CHAPTER 1: Decision-making based on price setting and capacity utilisation

CHAPTER 1

LEARNING UNIT 2: Cost concepts and classification

ASSESSMENT CRITERIA
After working through this learning unit, you should be able to
• Define the terms and concepts relating the costing of products
• Classify costs as product or period costs
• Classify costs as prime or conversion costs
• Classify costs as the elements of finished units of production
• Classify costs according to their traceability and behaviour

You should spend approximately 5-6 hours on mastering the learning outcomes of this Learning Unit.

2.1 INTRODUCTION

There are three basic types of business organisations and not all the elements of an integrated cost
accounting system as discussed in Learning Unit 3 will apply equally to each of them. These business
organisations are manufacturers, merchandisers and service organisations.

Manufacturers
Manufacturers purchase materials, hire labour and acquire other resources to convert the materials into
finished goods that can be sold for a profit. Tiger Brands is one of the largest manufacturers of food
products in South Africa. Wheat is an example of a material that is converted in the production of flour.
Costs assigned to finished goods (e.g., flour) that have not been sold yet are shown in an Inventory of
Finished Goods Account in the general ledger of the manufacturer. The cost of materials (e.g., wheat)
not yet used in the process manufacturing is shown in an Inventory of Materials Account in the general
ledger of the manufacturer. Both Inventory of Finished Goods and Inventory of Materials are disclosed
in the Statement of Financial Position.

Merchandisers
Merchandisers purchase finished goods that they then resell for a profit. Checkers is an example of a
merchandiser. One of the finished goods that Checkers buys to resell is the flour that was produced by
Tiger Brands. The cost of merchandise (e.g., flour) that have not been resold yet is shown in an
Inventory of Merchandise Account in the general ledger of the merchandiser. A bakery is also an
example of a retailer. The flour that a bakery buys from Checkers and not yet used is shown in an
Inventory of Materials Account in the general ledger of the bakery. You will notice how flour can be
considered as finished goods (Tiger Brands), merchandise (Checkers) or materials (bakery).

Service organisations
Service organisations provide services rather than goods. Some service providers, like auditors and
attorneys, sell services for a profit, while other service providers, like charities and government
departments, may provide services at no cost or little cost to the users of those services. Service
organisations do not have inventory accounts, other than maybe for stationery. The value of stationery
not yet used will, if large enough, be shown in an Inventory of Consumables Account in the general
ledger of any organisation.

Different organisations require different cost accounting systems and different cost classifications (with
their concomitant terminology), for useful information to system users and managers. Therefore,
management accountants need to accurately determine costs for, inter alia,
• the valuation of inventory in the financial statements
• the planning and control activities in the organisation
• decision-making that will improve the organisation’s efficiency
The focus of this module is on the role of the cost and management accountant in commerce and
industry, and more specifically in a manufacturing environment. Unlike the financial accountant, who
provides information in a prescribed manner to external users of financial statements, the cost

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accountant is not required to adhere to prescribed standards and can therefore be flexible and
innovative, but always ethical, in providing information for multiple purposes to management.

You will be introduced to a number of cost concepts used in a manufacturing environment. (Note that
we use the verbs manufacture and produce and their corresponding nouns interchangeably, as for our
purposes they have the same meaning.) As you will presently see, there are many costing terms and
you may well feel somewhat overwhelmed. However, as you progress through the study guide, these
terms and concepts and the need for distinguishing between them will become clear.

2.2 COSTING TERMS AND CONCEPTS

There are many concepts that are unique to cost accounting in a manufacturing environment. The
concepts defined in this paragraph do not make an exhaustive list, but it is important that you are familiar
with them at the outset. More concepts will be introduced as we work through this guide. A glossary of
terms and concepts appear at the end of the study guide. Different sources will give different definitions
for these terms, but they mean the same thing. That is why it is important that you are able to explain
these terms and concepts; instead of memorising them parrot fashion, you must make every effort to
understand them and describe them in your own words.
What is a cost?
Simply put, cost refers to the amount of money that must be paid to get something. For example, the
cost of a loaf of bread is R15,00 (depending on the type of bread and where you buy). In a business
environment, cost means any cost incurred by the business entity. It is important to understand how
cost is established and for what purposes. Both financial accounting and management accounting are
concerned with costs. The objective of financial accounting is to ensure that all costs incurred by an
entity during a specific period, e.g., a year, are recorded in the accounting records for that period (year)
and accurately disclosed in the financial statements in accordance with applicable legislation and
accounting standards. Costs are classified as either assets or expenses. For example, the cost of
equipment is accounted for as an asset in the Statement of Financial Position and the cost of salaries
is accounted for as an expense in the Statement of Comprehensive Income. The objective of
management accounting is, among others, to ensure that its integrated cost accounting system
accurately identifies and assigns all costs incurred in the manufacturing process to the cost of the
products manufactured, according to the basis and methods adopted by the organisation (see Learning
Unit 3). The integrated cost accounting system, among others, provides the financial accountant with
the value (cost) of inventories for inclusion in the financial statements.
Cost objects
The main objective of cost accounting is to establish the cost of things. These things are called cost
objects. Anything you wish to determine the cost of, is a cost object. The painting that the artist wishes
to know the cost of is a cost object and costs incurred are typically paint, canvas, brushes, the use of
an easel, the artist’s time, etc. Other examples of cost objects are the clients of auditors and attorneys;
the branches of a national retailer (e.g., for purposes of branch accounting); even a monthly budget
variance report can be a cost object if you wish to know how much it costs to produce it. Keeping track
of how much it costs to raise your child makes the child a cost object! In a manufacturing environment,
the cost object is ultimately the products manufactured.
Cost drivers
A cost driver is a factor (called a variable) that causes a change in the cost of a cost object. The factor
may be an activity (such as quality inspections), a volume (such as the number of units manufactured,
also referred to as the production output) or a quantity (such as components used in production). The
higher the level of activity (or volume or output or quantity), the higher the cost that it drives. Activities
are used as bases for the apportionment of overheads in an activity-based costing system, while output
volume or other quantities are used as bases for the apportionment of overheads in a traditional costing
system.
Product costs
In a manufacturing entity, we distinguish between product costs (manufacturing costs) and period costs
(non-manufacturing costs). Product costs are those costs that are incurred as a result of the manufacturing
operation. A merchandiser, i.e., where there is no manufacturing operation, will not have product costs.
Product costs are treated as assets in the form of inventory until the manufactured goods are sold.

