CHAPTER # 4

Description

Definition

Cost unit – a unit of product or service to which costs can be associated.

In cost accounting, a cost unit is a unit of a product or service to which costs can be associated.
Different organisations use different cost units. The following are some possible cost units for
organisations:

Organisation Possible Cost Unit

Microchip manufacturer A unit of microchip

Train operator Kilometre travelled

University Full-time student

Restaurant Meal served

Bakery A loaf of bread

A cost unit is not always a single item. It might also be calculated in batches.
For example, a single cost unit might be a batch of 1,000 bricks for an organisation that manufactures
bricks.
A cost unit is linked to the product or service delivered to the customer. There is a link between how a unit
of production is costed and eventually priced.
The same organisation may also have different cost units. For example, a baker might treat a batch of 30
loaves of bread as one cost unit and an order for a wedding cake as another cost unit.

Key Point

An organisation may have to use different cost units to associate costs. It depends on what management wants to examine.

Building on the previous example:

Organisation Possible Cost Unit

Microchip manufacturer A unit of Model A microchip

A unit of Model B microchip
 (different models of output may be other cost units)

A kilometre travelled
Train operator A passenger

A full-time student
A course
A semester
University
(cost units may focus on different things)

A meal served
A table
Restaurant A customer

A loaf of bread
A wedding cake
A batch of 100 muffins
Bakery
(quantity may be in batches)
Activity 1: Cost Units

Match the business with the most appropriate cost unit

Business Cost Unit

A laptop manufacturer A chargeable hour

A barber An operating theatre hour

An artist A laptop

A hospital A haircut

An accountant A painting

*Please use the notes feature in the toolbar to help formulate your answer.

Business Cost Unit

A laptop manufacturer A laptop

A barber A haircut

An artist A painting

A hospital An operating theatre hour

An accountant A chargeable hour

Composite Cost Units

In some situations (particularly for organisations that provide a service), it may be more beneficial to use
a composite cost unit or a cost unit comprised of two parts.
For example, the composite cost unit for a bus company might be a passenger-kilometre (to determine
the cost of carrying one passenger for one kilometre). At a hotel, it might be a room-night (to determine
the cost of providing one room for one night).
Including two parts in the cost unit can help organisations monitor costs more appropriately and improve
cost control.
For instance, in the example of the bus company, the cost per passenger is not particularly useful for
decision-making because it will vary depending on the length of the passenger’s journey. However, the
cost of carrying one passenger for one kilometre is not affected by the trip distance and is, therefore,
more useful for monitoring and controlling costs.
Some additional examples are:

Organisation Composite Cost Units

Airline A passenger-kilometre
Transport firm A kilogram-kilometre

Computer Centre A computer-hour

Hospital A patient-bed night

Power utility A kilowatt-hour

Cost Unit Information

Managers need to know the cost and resources required to produce cost units to make well-informed
decisions. This information can be used in several different ways.
  To determine a selling price
Managers need to know the cost of a cost unit produced to determine the selling price required to
profit.
 To decide what to produce
To determine what to produce, managers need to know how much profit each cost unit is expected to
make.
 To help with cost control
Over time, an organisation will know each cost unit's costs and production times. If they vary from
expectations (for instance, significantly higher), this will trigger an investigation and action to bring
things back on track.
 To plan and budget
Managers need the information to help calculate a realistic budget. They need to know how much the
intended output of cost units will cost, what resources they will need and whether the organisation
can afford it.
Definition

Budget - a plan expressed in monetary or quantity terms.

There are many different types of budgets: the sales budget, the production budget, the expenditure budget, and others.

