Cost Classification

1 Introduction

This chapter looks at the different ways in which costs are classified, how costs behave as activity changes, and how profit statements are prepared in marginal costing and total absorption costing formats.

2 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.

3 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 not 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 increases. 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, semi-variable 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:

4 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.

5 The nature and purpose of, profit statements and their preparation in absorption and marginal costing formats.

Some definitions:

Marginal cost (MC):   the additional cost caused when one more unit is made. Marginal cost will be the sum of all variable costs per unit.

Total absorption cost (TAC):   the total cost of manufacturing a unit. This is the sum of the marginal cost and a fair share of the fixed production costs.

Fixed overhead absorption rate:   budgeted fixed production costs divided by budgeted output in units.

Profit per unit:   selling price per unit less total absorption cost per unit ie less marginal costs and all fixed production costs.

Contribution per unit:   selling price per unit less marginal cost per unit

Here is a cost card showing selling price and costs per unit:

Note: total absorption cost per unit = $65 ($40 marginal cost + $25 fixed cost per unit)

Let us say that in a month, 1000 units were made and 900 of those were sold. This means that there must be 100 items left in inventory. The profit can be calculated in two ways.

Marginal cost (MC) approach

Note:

1.   Under marginal costing closing inventory is valued at its marginal cost

2.   All fixed costs are deducted as a lump sum, sometimes referred to as a period cost.

Total absorption cost (TAC) approach

Note:

1.   Under TAC closing inventory is valued at its total absorption cost

Fixed costs are accounted for in the total absorption cost of sales.

5.2 Commentary on the two methods of calculating profits

You will see that the two profits are different, with TAC profits of $31,500 and MC profits of 29,000, i.e. TAC profits are $2,500 greater.

This difference can be reconciled to the difference in closing inventory valuation. In TAC, the closing inventory of $6,500 contains some fixed costs ($6,500 = 100 x ($40 + $25)). These will be accounted for in the next period when those items are sold. In the MC approach all fixed costs are deducted in the period.

Both methods are correct. It’s simply if inventories are valued differently then profits will be different.

5.3 Commentary on the two methods of calculating the cost of production

Marginal cost: each unit causes $40 additional costs and when sold will generate $100 additional revenue. The contribution of $60 means that each unit makes the company $60 richer. It would even be worthwhile making for $40 MC and selling as low as $41 as that would generate a small contribution. Marginal cost is therefore good for decision making.

However, because MC does not take into account all production costs, it can be argued that the cost of production and the value of inventory is understated.

Total absorption cost: each unit costs $65 to produce, but each unit does not cause an extra $65 as fixed costs are fixed. Despite a TAC of $65 it would still be worth selling units at $50, so TAC can be bad for decision making.

However, all production costs are taken into account and arguably TAC is better for inventory valuation.

Either methods can be used in internal cost accounting, but for external reporting in the financial statements TAC has to be used for inventory valuation.

6 Calculating the cost of a product or service

This part of the syllabus has been substantially covered. All that remains is to introduce a couple of pieces of terminology.

Prime cost = direct material + direct labour + direct expenses

Factory cost = prime cost + production overheads

Total cost = factory cost + non-production overheads