Dar es Salaam CPA REVIEW Center B5-Performance Management CPA (T) DAVID D KIWIA

CHAPTER ONE

COST AND COST CLASSIFICATION

COST

Cost is the value sacrificed for goods or services that are expected to bring current or future economic
benefits to the firm/individual. It is a sacrificed resource to achieve a specific objective

Costing is the process of determining the cost of doing something, e.g. the cost of manufacturing an
article, rendering a service or performing a function.

• Actual cost – a cost that has occurred

• Budgeted cost – a predicted cost
• Cost accumulation – a collection of cost data in an organized manner
• Cost assignment – a general term that includes gathering accumulated costs to a cost object.
• A cost object is any activity for which a separate measurement of costs is desired. Or anything
of interest for which a cost is desired/incurred in other words, if the users of accounting
information want to know the cost of something, this something is called a cost object.
• A cost driver can be defined as any factor whose change causes a change in the total cost of
an activity. Examples of cost drivers include direct labour hours, machine hours, units of output
and number of production run set-ups. Throughout

COST CLASSIFICATION

Cost classification is the arrangement of cost items into their logical groups basing on their nature and
purpose.

• The purpose of cost classification is to device an efficient system to collect and analyze cost
information for to be used for decision making
• There many different ways of cost classification, the level of details used in the
classification/grouping depends on the purpose for which the costs are classified as follows

Costs can be classified in a number of different ways.

• Element – classify costs as to whether they relate to material, labour or expenses. This is useful
for cost control.
• Nature – classify costs as to how they relate to production. Are they directly involved in the
production of the product/service or indirectly involved in production? This is useful for cost
accounting.

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• Function – classify costs based on whether they are production costs or non-production costs.
This is useful for the financial accounts.
• Behaviour – classify costs based on how they change in relation to levels of output or activity.
This is useful for budgeting and decision making.
• Product Cost and Period and

I. Cost Classification by Element

When costs are classified by element, the costs are grouped into three groups, material cost, labor cost
and expenses.

a) Materials Cost – all costs of materials purchased for production or non- production
activities. For example, raw materials, components, cleaning materials, maintenance
materials and stationery.
b) Labour Cost – all staff costs relating to employees on the payroll of the organisation. They
include the cost relating to wages, salaries and their related employment costs in an
organization
c) Expenses Cost – all other costs which are not materials or labour. This includes all bought-
in services, for example, rent, telephone, sub- contractors and costs such as the depreciation
of equipment.

II Cost Classification by Nature

Classification of cost by nature involves grouping cost items based on easy of traceability to the cost
object. By nature, cost items are grouped into direct costs and indirect costs.

a) Direct costs - Is the cost which can be directly identified and traced in the
item/thing/output/activity.
There are three main types of direct cost – direct material, direct labour and direct expenses.
The direct costs associated with a shirt (cost unit) manufactured by a clothing company would
be:
• Direct materials – cloth for making shirts
• Direct labour – the wages of the workers stitching the cloth to make the shirts
• Direct expenses – the royalties paid to a designer.
• The total of direct costs is known as the prime cost.

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b) Indirect cost - Is the cost that cannot be identified or traced directly to an item/activity/output
etc. It is a cost that cannot be directly attributed to a particular cost unit, although it is clear that
the cost has been incurred in the production of output
The indirect costs associated with a shirt (cost unit) manufactured by a clothing company would
be:
• Indirect materials – these include materials that cannot be traced to an individual
item for example cleaning fluids for cleaning the machinery
• Indirect labour – the cost of a supervisor who supervises the shirt makers
• Indirect expenses – the cost of renting the factory where the shirts are manufactured.
The total of indirect costs is known as overheads.
Overheads is widely used instead of indirect costs. In a manufacturing organization overhead
costs are categorized as either manufacturing, administration and marketing (or selling)
overheads.
III. Cost Classification by Function
In terms of functions costs can be grouped in accordance to functional departments within the firm,
a) Production costs
Production costs are costs that relate to the manufacture of a product or provision of a service. These
costs are found in the cost of sales section of the statement of profit or loss.
Production costs, such as direct materials, direct labour, direct expenses and production overheads,
are included in the valuation of inventory.