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Period costs
Costs that are not incurred in the manufacturing operation and are therefore not classified as product
costs, are period costs (meaning they were incurred for that period only). Period costs are expenses
that are categorised as either administrative expenses or marketing, selling and distribution (MSD)
expenses. Under the variable costing method, fixed manufacturing costs are also treated as period
costs, but more about this later. Administrative expenses are the costs incurred in directing and
controlling the company, for example the remuneration paid to executives, general accounting costs,
secretarial costs and similar costs relating to the general management of a company. MSD costs include
all the expenses relating to the sale and delivery of finished products. Examples of MSD expenses are
the cost of advertising, sales commission, sales salaries and the cost of delivery to customers.
Relevant range
As you will see later, accountants assume that, within a certain range of activity (output volume or
quantity), the relationship between output levels and their associated costs is linear; i.e., the relationship
can be represented by a straight line. This range of output is referred to as the relevant range and it
has a minimum boundary and a maximum boundary. The relevant range refers to the range of output
within which the company expects to be operating in the short-term, e.g., the budget period. For
example, the timber industry uses a machine to measure the stiffness of wood and applies a correlation
between stiffness and strength to assign a stress grade for the wood. If one machine can carry out a
maximum of 3 000 stiffness tests in one month, then the relevant range of the machine 0–3 000 tests.
Suppose that the machine is leased at a cost of R50 000 per month, then the cost of R50 000 is valid
only if the number of tests during the month falls within the relevant range of 0–3 000. If more than
3 000 tests are required, then an additional machine will have to be leased, increasing the cost. Normal
operations will usually occur within the relevant range. The relevant range is particularly important for
product costing when cost behaviour is considered.
Cost assignment
All product costs are ultimately assigned to the goods being manufactured, i.e., the cost objects. The
products/goods being manufactured, e.g., books, cutlery, furniture, etc are usually referred to as units
of production. Cost assignment can occur either through direct cost tracing, direct cost allocation or
indirect cost apportionment. Product costs that can be traced directly to the units of production are
assigned directly to those units of production; product costs relating to specific departments are
allocated directly to those department; other product costs are apportioned to the products or
departments, based on appropriate rates of apportionment. You will learn more about direct cost tracing
and allocation and cost apportionment based on pre-determined rates later in this study guide.
Historical and replacement cost
Historical cost means the original, actual amount paid for goods and services at the time the transaction
was entered into. Purchases of office stationery, for example, are recorded at historical cost. On an
actual costing basis (see Learning Unit 3) all product costs will be recorded at their historical cost. As a
result of inflation, the historical cost of an item held in inventory will often be lower than the current cost
at which the item could be replaced (replacement cost).

ACTIVITY 2.1

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).
1.1 Period costs are found only in manufacturing companies and not in merchandising companies
or service organisations.
1.2 The term cost refers to the value of the sacrifice made to acquire goods or services.
1.3 Factory rent is a product cost but rent for the administration office is a period cost.
1.4 Product costs can also be called inventoriable costs.

2.3 COST CLASSIFICATION

In this study guide, the focus is on cost determination in a manufacturing environment. We know that a
manufacturing entity converts materials into finished goods and then sells the finished goods. Cost

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accounting deals with accounting for the costs of materials and the costs of converting the materials
into finished goods.
Cost classification means grouping costs according to commonality. The employees of a company may,
for example, be classified according to gender, age group, and post level. The same employee will fall
into more than one classification category, e.g., female; 30-35 years old; post level 6. Similarly, the
same cost can be classified into more than one category, as you will presently see.
We already know that the costs of a manufacturing entity are classified as either product costs or period
costs; we shall look at this again in greater detail below. We shall also see how product costs can be
further classified as prime costs and/or conversion costs as well as according to type, traceability and
behaviour.

2.3.1 Classification of costs by function

Product costs
Product costs are those costs that are incurred as a direct result of the manufacturing of inventory. The
costs assigned to inventory of goods completed but unsold at the end of a period are called the
unexpired costs and the value (cost) of unsold goods is shown as inventory in the Statement of Financial
Position. The cost of goods that had been sold during the period is called expired costs; it is transferred
from the inventory account to the cost of goods sold (cost of sales) account and is shown as an expense
in the Statement of Comprehensive Income.
You will remember that financial accounting classifies costs as either assets or expenses. Product costs
are treated as assets (in the form of inventory). When finished goods are sold, the product costs
assigned to the units sold are expensed, i.e., they become period costs, by transferring the costs from
inventory to cost of sales.

