Cost classification

Direct cost
• Direct costs (Prime costs) of a product or service are those items that are
easily traced (identified) to the product or service.
• Direct labour, direct material and direct expenses are direct costs.

• Indirect cost (Overheads) includes indirect labor and indirect material

costs as well as other types of general manufacturing costs that cannot be
directly traced, or are not worth tracing, to units being produced.
Examples include the cost of the purchasing department; factory property
taxes, maintenance, depreciation, insurance, and security guards; and
some engineering services. Indirect cost is another term for overhead
Direct costs
• Direct Material (DM)
• Direct material is all material becoming part of the product (unless used in
negligible amounts and/or having negligible cost).
• The costs included in the direct material cost are all of the costs associated with
acquiring it – the item itself, shipping, insurance and taxes, among others.
Common examples of direct materials are plastic and components.
• Direct labour (IDM)
• These are the costs of labor that can be directly traced to the production of a unit.
• Direct expenses (DE)
• Direct expenses are any expenses which are incurred on a specific product other
than direct material cost and direct wages
Indirect costs
• Indirect material (IM)
• Indirect materials are materials that are not the main components of the finished
goods.

• Indirect labour (IL)

• Indirect labour is part of the overall production process but doesn’t come into direct
contact with the product.

• Indirect expenses (IE)

• Indirect expenses are general expenses which are not directly related to the product
or service
• The distinction between overhead and direct costs can be difficult to
determine at times. For example, should the $0.03 worth of glue used
in each bookcase containing $9 of wood and $30 of direct labor be
treated as a direct or an indirect cost?
• To apply a cost–benefit criterion, we must decide what decisions will
be affected if the glue is classified as direct versus indirect.
• In most cases, small dollar amounts of direct costs are treated as
overhead because the costs of tracking and reporting them separately
exceed the benefits.
Points to remember
• A direct cost is a cost that can be traced in full to the product, service or department that is
being costed
• Direct costs are made up of direct materials, direct labour and direct expenses
• Total direct costs are known as prime cost
• An indirect cost is a cost which cannot be traced directly to the product, service or
department
• Indirect costs are also known as overheads
• Examples are indirect materials, indirect labour, indirect expenses, administration
overhead, selling/distribution overhead
• Costs can also be classified according to their function
• Examples will be production costs, administration costs, marketing or selling and
distribution costs
• Product costs consist of direct material, direct labour, direct expenses
and production overhead.
• The term conversion costs refers to direct labour, direct expense and
factory overhead.
• Period costs consist of selling, general, and administrative costs.
Points to remember
• There are also other ways in which costs can be classified
• These might include discretionary costs, avoidable/unavoidable costs,
controllable/non-controllable costs
• Product costs are costs identified with a finished product and are part of
the inventory value
• When the goods are sold these costs become expenses (cost of goods
sold)
• Non-product or period costs are costs that are deducted as expenses
during a period
• These costs are never part of the inventory value
Functional costs
• Classification by function involves classifying costs as
• production/manufacturing costs,
• administration costs
• marketing/selling and distribution costs.
Group the costs that are listed below as
DM, IDM, DL, IDL, DE, IDE
• Telephone bill of office.

• A person who serve lunch in the sales department

• Rent of machine hired to finish a particular job.

• Machine operators in cutting department.

Group the costs that are listed below as
DM, IDM, DL, IDL, DE, IDE
• Pages used in the printing of books in a publishing house.

• A store assistant in a factory store.

• Plasterers in a construction company

• Production supervisor who is supervising multiple jobs

• Fork lift driver who handles the raw material.

• Assembly worker in a company manufacturing televisions.

Group the costs that are listed below as
DM, IDM, DL, IDL, DE, IDE
• Maintenance cost of delivery vehicle.

• Chief accountant

• Painting material used in advertising slogans on delivery vans.

• Advertising cost on television

• Maintenance contract for office photocopying machine.

Group the costs that are listed below as
DM, IDM, DL, IDL, DE, IDE (HW)
• Leather in the manufacturing of purse.

• Interest paid for the loan taken to buy a new delivery van.

• Rent of factory.

• Royalty paid on number of units of a particular product produced.

