The nature of costs and

their classification

Lect. Erika Besusparienė

erika.besuspariene@vdu.lt

2022-08-25 1
Concept of Cost

 Cost is the amount of resource given up in exchange for some goods or

services. Example, the price of orange is CU2 per kilogram. We purchased 3
kg of orange. Our costs of orange is CU2.
 The definition of costs - the amount of expenditure (actual or notional)
incurred on, or attributable to a specified thing or activity.
 This activity may be the manufacture of a product or the rendering of a service
which involves expenditure under various heads, e.g., materials, labour, other
expenses, etc.
 A manufacturing organisation is interested in ascertaining the cost per unit of
the product manufactured while an organisation rendering service (e.g.,
transport undertaking, canteen, electricity company, municipality, etc.) is
interested in ascertaining the costs of the service it renders.
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Concept of Cost

 In its simplest form, the cost per unit is arrived at by dividing the total
expenditure incurred by the total units produced or the quantum of service
rendered.
Costs per unit = Total expenditure / Total units produced
 But this method is applicable if the manufacturer produces only one product.
If the manufacturer produces more than one product, it becomes imperative to
split up the total expenditure between the various products so that the cost of
each product can be ascertained separately.
 Even if only one product is manufactured, it may be necessary to analyse the
cost per unit of each item of expenditure that goes to make up the total cost.
 The problem becomes more complicated where a multiplicity of products is
produced and it is necessary to analyse the cost per unit of each product into
various items of expenditures that make up the total cost. 3
Concept of Costing

 The process of ascertaining the cost is known as costing.

 It consists of principles and rules governing the procedure of finding out the
costs of goods/services.
 It aims at ascertaining the total cost and also per unit cost. For instance, in
transport companies the total cost for the period is ascertained and used to
find out the cost per passenger/mile. i.e. the cost of carrying one passenger
for one mile.
 It provides for analysis of expenditure in such a way that the management gets
complete idea about even the smallest item of cost.

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Concept of Costing

 Costing is the techniques and processes of ascertaining costs. These

techniques consist of principles and rules which govern the procedure of
ascertaining cost of products or services.
 The techniques to be followed for the analysis of expenses and the processes
of different products or services differ from industry to industry.
 The main object of costing is the analysis of financial records, so as to
subdivide expenditure and to allocate it carefully to selected cost centers, and
hence to build up a total cost for the departments, processes or jobs or
contracts of the undertaking.
 Cost classification is one more important aspect for costing and costs
analysis.

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Costs Clasification

 Cost classification systems in practice are as varied as the businesses they

serve. The functions of management are described as: planning, decision
making and control.
 For purposes of classification it is convenient to take planning and control
as a combined function because the classifications required by each are
similar. For decision making, particular care has to be taken to use
classifications of cost which are relevant to the decision under consideration.

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Costs Clasification

 Exists the different bases of cost classification:

 By time (Historical, Pre-determined).
 By nature or elements (Material, Labour and Overhead).
 By degree of traceability to the product (Direct, Indirect).
 Association with the product (Product, Period).
 By Changes in activity or volume (Fixed, Variable, Semi-variable).
 By function (Manufacturing, Administrative, Selling, Research and
development, Pre-production).
 Relationship with accounting period (Capital, Revenue).
 Controllability (Controllable, Non-controllable).
 Cost for analytical and decision-making purposes (Opportunity, Sunk, Differential,
Joint, Common,
 Imputed, Out-of-pocket, Marginal, Uniform, Replacement).
 Others (Conversion, Traceable, Normal, Avoidable, Unavoidable, Total).
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Costs Clasification

 Below are three traditional types of cost classification:

1. variable costs and fixed costs;
2. direct costs and indirect costs; and
3. product costs and period costs.

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The nature of costs

 Material – the substance from which the product is made is known as

material. It can be direct as well as indirect.
 Labour – labour cost can be classified into direct labour and indirect labour.
 Expenses – expenses may be direct or indirect. More often their are indirect
and are included into overhead costs.
 Manufacturing overhead, or all other costs of transforming the materials to a
finished product. Examples include materials and labor not easily traced to a
product and other manufacturing costs (excluding direct materials and direct
labor) such as depreciation and insurance for the factory building, heat, light,
power, and similar expenses incurred to keep the factory operating.

