Chapter 2:

Concept and
Classifications of
Costs

Madam Siti Amiroh Bt Md

Isa
 Introduction

• Cost accumulation involves identifying, measuring and

recording cost information whereas cost assignment is about
assigning cost to cost objects.
• The TERM “cost” is simply the expenditure incurred in
producing a product or providing a service.
• The accumulation of costs for a specific purpose is broadly
referred to as cost classification.
• Cost classification is the arrangement of cost items into logical
groups. While costs assignment is the assigning costs to cost
objects.
• Before further explanation of classifications costs, the basic
costing terms and concepts should be understanding first.
Costing Terms and Concepts

Cost

Cost Cost
centers Object

Opportunity
Cost Unit
costs
 a. Cost

• The term cost reflects a monetary measure of the resources

sacrificed or forgone to achieve a specific objective. (Such
acquiring a goods or services)
• Cost is made up of two component i.e. Quantity X Price
• There are various elements of product costs.
• Example: material cost, labour and overhead cost.
• Example: Cost for materials in baking cake RM 5,000.
 b. Cost Objects

• A cost object is any item or activity that separate

measurement of cost can be traced. In other words, if the
users of accounting information want to know the cost of
something, this something is called a cost object.
• Examples cost objects include the cost of producing a
product, cost of providing a service to patient, the cost of
operating a department or any activities for which costs are
measured and assigned.
• Costs accumulated to cost objects are classified into various
elements such material, labour and overhead costs.
• These cost are then assigned to cost objects such as product
either directly or indirectly.
 b. Cost Objects
• Example : cost of Object

Cost Object Illustration

Product A Proton Waja Car

Service Airline flight
Program Program offer by UM
Department Quality control in a factory
Activity Inspection to determine the
level of quality for a product
 c. Cost Unit

• A cost unit/driver is a quantitative unit of products or services

which cost can be ascertained. In other word, it is a measure
of whatever causes the incurrence of a cost.
• A change in a cost unit/driver will cause a change in the total
cost of a related cost object.
• Example: kilograms of sugar, direct labour hours, machine
hours, unit produced, unit sold, the number of miles driven by
sales persons, number of calls handed by technical support
staff, number of beds occupied in a hospital.
 Continue
• Example of cost drivers/unit for business function area in the
value chain
business function Example of cost drivers/unit
Production Number of unit produced, Number of setups,
Number of engineering change order
Marketing Number of advertisement runs, Number of sales
personnel
Distribution Number of item distributed, Number of customers
Weight of items distributed
Customer service Number of service calls, Number of product
services, hours spent servicing products
Administration Number of unit BOD members, hours of legal work
subcontracted
Design of products, Number of unit product, Number of part per
services and processes product, Number of engineering hours
 d. Cost Centre

• Cost centre is a location, person or item of equipment which

cost maybe ascertained or determined/charged.
• Cost centres are set up to help managers in ascertaining
costs and help them to control costs.
• Example : location (sales area, department), person
(salesman, consultant), item of equipment (delivery van).
• There are 2 types of costs centre:
- Production
- Non-production (service)
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Production Where production take place. Refer to all cost

cost centre centre that are involved in the actual production
products (department, sections).
Example: machine, assembling, moulding,
welding department
Non- Which provide services to other cost centres.
production Refer to all cost centre that are NOT INVOLVED
(Service) in the actual production of product but render
cost centre service to the production cost centre.
Example: maintenance, store, quality control,
production planning department and etc.
 e. Opportunity Costs

• A business often makes a sacrifice by using resources

in one particular way rather than in another way.
• Then value of this sacrifice is called opportunity cost.
• Opportunity cost is used in decision making where a
manager is faced with a choice or alternative.
 Classification of costs

Behavior
Cost is required to ascertain
profit, to prepare budgets
Traceability and to make decisions.
Cost can be classified in the
following ways:
Controllability

Relevance

Function
 Classification by Behaviour
• Refer to how cost will react or respond to changes in the level
of business activity.
• As the level of activity rises and falls, a particular cost may
rise and fall as well; or it may remain constant.
 Classification by Behaviour

Cost behavior means how a

cost will react to changes in
the level of business
Cost

activity.

Activity  fixed costs

 variable costs
Cost

Activity
 Classification by Behaviour

FIXED Total fixed costs do not change when activity

COST changes.
Mean, cost will remain constant for a given period of
time regardless of changes in the level of activity.
Example: Insurance, depreciation, director salary

VARIABLE Is a Cost that varies in direct proportion to changes

COST in the level of activity (volume)
The activity can be expressed in many ways (such
unit produced, unit sold, miles driven, beds occupied
and etc)
Example : Petrol consumption, Maintenance Cost,
direct labour, direct materials
 Classification by Behaviour

MIXED Contains both element of fixed and variable cost.

COST/ A characteristic of mixed cost that need to be
SEMI understood is that we usually have to separate fixed
VARIABLE and variables components of the total mixed cost
COST (using High-Low method)

Example: monthly electric utility charge / Telephone

bills, fixed service fee, Variable charge per kilowatt
hour used, costs of providing Xray services to
patients.
Classification by Behaviour - High-Low method

• Cost behavior is very important for decision making and

cost planning.
• Manager are constantly faced with decisions about price
and costs movements.
• How cost behave or vary is referred to as cost
behaviour. Each and every cost has to be identified as
fixed cost or variable cost(mixed cost). Thus, each and
every cost has a behaviour pattern called the cost
function.
• Cost function: is a relationship between cost and
volume. The function is linear. The linear cost function
can be stated as formula :
Classification by Behaviour - High-Low
method

Y = a + bx

y = estimated total cost (Mix Cost)

a = estimated fixed cost
b = variable cost per unit
x = unit produced or volume in units
Analysis of mixed cost-pg17
 Example 1

• Marbeles manufactures product YY. Below is the information

on the machine hour for production of product YY and
electricity costs for the first 6 months.
• Using HLM calculate the cost at a level of 80,000 machine
hours.

