CHAPTER 2: COST CLASSIFICATION

2.0 LESSON OUTCOMES;

 Understand the definition of cost classification as the logical arrangement of costs based
on their nature and purpose.
 Identify the main cost objectives for which costs are classified, including stock valuation,
decision-making, and control purposes.

 Differentiate between direct and indirect manufacturing costs, such as materials and
labor, and understand how they contribute to a product's total cost.

 Explain how costs behave in relation to changes in activity levels, distinguishing between
variable, fixed, and semi-variable costs.

 Recognize costs for decision-making purposes, including concepts like sunk costs,
opportunity costs, and differential costs, and understand their relevance.

 Distinguish between controllable and non-controllable costs, and recognize that only
controllable costs are relevant for decision-making.

 Classify costs based on their relationship with inventory, differentiating between product
costs (capitalized and expensed upon sale) and period costs (expensed in the period they
are incurred

2.1 DEFINITION

Cost classification may be defined as ‘the arrangement of cost items in a logical sequence

Having regard to their nature and purpose to be fulfilled’. Costs are classified according to the

Cost objectives. Cost objective is the activity for which a separate measure of cost is desired.

They include, cost stock valuation, cost for decision-making and cost for control purposes. The
Table below shows a summary of cost classifications given cost objectives:

Cost objective and Possible classification

1. Stock valuation

• Manufacturing and non-manufacturing costs

• Period and product costs

• Direct and indirect costs

2. Decision making

• Cost behavior: Variable, fixed, semi variable,

• Relevance: opportunity, sunk cost, historical cost, standard costs

3. Control purposes

• Controllable and non-controllable

• Avoidable and non-avoidable

2.2 MANUFACTURING COSTS

These are the costs incurred to produce a product. Remember that a product refers to both goods
and services. The elements of manufacturing costs are: direct material costs, direct labour costs;
and overhead costs. The elements make up the total cost of a product, as shown below:

Direct expenses are expenses incurred for a particular job, project or service e.g. royalties,
franchise, hire of special equipment, materials, labour, etc. they are traceable to that specific job.

These costs are discussed further in the following sections.

(a) Material costs:

Material refers to all the physical inputs into the production process. They do not only refer to
purely unprocessed materials or natural resources but refers to any material input in the
manufacturing process. Finished goods for one company can be raw materials for another for
instance; packed wheat flour is a finished good for the milling industry but a raw material to the
banking industry.

Raw materials can be classified as direct or indirect

Direct materials are those materials that can be easily traced to a product without any extra cost
or inconvenience. Examples include leather and sole for a shoe making industry.

Direct Materials are those materials that become an integral part of the finished product and that
can be physically and conveniently traced to it.

Direct expenses are expenses incurred for a particular job, project or service e.g.

• Royalties

• Franchise

• Hire of special equipment

Indirect materials are materials that become an integral part of the finished product but may be

traceable into the product only at great cost or inconvenience. Examples include glue and thread
for a shoe making industry.

An analysis of the various materials input into a production process is as follows

• Raw material

• Components and sub-assemblies

• Consumable materials

• Maintenance materials

(b) Labour

Labour is the physical and mental human input in a production process. Labour costs can be
divided into direct labour costs and indirect labour costs.
Direct labour cost refers to wages paid to workers who are directly involved in the production of

each item produced. Such labour cost can be physically traced to the creation of product without

undue cost. The cost can be readily identified with specific product or unit. For instance, wages
paid to factory supervisors, forklift truck drivers, factory store room clerks, etc.

The term direct labor is reserved for those labor costs that can be essentially traced to individual
units of products. Direct labor is sometime called touch labor, since direct labor workers
typically touch the product while it is being made. The labor cost of assembly line workers, for
example, is a direct labor cost, as would the labor cost of carpenter, bricklayer and machine
operator

Indirect labor costs refer to the wages paid to workers whose efforts cannot be readily identified
with specific product units or batches e.g. laborers paid to maintain all the premises utilized for
production of goods and services.

Labor costs that cannot be physically traced to the creation of products, or that can be traced only
at a great cost and inconvenience, are termed indirect labor and treated as part of manufacturing
overhead, along with indirect materials. Indirect labor includes the labor costs of janitors,
supervisors, materials handlers, and night security guards. Although the efforts of these workers
are essential to production, it would be either impractical or impossible to accurately trace their
costs to specific units of product. Hence, such labor costs are treated as indirect labor.

NOTE

Direct Materials cost combined with direct labor cost is called prime cost.

In equation form:

Prime Cost = Direct Materials Cost + Direct Labor Cost

For example, total direct materials cost incurred by the company is shs.4, 500 and direct labor
cost is Shs. 3,000 then prime cost is sh7,500 (sh4,500 + sh3,000).

