cost classification for profit determination

1. COST AND MANAGEMENT
ACCOUNTING I
TOPIC
Costs Classification and Purposes

2. Learning Objectives
 Discuss various cost terms and concepts

3. Introduction
 What do you understand by the following
terms?
 Cost?
 Price?
 Expense?
 A Cost Object?

4. Introduction Cont…
 Can cost data compiled for a particular
purpose be appropriate for other use? e.g.
 Profit measurement?
 Decision making
 Since the word cost can mean different things
for different purposes – for cost information
to be at all useful it needs first to be classified
so that managers are able to understand it.

5. Cost Classification
 Four most common and useful categorisations
for management accounting purposes
 Function – e.g. production, marketing, administration
etc.
 Behaviour – e.g. fixed, variable
 Nature – e.g. direct, indirect
 Element – e.g. material, labour

6. Classification by “Nature”
 A cost that can be easily and accurately
traced/identified with a particular cost
unit/object (e.g. department) is called “Direct
cost”, e.g. timber in furniture.
 The cost that is not directly traceable to a
particular cost unit is referred to as an
“Indirect cost” of that unit. Think of the GM
of ABC co. is an indirect cost of each of the
company’s production departments.

7. Classification by “Element” of Production
 Integral elements of production includes: direct
materials, direct labour, direct expenses and
overheads.
 Direct materials consist of all those materials that
can be identified with a specific product.
They represent a major cost of producing that
product.
They are principal substances used in production of
finished goods by the addition of labour and
overheads.

8. Classification by “Element” of production
Cont…
 Labour is the physical/mental efforts
expended in the production of a
product/service.
So “direct labour” involves the cost of
salaries, wages, etc, that can directly be traced
to or identified with a particular product.
They represent major labour costs!!

9. Classification by “Element” of production
Cont…
 “Direct expenses” these represents costs that
are directly attributable to the production
process e.g.
hire of special machine tools for one-off jobs,
royalties for patents etc

10. Overheads
 All other costs – other than direct materials,
labour and expenses – of producing a product.
For instances materials which does not become
an integral part of a finished product and the
cost of personnel who do not work directly on
the product, but whose services are necessary
for the production process are classified as
indirect material and labour respectively.

11. Total Costs Structured by Nature and by
Element
Direct material + Indirect materials = Total material cost
Direct Labour + Indirect labour = Total labour cost
Direct expense + Indirect expense = Total expenses
Prime Cost + Overheads = Total cost
In short all direct costs are prime costs of
production; together with overhead they make up the
total cost of a product cost unit

12. Classification by “Behaviour”
 When classifying costs by behaviour the major focus
rests on variable and fixed costs. Though other
‘hybrid’ pattern called step and semi-variable costs
exists.
 Cost that is sensitive, and varies in proportion, to
corresponding changes in the activity level is known
as variable cost.
 Cost that is insensitive to activity level fluctuations
but is determined by the influence of time (and its
passing) is called fixed cost.

13. Variable Cost Behaviour
 Variable cost comprises of the following:
 Variable overheads + direct (prime) costs =
variable costs
 Illustration
 Assume a firm employs Wamachinga selling “Yebo-
yebo” for commission – only earnings door to door.
Wamachinga are paid a commission of 10% for each
product sold. Yebo-yebos are priced at Tshs. 400.
 Required: Provide a graphical and algebraic expressions
of this variable cost pattern. (Linear, non-linear,
curvilinear)

14. Fixed Cost Behaviour
 Fixed (a.k.a period) - cost is said to be fixed
with respect to two factors:
 Short-run time periods, i.e. up to and including a full year
 Volume (although under very extreme circumstances, such
as complete shutdown where the volume is sustained at zero,
even fixed costs may change or be avoided entirely
 All fixed costs are overhead and they are often
alternatively given the full title “fixed overhead costs”
 The algebraic expression is Y = a; where ‘Y’ is cost and ‘a’
is a constant.
 Fixed overheads are constant/fixed in total!!!

15. Other Patterns of Cost Behaviour
 Step costs
 These remains constant for a given volume range before
stepping up to a higher cost level at a specific, discrete
point which signifies the end of the given range. The
same can repeat for the second, third,…so the pattern
continues to be repeated
 This is characterised by “lump-sum” injections of a single
cost amount at discrete points on the activity scale.

16. Other Patterns of Cost Behaviour Cont..
 Semi-variable/fixed costs (mixed)
 This cost behaviour includes, in a single cost
object, both fixed and variable components of
cost e.g. landline telephone charges
Units
FC component ‘a’
VC component ‘bx’
Tshs
Telephone

17. Cost as Assets and Expenses
 The issue of timing i.e. when should the cost
of acquiring an asset be recognized as an
expense.
 Expense - the cost incurred when an asset is used up or
sold for the purpose of generating revenue (when benefits
are received, the cost becomes an expense)
 The timing with which various expenses are recognised is
described by the following terms:
 Product costs
 Period costs

18. Product Costs
 Product cost = a cost of goods purchased or
manufactured for resale (assets).
 Are inventoriable costs for reporting on B/S and
P&L
 Are used to decide which product to produce and
to determine selling prices
 Once the goods are sold, product costs
becomes expenses – called cost of goods sold.

19. Period Costs
 All cost that are not product costs are
called period costs.
 Costs which are not necessary for
production (not inventoriable)
 They are written of as expenses (in the
P&L) in the period in which these are
incurred – e.g. rent, salary of executives,
travel expenses etc.

20. Unit costs and Total costs
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