CHAPTER 2

COSTS AND COST

BEHAVIOUR
1. Cost centres
A cost centre is a location where all costs relating to certain activities and
functions are stored. This is not a literal location, though! A cost centre is an
abstract idea used to group related costs together.

Let’s consider that we run a pie shop, for example. We might group together costs
associated with the kitchen, where we produce the pies, and thus separate them from
the costs associated with the shop, where the pies are sold. This breakdown can be
useful for a number of reasons.

We could, for instance, hold different staff responsible for different cost centres – our
shop manager and our production manager here perhaps. This could help them
understand their costs better and control them.

In addition we could produce a budget for each cost centre and then compare what
they actually spent with the budget to help control spending.

Types of cost centre

Cost centres can come in all different shapes and sizes and are not limited
exclusively to direct costs and production. We can distinguish different cost
centres based on 4 key areas:

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 Costs and Cost Behaviour

1. Function
A function cost centre refers to an entire department or a role within the
organisation.

For example, an admin department would be a functional cost centre, in which there
would be costs relating to personnel, furnishings, computers and all other supplies
needed to ensure the employees can do their job (right down to the tea bags!)
Likewise, in a production department, all of the costs associated with creating the
product, for instance the making and baking of pies in a pie shop, would be included.

2. Activity
An activity cost centre is created by consolidating the costs associated with a
particular activity within a department or role.

For example, the costs associated with the baking of our pies in our pie shop’s
production department, or all the costs that go into office supplies in our admin
department, may be collected together to form an activity cost centre. It’s a sub-
section related to a specific task that is undertaken.

3. Service location
A service location cost centre involves the pooling and classifying of costs based
on a particular location, meaning a cost centre is defined by where it is based.

For instance, this may be done at an individual level, like each specific shop or outlet,
at a regional level, like London, New York, or the English South West, or even the
national level, collecting all of the costs associated with a particular country.

4. Equipment
An equipment cost centre consists of all of the costs associated with the
purchasing and running of a particular piece of equipment or machinery.

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 Costs and Cost Behaviour

For example, let’s say we have a machine that puts the filling in all of the pies in our
pie shop, what costs are related to this machine? The purchase price, insurance,
warranties, maintenance, etc. These are all costs associated with the acquisition and
running of the machine and so may be collected under the ‘pie filling machine’ cost
centre.

2. Cost classification and cost

elements
So we can group costs together based on commonalities to form a cost centre, but
before we can do that we need a system for collecting and sorting costs on a smaller
scale. How do we do that?

Usually, we can sort them by classifying them based on a number of different means.
This helps with the analysis of costs, which is one of the key responsibilities of
the management accountant, so that an organisation can manage costs and,
hopefully, increase profits.

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 Costs and Cost Behaviour

Classifying costs by element

One of the ways in which costs can be classified is by their element; this involves
categorising costs as either:

• Materials - All materials that go into the production of the product produced,
such as the eggs, wheat and fillings for our pies.

• Labour - The cost of wages, salaries and all other employment-related costs
such as personnel insurance, health benefits and pension plans, etc.

• Expenses - External overheads that are not directly linked to production and
operations. This may include costs such as rent on property or bills (heating,
electricity, water, etc.).

Classifying costs by nature

Essentially classification by nature asks whether or not the cost is directly related
to sales. To illustrate this, let's relate the types of costs to the various costs incurred
by our pie shop:

Production costs/Direct costs

Materials, labour and expenses that are used in the production of the
company’s products and directly relate to each unit of production. Here is an
example of each used:

• Direct materials - The pastry used to make the pies

• Direct labour - Employees who operate the ovens used in a pie’s production

• Direct expenses – Such as the baking dishes used to bake the pies in

Non-production costs/Indirect costs

Materials, labour and expenses that cannot be directly attributed to individual
units produced, but are nevertheless necessary for the business.

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 Costs and Cost Behaviour

Again, here is an example of each in the context of our pie shop:

• Indirect materials - Materials used in the maintenance and upkeep of the

ovens that bake the pies

• Indirect labour - The production supervisor’s salary

• Indirect expenses - Rent on the production building and the electricity

needed to run the machines all day

As you can see, none of the above costs can be specifically attributed to an individual
completed pie, but are all necessary in order for the business to run on a day-to-
day basis.

Prime costs and overheads

We can group together each element of a cost's classification to obtain the total
costs for that group.

