ACF 355/ACC507COST ACCOUNTING

AKUA PEPRAH –YEBOAH (MRS)

Sept 2017

LECTURE 1COST CLASSIFICATION

INTRODUCTIONCost classification is the arrangement of cost items into logical groups. It is an essential part of the cost

accounting system as how a cost item is classified determines how it will be treated.

The classification of cost as either direct or indirect, for example, is essential in the costing method used by

an organization to determine the cost of a unit, product or service.

The fixed and variable cost classifications, on the other hand are important in absorption and marginal

costing, cost behavior and cost-volume-profit analysis. You will meet all of these topics as we progress

though the study.

This lesson therefore acts as a foundation stone for a number of other topics and hence, an understanding

of the concepts covered in it is vital before we move on.

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LEARNING OBJECTIVES

After going through this lecture you should be able to

Explain and illustrate the various classifications of cost By element

By nature

By function

By behavior

Explain and illustrate the concept of cost objects, cost units and cost centers.

Distinguish between cost, profit, investment and revenue centers

Describe the differing needs for information of cost, profit, investment andrevenue center managers

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COST CLASSIFICATION: ELEMENTThe total cost of making a product or providing a service consists of the following elements:

Cost of materials:

This is the cost of commodities or ingredients used in a manufacturing concern inthe production of goods. It excludes all fixed assets.

Cost of the wages and salaries (labour costs):

Labour refers to the human effort which is applied to produce or manufacturegoods and services. It comprises all staff costs of employees on the organization’spayroll.

Cost of other expenses:

Expenses are costs incurred by businesses other than labour and material cost.This includes all bought in services, for example, rent, telephone, subcontractors andcosts such as the depreciation of equipment.

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COST CLASSIFICATION: NATURE

The nature of cost refers to their relationship with cost objects andunits.

i. A direct cost is a cost that can be traced in full to the product,service or department that is being costed.

ii. An indirect cost (or overhead) is a cost that is incurred in the courseof making a product, providing a service or running a department, butwhich cannot be traced directly and in full to the product, service ordepartment that is being costed.

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Further, costs can be described by combining the elements and their nature:

DIRECT COSTS

i. Direct material costs are the costs of material that are known to have been used in making and

selling a product (or even providing a service).

ii. Direct labour costs are the specific costs of the workforce used to make a product or provide a

service. Direct labour costs are established by measuring the time taken for a job, or the time taken in

‘direct production work’.

iii. Other direct expenses are those expenses that have been incurred in full as direct consequence of

making a product, or providing a service or running a department.

INDIRECT COST

i. Indirect materials: consumables, cleaning materials, stationery, etc.ii. Indirect labour: salaries and wages of administrative, purchasing, engineering, auxiliary etc. staff.iii. Indirect expenses: rent, rates, lighting, heating etc.

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DIRECT MATERIAL

Direct material is all material that becomes part of a product (unless used in negligible

amounts and/or having negligible cost).

Direct material costs are charged to the product as part of prime cost. Examples of

direct material are as follows.

(a) Component parts specially purchased for a particular job, order or process.

(b) Part-finished work which is transformed from department 1 to department 2

becomes finished work of department 1 and a direct material cost to department 2.

(c) Primary packing materials like cartons and boxes.

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DIRECT LABOUR

Direct wages are all wages paid for labour (either as basic hours or as overtime)

expended on work on the product itself. Direct wages cost are charged to the product

as part of the prime cost.

Examples of groups of labour receiving payment as direct wages are as follows.

(a) Workers engaged in altering the condition or composition of a product.

(b) Inspectors, analysts and testers specifically required for such production.

(c) Foremen, shop clerks and anyone else whose wages are specifically identified.

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DIRECT EXPENSES

Direct expenses are any expenses which are incurred on a specific

product other than direct material cost or direct wages.

Direct expenses are charged to the product as part of the prime cost.

Examples of direct expenses are as follows.

(a) The hire of tools or equipment for a particular job.

(b) Maintenance cost of tools, fixtures and so on.

Direct expenses are also referred to as chargeable expenses.

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ANALYSIS OF TOTAL COST

Materials = Direct materials + Indirect materials

+ + +

Labour = Direct labour + Indirect labour

+ + +

Expenses = Direct expenses + Indirect Expenses

TOTAL COST = PRIME COST + OVERHEADS

COST CLASSIFICATION: FUNCTION

Classification by function involves classifying costs as production/manufacturing costs,administration costs or marketing/selling and distribution costs.

In a ‘traditional’ costing system for a manufacturing organization, costs are classified asfollows.

i. Production costs are the costs which are incurred by the sequence of operations beginning withthe supply of raw materials and ending with the completion of the product ready for warehousingas a finished goods item. Packaging costs are production costs where they relate to ‘primary’packing (boxes, wrappers and so on).

ii. Administration costs are the costs of managing an organization, that is, planning and controlling itsoperations, but only in so far as such administration costs are not related to the production, sales,distribution or research and development functions.

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iii. Selling costs, sometimes known as marketing costs, are the cost of creating

demand for products and securing firm orders from customers.

iv. Distribution costs are the costs of the sequence of operations with the receipt of

finished goods from the production department and making them ready for dispatch and

ending with the reconditioning for reuse of empty containers.

v. Research costs are the costs of searching for a new or improved products,

whereas development costs are the costs incurred between the decision to produce a

new or improved product and the commencement of full manufacture of the product.

vi. Financing costs are costs incurred to finance the business such as loan interest.

