Introduction

Cost Classification
This chapter covers:

• Cost Accounting

• Cost

• Cost Unit

• Cost Center

• Cost Object

• Cost Classification

• Analysis of Cost Behaviours

• High Low Method

 Cost Accounting
“Cost accounting involves applying a set of principles, method and

techniques to determine and analyze costs within the separate units of

a business”.

This involves:

The establishment of budgets, standards costs and actual costs of

operations, processes, activities or products and the analysis of

variances, profitability or the social use of funds.

Cost:
“All expenses carryout to make one unit of a product is called a cost of that

unit”. For example, A marker is of $5 from a shop. Here $5 is the cost for the

customer.

Cost Per Unit:

“Cost of one unit of product is called cost per unit”.
Cost Unit:
“A unit of product or service to which cost is attached”. For example, a

notebook is of $10. Here notebook is cost unit.

Examples:

Cost Unit Costs.

 Brick $5 per unit

 Shirt $60 per unit

 Pack of 10 markers $100 per pack

Cost Center:
“A cost center is a production or service location, function, activity or item of

equipment for which costs are accumulated and analyzed”.

Examples:

• Production cost

• Administration cost

• Marketing cost, etc.

Cost is allocate to cost centers and then analyzed and charges to cost units.
Cost Object:
“A cost object is any activity or item for which a separate measurement of cost is

desired”. It could be a cost unit or cost center.

Cost Classification:
Cost classification is making logical groups of cost to help in analysis and control.

Here we have some classifications:

Cost Classification

1. By Nature

2. By Function

3. Product and Period cost

4. Controllable and Uncontrollable cost

5. By Behaviour
1. By Nature:
Nature wise there are three elements of cost:

• Material costs

• Labour costs

• Expenses

We further split into direct and indirect costs.

1. By Nature:
Direct cost: “A cost that can be directly identifiable with a specific

cost unit or cost center is called direct costs”.

Examples: Material used in production, Worker paid for making a

product, etc.
1. By Nature:
Indirect costs: “A cost that cannot be directly identifiable with a

specific cost unit or cost center is called indirect cost”. It is jointly

incurred and must be shared out on an equitable basis.

Examples: Salaries, Rent of the building, etc.

Material:
• Directly and easily associated/ related with a product.

• Traceable to a specific cost unit or cost center

• Form major part of the product.

Examples: For a chair Direct Indirect

Wood Nail
Iron Glue
Foam Paint
Fabric Polish
Spring
Labour:
• Directly and easily associated/ related with a product.

• Traceable to a specific cost unit or cost center.

• Directly involved in making a product.

Examples:

Direct Indirect

Machine Operator’s wage Supervisor’s salaries.

Accountants in firm, etc. General Manager’s salary.

Expense:
• Directly and easily associated/ related with a product.

• Traceable with a specific cost unit or cost center.

• Incurred to bring raw material from point of purchase to company premises.

Examples:

Direct Indirect

Transportation costs. Bills

Royalty Rent, etc.

 All Indirect
Sum of all costs are
direct cost is
called Prime
Cost accumulated
under one
cost. head,
Direct costs Indirect costs Overheads.
Direct Material Indirect Material
Direct Labour Indirect Labour
Direct Expense Indirect Expense

Overheads
Production Overheads Non-Production Overheads
Examples: Examples:
Machine oil Sales Manager’s salary
Glue Auditor’s Fee
Supervisors Salary, etc. Advertisement, etc.
Formulae:
 Prime Cost = Direct Material + Direct Labour + Direct Expense.

 Production Cost = Prime cost + Production Overheads.

 Total Cost = Production Cost + Non-Production Overheads.

 Conversion Cost = Direct Labour + Direct Expense + Production

Overheads.
2. By Function:
Function: “All activities and operations of the company are called

functions”. In this classification, we classify cost as per activity,

operation, product, individual segment, division, department, etc.

2. By Function:
Examples:

• Production cost: (Materials, Labour and expenses incurred, etc)

• Selling cost: (Advertisement, Discounts to customers, sales staff salaries,

wages & commission, Showroom rents & Bills, after sales services, etc)

• Distribution cost: (Fuel, drivers wages, Insurance, Vehicle maintenance,

secondary packing, Road Tax, Chalans, License fee, parking, etc)

• Administration Costs: (Office expenses, Accounts Dept expenses, Bills,

Salaries, Audit fee, Canteen Expenses, Legal fee, stationary, etc)

2. By Function:
Uses:

• Cost control

• Stock Valuation

• Financial Statements, etc.

Example 1: A company has 2 departments- one produces cakes and the other
produced tablecloths. The following expenses have been incurred in this month:

a. 1 tonne chocolate chips

b. Hours of cake decorator’s time
c. Rent of the factory
d. 300 meters of purple cotton
e. 2 sewing machine operators working 40 hours each
f. Cardboard cake boxes
g. Electricity bill for the whole factory

Classify the cost as Direct or Indirect Cost.

Example 2: Home Assignment
Example 11: The following data is given of a wooden furniture manufacturer:
$
Wood 4,000
Glue used in manufacturing 330
Leather skin for chairs 5,000
Designing costs (specific customer’s request) 1,200
Machine hire charges 20,000
Other factory overheads 3,200
Selling overheads 2,400
Admin overheads 1,500

Find the prime cost, the production cost and the total cost.
Example 9 &10: Home Assignments
3. Product & Period Costs:
Product Costs: “Cost of making or buying an item of inventory is

called product cost”.

