Chapter 2: Cost classification

1 Analyzing Costs

Responsibility Accounting

Responsibility accounting involves breaking down a business into segments managed by individual
managers, each responsible for performance.

Responsibility Centres

1. Cost Centres

o Defined as specific locations, functions, or activities where costs are tracked.

o Examples:

▪ Paint Manufacturer: Mixing department, packaging department,

administration.

▪ Accountancy Firm: Audit, taxation, administration, regional offices.

o Performance is assessed based on achieving cost targets.

2. Revenue Centres

o Focus solely on sales revenue generation.

o Examples include regional sales managers responsible for meeting sales targets.

o Revenue must be traceable to evaluate individual managers’ performance.

3. Profit Centres

o Track both costs and revenues.

o Often found in large, divisionalized organizations.

o Performance is measured by the profit generated, requiring managers to manage

both costs and revenues effectively.

4. Investment Centres

o Managers are accountable for investment decisions as well as costs and revenues.

o Performance is assessed through the Return on Capital Employed (ROCE).

o Example: Divisions of a multinational company, like UK and European divisions.

Cost Objects

• Any activity for which costs are measured, such as:

o Cost of a product

o Cost of a service
 o Cost of running a department

Cost Units

• A unit of product or service used to ascertain costs. Examples:

o Room in a hotel

o Litre of paint

o In-patient in a hospital

Cost Cards

• A tool to detail the costs involved in producing output, showing breakdowns such as:

o Direct materials

o Direct labor

o Variable and fixed production overheads

o Non-production overheads

2 Classifying Costs

Costs can be classified in various ways to facilitate management and decision-making:

1. By Element

• Materials: Costs of materials purchased (e.g., raw materials, maintenance supplies).

• Labour: Costs related to employees on the payroll.

• Expenses: All other costs, such as rent and utilities.

2. By Nature

• Direct Costs: Costs directly identifiable with a specific cost unit or centre.

o Examples:

▪ Direct materials (e.g., cloth for shirts)

▪ Direct labour (e.g., wages of shirt stitchers)

▪ Direct expenses (e.g., designer royalties)

o Total direct costs are known as Prime Cost.

• Indirect Costs: Costs not directly identifiable with a specific cost unit.

o Examples:

▪ Indirect materials (e.g., cleaning supplies)

▪ Indirect labour (e.g., supervisors' salaries)

 ▪ Indirect expenses (e.g., factory rent)

o Total indirect costs are known as Overheads.

3. By Function

• Production Costs: Costs associated with manufacturing a product or service.

o Found in the cost of sales section of profit statements.

o Examples: Direct materials, labour, variable and fixed overheads.

• Non-Production Costs: Costs not directly linked to production.

o Charged as expenses in the profit statement.

o Examples: Administrative costs, selling costs, finance costs.

4. By Behaviour

• Variable Costs: Change with levels of output (e.g., raw materials).

• Fixed Costs: Remain constant regardless of output (e.g., rent).

Summary of Cost Classifications

Classification Definition Examples

Element Material, Labour, Raw materials, employee wages, rent

Expense

Nature Direct or Indirect Costs Direct: cloth for shirts; Indirect: factory rent

Function Production or non- Production: wages of builders; non-production:

production marketing costs

Behaviour Variable or Fixed Costs Variable: materials; Fixed: salaries

3 Classification by Cost Behaviour

Costs can be classified based on their behavior in relation to changes in activity levels:

1. Variable Costs

• Definition: Costs that change in direct proportion to activity levels. As production increases,
total variable costs rise, while the cost per unit remains constant.

• Examples: Direct materials and direct labor.

• Numerical Example:
 o For a factory producing widgets, if it takes 4m² to make one widget at $2 per square
meter, producing 50 widgets costs $400 (50 widgets x $8 per widget). If 100 widgets
are made, the cost increases to $800.

2. Fixed Costs

• Definition: Costs that remain constant over a specific range of activity levels. Total fixed
costs do not change with the level of production, but the cost per unit decreases as
production increases.

• Examples: Rent, salaries, business rates.

• Numerical Example:

o If factory rent is $5,000 per month, this cost remains the same regardless of whether
2 or 200 widgets are produced. The fixed cost per unit decreases as more widgets are
produced.

