School of Business and Computer Science Limited FIA M2 Managing Costs and Finances

Lecture 2 - Cost Classification in a Cost Accounting System

The total cost of making a product or providing a service consists of the following: Cost of materials Labour Costs Cost of other expenses (overheads)

Total Cost can be classified as direct cost and Indirect cost Direct Cost is a cost that can be traced in full to the product, service, or department that is
being costed.

Examples of Direct Cost are:

(1) Direct material Cost (2) Direct Labour Cost (3) Direct Expenses

Direct materials cost + Direct labour costs + Direct expenses = Prime Cost

(1) Direct Material Cost

These are the costs of materials that are known to have been used in making and selling a product or service. Direct material costs are charged to the product as part of the prime cost. Examples of direct material cost are: (a) Component parts specially purchased for a particular job, order or process. (b) part-finished work which is transferred from department 1 to department 2 becomes finished work of department 1 and a direct material cost in department 2. (c) Primary packing materials like cartons and boxes

(2) Direct Labour Cost

These are the specific cost of the workforce used to make a product or provide a service. Direct labour costs are established by measuring the time taken for a job, or the time taken in direct production work. Direct wages costs are charged to the product as part of the prime costs. Examples of direct labour costs are: (a) Workers engaged in altering the condition or composition of the product (b) Inspectors, analysts and testers specifically required for such production (c) Foremen, shop clerks and anyone else whose wages are specifically identified. (d) Basic pay of direct workers and basic rate for overtime

(3) Direct Expenses

These are expenses that have been incurred in full as a direct consequence of making a product, or providing a service, or running a department. Direct expenses are charged to the product as part of the prime cost Examples of direct expenses are: (a) The hire of tools or equipment for a particular job (b) Maintenance costs of tools, fixtures etc. (c) Royalties Direct expenses are also referred to as chargeable expenses.

Indirect Cost or Overheads is a cost that is incurred in the course of making

a product, providing a service or running a department, but which cannot be traced directly and in full to the product, service or department.

Production Overhead

includes all indirect material costs, indirect wages and indirect expenses incurred in the factory from receipt of the order until its completion.

Production overhead includes the following: (1) Indirect Materials which cannot be traced in the finished products.
Examples include consumable stores, e.g. materials used in negligible amounts

(2) Indirect wages are not charged directly to a product.

Examples (1) wages of non-productive personnel in the production department e.g. foremen (2) Basic pay of Indirect Workers

(3) Overtime premium (4) Bonus Payments (5) Employers National Insurance Contributions (6) Idle time of direct and indirect workers

(3) Indirect Expenses other than material and labour not charged directly to production
Examples include rent, rates, insurance of a factory, depreciation charge of machinery, fuel, power, maintenance of plant, etc.

Indirect material cost + Indirect wages + Indirect Expenses = Overheads Overheads + Direct Cost = Total Cost

Other Non-Production Costs are:

(1) Administration Overhead is all indirect material costs, wages and expenses
incurred in the direction, control and administration of an undertaking.

Examples of Overhead Administration are:

Depreciation of office buildings and equipment Office salaries, including salaries of directors, secretaries and accountants Rent, rates, insurance, lighting, cleaning, telephone charges etc.

(2) Selling Overhead is all indirect material costs, wages and expenses incurred
in promoting sales and retaining customers.

Examples of selling overhead are as follows:

Printing and stationery, such as catalogues and price lists Salaries and commissions of salesmen, representatives and sales department staff Advertising and sales promotion, market research Rent, rates and insurance of sales offices and showrooms, bad debts etc.

(3) Distribution Overhead is all indirect material costs, wages and expenses
incurred in making the packed product ready for dispatch and delivering it to the customer.

Examples of distribution overhead are as follows.

Cost of packing cases Wages of packers, drivers and dispatch clerks Insurance charges, rent, rates, depreciation of warehouses etc.

Functional Costs
These are costs classified by different functions.

