Session 3

Cost classification
 Cost classification

The classification
of cost

Types of Direct or Behavior

Function
expense Indirect

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 Cost classification: function

Production costs
Finance costs

Administration costs
Add Your Text

Function
Selling costs

Distribution costs

Research costs

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 Cost classification: types of expense

Materials

Labour Types of expense

Expenses

4
 Cost classification: Direct/Indirect

Total cost

Direct (Prime) Production Indirect

Cost (Overhead) Cost

Direct Direct Direct Indirect Indirect Indirect

Material Labour Expense Material Labour Expense

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 Direct/Indirect cost
Direct Cost (Prime Cost)
Cost that can be traced in full to the product, services or department that is
being costed

• material becoming part of the product, charge as

Direct material prime cost: component parts, part-finished work,
and primary packing materials

• Direct wages are all wages paid for labour,

Direct labour charge as prime cost (take into account overtime
premium of direct labour force)

• are any expenses which are incurred on specific

product other than direct material and direct cost
Direct expenses • charged to the product as part of prime cost (cost
of special designs, drawing of layouts, hire of
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 Direct/Indirect cost
Indirect Cost/Overhead
Indirect costs is a cost that is incurred in the course of making a product,
producing a service or running a department but which cannot be traced
directly in full to the product/ service/ department

Production overhead
• Indirect Materials: e.g. Consumable stores, abnormal losses
• Indirect Wages: non-productive personnel, i.e. foremen
• Indirect Expenses: e.g. rents, rates, depreciation, utility

Administration overhead

Selling and distribution overhead

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Cost classification:
Behavior

A Cost behaviour is the

Fixed cost way in which costs
are affected by
changes in volume of
B output
Variable cost

C
Semi- Variable cost

D
Stepped- fixed cost

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 Variable cost: cost are changed in direct proportion to
the level of activity such as direct material, direct labour

• Variable cost in total: changes • Variable cost per unit

at the same rate as the level of
activity

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 Fixed Costs: Costs are not affected in total
by the level of activity

• Fixed cost in total • Fixed cost per unit

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• Semi-variable cost • Stepped cost

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 High-low method
• Purpose: identify the fixed and variable elements of a mixed
cost
• Assumption: costs are linear
Total cost = Fixed Cost + (Variable cost/ Unit * Total Units)
• Method: Take the highest and lowest activity volume
• Calculate variable cost VC = (TC1-TC2)/(Q1-Q2)
• Calculate fixed cost FC = TC1 – VC * Q1
TC1 = FC + VC * Q1
TC 2 = FC + VC * Q2

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Practice questions

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 Practice question
1. A particular cost is fixed in total for a period.
What is the effect on the cost per unit of a reduction in
activity of 50%?
A. Cost per unit increases by 50%
B. Cost per unit reduces by 50%
C. Cost per unit increases by 100%
D. Cost per unit is unchanged.

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 Practice question
2. Total production costs and output over three periods have been:
Period Production costs Output
1 £230,485 12,610 units
2 £254,554 14,870 units
3 £248,755 14,350 units
What are the estimated variable production costs per unit if
the high–low method is applied?
A. 10·50
B. £10·65
C. £11·15
D. £15·50

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 Practice question
3. The table shows the total of Cost Y at different production levels
of Product X:
Units of Product X Total Cost Y (£000)
50 60
100 60
150 60
200 90
250 90
What could have been the cause of the increase in cost?
A. Increased fuel and maintenance costs for delivery vehicles
B. Increased storage requirements
C. Loss of discounts on raw materials
D. Pay increase for direct labour
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 Other Cost classifications

Product Cost/ Period Costs:

• Product Cost: are cost identified with a finished product. Such a cost
are identified initially as part of the value of stock and recognized as
expenses (in the form of cost of goods sold) when stock is sold.
Example: Cost of Goods sold
• Period costs are costs that are deducted as expenses during the
current period without ever being included in the value of stock held.
Example: Interest/ advertising, etc
Avoidable cost/ Non-avoidable cost: Cost can be avoided
if certain activity does not happen and vice versa.

Controllable/Uncontrollable cost: Cost can be controlled

and vice versa

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 Cost code

• Once costs have been classified, a coding system can be

applied to make it easier to manage the cost data, both in
manual systems and in computerized systems
• A code is a system of symbols designed to be applied to
a classified set of items to give a brief, accurate
reference, facilitating entry, collection and analysis.

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 Cost code

Features:
• The code must be easy to use and communicate
• Each item should have a unique code
• The coding system must allow for expansion
• The code flexible
• Brief
• Uniform
• Minimise errors, avoid confusion

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 Cost code
Types of code

Sequential (progressive) codes: Numbers are given to items in

ordinary numerical sequence, so that there is no obvious connection
between an item and its code. For example:
00042: 4cm nail
00043: office stapler
00044: hand wrench

Block (group classification) codes: These are an improvement on

simple sequences codes, in that a digit (often the first one) indicates the
classification on an item. For example:
4NNNN: nails
5NNNN: screws
6NNNN: bolts
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 Cost code
Types of code

Mnemonic codes: the code mean something, it may be an

abbreviation of the object being coded. A well-known example of this
type of code is the three letter coding used for airports
LAX: Los Angeles
SIN: Singapore

Hierarchical codes: each digit represents a classification, and a digit

further to the right represents a smaller subset than those to the left.
For example:
3: Screws
31: Flat headed screws
32: Round headed screws
322: Steel round headed screws
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 Cost code
Types of code

Faceted codes: these are a refinement of group classification codes, in that

each digit of the code gives information about an item. For example:
The first digit: 1 Nails
2 Screws
3 Bolts
The second digit: 1 Steel
2 Brass
3 Copper
The third digit: 150mm
260mm
375mm

Significant digit codes: these incorporate some digit(s) which is (are) part
of the description of the item being coded. For example:
5000: screws
5050: 50 mm screws
5060: 60 mm screws
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