COST CLASSIFICATION

Lesson 4 and 5

Production and Non-Production Costs

Production costs are all the costs involved in the manufacture of goods. In the case of manufactured

goods, these costs consist of direct material, direct labor, and manufacturing overhead.

Non-production costs are taken directly to the statement of profit or loss (income statement) as

expenses in the period in which they are incurred; such costs consist of selling and administrative

expenses.

Total Product/Service Costs

The total cost of making a product or providing a service consists of the following.

(a) Cost of materials

(b) Cost of the wages and salaries (labour costs)

(c) Cost of other expenses

(i) Rent and rates

(ii) Electricity and gas bills

(iii) Depreciation

Cost classification according to their traceability

Direct costs and indirect costs

A direct cost is a cost that can be traced in full to the product, service or department that is being

costed.

An indirect cost (or overhead) is a cost that is incurred in the course of making a product, providing

a service or running a department, but which cannot be traced directly and in full to the product,

service or department.
Materials, labour costs and other expenses can be classified as either direct costs or indirect costs.

Direct material

Direct material costs are the costs of materials that are known to have been used in making and

selling a product (or even providing a service). Direct material is all material becoming part of the

product (unless used in negligible amounts and/or having negligible cost). They form part of the final

product.

Direct material costs are charged to the product as part of the prime cost. Examples of direct material

are as follows.

(a) Component parts, specially purchased for a particular job, order or process

(b) Part-finished work which is transferred from department 1 to department 2 becomes

finished work of department 1 and a direct material cost in department 2

(c) Primary packing materials like cartons and boxes

Direct labour

Direct labour costs are the specific costs of the workforce used to make a product or provide a service.

Direct labour costs are established by measuring the time taken for a job, or the time taken in 'direct

production work'.

Examples of groups of labour receiving payment as direct wages are as follows.

 • Workers engaged in altering the condition or composition of the product

• Inspectors, analysts and testers specifically required for such production

• Foremen, shop clerks and anyone else whose wages are specifically identified

Direct expenses

Direct expenses are any expenses which are incurred on a specific product other than direct material

cost and wages.

Direct expenses are charged to the product as part of the prime cost. Examples of direct expenses are

as follows.

• The hire of tools or equipment for a particular job

• Maintenance costs of tools, fixtures and so on

Direct expenses are also referred to as chargeable expenses

Production overhead

Production includes all indirect material costs, indirect wages and indirect expenses incurred in the

factory from receipt of the order until its completion.

Production overhead includes the following.

(a) Indirect materials which cannot be traced in the finished product. Consumable stores, eg

material used in negligible amounts

(b) Indirect wages, meaning all wages not charged directly to a product. Wages of non-productive

personnel in the production department, eg foremen

Indirect expenses (other than material and labour) not charged directly to production.

(i) Rent, rates and insurance of a factory

(ii) Depreciation, fuel, power, maintenance of plant, machinery and buildings

Administration overhead
Administration overhead is all indirect material costs, wages and expenses incurred in the direction,

control and administration of an organization.

Examples of administration overhead are as follows.

Depreciation of office buildings and equipment

Office salaries, including salaries of directors, secretaries and accountants

Rent, rates, insurance, lighting, cleaning, telephone charges and so on

Selling overhead

Selling overhead is all indirect materials costs, wages and expenses incurred in promoting sales and

retaining customers.

Examples of selling overhead are as follows.

Printing and stationery, such as catalogues and price lists

Salaries and commission of salespeople, representatives and sales department staff

Advertising and sales promotion, market research

Rent, rates and insurance of sales offices and showrooms, bad debts and so on.

Distribution overhead

Distribution overhead is all indirect material costs, wages and expenses incurred in making the

packed product ready for despatch and delivering it to the customer.

Examples of distribution overhead are as follows.

Cost of packing cases

Wages of packers, drivers and despatch clerks

Insurance charges, rent, rates, depreciation of warehouses and so on

Cost classification according to their function /Functional costs

(a) Production costs are the costs which are incurred by the sequence of operations beginning with

the supply of raw materials, and ending with the completion of the product ready for warehousing as

a finished goods item. Packaging costs are production costs where they relate to 'primary' packing

(boxes, wrappers and so on).

(b) Administration costs are the costs of managing an organisation; that is, planning and controlling

its operations, but only insofar as such administration costs are not related to the production, sales,

distribution or research and development functions.

(c) Selling costs, sometimes known as marketing costs, are the costs of creating demand for products

and securing firm orders from customers.

(d) Distribution costs are the costs of the sequence of operations with the receipt of finished goods

from the production department and making them ready for despatch and ending with the

reconditioning for reuse of empty containers.

(e) Research costs are the costs of searching for new or improved products, whereas development

costs are the costs incurred between the decision to produce a new or improved product and the

commencement of full manufacture of the product.

(f) Financing costs are costs incurred to finance the business, such as loan interest.

Cost Classification According to Their Behavior

Costs can be classified based on their behavior. Cost behavior refers to how costs change as the

level of business activity changes.