3. Stepped Fixed Costs

• Definition: Fixed costs that remain constant within certain activity levels but increase in
steps when those levels are exceeded.

• Examples: Costs for additional warehousing or supervisory staff as production scales up.

• Numerical Example:

o One supervisor is required for production up to 50 widgets, costing $18,000 per year.
For production between 51 and 100 widgets, two supervisors are needed, increasing
costs to $36,000.

4. Semi-Variable Costs

• Definition: Costs that have both fixed and variable components. These costs change with
the level of activity but also have a fixed baseline.

• Examples: Utility bills (fixed charge plus variable usage) and telephone bills.

4 Identifying Cost Behaviors

When analyzing costs at different production levels, understanding their behavior is essential for
effective planning and forecasting. Here’s a breakdown of the costs provided in your illustration:

Total Costs at Different Activity Levels

Cost 1,000 units 3,000 units 5,000 units 7,000 units

Cost 1 $19,000 $33,000 $47,000 $61,000

Cost 2 $1,920 $5,760 $9,600 $13,440

 Cost 3 $7,000 $7,000 $7,000 $7,000

Cost 4 $12,500 $12,500 $17,000 $17,000

Cost Per Unit at Different Activity Levels

Cost 1,000 units 3,000 units 5,000 units 7,000 units

Cost 1 $19.00 $11.00 $9.40 $8.71

Cost 2 $1.92 $1.92 $1.92 $1.92

Cost 3 $7.00 $2.33 $1.40 $1.00

Cost 4 $12.50 $4.17 $3.40 $2.43

Cost Behavior Identification

1. Cost 1: Semi-variable cost

o Reason: Total cost changes with activity levels, and cost per unit also varies.

2. Cost 2: Variable cost

o Reason: Cost per unit remains constant across all activity levels.

3. Cost 3: Fixed cost

o Reason: Total cost does not change regardless of the activity level.

4. Cost 4: Stepped fixed cost

o Reason: Total cost remains constant within certain ranges but increases to a new
level after reaching a threshold; cost per unit decreases as production increases,
then changes when the total cost steps up.

Summary

By identifying the behaviors of these costs, management can make more informed decisions
regarding budgeting, forecasting, and operational planning.

5 The High-Low Method for Separating Semi-Variable Costs

The high-low method is a straightforward technique used to separate the fixed and variable
components of semi-variable costs. Here’s how it works, along with examples and calculations.

Steps of the High-Low Method

1. Identify the highest and lowest activity levels and their associated costs.

2. Calculate the variable cost (VC) per unit:

VC per unit= Cost at high level−Cost at low level/High level of activity−Low level of activity
 3. Calculate the fixed cost by substituting either the high or low activity level into the total cost
formula:

Fixed cost=Total cost at activity level−(VC per unit×Activity level)

4. Estimate total costs at different activity levels using the formula:

Total costs=Total fixed costs+(Variable cost per unit×Activity level)

Example Illustration

Data:

• Output Levels and Costs

o 200 units: $7,000

o 400 units: $9,000

Step-by-Step Calculation

1. Identify High and Low Levels:

o High Level: 400 units, $9,000

o Low Level: 200 units, $7,000

2. Calculate Variable Cost per Unit:

VC per unit=9,000−7,000/400−200=2,000/200=$10 per unit
3. Calculate Total Fixed Cost (using high level):
Fixed cost=9,000−(10×400)=9,000−4,000=$5,000

4. Estimate Total Cost for 350 Units:

Variable cost=350×10=3,500
Total cost=5,000+3,500=$8,500

High-Low Method with Stepped Fixed Costs

Example Data:

Activity Levels:

• 4,000 units: $40,800

• 6,000 units: $50,000
• 7,500 units: $54,800

Variable Cost Calculation: Using activity levels 6,000 and 7,500 (since fixed costs are constant):

VC per unit=54,800−50,000/7,500−6,000=4,800/1,500=$3.20

Total Fixed Cost Above 5,500 units:

Total fixed cost=54,800−(7,500×3.20)=54,800−24,000=$30,800

Total Fixed Cost Below 5,500 units:

Total fixed cost=30,800/110×100=$28,000

Total Cost for 5,000 units:

Total cost=(5,000×3.20)+28,000=16,000+28,000=$44,000

Example with Changing Variable Costs

For output volumes above 350 units, variable costs fall by 10%

• Initial Variable Cost (below 350 units): $10 per unit

• New Variable Cost (above 350 units): $10 \times 90% = $9 per unit

To estimate the cost of producing 450 units:

Variable cost=450×9=4,050

Total cost=4,050+5,000=$9,050

Advantages and Limitations of the High-Low Method

Advantages:

• Simple and easy to use.