Examples of production costs

Examples of production costs for a construction company
• Direct materials – bricks, cement
• Direct labour – builders, plasterers, electricians
• Direct expenses – the cost of a subcontracted crane and driver
• Variable production overheads – electricity
• Fixed production overheads – site managers salary.

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b) Non-production costs
Non-production costs are costs that are not directly associated with the production of the businesses
output.
Non-production costs, such as administrative costs, selling costs and finance costs, are charged to the
statement of profit or loss as expenses for the period in which they are incurred.
Non-production costs are not included in the valuation of inventory.

Examples of non-production costs

• Administrative costs – the costs involved in running the general administration departments
of an organisation, for example, the accounts department.
• Selling costs – costs associated with taking orders from customers who wish to buy an
organisation’s products (sales department costs) and also marketing costs.
• Distribution costs – the costs involved in distributing an organisation’s finished products, such
as the cost of running the warehouse or delivery costs.
• Finance costs – the costs that are incurred in order to finance an organisation, for example,
loan interest.
IV. Period and Product Costs

Product costs are those costs that are identified with goods purchased or produced for resale. In a
manufacturing organization, they are costs that are attached to the product and that are included in the
inventory valuation for finished goods, or for partly completed goods (work in progress), until they
are sold; they are then recorded as expenses and matched against sales for calculating profit.

Period costs are those costs that are not included in the inventory valuation and as a result are treated
as expenses in the period in which they are incurred. In a manufacturing organization all manufacturing
costs are regarded as product costs and nonmanufacturing costs are regarded as period costs.

Recorded as an asset in the balance

Manufacturing cost Product sheet and becomes an expense in the
profit and loss account when the
product is sold

Recorded as an expense in the profit

Non-manufacturing cost Period and loss accounting in the current
accounting period. Treatment of
period and product costs.

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V. Cost Classification by Behaviour

Costs may be classified according to the way that they behave in relation to changes in levels of
activity. Cost behaviour classifies costs as one of the following:
• Variable Cost
• Fixed Cost
• Stepped Fixed Cost
• Semi-Variable Cost.
a) Variable Costs

Variable costs are costs that vary in direct proportion with the level of activity. As activity levels
increase then total variable costs will also increase.

• As total costs increase with activity levels,

• The cost per unit of variable costs remains constant.

Variable costs can be shown graphically as follows:

b) Fixed costs

A fixed cost is a cost which is incurred for an accounting period, and which, within certain activity
levels remains constant.

• Total cost remains constant over a given level of activity

• The cost per unit falls as the level of activity increases.

Examples of fixed costs:

• Rent
• Business Rates
• Executive Salaries.

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Fixed costs can be shown graphically as follows:

c) Stepped fixed costs

• This is a type of fixed cost that is only fixed within certain levels of activity.
• Once the upper limit of an activity level is reached then a new higher level of fixed cost
becomes relevant.
Examples of stepped fixed costs:
• warehousing costs (as more space is required, more warehouses must be purchased or rented)
• supervisors’ wages (as the number of employees increases, more supervisors are required).
Stepped fixed costs can be shown graphically as follows:

d) Semi-variable costs
Semi-variable costs contain both fixed and variable cost elements and are therefore partly affected by
changes in the level of activity.
Examples of semi-variable costs:
• Electricity bills (fixed standing charge plus variable cost per unit of electricity consumed)
• Telephone bills (fixed line rental plus variable cost per call).

