UNIT 1: CLASSIFICATION OF COST

Content
1.0 Aims and Objectives
1.1 Introduction
1.1.1 Cost Accumulation and Allocation
1.1.2 Relationship of Cost Accumulation to Cost Object.
1.2 Direct and Indirect Costs
1.2.1 Accuracy in Determining Costs.
1.3 Cost Drivers
1.4 Variable Cost and Fixed Cost
1.4.1 Major Assumption
1.4.2 Relevant Range
1.5 Manufacturing Costs
1.5.1 Components of Costs
1.6 The Three Manufacturing Cost Categories
1.6.1 Prime Cost and Conversion Cost
1.7 Costs as Assets and Expenses
1.8 Summary
1.9 Answer to Check Your Progress

1.0 AIMS AND OBJECTIVE

After completing this unit you should be able to:

 define and explain: - cost objects, direct costs, and indirect costs.
 explain the relationships of costs drivers, variable costs, and fixed costs.
 define and identify each of the three categories of a manufacturing product’s cost.
 differentiate between inventory able cost and period costs.

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 1.1 INTRODUCTION

Accountant usually defines cost as a resource sacrificed or forgone to achieve a specific

objective. For now, consider cost as being measured in the conventional accounting way,
as monetary unit (for example birr) that must be paid for goods and services.

To guide decisions, managers want data pertaining to a verity of purpose. They want the
cost of something. We call this something a cost object and define it as any activity or
item for which a separate measurement of costs is desired. A synonym is cost objective.
The cost object is a key feature of management accounting. It may be an activity or
operation in which resources are consumed or received (repairing automobiles,
responding in inquires for information, reconciling bank statement). The cost object may
be a product or service e.g. (Renting room, flying passenger from Addis Ababa to
Gondr). The cost object may be project e.g. constructing a house.

The cost objects maybe a department e.g. (producing department, procurement

department. The cost object may be a program e.g. (HIV/AIDS control program, athletic
program). To summarize the following are example of cost object.

Cost-Object

Activity or Product or Project Departments Program

operation services

By itself, the term cost is meaningless. Cost measurement must be tied to at least one cost
object. The same cost may pertain to many cost objects simultaneously. For instance, the
cost of materials may become part of the cost of a product and part of the cost of running
the department.

1.1.1 Cost Accumulation and Allocation

A cost system typically accounts for costs in two broad stages: (1) it accumulates costs by
some “natural” classification such as raw materials used, fuel consumed, or advertising
placed, and then (2) it allocate (trace) these costs to cost object. Cost accumulation is the
collection of cost data in same organized way through an accounting system. Cost

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allocation is a general term that refers to identifying accumulated cost with or tracing
accumulated cost-to-cost object such as department, activities, or products.

Cost object are chosen not for their own sake but to help decision-making. The most
economically feasible approach to the design of a cost system is typically to assume some
common classes of decision e.g. (inventory control, labor control) and to choose cost
object (for example, product and departments) that relate to those decisions. Nearly all
systems at least accumulate actual cost, which are amounts determined on the basis of
costs incurred as distinguished from predicated or forecasted costs.

1.1.2 Relationship of Cost Accumulation to cost object

Cost Accumulation Cost object

Product 1
Actual Raw Production
material Cost Department Product 2
Product 3
Purpose – to Purpose – To
Compute costs Computer costs of various
for evaluating products for decisions
departmental such as product pricing
efficiency and and product emphasis
managerial
performance

You should avoid widely held belief that cost accounting’s sole purpose is to measure
income and inventories. The best system collects data in a form suitable for a variety of
purposes. These systems provide a reliable basis for predicting the economic
consequence of various decisions such as the following.
 Which product should continue to make
 Should manufacture a product component or should acquire it from another
company.
 What price should we charge?
 Should buy the proposed equipment?
 Should change the manufacturing method. ?
 Should we expand a particular department?

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1.2 DIRECT COSTS AND INDIRECT COSTS

Classification depends on cost objects: -

A major question concerning costs in both manufacturing and non-manufacturing
functions is whether the cost has a direct or an indirect relationship to particular cost
object.
 Direct costs – Costs that can be identified specifically with or traced to a given
cost object in an economically feasible way.
 Indirect cost – Costs that cannot be identified specifically with or traced to a
given cost object in an economically feasible way.