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FULL COST OF SALES

A commonly found build-up of costs is shown in the cost card below:

GHS

Production costs

Direct materials A

Direct wages B

Direct expenses C .

Prime cost A+B+C

Production overheads D _

Full factory costs A+B+C+D

Administration costs E

Selling and distribution costs F _

Full cost of sales A+B+C+D+E+F

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The element of cost can be represented by a diagram below

COST CLASSIFICATION: BEHAVIOUR

A different way of analyzing and classifying costs is according to how theybehave or vary with output, cost or sales i.e. into fixed costs and variablecosts.

A fixed cost is a cost which is incurred for a particular period of time andwhich, within certain activity levels, is unaffected by changes in the level ofactivity.

A variable cost is a cost which tends to vary with the level of activity.

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OTHER COST CLASSIFICATIONSSunk cost is a cost that has already been incurred in the past and hence it is not relevant fordecision making as even if the decision is stopped, the cost can still not be avoided

Conversion cost is the sum of direct labour, direct expenses and manufacturing overheads. Itrepresents the cost of converting raw materials into finished products.

Avoidable costs are specific costs of an activity or business which would be avoided if the activityor business did not exist.

Unavoidable costs are costs which would be incurred whether or not an activity or sector existed.

A controllable cost is a cost which can be influenced by management decisions and actions.

An uncontrollable cost is any cost that cannot be affected by management within a given time span.

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An opportunity cost is a cost that measures the opportunity that is lost or sacrificed when the choice of one course of action requires that an alternative course of action is given up

Incremental costs, which are also called differential costs, are the difference between the costs of each alternative action that is being considered.

Marginal cost on the other hand refers to the additional costs an entity incurs as a result of increasing units of production by one

Discretionary cost are costs which are likely to arise from decisions made during the budgeting process. They are likely to be fixed amounts of money over fixed periods of time. Examples of discretionary costs are advertising, training, research and development.

Unit cost can be simply explained as the arithmetic average cost of producing only one unit of goods or service

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RESPONSIBILITY CENTRES

A responsibility center is a department or organizational

function whose performance is the direct responsibility of a

specific manager.

Cost centers, revenue centers, profit centers and investment

centers are also known as responsibility centers.

COST CENTRES

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When costs are incurred, they are generally allocated to a cost center.

Cost center may include the following.

A department

A machine, or group of machines

A project (e.g. the installation of a new computer system)

Overhead costs e.g. rent, rates, electricity (which may then be allocated to

departments or projects).

Cost centers are an essential ‘building block’ of a costing system. They are the starting

point for the following.

(a) The classification of actual costs incurred.

(b) The preparation of budget of plan costs.

(c) The comparison of actual costs and budgeted costs (management control).

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COST OBJECTS

A cost object is any activity of which a separate measurement of cost is

desired.

If the users of management information wish to know the cost of

‘something’, this ‘something’ is called a cost object. Examples includes the

following.

The cost of a product

The cost of a service

The cost of operating a department

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COST UNITS

A cost unit is a unit of product or service to which costs can be related. The cost unit is

the basic control unit for costing purposes.

Once costs have been traced to cost centers, they can be further analyzed in order to

establish a cost per cost unit. Alternatively, some items of cost may be charged directly

to a cost unit, for example, direct materials and direct labour costs.

Examples of cost units includes the following.

Patient episode (in a hospital)

Barrel (in the brewing industry)

Room (in a hotel)

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REVENUE CENTRES

Revenue centers are similar to cost centers but are accountable to

revenue only. Revenue center managers should normally have control

over how revenue are raised.

A revenue center manager is not accountable for costs. He will be

aiming purely to maximize sales revenue. He will want information on

markets and new products and he will look closely at pricing and the

sales performance of competitors – in addition to monitoring revenue

figures.

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PROFIT CENTRES

Profit centers are similar to cost centers but are accountable for costs and revenues. We

have seen that a cost center is where costs are collected. Some organizations, however,

work on a profit center basis.

Profit center managers should normally have control over how revenue is raised and how

costs are incurred. Often, several cost centers will comprise one profit center. The profit

center manager will be able to make decisions about both purchasing and selling and will be

expected to do both as profitably as possible.

A profit center manager will want information regarding both revenues and costs. He will

be judged on the profit margin achieved by his division. In practice, it may be that there are

fixed costs which he cannot control, so he should be judged on contribution, which is

revenue less variable costs. In this case, he will want information about which products yield

the highest contribution.

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INVESTMENT CENTRES

An investment center is a profit center with additional responsibilities for capital

investment and possibly for financing, and whose performance is measured by its return

on investments.

An investment center manager will take the same decisions as a profit center manager

but he has also additional responsibility for investment. So he will be judged additionally

on his handling of cash surpluses and he will seek to make only those investments which

will yield a higher percentage than the company’s notional cost of capital. So the

investment center manager will want the same information as the profit center manager

in addition he will require quite detailed appraisals of possible investments and

information regarding the results of investments already undertaken. He will have to

make decisions regarding the purchase or lease of non-current assets and investment of

cash surpluses. Most of these decisions involve large sums of money.

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