CLASSIFICATION OF COSTS BASED ON FUNCTION

PRODUCTION COSTS
All the costs relating to the production of goods or services, whether direct or indirect, are
included in the production cost. We can classify production costs into direct and indirect
production costs.
 Example of Direct Production Costs (also known as direct manufacturing costs)
 Direct Raw Material
 Direct Labor
 Other Direct Expenses such job work charges relating to particular product, etc.
Examples of Indirect Production Costs (also known as Production or Manufacturing Overheads)
 Salaries of Supervisors, Production Heads, Technical and Planning Staff etc
 Quality control costs
 Other labor-related expenses
 Store expenses etc
ADMINISTRATION COSTS
These costs are incurred in connection with the general management of the business. These are
normally indirect costs and are also known as administrative overheads. Example of such costs
can be following:
 Salaries of staff in general management
 Office related expenses such as rent, rates, taxes, telephone, stationery etc.
 Charges levied by bank
 Audit and legal fees
 Office related depreciation etc.
SELLING COSTS
Selling costs include all kinds of expenses incurred for achieving sales of the products and
services. These are also considered indirect expenses are known as selling overheads. Examples
of such costs are as follows:
 Salaries of selling staff
 Commission, conveyance, discount etc
 Product market research
 Royalty etc
DISTRIBUTION COSTS
Distribution costs include all kinds of expenses are incurred for distributing the products from its
point of production to its customers. Examples of distribution costs are as follows:
 Transportation costs
 Warehouse rents
 Commission to Distribution channel etc
RESEARCH AND DEVELOPMENT COSTS
Costs under these heads are the costs comprising of development costs of new products,
improvement related expenses etc.
Types of Costs by Behavior

Cost behavior refers to the way different types of production costs change when there is a change
in level of production.
There are three main types of costs according to their behavior:

Fixed Costs:

Fixed costs are those which do not change with the level of activity within the relevant range.
These costs will incur even if no units are produced. For example rent expense, straight-line
depreciation expense, etc.
Fixed cost per unit decreases with increase in production. Following example explains this fact:
Total Fixed Cost $30,000 $30,000 $30,000

÷ Units Produced 5,000 10,000 15,000

Fixed Cost per Unit $6.00 $3.00 $2.00

Variable Costs:

Variable costs change in direct proportion to the level of production. This means that total
variable cost increase when more units are produced and decreases when less units are produced.
Although variable in total, these costs are constant per unit. For example
Total Variable Cost $10,000 $20,000 $30,000

÷ Units Produced 5,000 10,000 15,000

Variable Cost per Unit $2.00 $2.00 $2.00

Mixed Costs:

Mixed costs or semi-variable costs have properties of both fixed and variable costs due to
presence of both variable and fixed components in them. An example of mixed cost is telephone
expense because it usually consists of a fixed component such as line rent and fixed subscription
charges as well as variable cost charged per minute cost. Another example of mixed cost is
delivery cost which has a fixed component of depreciation cost of trucks and a variable
component of fuel expense.
Since mixed cost figures are not useful in their raw form, therefore they are split into their fixed
and variable components by using cost behavior analysis techniques such as High-Low Method,
Scatter Diagram Method and Regression Analysis.
Several methods are used for segregating semi-variable costs into fixed and variable. There
are four major techniques that are found in practice and they may be listed as follows:
1. High and low points method

2. Scatter graph method

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3. Least squares regression method.

4. Accounting or analytical approach

1. High and Low Points Methods:

This approach considers the difference in total cost between two different volumes, and divides
the incremental cost by the volume. As the words ‘high’ and ‘low’ imply, the two levels of
volume chosen are the highest and the lowest for the periods under review. The result of this
division is the estimated variable cost per unit.

Then, the average activity level is computed together with the average cost for the periods in the
data base. The fixed cost is estimated by taking the total average cost and subtracting the variable
cost for the average activity level. The variable cost is computed by multiplying the average
activity level by the variable cost per unit as determined above.