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The nature of costs
Nature Direct
Material It refers to those materials which become a major part of the
finished product and can be easily traceable to the units.
Direct materials include: all materials specifically purchased
for a particular job/process; all material acquired and latter
requisitioned from stores; components purchased or
produced; primary packing materials; material passing from
one process to another.
Labour It is defined as the wages paid to workers who are engaged
in the production process whose time can be conveniently
and economically traceable to units of products. For
example, wages paid to compositors in a printing press, to
workers in the foundry in cast iron works etc.
Expenses These expenses are incurred on a specific cost unit and
identifiable with the cost unit. Examples are cost of special
layout, design or drawings, hiring of a particular tool or
equipment for a job; fees paid to consultants in connection
with a job etc. Often in services!!!
Indirect
All material which is used for purposes
ancillary to production and which can be
conveniently assigned to specific physical
units is termed as indirect materials.
Examples, oil, grease, consumable stores,
printing and stationary material etc.
Labour employed for the purpose of
carrying tasks incidental to goods or
services provided, is indirect labour. It
cannot be practically traced to specific units
of output. Examples, wages of store-
keepers, foreman, time-keepers, supervisors,
inspectors etc.
These are expenses which cannot be
directly, conveniently and wholly allocated
to cost centre or cost units. Examples are
rent, rates and taxes, insurance, power,
lighting and heating, depreciation etc. 10
The nature of costs
Example
 Direct materials consist of all materials that
can be identified with a specific product.
Indirect materials used for the repai of a
machine that is used for the manufacture of
many different desks.
 Direct labour consist of those labour costs that
can be specifically traced to or identifiied with a
particular product. Indirect labour who do not
work on the product itself but who assist in the
manyfacturing operation.
 Prime costs = Direct materials + Direct labour

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The nature of costs

 All costs may be classified to manufacturing and non-manufacturing cots,

this also is used for prime cost, conversion cost or full cost calculation.
Usually these costs is used for pricing decision.

Manufacturing costs Non- manufacturing costs

Direct Administrative
materials overheads
Prime cost
Direct labour Marketing
(sales)
overhead
Conversion cost
Manufacturing
overhead

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The nature of costs

 Example, the factory is bottling juice. Factory buys raw juice and bottles it,
and a production worker works on it. The factory also rents building for this
production and buys accounting services. In addition to the production
worker, there is a marketing worker and a company director.
Direct material Raw juice CU10,000
Bottle (primary packing)
Direct labour Production worker CU20,000
Manufacturing overhead Building rent CU5,000
Sales overhead (Non-manufacturing) Marketing worker CU8,000
Administrative overhead (Non-manufacturing) Company director CU5,000

For example factory produce 18,000 units bottles.

The prime cost CU1.67 per unit (10,000 +20,000)/18,000
The conversion cost CU1.94 per unit (10,000 +20,000 +5,000)/18,000
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Costs by Changes in activity or volume

 Fixed cost (FC) does not vary with 500

volume of activity, example: rent,
advertising, insurance, depreciations 400
and ect.
FC
 Variable cost (VC) vary with volume 300
of activity, example: direct materials, VC
direct labour and ect. 200 TC
 Total costs (TC) = fixed costs (FC) + 100
variable costs (VC)
0

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Costs by Changes in activity or volume

 A semi-variable cost is one which is

partly fixed and partly varies with
changes in the level of activity, over a
defined period of time.
 Examples of semi-variable cost are:
 office salaries where there is a core of
long-term secretarial staff plus
employment of temporary staff when
activity levels rise;
 maintenance charges where there is a
fixed basic charge per year plus a
variable element depending on the
number of call-outs per year. 15
Costs by Changes in activity or volume

 Example, the factory is bottling juice. Factory buys raw juice (CU0.30 per
liter) and bottles (of 1 liter CU0.10 per unit) it, and a production worker
(CU800 per month) works on it. The factory also rents building (CU3,000 per
month) for this production and buys accounting services (CU1,000 per
month). In addition to the production worker, there is a marketing worker
(CU1,00 per month) and a company director (CU2,000 per month). During
the month factory produce 10,000 units.
Cost Raw juice, Bottle, CU Factory Rent, CU Accounting Administration Total
CU labour, CU services, CU labour, CU
Variable 10,000x0.30 10,000x0.10 4,000
=3,000 =1,000
Fixed 800 3,000 1,000 2,000 6,800
Total 10,800
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Costs by Changes in activity or volume

 Based on the example, calculate full cost and conversion cost per one unit.
 How would the cost per unit change if production volume were (a) 8,000 units
or (b) 15,000 units?