For example, all direct expenses are consolidated to create a figure known as the
total direct costs or prime cost:

£
Direct material 5
Direct labour 10
Direct expenses 5
Prime cost 20

Indirect costs can be grouped together to become production overheads:

£
Indirect material 5
Indirect labour 5
Indirect expenses 10
Production overheads 20

This production overheads figure is then added to the prime cost to provide the total
production cost or factory cost.

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 Costs and Cost Behaviour

Prime cost + Production overhead = Total production cost/Factory cost

£20 + £20 = £40

Period and inventory costs

Period costs
These are expenses that are easier to attribute to amounts of time such as
accounting periods, rather than finished products or the manufacturing
process. Examples include advertising costs, administrative expenses, legal fees or
research expenditure. As none of these costs can be directly attributed to a product,
they are instead treated as expenses in the period in which they are incurred.

Inventory costs
On the other hand, inventory costs, also known as inventoriable costs or product
costs are those that can be attributed to the product or service that a company
is providing. This includes the cost of the direct labour, direct materials and any
other expenses or overhead costs that are incurred in the production process.

Inventory costs are treated as an asset on the balance sheet, until the related
product or service is sold, at which point these costs then form part of the cost
of goods sold figure on the income statement.

3. Cost behaviour
When accounting for costs it is imperative that you understand the ways in which
costs behave and what factors can affect cost. There are many external factors which
can affect costs such as inflation, exchange rates, or interest rates. However, cost
behaviour from the perspective of a management accountant relates to how
costs change depending on the level of production.

Fixed costs
We’ll start with fixed costs which, as the name may suggest, are fixed compared
with the level of production, meaning that no matter how many units are produced
the costs will remain the same.

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 Costs and Cost Behaviour

Standard fixed costs

For example, we pay £1,000 a month in commercial property rent for our pie shop.
This £1,000 will need to be paid each and every month regardless of how many pies
are made, or sold. We may not make or sell a single pie, but the rent would still be
£1,000. Likewise, we could make and sell a thousand pies and the rent would still be
£1,000.

Here is what our fixed costs would look like on a costs/production volume chart:

As you can see, no matter how many units we produce our costs remain constant.

Stepped fixed costs

Stepped fixed costs are slightly different but share similarities with standard fixed
costs in so far as costs remain constant within a certain level of activity. Where
they differ is that when production reaches a certain capacity the costs need to
move up to a new level.

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 Costs and Cost Behaviour

Returning to our pie shop, we pay £1,000 for the rent of our shop/kitchen. This
premises has a capacity of 5,000 pies a month, if we wish to produce more than that
we will need to rent out the premises next door to cope with the extra production.

These new premises will also cost £1,000 meaning that our fixed costs up to 5,000
units will be £1,000 and our fixed costs when producing over 5,000 units will be
£2,000. But only an additional 5,000 pies can be produced in this new premises and,
therefore, if we want to produce more than 10,000 pies (5,000 in the first premises,
5,000 in the second) we’ll need to rent another premises.

This increase in capacity can be ongoing and keep building up and up: let’s say each
premises adds an additional 5,000 units to capacity and costs an additional £1,000 in
rent, then from 10,000 to 15,000 units our fixed costs will be £3,000 and from 15,000
to 20,000 units the cost will be £4,000, and so on. This is perhaps most effectively
illustrated on a graph:

Therefore, the costs remain constant just as standard fixed costs are, but only
within a certain activity range.

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 Costs and Cost Behaviour

Fixed costs per unit

As you might expect, if production levels increase and fixed costs remain the
same then the fixed cost per unit decreases. This is because the same amount of
fixed costs is being used to create more products.

For example, if fixed costs are £1,000 and 100 units are being produced then the
fixed cost per unit is £10 (£1,000/100), but at 1,000 units it is £1 and at 10,000 units it
is just 10p.

A fixed cost per unit chart is likely to be curved with a very sharp initial gradient that
begins to level out before eventually plateauing, and may look a little like this:

Variable costs
In contrast to fixed costs, variable costs are directly linked to the level of
production. In this case, the more units you produce, the higher your variable
costs will be.

Let’s say all the direct costs (material, direct labour, etc.) that go into our pies comes
to £1 a pie. If we do not produce a single pie, then our variable costs will be £0, but if

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 Costs and Cost Behaviour

we produce 1,000 pies, then our variable costs will be £1,000 (1,000 x £1) and, if we
produce 2,000, the variable costs will £2,000 (2,000 x £1) and so on.

