Cost classification

Describe the different elements of production costs

Total product costs

The cost of making goods or providing services includes:
 Cost of materials
 Cost of labor (wages and salaries)
 Other expenses
Distinguish between direct and indirect costs in manufacturing and non-
manufacturing organizations
Product cost may be further reclassified as:

Direct
It is a cost that can be traced in full to a product.
cost
Indirect A cost that is incurred in the course of making or providing a
cost product which cannot be traced in full to it.
It may be further classified as:

Cost of materials that are known to have been used to

make goods or provide services.
Direct material
 All material part of product.
costs
 Not including ones in negligible amounts.
 Include components, parts, packing, etc.
Cost of workforce used to make goods or provide
services.
Direct labor
 Work on the product itself.
costs
 Include workers in making or altering goods,
inspection specifically for a product, etc.
Expenses that have been incurred in full as a direct
consequence of making goods or providing services.
Other direct
 Any other direct cost that is not material or
expenses
labor.
 Include tool hire, maintenance, repairs, etc.
Trends to note:
 Reduction in direct labor costs due to automation.
 Skilled costs increasing.
Question: Classify the following as either direct or indirect.
a. Basic pay of direct workers
b. Basic pay of indirect workers
c. Overtime premium
d. Bonus payments
e. Social insurance contributions
f. Idle time of direct workers
g. Work on installations of equipment
Analysis of total cost

Materials = Direct materials + Indirect materials

+ + +
Labor = Direct labor + Indirect labor
+ + +
Expenses = Direct expenses + Indirect expenses
Total cost = Direct cost /Prime cost + Overhead

Overheads

Production Includes all indirect materials, indirect labor and

overhead indirect expenses incurred in the factory from receipt
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Cost classification

of the order until its completion. e.g.

 Indirect materials: consumables, disposables
 Indirect labor: foreman, maintenance
 Indirect expenses: rent, rates, depreciation
All indirect material cost, labor and expenses incurred
Administration in the day to day operation of an organization.
overhead E.g. office equipment depreciation, director's salaries,
etc.
All indirect material cost, labor and expenses incurred
Selling overhead in promoting sales and retaining customers.
E.g. Catalogues, advertising, commissions, etc.
All indirect material cost, labor and expenses incurred
Distribution
in making products ready and delivered to customers.
overhead
E.g. packing cartons, packers wages, drivers, etc.
Question:
A direct labor employee's wages in week 5 consists of the following:

$
Basic pay for normal hours worked 36 hours x $4 144
Pay at the basic rate for overtime 6 hours x $4 24
O/T premium with overtime paid at 1¼ ¼ x 6 hours x $4 6
Bonus payment under group bonus scheme 30
Total gross wages 204
What is the direct labor cost for this employee in week 5?

Explain and illustrate production and non-production costs

Classification by function
Involves classifying costs (traditionally) as:
 Production costs: Costs associated with the factory.
 Administration costs: Costs associated with general office.
 Marketing (Selling & distribution) costs: Costs associated with marketing, sales, warehousing and transport.
Full cost of sales
$
Direct materials A
Direct labor B
Direct expenses C
Prime cost A+B+C
Production overheads D
Full factory cost A+B+C+D
Administration cost E
Selling and distribution cost F
Full cost of sales A+B+C+D+E+F

Functional costs
Production Costs incurred by the sequence of production.
costs
Administration Costs of managing an organization.
costs
Selling costs Costs of creating demand for products and securing
firm orders from customers. Also known as marketing
costs.
Distribution Cost incurred by the sequence of making products
costs ready for despatch and delivering to customers.

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Cost classification

Research costs Costs of searching for new or improved products.

Development Costs incurred from the decision to produce new or
costs improved products to the point of actual production.
Part of research (as research and development).
Financing costs Costs incurred to finance the business.
Question:
Within the costing system of a manufacturing company the following types of expenses are incurred.

Ref No.
1 Cost of oils used to lubricate production machinery
2 Motor vehicle licenses for lorries
3 Depreciation of factory plant and equipment
4 Cost of chemicals used in laboratory
5 Commission paid to sales representatives
6 Salary of the secretary to the finance director
7 Trade discounts given to customers
8 Holiday pay of machine operatives
9 Salary of security guard in raw material stores
10 Fees to advertising agency
11 Rent of finished goods warehouse
12 Salary of scientist in laboratory
13 Insurance of a company's premises
14 Salary of supervisor working in a factory
15 Cost of typewriter ribbons in the general office
16 Protective clothing for machine operatives.
Required: Complete the following table by placing each expense in the correct cost classification.

Cost classification Ref Number

Production costs
Selling & distribution costs
Administration costs
Research and development

Explain the importance of the distinction between production and non-production

costs when valuing output and inventories
Fixed costs and variable costs

A fixed cost is a cost which tends to be unaffected by changes in the

volume of output. E.g.

 Rent
 Depreciation
 Insurance

A variable cost is a cost which tends to vary directly with the volume of
output. The variable cost per unit is the same amount for each unit
produced. E.g.