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Semi-variable costs can be shown graphically as follows:

Note
• Fixed costs are constant in total
• Variable costs are constant per unit
• Semi-variable costs are neither constant in total nor constant per unit.
• Stepped fixed costs will be constant in total within a certain range.
Example One – Identifying cost behaviours
A company has a mix of variable, semi variable, fixed and stepped fixed costs.
Total cost at different activity levels
Cost 1,000 units 3,000 units 5,000 units 7,000 units
1 $19,000 $33,000 $47,000 $61,000
2 $1,920 $5,760 $9,600 $13,440
3 $7,000 $7,000 $7,000 $7,000
4 $12,500 $12,500 $17,000 $17,000
Cost per unit at different activity levels:
Cost 1,000 units 3,000 units 5,000 units 7,000 units
1 $19.00 $11.00 $9.40 $8.71
2 $1.92 $1.92 $1.92 $1.92
3 $7.00 $2.33 $1.40 $1.00
4 $12.50 $4.17 $3.40 $2.43
Identify the behaviour for each of the costs
• Cost 1 is a semi-variable cost as the total cost changes when activity level change and the cost
per unit also changes at the different activity levels
• Cost 2 is a variable cost as the cost per unit is constant at each activity level
• Cost 3 is a fixed cost as the total cost does not change as activity level changes
• Cost 4 is a stepped fixed cost as the total cost is constant then increases to a new constant
level and the cost per unit is changing at each activity level

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The high/low method used for separating a semi-variable cost

The total cost of a semi-variable cost is:
Total costs = Total fixed costs + (Variable cost per unit × Activity level)
To be able to predict costs at different activity levels it is necessary to separate the fixed cost element
from the variable cost element. The high-low method can be used to approximate the variable cost
per unit and the total fixed cost.
The high/low method
Step 1
Select the highest and lowest activity levels, and their associated costs.
Step 2
Calculate the variable cost (VC) per unit:

Cost at high level of activity – cost at low level of activity

VC per unit =
High level of activity – low level of activity

Step 3

Calculate the fixed cost by substitution, using either the high or low activity level.

Fixed cost = Total cost at activity level – (Variable cost × Activity level)

Step 4

Use the total fixed cost and the variable cost per unit values from steps 2 and 3 to calculate the
estimated cost at different activity levels.

Total costs = Total fixed costs + (Variable cost per unit × Activity level)

Example 2 – The high/low method

Output (units) Total cost (TZS)

200 7,000
300 8,000
400 9,000
Required:

a) Calculate the variable cost per unit.

b) Calculate the total fixed cost.
c) Estimate the total cost if output is 350 units.
d) Estimate the total cost if output is 600 units.

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Solution

(a) Variable cost per unit = ($9,000 – $7,000)/(400 – 200) = $2,000/200 = $10 per unit
b) Total fixed cost by substituting at high activity level:
Total cost = $9,000
Total variable cost = 400 × $10 $4,000
Therefore fixed cost = $5,000
(c) If output is 350units
Variable cost = 350 × $10 = $3,500
Fixed cost = $5,000
Total cost = $8,500
(d) If output is 600 units:
Variable cost = 600 × $10 = $6,000
Fixed cost = $5,000
Total cost = $11,000

High/low method with stepped fixed costs

Sometimes fixed costs are only fixed within certain levels of activity (stepped fixed costs). The
high/low method can still be used to estimate fixed and variable costs.

• Choose the two activity levels where the fixed costs remain unchanged and calculate the
variable cost per unit and the total fixed cost using the high/low technique.
• Adjustments may need to be made to the fixed costs when calculating the total cost for a new
activity level.

Example three – the high/low method with stepped fixed costs

An organisation has the following total costs at three activity levels

Activity level (units) 4,000 6,000 7,500

Total cost $40,800 $50,000 $54,800
Variable cost per unit is constant within this activity range and there is a step up of 10% in the total
fixed costs when the activity level exceeds 5,500 units.

What is the total cost at an activity level of 5,000 units?