Variable costs are represented on a graph by a straight line beginning at

(0, 0) with the gradient determined by the cost per unit. In our example each unit
costs £1 so the line will increase on the Y axis at the same rate of the X axis:

(1, 1) (2, 2) (3, 3) (4, 4)… and so on:

Non–linear variable costs

Generally speaking the variable cost per unit remains linear (as in the variable
cost per unit will always be £1 regardless of whether 1 pie is made or a million),
variable costs are often examined this way.

However, that is not to say that variable costs cannot be non-linear as this may
occur in practice. The variable cost per unit may decrease as production increases as
there may be cost discounts when buying in bulk (economies of scale).

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 Costs and Cost Behaviour

For example, our pie shop’s egg provider may charge us 10p per egg, but if we buy
more than 100 at a time they’ll sell them to us at 9p per egg, and 300 at a time, 8p
per egg with more discounts for even larger orders. This will lead to a reduction in
variable costs as production increases:

Likewise, variable costs may increase with production. If, for example, our pie
maker reaches the end of his normal working hours, he may want to be paid
overtime for additional hours, increasing the variable cost over a certain limit.

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 Costs and Cost Behaviour

This situation tends to happen when there is limited resources in some way – here
one skilled pie-maker who can therefore demand higher wages for overtime. In this
instance, our graph would look as above.

Semi-variable costs
Semi–variable costs (note that they can also be referred to as semi-fixed costs or
mixed costs) are costs which contain both fixed and variable components and so
are, to an extent, affected by changes in production.

To illustrate, our pie shop has a van that is used to deliver orders to business
customers. The insurance/tax, etc. on the van will need to be paid regardless of how
much we use the van; however, the fuel is variable as the more orders we deliver the
more fuel we will use.

Another example of this would be electricity usage, our shop pays a £50 a month
standing charge to the electricity company which is payable regardless of usage, but
then pays a certain price for every KW used; the standing charge is fixed and the
price per KW used is variable.

On a cost/production volume chart the fixed cost line is constructed as normal.

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 Costs and Cost Behaviour

The variable portion is then calculated in the same fashion as variable costs, but
rather than beginning from the origin they begin at the moment the fixed costs meet
the Y axis, like so:

It is worth noting that: Total costs = variable costs + fixed costs

And so if for 1,000 pies, our variable costs total £1,000 and fixed costs £1,500 our
total costs at that output level are £2,500.

For 2,000 pies our variable costs will have risen, say to £2,000 while the fixed costs
stay the same and so total costs are £3,500.

Also consider that variable costs will not always begin at the origin and may
start further along the fixed cost line. This may occur if the fixed cost represents
an allowance and only once this allowance has been reached will additional cost be
added.

Coming back to our electricity example, the fixed cost for the retainer/being with that
provider may allow up to a certain KW usage free of charge, it is only when this limit

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 Costs and Cost Behaviour

is reached that additional charges per KW are included. If that is the case the semi-
variable chart will look more like this:

Classifying fixed and variable costs

Fixed and variable costs can also be classified as either direct or indirect. As a
reminder, direct costs are those which can be directly attributed to an individual unit
of production, whereas indirect costs cannot be attributed to an individual product,
but nevertheless are necessary in order for the business to operate.

The following table outlines the four dual-cost classifications, the features of each
and an example in the case of our pie shop.

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 Costs and Cost Behaviour

Cost directly Total cost changes

Type of
attributable to the in line with the Example
cost
product? change in output?

Direct materials
Direct
Yes Yes
variable e.g. cost of ingredients

Indirect Variable overheads

No Yes
variable e.g. electricity

Direct Salaried production

Yes No
fixed staff

Indirect
No No Salaried admin staff
fixed

4. Costing digital products

Digital products bring about further considerations when thinking about costing. We
can’t just look at the physical parts we have used to create them, as they are virtual
products. This makes the task a bit more difficult, and we have to think about costing
in a different way.

Digital products include such things as apps, e-books, online music and software
systems, which are stored and purchased for use online. Once these products are
made, that’s it – they are made! For example, once an e-book is online, it requires no
further production to be bought again and again by customers. This is unlike physical
products, for which a new unit will need to be made for each customer purchase. This
means that for digital products, most of the associated costs are already incurred
by the time the product is first released.

So, let’s briefly think about how this would affect pricing. These upfront, overhead
costs are the highest costs that digital products incur, so are what should be used in
pricing, unlike traditional costing, which relies on marginal costs.