Cost Categories

Category Description

Costs can be classified according to their related business function—for example, production costs, sales
and marketing costs, or finance costs.
Function

Costs can be classified according to the person responsible for their control. For example, a manager might
be responsible for the costs incurred at their branch.
Responsibility

Costs can be classified by their behaviour. For example, whether they increase if activity increases (variable
costs) or stay the same regardless of the activity level (fixed costs).
Behaviour

Costs can be classified by the item or activity that incurs them. For example, the costs may relate to the work
performed (labour) or the cost of items used in production (materials).
Type
 Costs can be classified by how closely they can be traced to a specific cost unit. For example, whether it is
easily traceable (direct cost) or not easily traceable (indirect cost).
Traceability
Fixed costs and variable costs are discussed in Section 4 later in this chapter.
Direct costs and indirect costs are discussed in Section 3 later in this chapter.
Classifying Costs

Key Point

Depending on the management's perspective, a specific cost may be classified in many ways.

It is important to note that costs can be classified using more than one category. This is because different
cost classifications look at the cost from different perspectives. For example, fuel for a delivery van might
be classified by function (as a distribution cost), behaviour (as a variable cost) or by traceability (as an
indirect cost).
Different organisations will use different cost classifications depending on how they operate. This is a
prime example of the flexibility involved in cost and management accounting compared with financial
accounting.
Activity 2: Ravi’s Quality Bakery (Cost Classification)

Revisiting Ravi’s Quality Bakery (RQB),

Determine whether the description of the cost classification is true or false.
True or
Scenario False

Ravi classifies the cost of delivering products to local cafes as distribution costs. This is an example of
classifying costs by business function.

Ravi analyses RQB’s main production costs between the ingredients used and the wages of employees working
in the bakery. This is an example of classifying costs by responsibility.

Ravi has authorised the office manager to purchase office supplies and other products and services required to
run the office. Ravi reviews office and administration costs monthly, asking the office manager to justify the
expenditure. Ravi uses both function and responsibility to classify costs in this situation.

*Please use the notes feature in the toolbar to help formulate your answer.

Scenario True or False

True
Ravi classifies the cost of delivering products to local cafes as Ravi is grouping distribution costs together in
distribution costs. This is an example of classifying costs by business a single classification. Distribution is an
function. example of an organisational function.
 Ravi analyses RQB’s main production costs between the ingredients False
used and the wages of employees working in the bakery. This is an Ravi classifies costs by the type of item they
example of classifying costs by responsibility. relate to (materials and labour).

True
Ravi has authorised the office manager to purchase office supplies Ravi has grouped administration costs
and other products and services required to run the office. Ravi (classification by function) and has identified
reviews office and administration costs monthly, asking the office these as costs that are controllable by the
manager to justify the expenditure. Ravi uses both function and office manager (classification by
responsibility to classify costs in this situation. responsibility).
Direct Costs

Definitions

Direct Costs – Costs that can be measured reliably and directly traced to a specific cost unit.
All other costs are indirect costs.
Prime Costs – The sum of direct costs, also known as the total direct cost.
In cost accounting, costs can be classified into direct and indirect costs depending on whether they can
be easily traced to a specific cost unit, such as the production of a unit of product or service.
Common categories of direct costs are:

Direct materials are the materials that form part of the end product.
Direct
materials For example, the cost of flour used in bread production in Ravi’s Quality Bakery (RQB).

Direct labour is the labour involved in the production of the end product.
Direct
labour For example, the cost of the baker's wages in RQB.

Direct expenses are the expenses incurred in producing a specific cost unit.
Direct For example, if a specialist machine had to be hired to decorate a speciality cake for a customer, the cost of
expenses machine hire would be a direct expense of the speciality cake. It can be traced directly to that specific cost unit.
The computation of prime cost is:

DIRECT MATERIALS + DIRECT LABOUR + DIRECT EXPENSES = PRIME COST

Indirect Costs

Definition

Indirect Costs – Costs that are not directly traceable to a cost unit, also known as overheads.
Indirect costs used in production are:

Indirect Indirect materials are materials that do not form part of the end product.
materials
For example, the cooking spray (grease) cost on each baking tray at RQB. Measuring the quantity of cooking
 spray on each tray is not worthwhile because the cost is not high, so the cost is not traced directly to each unit
of the end product.