Period costs
Period costs include expensed (expired) product costs as well as all costs not classified as product
costs. Depending on the method selected for the valuation of finished goods, period costs may or may
not include fixed manufacturing (production) overheads. You will learn more about this later in this study
guide. Period costs are treated as expenses in the Statement of Comprehensive Income in the period
in which they are incurred. For example, rent for an administration office building and marketing costs
are not included as part of the cost of a manufactured product and will appear in the Statement of
Comprehensive Income for the period in which they are incurred. Note, however, that the rent of a
factory building is a product cost because it is incurred as a direct result of the manufacturing process.
Costs relating to the inefficient use of production resources will, however, be treated as a period cost
and not as product cost. You will learn more about this later in this study guide.

ACTIVITY 2.2
QUESTION 1
A company manufactures wooden chairs. Carefully consider the following statements and indicate
whether they are TRUE (T) or FALSE (F).
1.1 The cost of wood used to manufacture a chair is treated as a period cost in the month that the
chair is manufactured.
1.2 The cost of the electricity used by the sanding machine in the production of wooden chairs is a
period cost in the month that the electricity account is paid.
1.3 The salary of the cutting machine operator in the production of wooden chairs is a product cost.
1.4 The commission paid to the salesperson who sold a wooden chair is a product cost.
1.5 The courier cost to deliver the sold chair to a customer is a product cost.
1.6 The salary of the chief executive officer of the manufacturing company is a period cost.

QUESTION 2

For each of the following questions, read carefully through the information provided and select only the
most correct option as your answer.

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2.1 Costs expensed in the income statement in the period that they are incurred are called …
(a) product costs.
(b) operating expenses.
(c) period costs.
(d) manufacturing costs.
2.2 Product costs appear on the statement of financial position …
(a) only if goods are partially completed at the end of the period.
(b) only if goods are fully completed at the end of the period.
(c) if goods are partially or fully completed at the end of the period.
(d) if goods are partially or fully completed and unsold at the end of the period.

2.3.2 Classification of product costs according to product elements

Product costs are made up by the cost of the three elements associated with the manufacturing process
namely materials, labour and factory overheads.
Materials cost
Materials cost is the cost of those physical items that are used to manufacture products (units) that will
be sold. For example, the following materials are used in manufacturing furniture: wood, metal, fabric,
glue, staples and varnish, but also oil, grease, light bulbs and cleaning materials. (Physical items refer
to things you can see and touch.)
Labour cost
Labour cost consists of the cost of salaries, wages and benefits paid to the people employed in the
manufacturing section of the entity.
Factory overhead cost
Factory overhead cost refers to those other costs necessarily incurred to operate the factory and that
are not materials or labour costs. Such costs include the cost of electricity used in the factory, the
depreciation of the manufacturing equipment, rent of the factory building, factory insurance and so forth.
Materials, labour and overhead costs are classified in more detail according to their nature and traceability.

2.3.3 Classification of product costs according to their nature and traceability

Product costs are, based on their traceability, classified as either direct costs or indirect costs.
Direct costs are product costs that can be directly traced to manufactured products (cost objects),
except when it is impractical to trace the costs. Costs that are impossible to trace directly to
manufactured products, as well as costs that are impractical to trace directly to manufactured products,
are classified as indirect costs. In other words, a cost is considered as an indirect cost when it is either
impractical or impossible or both, to trace it to the manufactured products. A cost would be considered
as a direct cost only if it is both possible and practical to trace it to the finished product.
Materials costs
Materials costs are classified as either direct material costs or indirect material costs. Direct material
costs are those costs that can easily be traced to the products manufactured and indirect material
costs are all the material costs that are not direct material costs, i.e., materials whose costs are
impossible or impractical or both to trace to the products manufactured.
Direct material costs (also called raw material costs) would consist of e.g., the cost of the wood, metal and
fabric used to manufacture furniture. These materials become an integral part of the finished product as
you can very easily trace them to the finished products; you can literally see the wood, the metal and the
fabric in the final product. Because of their quantities used, it would be both practical and possible to trace
the cost thereof. For example, if one metre of fabric is required in the production of one chair, it would be
quite easy to directly trace the cost of one metre of fabric to each chair manufactured.
Glue, staples and varnish are materials that also form an integral part of the manufactured products as
they can be seen in the finished product, but their cost would in all probability be considered as indirect
material cost because it would be impractical to trace their cost to the manufactured product. Consider
for example how impractical, if not impossible, it would be to trace the cost of varnish to all the many
chairs, tables and cabinets that were painted from a single can of varnish. If it is possible and not too
costly to trace materials directly to products, they should be classified as direct materials.

