Chapter 19 Cost classification, Concepts and Terminology

Notes to Teachers
1 Teachers should follow the sequence of chapters in the textbook. You will find
that each chapter is built upon an understanding of the previous chapter.

2 Start with the Learn More section on p. 4, reviewing the features of financial
accounting and introducing the features of management accounting.

3 The examples in Fig. 19.3, Fig. 19.4 and Fig. 19.5 give students a more concrete
picture of the functions of cost accounting.

4 There are many fundamental cost concepts in this chapter, such as cost objects,
cost units, direct costs, indirect costs, fixed costs, variable costs, product costs
and period costs. They may sound rather abstract to beginners, so teachers should
use as many real-life examples as possible in their explanations.

5 When classifying costs into direct and indirect costs, it is essential to define the
cost object clearly. This is usually a particular product, even though it can be
other things such as a process or a department.

6 Likewise, when classifying costs into fixed and variable costs, it is essential to
define the activity clearly, which is usually the production volume or sales
volume.

7 There is another way of classifying costs into fixed costs, variable costs and
mixed costs.
(i) When the cost total remains the same with changes in the activity level, that
cost tends to be a fixed cost.
(ii) When the cost total changes but the cost per unit remains the same with
changes in the activity level, that cost tends to be a variable cost.
(iii) When both the cost total and cost per unit change with the activity level, that
cost tends to be a mixed cost.

8 Use the diagrams on p.28 to compare the characteristics of fixed costs, variable
costs, step costs and mixed costs, even though graphical representation may not
be required in the HKDSE Examination.

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9 Make sure that students have mastered all the fundamental cost concepts. Such
concepts are necessary for an understanding of the subsequent chapters.

Check Your Progress

Q19-1 Recording transactions, classifying and summarising data, and
communicating information to users
(The managerial functions of accounting, such as planning and controlling,
may also be mentioned.)

Q19-2 Cost accounting refers to the process of recording, tracking and analysing
the costs associated with a cost object.

Q19-3 A cost object is anything which requires a separate measurement of costs. It

can be a product, a process, a department or even the entire business. The
unit of measurement of the cost object is known as a cost unit, which is
usually a physical unit, such as the quantity or weight of a product.

Q19-4 A production process, a department or even the entire business

Q19-5 (a) False. Cost accounting is a branch of management accounting.

(b) True.
(c) False. There is no standard reporting format. Cost information can be
presented in any format according to the needs of users.
(d) True.

Q19-6 The business needs to estimate the additional costs involved in developing
the new product. The plan should be implemented only if estimated costs
are more than covered by expected benefits.

Q19-7 The business needs to monitor the actual costs incurred and take remedial
measures if actual expenditures exceed budgeted amounts.

Q19-8 Cost accounting provides costing information for both management and
accountants in planning and controlling, financial reporting, and business
decision making.

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Q19-9 Carriage inwards on direct materials, royalties
(Any one of the above or other reasonable answer)

Q19-10 It is an indirect cost. This is because the factory’s fire insurance premium is
related to the manufacturing of a product but it is difficult to trace it to a
particular cost object.

Q19-11 It is a fixed cost. This is because it normally remains unchanged within a

certain range of production volume.

Q19-12 Fixed cost: Factory rent, factory supervisors’ salaries

Variable cost: Cost of raw materials, wages of manufacturing workers (on
an hourly basis or a piece basis)
(Any one of the above or other reasonable answer)

Q19-13 Charge per additional minute:

($1,120 ˗ $600) ÷ (1,620 ˗ 1,100) = $1

Fixed monthly fee:

$1,120 ˗ [(1,620 ˗ 800) × $1] = $300

Q19-14 Manufacturing overheads (also called factory overheads or production

overheads) are the costs that are associated with the manufacturing of a
particular product but which cannot be easily traced to it.

Non-manufacturing overheads are the costs that are not associated with
manufacturing but which are necessary for the operation of a manufacturing
business.

Q19-15 Product costs are the costs that are involved in the making of a product.
They are written off to the profit and loss account only when the goods are
sold. If the goods remain unsold at the end of an accounting period, their
product costs will be carried forward as inventories.
Examples: Direct materials, direct labour, manufacturing overheads
(Any one or other reasonable answer)

Period costs are the costs that are not associated with the making of a
product. They must be written off to the profit and loss account in the

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 period in which they are incurred.
Examples: Salespersons’ commissions, office rent
(Any one or other reasonable answer)

Try This Activity

A19-1 Internal users: (a), (c), (e)
External users: (b), (d), (f)

A19-2 (a) Cost object: Oil refined

Cost unit: Barrels of oil refined

(b) Cost object: A particular type of banking service provided, e.g., credit
card service
Cost unit: Each customer served

A19-3 Cost accounting can provide management with data on the relevant costs of
retaining and replacing an existing machine. It can then compare the costs
and choose the less costly alternative.

