Costing

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Costing is a key element of management accounting. This page is an introduction to
the topic but further detail can be explored using the above navigation bar.

Terminology - cost units and cost centres

Cost units

To help with the above purposes of planning, control and decision making,
businesses often need to calculate a cost per unit of output.

A key question, however, is what exactly we mean by a �unit of output�, or �cost

unit�. This will mean different things to different businesses but we always looks
at what the business produces.

A car manufacturer will want to determine the cost of each car and probably
different components as well.
In a printing firm, the cost unit could be the specific customer order.
For a paint manufacturer, the unit could be a litre of paint.
An accountancy firm will want to know the costs incurred for each client. To help
with this it is common to calculate the cost per hour of chargeable time spent by
staff.
A hospital might wish to calculate the cost per patient treated, the cost of
providing a bed for each day or the cost of an operation, say.
Cost centres

A cost centre is a small part of a business for which costs are determined. This
varies from business to business but could include any of the following:

The Research and Development department

The Human Resources function
A warehouse
A factory in a particular location
It is important to recognise that cost centre costs are necessary for control
purposes, as well as for relating costs to cost units. This is because the manager
of a cost centre will be responsible for the costs incurred.

Cost, profit and investment centres

Some businesses use the term �cost centre� in a more precise way than that given
above:

A cost centre is when the manager of the centre (department or division or location
or...) is responsible for costs but not revenue or investment. This is usually
because the centre has no revenue stream.
For example, a research and development department.
A profit centre is when the manager of the centre (department or division or
location or...) is responsible for costs and revenues but not investment.
For example, a local supermarket where investment decisions are made by the main
Board.
An investment centre is when the manager of the centre (usually a division) is
responsible for costs and revenues and the level of investment in the division.
For example, the US subsidiary of a global firm. The CEO would usually have
authority to open new factories, close others and so on.
Cost classification

Costs can be classified (collected into logical groups) in many ways. The
particular classification selected will depend upon the purpose for which the
resulting analysed data will be used, for example:

Purpose Classification
Financial accounts By function - Cost of sales,
distribution costs, administrative expenses
Cost control By element � materials, labour,
other expenses
Cost accounts By relationship to cost units � direct, indirect
Budgeting, decision making By behaviour � fixed, variable

Classification by function

For financial accounting purposes costs are split into the following categories:

Cost of sales � also known as production costs. This category could include
production labour, materials, supervisor salaries and factory rent.
Distribution costs � this includes selling and distribution costs such as sales
team commission and delivery costs.
Administrative costs � this includes head office costs, IT support, HR support and
so on.
Note that some costs impact each of the above - e.g. depreciation. This is a
measure of how much an asset is wearing out or being used up. The classification
will depend on which asset is being depreciated. For example,

Cost of sales � depreciation on a machine in the production line

Distribution � depreciation of a delivery van
Admin � depreciation of a computer in the accounts department
Cost classification by element

The simplest classification is splitting costs according to element as follows:

Materials - includes raw materials for a manufacturer or alternatively the cost of

goods that are to be resold in a retail organisation
Labour - Labour costs can consist of not only basic pay but overtime, commissions
and bonuses as well.
Other expenses � also known as overheads. This includes electricity, depreciation,
rent and so on.
Cost classification by nature - direct and indirect

Direct costs

Direct costs are costs which can be directly identified with a specific cost unit
or cost centre. There are three main types of direct cost:

direct materials - for example, cloth for making shirts

direct labour - for example, the wages of the workers stitching the cloth to make
the shirts
direct expenses - for example, the royalties paid to a designer, or the freight
charges for imported special materials.
The total of direct costs is known as the prime cost.

Indirect costs

Indirect costs are costs which cannot be directly identified with a specific cost
unit or cost centre. Examples of indirect costs include the following:

indirect materials - these include materials that cannot be traced to an individual

shirt, for example, cotton
indirect labour - for example, the cost of a supervisor who supervises the shirt
makers
indirect expenses - for example, the cost of renting the factory where the shirts
are manufactured.
The total of indirect costs is known as overheads.

Cost classification by behaviour

Costs may be classified according to the way that they behave. Cost behaviour is
the way in which input costs vary with different levels of activity. Cost behaviour
tends to classify costs as one of the following:

Variable costs are costs that tend to vary in total with the level of activity. As
activity levels increase then total variable costs will also increase
A fixed cost is a cost which is incurred for an accounting period, and which,
within certain activity levels remains constant.
A stepped fixed cost is only fixed within certain levels of activity. Once the
upper limit of an activity level is reached then a new higher level of fixed cost
becomes relevant
Semi-variable costs contain both fixed and variable cost elements and are therefore
partly affected by fluctuations in the level of activity
Cost cards

Once costs have been analysed, management may wish to collect the costs together on
a cost card. A cost card (or unit cost card) lists out all of the costs involved in
making one unit of a product.

COST CARD - statement of the total cost of one unit of a product

Understanding a cost card

The total production cost is the marginal production cost (total direct costs) plus
any fixed production overheads.
It is important that the total production cost of a product is clearly identified
as being such. Non-production costs must be analysed separately. This is because
when finished products are transferred to the warehouse as finished goods, they are
transferred at a value that reflects the direct manufacturing costs that were
involved in producing them, i.e. total production cost.
When finished goods are transferred to the warehouse, this is where they remain
until they are sold to customers or held as inventory. When inventory is sold, it
is important that it is given a value that reflects the 'cost of sale' of the
product, so that a profit can be calculated and reported in the income statement.
Similarly, at the end of an accounting period, inventory is valued and reported in
the balance sheet of an organisation at its total production cost.
It is important, therefore, that the production costs and the non-production costs
are clearly distinguished for the purposes of valuing output and inventories.
Standard costing

Many businesses will determine an expected or standard cost at the start of a

period and then use this as the basis for evaluating actual costs.

Determining the components of a cost card.

For any business the elements of a cost card that require the most work are the
following (click on the links to explore in more detail):

materials costs
labour costs
overhead costs
Marginal and absorption costing

Different businesses have different approaches to whether or not they include fixed
overheads in their cost per unit calculation. Marginal costing (MC) excluded fixed
overheads but total absorption costing (TAC) includes fixed production overheads.

Costing in different industries

Different organisations have different types of production, which impacts on their

costing systems:

Specific order costing is the costing system used when the work done by an
organisation consists of separately identifiable jobs or batches.
Continuous operation costing is the costing method used when goods or services are
produced as a direct result of a sequence of continuous operations or processes,
for example process and service costing.
To explore the implications of this further please click on the following links:

Job costing
Batch costing
Process costing
Service and operations costing
Joint and by-product costing
Cost control and cost reduction

Cost control and cost reduction are priorities for many businesses. To explore
these aspects further click on the following links:

Cost control
Cost reduction techniques