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Oil, grease, light bulbs, cleaning materials, etc, do not form part of the products manufactured, but they
are consumed (used up) in the manufacturing process. We refer to this type of material as consumables.
Consumables are incidental to the manufacturing process. The cost of consumables used in the
manufacturing process is classified as indirect material costs which would be impossible to trace to the
manufactured products.
Labour costs
Labour costs are also classified as either direct labour costs or indirect labour costs. Direct labour
costs in the manufacture of furniture, for example, would consist of the labour cost of the cutting
machine operators and assemblers whose labour can be directly traced to the manufactured furniture.
Direct labour is also referred to as touch labour, i.e., the labour of those people who literally touch the
materials while converting them into finished goods. The remuneration cost of the supervisors, quality
controllers, cleaners, etc are considered as indirect labour cost, as it cannot be traced to specific
products.
Factory overhead costs
It was mentioned earlier that factory overheads consist of the costs, other than the cost of material and
labour, necessary to operate the factory. These costs include for example, electricity and depreciation
and rent. However, indirect material costs and indirect labour costs are also considered to be overhead
costs. Indirect material costs plus indirect labour costs plus factory overhead costs collectively, is
referred to as production overheads (or indirect costs or manufacturing overheads or just overheads.)
Earlier, we said that product costs consist of materials costs plus labour costs plus factory overhead
costs. We can, and should, now rephrase that and say that product costs consist of direct materials
cost plus direct labour cost plus production overhead cost.

ACTIVITY 2.3

QUESTION 1

A company manufactures wood furniture. Carefully consider the following statements and indicate
whether they are TRUE (T) or FALSE (F).
1.1 A particular, bespoke desk being manufactured is a cost object.
The cost of the special sandal wood used in the manufacture of the desk is a manufacturing
overhead because one piece of wood is cut up to make several desks.
1.2 The cost of the wages paid to the craftsmen assembling the desks are manufacturing overhead
costs because craftsmen are not labourers.
1.3 The cost of the special varnish used to finish the desks is an indirect material cost because it is
impractical to directly trace the cost to the desks.
1.4 The cost of the wages of the factory cleaning staff is an indirect labour cost because they do not
work directly with converting the wood into chairs.
1.5 The cost of the incentives paid to salespersons to sell the desks is a direct labour cost because
it can be traced directly to the desks.

QUESTION 2

For each of the following questions, read carefully through the information provided and select only the
most correct option as your answer.
2.1 … correctly reflect a collection of manufacturing costs.
(a) Material, direct labour, indirect labour, and factory equipment repairs
(b) Material, direct labour, marketing cost, and the salary of machine operator
(c) Material, direct labour, indirect labour, and marketing cost
(d) Material, direct labour, indirect labour, and administration costs
2.2 … is not an inventory category.
(a) Materials
(b) Finished goods
(c) Overheads
(d) Merchandise

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2.3 The cost of lubricants used to grease a production machine in a manufacturing company is an
example of a(n) …
(a) period cost.
(b) direct material cost.
(c) indirect material cost.
(d) non-inventoriable cost.

QUESTION 3

Hobby Hen is an arts and crafts shop that makes and sells, among others, high quality model
assembling kits. The models include anything from model airplanes to models of famous buildings, etc.
A customer ordered 30 of the 1961 Chevrolet Impala models, for payment and collection in December.
All the kits were produced during November at a total cost of R15 000,00. There will be 20% added for
profit when the kits are sold in December.
REQUIRED:
3.1 Calculate the profit that will be realised in December.
3.2 Explain how the amount of R15 000 will be treated in the financial statements of Hobby Hen at
the end of November and December.

2.3.4 Classification of product costs as prime costs and/or conversion costs

Prime cost
Prime costs are direct costs, i.e., the cost of direct material and the cost of direct labour.
Conversion cost
Conversion costs are the costs incurred in converting the direct materials into finished goods, i.e., the
cost of direct labour and the cost of production overheads.

FIGURE 2.1: Classification of manufacturing costs as prime and/or conversion costs

Direct material costs Direct labour costs Production overhead costs

(Indirect materials, indirect
labour and factory overheads)

Prime costs Conversion costs

Figure 2.1 clearly demonstrates that direct labour is both a prime cost and a conversion cost.

ACTIVITY 2.4

QUESTION 1

Tebogo Manufacturers incurred the following costs: R

Direct materials 250 000
Direct labour 150 000
Manufacturing overheads 500 000
Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).
1.1 Total cost of production is R900 000.
1.2 Prime costs amount to R400 000.
1.3 Conversion costs amount to R500 000.

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QUESTION 2

For each of the following questions, read carefully through the information provided and select only the
most correct option as your answer.
2.1 Indirect labour is a …
(a) prime cost.
(b) conversion cost.
(c) period cost.
(d) non-manufacturing cost.
2.2 The wages paid to the factory supervisor is an example of …
(a) a prime cost, but not a conversion cost.
(b) a prime cost and a conversion cost.
(c) a conversion cost but not a prime cost.
(d) neither a conversion cost nor a prime cost.
2.3 What is a common element of both prime and conversion costs?
(a) Direct materials
(b) Direct labour
(c) Variable production overheads
(d) Fixed production overheads
2.4 Direct materials and direct labour costs amount to R35 000 and R38 000 respectively. If direct
labour equals 20% of total conversion costs, then production overhead cost is …
(a) R18 250.
(b) R9 500.
(c) R8 750.
(d) R152 000.
2.5 Z Ltd incurred the following costs in January:
Direct materials R35 000
Direct labour R30 000
Production overheads R70 000
Selling expenses R15 000
Administrative expenses R20 000
Total conversion costs for January were …:
(a) R65 000.
(b) R135 000.
(c) R100 000.
(d) R170 000.

