Cost Classification

1 Introduction

This chapter looks at how costs can be classified and how profit statements can be prepared using both marginal cost and total absorption costing approaches.

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 Analysing semi-variable costs using the high-low (or range) method.

When trying to draw up budgets, which are really just plans quantifying sales and costs, it is essential to understand how costs will behave so that reasonable predictions can be made.

Variable costs are easy as they vary in direct proportion to output. Fixed costs are relatively easy as they stay fixed within a range of activity. At some point there might be a step, but that is not usually difficult to build into a budget. However, semi-variable costs need to be split into their fixed and variable parts so that each component can be handled appropriately.

Assume that the fixed part of a semi-variable cost = F, and that the variable part of the semi-variable cost is V per unit. Then:

At a high production level P2:   Total semi-variable cost = F + V P2

At a low production level P1:   Total semi-variable cost = F + V P1

Subtracting:

  (F + VP2) – (F + VP1) = VP2 – VP1

So the increase in units (P2 – P1) has caused the increase in total variable costs

Therefore, the variable cost per unit will be the increase in total costs divided by the increase in the units.

5 The effect of activity levels on unit costs

Total pure variable costs increase in direct proportion to units produced. If output doubles then total variable costs double. However, in simple cases the variable cost per unit will stay constant. Variable cost per unit might change at high levels of production where overtime has to be paid or more expensive supplies of raw material have to be used.

Total pure fixed costs are constant over a given range of production. However, the fixed cost per unit will decrease because the constant fixed costs are being spread over more items. Better use is being made of fixed costs as more units are made.

Look at this example

Variable cost per unit = $5

Fixed costs = $1,000

6 Direct and indirect expenses

There are three types of production expenses:

• Material
  

• Labour
  

• Expenses (often known as overheads)
  

Each can be direct or indirect

• Direct material means material traceable to units of production (for example, tracing wood into furniture)
  

• Indirect material means material that is not traceable into specific units (for example, tracing sand paper in sanding machinery).
  

• Direct labour means labour directly involved in making units.
  

• Indirect labour. Not directly involved with specific units. For example maintenance engineers.
  

• Direct expenses. Rare, but an example would be a royalty that had to be paid for each unit of production.
  

• Indirect expenses. For example, the rent and heating expenses for the factory.
  

Direct expenses are usually also variable costs.

Indirect expenses are usually fixed or stepped-fixed.

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.

Expenses by function

Classifying costs by function means grouping them by the part of the business that causes them. It is the classification used in the statement of profit or loss, and it is how a manager is held responsible for a cost.

• Production costs: everything incurred in making the product up to the point at which it is finished — direct material, direct labour, direct expenses and production overheads such as factory rent, factory power and the production supervisor. These costs go into the cost of inventory.
  

• Administration costs: running the business as a whole — the accounts department, the human resources department, head office rent, audit and legal fees.
  

• Selling and distribution costs: getting the product sold and delivered — advertising, sales staff salaries and commission, warehousing of finished goods, delivery vehicles and carriage outwards.
  

• Finance costs: the cost of the money the business uses — loan interest, overdraft interest and bank charges.
  

The distinction is not cosmetic. Only production costs are absorbed into the cost of a unit and carried in inventory; administration, selling and finance costs are written off in the period in which they arise. Putting a cost in the wrong function therefore changes both the reported inventory value and the reported profit.

Question

Lubricating oil poured over a drilling machine to reduce friction and to keep it cool would be classified as a

A   Direct material cost

B   Indirect material cost

C   Direct expense

D   Indirect expense

The expenses costing system and the expense accounting system

An expense is recorded twice, for two different audiences. The expense accounting system is the financial one: it records what the business owes and what it has paid, supplier by supplier, and produces the expense figures in the statement of profit or loss. The expenses costing system takes those same amounts and asks a different question — which product, job, process or cost centre caused this, and how much of it belongs in the cost of a unit?

The invoice is the point where the two meet. One posting settles the supplier's account and hits the correct expense line for the financial statements; the same posting carries a cost centre or job code that sends the amount into the cost accounts, where it will be allocated, apportioned and absorbed.

In an integrated system there is a single ledger, so the two are automatically consistent and no reconciliation is needed. In an interlocking system the cost ledger is kept separately, and the total expenses in the cost accounts must then be reconciled back to the financial accounts — the difference being items the cost accounts deliberately leave out, such as interest, or treat differently, such as depreciation charged at a notional rate.

7 Capital and revenue expenditure

Capital expenditure is expenditure on acquiring or upgrading non-current assets. Such expenditure will enhance the scope of an operation’s activities. Non-current assets will provide benefits for more than one accounting period.

Examples are: buying additional production machinery, extending the office, upgrading the memory in a computer.

Revenue expenditure is incurred for the purposes of trading or for maintaining the earning capacity of non-current assets.

Examples are: rent, electricity, advertising and the repair and maintenance of machinery.

Revenue expenditure will appear as an expense on the income statement. Sometimes a payment will relate to a single accounting period; sometimes it might span more than one. For example, if rent of $18,000 is paid for the year ended 30 September 2014, then 3/12 of that ($4,500) will relate to the accounting year ended 31/12/2013 and 9/12 ($13,500) will relate to the accounting period ending 31/12/2014.

In contrast, several periods will always benefit from capital expenditure. For example, a machine bought for $72,000 might be expected to last for 6 years. At the end of that period it might be worth nothing, so it would be fair to charge each of the 6 years with $72,000/6 = $12,000 to match, as fairly as possible the income of each year with the cost of the machine.

The $12,000 cost per year is known as depreciation.

There are four approaches to calculating depreciation:

• Straight line
  

• Reducing balance
  

• Machine hours
  

• Product unit
  

All aim to write off (ie gradually expense) the asset over its estimated useful life.

Straight line

This is the easiest approach: the asset is written down from cost to residual value over its estimated useful life.

Reducing balance method

Each year’s depreciation is based on the brought forward written down value

Machine hours method

Each year’s depreciation is based on the hours worked that year divided by the machine’s initial total estimated working hours

Product unit method

Each year’s depreciation is based on units produced in that year divided by estimated total units the machine could make over its life.