F2-ManagementAccount

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 Cost   classification 
De欍nitions used: 
 
Classi欍cation  of  costs means putting costs into groups of similar items. The ways in which 
costs   can   be   classified   include: 
 
Cost classi欍cation:  
 
1) By  element  -  this  means  grouping  costs  according  to  whether  they  are  materials, 
labour or expenses; 
2) By  nature  -  this means classifying costs one step further according to whether they are 
direct or indirect costs; 
3) By  function  -  this  involves  classifying  costs  according  to  the kind of work that is being 
carried out. Work is normally classi欍ed as production or non-production; 
4) By  behaviour  -  individual  costs  behave  in  di垽槦erent  ways  and  so  can  be  classi欍ed  as 
variable, semi-variable, 欍xed or stepped 欍xed costs; 
 
Classi欍cation by function:  
 
The main production costs are: 
 
1) Materials; 
2) Labour; 
3) Overheads. 
 
The main non-production costs are: 
 
1) Selling costs; 
2) Distribution costs; 
3) Administrative costs; 
4) Financing costs. 
 
Note:  It  is  important  that  the  costs  associated  with  making  a  product (the materials, labour 
and  expenses),  are  included  in  the  cost  of  the  unit  of inventory. This allows an organisation 
to work out how much pro欍t it makes when it sells the product. 
 
Gross pro欍t = Revenue - Cost of sales 
 
Classi欍cation by nature: 
 
Direct costs are those costs which can be directly attributed to a unit of a product. 
 
Indirect costs are those costs which cannot be directly attributed to a unit of a product. 
 
Direct material + Direct labour + Direct expense = Prime costs 
 
Indirect material + Indirect labour + Indirect expense = Overheads 
 

 
Other classi欍cations: 
 
Note:  Sometimes  costs  are  grouped  together  for other reasons. For example, costs may be 
collected in cost objects, cost units and cost centres. 
 
Cost  objects  are  objects  for  which  costs  can  be  collected,  for  example,  a  product  that  is 
produced, a service that is provided or a department in an organisation. 
 
Cost  units  are  units  of  a  product  or  service  for  which  costs  can  be  identi欍ed  (not 
necessarily single product or service). 
 
Cost  centres  are  centres  where  the  costs  of  a  department  or  organisational  unit  are 
collected.  
 
Capital and revenue expenditure: 
 
It  is  important  to  be  able  to  distinguish  between  capital  and  revenue  expenditure  because 
they are treated di垽槦erently in the 欍nancial accounts. 
 
The  cost  of  purchasing  or  making  improvements  to  non-current assets is known as capital 
expenditure. 
 
All  other  costs  incurred  in  running  an  organisation  are  known  as  revenue  expenditure. 
Revenue  expenditure  includes  costs  such  as  wages and salaries, production costs, 欍nance 
costs and administration costs. 
 
Responsibility centres: 
 
Sometimes  costs  and  revenues  are  grouped  into  one  centre  where  one  individual manager 
or  group  of  managers  is  responsible  for  that  centre.  Such  ‘centres’  are  known  as 
responsibility centres and are usually a department within an organisation. 
 
Responsibility centres include: 
 
1) Cost  centres  -  where  the  costs  of  a  department  are  collected  (materials,  labour, 
expenses, overheads);  
2) Revenue  centres  -  where  revenues  from  the goods and services sold by a department 
will be collected; 
3) Pro欍t centres - are a combination of cost and revenue centres. 
4) Investment  centres - are similar to pro欍t centres, but in addition to costs and revenues 
they also include capital expenditure.