“Economically feasible” means “Cost effective”. Managers do not want cost accounting
to be too expensive in relation to expected benefits. The cost of tracing relatively in
expensive items may exceed the benefit of having the resulting information. For example,
it may be economically feasible to trace specifically the exact cost of steel and fabric
(direct cost) to a specific lot of desk chairs, but it may be economically not feasible to
trace specific the exact cost of rivets or thread (indirect costs) to the chars.

Managers prefer to classify costs as direct rather than indirect. Why? Because they have
greater confidence in the accuracy of the reported cost of products and services. When is
a cost considered direct or indirect? The answer depends on the particular cost object.
Consider a supervisor’s salary in a maintenance department of a telephone company. If
the cost object is the department, the supervisor salary is a direct cost.

In contrast, if the cost object is a service (the product of the company), such as a
telephone call, the supervisor salary is an indirect cost.

1.2.1 Accuracy in determining costs

Before proceeding, ponder how the direct and indirect costs generally relate to various
cost objects. The cost object may be a broadly defined activity (total operation of an
airplane repair facility) or a narrowly defined activity (the painting operation of an

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airplane repair facility). It may be a broadly defined project (designing a new automobile)
or narrowly defined project (designing a knob for radio in a new automobile).
A useful rule of thumb is that the broader the definition of the cost object, the higher the
proportion of its total cost are its direct cost and more confidence management has in the
accuracy of the resulting cost amounts. The narrower the definition of the cost object, the
lower the proportion of its total cost are it’s direct costs the less confidence management
has in the accuracy of resulting cost amount.

1.3 COST DRIVERS

A cost driver is any factor whose change causes a change in the total cost of a related cost
object. Drivers are casual factors whose effects are increases in total costs. There are
many possible cost drivers. Ex. In factory setting, the total cost of material used may be
driven not only by the production volume but also by the quality of the material, the skills
of the worker, and the number of parts in a finished product, and the condition of the
applicable machines.

Cost drive is an intuitively appealing term. It encompasses any underling factor that
causes, or drives, costs. It facilitates the subsequent explanation that factors in addition to
production volume.

Example of cost drivers

Total Costs of Activity Cost Drive

Product design Number of products, number of parts
Distribution Type of transportation, miles driven
Weight number of stops, speed
Manufacturing Production volume, in unit of
Products, number of setups, number
Of parts

1.4 VARIABLE COSTS AND FIXED COSTS

Let us now consider two basic types of costs variable costs and fixed costs. We may
define each in terms of whether its total cost changes in response to change in a related

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cost driver. A variable cost is a cost that does change in total in direct proportion to
changes of a cost driver. A fixed cost is a cost that does not change in total despite
changes of a cost driver. Conceder the following:

Examples:
1. If A.M.C.H plc buys one type of special clamp at 1 birr for each of its cars, then the
total cost of clamps should be 1 times the number of cars produced. This is an
example of a variable cost a cost that is unchanged per unit of cost driver but
change in total in direct proportion to changes in the cost driver.
2. A.M.C.H plc may incur 100, thousands in a given year for a factory taxes, executive
salaries, rent, and insurances. These are examples of fixed costs, costs that are
unchanged in total over a wide range of the cost deriver during a given time span
but became progressively smaller on a per unit basis as the cost driver increases.

1.4.1 Major Assumptions

The definitions of variable costs and fixed costs have important underlying assumptions.
1. The cost object must be specified. Examples are activities, products, services,
projects, departments etc.
2. The time span must be specified. Examples are months, quarters, years and
product life cycles.
3. Costs are linear: That is, when plotted on ordinary graph paper, a total cost in
relation to the cost drive will appear as an unbroken straight line.
4. For the time being, all costs are either variable or fixed. In practices, of course,
classification is difficult and nearly always necessitates some simplifying
assumptions.
5. There is only one cost drive. The influences of other possible cost drivers on the
total cost are held constant or deemed to be insignificant. Volume, often
expressed in measures of units produced or sold.
6. The relevant range of fluctuations in the cost driver must be specified.

