Chapter 2: Cost Classification

Chapter Learning Objectives

Distinguish between cost, profit, investment, and revenue centers.

Describe the differing information needs for cost, profit, investment, and revenue center
managers.
Explain and illustrate production and non-production costs.
Describe the different elements of non-production costs – administrative, selling, distribution,
and finance.
Describe the different elements of production cost – materials, labor, and overheads.
Explain the importance of the distinction between production and non-production costs when
valuing output and inventories.
Explain and illustrate with examples classifications used in the analysis of the product/
service costs including by function, direct and indirect, fixed and variable, stepped fixed, and
semi-variable costs.
Identify and interpret graphical representations of different types of cost behavior.
Use high-low analysis to separate the fixed and variable elements of total costs including
situations involving semi-variable and stepped fixed costs and changes in the variable cost
per unit.
Explain the advantages and disadvantages of using the high-low method to estimate the fixed
and variable element of costing.
Explain the structure of linear functions and equations.
Explain and illustrate the concepts of cost objects, cost units, and cost centers.
Explain and illustrate the use of codes in categorizing transactions.

1. Analyzing Costs

Responsibility accounting is based on identifying individual parts of a business that are the
responsibility of a single manager.
A responsibility center is an individual part of a business whose manager has personal
responsibility for its performance.
Cost Centers

A
cost center
is a production or service location, function, activity, or item of equipment whose costs are
identified and recorded.
For a paint manufacturer, cost centers might be: mixing department, packaging
department, administration, or marketing departments.
For an accountancy firm, the cost centers might be: audit, taxation, accountancy,
administration, and canteen. Alternatively, they might be the various geographical
locations, e.g., the London office, the Rome office, and the Peru office.

Cost center managers need to have information about costs that are incurred and charged to
their cost centers.
The performance of a cost center manager is judged on the extent to which cost targets have
been achieved.

Revenue Centers

A revenue center is a part of the organization that earns sales revenue. It is similar to a cost
center, but only revenues, and not costs, are recorded.
Revenue centers are generally associated with selling activities. For example, regional sales
managers may have responsibility for the regional sales revenues generated.
Each regional manager would probably have sales targets to reach and would be held
responsible for reaching these targets.
Sales revenues earned must be able to be traced back to individual (regional) revenue centers
so that the performance of individual revenue center managers can be assessed.

Profit Centers

A profit center is a part of the business for which both the costs incurred and the revenues
 earned are identified.
Profit centers are often found in large organizations with a divisionalized structure, and each
division is treated as a profit center. combo of cost and
revenue centers is
Within each profit center, there could be several cost centers and revenue centers. 'one' profit center
.
The performance of a profit center manager is measured in terms of the profit made by the
center.
The manager must therefore be responsible for both costs and revenues and be in a position
to plan and control both.
Data and information relating to both costs and revenues must be collected and allocated to
the relevant profit centers.

Investment Centers

Managers of investment centers are responsible for investment decisions as well as

decisions affecting costs and revenues.
Investment center managers are therefore accountable for the performance of capital
employed as well as profits (costs and revenues).
The performance of investment centers is measured in terms of the profit earned relative to
the capital invested (employed). This is known as the return on capital employed (ROCE).
An example of an investment center could be the UK and European divisions of a
multinational company.

Cost Objects

A
cost object
is any activity for which a separate measurement of cost is undertaken.
Examples of cost objects:
Cost of a product
Cost of a service
Cost of running a department
Cost of running a regional office.
Cost Units

A
cost unit
is a unit of product or service in relation to which costs are ascertained.
Examples of cost units:
A room (in a hotel)
A liter of paint (paint manufacturers)
In-patient (in a hospital).

Cost Cards

A cost card is used to show the breakdown of the costs of producing output based on the
classification of each cost. A cost card can be produced for one unit or a planned level of
production.
The following costs are brought together and recorded on a cost card:
Direct materials
Direct labor
Direct expenses
Prime cost (total direct costs)
Variable production overheads
Fixed production overheads
Non-production overheads

Illustration 1 - Cost Card

A cost card for a hand-made wooden train set is shown below.

The cutting and assembly department and the painting department are cost centers.
One hand-made wooden train set is a cost unit (but may also be classed as a cost object).