• Road licenses for delivery vehicles

Group the costs that are listed below as
DM, IDM, DL, IDL, DE, IDE (HW)
• Lubricants used in factory machinery

• Maintenance cost of factory plant and equipment

• Chemicals used to test raw material

• Secretary to the Finance Director

• Security guard in raw material warehouse

• Fees to advertising agency

 £

Direct expense 15,000

Direct material cost 23,000
Direct labour cost 19,000
Indirect material (factory) 4,100
Maintenance cost of building (70% production, 15% admin, balance sales dept) 7,500
Office salaries 2,000
Salesmen commission 1,000
Rent of factory 1,000
Insurance expense (60% production, 25% admin, balance sales dept) 8,000
Salary of the secretary to the finance director 3,000
Electricity expense (75% production, 15% admin, balance sales dept) 15,000
Maintenance cost of delivery van 1,500
Repairs of machinery 2,000
• Required:
• Production overheads/ manufacturing overheads/ factory overheads
• Administration overheads
• Sales and marketing overheads
• Prime cost
• Production cost / manufacturing cost / factory cost
• Total cost
• Conversion cost
 Production OHds Admin OHds Sales and
marketing OHds
Indirect material (factory) 4100
Maintenance cost of building 5250 1125 1125
Office salaries 2000
Salesmen commission 1000
Rent of factory 1000
Insurance expense 4800 2000 1200
Salary of the secretary to the finance director 3000
Electricity expense 11250 2250 1500
Maintenance cost of delivery van 1500
Repairs of machinery 2000
Total 28400 10375 6325
Multiple Choice Questions
1.
• A company manufactures dog leads. It buys leather, thread and metal
chip to make them, employs labour to operate stitching machines and
assembles the finished leads and has various running costs for the
rented factory space it uses. Which of the following activities would
be classified as indirect labour costs?
• Dog lead chip
• Factory rent
• Wages for machine operator
• Wages for factory manager
2.
• A pharmaceutical company has employed two lawyers to handle legal
matters of company.
• How would the cost of lawyers will be classified as?
• direct labour C. indirect labour
• variable production overheads D. direct expense
3.
• Which one of the following group of workers would be classified as
indirect labour?
• (i) Machinists in a company manufacturing clothes.
• (ii) Carpenter manufacturing chairs in a furniture company.
• (iii) Maintenance workers in a hat factory.
• A (i) only B (ii) only
• C (i) and (ii) D (iii) only
4.
• A company employs three chefs in factory canteen. How would it will
be classified as
• Direct labour C. Indirect labour
• Direct expense D. Indirect expense
5.
• A company makes one delivery per week to all of its customers.
• The cost of these deliveries will be
• prime cost
• selling and distribution cost
• production overheads
• direct production expense
6.
• The following relate to a factory.
• 1 carriage inward cost of material
• 2 depreciation of factory machinery
• 3 machine operators’ wages
• 4 insurance of machinery
• 5 royalties on production
• Which items make up production overhead?
• A 1 and 2B 2 and 3
• C 2 and 4 D 4 and 5
7.
• What is a direct expense for a printing business?
• A Rent of printing machinery used in a particular job
• B paper used in the printing process
• C rent and rates of the factory premises
• D the capital cost of printing machinery
8.
• Which one of the following would be treated as indirect cost?
• wood used to make chair
• metal used for the manufacturing of chair
• fabric to cover seat of chair
• Staples to fix the fabric to the seats of chair
9.
• Which of the following will be treated as a direct labour?
• personnel manager in a company servicing cars
• Bricklayer in a construction company
• General manager in a chocolate company
• Maintenance manager in company producing camera.
10.
• Which of the following would be a direct expense?
• material used in production
• cost of rights to manufacture a particular products
• electricity
• rent of factory
11.
• Which one of the following is included in production overheads?
• marketing manager’s salary
• interest paid on loan taken
• salary of accountant
• repairs made to the factory machines
12.
• Which one of the following would be an example of indirect labour?
• Machine operators in a company manufacturing washing machines.
• A store assistant in a factory store
• Plumber in a construction company
• Lawyers in a law consultancy firm
Cost behavior
Cost behaviour (according to activity level)
• Fixed costs

• Variable costs

• Semi variable cost

• Step cost
Fixed costs
• A fixed cost is a 'cost incurred for an accounting period, that, within
relevant range, tends to be unaffected by fluctuations in the levels of
activity.

• Fixed cost in total remain same

• Fixed cost per unit changes* with activity level with

Fixed costs Total Cost
Units Total Cost Unit Cost 35000

30000

25000
1000 $30000 $30
20000 Total Cost

15000
1500 $30000 $20
10000

5000
2000 $30000 $15
0
500 1000 1500 2000 2500 3000 3500 4000 4500 5000 5500

2500 $30000 $12 Unit Cost

35

3000 $30000 $10 30

25

4000 $30000 $7.5 20 Unit Cost

15

5000 $30000 $6 10

0
500 1000 1500 2000 2500 3000 3500 4000 4500 5000 5500
Fixed cost
• Fixed cost in total Fixed cost per unit
Variable cost
• A variable cost is a cost which in total vary directly with the activity
level (with in relevant range).

• Variable cost per unit remain same.

