PRINCIPLES OF COSTING

STUDY TEXT

Qualifications and Credit Framework

Q2022

This Study Text supports study for the following AAT qualifications:

AAT Level 2 Certificate in Accounting

AAT Level 2 Certificate in Bookkeeping

AAT Certificate in Accounting at SCQF Level 6

 PRINCIPLES OF COSTING

CONTENTS
Page number

Introduction P.5

Unit guide P.9

The assessment P.19

Unit link to the End Point Assessment (EPA) P.20

Study skills P.21

STUDY TEXT

Chapter Study text

1 Introduction to costing systems 1
2 Cost classification 15
3 Materials and inventory 53
4 Labour costs 97
5 Overheads 127
6 Budgeting and variances 157
7 Introduction to spreadsheets 191
Mock Assessment Questions 229
Mock Assessment Answers 239
Index I.1

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 PRINCIPLES OF COSTING

INTRODUCTION
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 PRINCIPLES OF COSTING

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 PRINCIPLES OF COSTING

Introduction to costing systems

Introduction
This chapter introduces the different costing systems used within
organisations and their importance as sources of information for
management accountants. The key differences between management and
financial accounting are explored and some key terminology is introduced.
This chapter contains some fundamental principles that the rest of the
course is built on.

ASSESSMENT CRITERIA CONTENTS

Collection and classification of costs in 1 Financial accounting

different types of organisations (1.1) and management
accounting
Relationships between costing and
financial accounting systems within 2 Terminology – cost
organisations (1.3) units and cost centres
Sources of information on income and
expenditure (1.4)
Differences between cost, profit and
investment centres (1.5)

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 Introduction to costing systems: Chapter 1

Test your understanding 2

The table below lists some of the characteristics of financial accounting
and management accounting systems.
Indicate the characteristics for each system by putting a tick in the
relevant column of the table.

Financial Management
Characteristic
accounting accounting
Content can include anything useful.  
To help managers run the business.  
Formats dictated by accounting rules.  
Looks mainly at historical information.  
Produced for shareholders.  

2 Terminology – cost units and cost centres

2.1 Cost units

To help with the above purposes of planning, control and decision making,
businesses often need to calculate a cost per unit of output.
A key question, however, is what exactly we mean by a 'unit of output', or
'cost unit'. This will mean different things to different businesses but we
always look at what the business produces.
 A car manufacturer will want to determine the cost of each car and
probably different components as well.
 In a printing firm, the cost unit could be the specific customer order.
 For a paint manufacturer, the unit could be a litre of paint.
 An accountancy firm will want to know the costs incurred for each
client. To help with this it is common to calculate the cost per hour of
chargeable time spent by staff.
 A hospital might wish to calculate the cost per patient treated, the
cost of providing a bed for each day or the cost of an operation.

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 PRINCIPLES OF COSTING

5 Classification by behaviour

5.1 Cost classification by behaviour

The final cost classification we will look at is classifying costs depending
on their behaviour.
In management accounting, when we talk about cost behaviour we are
referring to the way in which costs vary with differing levels of activity
(i.e. the number of cost units).
An understanding of cost behaviour patterns is essential for many
management tasks, particularly in the areas of planning, decision making
and control; in particular for short-term budgeting purposes.
For example, if a furniture manufacturer expected to produce 1,000 chairs
in a particular month, what should the budget be for the costs of wood,
labour, oil, selling costs, factory heat and light, manager’s salaries, etc.?
How would these costs differ (if at all) if it expected to produce 2,000
chairs instead?
To be able to answer such questions and to make budgeting and
forecasting easier, costs are split into the following categories of
behaviour:
 Variable
 Fixed
 Stepped
 Semi-variable

5.2 Variable costs

Variable costs are costs that vary (usually assumed in direct proportion)
with changes in level of activity. Variable costs are constant per unit of
output and increase in total in direct proportion to activity.
For example, if you make twice the number of chairs then the total amount
of wood used would double, and hence the total cost increases
proportionally. This relationship is shown in the first of the following
graphs.
The variable cost per unit would remain the same, as the cost of the
wood needed in each chair is the same. This is shown in the second of the
following graphs.

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 Cost classification: Chapter 2

Total variable Variable cost per

cost, £ unit, £

Activity level Activity level

Example 1
If a business has total variable costs of £20,000 when it produces 1,000
units what is the variable cost per unit?
£20,000/1,000 = £20
What would be the total variable cost if the activity increased to 3,000
units?
£20 × 3,000 = £60,000

5.3 Fixed costs

Fixed costs are costs that, in the short term, are not affected by changes
in activity level. The total cost stays constant as activity levels change.
For example, the rent on the factory. This is shown in the first of the
following graphs.
The fixed cost per unit reduces as the activity levels in increased.
This is because the same amount of fixed cost is being spread over an
increasing number of units. This is shown in the second of the following
graphs.
Note that the graph showing the variable cost per unit looks exactly the
same as the total fixed cost graph. It is therefore always important to
check the vertical axis on the graph as these two are easily confused.

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