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1.4.2 Relevant Range

A relevant range is the band of the cost driver in which a specific relationship between
cost (revenue) and cost (revenue) driver is valid. A fixed cost is fixed only in relation to a
given relevant volume range (usually large) and a given time (usually a particular budget
period). For example the following diagram shows that a fixed cost level of $600,00
applies to a relevant range of 30,000 to 95,000 machine hours – the cost drive per year.
The diagram also shows that operations on either side of the relevant range would result
in different fixed costs. With out put the range from zero hours to 30,000 machines –
hours, service and executive personal would likely to be laid off. An increase in volume
above 95,000-machine hours would increase fixed costs. The business might hire
additional personnel to help the increased operation. Fixed costs may differ from one year
to the next wholly because of changes in items other than the volume cost driver, such as
rent terms, salary level, and property tax rates.

Total analysis fixed costs – Conceptual analysis

300,000

600,000

300,000

0
Relevant range

Volume in Thousand of machine hours.

20 40 60 80 90 100

1.5 MANUFACTURING COSTS

The objective of the topic is to define and identify each of the three categories of a
manufacturing product costs.

1.5.1 Components of Costs

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Some types of cost accounting applies to any entity, including manufacturing companies,
airlines, retail stores etc. regardless of whether they operate for a profit goal.

Historically, accounting techniques for planning and control arise in conjunction with
manufacturing rather than non-manufacturing. Because measurement problems were less
imposing and environmental factor such as economic conditions, customer reaction, and
competitor activity were generally less influential in manufacturing. However the basic
concepts of planning and control apply equally well to both manufacturing and non-
manufacturing activates.

Manufacturing is the transformation of materials into other goods through the use of
labor and factory facilities. Merchandising is the marketing of goods without changing
their basic form. For example, assume Bershaco cosmetic manufacturing company wants
to make shampoo and sell it directly to retailers. The company may purchase a factory
and equipment, buy certain oils and containers, hire some workers, and manufacture
thousands of units of finished product. This is the company manufacturing function. But
to persuade retails to buy the product, the company will have to convince the ultimate
consumer that this product is desirable. This means advertising, including the
development of a sales appeal, the selection of a brand name, the choice of media and so
forth. To maximize the success, the company must effectively manage both
manufacturing and merchandising function.

Instead of handling the merchandising, the Bershaco cosmetic manufacturing company

may sell its product through retailers that will resell the product to the final consumer.
The difference between manufacturer and merchandiser shows up in the income
statement. The manufacture income statement includes the cost arising as the result of
production (cost of goods manufactured) but the merchandising business income
statement do not show the cost of production since it does not produce the product itself

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1.6 THREE MANUFACTURING COST CATEGORIES

Many companies recognize three major categories of the cost of manufactured product:
1. Direct materials cost: - The acquisition costs of all materials that are identified as
part of the cost object and that may be traced to the cost object in an economically
feasible way. Acquisition costs of direct materials include in ward delivery charges,
sales tax, and custom duties. Direct material often does not include minor items
such as glue or tacks. Why because the cost of tracing insignificant items do not
seem worth the possible benefits of having more accurate product costs. Such items
are called supplies or indirect materials and are classified as part of the indirect
manufacturing costs.
2. Direct labor: - The compensation of all labor that can be identified in an
economically feasible way with a cost object. Examples in manufacturing are the
labor of machine operators and assembler. Indirect labor costs are all factory labor
compensation other than direct labor compensation. These are labor costs that are
impassible or impractical to trace to a specific product. They are classified as part of
the indirect manufacturing cost ex. Wages of janitors and plant guards.
3. Indirect manufacturing costs (manufacturing overhead): - all manufacturing costs
that cannot be identified specifically with or traced to the cost object in an
economically feasible way. Other terms used are factory overhead, factory burden,
manufacturing overhead and manufacturing expenses. The term indirect
manufacturing costs is a clear descriptor than factory overhead, but the latter will be
used through this text because it is briefer. Examples of factory overhead when
products are cost object include power, supplies, indirect labor, factory rant,
insurance, property taxes, and depreciation.