Functional Costs include:

(1) Production Costs
are the costs which are incurred by the sequence of operations beginning with the supply of raw materials, and ending with the completion of the product ready for warehousing as a finished goods item.

(2) Administration Costs are the costs of managing an organization that is, planning
and controlling its operations.

(3) Selling Costs, sometimes known as marketing costs, are the costs of creating demand
for products and securing firm orders from customers.

(4) Distribution Costs

are the costs of the sequence of operations with the receipt of finished goods from the production department and making them ready for dispatch and ending with the reconditioning for reuse of empty containers.

(5) Research costs

are the costs of searching for new or improved products, whereas development costs are the costs incurred between the decision to produce a new or improved product and the commencement of full manufacture of the product.

(6) Financing costs ate costs incurred to finance the business such as loan interest.

Costs Classified by Behavior

Costs are also classified into fixed costs and variable costs. Fixed Costs is a cost which is incurred for a particular period of time and which, within
certain activity levels, is unaffected by changes in the level of activity.

Examples are:

(1) The Rental cost of business premises (2) Managers Salary

Variable Cost is a cost which tends to vary with the level of activity. Examples are: (1) Direct material costs
(2) Sales Commission

Semi fixed or semi-variable cost is a cost where there is an element of both

fixed and variable costs.

Examples are: (1) Telephone call charges

(2) Electricity charges

Costs Classified by Responsibility Introduction:

The Managers of a business need to monitor how their particular section of the business is performing hence control measures can be put in place to ensure the organizations objectives are being met.

Responsibility Centres
A Responsibility Centre is any part of an organization for which the performance can be measured and whose performance is the direct responsibility of a specific manager. A manager is responsible for Responsible Accounting. Responsibility Accounting is a system of accounting that segregates revenue and costs into areas of personnel responsibility in order to monitor and assess the performance of each part of an organization.

Responsibility Centres are usually divided into different categories.

(1) Cost Centres (2) Profit Centres (3) Investment Centres (4) Costs Object

(1) Cost Centres

A Cost Centre is a production or service location, function, activity or item of equipment for which costs can be determined. A cost centre is a responsibility centre to which costs can be related.

Examples of Cost Centres: Manufacturing Company

Production Cost Centres Mixing dept, Packaging dept Service Cost Centres Stores dept, Maintenance dept, Canteen dept, Administration and Selling and Marketing depts.

Example of Cost Centres Accountancy Practice

Audit, Taxation, Accountancy, Administration, Canteen or various geographical locations.

Determining the Costs for each Cost centre is important for several reasons such as: Relating costs to cost units, i.e. to the individual units of product or service produced Planning future costs Controlling costs, i.e. comparing either actual to budgeted cost

A Cost Centre Manager is responsible only for the cost incurred in the centre.

(2) Profit Centres

A Profit Centre is a production or service location, function or activity for which costs and revenues, and therefore profit, can be determined. Example of a Profit Centre for a Manufacturing Company might be a specific site or factory.

Example of a Profit Centre for Accountancy Practice might be the individual location, the type of business undertaken. All Profit Centres can also be Cost Centres, but not all Cost Centres can be Profit Centres. Determining the Profit for each centre is important because: Planning future profits Controlling costs and Revenues Measuring management performance.

The Manager of a Profit Centre is therefore accountable for costs, revenues and profit.

(3) Investment Centres

An Investment Centre is a production or service location, function or activity for which costs, revenues and net assets can be determined. This centre is responsible for capital investment and possibly financing and whose performance is measured by its returns on investment. An Investment Centre Manager is accountable for costs, revenues, profit and assets employed in the responsibility centre. Example of Investment Centres are a group of sites or factories or service several branches. There may be several cost centres within a single profit centre; several profit centres within an investment centre and several investment centres within the organization as a whole.

(4) Cost Object

This is any activity for which a separate measure of costs is desired. If the users of Management Information which to know the cost of something, this something is called a cost object. Examples of Cost Objects are: The cost of a product The cost of a service The cost of operating a department