QUESTION 3

Modern Tops supplies boutiques with their exclusive brand of women’s blouses. One Aphrodite blouse
requires the following materials:
1½ metres of satin at R180 per metre
2 metres of lace border R240 per metre
12 exclusive buttons at R21 per button
Sewing thread costs R180 per spool
It takes the cutter 30 minutes to cut the fabric for one blouse, whereafter the seamstress takes 5 hours
and 15 minutes to sew and finish a blouse. Both the cutter and the seamstress are hourly workers,
earning R150 per hour.
REQUIRED
Determine the prime cost per Aphrodite blouse.

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2.3.5 Classification of product costs according to cost behaviour

In analysing costs according to behaviour, accountants attempt to understand how costs behave
(change) at different levels of output. Examples of the level of output are the number of units produced,
the number of hours worked, the number of machine inspections, etc.
Cost behaviour classifies a cost as being a fixed cost, a variable cost, a mixed cost or a stepped cost.
Cost behaviour is particularly important in planning and budgeting. We know that production costs
consist of the cost of direct materials, direct labour and production overheads, but they are just
headings; the list of costs under each heading can be very long. Below are only a very few examples
of production overhead costs:
Indirect materials R Indirect Labour R Factory overheads R
Glue xxx Supervisors xxx Electricity xxx
Staples xxx Inspectors xxx Water xxx
Varnish xxx Machine technicians xxx Factory rent xxx
Springs xxx Cleaners xxx Factory insurance xxx
Ticking xxx Factory manager xxx Depreciation xxx
The behaviour of each of the above cost items can change within different ranges of different levels of
output. Output can refer to e.g., number of units manufactured or the quantity of direct materials used
or the number or direct labour hours worked, etc. During the budgeting stage, the behaviour of each of
the many cost items is considered and classified. It is during the planning and budgeting stage that
assumptions about the relevant range are made. We shall frequently refer to the relevant range in the
discussion of the classification of cost according to cost behaviour. It is, however, important that you
understand, right at the outset, that assumptions made about cost behaviour are valid only within the
relevant range of output.
In the discussion that follows, we shall use graphs to illustrate cost behaviour at different levels of
output. You may recall from your school maths that a graph has an x-axis (the horizontal line of the graph)
and a y-axis (the vertical line of the graph). Output predicts the extent of the cost. The cost depends on
output and is therefore called the dependent variable; the dependent variable is shown on the y-axis.
The predictor variable, output, is called the independent variable; the independent variable is shown on
the x-axis.
Fixed costs
Total fixed costs will remain unchanged regardless of output, provided the output level is within a
relevant range. Say, for example, the output is the number of units produced and the relevant range is
2 000 to 8 000 units. Factory rent and insurance are examples of fixed production overhead costs that
will be the same in total, even if output levels fall below the relevant range; it does not matter what
number of units between zero and 8 000 are produced, the total fixed cost will remain constant at say,
R30 000. However, the fixed cost per unit produced will decrease as more units are produced. See
Table 2.1 below.
TABLE 2.1: Fixed cost (e.g., rent and insurance) behaviour per unit of output
Units produced Total fixed costs Fixed cost per unit produced
(independent variable) (dependent variable) R
x y
0 R30 000 Not applicable
2 000 R30 000 R15,00 (R30000 ÷ 2 000 units) *
4 000 R30 000 R7,50 (R30000 ÷ 4 000 units)
6 000 R30 000 R5,00 (R30000 ÷ 6 000 units)
8 000 R30 000 R3,75 (R30000 ÷ 8 000 units)
* Note that a solidus (/) is often used in the place of the division symbol (÷). So instead of writing R30000 ÷ 2000
units, we can also write R30000 / 2000 units.

The data from Table 2.1 are now plotted on a graph (Figure 2.2) by placing a dot (•) on the spot where
the readings for units produced and total fixed costs meet: for 0 units, total cost = R30 000; for 2 000 units,
total cost = R30 000, and for 8 000 units, total cost = R30 000. The dots are then connected with a line.

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Note that the word data is a plural noun; its singular form is datum. Other similar words are curriculum and curricula;
stratum and strata; memorandum and memoranda; etc. Strictly speaking, we should say data are and datum is,
but to be honest, the word datum is seldom seen or heard of anymore. It has become widely accepted to treat the
word data as both singular and plural and it is not strange to read data is. It is therefore acceptable to use either
data are or data is. (It is following the fate of agendum and agenda; agenda, that used to be the plural form, has
now become the singular with agendas its plural).
FIGURE 2.2: Total fixed overhead costs per output level
y
Total fixed costs in R'000

150'

120'

90'

60'

30' • • • • •

0
x
0 2' 4' 6' 8'

