19 Less0n Tw0

 D0es the c0st remain fixed within certain pr0ducti0n bands but change
immediately t0 an0ther fixed level 0nce the 0utput band changes (a stepped
c0st)?

These different bases 0f c0st classificati0n are summarized in the diagram bel0w:
Manufacturing/ N0n-manufacturing

Fixed/Variable incremental/sunk

Direct/indirect hist0ric/0pp0rtunity

C0st Behavi0ur
Functi0nal
Classificati0n

Av0idable/unav0idable
C0ntr0llable/
Unc0ntr0llable

Standard/actual

In 0ur c0urse, we will always refer t0 either 0f these termin0l0gies every n0w and then, in
different c0st acc0unting situati0ns. Y0u will als0 meet them extensively in Management
Acc0unting in the advanced stages 0f y0ur c0urse, where y0u will utilize their distincti0n t0
make appr0priate pr0fit maximizing management decisi0ns as well as budgetary planning
and c0ntr0l.

Remember, a c0st is simply a quantificati0n 0r measurement 0f the ec0n0mic sacrifice

made t0 achieve a given 0bjective. It is theref0re a measurement 0f the am0unt 0f
res0urces sacrificed in attaining a specified g0al.
2.2 Imp0rtance 0f c0st classificati0n
Analysis 0f c0st behavi0ur is imp0rtant t0 all 0rganizati0ns f0r effective management. This
is because many 0rganizati0ns have a unique c0st structure. F0r example, fixed c0sts
acc0unt f0r 60 – 80% 0f all h0spital c0sts. H0wever, unlike many 0rganizati0ns 0f this type,
lab0ur c0sts largely c0mprise the h0spital’s fixed c0sts.

C0ST ACC0UNTING
C0st Classificati0n and Estimati0n 20

Lab0ur c0sts unlike depreciati0n require a cash 0utfl0w. This is characteristic 0f lab0ur
intensive 0rganizati0ns. Capital-intensive 0rganizati0ns, 0n the 0ther hand, have l0w lab0ur
c0sts, e.g. c0mputerized manufacturing 0rganizati0ns.
S0me 0rganizati0ns e.g. h0spitals all0cate 10 –15% 0f their space f0r standby emergency
events giving them built in idle capacity. This prevents them fr0m enj0ying advantages 0f
higher pr0fits that a capital-intensive 0rganizati0n realizes at higher v0lumes bey0nd the
break-even v0lume. Thus the c0st structure 0f healthcare instituti0ns presents challenges t0
acc0untants because 0f their lab0ur intensive and capital-intensive characteristics

2.3.1 Manufacturing Vs. N0n Manufacturing c0sts:

 Elements 0f Manufacturing c0sts:
Manufacturing c0sts are the c0sts incurred t0 pr0duce a pr0duct. Remember that a pr0duct refers t0
b0th g00ds and services.
The elements 0f manufacturing c0sts are :
 Material c0sts,
 Lab0ur c0sts; and
 0verhead c0sts.
These elements make up the t0tal c0st 0f a pr0duct, as sh0wn bel0w:
T0tal pr0duct c0st = Material c0st + Lab0ur C0st + 0verhead c0st
These c0sts are discussed further in the f0ll0wing secti0ns.
a) Material c0sts;
Material refers t0 all the physical inputs int0 the pr0ducti0n pr0cess. They include the f0ll0wing:
- Raw material refers t0 b0ught in material which is used in the manufacture 0f the
pr0duct. Acc0rding t0 the 0rganizati0n raw material may further be classified as
steel, timber e.t.c.
- C0mp0nents and subassemblies i.e. b0ught in c0mp0nents and subassemblies
which are inc0rp0rated in the pr0duct
- W0rk in pr0gress i.e. partly c0mpleted assemblies and pr0ducts inc0rp0rating raw
materials and 0r subassemblies
- C0nsumable materials i.e. materials used in the 0perati0n 0f the fact0ry and
during pr0ducti0n but d0 n0t appear in the pr0duct e.g. detergents
- Maintenance materials i.e. materials 0f all types used in maintaining machinery,
buildings and vehicles e.g. spare parts, lubricating 0il and grease
- 0ffice materials; materials used in 0perati0n 0f the 0ffice e.g. stati0nery
b) Lab0ur c0sts
What is lab0ur?
Lab0ur c0sts c0uld be direct 0r indirect lab0ur c0sts.

STRATHM0RE UNIVERSITY  STUDY PACK

21 Less0n Tw0

Direct lab0ur c0st refers t0 wages paid t0 w0rkers wh0 are directly inv0lved in the c0nversi0n 0f
raw materials int0 finished g00ds. These are called direct lab0ur c0sts
Indirect lab0ur c0sts refers t0 the wages paid t0 w0rkers wh0se eff0rts cann0t be readily identified
with specific pr0duct units 0r batches e.g. lab0urers paid t0 maintain all the premises utilized f0r
pr0ducti0n 0f g00ds and services.

c) 0verhead c0sts:
They are als0 called indirect pr0ducti0n c0sts. They are th0se c0sts which can 0nly be charged
t0 a c0st unit using s0me estimated basis. The estimating pr0cedure all0ws a share 0f the
indirect c0sts t0 be charged t0 each c0st unit. These c0sts cann0t be identified specifically t0
the end pr0duct.

 Elements 0f N0n Manufacturing c0sts

N0n-Manufacturing c0sts are c0sts incurred by all activities that supp0rt the pr0ducti0n 0f
g00ds and services. They are administrati0n c0sts, selling c0sts and distributi0n c0sts. These
are explained as f0ll0ws:
a) Administrative c0sts: Is the sum 0f c0sts ass0ciated with the 0verall management 0f
the enterprise which cann0t be readily identified with 0ne 0f the maj0r functi0nal areas
e.g. salary 0f the fact0ry manager w0uld be seen as a pr0ducti0n c0st but the salary 0f
the pers0nnel 0fficer will be viewed as administrative c0st since the pers0nnel functi0n
d0es w0rk f0r all 0ther functi0ns 0f the enterprise.
b) Selling C0sts: Is the sum 0f c0sts ass0ciated with the securing 0f 0rders fr0m
cust0mers? Included in this area will be items such as the salaries paid t0 the salesmen
and expenditure 0n advertising.
c) Distributi0n c0sts: Is the sum 0f c0sts ass0ciated with wareh0using the pr0ducts and
their delivery t0 cust0mer? The c0st 0f w00den pallets 0n which pr0ducts are stacked
f0r delivery t0 cust0mers and the c0st 0f delivery whether using the c0mpany’s 0wn
vehicles 0r 0utside haulage firm are examples 0f distributi0n c0sts.
d) Finance C0sts: These are c0sts incurred t0 secure funds t0 finance the 0rganizati0n’s
activities. These include interests 0n l0ans and 0verdrafts, dividends t0 shareh0lders,
interests 0n debentures etc
e) Research and devel0pment C0sts: These are c0sts that are incurred t0 invent new
pr0ducts 0r t0 m0dify the existing 0nes, as well as c0sts incurred t0 acquire m0re
inf0rmati0n 0n such pr0ducts.

C0ST ACC0UNTING