Indirect labour is the cost of labour required for production but is not easily traced to a specific cost unit.
Indirect
labour For example, the cost of wages for regularly cleaning RQB's factory floor.

Indirect expenses are incurred as part of production but are not traced to a specific cost unit.
Indirect
expenses For example, the electricity required to light the bakery and power the ovens.
Indirect costs used in production are collectively known as production overheads.
INDIRECT MATERIALS + INDIRECT LABOUR + INDIRECT EXPENSES = PRODUCTION OVERHEADS

Non-production overheads are the indirect expenses not incurred in the production process.
For example, the office manager's wages at RQB and the cost of advertising.
 Indirect
expenses Non-
Direct Direct Direct Indirect Indirect (production production
materials labour expenses materials labour overhead) overhead

Small amounts of icing

sugar sprinkled on some
of the cakes.

Wages of the factory

supervisor

Vehicle rental cost of a

delivery van

Eggs

Wages of the person

who packs the bread at
the end of the
production line

Office manager’s wages

Business rates (a local

government tax) bill for
the bakery

The cost of a one-off

machine set up for a
specific customer’s
order

To determine the total cost of producing and selling a cost unit, it will be necessary to include these costs
in the calculations.

Key Point

Non-production overheads usually include selling, distribution, and administration costs.

Activity 3: Direct and Indirect Costs

Classify the given costs to the appropriate cost category

(Place a tick in each row to the column with the appropriate cost category)
 Indirect
expenses Non-
Direct Direct Direct Indirect Indirect (production production
materials labour expenses materials labour overhead) overhead

Small amounts of icing

sugar sprinkled on
some of the cakes. ✓

Wages of the factory

supervisor ✓

Vehicle rental cost of a

delivery van ✓

Eggs ✓

Wages of the person

who packs the bread
at the end of the
production line ✓

Office manager’s
wages ✓

Business rates (a local

government tax) bill
for the bakery ✓

The cost of a one-off

machine set up for a
specific customer’s
order ✓

*Please use the notes feature in the toolbar to help formulate your answer.

Feedback

Small amounts of icing sugar This is an indirect cost because it is not worth tracing to individual cost units. It is
sprinkled on some of the cakes also a material.

This is an indirect cost because it is not traced to individual cost units. It is also
Wages of the factory supervisor an internal labour cost.

Vehicle rental cost of a delivery

van This is not related to production, so it is a non-production overhead.

Eggs This is a direct cost traced directly to individual cost units. It is also a material.

Wages of the person who packs This is a direct cost traced directly to individual cost units. It is also a labour cost.
 the bread at the end of the
production line

Office manager’s wages This is not related to production, so it is a non-production overhead.

This is an indirect cost because it is not traced to individual cost units. It is also
Business rates (a local an expense related to the production activity because it would not be possible to
government tax) bill for the bakery continue production without this expense.

The cost of a one-off machine set This is a direct cost because it can be traced directly to a particular cost unit. It is
up for a specific customer’s order also an expense related to the production activity.
Variable Costs

Definitions

Cost Behaviour – The changes in cost according to the level of activity.

Variable Costs – Costs that change according to the level of activity
Cost behaviour is how costs react due to changes in activity level – for example, the number of units
produced.
Costs that respond to changes in activity level are known as variable costs. The costs unaffected by
changes in the level of activity are fixed costs.
In the long term, all costs are variable because they (such as rent for the office) inevitably change over
time.

Key Point

Do not assume that all direct costs are variable costs.

A direct cost can be a fixed cost.
For example, the fixed rental fee of a specialist machine for a specific batch of products. This would be a direct fixed cost.