$ per unit

Direct materials:

Wood 5m² @ $2.50 per m² 12.50

Paint 0.1 liters at $10 per liter 1.00

Direct labor:

Cutting and assembly department 0.5 hours at $6.00 per hour 3.00

Painting department 1.0 hours @ $7.00 per hour 7.00

Direct expenses:

Licence fee $2 per train set 2.00

PRIME COST 25.50

Variable production overheads:

Power for electric saws 0.25 hours @ $2.00 per hour 0.50

TOTAL VARIABLE (MARGINAL) PRODUCTION COST 26.00

Fixed production overheads:

1.5 labour hours @ $10.00 per labour hour 15.00

TOTAL PRODUCTION (ABSORPTION) COST 41.00

Non-production overheads:

Administration, selling and distribution 20% of total production cost 8.20

TOTAL COST 49.20

Mark-up:
There is to be a 20% mark-up applied when calculating the selling price:
Mark-up = 49.20/100 * 20 = $9.84
Selling price = $49.20 + $9.84 = $59.04
 Margin:
There is to be a margin of 10% applied when calculating the selling price:
Margin = $49.20/90 * 10 = $5.47
Selling price = $49.20 + $5.47 = $54.67

2. Classifying Costs

Element: classify costs as to whether they relate to material, labor, or expenses. This is useful
for cost control.
Nature: classify costs as to how they relate to production. Are they directly involved in the
production of the product/service or indirectly involved in production? This is useful for cost
accounting.
Function: classify costs based on whether they are production costs or non-production costs.
This is useful for the financial accounts.
Behavior: classify costs based on how they change in relation to levels of output or activity.
This is useful for budgeting and decision-making.

Classification by element

Materials: all costs of materials purchased for production or non-production activities. For
example, raw materials, components, cleaning materials, maintenance materials, and
stationery.
Labor: all staff costs relating to employees on the payroll of the organization.
Expenses: all other costs which are not materials or labor. This includes all bought-in
services, for example, rent, telephone, sub-contractors, and costs such as the depreciation of
equipment.

Classification by nature

Direct costs
 Direct costs are costs that can be directly identified with a specific cost unit or cost center.
There are three main types of direct cost - direct material, direct labor, and direct expenses.
The total of direct costs is known as the prime cost.

Indirect costs

Indirect costs are costs that cannot be directly identified with a specific cost unit or cost
center.
The total of indirect costs is known as overheads.

Direct and indirect cost

The salary of the machining department supervisor is a direct cost of that department or cost
center because it can be specifically identified with the department. However, it is an indirect
cost of each of the cost units processed in the machining department because it cannot be
specifically identified with any particular cost unit.

Test your understanding 1

Cost Materials, labor or Direct or

expense indirect?

The hire of specific tools or equipment Expense Direct

Rent of the factory Expense Indirect

Supervisors' salaries Labor Indirect

Oil for lubricating machines Material Indirect

Wages of factory workers involved in Labor Direct

production

Depreciation of equipment Expense Indirect

Test your understanding 2

(a) B. A stores assistant in a factory storeroom. (b) B. costs which can be identified with a single
cost unit or cost center.

Classification by function

Production costs

Production costs are costs that relate to the manufacture of a product or the provision of a
service. These costs are found in the cost of sales section of the statement of profit or loss.
Production costs, such as direct materials, direct labor, direct expenses, and production
overheads, are included in the valuation of inventory.

Production Costs

Direct Materials
Direct Labor
Direct Expenses
Variable Production Overheads
Fixed Production Overheads

Examples of production costs

Examples of production costs for a construction company:

Direct materials – bricks, cement

Direct labor – builders, plasterers, electricians
Direct expenses – the cost of a subcontracted crane and driver
 Variable production overheads – electricity
Fixed production overheads – site managers salary.

Non-production costs

Non-production costs are costs that are not directly associated with the production of the
business's output.
Non-production costs, such as administrative costs, selling costs, and finance costs, are
charged to the statement of profit or loss as expenses for the period in which they are
incurred. Non-production costs are not included in the valuation of inventory.

Non-Production Costs

Administrative Costs
Selling Costs
Distribution Costs
Finance Costs

Examples of non-production costs

Administrative costs – the costs involved in running the general administration departments
of an organization, for example, the accounts department.
Selling costs – costs associated with taking orders from customers who wish to buy an
organization's products (sales department costs) and also marketing costs.
Distribution costs – the costs involved in distributing an organization's finished products,
such as the cost of running the warehouse or delivery costs.
Finance costs – the costs that are incurred in order to finance an organization, for example,
loan interest.