Costs can be classified as:

• Fixed costs

• Variable costs

• Semi variable/semi-fixed/ mixed costs

• Stepped fixed costs

Fixed Costs

A fixed cost is a cost which tends to be unaffected in total by increases or decreases in the volume

of output. Fixed costs are constant over a wide range of activity. Fixed costs are a period charge,

in that they relate to a span of time; as the time span increases, so too will the fixed costs (which

are sometimes referred to as period costs for this reason).

In a graph, fixed costs appear as follows:

Examples of fixed costs include:

(a) The salary of the managing director (per month or per annum)

(b) The rent of a single factory building (per month or per annum)

(c) Straight line depreciation of a single machine (per month or per annum
Variable Costs

A variable cost is a cost which tends to vary in total directly with the volume of output. Variable

costs are directly proportional to the level of activity. That is, if the number of units produced

doubles, then variable production costs will double also.

An example would be the cost of material used to produce units. If the number of units sold

increases by 20% then variable selling and distribution costs would increase by 20% also.

On a graph, variable costs would look like:

The following are variable costs.

(a) The cost of raw materials, because the volume of raw materials purchased relates to the

volume used in production.

(b) Direct labour costs. This is due to the ability to increase or decrease the number of workers

and therefore the total cost.

(c) Sales commission is variable in relation to the volume or value of sales.

Semi-variable/semi-fixed/mixed costs

Mixed costs (semi-variable/semi-fixed costs) are partly fixed and partly variable, and therefore

only partly affected by changes in activity levels. Semi-variable costs have a fixed element and a

variable element.
Examples of these costs can include utility bills, if there is a standing basic charge plus a variable

charge per unit of consumption. An example would be a telephone bill. Usually there is a fixed

cost for the line rental then each minute of telephone calls causes an additional cost.

On a graph, fixed costs would appear as:

Stepped-fixed costs

Stepped-fixed costs are costs which are fixed in nature within certain levels of activity. The

costsare constant over a range of activity then a sudden increase, then constant again
 Examples of stepped-fixed costs are as follows.

a. Rent, where accommodation requirements increase as output levels get higher.

b. Supervisor salaries. One supervisor may be able to supervise a maximum of ten

employees.When the number of employees increases above a multiple of ten an extra

supervisor will be required.

Other possible costs patterns:

For variable costs

Graph 2: Up to output A, no bonus is earned.

Imagine if, up to a given level of activity, the purchase price per unit of raw material is constant.

After that point, a quantity discount is given so the price per unit is lower for further purchases and

also retrospectively to all units already purchased. The graph would be as follows.
 Imagine if, up to a given level of activity, the purchase price per unit of raw material is

constant. After that point, a discount is given so that the price per unit is lower for further

purchases but not for the units already purchased. The graph would be as follows

Non-linear or curvilinear variable costs

If the relationship between total variable cost and volume of output can be shown as a curved

line on a graph, the relationship is said to be curvilinear.

Two typical relationships are as follows:

 Each extra unit of output in graph (a) causes a less than proportionate

Elements Of Semi-Variable

Each extra unit of output in graph (a) causes a less than proportionate increase in cost, whereas

in graph (b) each extra unit of output causes a more than proportionate increase in cost.

The cost of a piecework scheme for individual workers with differential rates could behave in a

curvilinear fashion if the rates increase by small amounts at progressively higher output levels.

Other patterns

Graph (a) represents an item of cost which is variable with output up to a certain maximum level

of cost.

Graph (b) represents a cost which is variable with output, subject to a minimum (fixed) charge.
Cost behaviour and cost per unit

The variable cost per unit remains constant.

The fixed cost per unit falls.

The total cost per unit falls.

Analyzing costs: Determining the Fixed and Variable Elements of Semi-Variable Costs

The fixed and variable elements of semi-variable costs can be determined by the high-low method.

It is generally assumed that costs are one of the following.

Variable

Semi-variable

Fixed

High-low method

The fixed and variable elements of semi-variable costs can be determined by the high-low method.

Step 1 Review records of costs in previous periods.

Select the period with the highest activity level.

Select the period with the lowest activity level

Step 2 Determine the following.

Total cost at high activity level

Total cost at low activity level

Total units at high activity level

Total units at low activity level

Step 3 Calculate the following.

Step 4 The fixed costs can be determined as follows.

(Total cost at high activity level) – (total units at high activity level × variable cost per unit)

Illustration
Solution
The high-low method with stepped fixed costs

Solution

Before we can compare high output costs with low output costs in the normal way, we must

eliminate the part of the high output costs that are due to the step up in fixed costs.

Total cost for 15,100 without step up in fixed costs = $83,585 – $4,700 = $78,885

We can now proceed in the normal way using the revised cost above.

Before we can calculate the total cost for 14,500 square metres we need to find the fixed costs.

As the fixed costs for 14,500 square metres will include the step up of $4,700, we can use the

activity level of 15,100 square metres for the fixed cost calculation.
The high-low method with a change in the variable cost per unit

Same data as the previous question.

Additionally, a round of wage negotiations have just taken place which will cost an additional $1

per square metre.

Solution

Estimated overheads to clean 14,500 square metres.

Practice Question

Solution
Practice Question 1

Solution

Practice Question 2

Solution
Practice Question 3

Solution
Solution

The correct answer is: Fixed, Variable, and Semi-variable