Month Machine (hours) Electricity cost

(RM)
Jan 35,000 69,100
Feb 50,000 78,600
March 30,000 64,100
April 45,000 76,679
May 34,000 68,900
June 47,000 77,090
 Example 1- Answer
Required:
Based on the above, calculate variable cost per unit of electricity
cost, total fixed cost of electricity cost and determine cost
function.

STEP 1:
Choose the highest and the lowest pair for x-y

Highest activity (Hours) Highest cost (RM)

50,000 78,600
Lowest activity (Hours) Lowest cost (RM)
30,000 64,100
 Example 1- Answer
STEP 2
Compute the variable rate, b. Y = a + bx
b = Difference in mixed cost, y
Difference in activity, x

b= RM78,600 – RM64,100
50,000hours – 30,000 hours

b= 0.725 per hour

@
Y= a + 0.725x
 Example 1- Answer
STEP 3
Compute the fixed cost components, a
Can choose either one, highest or lowest pair.

Formula: Fixed cost = Total mixed cost – Variable cost

If choose the highest x-y pair

= RM78,600 – (50,000hours x RM 0.725) RM 42,350
= RM78,600 – RM36,250
If choose the lowest x-y pair
= RM64,100 – (30,000hours X RM0.725) RM 42,350
= RM64,100 – RM21,750
Y= RM42,350 + 0.725x
 Example 1- Answer

STEP 4
Cost function

Y = RM42,350 + RM0.725x
↑ ↑
fixed cost variable cost

Total cost at 80,000 machine hour:

Y = RM42,350 + RM0.725 (80,000)

= RM42,350 + RM58,000
= RM100,350
 Classification by Traceability
• Refer to cost that classified according to how costs are
related to a product, that is traceable/identifiable or not
traceable to the product.
Indirect cost
Direct cost
• Cannot be identified and
• Cost directly identified traceable in full to finished
and exclusively product. The materials
traceable as integral used generally not
part of a finished charged directly to a
product. product.
• Example: direct • Example: manufacturing
material, direct labor, overhead
direct expenses
 Classification by Traceability

COST DIRECT COST INDIRECT COST

OBJECT
Product Wages of production Salary of supervisor
workers
Raw materials cots Warehouse rental
Purchase Salary of purchase Rental of office building
Dep. dept. workers Electricity Cost
A business Rental of building Rental of headquarter’s
branch Salaries of branch’s building
workers Administration costs
 Classification by Controllability

• The degree of control depends on the level of management in

the organization.

Very little control

Classification by Relevance: Opportunity Costs

The potential benefit that is given

up when one alternative is
selected over another.
• Example: If you were
not attending college,
you could be earning
RM15,000 per year.
Your opportunity cost
of attending college for one
year is RM15,000.
 Classification by Relevance: Sunk Costs

All costs incurred in the past and cannot be changed by any

decision made now or in the future.

Sunk costs should not be considered in decisions because

the cost considered as historical cost

Example: You bought an automobile that cost RM50,000 Three

years ago. The RM50,000 cost is sunk because whether
you drive it, park it, trade it, or sell it, you cannot change the
RM50,000 cost.
 Classification by Function

• Refer to cost incurred in each activities involved by a

business.
• Ex: Classifying costs as direct, indirect, product cost and
period costs.
 Classification by Function – Period cost

Period costs are expenses

not charged to the product

Administrative Costs
Selling Costs
Non-manufacturing costs
Costs incurred to obtain
of staff support and
customer orders and to
administrative functions –
deliver finished goods
accounting, data processing,
to customers –
personnel, research
advertising and shipping.
and development.
 Classification by Function – Product cost

• associated with goods for sales – Cost of good sold

DIRECT Explanation
DIRECT Consist of all those materials that can be identified
MATERIALS with a specific product
DIRECT Consist of those labor costs that can be specifically
LABOURS traced to or identified with a particular product

DIRECT Other cost incurred that can be traced directly to

EXPENSES product (hire special machine for producing a specific
product)
PRIME COST Refer to the direct costs of the product and consist of
direct labors cost + direct materials + direct expenses
 Classification by Function – Product cost
Direct Direct Manufacturing
Materials Labour Overheads

Cost elements RM

Prime Conversion Direct materials X

Costs Costs Direct labour X

Direct expenses X

Prime costs X

Manufacturing X
overhead
Total manufacturing XX
cost
 Classification by Function – Product cost
and Period cost

• For income and profit measurement, costs are broadly

classified as product and period costs.
• Product costs included in stock valuation costs identified
with goods produced or purchased for resale.
• Period costs are those costs which are not included for
stock valuation purposes.
 Classification by Function

Costs for stock valuation

and profit determination

Product costs- Period costs-

manufacturing costs Non-manufacturing costs

Prime Production Administration Selling and

costs overheads expenses distribution
expenses

Direct Direct Direct Indirect Indirect Indirect

materials labour expenses material labour expenses
 Classification by Function – Product cost and
Period cost
Trading company Manufacturing company
• Product cost are costs • Cost can be classified into two:
identified with goods – Manufacturing costs
purchased for resales. – Non-manufacturing costs
• All other costs such
Manufacturing costs
selling and distribution,
administration
expenses treated as – include calculation of product and
period costs stock valuation of finished goods

Non-Manufacturing costs

– costs related as period costs

(consists of all indirect costs)
Thank You