Example 1: Ravi’s Quality Bakery (Variable Costs)

Ravi’s Quality Bakery (RQB) uses flour to make bread. RQB’s accountant has produced the following cost information and
graphs:
Total Cost Graph
 Example 1: Ravi’s Quality Bakery (Variable Costs)

This graph shows that the total cost of flour increases as activity increases.
This may also be expressed in a table:

Activity Level
(units) Flour cost per unit ($ per unit) Total flour cost ($)

100 0.10 10

200 0.10 20
Note that the flour cost per loaf does not change—the total cost of flour used in production changes.
For example, the cost of flour per loaf to produce 100 loaves is $0.10 (calculated as $10 / 100 loaves).
When activity increases to 200 loaves, the cost of flour per loaf remains at $0.10 (calculated as $20 / 200 loaves).
Cost per unit graph
 Example 1: Ravi’s Quality Bakery (Variable Costs)

This graph shows that the cost of flour per loaf of bread (per unit) remains the same.

Key Point

For variable costs:

 Cost per unit is usually constant within the relevant range of activity
 Total variable cost will increase as activity increases
Fixed Costs

Definition

Fixed costs – Costs that remain constant (unchanged) regardless of the level of activity
 Example 2: Ravi’s Quality Bakery (Fixed Costs)

Ravi’s Quality Bakery (RQB) pays $1000 monthly for its baking premises. RQB’s accountant has produced the following cost informat
and graphs:
Total cost graph

The graph shows that the rental cost does not change within the given range of activity.
This information may also be presented in a table, with possible activity levels of units per month:

Activity level per month (units) Rent cost per unit ($ per unit) Total rent cost ($)

1,000 1.00 1,000

2,000 0.50 1,000

Cost per unit graph
 Example 2: Ravi’s Quality Bakery (Fixed Costs)

Because the fixed cost of rent remains the same, the fixed cost per unit will decrease as more units are produced. This is because the
cost of the rent is spread over more units.
The $1,000 rent per month shared out over 1,000 loaves of bread is a fixed cost of $1 per unit at this activity level ($1,000 / 1000).
If RQB produce 2,000 loaves in a month, then the total fixed cost of rent remains at $1,000, but the fixed cost per loaf of bread is now
$0.50 ($1,000 / 2,000)
RQB now has lower unit costs and higher profit per loaf of bread by producing more loaves while keeping the rent cost fixed.

Key Point

For fixed costs:

 Cost per unit will decrease as activity increases.
 Total fixed cost will remain constant regardless of activity level.
Activity 4: Fixed and Variable Costs

Determine whether the statements are correct or incorrect.

 Statement Correct or Incorrect

The salary of an office manager is a fixed cost.

The wages of a delivery driver paid at an hourly rate are always a variable cost.

The cost of ingredients for a restaurant is usually variable.

*Please use the notes feature in the toolbar to help formulate your answer.

Statement Correct or Incorrect

Correct
The salary of an office manager is a In most organisations, the office manager is paid the same amount regardless
fixed cost. of the activity level.

Incorrect
This will not always be a variable cost. It depends on the employment
arrangement.
In most cases, the driver's hourly rate is a variable cost depending on the
number of hours worked.
The wages of a delivery driver paid at However, in some cases, the driver may be paid an hourly rate for a fixed
an hourly rate are always a variable number of hours (e.g. 40 hours per week), even if fewer hours are worked.
cost. This would be a fixed cost.

Correct
The cost of ingredients varies depending on the number of meals served in
The cost of ingredients for a the restaurant – the total cost of ingredients increases as the level of activity
restaurant is usually variable. increases.
Mixed Costs

Definition

Mixed Cost - A cost with fixed and variable elements, also known as semi-variable or semi-fixed costs.
Some costs include a fixed element and a variable element. These are called mixed costs. This means
that only part of the cost is affected by activity levels.
Some examples are:
 Utilities
Some utilities like gas, electricity, and cell phone services often include a fixed connection fee for the
period and a variable charge based on usage – for example, text messages and minutes.
 Wages
Some wage schemes may include a fixed base salary for the period and an additional variable
element linked to the output achieved.
 Machine or vehicle rental/lease
Machine or vehicle rental may include a fixed rental charge for the period and a variable charge – for
example, for each hour the machinery is in use or for each kilometre the vehicle is driven.
Example 3: Mixed Costs

The following graph shows the total cost behaviour of a mixed cost (i.e. the variable and fixed portions of the total cost.
 Example 3: Mixed Costs

Total Cost Graph

The total cost increases as the level of activity increases.

