are wages and even though they are a production cost. They cannot be measured into one desk, so they are an overhead — see Example 3.

3.3 Indirect production costs (production overheads)

Production overhead

An indirect production cost, or production overhead, is a cost which is incurred in the course of making the product or delivering the service but which cannot be identified with a particular cost unit.

Indirect production costs

Give five examples of indirect production costs in a factory making desks, and say in each case why the cost cannot be treated as direct.

Indirect production costs

Overhead	Why it is indirect
Rent and rates of the factory	Incurred for the building as a whole. You cannot measure how much rent is in one desk
Wages of maintenance staff	Labour, and a production cost, but they make nothing. Their time cannot be attached to a unit
Salaries of production supervisors	They supervise all output. There is no meaningful measure of supervision per desk
Depreciation of factory machinery	A cost of having the capacity to produce, not of producing any one unit
Factory power, heat and light	One meter for the building. Some of it varies with output and some does not, and neither part is traceable to a unit
Indirect materials — glue, lubricants, abrasives	Materials, but consumed in amounts too small to be worth measuring per unit. The cost of measuring would exceed the value of knowing

The last row is the practical point behind the whole classification. A cost is treated as indirect either because it cannot be traced or because it is not worth tracing. That is a cost-effectiveness judgement, which is the same judgement chapter 4 makes about activity based costing.

Total production cost = Prime cost + Production overheads

3.4 Non-production costs

The other costs of running the business. They are not part of the cost of a unit of output and are never included in the value of inventory.

Non-production costs

Classify the following as administration, selling, or distribution costs, and state why none of them may be included in the value of finished goods inventory.

The salaries of the accounts department
Rent of the head office
Commission paid to sales representatives
Advertising
The cost of delivering finished goods to customers
The cost of the finished goods warehouse

Non-production costs

	Cost	Classification
1	Salaries of the accounts department	Administration
2	Rent of the head office	Administration
3	Sales commission	Selling
4	Advertising	Selling
5	Delivery to customers	Distribution
6	Finished goods warehouse	Distribution

Why none of them is in inventory. Inventory is measured at the cost of bringing the goods to their present location and condition — that is, the cost of making them. Administration, selling and distribution costs are incurred after production is complete, or irrespective of it, so they are period costs and are charged in full against the profit of the period. Including them would capitalise into an asset costs that produce no future benefit. Chapter 3 works the consequences of that rule for reported profit.

Note the trap in items (3) and (5): both vary with the number of units sold. Being variable does not make a cost a production cost, and being a production cost does not make a cost variable. The two classifications are independent — section 4.4.

Total cost = Production costs + Administration + Selling and distribution

4 Cost behaviour

It is expected that total costs will increase as output increases, but the exact way in which a cost behaves differs from cost to cost. Cost behaviour is the classification that matters for decisions, budgets and break-even analysis, and it cuts across the direct/indirect classification completely.

Part 2 of two recordings for this chapter. It teaches section 4 — the four patterns of cost behaviour, the linear assumption and the behaviour of manufacturing costs — and works Example 6 by the high-low method: $100 a unit and $10,000 fixed. Three points before you play it.

One step to check: to show that Example 6’s cost is not purely variable, divide each total by its output: $30,000 ÷ 200 = $150 a unit, against $110,000 ÷ 1,000 = $110 a unit.

Prior paper: “paper F2” is an ACCA code; the CIMA equivalent is BA2 Fundamentals of Management Accounting.

Where it points you: its “section 2” is section 4 here. Responsibility accounting, which it mentions at the end, is in Chapter 11 §6.4; divisionalisation belongs to P2. The cost card in section 5 is left to you.

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4.1 The four patterns

Types of cost behaviour

For each of the four patterns of cost behaviour, state how the total cost behaves as output rises, how the cost per unit behaves, and give an example.

Types of cost behaviour

Behaviour	Total cost as output rises	Cost per unit	Example
Variable	Rises in direct proportion, from nil at zero output	Constant	Direct materials at $5 a unit
Fixed	Unchanged	Falls as output rises	Rent of the factory at $10,000 a month
Stepped fixed	Unchanged over a range, then jumps to a new level	Falls within each step, then jumps	Rent, where a second factory is needed above 100,000 units
Semi-variable (mixed)	Rises from a positive intercept	Falls, but towards the variable rate rather than towards nil	A power bill: lighting the factory is fixed, running the machines is variable

Drawn against output, the four look like this. Each line is a different cost; they are put on one pair of axes only so the shapes can be compared.

Fixed does not mean unchanging. The rent of the factory may well rise next year. What makes it a fixed cost is that it does not change with the level of output — which is the only question cost behaviour asks.