A19-4 Indirect materials usually involve the manufacturing of several products at

the same time. It would be technically infeasible or uneconomical to trace
their costs to a particular product. Examples are lubricants and coolants for
machines.
(Any other reasonable answers)

A19-5 Indirect labour usually involves the manufacturing of several products at

the same time. It would be technically infeasible or uneconomical to trace
its costs to a particular product. Examples are the wages of factory security
guards and machine maintenance workers.
(Any other reasonable answers)

A19-6 Direct costs: Cost of leather, wages of shoe workers

Indirect costs: Electricity consumed by machines, salaries of factory
supervisors
(Any other reasonable answers)

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A19-7 Direct costs: Salaries of shoe department’s salespersons, cost of shoe
display shelves
Indirect costs: Salaries of department store managers, the department
store’s utility bills
(Any other reasonable answers)

A19-8 The rent of the shop premises would remain unchanged regardless of the
level of sales revenueNote while the salesmen’s commissions would rise with
increases in sales revenue.
Note: The rent would change if the retail shop is charged a base rent plus a
percentage of sales revenue. This method is used by many shopping
malls in Hong Kong.

A19-9 Activity: Number of students enrolled

Fixed costs: Salaries of the principal and teaching staff, fire insurance
premiums for the school premises
Variable costs: Cost of paper consumed, printing cost
(Any other reasonable answer)

A19-10 No. An indirect cost can be a variable cost, such as factory electricity,
which varies with the output produced. By the same logic, a direct cost can
be a fixed cost, such as the salaries of manufacturing workers paid on a
monthly basis.

A19-11 (a) Salaries of manufacturing workers paid on a monthly basis

(b) Cost of raw materials consumed
(c) Factory rent
(d) Cost of indirect materials such as machine lubricants
(Any other reasonable answer)

A19-12 An operating lease for a machine with a charge of $10 per unit of output
when fewer than 10,000 units are produced or a lump sum charge of
$100,000 when 10,000 or more units are produced.
(Any other reasonable answer)

A19-13 Agree. Non-manufacturing overheads are not associated with

manufacturing and therefore these costs could not be traced to a particular
product.

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A19-14 Product costs are written off to the profit and loss accounts when the goods
are sold (i.e., when sales revenue is recognised). If the goods remain unsold
at the end of an accounting period, their product costs will be carried
forward as inventories.

Period costs are not associated with the manufacturing of a product. It is

difficult to ascertain whether and when revenue will be generated from the
amounts spent on these costs. Therefore, they are written off to the profit
and loss account in the period in which they are incurred.

A19-15 (a) Postage

(b) Sales tax
(c) Laboratory rent
(d) Penalty on overdue loans
(Any other reasonable answer)

Case Study
1 The fare increase was partly due to the expected increased operating expenses,
which were measured by the company’s cost accountants.

2 Yes, such as government regulations on fare adjustments, public response to

fare increases, fares charged by other competitors (or any other acceptable
answers).

Assessment
Short Questions
19.1
(a) Cost accounting: costs associated with a cost object, which may be a product, a
process or a department 1

Financial accounting: past financial performance and position of an entity 1

(b) Cost accounting: internal users 1

Financial accounting: external users 1

(c) Cost accounting: flexible, depending on the users’ needs 1

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 Financial accounting: rigid, based on generally accepted accounting principles 1

(d) Cost accounting: flexible, depending on the users’ needs 1

Financial accounting: regular, at least once a year 1

19.2
A cost object is anything which requires a separate measurement of costs. It can be a
product, a process, a department or even the whole business. 2

Examples: milk produced by a dairy farmer, audit department of a CPA firm.

(Any other reasonable answers, 1 mark each)

19.3
(a) Cost per customer 1

(b) Cost per tonne of coal mined 1

(c) Cost per patient 1

(d) Cost per passenger 1

(e) Cost per employee of the company 1

19.4X
(a) Cost per toy produced 1

(b) Cost per student 1

(c) Cost per chargeable hour 1

(d) Cost per housing unit completed or cost per site developed 1

(e) Cost per bottle of beer 1

19.5X
Direct costs are the costs that are related to a particular cost object and can be easily
traced to it. 1

Indirect costs are the costs that are related to a particular cost object but cannot be
easily traced to it. 1

The classification of a cost as direct or indirect depends on the choice of the cost

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object. A particular cost can be both a direct cost and an indirect cost. 2

For example, the salary of a supervisor in the assembly department would be

considered a direct cost of the assembly department but an indirect cost of one of
many products made by the assembly department. 1

19.6
Direct cost: Cost of paper 1

Indirect cost: Salary of the chief editor in charge of a number of magazines 1

(Any other reasonable answer)

19.7X
Direct cost: salaries paid to the employees of this department 1

Indirect cost: water and electricity consumed by this department 1

(Any other reasonable answers)

19.8
(a) Variable cost 1

(b) Variable cost 1

(c) Fixed cost 1

(d) Mixed cost 1

19.9X
If the cost object changes to a product line or even the plant as a whole, plant
supervisors’ salaries can become a variable cost. 1

This is because when product lines or plants are added, more plant supervisors will
have to be hired, resulting in higher salary expenses. 2

Application Problems
19.10
(a) Direct manufacturing costs: (i), (ii), (v) 1 each

(b) Manufacturing overheads: (iii), (vii), (viii), (x) 1 each

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(c) Non-manufacturing overheads: (iv), (vi), (ix), (xi), (xii) 1 each