For example, the total cost of renting a vehicle increases as the kilometres driven increase. Note that the fixed rental cost is still incurr
even if the rented vehicle is not driven.
Consider the following example of a mixed cost:
The rental for a van for a day is $200. There is an additional fee of $1 per kilometre driven.
The table below illustrates the total cost at different activity levels (kilometres travelled in a day).

Activity level Variable rate ($ Variable fixed cost − Total cost Fixed Cost per unit ($
(kilometres per day) per kilometre) cost ($) daily rental ($) + Variable ($) per kilometre)

0 1 0 200 200 NA

50 1 50 200 250 5
 Example 3: Mixed Costs

100 1 100 200 300 3

The following can be observed from the table:

 activity increases, cost per unit decreases.
 a zero activity level, the total cost equals fixed cost.
 activity increases, total cost increases.
Cost per unit graph

Because the total fixed cost remains the same for all activity levels, the cost per unit decreases as the activity increases.

Stepped-Fixed Costs

Definition

Stepped-Fixed Cost - A cost that remains fixed within an activity range. If activity increases beyond that range, the cost will
step up to another fixed level for the higher activity range.
The final type of cost behaviour is stepped-fixed costs.
Stepped-fixed costs remain fixed over a specific range of activity, but once the activity level increases
past a certain point, the cost takes a significant ‘step up’.
 For example, a jeans manufacturer might have the machinery, employees and workspace to produce 50
pairs of jeans per week. If the weekly production requirement rises to 200 pairs, the organisation may
need to invest in new machinery, hire more employees and rent more workspace to meet this production
load.
This cost behaviour, stepping up in stages, is called a step cost.

Example 4: Stepped-Fixed Costs

Total Cost Graph

Once the upper limit of an activity level is reached, a new higher level of fixed cost becomes relevant.
For example, a business hires a machine at $200 per day. This machine can produce up to 100 units per day. If more units are
required, additional machines will need to be hired. At least one machine must be hired for the day.
The table below illustrates the behaviour of the machine hire cost at different activity levels:

Activity Level (units Number of machines Daily Rental rate Total Hire cost Cost per unit ($ per
produced) required ($) ($) unit)

0 1 200 200 NA

50 1 200 200 4

100 1 200 200 2

 Example 4: Stepped-Fixed Costs

150 2 200 400 2.7

200 2 200 400 2

250 3 200 600 2.4

The following may be observed from the table:

 Within a specific range (in this case, the capacity of 1 machine), the cost is fixed.
 Within this range, the cost per unit reduces
 If the activity level increase beyond this range (such as above 100 units), the fixed costs increase to a new fixed level,
which would apply to the higher range.

Key Point

The exam may require the recognition of different cost behaviours from graphs or data sets.

4 Summary and Quiz

Summary and Quiz
 A cost unit is a unit of product or service that costs are allocated to.
 A cost unit may be a batch of products.
 Composite cost units comprise two different parts.
 The classification of costs into categories depends on what information is needed from the
management’s perspective
 Direct costs are costs that are directly traceable to specific cost units and can be measured reliably.
 The sum of all direct costs is prime cost.
 Indirect costs are costs that are not directly traceable to cost units. Indirect production costs are
known as production overheads.
 Non-production costs include selling, distribution, and administration costs.
 Variable costs change according to the activity level.
 Fixed costs remain constant regardless of activity level.
 A mixed cost has both variable and fixed elements.
 A stepped-fixed cost is constant for an activity range; it will step up to a higher constant for a higher
activity range.