2. Chapter Outline
1. The cost concept
2. Cost classification in relation to product or period
i. Manufacturing costs
ii. Non-manufacturing costs
3. Cost classification in relation to cost behavior
i. Fixed costs
ii. Variable costs
iii. Semi-variable, Semi-fixed or mixed costs
4. Separating a mixed cost
5. Cost classification for control or evaluation
i. Controllable costs
ii. Non-controllable costs
6. Cost classification for decision making
i. Relevant costs
ii. Irrelevant costs
3. Cost Concept
A cost is defined as follows:
A cost is a resource that is sacrificed or foregone in order to
achieve a specific objective.
Costs are incurred to ensure future profits
4. Cost classification in relation to the product or
period
Costs and expenses classification process begins by relating them to the different phase in a
business’s operation.
In case of a manufacturing organization, the total operating costs are classified manufacturing
costs (product costs) and non-manufacturing costs (period costs).
A. Product costs
Costs associated with the manufacturing of certain products. These includes: direct material, direct
labour and manufacturing overheads.
Direct material and direct labour may be combined into a classification called prime cost.
Direct labour may be combined with manufacturing overheads into another classification called
conversion cost.
Conversion cost represent the cost of converting direct material into finished goods.
5. Cost classification in relation to the product or
period
Direct materials
Materials that forms an integral part of the finished good and that can be included directly in calculating the
cost of the product. Example: wood used to make furniture and flour used to bake bread.
Direct labour
Labour expended to convert direct materials into the finished good. Example: wages paid to the carpenter in
the furniture factory and wages of assembly line workers in a car plant.
Manufacturing overheads
Indirect material, indirect labour and all other manufacturing costs that cannot be allocated directly to a
product. Example: Factory rent, depreciation of manufacturing plant and equipment, repairs and maintenance
and water and electricity.
Indirect materials
Materials needed for completing the product but their consumption is minimal or the tracing is so complex
that treating them as direct materials is futile or uneconomical. Example: Nails, screws, glue and factory
supplies
Indirect labour
Labour expended that does not directly affect the production of the finished good. Example: wages of
supervisors, maintenance workers and security guards.
6. Cost classification in relation to the product or
period
B. Period costs
Costs associated with a specific accounting period and not a specific product.
They are incurred in generating sales in a given accounting period, but are not linked to specific
unit of finished good sold.
These costs are treated as expense of the period in which they are incurred because they are
presumed not to benefit the future periods.
These costs include marketing (selling and distribution) expenses and administrative expenses.
Marketing expenses include selling and delivery expenses such as sales salaries, commissions, travel
expenses and advertising
Administrative expenses include the salary of the CEO, office expenses, depreciation on office
equipment and legal expenses.
7. Cost classification in relation to the cost behaviour
It is important to understand how costs behave and what factors affects their behavior.
Behavioural patterns affected by costs are affected by the level of activity (volume) and time.
Behavioural patterns exhibited by costs are:
Fixed
Variable
Semi-variable, semi-fixed or mixed.
A. Fixed costs
Costs that remain constant in total, regardless of changes in the level of activity, but on a per-unit
basis it varies/changes with the level of activity
B. Variable costs
Costs that varies/changes in total in direct proportion to variation in the level of activity, but on a
per-unit basis it remains constant.
8. Cost classification in relation to the cost behaviour
C. Semi-variable, semi-fixed or mixed cost
Costs that contains a variable portion and fixed portion.
D. Separating a mixed cost
Mixed costs must be separated into fixed and variable portions for decision making.
Three methods are used to separate a mixed cost, namely:
High-low method
Scattergraph
Least-squares method (regression analysis)
The high-low method uses the difference between highest and lowest activity and their
corresponding costs, in order to determine the variable portion of the semi-variable cost or fixed
portion of the semi-fixed cost.
The formula used is:
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑐𝑜𝑠𝑡
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦
9. Cost classification in relation to the cost behaviour
Fixed costs example
The monthly rental charge for a photocopy machine is R20 000
The monthly rental cost of R20 000 will be incurred regardless of the number of copies made
during the month.
10. Cost classification in relation to the cost behaviour
Variable costs example
A company produces external hard drives and each hard drive requires a component that costs
R80.
The total costs increases and decreases as the activity level increases and decreases, but the
variable cost expressed on a per-unit basis is constant, that is, R80 per component.