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 Costs and Cost Behaviour

Costing products
Taking a simple physical product like a mug, how would we figure out how much one
unit costs to make? Well, each mug needs a set amount of clay, the energy and
maintenance costs of the oven to cook the clay, and the labour costs for someone to
mould and paint it. By working out the cost of labour, materials and machine time,
you get the marginal cost – the cost for making one unit. This example doesn’t
consider overheads, but you see that it’s a relatively straightforward process.

Now let’s think of a digital product, something most of us will be familiar with – a
mobile game. Take a minute to think how about this would be harder to cost when
compared to a physical product like a mug. A company has created and released a
mobile game, which can be bought and used over and over without any extra cost to
the company. So how can we work out what the cost of producing one unit of this
digital product is?

This is where it gets difficult – without a marginal cost it’s hard to assign a cost
value to a single unit. Instead, all overhead costs must be considered over the
expected life of the game, to help settle on a value for a unit of the game.

Costs associated with a digital product

Now we can have a look at some specific costs and how they differ to traditional
products, using our game as an example. As we know, most of these will be overhead
costs, incurred by the general creation of the game, rather than attributable to each
individual unit. Traditional physical products do incur some of the following costs,
but some are exclusive to digital products as we will see.

Design, research and development

The majority of these costs will be incurred before the game is released, and can
be considered an overhead cost. Digital products such as games may require
millions of dollars to develop (Grand theft auto V, released in 2013, cost $265
million), which is essentially the total production stage of the product. Game
updates incur small additional development charges after the release of the game,
which will again be overhead costs.

These are overhead costs because they are not dependent on sales. The game could
sell a million copies, or it may not sell a single copy. The costs will be the same.

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 Costs and Cost Behaviour

However, design, research and development costs are also incurred with traditional
products like our mug, although this is usually a much smaller proportion of the total
incurred costs as there are many direct production costs that are incurred with it.
However, some physical products will have high R&D costs, like autonomous cars
and space probes.

Platform types
In the digital world, the platform is the system used to play the game on, or the
system you read the e-book on. For example, our mobile game can be played on an
android (google) operating system or an Apple operating system. Often a product
will need adapting to work on each system (Xbox games won’t play on a PlayStation
system, etc.), so this can increase development costs.

Depending on the chosen operating system (OS) the game is launched on, varying
costs would be incurred. For example, operating on Apple’s OS, including server
usage and storage costs is more expensive than android’s OS in 2019. These are
overhead costs charged by the owner of the OS, again primarily incurred before the
release of the product and not dependent on units sold.

These costs could also be relevant in the future; mobile OSs are continually being
updated, so new game versions need to be created to keep games compatible. A
company may also choose to make its game available on more platforms, if it proved
popular, again, incurring these costs in the future.

This is a cost unique to digital products – you wouldn’t have operating system costs
for a mug!

Marketing
These associated costs are often first incurred before the release of the product
and are ongoing, although they are often a budgeted fixed cost. A company may
begin an ad campaign before the release of a product to create anticipation;
continuing after the release. This is a cost that is relatively similar to costing for
traditional products; however, the advertising for digital products is likely to be more
online-focused, and through the very platforms the digital product will be consumed
on.

Again, marketing is an overhead as it is not tied to sales volumes. We could spend

£100,000 on marketing and sell one million copies, or we could spend £100 million
and sell 10!

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 Costs and Cost Behaviour

Testing and support

We all know how powerful bad reviews can be! So it’s clear why companies
constantly test and update the service of their online game. This might be in the form
of full-time staff, or outsourced or freelanced staff. Although, most of the testing will
ideally be done before the game is released, ongoing testing is essential to ensure
the game is useful for as long as possible. This is an example of a variable cost and
will depend on how many issues are found with the game.

With products such as mobile games especially, users will expect any issues with
gameplay and systems to be updated and quickly resolved. Think about games apps
on mobile devices, and how many times they have been updated. A lot! So this is an
ongoing process for digital products. With traditional products, companies continue
testing and improving their products, so this is a cost which is quite similar!

Functionality
There will be many product functions for a mobile game, including push
notifications, offline gaming and in-app messaging capabilities. To develop and
incorporate these into the game will all come at a cost! For a company which makes
multiple games, the games may share some of these features, and so share the cost.

Functionality costs are exclusive to digital products.

Royalties
These are an ongoing variable cost. The game publisher will have to pay a
percentage of the game cost as royalties for copyrighted features (i.e. music), as well
as to the game developer. There are more examples of royalties, so they can soon
add up! Traditional products also may incur royalty costs, but digital products often
incur more! Companies like Amazon and Apple can charge up to 50%. This is the
most obvious digital cost that is sales-dependent.