Test your understanding 3

Cost Classification

Overalls for machine workers 1

Cost of printer cartridges in general office 4

Salary of factory supervisor 1

Salary of payroll supervisor 4

Rent of warehouse for storing goods ready for sale 3

Loan interest 5

Salary of factory security guard 1

Early settlement discounts for customers who pay early 2

Salary of the Chairman's PA 4

Road tax license for delivery vehicles 3

Bank overdraft fee 5

Salesmen's commissions 2

3. Classification by behavior

Variable cost
Fixed cost
Stepped fixed cost
Semi-variable cost

Variable Costs

Variable costs are costs that vary in direct proportion with the level of activity. As activity
levels increase, then total variable costs will also increase.
Graph 1: Total cost increases with the level of activity.
Graph 2: Cost per unit remains constant.
Examples of variable costs include direct costs such as raw materials and direct labor.
Numerical example of variable costs

A factory is producing widgets. It takes 4m² to make one widget and it costs $2 per square
meter. If the factory makes 50 widgets it costs $400, if the factory makes 100 widgets it
costs $800. The cost incurred increases in line with the volume being produced - graph 1
demonstrates this.
The material for each widget costs 4 x $2 = $8 and it does not change if more or less widgets
are made. The variable cost per unit remains constant - graph 2 demonstrates this.

Material cost and discounts

Direct material costs are assumed to have a variable cost behavior, but sometimes quantity
discounts are available when purchases exceed a certain order size.

Scenario 1: Discounts are received on additional purchases of material above a set order
quantity and the discount only applies to the extra units.

Scenario 2: Discounts are received when total purchases exceed a certain level and all units
purchased are invoiced at a lower cost per unit. Note: the data line will always return to the
origin.

Fixed Costs

A fixed cost is a cost which is incurred for an accounting period, and which, within certain
activity levels, remains constant.
Graph 1: Total cost remains constant with the level of activity.
Graph 2: Cost per unit decreases with an increase in activity.
Examples of fixed costs:
Rent
 Business rates
Executive salaries.

Numerical example of fixed costs

If factory rent is $5,000 per month, this cost will be incurred whether 2 widgets are made, or
200 widgets are made - graph 1 demonstrates this.
If 2 widgets are made the fixed cost per unit is $5,000 + 2, i.e. $2,500 per widget.
If 200 widgets are made the fixed cost per unit is $5,000 + 200, i.e. $25 per widget.
Therefore, the fixed cost per unit falls at a reducing rate but never reaches zero - graph 2
demonstrates this.

Test your understanding 4

ILCB has the following information relating to one of its products:

Direct material cost per unit $1

Direct labor cost per unit $3
Variable production cost per unit $3
Fixed production overhead $30,000 per month
Budgeted production 15,000 units per month

Required: Calculate the cost per unit and the total cost of the budgeted monthly production?

Direct material cost = 15,000 units * $1 = $15,000

Direct labor cost = 15,000 units * $3 = $45,000
Variable production cost = 15,000 units * $3 = $45,000
Fixed production cost = $30,000
Total production cost = $135,000
Production cost per unit = $135,000 / 15,000 = $9
Stepped Fixed Costs

This is a type of fixed cost that is only fixed within certain levels of activity. Once the upper
limit of an activity level is reached, then a new, higher level of fixed cost becomes relevant.
Examples of stepped fixed costs:
Warehousing costs (as more space is required, more warehouses must be purchased or
rented)
Supervisors' wages (as the number of employees increases, more supervisors are
required).

Numerical example of stepped costs

For production of up to 50 widgets, only one supervisor is required but if production is

between 50 and 100 widgets, two supervisors are required.
The cost of one supervisor is $18,000 per annum and the cost of two supervisors is therefore
$36,000.
The fixed costs therefore increase in steps.

Semi-variable costs

Semi-variable costs contain both fixed and variable cost elements and are therefore partly
affected by changes in the level of activity.
Examples of semi-variable costs:
Electricity bills (fixed standing charge plus variable cost per unit of electricity consumed)
Telephone bills (fixed line rental plus variable cost per call).

Test your understanding 5

Classify the following items of expenditure according to their behavior i.e., as fixed, variable,
semi-variable, or stepped fixed costs.

1. Monthly rent - Fixed

2. Council tax charge - Fixed
3. Production line workers wages - Variable
4. Electricity bill - Semi-variable
5. Telephone bill - Semi-variable
6. Annual salary - Fixed
7. Depreciation of 1, 2, or 3 machines - Stepped fixed
8. Raw materials - Variable

Test your understanding 6

Study the following graphs, where the vertical axis represents "Total Costs" or "Cost per unit."