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Solution

Calculate the variable cost per unit by comparing two output levels where fixed costs will be the same:

Variable cost per unit = [(54,800 – 50,000) ÷ (7,500 – 6,000)] = $3.20

Total fixed cost above 5,500 units = [54,800 – (7,500 × 3.20)] = $30,800

Total fixed cost below 5,500 units = 30,800/110 × 100 = $28,000

Total cost for 5,000 units = [(5,000 × 3.20) + 28,000] = $44,000

High/low method with changes in the variable cost per unit

Sometimes there may be changes in the variable cost per unit, and the high/low method can still be
used to determine the fixed and variable elements of semi- variable costs. As with the stepped fixed
costs – choose activity levels where the variable costs per unit remain unchanged.

Example Four – The high/low method with changing variable costs

The following information relates to the manufacture of Product LL:

Output (units) Total cost ($)

200 7,000
300 8,000
400 8,600
For output volumes above 350 units the variable cost per unit falls by 10%. (Note: this fall applies to
all units – not just the excess above 350).

Required:

Estimate the cost of producing 450 units of Product LL.

Solution

$8,000 – $7,000
Variable cost per unit “ < 350” =
300 – 200
$1,000
= = $10 per unit
100

Total cost at 300 units = $8,000

Total variable cost = 300 × $10 $3,000
Therefore fixed cost = $5,000

If output is 450 units:

Variable cost = 450 × $10 × 90% $4,050
Fixed cost = $5,000
Total cost = $9,050

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Advantages and limitations of the high/low method

The main advantage of the high/low method is that it is easy to understand and easy to use.

The limitations of the high/low method are as follows:

• It relies on historical cost data and assumes this data can reliably predict future costs
• It assumes that activity levels are the only factor affecting costs
• It uses only two values (highest and lowest) to predict future costs and these results may be
distorted because of random variations which may have occurred
• Bulk discounts may be available for purchasing resources in large quantities.

VI. Relevant and Irrelevant Costs And Revenues

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

VII. and Unavoidable Costs

Sometimes the terms avoidable and unavoidable costs are used instead of relevant and irrelevant cost.
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.

VIII. 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. Incremental costs can include both fixed and variable 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 in the future.

Opportunity Costs

An opportunity cost is a cost that measures the opportunity that is lost or sacrificed when the choice
of one course of action requires that an alternative course of action is given up.

Opportunity costs cannot normally be recorded in the accounting system since they do not involve
cash outlays. Opportunity costs are of vital importance for decision-making. If no alternative use of

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resources exists then the opportunity cost is zero, but if resources have an alternative use, and are
scarce, then an opportunity cost does exist.

Element of Costs

The elements of cost are the constituent parts of cost which makeup the total cost of a unit. Elements
of cost includes

• Prime costs- Is the total cost of all direct costs of production. Prime cost is the sum of direct
material cost, direct labor cost and direct expenses.
• Production overhead cost- Is the total of all indirect production costs. Production overhead cost
is the sum of indirect material cost, indirect labor cost and indirect expenses
• Total production/Factory cost- Is the total of cost of the production facility. It is the sum of prime
production cost and production overhead cost
• Total cost- Is the total cost incurred by the company from production point to the sale of the
outputs. It is the sum of the total production/factory cost, selling and distribution costs and
administrative costs incurred for the period.
• Conversional costs- Is the total cost incurred when converting raw material to the finished goods.
It is the sum of direct labor cost and manufacturing overhead costs. It represents the cost of
converting raw materials into finished products.
• Cost Driver – a variable that causally affects costs over a given time span
• Relevant Range – the band of normal activity level (or volume) in which there is a specific
relationship between the level of activity (or volume) and a given cost.
o For example, fixed costs are considered fixed only within the relevant range.
• Direct Materials – resources in-stock and available for use
• Work-in-Process (or progress) – products started but not yet completed. Often abbreviated as
WIP
• Finished Goods – products completed and ready for sale.

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