Units produced in '000

If the relevant range is 2 000 to 8 000 and production exceeds 8 000 units (the upper limit of the relevant
range), then for example, additional factory space may be required and the total fixed cost will increase.
Within the relevant range, however, the cost remains unchanged, i.e., fixed.
Variable costs
Total variable costs will increase in direct proportion to an increase in output, e.g., the number of units
manufactured, while variable cost per unit will remain unchanged, regardless of the number of units
manufactured. Direct material is an example of a variable production cost. Assume the variable cost of
direct material per unit manufactured is R15. It should be obvious that, when no units are produced, the
material (variable) cost is zero (because no material would be used); when 2 000 units are produced
the total variable cost is R30 000 (2 000 units × R15); when 4 000 units are produced the total variable
cost is R60 000 and when 8 000 units are produced the total variable cost is R120 000. See Table 2.2
and Figure 2.3.
TABLE 2.2: Variable cost (e.g., direct material cost) behaviour per unit of output
Units produced Total variable costs Variable cost per unit
independent dependent R
x y
0 0 0
2 000 R30 000 R15 (y/x)
4 000 R60 000 R15 (y/x)
6 000 R90 000 R15 (y/x)
8 000 R120 000 R15 (y/x)

Again, a line is drawn through the points (×) where the readings for the output units and costs meet.
Total variable costs (e.g., total direct material costs) increase in direct proportion to the increase in the
number of units manufactured, but the variable cost per unit will stay the same. It should, however, be
noted that variable cost per unit may also change outside the relevant range. If the relevant range is
2 000 to 8 000 units and production exceeds 8 000 units, volume discounts may be negotiated with
suppliers of direct materials and the cost per unit may decrease accordingly.

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FIGURE 2.3: Total variable costs per output level

Variable costs in R'000 150'

120' ×
90' ×
60' ×
30' ×
0 ×

0 2' 4' 6' 8' x

Units manufactured in '000
The broken lines in Figure 2.3 indicate the following coordinates of the straight line:
y-reading x-reading
(dependent variable) (independent variable)
R production units
90 000 6 000
60 000 4 000
Change 30 000 2 000
Change = 30 000/2 000 = 15
Output, the independent variable (in this case, units manufactured), is graphed on the x-axis and total
cost, the dependant variable (in this case, total variable costs), is graphed on the y-axis. The slope or
incline of the straight line connecting the plotted data is defined as the change in the y-direction (30 000)
divided by the change in the x-direction (2 000), i.e., the change in the dependent variable divided by
the change in the independent variable (30 000 / 2 000 = 15). The slope is expressed as the units on
the y-axis that the dependent variable will move for every one unit on the x-axis that the independent
variable moves. It means that for every 1 unit manufactured, there is an increase of R15 in the cost.
You may already have noticed that the slope of the line is the same as the variable cost per unit,
because every unit manufactured adds R15 to the total variable costs. This is important to remember
when we get to our discussion of regression analysis later on.
Table 2.3 and Figure 2.4 demonstrate the behaviour of fixed costs, variable costs and total costs.
TABLE 2.3: Total production costs
Units produced Total fixed costs Total variable costs Total production costs
R at R15 per unit R
x y y y
0 30 000 0 30 000
2 000 30 000 30 000 60 000
4 000 30 000 60 000 90 000
6 000 30 000 90 000 120 000
8 000 30 000 120 000 150 000

You will notice the following:

• Variable costs (×) start at R0 where 0 units are made and increase proportional to an increase in
the number of units produced.
• Fixed costs start at R30 000 and continue to be R30 000 regardless of number of units produced.
• Total costs (●) start on fixed costs at R30 000. The total costs line runs parallel with the total variable
costs line; this is because every extra unit adds R15 to both variable costs and total costs. The total
costs line can be likened to the variable cost line being moved and placed on top of the fixed cost

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line. This is so because total cost = variable cost + fixed cost. The arrows indicate the R30 000
fixed costs consistently added to the total variable costs to give the total production costs.

FIGURE 2.4: Total production costs

total production costs

150' ● total variable costs

120' ● ×
Costs in R'000

90' ● ×
60' ● ×
30' ● × total fixed costs

0 ×

0 2' 4' 6' 8'

Units in '000
ACTIVITY 2.5

QUESTION 1

Sweet Tooth Limited is the manufacturer of the Toff’o’Choc chocolate bar. Each chocolate bar is
wrapped in a foil wrapper with Toff’o’Choc printed on it, along with the ingredients and nutritional
information of the chocolate. During the year, 100 000 of the bars were manufactured. Once sold,
Toff’o’Chocs are packed into cardboard boxes in lots of 100 and shipped to retailers. The cost of each
box is R20. Total variable manufacturing overheads amounted to R250 000.
Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).
1.1 In terms of traceability, the cost of the wrapper is classified as a direct material cost because the
wrapper is an integral part of the finished product and it is both possible and practical to trace
the cost thereof to the chocolate bars manufactured.
1.2 In terms of being a prime or a conversion cost, the cost of the wrapper is a conversion cost,
because it converts the chocolate bars into products ready for sale.
1.3 In terms of cost behaviour, the cost of the wrapper is a fixed cost because there will always be
only one wrapper required for one chocolate bar.
1.4 The variable cost per chocolate bar is R2,50.
1.5 The cost of the cartons is a variable, direct material cost.

QUESTION 2

For each of the following questions, read carefully through the information provided and select only the
most correct option as your answer.
2.1 Variable costs mean all costs …
(a) associated with marketing, distribution and activities.
(b) incurred in the manufacture of goods.
(c) that do not change in total within the relevant range, but become progressively smaller on a per
unit basis as volume increases.
(d) that fluctuate in total in response to changes in output.
2.2 The following data is available for cost A and cost B:
Production Cost per unit Total cost
Cost A 1 unit R10
10 units R100
100 units R1 000
1 000 units R10 000

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Cost B 1 unit R5 000

10 units R500
100 units R50
1 000 units R5
The behaviour of costs A and B is best described as …
(a) cost A is fixed and cost B is variable.
(b) cost A is variable and cost B is fixed
(c) both Cost A and Cost B are variable.
(d) both Cost A and Cost B are fixed.

