Classification of Costs

Classification of Costs

• Costs are classified into different categories according to their nature, which is important for the control function to identify problem areas.
• Examples of functions by which costs can be classified include Production, Administration, and Selling and Distribution.

Cost Centres and Cost Units

• Cost Centres are locations such as departments, individual employees, or machines.
• Cost Units are sub-divisions of cost centres, which can be a single job, batch, contract, or product group, depending on the business type.

Example of Cost Centres and Cost Units

• A firm producing leather goods has four departments, each producing a different type of product (shoes, gloves, handbags, and wallets), making each department a cost centre.
• Within the handbag department, each batch of 100 bags produced is a cost unit.

Elements of Production Cost

• The cost unit can be broken down into three elements of production cost:
  • Material Cost: the cost of raw materials used in production.
  • Labour Cost: wages, salaries, and bonuses incurred in production.
  • Direct Expenses: rare, but may include the hire of equipment necessary for the process.
• These three elements combined are called the Prime Cost of Production/Service.

Indirect Costs

• Any cost that cannot be directly allocated to production or service provision is an indirect cost.
• Indirect costs are apportioned to the cost centre and absorbed into the cost unit.
• Examples of indirect costs include:
  • Indirect Labour Costs: wages and salaries of typists, salesmen, and accountants.
  • Indirect Material Costs: stationery.
  • Indirect Expenses: gas and electricity.

Overheads and Total Cost

• Indirect costs are called overheads and are sub-divided into production/factory overheads, administration overheads, and selling and distribution overheads.
• Factory overheads include supervisors' salaries, factory gas and electricity, and rent and rates.
• Administration overheads include stationery, typists' wages, and employee insurance.
• Selling and Distribution overheads include salesmen's commission, advertising, and sales department costs.
• Once all costs have been collected, allocated, and absorbed, the price at which the goods must be sold to make a required profit can be calculated.

Fixed Costs

• Fixed costs are incurred by an organisation regardless of the level of activity.
• Examples of fixed costs include rates on the factory, rent, and insurance costs.
• These costs are often termed 'period costs' since they are incurred on a time basis as opposed to an output basis.
• Fixed costs will only be fixed over a relevant production scale.
• If the scale of production changes, the fixed cost may also change, but it will remain fixed at the new level.

Variable Costs

• Variable costs vary directly with activity.
• If the level of output or service is doubled, the variable costs will also double.
• However, this will only be the case over a relevant production scale.
• Large increases in provision may lead to economies of scale, which can result in discounts.

Semi-Variable Costs

• Semi-variable costs change when the level of output changes but not directly.
• Indirect labour costs are an example of a semi-variable cost.
• Semi-variable costs are a mixture of fixed and variable costs and are often described as 'stepped costs'.
• Examples of semi-variable costs include a photocopier with a monthly charge plus a charge per copy, or a landline with a line rental plus a charge per call minute.

Step Fixed Costs

• Step fixed costs are a type of fixed cost that is only fixed within certain levels of activity.
• Once the upper limit of an activity level is reached, a new higher level of fixed cost becomes relevant.
• Examples of stepped fixed costs include warehousing costs and supervisors' wages.
• Numerical example: for production of up to 50 widgets, one supervisor is required, but if production is between 50 and 100 widgets, two supervisors are required, resulting in a step increase in fixed costs.