Graph 1: Total Variable Cost

Graph 2: A Stepped fixed cost is shown in graph
Graph 3: Total Semi-Variable Cost
Graph 4: Total fixed cost is shown in graph
Graph 5: Total variable cost is shown in graph
Graph 6: Fixed cost per unit is shown in graph

4. Identifying Cost Behaviors

The behavioral characteristics of costs are used when planning or forecasting costs at
different levels of production or activity. When producing a forecast it may be necessary to
identify the type of behavior a cost is exhibiting. It is useful to remember the following:
Fixed costs are constant in total
Variable costs are constant per unit
Semi-variable costs are neither constant in total nor constant per unit
Stepped fixed costs will be constant in total within a certain range.
Illustration 2 – Identifying cost behaviors

A company has a mix of variable, semi-variable, fixed, and stepped fixed costs. Identify the
behavior for each of the costs

Cost 1 is a semi-variable cost as the total cost changes when activity level change and the
cost per unit also changes at the different activity levels
Cost 2 is a variable cost as the cost per unit is constant at each activity level
Cost 3 is a fixed cost as the total cost does not change as activity level changes
Cost 4 is a stepped fixed cost as the total cost is constant then increases to a new constant
level and the cost per unit is changing at each activity level

5. The High Low Method used for Separating a Semi-

Variable Cost

The total cost of a semi-variable cost is:

Total costs = Total fixed costs + (Variable cost per unit x Activity level)

To be able to predict costs at different activity levels it is necessary to separate the fixed cost
element from the variable cost element. The high-low method can be used to approximate
the variable cost per unit and the total fixed cost.

The High Low Method

Step 1: Select the highest and lowest activity levels, and their associated costs.
Step 2: Calculate the variable cost (VC) per unit:
VC per unit = (Cost at high level of activity - cost at low level of activity) / (High level of activity -
low level of activity)

Step 3: Calculate the fixed cost by substitution, using either the high or low activity level:

Fixed cost = Total cost at activity level - (Variable cost per unit x Activity level)

Step 4: Use the total fixed cost and the variable cost per unit values from steps 2 and 3 to
calculate the estimated cost at different activity levels:

Total costs = Total fixed costs + (Variable cost per unit x Activity level)

Assumption underlying the high low method

Assumptions of the high-low method are as follows:

the only thing causing any change in cost is the change in activity
the cost under consideration is potentially semi-variable (i.e., it has both fixed and variable
elements)
the linear model of cost behavior is valid, i.e., y = a + bx (we will study this in more detail
later on in this chapter).

Illustration 3 – The High Low Method

(a) Variable cost per unit = ($9,000 – $7,000)/(400 – 200) = $2,000/200 = $10 per unit
(b)
Total fixed cost by substituting at high activity level:
Total cost = $9,000
Total variable cost = 400 x $10 = $4,000
Therefore fixed cost = $5,000
 (c)
If output is 350 units
Variable cost = 350 * $10 = $3,500
Fixed cost = $5,000
Total cost = $8,500

(d)
If output is 600 units:
Variable cost = 600 x $10 = $6,000
Fixed cost = $5,000
Total cost = $11,000

Test your understanding 7

Using the high low method, analyze the total cost into fixed and variable components.
Variable cost per unit = $31 per unit
Fixed cost = $5,760

High low method with stepped fixed costs

Sometimes fixed costs are only fixed within certain levels of activity (stepped fixed costs).
The high low method can still be used to estimate fixed and variable costs.
Choose the two activity levels where the fixed costs remain unchanged and calculate the
variable cost per unit and the total fixed cost using the high low technique.
Adjustments may need to be made to the fixed costs when calculating the total cost for a
new activity level.

Illustration 4 – the high low method with stepped fixed

costs
 (a)
Calculate the variable cost per unit by comparing two output levels where fixed costs will be
the same:
Variable cost per unit = [(54,800 - 50,000) + (7,500 - 6,000)] = $3.20
Total fixed cost above 5,500 units = [54,800 - (7,500 x 3.20)] = $30,800
Total fixed cost below 5,500 units = 30,800/110 x 100 = $28,000
Total cost for 5,000 units = [(5,000 x 3.20) + 28,000] = $44,000

High low method with changes in the variable cost per

unit

Sometimes there may be changes in the variable cost per unit, and the high low method can
still be used to determine the fixed and variable elements of semi-variable costs. As with the
stepped fixed costs - choose activity levels where the variable costs per unit remain
unchanged.

Illustration 5 - The high low method with changing

variable costs

For output volumes above 350 units, the variable cost per unit falls by 10%. (Note: this fall
applies to all units - not just the excess above 350).
Variable cost per unit (<350) = $10 per unit
Total cost at 300 units = $8,000
Total variable cost = 300 x $10 = $3,000
Therefore fixed cost = $5,000
If output is 450 units:
Variable cost = 450 x $10 x 90% = $4,050
Fixed cost = $5,000
Total cost = $9,050
Test your understanding 8

Calculate the estimated total costs of producing 100 units in 20X4.