Mixed costs
Also referred to as a semi-variable cost, a mixed cost contains both fixed cost and variable cost
elements. The fixed portion of the cost (the base-level cost) will, like other fixed costs, be incurred
repeatedly over time, regardless of output level, while the variable portion will, like other variable costs,
be incurred only when there is output and increase or decrease in output. An example of a mixed cost
is the charges on a cell phone contract, where the subscription charge is a fixed, base-line charge
(which may include free calls, etc), but further call charges and services (e.g., data) vary, depending on
usage. Another example is equipment maintenance, where the cost of routine monthly, preventive
maintenance inspections will be fixed regardless of level of output, but the cost of any call-outs for
breakdowns will vary, although not necessarily proportionally, with the level of the output (e.g., machine
hours used).
TABLE 2.4: Mixed cost (e.g., equipment maintenance cost) behaviour per unit of output
Total maintenance Mixed cost per
Machine hours cost machine hour
(R) (R)
160 7 300 45,63
180 8 000 44,44
200 8 200 41,00
220 9 000 40,91
260 9 300 35,77
300 10 000 33,33
Total mixed costs will, like variable costs, increase with an increase in output, while mixed costs per
unit of output will, like fixed costs, decrease. As was the case with total variable costs, the line for total
mixed costs slopes up, albeit not in a straight line. This is so because the variable portion of a mixed
cost is not always the same per unit of production, i.e., the cost does not change in direct proportion to
the output level. Take for example machine maintenance: the cost of routine, planned maintenance
inspections will be fixed, but the cost of call-outs would depend on the work required, for example, one
call-out may require spare parts, while another may require only one hour’s labour. The cost of
maintenance call-outs is a variable cost, but it does not vary proportionally to the level of output.
FIGURE 2.5: Total mixed costs per output level
y
10000 •
Total mixed costs (R)

9500 •

9000 •

8500 •
8000 •

7500 • x
160 180 200 220 240 260 280 300

Total machine hours worked

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Stepped costs
Stepped costs refer to the behaviour of a fixed cost at various output levels. Often the behaviour of a
cost is to remain fixed and then at some point it jumps to a higher cost. The increased cost will then be
fixed for a further range of output level and then jump again. You are reminded that assumptions about
cost behaviour are made where the output level is within the relevant range and that the relevant range
is usually defined as the capacity at which the organisation normally operates. Assume that one
machine operator can make 1 000 units and that a supervisor is required for every 10 machine
operators. The relevant range for the appointment of one supervisor is 1–10 employees. Now also
assume that the normal production capacity, i.e., relevant range for production is 10 0000–30 000 units.
If the salary of one supervisor is R40 000, the behaviour of this cost within the relevant production range
(10 000–30 000 units) will be as follows:
TABLE 2.5: Supervisors required at different output levels within the relevant range
Units produced Operators Supervisors Total supervisor
salaries (R)
x y
10 000 10 1 40 000
20 000 20 2 80 000
30 000 30 3 120 000
Figure 2.5 depicts the cost behaviour of supervisors’ salaries at different levels of production output
within the relevant range for production.
FIGURE 2.6: Supervisors’ salaries at different output levels within relevant range for production
y
Total salary (R000)
40 80 120

x
10 000 units 20 000 units 30 000 units

ACTIVITY 2.6

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).
1.1 A factory supervisor’s salary is a fixed, direct labour cost.
1.2 The cost of paper used in textbook production is a fixed, direct material cost.
1.3 Factory insurance cost is a fixed production overhead.
1.4 The cost of screws used in furniture production is a variable, direct material cost.
1.5 The lease cost of the administration building is a fixed, production overhead cost.
1.6 The wages paid to assembly line workers, with an additional shift added at the beginning of
month 4, another additional shift at the beginning of month 7 and another additional shift at the
beginning of month 10, is a mixed indirect labour cost.
1.7 The cost of routine, monthly maintenance of machinery and several call-outs for breakdowns is
a stepped, direct labour cost.

QUESTION 2

During April, 10 000 units of the single product manufactured by Honey Ltd were produced. The total
production cost per unit was R60, of which variable cost was 40%. The relevant range is the production
of 5 000–15 000 units per month. During May 16 000 units were manufactured, which caused an
increase of R72 000 in fixed costs.
REQUIRED

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Calculate the unit and total cost of production for the month of May, clearly distinguishing between fixed
and variable costs.

2.4 IMPORTANT ASPECTS OF COST BEHAVIOUR

2.4.1 Fixed costs

Fixed costs remain constant, in total, regardless of changes in the level of output, provided the changes
occur within the relevant range.
Fixed costs are incurred to sustain a certain level of production e.g., between 8 000 and 10 000 units. This
means that the fixed cost per unit will decrease when the output level increases from, say, 8 000 to 9 000
units and that the fixed cost per unit will increase when the output level decreases. Refer to Table 2.1.
The apportionment of fixed cost to products is based on the chosen method for apportioning production
overheads (see Learning Unit 3).
The control of fixed costs is the responsibility of higher-level management rather than that of operational
managers or accountants.

