TOPIC TWO

COST CLASSIFICATION, BEHAVIOUR AND PURPOSE

Costs in General
The term cost reflects a monetary measure of the resources sacrificed or forgone to
achieve a specific objective, such as acquiring a good or service. However, the term cost
has multiple meanings and different types of cost are used in different situations. A cost
object is any activity for which a separate measurement of costs is desired. In other words,
if the users of accounting information want to know the cost of something, this something
is called a cost object.
Examples of cost objects include the cost of a product, the cost of rendering a service to
a bank customer or hospital patient, the cost of operating a particular department or sales
territory, or indeed anything for which one wants to measure the cost of resources used.
Cost Terms and Concepts
We shall focus on the following cost terms and concepts:
• Direct and indirect costs;
• Period and product costs;
• Cost behaviour in relation to volume of activity;
• Relevant and irrelevant costs;
• Avoidable and unavoidable costs;
• Sunk costs;
• Opportunity costs;
• Incremental and Marginal cost.

Total costs
The total cost of making a product or providing a service consists:
(a) Cost of materials;
(b) Cost of the wages and salaries (labour costs);
(c) Cost of other expenses: eg. Rent and rates, Electricity and gas bills, Depreciation,
etc.

Direct costs and indirect costs

A direct cost is a cost that can be traced in full to the product, service, or department that
is being costed. An indirect cost (or overhead) is a cost that is incurred in the course of
making a product, providing a service or running a department, but which cannot be
traced directly and in full to the product, service or department.
Materials, labour costs and other expenses can be classified as either direct costs or
indirect costs.
(a) Direct material costs are the costs of materials that are known to have been used
in making and selling a product (or even providing a service).
(b) Direct labour costs are the specific costs of the workforce used to make a product
or provide a service. Direct labour costs are established by measuring the time
taken for a job, or the time taken in 'direct production work'.
(c) Other direct expenses are those expenses that have been incurred in full as a
direct consequence of making a product, or providing a service, or running a
department.
Examples of indirect costs include supervisors' wages, cleaning materials and buildings
insurance.

Analysis of total cost

Materials = Direct materials + Indirect materials
+ + +
Labour = Direct labour + Indirect labour
+ + +
Expenses = Direct expenses + Indirect expenses
Total cost = Direct cost + Overhead

Direct material
Direct material is all material becoming part of the product (unless used in negligible
amounts and/or having negligible cost).

Direct material costs are charged to the product as part of the prime cost. Examples of
direct material are:
(a) Component parts, specially purchased for a particular job, order or process.
(b) Part-finished work which is transferred from department A to department B
becomes finished work of department A and a direct material cost in department
B.
(c) Primary packing materials like cartons and boxes.
Direct labour
 Direct wages are all wages paid for labour (either as basic hours or as overtime)
expended on work on the product itself.

Direct wages costs are charged to the product as part of the prime cost.
Examples of groups of labour receiving payment as direct wages are as follows.
(a) Workers engaged in altering the condition or composition of the product.
(b) Inspectors, analysts and testers specifically required for such production.
(c) Foremen, shop clerks and anyone else whose wages are specifically identified.
Two trends may be identified in direct labour costs.
✓ The ratio of direct labour costs to total product cost is falling as the use of
machinery increases, and hence depreciation charges increase.
✓ Skilled labour costs and sub-contractors' costs are increasing as direct labour
costs decrease.
Direct expenses
Direct expenses are any expenses which are incurred on a specific product other than
direct material cost and direct wages

Direct expenses are charged to the product as part of the prime cost.
Examples of direct expenses are:
✓ The hire of tools or equipment for a particular job;
✓ Maintenance costs of tools, fixtures and so on.
Production overhead
Production (or factory) overhead includes all indirect material costs, indirect wages and
indirect expenses incurred in the factory from receipt of the order until its completion

Production overhead includes:

(a) Indirect materials which cannot be traced in the finished product. Consumable
stores, eg material used in negligible amounts;
(b) Indirect wages, meaning all wages not charged directly to a product. Wages of
non-productive personnel in the production department, eg foremen; and
(c) Indirect expenses (other than material and labour) not charged directly to
production. Eg. Rent, rates and insurance of a factory, Depreciation, fuel, power,
maintenance of plant, machinery and buildings.

Administration overhead
 Administration overhead is all indirect material costs, wages and expenses incurred in
the direction, control and administration of an undertaking.

Examples of administration overhead are:

✓ Depreciation of office buildings and equipment.
✓ Office salaries, including salaries of directors, secretaries and accountants.
✓ Rent, rates, insurance, lighting, cleaning, telephone charges and so on.

Selling overhead
Selling overhead is all indirect materials costs, wages and expenses incurred in
promoting sales and retaining customers.

Examples of selling overhead are:

✓ Printing and stationery, such as catalogues and price lists.
✓ Salaries and commission of salesmen, representatives and sales department staff.
✓ Advertising and sales promotion, market research.
✓ Rent, rates and insurance of sales offices and showrooms, bad debts and so on.

Distribution overhead
Distribution overhead is all indirect material costs, wages and expenses incurred in
making the packed product ready for despatch and delivering it to the customer.

Examples of distribution overhead are:

✓ Cost of packing cases.
✓ Wages of packers, drivers and despatch clerks.
✓ Insurance charges, rent, rates, depreciation of warehouses and so on.