Number of hard drives Cost per component Total variable cost for the
hard drive
1
500
1 000
R80
R80
R80
R80
R40 000
R80 000
11. Cost classification in relation to the cost behaviour
Mixed cost example
A company has incurred the following maintenance cost over a 12-month period.
Months Maintenance hours Maintenance Costs (R)
January 90 5 300
February 50 4 500
March 70 4 900
April 55 4 600
May 60 4 700
June 75 5 000
July 95 5 400
August 65 4 800
September 80 5 100
October 85 5 200
November 40 4 300
December 45 4 400
12. Cost classification in relation to the cost behaviour
The maintenance cost is a semi-variable cost and the production manager has asked you to separate it
into its fixed and variable portion using the high-low method.
Step 1
Find the highest activity level and its corresponding costs
Find the lowest activity level and its corresponding costs
Use the formula to determine the variable portion
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑐𝑜𝑠𝑡
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦
=
5 400 −4 300
95 −40
=
𝑅1 100
55
R20
Step 2
Determine the fixed portion of the semi-variable cost, using the following formula:
Fixed cost = Total cost – Variable cost
R4 300 – (R20 * 40)
R3 500
You can apply the formula to determine the fixed cost using either the lowest or highest activity levels with
corresponding costs.
13. Cost classification for decision making
It is important to identify the costs and revenues that are relevant to the decision when
deciding among a number of possible alternative or actions.
Consideration of irrelevant items can be a significant waste of time and resources.
A. Relevant costs
A cost is relevant if it is going to affect a decision being taken.
Opportunity, differential/incremental and avoidable costs are all considered to be relevant costs.
Opportunity cost
The value of the potential benefit that is lost or sacrificed when one course of action is chosen above the
competing course of action.
Example 1
Wesley is employed on a part-time basis at a chain store. His rate of pay is R500 per week. He would like to
spend a week with his grandparents on their farm but he has no leave available. If he takes a week’s leave
anyway, he would lose R500. This R500 in lost wage will be termed an opportunity cost.
14. Cost classification for decision making
Example 2
Paul is an administrative officer for a company that pays him a salary of R150 000 per annum. He would like to
further his current qualification and is thinking about leaving the company and returning to university to study full-
time. If he returns to university, he would have to give up his R150 000 salary. The forgone salary would be an
opportunity cost, that is, the cost of seeking higher education.
Opportunity costs are not recorded in the books, but must be considered when making decisions
Differential/incremental cost
Cost that is present under one option but is absent in total or in part under another option.
The difference in total cost between two alternatives.
Differential/incremental revenue is the difference in revenue between the two alternative.
Avoidable cost
Any cost that can be avoided is relevant to the decision making process.
This is the cost of an activity that can be avoided if that activity did not exist
All costs are considered avoidable, except
Sunk costs
Future costs that do not differ between alternative at hand
Unavoidable costs must be eliminated from the decision at hand.
15. Cost classification for decision making
A company produces two products, Trix and Trex. Product Trex is currently making a loss. Should the
company drop the product?. (Option 1: Keep, Option 2: Drop)
*Irrelevant/unavoidable costs. Do not drop product Trex since the net loss will increase by R3 250
Option 1 Option 2 Difference (+ / - )
Sales 80 000 0 (80 000)
Less: Variable cost 55 000 0 55 000
Marginal income 25 000 0 (25 000)
Less: Fixed costs 39 750 18 000 21 750
Rental* 6 000 6 000 0
Salaries and wages 12 000 0 12 000
Advertising 9 750 0 9 750
Depreciation on factory equipment* 3 000 3 000 0
Administrative expense* 9 000 9 000 0
Net profit/loss (14 750) (18 000) (3 250)
16. Cost classification for decision making
B. Irrelevant cost
Irrelevant cost are costs that remain the same regardless of the decision taken.
Sunk costs
A cost that has already been incurred and that cannot be changed by any decision made now or in the
future.
They should not be used in analysing future course of actions.
All fixed costs are sunk costs, for example depreciation.
Example:
A company has recently spent R100 000 on developing a new product. The money cannot be recovered even if
a decision taken to abandon further development of the new product. The cost is therefore irrelevant to future
decisions concerning the product. It is a sunk cost.