4.2 Total cost and cost per unit move in opposite directions

This is the single most common trap in objective questions on this chapter, and it is worth stating on its own.

	Total cost	Cost per unit
Variable cost	Varies with output	CONSTANT
Fixed cost	CONSTANT	Varies with output — it falls as output rises

Take a fixed cost of $10,000. Produce one unit and it costs $10,000 a unit; produce two and it costs $5,000 each; produce 100 and it costs $100 each. The total never moved. A question that says “the fixed cost per unit” is asking about a number that changes every time output does — which is exactly why chapter 3's absorption rate is only valid at the output it was set for.

4.3 The linear assumption and the relevant range

For this examination we assume that total variable costs vary linearly with the level of output — equivalently, that the variable cost per unit is constant. In practice it need not be: bulk discounts reduce the material cost per unit at high volumes, and overtime premiums raise the labour cost per unit.

The assumption holds within the relevant range — the range of output over which the organisation actually operates and over which the observed cost behaviour was measured. Outside it, fixed costs step and variable rates change. Every technique in chapters 3, 5, 12, 13 and 15 rests on this assumption, so it is worth knowing where it stops being true.

4.4 Behaviour of manufacturing costs

With the linear assumption, every cost is fixed, variable, or a combination of the two. That fits together with the classification in section 3, but it does not run parallel to it:

	Fixed	Variable
Direct costs		✓
Production overheads	✓	✓
Non-production costs	✓	✓

Direct costs are variable by their nature: if you can measure a cost into one unit, making another unit incurs it again. Overheads can be either — factory power is partly variable, factory rent is fixed — and so can non-production costs: the accounts department is fixed, sales commission and delivery are variable with sales volume.

Direct and variable are not synonyms, and neither are indirect and fixed.

Direct/indirect asks whether a cost can be traced to a cost unit. Fixed/variable asks whether it changes with output. A variable overhead — power for the machines — is variable and indirect at the same time. Objective questions exploit this constantly.

4.5 Semi-variable costs and the high-low method

A semi-variable cost arrives as one figure and has to be split into its fixed and variable elements before it can be used in a budget or a decision. The high-low method does that from two observations of total cost at two different levels of output.

Because the fixed element is the same at both levels, the whole of the difference in total cost between them must be the variable cost of the extra units:

Variable cost per unit = (Total cost at high output − Total cost at low output) ÷ (High output − Low output)

The fixed element then follows by substituting back into either observation — it does not matter which, and in the exam there is no time to check both.

The high-low method

The total costs of a business for differing levels of output are as follows:

Output	Total costs
(units)	($’000)
200	30
1,000	110

Required:

What are the fixed and variable elements of the total cost, using the high-low method?
Describe the relationship between output and cost in the form of a linear equation.

The high-low method

(1) The fixed and variable elements

	Units	Cost $
High	1,000	110,000
Low	200	30,000
Difference	800	80,000

The fixed cost is the same at both levels, so the whole of the $80,000 difference is the variable cost of the extra 800 units:

Variable cost per unit = 80,000 ÷ 800 = $100

Substituting back into the high observation:

Total cost at 1,000 units	110,000
Less variable cost (1,000 × $100)	(100,000)
Fixed cost	10,000

Checking against the low observation, which you would not do in the exam: (200 × $100) + $10,000 = $20,000 + $10,000 = $30,000 ✓.

(2) The linear equation

y = 100x + 10,000

where y is total cost in $ and x is output in units. The variable cost per unit is the gradient of the line and the fixed cost is its intercept — which is why the same two numbers reappear as b and a in the regression equation y = a + bx in chapter 12.

High-low uses only two of the available observations and takes no account of any of the others, so it is quick and crude. Chapter 12 revisits the same split using regression analysis, which uses every observation.

5 The cost card

Everything in this chapter comes together in a cost card — the statement of what one cost unit costs, built up element by element. It is the output of chapters 3 and 4, the input to chapters 9 and 10's variance analysis, and the thing a standard cost is a card of.

	$/unit
Direct costs:
Direct materials (2 kg @ $1.50/kg)	3.00
Direct labour (3 hrs @ $4.00/hr)	12.00
Prime cost	15.00
Indirect costs:
Variable production overheads	2.00
Fixed production overheads	3.00
Full production cost	20.00

Two things about this card decide most of what follows. The marginal cost is $17.00 — everything above the fixed line — and the full production cost is $20.00. Chapter 3 shows that valuing inventory at one rather than the other changes the reported profit, and chapter 14 shows that using the wrong one wrecks a decision.

6 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.

Answer the questions one at a time. Your progress is saved so you can leave and come back.

Open chapter practice