Introduction to Management Accounting (ACC2008)

UNIT 2: COST CLASSIFICATION

INTRODUCTION
The total cost of making a product or providing a service consists of the following.
(a) Cost of materials
(b) Cost of the wages and salaries (labour costs)
(c) Cost of other expenses
(i) Rent and rates
(ii) Electricity and gas bills
(iii) Depreciation

The term cost denotes the amount of expenditure incurred on, or attributable to, a specific thing.
Cost provides a common denominator so that different items can be reflected in monetary terms.
Thus, comparisons can be made between different locations, functions, or items, based on their
relative cost.

A cost object is anything for which a separate measurement of cost is desired. A cost object can
include:
 The cost of a product
 The cost of providing a service to customers
 The cost of operating a department
 The cost of resources used

A cost unit is a unit of quantity of product, service or time in relation to which costs may be
ascertained or expressed.

Examples of cost objects and cost units are outlined in the table below.

Business Type Cost Object Cost Unit

Cement Company Cement Per kg
Per tonne
Hotel Guest Guest/night
Bed occupied/night
Accountant Client Chargeable hour
IT Desktop Number
Transportation Passenger Passenger/kilometre

Costs can be classified into various categories, according to:

1. Their management function

(a) Manufacturing costs
(b) Non-Manufacturing costs

2. Their ease of traceability

(a) Direct costs
(b) Indirect costs
3. Their timing of charges against sales revenue
(a) Product costs
(b) Period expenses

4. Their behaviour with respect to changes in activity

(a) Variable costs
(b) Fixed costs
(c) Semi-variable costs
5. Their relevance to control and decision-making
(a) Sunk costs
(b) Relevant costs
(c) Incremental costs
(d) Opportunity costs
(e) Controllable and Non-controllable costs
(f) Committed and Discretionary Fixed Costs
(g) Avoidable and Unavoidable Costs

COSTS BY MANAGEMENT FUNCTION

In a manufacturing firm, costs are divided into two major categories, by the functional activities
they are associated with: (1) manufacturing costs and (2) non-manufacturing costs, also called
operating expenses.

Manufacturing Costs

Manufacturing costs are those costs associated with the production activities of the company.
Manufacturing costs can be subdivided into three categories: direct materials, direct labour, and
factory overheads.

Direct materials are all materials that become an integral part of the finished product.
Examples are the steel used to make an automobile and the wood to make furniture. Glues, nails
and other minor items are called indirect materials (or supplies) and are classified as part of
factory overhead.

Direct labour is the labour directly involved in making the product. Examples of direct
labour costs are the wages of the assembly line and the wages of machine tool operators in a
machine shop. Indirect labour such as wages of supervisory personnel, store-keepers and security
guards, is classified as part of factory overhead.

Factory overhead can be defined as including all other costs of manufacturing except
direct materials and direct labour. Examples include factory depreciation, rent, insurance, fringe
benefits, payroll taxes and the cost of idle time. Factory overhead is also called manufacturing
overhead, indirect manufacturing expenses and factory burden.

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Non-Manufacturing Costs

Non-manufacturing costs (or operating expenses) are subdivided into selling expenses and
general and administrative expenses.

Selling and distribution expenses are all the expenses associated with obtaining sales
and the delivery of the product (i.e. getting your finished products from your place of business to
your customers. Examples are advertising, sales commissions, delivery costs to customers.

General and Administrative expenses include all the expenses that are incurred in
connection with performing general and administrative activities. Examples are executive
salaries and legal fees.

DIRECT COSTS AND INDIRECT COSTS

Costs may be viewed as either direct or indirect in terms of the extent to which they are traceable
to a particular object of costing such as products, jobs, departments, and sales territories.

Direct costs are those costs that can be directly traced to the cost object under
consideration. Examples are steel and plastic used in the manufacture of a car.

Indirect costs are costs that are difficult to directly trace to a specific costing object.
Factory overhead items are all indirect costs. Costs shared by different departments, products, or
jobs called common costs or joint costs, are also indirect costs. National advertising that benefits
more than one product and sales territory is an example of an indirect cost.

PRODUCT COSTS AND PERIOD COSTS

By their timing of charges against revenue or by whether they are inventoriable, costs are
classified into: (a) product costs and (b) period costs.

Product costs are inventoriable costs, identified as part of the inventory on hand. They
are therefore assets until they are sold. Once they are sold, they become expenses, ie, cost of
goods sold. All manufacturing costs are product costs.