• Quick estimation of fixed and variable components.

Limitations:

• Relies on historical data, which may not predict future costs accurately.

• Assumes only activity level affects costs.

• Uses only two data points, which may overlook other variations.

This method serves as a useful tool for initial cost analysis but should be supplemented with more
detailed approaches when necessary.

6 Cost Equations and Their Applications

Cost equations are critical for estimating future costs based on historical data. The fundamental
linear cost equation is:

y=a+bx

Where:
 • y = total cost (dependent variable)

• a = fixed cost (intercept)

• b = variable cost per unit (slope)

• x = activity level (independent variable)

Example Illustration

Given Cost Equation: If y=8,000+40x:

1. Fixed Cost:

o a=8,000

2. Variable Cost per Unit:

o b=40

3. Total Cost for 200 Units: 8,000+(40×200) = 16,000

7 Cost Codes

A cost code is a systematic way to categorize and reference costs within an organization, allowing for
easier tracking, recording, and analysis of expenses.

Types of Cost Codes

1. Cost Centre Codes: Identify the department or area responsible for costs. For example,
Machine Group 7 could have a cost code of 07, while a canteen might be coded as 16.

2. Generic or Functional Codes: After assigning a cost centre code, additional digits specify
the type of expense. For instance, oil for Machine Group 7 could be coded as 0723 (indirect
materials), while frozen peas for the canteen might be 1602 (food purchases).

3. Specific Codes: These codes provide detailed identification for a specific item. For example,
the oil for Machine Group 7 could be coded as 072304 (Machine Group 7, indirect material,
oil), and frozen peas for the canteen as 160219.

Coding Systems Explained

1. Sequential Codes:

o Definition: A straightforward numerical or alphabetical sequence.

o Example: Codes for expenses could start at 001 for Motor Expenses and follow
numerically (e.g., 002 for Electricity).

o Usage: Simple categorization, allowing for up to 999 different types of expenses.

2. Block Codes:

o Definition: Categorizes sequential codes into groups.

o Example:

▪ 0000: Expenses

▪ 1000: Revenue

▪ 2000: Non-current assets

o Usage: Helps to organize codes into broader categories, allowing for up to 1,000 sub -
categories within each block.

3. Hierarchical Codes

Definition: A hierarchical code organizes data into a multi-level structure, where each digit or
character in the code represents a different level of classification. As you progress from left to
right, each digit indicates a smaller subset of the previous category.

Example:

1: Revenue

1.1: Revenue from the UK

1.2: Revenue from the USA

1.3: Revenue from China

1.1.1: Revenue in the UK from laptop sales

1.1.2: Revenue in the UK from photocopier sales

Usage: This system allows for infinite expandability and detailed categorization, making it useful
for organizations with complex structures or diverse product lines. Each sub -category can be
further divided as needed.

4. Significant Digit Codes:

o Definition: Uses individual digits and letters to represent specific features of an item.

o Example:

▪ 2000: Paper file dividers

▪ 2010: 10-pack of paper file dividers

o Usage: Enables more specific categorization of items within a broader category.

 5. Faceted Codes:

o Definition: Breaks codes into multiple facets or fields, each signifying a unit of
information.

o Example:

▪ Region Code (2 digits)

▪ Department Code (2 digits)

▪ Expense Code (4 digits)

▪ Example Code: 03020247 for a bonus paid to the production department of

the USA.

o Usage: Provides detailed classifications, useful for complex organizations with many
subdivisions.

Mnemonic Codes: This coding uses alphabetical symbols to aid memory and understanding,
simplifying information by abbreviating terms. For example:

• Code | Meaning

• NCA | Non-current assets

• EXP | Expenses

• REV | Revenue

Mnemonic codes are effective for quickly conveying information but can struggle with categorizing
large numbers of items (e.g., over 999 types of expenses).