Inventory and associated storage costs

So, we have seen examples of costs associated with digital products that we don’t
see with traditional products, now it’s time to see the opposite! Digital products
such as mobile games don’t incur costs from inventory in the same way as
traditional products do. Due to the products being in a virtual location, inventory
storage and valuation costs are saved when it comes to digital products.

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 Costs and Cost Behaviour

These are just a few examples of costs that a digital product like a mobile game
might incur, and how they differ from traditional physical products. One of the key
takeaways of digital costing is that costs are not sales-dependent, with the
exception of royalties.

Difficulties in costing digital products

Let’s have a more detailed look at why the process of costing is more difficult for
digital products.

Difficulty Explanation

Often many digital products will need to use the same resources,
e.g. hardware and software. This makes absorbing costs fairly a
Shared
complex process for the finance function to carry out. If we use the
resources
same hardware to produce mobile game one and mobile game
two, how do we allocate the costs of the hardware?

Different digital products may share the same features, again

creating difficulty of calculating where to absorb overheads. If we
Shared
reuse 80% of the coding from mobile game one in mobile game
features
two, are the development costs still attributed to mobile game
one?

The useful life of a digital product is difficult to calculate in

comparison to a physical product, due in part to rapid
Calculating
technological advancements and saturated digital markets. An
product life
appropriate pricing strategy is therefore hard to create, as revenue
over the whole of the useful life must be considered.

A rapidly This creates issues not only with an uncertain product life, but this
changing also means that product costs and prices are likely to change with
market minimal notice because of technological developments.

Due to the difficulty in having a standard time or cost for

Standard
products, it is not feasible to use standard costing. This is because
costing
there are no standard inputs.

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 Costs and Cost Behaviour

Difficulty Explanation

Cost timings can be difficult to estimate accurately for digital

products, unlike physical products. There may be costs such as
Cost
royalties as well as marketing costs that will only be relevant after
timings
the creation of the product. Costs such as these will be spread
across multiple accounting periods.

The majority of costs will be fixed in nature, and often marginal

Marginal costs are impossible to determine, so are inappropriate to use. As
costs we have already looked at, the initial cost of creating a digital
product is high, but subsequent costs are very low!

5. Methods of digital costing

Technology speeds up a huge number of processes in the modern business world,
and costing is another one of these processes! Digital costing methods can replace
traditional costing methods through systems designed to collect, analyse and
allocate relevant data. These can then be used to compare and review different
costing options and scenarios. These systems enable a company to make informed
production and pricing decisions, that will be of optimum benefit to it.

Systems are able to collect data from markets and suppliers and apply different
possible costs to a range of scenarios, using real-time information. By working
alongside product design programmes, digital costing systems can provide highly
detailed and accurate cost options, based on exact component prices and production
time.

In a small company which creates only a limited range of products, investing in an

expensive digital costing system is unlikely to be necessary. These systems are most
relevant for larger companies manufacturing complex products, which have many
components and production stages.

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 Costs and Cost Behaviour

Benefits of digital costing systems

• Component value – Using systems such as these will show a greater variety
of real-time supplier information on production components, enabling
purchases of the most suitable and best-priced materials

• Time saved – Whereas costing a complex product may take the workforce a
significant amount of time, a digital costing system could do it in the fraction
of the time. Therefore, complex purchasing decisions can be processed
efficiently

• Money saved – After the initial set-up cost, these systems are cheap to run,
and can save on staffing costs where costing was previously done manually.
As the systems also give the most cost-effective options, money can also be
saved in this way

• Easy to use – The systems present information clearly so can be used and
understood at all levels in a company

• Better information – Digital costing can process more information, so it will

give better results than manual costing. Digital systems can give better
information on cost drivers and how costs should be absorbed

• Cost behaviour – Due to the digital methods of presentation and the ease of
analysis of data, (relative to other factors e.g. price and quantity) cost
behaviours are clearer and easier to understand. These systems also help to
show which costs are variable, helping a company to more effectively plan for
future costs

• Streamlines overall processes – Digital costing systems can be set up to

work across departments. This allows processes to flow more easily, as each
department is notified digitally of their required actions in the production
process

• Flexible pricing – Due to the real-time information, companies can change

product pricing in line with the actual costs incurred, a technique which some
businesses have started using

• Meeting target costs – When businesses cannot control selling prices, these
systems help to reach a target cost instead, to ensure that required profit
levels are reached

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