• Variable cost in total changes with activity level

Variable cost
Total Cost
Units Total Cost Unit Cost 25000

20000
1000 $4000 $4
15000 Total Cost
1500 $6000 $4 10000

5000
2000 $8000 $4
0
500 1000 1500 2000 2500 3000 3500 4000 4500 5000 5500
2500 $10000 $4
Unit Cost
3000 $12000 $4 4.5
4
3.5
4000 $16000 $4 3
2.5 Unit Cost

2
5000 $20000 $4 1.5
1
0.5
0
500 1000 1500 2000 2500 3000 3500 4000 4500 5000 5500
Variable cost
• Variable cost per unit Variable in total
Semi variable cost
• A semi-variable cost is a 'cost containing both fixed and variable
components and thus partly affected by a change in the level of
activity'.

• Semi variable cost in total increases with increase activity level

• Semi variable cost per unit decreases with increase activity level
Semi variable cost Total Cost
Units Total Cost Unit Cost 25000

20000
1000 $7000 $7
15000 Total Cost

1500 $9000 $6 10000

5000
2000 $11000 $5.5
0
500 1000 1500 2000 2500 3000 3500 4000 4500 5000 5500

2500 $13000 $5.2 Unit Cost

8

3000 $15000 $5 7
6
5
4000 $19000 $4.75 4
Unit Cost

3
5000 $23000 $4.6 2
1
0
500 1000 1500 2000 2500 3000 3500 4000 4500 5000 5500
Semi variable cost
• Semi variable cost in total Semi variable cost per unit
Step cost
• Step costs are expenses that are constant for a given level of activity
but increases or decreases once threshold is crossed.

• Step fixed cost

• Step variable costs

Step fixed cost
Units Total Cost Unit Cost Total Cost
35000

30000
1000 $15000 $15
25000

20000 Total Cost

1500 $15000 $10
15000

10000
2000 $15000 $7.5 5000

0
2500 $15000 $6 500 1000 1500 2000 2500 3000 3500 4000 4500 5000 5500

Unit Cost
2501 $30000 $12 16
14
12
3000 $30000 $10 10
Unit Cost
8
4000 $30000 $7.5 6
4
2
5000 $30000 $6
0
500 1000 1500 2000 2500 3000 3500 4000 4500 5000 5500
Step variable costs (Descending)
Units Total Cost Unit Cost Total Cost
16000
14000
1000 $4000 $4
12000
10000
Total Cost
1500 $6000 $4 8000
6000

2000 $8000 $4 4000

2000
0
2500 $10000 $4 500 1000 1500 2000 2500 3000 3500 4000 4500 5000 5500

Unit Cost
2501 $7503 $3 4.5
4
3000 $9000 $3 3.5
3
2.5 Unit Cost
4000 $12000 $3 2
1.5

5000 $15000 $3 1
0.5
0
500 1000 1500 2000 2500 3000 3500 4000 4500 5000 5500
Step variable costs (Ascending)
Units Total Cost Unit Cost Total Cost
30000

1000 $4000 $4 25000

20000
Total Cost
1500 $6000 $4 15000

10000
2000 $8000 $4 5000

0
2500 $10000 $4 500 1000 1500 2000 2500 3000 3500 4000 4500 5000 5500

Unit Cost
2501 $12505 $5 6

3000 $15000 $5 4
Unit Cost
3
4000 $20000 $5
2

1
5000 $25000 $5
0
500 1000 1500 2000 2500 3000 3500 4000 4500 5000 5500
Identify behavior of cost
• Expense at Expense at Expense at Expense at
• 500 units1000 units 2000 units 2,500 units
• £ £ ££
• Expense A 2,0002,000 2,000 2,000
• Expense B 8,0008,000 9,000 9,000
• Expense C 625 1,250 2,500 3,125
• Expense D 400 800 1,600 2,000
• Expense E 2,5005,000 12,000 15,000
• Expense F 11,500 16,500 26,500 31,500
• Required: -
• Classify above costs according to their behaviors that either they are fixed, variable or semi variable.
• A __________________.B __________________.
• C __________________. D __________________.
• E __________________.
1.
• The following shows the cost per unit of an item of expense at different levels
of activity:
• Activity (units) Cost per unit (£)
• 1 10,000
• 50 200
• 100 120
• 150 80
• What is the correct behavioural classification for the expense item?
• A Fixed cost B Semi-variable cost
• C Stepped-fixed cost D Variable cost
2.
• Which of the following would be classified as a fixed cost in the
operation of a motor vehicle?
• A Oil change every 10,000 kilometres
• B Petrol
• C Insurance
• D Tyre replacement
3.

• Which cost follows this pattern?