Manufacturing, Merchandising and Service Organizations

To provide a better understanding of how different cost terms are used in organizations,
it is appropriate to describe the major features of activities undertaken in the
manufacturing, merchandising and service organizations.
Manufacturing organizations purchase raw materials from suppliers and convert these
materials into tangible products through the use of labour and capital inputs (e.g. plant
and machinery). This process results in manufacturing organizations having the following
types of inventory:
 • Raw material inventories consisting of purchased raw materials in stock awaiting
use in the manufacturing process;
• Work in progress inventory (also called work in process) consisting of partially
complete products awaiting completion; and
• Finished goods inventory consisting of fully completed products that have not yet
been sold.
Merchandising companies such as supermarkets, retail departmental stores and
wholesalers sell tangible products that they have previously purchased in the same basic
form from suppliers. Therefore they have only finished goods inventories.
Service organizations such as accounting firms, insurance companies, advertising
agencies and hospitals provide tasks or activities for customers. A major feature of
service organizations is that they provide perishable services that cannot be stored for
future use. Therefore service organizations do not have finished goods inventory but
some service organizations do have work in process.
For example, a firm of lawyers may have clients whose work is partially complete at the
end of the accounting period.

Costs as Assets and Expenses

A Capitalized Cost is a cost that is incurred in the purchase of a fixed asset. In this case
the value of the asset equals the cost used to acquire it and hence cost can be taken as
asset in this case.

An expense is a cost that businesses incur in running their operations. Expenses include
wages, salaries, maintenance, rent, and depreciation. Expenses are deducted from
revenue to arrive at profits. In this situation, cost is regarded as expense.
Opportunity Cost

Opportunity cost represents the potential benefits that a business, an investor, or an

individual consumer misses out on when choosing one alternative over another. While
opportunity costs can't be predicted with total certainty, taking them into consideration
can lead to better decision making.

Formula for Calculating Opportunity Cost

Opportunity Cost = FO – CO

where:

FO = Return on best forgone option

CO = Return on chosen option
The formula for calculating an opportunity cost is simply the difference between the
expected returns of each option.

Consider the situation where a student is contemplating taking a gap year overseas after
completing his or her studies. Assume that the student has an offer of a job on completion
of his/her studies. The lost salary is an opportunity cost of choosing the gap year that
must be taken into account when considering the financial implications of the decision.

Incremental and Marginal Costs

Incremental costs, which are also called differential costs, are the difference between the
costs of each alternative action that is being considered.

For example, a university is evaluating the financial implications of increasing student

numbers by 20 per cent. The two alternatives are:

➢ No increase in the number of students.

➢ A 20 per cent increase in the number of students.

If alternative 2 is chosen, the university will have to increase its budget for full-time
lecturers on permanent contracts by shs.150,000,000 per annum. It will also need to
employ additional part-time lecturers at a cost of shs.15,000,000 (300 hours at shs.
50,000 per hour) per annum.

The incremental/differential cost between the two alternatives is shs.165,000,000.

Incremental costs can include both fixed and variable costs. In the example above, the
full-time staff represent a fixed cost and the part-time staff represent a variable cost.

The incremental, or differential, revenues are the difference in revenues resulting from
each alternative.

Relevant and Irrelevant Costs and Revenues

For decision-making, costs and revenues can be classified according to whether they are
relevant to a particular decision.

Relevant costs and revenues are those future costs and revenues that will be changed
by a decision, whereas irrelevant costs and revenues are those that will not be affected
by the decision.

For example, if you are faced with a choice of making a journey using your own car or by
public transport, the car tax and insurance costs are irrelevant, since they will remain the
same whether or not you use your car for this journey. However, fuel costs for the car will
differ depending on which alternative is chosen and this cost will be relevant for decision-
making.
Avoidable and Unavoidable Costs

Avoidable costs are those costs that may be saved by not adopting a given alternative,
whereas unavoidable costs cannot be saved. Only avoidable costs are relevant for
decision-making purposes. The decision rule is to accept those alternatives that generate
revenues in excess of the avoidable costs.

Sunk Costs

These costs are the cost of resources already acquired where the total will be unaffected
by the choice between various alternatives. They are costs that have been created by a
decision made in the past and that cannot be changed by any decision that will be made
now or in the future.

COST Behaviour
The terms ‘variable’, ‘fixed’, ‘semi-variable’ and ‘semi-fixed’ have been traditionally used
in the management accounting literature to describe how a cost reacts to changes in
activity.
Variable costs vary in direct proportion to the volume of activity; that is, doubling the level
of activity will double the total variable cost. Consequently, total variable costs are linear
and unit variable cost is constant.
Examples of variable costs in a manufacturing organization include direct materials,
energy to operate the machines and sales commissions. Examples of variable costs in a
merchandising company, such as a supermarket, include the purchase costs of all items
that are sold. In a hospital, variable costs include the cost of drugs and meals which may
be assumed to fluctuate with the number of patient days.
Consider the example of a bicycle manufacturer who purchases component parts.
Assume that the cost of purchasing two wheels for a particular bicycle is shs10,000 per
bicycle.
The figure below illustrates the concept of variable costs in graphic form.
As the number of units of output of bicycles increases or decreases, the total variable
cost of wheels increases and decreases proportionately. Variable cost per unit of output
is constant even though total variable cost increases/decreases proportionately with
changes in activity.
Fixed costs remain constant over wide ranges of activity for a specified time period. They
are not affected by changes in activity.
Examples of fixed costs include depreciation of equipment, property taxes, insurance
costs, supervisory salaries and leasing charges for cars used by the sales force.
The graph below shows how total fixed costs react with changes in the level of activity.