(c) Overhead costs

They are also called indirect production costs. They include all costs of manufacturing except
direct materials and direct labour. They are incurred for the benefit of all products thus the
amount of overhead allocated can only be an estimate. They include indirect materials, indirect
labour and other indirect expenses that cannot be traced directly to a product. They are at times
referred to as factory burden, factory overheads or manufacturing expense.

NOTE

Examples of manufacturing overhead include items such as indirect material, indirect labor,

maintenance and repairs on production equipment and heat and light, property taxes,
depreciation, and insurance on manufacturing facilities. Indirect materials are minor items such
as thread and glue in manufacturing industries. These are not included in direct materials costs.
Indirect labor is a labor cost that cannot be traced to the creation of products or that can be traced
only at great cost and inconvenience. Indirect labor includes the labor cost of janitors,
supervisors, materials handlers and night security guards. Costs incurred for heat and light,
property taxes, insurance, depreciation and so forth associated with selling and administrative
functions are not included in manufacturing overhead.

Studies have found that manufacturing overhead averages about 16% of sales revenue.
Manufacturing overhead is known by various names, such as indirect manufacturing cost, factory
overhead, and factory burden. All of these terms are synonymous with manufacturing overhead.
Manufacturing overhead cost combined with direct labor is called conversion cost.

In equation form:

Conversion Cost = Direct Labor Cost + Manufacturing Overhead Cost

2.3 FUNCTIONAL CLASSIFICATION

Non-manufacturing costs are costs incurred by all activities that support the production of goods
and services. They are administration costs, selling costs and distribution costs. These are
explained as follows:

a) Production costs: these are costs incurred in the manufacturing process. They include
material costs, labour costs and overhead costs as discussed above.

b) Administrations cost: Is the sum of costs associated with the overall management of the

enterprise, which cannot be readily identified with one of the major functional areas e.g. salary of
the factory manager would be seen as a production cost but the salary of the personnel officer

will be viewed as administrative cost since the personnel function does work for all other

functions of the enterprise.

c) Selling Cost: this is the sum of costs associated with the securing of orders from customers.

Included in this area will be items such as the salaries paid to the salesmen and expenditure on

advertising.

d) Distribution costs: these are costs associated with warehousing the products and their
delivery to customers. They are incurred in getting the finished product to customers for
instance, depreciation of the distribution van.

e) Finance costs: These are costs incurred to secure funds to finance the organization’s
activities.

These include interests on loans and overdrafts, dividends to shareholders, interests on

debentures etc.

f) Research and development costs: These are costs that are incurred to invent new products or
to modify the existing ones, as well as costs incurred to acquire more information on such
products.

2.4 BEHAVIORAL CLASSIFICATION

Cost behavior means how costs will respond or react to changes in the activity level. ie. as we
increase output or sales, are the costs rising, dropping or remaining the same. Cost Behavior can
be used to produce various classifications of costs such as:

i) Variable costs

ii) Fixed Costs

iii) Semi fixed costs

i) Variable costs

Costs will be classified according to nature or behavior in relationship to change in the levels of
production such as: These are costs that increase or decrease, in total, in direct proportion to
changes in the total level of activity or number of units produced i.e. that portion of the cost of an
activity that change with the level of output. They are costs which tend to vary directly with the
levels of output.

Examples of variable costs include, cost of raw materials, direct expenses, wages paid to casual

employees paid on an hourly basis and fuel cost based on mileage. With variable costs, the cost
level is zero when production is zero. The cost increases in proportion to the increase in the
activity level because variable cost per unit of activity level is constant, thus the variable cost
function is represented by a straight line from the origin. The gradient of the function indicates
the variable cost per unit. For a cost to be variable there should be an activity base which drives
it. This activity base is a measure of effort that operates as a casual factor in the incurrence of
variable costs. Thus to control these costs, cost accountants should be well acquainted with the
various cost drivers (activity bases) within the organization.

To illustrate variable costs

Variable cost

Cost

ii) Fixed Costs

These are costs whose total will tend to remain fixed irrespective of changes in output they do
not change with the level of output. They are also called autonomous costs, as they remain the
same irrespective of the activity level e.g. Salaries, rent etc. The classification of cost into fixed
and variable costs would only hold within a relevant range beyond which all costs are variable.
The relevant range is the activity limits within which the cost behavior can be predicted.

To illustrate fixed costs

iii) Semi variable costs

These are costs with both a fixed and variable cost component .ie. they are fixed up to certain
output levels and thereafter increase and get fixed at higher levels. They are partially fixed and
partially variable. The fixed component is that portion which is constant irrespective of the level
of activity. They are variable within certain activity levels but are fixed within other activity
levels, as shown below:

examples include salesmen salaries (salary plus commission), telephone charges, water bills,
electrical costs etc.