Cost Raw juice, Bottle, CU Factory Rent, CU Accounting Administration Total

CU labour, CU services, CU labour, CU
Variable 10,000x0.30 10,000x0.10 4,000
=3,000 =1,000
Fixed 800 3,000 1,000 2,000 6,800
Total 10,800

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Costs by Association with the product

 Product Costs: Product costs are those which are traceable to the product and
included in inventory values. In a manufacturing concern it comprises the cost
of direct materials, direct labour and manufacturing overheads. Product cost is
a full factory cost. Product costs are used for valuing inventories which are
shown in the balance sheet as asset till they are sold. The product cost of
goods sold is transferred to the cost of goods sold account.
 Period Costs: Period costs are incurred on the basis of time such as rent,
salaries, etc., include many selling and administrative costs essential to keep
the business running. Though they are necessary to generate revenue, they are
not associated with production, therefore, they cannot be assigned to a
product. They are charged to the period in which they are incurred and are
treated as expenses.
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Costs by Association with the product

 Selling and administrative costs are treated as period costs for the following
reasons:
 Most of these expenses are fixed in nature.
 It is difficult to apportion these costs to products equitably.
 It is difficult to determine the relationship between such cost and the product.
 The benefits accruing from these expenses cannot be easily established.

• Part of inventory
Product costs • Expensed when sold
• Not part of inventory
Period costs • Expensed when incurred

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Costs by Association with the product

 In a manufacturing organization all manufacturing costs are regarded as

product costs and non-manufacturing costs are regarded as period costs.

Recorded as an assests
Unsold (inventory) in the balance
Manufacturing cost Product cost sheet and becomes an
expenses in the P&L account
when the product is sold

Recorded as an expenses in
Non-manufacturing cost Period cost the P&L account current
accounting period

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Costs by Association with the product

The X company produces 100 000 identical Net sales revenue 750 000
units of a products during period 1. The
costs for for period are as follows: During period 1, the company Costs of goods sold (400 000)
Direct materials 400 000 Eur sold 50 000 units for 750 000 Beginning inventory 0
Eur, and the remaining 50 000 Manufactoring costs 800 000
Direct labour 200 000 Eur units were unsold ar the end of Ending inventory 400 000
Manufacturing overhead 200 000 Eur the period. There was no
opening stock at the start of Gross profit 350 000
Total manufacturing cost 800 000 Eur the period. The profit and loss
Non – manufacturing costs 300 000 Eur account (Income statement) Selling and administrative (300 000)
for period 1 will be as follows: expense
Other income (expenses) -

Net Income 50 000

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Exercise No. 1

 Classify each of the following as being primarily a fixed cost or a variable

cost, and, if necessary, explain why you think such a classification would
be difficult without more information being provided:
A. direct materials;
B. factory insurance;
C. production manager’s salary;
D. advertising of the product;
E. direct labour;
F. indirect labour;
G. depreciation of machinery;
H. lubricants for machines;
I. payment of a licence fee for the right to exclusive manufacture; and
J. canteen manager’s salary. 22
Exercise No. 2

 During the month of May, 4,000 metal towel rails were produced and
3,500 were sold. There had been none in store at the start of the month.
There was no inventory (stock) of raw materials at either the start or end
of the period. Costs incurred during May in respect of towel rails were as
follows:
Metal piping CU12,000

Wages to welders and painters CU9,000

Supplies for welding CU1,400

Advertising campaign CU2,000

Production managers’s salary CU1,800

Accounts department computer costs for dealing with production records CU1,200
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Exercise No. 2

 Classify the list of costs set out above, into product costs and period costs.
 Explain how you would value inventory held at the end of the month.

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Resources
• Drury, C. (2018). Cost and Management Accounting.
• Weetman, P. (2006). Financial and management accounting. An Introduction. Fourth Edition.
• CMA (2017). Costs and Management accounting. THE INSTITUTE OF COMPANY SECRETARIES OF INDIA

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