2.4.2 Variable costs

A variable cost is a cost that varies, in total, in direct proportion and in the same direction as the output.
Within the relevant range, the variable cost per unit of output is constant. This means that, if, say the
output volume doubles, the total variable costs will also double. See Table 2.2. Tracing of direct,
variable production costs directly to products can be done with reasonable ease and accuracy.
A variable cost is variable in two respects: on the one hand is quantity/volume and on the other is cost.
For example, say a manufacturer of tents uses, among others, 10 metres of canvas (quantity) that it
buys at R120 per metre (cost) to make one tent; say also that it takes 1½ hours (quantity) at a wage
rate of R190 per hour (cost) to make one tent. The quantities (metres of canvas and labour hours) will
increase with an increase in output (tents manufactured); subsequently, the cost attached to the
quantity will also increase. You will learn more about this later.
The quantity used is controlled by a specific operating level supervisor. For example the canvas is
requisitioned from the stores and the Procurement Department will source quotations/tenders for
purchasing the canvas; the Human Resources Department sets the staffing and remuneration
structure. Direct materials and direct labour (the prime costs) are the most important elements of
variable costs.
Note that the labour costs of permanent employees of the manufacturing operation will only be considered
as a variable cost if management is able to hire and retrench workers in the short term. For this module,
you may assume that direct labour cost is a variable cost, unless specifically stated otherwise.

ACTIVITY 2.7

QUESTION 1

Happy Toy Shop produces only one toy, a cuddly dog. The following information pertains to April:

Number of dogs manufactured and sold 10 000 units

Total direct material cost
R20 000
Total direct labour cost R30 000
Total production overhead cost R22 000
Total selling and administrative cost R28 000
Selling price per dog R18
each
REQUIRED
1.1 What is the conversion cost per unit (cuddly dog)?
1.2 How much is cost of sales for the month?

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1.3 What was the period cost for the month?

QUESTION 2

Ntombeni Limited has a financial year that starts on 1 March and ends on 28 February. The
management accountant of the company has just prepared the budget for the forthcoming year, based
on the following cost structure:
Number of units to be manufactured: 7 000
Direct material: R 49 per unit
Direct labour: R 21 per unit
Indirect labour (all variable): R28 000
Other manufacturing overheads: R21 000, of which 60% is variable
Selling and administrative expenses (fixed): R28 000
REQUIRED
Calculate the following:
2.1 Prime costs per unit
2.2 Total conversion costs
2.3 Total manufacturing costs
2.4 Total period costs
2.5 Total variable manufacturing costs
2.6 If the company produces fewer than 7 000 units in the forthcoming year, would you expect the
total variable costs to increase, decrease or remain constant? (Explain only – no calculations
are necessary.)

2.5 TIME TO REFLECT

The major portion of this leaning unit was dedicated to an explanation of cost concepts and cost
classification. We did see, however, that procurement of materials used in production is carried out by
the Procurement Department and that the Human Resources Department is responsible for recruitment
of staff. Think about what you learn about segregation of duties as part of the internal control system in
Auditing. You should also reflect on what you learn about these functions in the Business Management
module and how these functions can contribute to an ethical organisation. For example, are the
employment practices fair? Are staff members at all levels fairly remunerated or are some staff
members perhaps subjected to zero-hour contracts, where they will receive no remuneration say,
during December when the factory is closed?

Are the materials used in the production process the best choice for the environment? In our example
of the chocolate manufacturer, would a paper wrapping, that is biodegradable, not be preferable to a
tin foil wrapping? Are the materials used ethically sourced, or is the company guilty of buying or
importing from suppliers making use of child labour and/or are operating under sweatshop conditions?
Sweatshops typically violate labour laws, have poor working conditions, unfair wages, unreasonable
hours and a lack of benefits for their workers.

Are materials perhaps sourced from suppliers with no regard for the environment? What about the
manufacturing processes employed by suppliers under our consideration? Do they have policies to
protect the environment?

Discuss these issues in the myUnisa forum.

2.6 SUMMARY

In this learning unit, we introduced you to the three basic types of business organisations, i.e.,
manufacturers, retailers and service organisations (paragraph 2.1). You have also learnt the meaning of
several costing terms and concepts (paragraph 2.2) and the classification of costs (paragraph 2.3) as
either a product cost or a period cost and then further classification of product costs

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• as a prime cost and /or a conversion cost

• according to the elements of the finished product, i.e., direct material, direct labour or production
overhead costs
• according to the traceability of the cost to the finished product, i.e., direct costs or indirect costs
• according to the behaviour of the cost, i.e., a fixed cost, variable cost, stepped cost or mixed cost

For example, the cost ‘electricity used in the factory’ is a product cost and a conversion cost and a
mixed cost and an indirect cost and, because it is an indirect cost, it is also an overhead cost.

In paragraph 2.4 we expanded your understanding of fixed costs and variable costs and in paragraph
2.5 we reflected on your knowledge from other modules and some ethical issues of importance.

Later in this study guide, you will learn about the linear cost function and how the methods that are used
for separating mixed costs into their fixed cost and variable cost components are based on the linear
cost function. You will also learn how a cost-volume-profit analysis can help to project or forecast costs
at different levels of output.

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