To illustrate semi variable costs

2.5 CLASSIFICATION ACCORDING TO CONTROLLABILITY

Controllable cost: Refers to the cost, which can be influenced by the actions of a person in
whom authority for such control is vested. Cost is said to be controllable at a particular level of
management if that level has the power to authorize its incurrence. In other words, controllable
costs are costs that are reasonably subject to regulations by the manager with whose
responsibility those costs are being identified. For instance, a decision to hire more personnel to
an organization at affordable rates can be controlled.

Non controllable cost: is a cost which cannot be influenced by a person in whom authority for
such control is vested. They are costs, which cannot be adjusted without affecting the long term
objective of the firm. For example, if the trade union demands an increase in wages, the
increment is a non- controllable cost. Similarly, the depreciation of a building is a non-
controllable cost to a manager as he does not have authority over depreciation.

In decision making, only controllable costs are relevant because they can be changed by the
decision maker. There is little or nothing that the decision maker can do about the non-
controllable costs thus they are irrelevant in decision making.

2.6 CLASSIFICATION ACCORDING TO NORMALITY

Normal costs: these are costs that are expected to be incurred given a specific level of
production. They may also be referred to as standard costs.

Abnormal costs: abnormal costs are costs above the normal costs given a specific level of
activity. For instance, abnormal costs may be incurred in production where the prices of
materials have significantly and adversely varied from the standard.

2.7 CLASSIFICATION ACCORDING TO TIME

Historical costs: these are costs that were incurred at a given time in the past. They are
irrelevant for decision making. An example is acquisition cost of an asset.

Predetermined costs: these are estimated costs that have been estimated for purposes of
decision making. An example of such costs include overheads which are absorbed on a given
predetermined overhead absorption rate. They are not always accurate.

2.8 CLASSIFICATION BASED ON IDENTIFICATION WITH INVENTORY

Under this classification, costs are classified according to the function they perform in an

organization. Costs can functionally be classified as:

(a) Product costs: are all the costs incurred in production of units during a time period e.g. raw

material costs, direct labour costs and production overheads. Such costs are capitalized and
expensed (charged to the profit and loss account) only when the manufacturer sells inventory.
These costs may be carried from one period to the other.

(b) Period costs: these are costs mainly incurred in the ordinary running of the business
enterprise. They include costs like electricity bill paid, salaries and allowances and rent
payments. They are referred to as period costs since they are expensed in the period they are
incurred.

2.9 CLASSIFICATION FOR DECISION MAKING

a) Sunk costs: these are costs, which have already been incurred. They cannot be changed by
any decision made after incurrence. Such costs are irrelevant for decision making. For example,
cost of a delivery van already acquired by the organization shall be irrelevant as it cannot be
changed by any course of action taken by management.

b) Marginal cost: is the additional cost of producing an extra unit of output.

c) Opportunity cost: is defined as the cost of the next best foregone alternative or the potential

benefit that is lost by taking one course of action and giving up the other. For instance, by

deciding to take on a leave and forego wages, the opportunity cost of the decision shall be the

foregone wages.
d) Differential cost/incremental cost: these are costs that differ among alternatives. To find the
differential cost, you simply subtract the total cost of one alternative from the total costs of
another alternative. They are costs relevant for decision making. They may be either variable
or fixed. For instance, if taking up a different business apartment amounts to an extra Shs2,000
rent expense, the differential (incremental) cost of the decision shall be the Sh.2,000.

e) Imputed cost- this is a hypothetical cost, also known as implicit or opportunity cost that is not
a direct cash transaction but is assumed in accounting and decision-making to represent the value
of resources the business already owns and uses. For example, a firm using its own building has
an imputed rent cost, which is the rent it could have earned by leasing the building to another
tenant. Is an expense not incurred directly, but actually borne e.g example, a person who owns a
home debt-free has an imputed rent expense equal to the amount of interest that could be earned
on the proceeds from the sale of the home if the home were sold.

f) Replacement cost

The amount it would cost to replace an asset at current prices. If the cost of replacing an asset in
its current physical condition is lower than the cost of replacing the asset so as to obtain the level
of services enjoyed when the asset was bought, then the asset is in poor condition and the firm
would probably not want to replace it

g) Standard cost -A management tool used to estimate the overall cost of production, assuming
normal operations.

h) Budgeted cost -This is the cost estimated to be incurred and used for budgeting purposes. It is
a cost included in the budget representing cost expected. Most of the times, budgeted cost will be
derived from standard cost.