• A administrative salaries B commission on sales
• C Insurance of factory D office rent
4.
• If production level increases then which of the following statements
are consistent with it?
• total fixed cost will remain same [true / false]
• fixed cost per unit increases [true / false]
• total variable cost will also increase [true / false]
• variable cost per unit will remain same [true / false]
 5. (option C)
The chart below shows the behaviour of a total cost as the volume of output changes:

What sort of cost is being illustrated?

A Fixed cost B Semi-variable cost
C Stepped-fixed cost D Variable cost
6.
:Variable costs are deemed to •
.A. be constant per unit of output within relevant range •
B. vary per unit of output as production volumes changes •
C. be constant in total when production volumes changes •
.D. Vary, in total, from period to period when production is constant •
7.
• Fixed cost per unit increases when
• Production volume decreases
• Production volume increases
• Variable cost per unit decreases
• Variable cost per unit increases
8.
• A manufacturing company has four types of cost (identified as T1, T2 , T3 and T4).
• The total cost for each type at two different production levels is:
• Total cost for Total cost for
• Cost type 125 units 180 units
• £ £
• T1 1,000 1,260
• T2 1,750 2,520
• T3 2,475 2,826
• T4 3,225 4,644
• Which two cost types would be classified as being variable cost?
• A T1 and T3 B T1 and T4 C T2 and T3 D T2 and T4
9. (option D)
The following charts demonstrate various costs in relation to activity:

Which of the above charts represents unit fixed cost?

A Chart 1 B Chart 2 C Chart 3 D Chart 4
10.
• What is meant by classification of costs by behavior?
• classification of costs as materials, labour or expenses
• classification of costs according to how they change according to
activity levels
• classification of costs as direct or indirect
• classification of costs according to their function within the business
 11. (option A)

The total cost of making product X is shown on the graph.

What is the variable cost per unit?

A $0.50 B $0.83 C $1.00 D $1.50
12.
• The following shows the cost per unit of an item of expense at different levels
of activity:
• Activity (units) Cost per unit (£)
• 1 10,000
• 50 200
• 100 120
• 150 80
• What is the correct behavioural classification for the expense item?
• A Fixed cost B Semi-variable cost
• C Stepped-fixed cost D Variable cost
• Bowen plc provides a call centre service to a number of utility and financial services
customers. It has four separate call centre buildings plus a head office. Many of the
telephone staff are students and casual employees who are paid weekly, on an hourly
basis. Their contracts state that Bowen plc has no duty to provide them with work. The
telephone staff are managed by permanent supervisors and managers. Although there
are no direct material costs as such, the company incurs telephone charges which are
directly related to the number of calls it handles. There is a central computerised
exchange which routes the calls received.
• Which of the following costs would you classify as fixed costs?
• (1) Lease charges for the buildings
• (2) Telephone staff costs
• (3) Supervisor and management costs
• (4) Telephone charges
• (5) Computer exchange lease costs
• A (1), (3) and (4) B (2) and (4)
• C (1), (3) and (5) D All of them
High low method- Simple
• Production units and total costs relating to the last three periods
have been:
• Period 1 Period 2 Period 3
• Production (units) 129,440 117,620 126,310
• Total costs (£) 198,968 187,739 195,376
• Using the high-low method, what is the estimated variable cost per
unit of production? ____0.95____.
High low method- Simple
• A hospital’s records show that the cost of carrying out health checks in the last
four accounting periods have been as follows:
• Period Number of patients seen Total cost
• $
• 1 650 17,125
• 2 940 17,800
• 3 1,260 18,650
• 4 1,150 18,360
• Using the high-low method and ignoring inflation, the estimated cost of carrying
out health checks on 850 patients in period 6 is ______17,125________.
High low method- with step fixed costs
• An organisation has the following total costs at two activity levels:
• Activity level (units) 15,000 24,000
• Total costs £380,000 £470,000
• Variable cost per unit is constant in this activity range but there is a
step up of £18,000 in the total fixed costs when the activity exceeds
20,000 units.
• What are the total costs at an activity level of 18,000 units?
• A £404,000 B £410,000
• C £422,000 D £428,000
High low method- with step fixed costs
• An organisation has the following total costs at two activity levels:
• Activity level (units) 16,000 22,000
• Total costs ($) 135,000 170,000
• Variable cost per unit is constant within this range of activity but there
is a step up of $5,000 in the total fixed costs when the activity exceeds
17,500 units.
• What is the total cost at an activity of 20,000 units?
_______160,000______.
High low method- with step variable costs
• The following observations have been made of total overhead cost.
• Output level (units) 5,000 10,000
• Total overhead cost ($) 14,000 27,000
• The variable element of total overhead cost is known to increase by
$1 per unit at output levels above 7,000 units.
• What is the variable element of total overhead cost at an output
level of 5,000 units?
• A $2.00 per unit B $2.60 per unit
• C $3.20 per unit D $3.60 per unit