Chapter 1

Cost unit and Cost classification

Difference between financial accounting & management accounting

What is Cost
Cost means all the expenses a business spends to make a product or service.
Example: Ice Cream Shop, Buying milk, sugar, and cones = cost.
Exam Preparation, Books + tuition fee = cost of preparing for exams.
So, cost + profit = price

✓ Cost object: anything for which a separate measurement of cost is required or

the “thing” we calculate cost for. Example is trip, event, cake
✓ Cost unit: a unit of product which has cost attached to it or the “unit” in which that
cost is measured. Trip=per head, event=per person, cake= per cake.
✓ Cost center: is a part/ department of a business where we spend money cost but
it does not directly generate profits or revenue
• There are two types of cost centers i.e. Production cost center and
service cost center. Production cost centers is A department where the
actual product is made. Service cost center is a department A
department that supports production but does not make the product
directly.
✓ Profit center: is a part/department of a business that bring in revenues(sales).

Bakery Example
• Cost Centre → Baking Department (tracks flour, sugar, electricity costs).
• Cost Unit → One Cake (we calculate the cost per cake).
• Profit Centre → Sales Department (earns money by selling cakes).
Hospital Example
• Cost Centre → Laboratory (spends on chemicals, staff salaries).
• Cost Unit → One Patient / One Bed-Day (cost per patient treated).
• Profit Centre → Surgery Department (earns revenue from surgery fees).

Car Factory Example

• Cost Centre → Painting Department (uses paint, wages, electricity).
• Cost Unit → One Car (cost per car is measured).
• Profit Centre → Showroom / Sales Department (sells cars and earns profit).

School Example
• Cost Centre → Library (books, librarian salary).
• Cost Unit → Cost per Student.
• Profit Centre → Admission/Teaching Department (students pay fees → revenue).

Practice
Question 1:
Which of the following would not be a cost unit in a hospital?
a) Patient night
b) Ward bed
c) X ray department
d) Canteen meal

Question 2:
which of the following would be an appropriate cost unit for a manufacturing company?
1. A unit of output
2. 1 batch of product consisting of 1000 units
3. The finance department
4. A member of a sales team
a) 1 and 4 only
b) 1,2, and 4
c) 3 and 4
d) 1 and 2 only

Question 3:
Which of the following statements is TRUE?
a) A cost centre always generates revenue.
b) A cost unit is the same as a cost centre.
c) A cost centre is used to collect costs, while a cost unit is used to measure cost per
product/service.
 d) A cost unit cannot exist without a profit centre.

Question 4:
In a hotel, which of the following would be classified as a cost unit?
a) Room service department
b) One occupied room night
c) Housekeeping department
d) Maintenance workshop

Question 5:
Which of the following best describes a production cost centre?
a) It directly works on the product.
b) It provides support but does not directly work on the product.
c) It earns profit by selling products.
d) It records only administrative expenses.

Question 6:
In an airline company, which of the following is a service cost centre?
a) Cabin crew
b) Ticketing counter (sales)
c) IT support department
d) Flight operations

Cost classification: means grouping costs into categories so they are easier to
understand and manage.
By Nature (What the cost is):
• Material
• Labour
• Expenses
By Function (Where the cost is used):
• Production cost (making)
• Administration cost (managing)
• Selling & distribution cost (marketing/delivery)
By Behavior (How cost changes with activity):
• Fixed cost → stays same
• Variable cost → changes with output
• Semi-variable → partly fixed, partly variable
By Identifiability:
• Direct cost → directly traced
• Indirect cost → shared/common
Cost classification By Function (Where the cost is used):
Function: any activity performed in a business
• Finance cost
• Research cost
• Distribution cost
• Production cost
• Seling cost
• Administration cost
Selling cost = the cost of activities done to sell the product (to attract customers and
make sales). It includes all expenses from marketing to actually selling. Examples
• Advertising on TV, social media, or posters
• Salesperson’s salary or commission
• Free samples given to customers
• Cost of showrooms or shops (depreciation, rent)
• Discounts offered to customers
• Packaging that is specially designed for attracting buyers

Admin cost = the expenses of running and managing the business (not making or selling
products). It’s the office and management expenses. Examples of Admin Costs:
• Office staff salaries (managers, accountants, clerks)
• Office rent and electricity
• Stationery and printing
• Telephone and internet bills
• Audit fees / legal fees
• Office furniture depreciation

Distribution cost = cost incurred to deliver a product from the business to the customer.
• Transportation charges (truck repair, maintenance, insurance depreciation etc.,
fuel, driver salary)
• Road tax
• Warehouse cost
• Packaging cost