19.11X
(i) Direct and variable cost 1 each

(ii) Direct and fixed cost 1

each

(iii) Indirect and variable cost 1

each

(iv) Indirect and fixed cost 1

each

19.12
(a)

(b)

(c)

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 (d)

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19.13
(a) Fixed cost. This is because the depreciation on factory machinery would not
change with the volume of output. 2

(b) Fixed cost. This is because the depreciation on factory machinery would not
change with the volume of output. 2

(c) Variable cost. This is because the depreciation on factory machinery would
change (increase) with the volume of output. 2

19.14X
(a) Fixed cost: Factory supervisors’ salaries, factory insurance, clerical staff
salaries 1 each

(b) Variable cost: Direct materials, direct labour 1 each

(c) Mixed cost: Factory water and electricity, depreciation on factory and
machinery, salesmen’s salaries 1 each

19.15X
(a) (i) Production overheads: (iv) and (vi) 1 each

(ii) Administrative overheads: (vii), (viii) and (xi) 1 each

(iii) Selling and distribution overheads: (iii) and (x) 1 each

(iv) Research and development overheads: (ii) and (v) 1 each

(v) Finance costs: (xii) 1

(b) Production overheads should be treated as product costs, which are written off
to the profit and loss account only when the goods are sold. If the goods remain
unsold at the end of an accounting period, their product costs will be carried
forward as inventories. 2

In contrast, all non-manufacturing overheads are treated as period costs, which

are written off in the period in which they are incurred. 1

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19.16
(a) Variable cost per unit
= ($2,200,000 ˗ $1,600,000) ÷ (20,000 ˗ 10,000)
= $60 1

Total fixed costs

= $1,600,000 ˗ (10,000 × $60) = $1,000,000 1

Units produced Unit costs

10,000 $160 1

20,000 $110 1

50,000 $80 1

80,000 $72.5 1

100,000 $70 1

(b) Total costs increase but at a decreasing rate with the increase in level of
production. 1

Unit costs decrease with the increase in level of production. 1

19.17
Cost 25,000 units/month
$
Direct materials 1,250,000 2

Direct labour (Workings) 700,000 2

Factory overheads 190,000 1

Total 2,140,000 1

Workings:
Variable direct labour cost = ($800,000 − $400,000) ÷ (30,000 − 10,000)
= $20 per unit

Fixed direct labour cost at 30,000 units = $800,000 − (30,000 × $20)

= $200,000

Direct labour at 25,000 units = $200,000 + (25,000 × $20)

= $700,000

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19.18
(a) Unit product cost = $50 + $40 × 2 + $10 + $19 2

= $140 1

(b) Unit selling price = $140 × 150% = $210 1

19.19X
(a) Prime cost
= $7,600,000 + $800,000 1

= $8,400,000 1

Factory overheads
= $600,000 + ($80,000 × 80%) + ($119,000 × 70%) + $19,000 2

= $766,300 1

Non-manufacturing overheads
= $140,000 + ($80,000 × 20%) + ($119,000 × 30%) + $10,000 + $8,000 2

= $209,700 1

(b)　Prime cost and factory overheads are treated as product costs and written off to
the profit and loss account when the goods are sold. If the goods remain unsold
at the end of the accounting period, their product costs will be carried forward to
the next period as inventories. 2

Non-manufacturing overheads are treated as period costs and written off to the
profit and loss account in the period in which they are incurred. 1

19.20X
(a) (i) Direct costs: (i), (ii) 1 each

Indirect costs: (iii), (iv), (v), (vi) 1 each

(ii) Fixed costs: (iii), (iv), (v), (vi) 1 each

Variable costs (i), (ii) 1 each

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(b) Total product costs of model X
= ($80 + $40) × 200 + $18,000 × 2 ÷ 3 + $12,000 × 2 ÷ 3
+ $1,440 × 1 ÷ 12 × 2 ÷ 3 1

= $44,080 1

Unit product cost of model X

= $44,080 ÷ 200 1

= $220.4 1

Total product costs of model Y

= ($60 + $30) × 100 + $18,000 × 1 ÷ 3 + $12,000 × 1 ÷ 3
+ $1,440 × 1 ÷ 12 × 1 ÷ 3 1

= $19,040 1

Unit product cost of model Y

= $19,040 ÷100 1

= $190.4 1

(c) If the plant has reached its maximum production capacity, additional plant space
will be required to produce a higher level of output in a given period. As a
result, the monthly plant rent and fire insurance will increase. 2

Past Exam Questions

19.21
(a) Indirect product cost
(b) Period cost
(c) Period cost
(d) Period cost
(e) Indirect product cost
(f) Period cost
(g) Indirect product cost
(h) Period cost

19.22X
(a) Within the relevant range, fixed cost is unaffected by fluctuations in the levels

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 of activity.
Variable cost is a cost which varies proportionately with a change in the levels
of activity.

(b) Even though annual depreciation using reducing balance method declines over
time, such decline is unaffected by fluctuations in the levels of activity. Thus,
such depreciation should be classified as a fixed cost.

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