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3: Cost classification
Topic List
Direct฀costs฀and฀indirect฀costs
Fixed฀costs฀and฀variable฀costs
Other฀cost฀classifications
Responsibility฀centres฀and฀cost฀units
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The฀classification฀of฀costs฀is฀an฀essential฀management
accounting฀technique. Its฀main฀uses฀are฀as฀follows:
 Determination฀of฀the฀cost฀of฀a฀unit฀of฀product฀or฀service
 Cost฀behaviour
 Absorption฀and฀marginal฀costing
Once฀costs฀have฀been฀classified,฀a฀coding฀system฀can฀be
applied฀to฀make฀it฀easier฀to฀manage฀cost฀data.
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Direct costs and Fixed฀costs฀and Other฀cost Responsibility฀centres

indirect costs variable฀costs classifications and฀cost฀units

Direct cost Indirect cost (overhead)

... is฀a฀cost฀that฀can฀be฀traced in full to฀the ... is฀a฀cost฀that฀is฀incurred฀whilst฀making฀a
product,฀service฀or฀department฀that฀is฀being product฀but฀which฀cannot be traced

+
costed. directly to฀the฀product,฀service฀or
department.

Direct costs include Indirect costs include

 Direct฀materials  Indirect฀materials
 Direct฀labour  Indirect฀labour
 Indirect฀expenses
 Direct฀expenses
 Administration฀overhead
 Total฀direct฀costs฀=฀prime฀cost
Total product cost  Selling฀and฀distribution฀overhead

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Direct฀costs฀and Fixed costs and Other฀cost Responsibility฀centres

indirect฀costs variable costs classifications and฀cost฀units

Fixed cost Variable cost

... is฀a฀cost฀which฀is฀unaffected฀by฀changes ... is฀a฀cost฀which฀tends฀to฀vary฀with฀the
in฀the฀level฀of฀activity. level฀of฀activity.

Fixed costs include Costs฀may฀also฀be Variable costs include

semi-fixed฀or฀semi-
variable฀or฀mixed
 Rent฀of฀a฀building costs. For฀example,฀an  Direct฀materials
 Business฀rates electricity฀bill฀has฀a  Direct฀labour
fixed฀standing฀charge
 Salary฀of฀a฀director and฀a฀variable฀cost  Sales฀commission฀(varies฀with
per฀unit฀of฀electricity volume฀of฀sales)
used.

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Direct฀costs฀and Fixed฀costs฀and Other cost Responsibility฀centres

indirect฀costs variable฀costs classifications and฀cost฀units

Functional costs Product/Production costs Period costs

... are฀classified฀as: production or ... are฀costs฀identified฀with฀a฀finished ... are฀costs฀that฀are฀deducted
manufacturing costs; product฀and฀are฀part฀of฀the฀inventory as฀expenses฀during฀a฀period
administration฀costs; marketing or value฀until฀they฀are฀sold฀when฀they without฀ever฀being฀part฀of฀the
selling and฀distribution costs. become฀expenses฀(cost฀of฀goods฀sold). inventory฀value.

Discretionary costs Avoidable costs Unavoidable costs

... are฀costs฀which฀are฀likely฀to ... are฀costs฀specific฀to฀an฀activity฀or ... are฀costs฀which฀would฀be
arise฀from฀decisions฀made business฀which฀would฀be฀avoided฀if incurred฀whether฀or฀not฀the
during฀the฀budgeting฀process. the฀activity฀or฀business฀did฀not฀exist. activity฀or฀business฀existed.

Controllable cost Uncontrollable cost

... is฀a฀cost฀which฀can฀be฀influenced฀by ... is฀any฀cost฀that฀cannot฀be฀affected฀by
management฀decisions฀and฀actions. management฀within฀a฀given฀time฀span.

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Production costs (product costs)

... are฀costs฀identified฀with฀goods฀produced฀for฀resale Used฀to฀value฀inventory฀and฀output

Non production costs

... are฀costs฀deducted฀as฀expenses฀during฀the฀period
such฀as฀administration,฀selling,฀distribution฀and฀finance Not฀included฀in฀inventory฀valuation฀and฀output

Examples
Administration฀–฀eg฀management,฀secretarial฀and฀accounting฀costs
Selling฀and฀distribution฀–฀eg฀advertising,฀delivery฀costs,฀sales฀staff฀salaries
Finance฀–฀eg฀cost฀of฀raising฀money฀to฀finance฀business฀such฀as฀a฀loan฀or฀overdraft

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Direct฀costs฀and Fixed฀costs฀and Other฀cost Responsibility

indirect฀costs variable฀costs classifications centres and cost units

A฀responsibility฀centre฀is฀a฀department฀or฀organisational฀function฀whose฀performance฀is฀the฀direct฀responsibility
of฀a฀specific฀manager.

Cost centre Revenue centre

... is฀a฀collecting฀place฀for฀costs฀before฀they ... is฀a฀collecting฀place฀for฀revenues฀before
are฀analysed฀further. they฀are฀analysed฀further.

Cost centre managers are Revenue centre managers are

responsible for costs only responsible for revenues only

Profit centre Investment centre

 Similar฀to฀a฀cost฀centre  Profit฀centre฀with฀additional฀responsibilities
 Responsible฀for฀costs and revenues  Responsible฀for฀costs฀and revenues
 Responsible฀for฀capital฀investment฀and
financing

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Cost unit Cost object

... is฀a฀unit฀of฀product฀or฀service฀to ... is฀any฀activity฀for฀which฀a฀separate
which฀costs฀can฀be฀related. measurement฀of฀cost฀is฀desired

Example Example
 Patient฀episode฀(in฀a฀hospital)  The฀cost฀of฀a฀product
 Barrel฀(in฀the฀brewing฀industry)  The฀cost฀of฀a฀service
 Room฀(in฀a฀hotel)  The฀cost฀of฀operating฀a฀department

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