 Direct materials
 Sales commission
 Hourly rate wages

A semi-variable/semi-fixed/mixed cost is a cost which contains both

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Cost classification

fixed and variable components and so is partly affected by changes in

the level of activity. E.g.

 Telephone charges
 Revenue based rent
 Car rental

Explain and illustrate production and non-production costs

Production and non-production costs
For preparation of financial statements, costs are classified as:

Costs identified with goods produced for resale. It

includes:

Production costs
 Direct material / labor / expenses
 Production overhead

Costs deducted as expenses during the current

period. It includes
Non-production
costs
 Administration
 Marketing (selling and distribution)
Example:
A business have the following costs for a period:
$
Materials 600
Labor 1,000
Production overheads 500
Administration overheads 700
2,800
During the period 100 units were produced. If all of these costs were allocated to it, each unit would be valued at $28. This would be incorrect as
administration overhead is also added on. Administration overhead is non-production. A distinction must be made.

The correct valuation should be $21 [(600 + 1,000 + 500) / 100]

This is important as it affects the preparation of accounts. If 80 units were sold at $40, the gross profit will be:
$
Sales (80 x 40) 3,200
Cost of sales (80 x 21) -1,680
Gross profit 1,520
The value of the closing stock will be $420 (20 x 21).

Describe the different elements of non-production costs

Other cost classifications

Specific costs of an activity which would be avoided if

Avoidable costs
the activity did not exist.
Unavoidable Costs which would be incurred whether or not an
costs activity existed.
Controllable Costs which can be influenced by management
costs actions.
Uncontrollable Costs which cannot be affected by management
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Cost classification

costs within a given time frame.

Costs which are likely to arise from decisions made
during the budgeting process.
Discretionary
costs  Likely to be fixed amounts over fixed periods.
 E.g. Advertising, R&D, training, etc.

Distinguish between cost, profit, investment and revenue centers

Collecting places for costs before they are analyzed. Costs are
Cost
further analyzed into cost units once they have been traced to
center
cost centers.
Cost centers may include:
 A department
 A machine
 A project
 A person
They are building blocks of a costing system. They enable:
 Classification of actual costs incurred.
 Preparation of budgets of planned costs.
 Comparison of actual costs and budgeted costs.
Cost unit A unit of product to which costs can be related.
Example:
 School - full-time student
 Winery - barrel
 Invoicing department - invoice issued
 Consultant - consultant hour
Question: Suggest suitable cost units which could be used to aid control within the following organization.
a. Hotel with 50 double rooms and 10 single rooms
b. Hospital
c. Road haulage business
Cost Any activity for which a separate measurement of costs is
object desired
If the users of management accounting wish to know the cost of something. this something is called a cost object.
 The cost of a good (physical product)
 The cost of a service
 The cost of operating a department
Similar to cost center but are accountable for costs and
Profit center
revenues.
Revenue Similar to cost center but are accountable for revenue
center only.
It is a profit center with responsibilities for capital
Investment
investment and possibly for financing, and whose
center
performance is measured by its return on investment.
It is an organizational function whose performance is
the direct responsibility of a specific manager.

Responsibility It includes all of the above mentioned centers:

center
 Cost center
 Revenue center
 Profit center

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Cost classification

 Investment center

Question: Which of the following is a characteristic of an investment center?

A. Managers have control over marketing.
B. Management have a sales team.
C. Management have a sales team and are given a credit control function.
D. Managers can purchase capital assets.
Key point summary
 A direct cost is a cost that can be traced in full to a product.
 An indirect cost is a cost that is incurred in the course of making or providing a product which cannot be traced in full to it.
 Classification by function involves classifying costs as production/manufacturing costs, administration costs or marketing/selling and distribution
costs.
 A different way of analyzing and classifying costs is into fixed and variable costs. Many items of expenditure may also be part fixed and part
variable and hence are termed semi-fixed or semi-variable.
 For the preparation of financial statements, costs are often classified as production and non-production costs.
 Production costs are costs identified with goods produced or purchased for resale.
 Non-production costs are costs deducted as expenses during the current period.
 Cost centers are collecting places for cost before they are further analyzed. Costs are further analyzed into cost units once they have been traced
to cost centers.
 A cost unit is a unit of good or service to which costs can be related. The cost unit is the basic control unit for costing purposes.
 A cost object is any activity for which a separate measurement of costs is desired.
 Profit centers are similar to cost centers but are accountable for both costs and revenues.
 Revenue centers are similar to cost centers but are accountable for revenue only.
 An investment center is a profit center with additional responsibilities for capital investment and possibly financing. and whose performance is
measured by its return on investment.
 A responsibility center is a function whose performance is the direct responsibility of a specific manager.
Exercises
1. Give two examples of direct expenses.
2. Give an example of an: administration overhead, selling overhead and distribution overhead.
3. What are functional costs?
4. What is the distinction between fixed and variable costs?
5. What are production and non-production costs?
6. What is a cost center?
7. What is a cost unit?
8. What is a profit center?
9. What is an investment center?