Finance cost = cost of arranging finances e.g., interest

Research cost= which is incurred prior to the production e.g.
• Researcher salary
• Laboratory cost
Production cost = cost of producing a product e.g.
• Material, labor, expenses
Cost classification by nature (what the cost is):
There are three elements of cost by nature
1. Material
2. Labor
3. Expenses
Element Examples (Bakery)
Material Flour, sugar, butter, eggs
Labor Bakers, cake decorators
Expenses Rent, electricity, ads, delivery

Elements Examples (Education)

Material notes books, board, markers
Labor teachers, staff
Expenses class room rent, electricity, internet, maintenance
Cost classification by identifiability (type of cost)
• Direct cost: is a cost which can be traced in full to a specific cost unit.
• Indirect cost: is a cost which cannot be traced in a full to a specific cost unit.
Example

Cost

Direct cost Indirect cost

(element are material, labor, expenses) (elements are material, labor, expenses)
So
direct material, direct labor, direct expenses indirect material, indirect labor, indirect
Are three elements of direct cost labor are three elements of indirect cost

Direct material: the raw materials that are used directly to make a product and can be
easily traced to that product.
Examples:
• Wood for making a table
• Flour for baking a cake
• Fabric for making a dress
• Steel for making a car
• Leather for making shoes
•
Direct labor: workers who are directly involved in making a product and whose work can
be easily traced to that product.
Examples:
 • Carpenter building a table
• Baker baking a cake
• Tailor sewing a dress
• Worker assembling a car
• Shoemaker stitching shoes
Direct expenses: Costs that are specifically incurred for a particular product, job, or
service and can be directly traced to it.
Examples
• Special packaging for a product
• Royalty paid per product made
• Hiring a machine for a specific job
• License fees for producing a particular product
Note: Prime cost = direct material + direct labor + direct expenses

Example:
Wood → $50
Carpenter wages → $30
Special varnish for table → $5
Prime Cost = 50 + 30 + 5 = $85

Indirect material: Materials used in production that cannot be directly traced to a specific
product.
Examples:
• Glue or nails used in the workshop
• Oil or lubricants for machines
• Cleaning supplies for the factory
• Paint for factory walls
• Small tools used across many products

Indirect labor: helps production generally but is not part of the product directly.
Examples:
• Factory supervisor
• Security guards
• Maintenance staff
• Office staff in the production department
• Cleaner/janitor

Indirect expenses: Indirect expenses support the business or production generally but
cannot be assigned to one product directly.
Examples:
• Factory rent
• Electricity for the whole factory
• Depreciation of machinery
• Insurance for the factory
• Property taxes
Note: Production overheads=indirect material + indirect labor + indirect expense

Direct material
Direct labor Prime cost
Direct expense

+ total production cost

Indirect material Total

Indirect labor production overheads cost
Indirect expenses
+

Selling cost
Admin cost
Finance cost non production overheads
Research cost
Distribution cost

Non-Production Overheads: Costs for running the business that are not related to
making the product. Examples:
Main Types:
Selling Overheads – Costs to sell the product
• Advertising, sales staff salaries, delivery costs

Administrative Overheads – Costs to run the business office

• Office salaries, office rent, office electricity

Finance Overheads – Costs of borrowing money

• Interest on loans, bank charges
Question: 7
Which of the following costs would be classified as direct costs in a manufacturing
business?
1. Wages of factory workers assembling products
2. Electricity used in the office
3. Cost of raw materials used in production
4. Rent of the sales office
a) 1 and 2 only
b) 1 and 3 only
c) 2 and 4 only
d) 1, 2, and 3
Tip
Type of Overhead Meaning Examples
Production/Indirect Costs inside the factory to Factory rent, indirect labor, indirect
Expenses make products material, electricity for machines
Selling: advertising, sales salaries,
delivery
Non-Production Costs outside the factory, not
Administrative: office salaries, office
Overheads part of product
rent, office electricity
Finance: interest on loans, bank charges

Conversion cost is the total cost incurred to convert raw materials into finished
products.
Conversion cost = direct labor + direct expenses+ production overheads
OR
Production cost – direct material

Question 8:
A bakery produces 1,000 cakes. The flour and sugar used in the cakes cost $500. The
baker’s wages are $300. The electricity for the bakery is $100. Which of these are direct
costs?
a) Flour and sugar only
b) Baker’s wages only
c) Flour, sugar, and baker’s wages
d) Electricity

Question 9:
A chocolate factory spends on:
• Cocoa and sugar for chocolates
• Wages of chocolatiers
 • Cleaning staff wages
• Office rent
Cost Type
a) Cocoa and sugar ?
b) Chocolatiers’ wages ?
c) Cleaning staff wages ?
d) Office rent ?

Cost behavior: cost behavior refers to how a cost changes (increase, decrease or
stays the same) when the level of business activity changes.
• Fixed cost
• Variable cost
• Semi variable/ mixed cost
• Step cost
Before start the topic we have to understand one related concept i.e.

Fixed cost: cost which do not change with the change in activity level. Example is company has
produced 5000 units and incurred cost of $10000