Variable cost per unit = $31

Variable cost = 100 x $31 x 1.1 = $3,410
Fixed cost = $5,760 x 2 = $11,520
Total cost = $14,930

Advantages and limitations of the high low method

The main advantage of the high low method is that it is easy to understand and easy to use.
The limitations of the high-low method are as follows:
it relies on historical cost data and assumes this data can reliably predict future costs
it assumes that activity levels are the only factor affecting costs
it uses only two values (highest and lowest) to predict future costs and these results may
be distorted because of random variations which may have occurred
bulk discounts may be available for purchasing resources in large quantities.

6. Cost equations

Cost equations are derived from historical cost data. Once a cost equation has been
established, for example, distinguishing the fixed and variable costs using the high low
method, it can be used to estimate future costs. Cost equations are assumed to have a linear
function, and therefore the equation of a straight line can be applied: y = a + bx
Where:
'a' is the intercept, i.e., the point at which the line y = a + bx cuts the y-axis (the value of y
when x = 0).
'b' is the gradient/slope of the line y = a + bx (the change in y when x increases by one
 unit).
'x' = independent variable.
'y' = dependent variable (its value depends on the value of 'x').

This formula can be related to the results of the high-low calculation as follows:
'a' is the fixed cost per period (the intercept)
'b' is the variable cost per unit (the gradient)
'x' is the activity level (the independent variable)
'y' is the total cost = fixed cost + variable cost (dependent on the activity level)

Suppose a cost has a cost equation of y = $5,000 + 10x, this can be shown graphically as
follows:
Illustration 6 - Cost equations
(a) Fixed cost = $8,000
(b) Variable cost per unit = $40
(c) Total cost for 200 units = $16,000

Test your understanding 9

(a) The line would cross the y-axis at the point 1,488
(b) The gradient of the line is 20
(c) The independent variable is x
(d) The dependent variable is y

Test your understanding 10

(a) The fixed cost is $4,800

(b) The variable cost per unit is $8
(c) The total cost of producing 100 units is $5,600

7. Cost codes
 A code is a system of symbols designed to be applied to a classified set of items, to give a
brief accurate reference, which helps entry into the records, collation, and analysis.
A cost code is a code used in a costing system.
The first step in creating a cost code will be to determine the cost center to which the cost
relates and then to allocate the correct cost center code.

Illustration 7 - Cost code example

If a cost relates to Machine Group 7, the cost center code might be 07.
If the cost relates to the canteen, the cost center code might be 16.

Generic or functional codes

Once a cost has been allocated its correct cost center code, then it may also be useful to
know the particular type of expense involved. Therefore, some more digits might be added to
the cost center code to represent the precise type of cost.

Illustration 8 – Generic or functional codes

If an expense for Machine Group 7 is for oil, then its code might be 07 (for its cost center)
followed by 23 to represent indirect materials.
If an expense of the canteen is identified as frozen peas, then its cost code might be 16 (its
cost center) followed by 02 to represent food purchases.

Specific codes

Finally, it may be necessary for cost allocation, decision-making, or accounting purposes to

allocate a code which specifically identifies the item of cost.
Illustration 9 – Specific codes example

The oil for Machine Group 7 might eventually be coded as 072304. This represents Machine
Group 7 (07) indirect material use (23) of oil (04).
The frozen peas for the canteen might be coded as 160219. This represents canteen (16)
food purchases (02) of frozen peas (19).
A cost code is designed to analyze and classify the costs of an organization in the most
appropriate manner for that organization. Therefore, there are no set methods of designing a
cost code, and the cost code of a particular organization will be that which best suits the
operations and costs of that business.

Test your understanding 11

The code is: EDSP

Coding systems

Sequential code
Block code
Hierarchical code
Significant digit code
Faceted code
Mnemonic code

Test your understanding 12

(a) Sequence codes allocate a number, or a letter, to items in a simple list. Their main
advantage lies in simplicity of allocation, but they provide no correlation between the items
and their code numbers, and insertions and deletions are not so easily handled.
(b) Block codes allocate bands of numbers to particular categories. With each category, there
is usually a limited amount of possible expansion. They have the merit of simplicity and give
 a more direct relationship between items and codes, which may help with indexing or
information retrieval.
(c) Significant digit codes are when individual digits and letters are used to represent features
of the coded item.
(d) Faceted codes are when the digits of the code are divided into facets of several digits, and
each facet represents some attribute of the item being coded. These codes are similar to
significant digit codes but are purely numerical, which may be preferable in computer
systems.

Test your understanding 13

Test your understanding 14

Test your understanding 15