Period costs are not inventoriable and hence are charged against sales revenue in the
period in which the revenue is earned. Selling and general administrative expenses are period
costs.

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VARIABLE COSTS, FIXED COSTS, AND SEMIVARIABLE COSTS

From a planning and control standpoint, perhaps the most important way to classify costs is by
how they behave per changes in volume or some measure of activity. By behaviour, costs can be
classified into three basic categories:
Variable costs are costs that vary in total in direct proportion to changes in activity.
Examples are direct materials and gasoline expenses based on mileage driven.

Fixed costs are costs that remain in total regardless of changes in activity. Examples are
rent, insurance and taxes.

Semivariable (or mixed) costs are costs that vary with changes in volume but, unlike
variable costs, do not vary in direct proportion. In other words, these costs contain both a
variable component and a fixed component. Examples are the rental of a delivery truck, where a
fixed rental fee plus a variable charge based on mileage is made; and power cots, where the
expense consists of a fixed amount plus a variable charge based on consumption.
The breakdown of costs into their variable components and their fixed components is
very important in many areas of management accounting, such as flexible budgeting, break-even
analysis and short-term decision making.

COSTS FOR PLANNING, CONTROLLING AND DECISION MAKING

Sunk costs. Sunk costs are the costs of resources that have already been incurred and whose total
will not be affected by any decision made now or in the future. They represent past or historical
costs.
Relevant costs are expected future costs that will differ between alternatives.

Incremental (Differential costs). The incremental cost is the difference in cost between two or
more alternatives.
Consider two alternatives A and B whose costs are as follows:

A B Incremental costs (B – A)

Direct Materials $10,000 $10,000 $0

Direct Labour $10,000 $15,000 $5,000

Opportunity costs. An opportunity cost is the net revenue foregone by rejecting an alternative.

Discretionary versus Committed costs. Strictly speaking, these classifications as with many
others are only pertinent in the short run. A discretionary cost is a cost that may or may not be
incurred based on the decision of a particular person, usually the general manager.
Nonemergency maintenance is an example of a discretionary cost. Other examples include
advertising expenses, training costs and research and development costs. Committed costs are
those costs that are the result of commitments previously made. Costs such as rent, depreciation,

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insurance, and executive salaries are committed costs since management has committed itself for
a long period of time regarding the company’s production facilities and manpower requirements.

Controllable versus non-controllable costs. A cost is said to be controllable when the amount
of the cost is assigned to the head of a department and the level of the cost is significantly under
the manager’s influence. Non-controllable costs are those costs not subject to influence at a
given level of managerial supervision.
For example, the kitchen manager can influence the amount spent on food. However, it is
unlikely the kitchen manager can influence the amount spent on rent, especially in the short term.

Avoidable versus Unavoidable Costs.

Avoidable costs are costs that will not continue if an ongoing operation is changed or deleted.
Unavoidable costs are costs that will continue even if an ongoing operation is changed or
deleted.

Source: Brandford, 2008

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Figure 1: Cost Classification

Cost Classifications

Period Costs
Product Costs (Inventoriable Costs)
(Non-Inventoriable Costs)

Direct Materials Direct Labour Factory Overheads

Selling, General &
Administrative Expenses

Prime Costs

Conversion Costs

Indirect Costs

Direct Costs

Direct or Indirect Costs

Source: Brandford, 2008

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Figure 2: Classification based on Management Function

Direct Materials

Cost By Management
Function PLUS

Direct Labour

PLUS

Indirect Materials Indirect Labour Indirect Expenses EQUALS Factory Overheads

PLUS PLUS

Rent
Insurance
Supervision Property Taxes
Factory Supplies Inspection Depreciation-
Glues and nails Security Guards factory
Small tools Factory Clerks Maintenance and repair
Janitors utilities EQUALS
Employer payroll taxes-
factory labour
Overtime premium
cost of idle time

Manufacturing Costs

PLUS

PLUS General and Administrative Non-Manufacturing

Selling Expenses
Expenses Expenses

Sales salaries and EQUALS

Administrative and office
commission
salaries
Employer payroll taxes-
Employer payroll taxes-
sales
office EQUALS
Advertising
Rent
Samples
Depreciation-office
Entertainment and travel
Property taxes-office
Rent
auditing expenses
Depreciation-sales
Legal expenses
Property taxes on sales
Bad Debts
office
Travel and Entertainment
Freight out

Total Costs

Source: Brandford, 2008

References
Brandford, E. (2008). Introduction to Management Accounting (ACC2008).

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