Examples:

• Materials

• Labour

• Other expenses.
3. Product & Period Costs:
Period Costs: “A cost that does not change, which remains fix. It

relates with the passage of time rather than the output of

individual product or service is called period cost”.

Examples:

•Salaries

•Rent of building, etc.

3. Product & Period Costs:
Uses:

• Cost control

• Inventory valuation

• Absorption& Marginal costing, etc.

4. Controllable & Uncontrollable Costs:

Normally the costs incur within the organisation are controllable

whereas the costs charged from outside the organisation are

generally considered as uncontrollable costs for management.

4. Controllable & Uncontrollable Costs:
Examples:

Controllable:

• Material used for production

• Labour paid to production workers

Uncontrollable:

• Share in the rental cost of the building

• Share in the organisation’s bills.

Activity Level: “The amount of work done or the volume of

production is called activity level”.

Examples:

• 10,000 shirts produced.

• 20,000 labour hours worked.

• 5,000 machine hours worked, etc.

5. By Behaviour:
Some costs varies with the change in activity level and some of them remain

unchanged. In the cost behavior we will see the effect on costs with the

change in activity level. By behaviour we split it in four categories.

 Variable cost

 Fixed cost

 Stepped fixed cost

 Semi-variable/ Semi-fixed/ Mixed/ Total cost

Variable Cost:
“A cost that varies in total with the change in activity level but

remains constant in per unit is called variable costs”.

Examples:

• Material purchased.

• Worker paid per unit.

• Royalty paid per unit.

Variable Cost:
Charts:

In Total: In per unit:

$ $

0 Activity level 0 Activity level

Fixed Costs:
“A cost that remains fix in total with the change in activity level

(within a specific range) but changes in per unit is called fixed

cost”. Fixed cost does not depend on the activity level, it relates

with the passage of time

Fixed Costs:
Example:
• Rent
• Salaries
• Straight line depreciation, etc.

Charts:
In Total: In per unit:

$ $

0 Activity level 0 Activity level

Stepped Fixed Cost:
“A cost that fix for a certain level of activity, will increase and will

then remain fix again until another level of production is called

stepped fixed cost”.

Examples:

• Store rent

• Supervisor’s salaries

• Tyre replacement
Stepped Fixed Cost:
Charts:
In total In per unit

$ $

0 Activity level 0 Activity level

Semi-Variable Cost:
“A cost which has both elements fixed and variable is called semi-

variable cost”.

Examples:

• Bills

• Salesmen salaries plus commission

• Cost of running a car (Fixed: Road tax, insurance

Variable: Petrol, oil, repairs, etc.)

Semi-Variable Cost:
Charts:
In total In per unit

$ $

0 Activity level 0 Activity level

Example 3: A company has established the following information
for the costs and revenues at an activity level of 100 units:

Sales revenue $15,000

Direct Materials ($6,500)
Direct labour ($3,000)
Production overheads ($500)
Selling overheads ($1,000)
Profit/ (Loss) $4,000

50% of the selling costs and 20% of the production overheads are
fixed over all levels of activity.
What will be the total profit at an activity level of 200 units?
Solution:
HIGH-LOW METHOD
This a method used to determine fixed and variable elements

from mixed cost. It relies on the assumption that mixed costs are

linear.

APPLYING HIGH LOW METHOD

This method consists of selecting the periods of highest and lowest

activity levels and comparing the changes in costs that result from

two levels.
HIGH-LOW METHOD
Application of the method requires the following steps:

1. Identify two different levels of activities: the highest and the lowest level of

activities and the corresponding costs.

2. Find the variable cost per unit by

Total costs at highest activity level – Total costs at lowest activity level

Units at highest activity level – Units at lowest activity level

HIGH-LOW METHOD
3. Compare the variable cost with the total costs at either the

lowest activity level or highest activity level to compute the total

fixed cost.

Total costs at highest activity level – (Total units at highest level x

Variable cost per unit)

4. Form the equation

Total Cost = Total Fixed Cost + Total Variable cost

Total Cost = Total Fixed Cost + (Variable cost per unit x Number of

Units)

Y = a + bx
 Y = a + bx

Where,

Y is the dependent variable i.e. the total cost for the period at

activity level of X

X is the independent variable, i.e. the activity level

a is the constant, i.e. the total fixed cost for the period

b is also a constant, i.e. the variable cost per unit of activity

ADVANTAGES AND DISADVANTAGES OF HIGH LOW

METHOD

Advantages

• It is easy to use and understandable

Disadvantages

• It relies on historical data assuming that level of activity is the only

factor affecting cost and historical cost can reliably predict

future cost.

• It uses only two level of activity highest and lowest, which means

that the result may be distorted because of random variation of

these values.
Example 4: The following data was collected for the period of

January to March last year:

Months Sales Units Total Cost($)

January 8,500 46,000
February 9,100 50,000
March 10,200 54,925

Estimate the total costs when output is 9,500 units using high – low

method.
Solution:
Example: A cost is said to be semi-variable cost. What will happen to
cost per unit, if activity level increase by 10%?
a. It will increase but more than 10%
b. It will increase but less than 10%
c. It will decrease but more than 10%
d. It will decrease but less than 10%
Example: A cost is said to be Fixed cost. What will happen to cost per
unit, if activity level increase by 50%?
a. It will increase by 33.33%
b. It will decrease by 33.33%
c. It will increase by 100%
d. It will decrease by 100%
e. It will remain constant
Practice Questions: Home Assignment