As indicated above, managers and accountants design their cost accounting system in
light of perceived costs and benefits. How detailed is the tracking of costs? Where the
costs of any single category or item become relatively insignificant, separate tracking
may not longer be desirable. Example, in highly automated factories direct labor is often
less than 6% of total manufacturing costs. Many of these factories no longer track direct
labor costs separately as one of the major cost categories.

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1.6.1 Prime Costs, and Conversion Costs

Two of the three major categories of the cost of a manufactured product are sometimes
combined in cost terminology as follow: - Prime costs are all direct manufacturing costs.
Conversion costs are all manufacturing costs other than direct materials costs.

Some companies have stopped considering direct labor as a separate cost categories.
Direct labor costs have become less and less important in relation to total manufacturing
costs. An important point emerges. The direct indirect distinction between costs depends
heavily on the underlying manufacturing processes. Many cost accounting systems have
retained the classic three fold cost categories, but other systems uses two-fold categories.

Three fold Categories Two fold Categories

Direct material direct materials

Direct labor Conversion Costs
Factory overhead

As the two-fold category indicates, conversion costs envelop all manufacturing costs
other than direct materials. Many companies use the label conversion costs for these
indirect costs, but other companies use factory overhead. In these companies, direct labor
has disappeared as a major cost category; instead, it has merely become another element
of factory overhead.

To recapitulate, the classic major distinctions among manufacturing products costs are
direct materials, direct labor, and factory overhead. However, be ware that various
companies may have other major categories. Some may have only two: direct material
and conversion costs. As information technology improve and some indirect costs
become more significant, some companies may add categories by no longer classifying
selected costs as indirect. For example, power costs might be metered in various specific
area of a factory. Then a company might have the following: direct materials, direct
labor, other direct costs (such as the specifically metered power), and factory overhead.
In short, the time honored three fold categories still dominate, but not as much as before

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1.7 COST AS ASSETS AND EXPENSES

The rules of financial accounting have major influence on accounting for manufacturing
costs. For example, under generally accepted accounting principles, the manufacturing
costs of a product are initially regarded as measure of assets. They are inventor able
costs, which are all cost of a product that are regarded as an asset for financial reporting
under generally accepted accounting principles. Such cost become expenses (in the form
of cost of good sold) only when the units in inventory are sold.

Other costs, often called period cost, are regarded as immediate expenses. These costs are
always expensed in the same period in which they are incurred; they are not considered
inventeriable costs. Example: research, marketing, and administrative costs.

Check Your Progress

1. Give three examples of cost object.

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2. Explain “economically feasible” or “Cost effective” as applied to cost accounting.
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3. What costs are considered direct? Indirect?
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4. Give three examples of cost drive.

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5. Distinguish between manufacturing and merchandising.
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6. Fixed Cost declines as production increases. Do you agree?
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7. Cost of good sold is an expense. Do you agree?
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1.8 SUMMARY

Accounting systems should serve multiple decision purposes, and there are different
measures of cost for different purposes. The most economically feasible approach to
designing a management accounting system is to assume some common wants favorite of
decisions and choose cost objects for routine data accumulation in light of these wants.

The chapter has concentrated on definitions and explanations of many widely used cost
accounting terms. The most basic distinction is between direct and indirect costs. The
same cost may be direct regarding one cost object and indirect regarding other cost
objects.

This unit has merely linked the vast number of classification of costs that have proved
useful for various purposes. Calcification can be made on the basis of

1. Ease of irascibility

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 a. Direct
b. Indirect
2. Behavior in relation to change of cost drive
A variable
b. Fixed
3. Management function
a. Manufacturing costs
b. Marketing
c. Administrative
4. Asset or expenses
a. Inventorial
b. Period cost

1.9 ANSWER TO CHECK YOUR PROGRESS

1. Product, project, department

2. The result we get should be grater than the cost we have incurred
3. Direct cost: are costs that become significant part of finished product
Indirect costs are costs that are difficult to allocate to the product and considered
insignificant part of the finished product.
4. Production volume.
Quality of material
Skill of manpower.
5. Manufacturing enterprise go under the process of transforming raw materials to
finished goods
Merchandising enterprises- do not produce the product by themselves rather they
purchase the product from manufacturing enterprise and distribute the product to final
consumers

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