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As an illustration, assume that a company incurred the following costs in two periods (high
and low) in which 5,000 units and 10,000 units were produced:
Cost:

Since insurance remained constant at the two volumes, there is no variable component. Since a
100% increase in volume resulted in a 100% increases in depreciation, there is no fixed
component. Indirect materials contain both a fixed and variable component.
2. Scatter-Graph Method:
Another approach to the estimation of the fixed and variable components of a mixed cost is the
scatter-graph method. With this procedure, various costs are plotted on a vertical line, the y-axis,
and measurement figures (activity levels such as direct labour hours, units of output, percentage
of capacity or direct labour cost) are plotted along a horizontal line, the x-axis.

A straight line is fitted to this scatter of points by visual approximation. The slope of the line is
used to estimate the variable costs and the intercept of the line with the vertical axis is considered
as the estimated fixed cost. The following examples illustrates the scatter-graph method.

The first step in constructing a scatter-graph requires plotting each of the observation on graph
paper. The second step is fitting a regression line or trend line to the data. In the chart, line B is
plotted by visual inspection. Ideally, there should be as many dots above as below the line.

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Another line is drawn parallel to the base line from the point of inter section on the y-axis, which
is at Rs 2, 20,000. This line A represents the fixed portion of the expenses for all levels of
activity within a reasonable range. The triangle formed by line A and B shows the increase in the
expenses as direct labour hours increase.
Fixed expenses per month = Rs 2, 20,000

Fixed expenses per year = 2, 20,000 x 12 = Rs 26, 40,000

Subtracting the fixed portion from the total expenses = Rs 34, 20,000 – 26, 40,000 = Rs 7,
80,000

Rs 7, 80,000 is the total variable portion of the expenses.

Variable cost per direct labour = Rs 7, 80,000/2, 10,000 Rs 3.7 per Hour.

Thus, expenses consist of Rs 2, 20,000 fixed expenses and variable factor Rs 3.7 per unit direct
labour hour.

On the scatter-graph, although the points are scattered, a definite upward line or cost trend in
relation to volume is clearly apparent. Placing transparent ruler over the points, the accountant
tries to fit a line to the points in such a way that the areas above and below the line are about
equal. Interaction of the trend line with the cost axis determines the fixed component. The
variable components can be found by subtracting the fixed component from the total cost at any
volume. In the scatter-graph method, data being irregular, the trend line would not be so obvious
and drawing the line would be difficult.

A definite trend upward is apparent but exactly where the trend line should fall is not so easy to
locate.

The scatter-graph is a simple device requiring no complicated formula or calculation. It shows a

cost behaviour pattern graphically and is easily understood. As a graph it does not possess a high
degree of accuracy. It has within itself a measure of reliability. Correlation, if any, that exists
between cost and volume is apparent. If costs are behaving irregularly, this fact will be known as
soon as the observations are plotted. The Scatter-graph has, however, one drawback. Fitting the
trend line by observation introduces a personal bias which can be removed only by fitting the
line mathematically.

3. Least Squares Regression Method:

The method of least squares uses the equation for a straight line: Y = a + bx, with a as the fixed
element, and b the degree of variability. For many accounting application, regression provides an
accurate estimate of fixed and variable costs.

The answer under regression differs from the scatter-graph method because observation does not
offer so accurate an answer as this mathematical procedure. Individuals cannot differ in their
separation of fixed and variable components. However, this method has drawbacks; it fits a
straight line to any set of cost data no matter how erratic the cost behaviour pattern may be.
Further, unless a computer is available for this work, the calculations required by the method of
least squares are laborious and time-consuming.

4. Accounting or Analytical Approach:

This approach to cost behaviour analysis is close scrutiny of the chart of accounts and a clas-
sification of costs into their fixed and variable components according to their basic
characteristics determined by the accountant using good judgment, knowledge, and experience.
This approach is simple and inexpensive but in its simplicity lies its inherent weakness.

The results obtained are not accurate and may happen to be mere guesses. To improve this
method, costs over a period of time can be watched. The time selected must be long enough to
provide valuable data over a wide range of activity. Having collected cost data at different
production levels, the accountant then proceeds to identify fixed and variable costs. Costs which
appear to be semi -variable must be set aside for further analysis into fixed and variable
components.

Example:
The following are the Maintenance Costs incurred in a Machine shop for the six month
with corresponding machine hours:

Analyse the Maintenance Cost which is semi -variable into fixed and variable element.

Solution:
Computation of Variable Cost and Fixed Cost has been done according to Range Method.