Chapter 2

Cost Classification & Cost

Behaviour Ibrahim Sameer (MBA - Specialized in Finance,

B.Com – Specialized in Accounting & Marketing)

Total Cost / Service Costs

• The total cost of making a product or providing a

service consists of the following:

• Cost of materials

• Cost of the wages and salaries (labour costs)

• Cost of other expenses (rent and rates, electricity

bill, depreciation)

Direct Cost & Indirect Cost

• A direct cost is a cost that can be traced in full to

the product, service, or department that is being

costed.

• An indirect cost (or overhead) 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.

Examples of Direct Cost &

Indirect Cost

Direct Cost & Indirect Cost

Direct Cost & Indirect Cost

• Direct Materials

• Direct materials is all material becoming part of

the product.

• For eg: component part, part finished product,

primary packing materials.

Direct Cost & Indirect Cost

• Direct Labour

• Direct wages are all wages paid for labour

expended on work on the product itself.

Direct Cost & Indirect Cost

• Direct Expenses

• Direct expenses are any expenses which are

incurred on a specific product other than direct

material cost and direct wages. It is also referred

as chargeable expenses.

• For eg: the hire of tool or equipment for particular

job, maintenance costs of tool.

Direct Cost & Indirect Cost

• Prime cost: is total of direct materials, direct

labour & direct expenses.

Direct Cost & Indirect Cost

• Production overhead

• Production OH include all indirect material costs,

indirect wages and indirect expenses incurred

in the factory from receipt of the order until its

completion.

Functional Costs

• Classification by Function

• Classification by function involves classifying

costs as production / manufacturing costs,

administration costs or marketing / selling and

distribution cost.

Functional Costs

• Functional cost Includes:

• Production cost

• Administration cost

• Selling cost

• Distribution costs

Fixed Costs & Variable Costs

• A fixed cost 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.

• Eg: Rent

Fixed Costs & Variable Costs

• A variable cost is a cost which tends to vary with

level of activity.

• Eg: Direct materials, sales commission

Fixed Costs & Variable Costs

• Many items of expenditure are part fixed and part

variable and hence are termed as semi fixed or

semi variable costs.

• Eg: telephone call charges

Production & Non Production

Cost

• For the preparation of financial statements, costs

are often classified as production costs and non

production costs.

Production & Non Production

Cost

• Production costs are all the costs involved in

the manufacture of goods. In the case of

manufactured goods, these costs consist of direct

material, direct labour and manufacturing

overheads.

Production & Non Production

Cost

• Non - Production costs are taken directly to the

income statement as expenses in the period in

which they are incurred; such cost consist of

selling and administrative expenses.

Controllable cost & Period cost

• Controllable cost

• Controllable costs are items of expenditure which

can be directly influenced by a given manager

within a given time span. OR

• A cost which can be influenced by its budget

holder.

Controllable cost & Period cost

• Period cost

• Period costs is charged against the sales for the

period. It is not carried forward in inventory to a

future period. OR

• A cost that relates to a time period which is

deducted as expenses for the period and is not

included in the inventory valuation.

Introduction to Cost Behaviour

• Cost behaviour is the way in which costs are

affected by changes in the volume of output.

• The basic principle of cost behaviour is that as the

level of activity rises, costs will usually rise. It

will cost more to produce 2,000 unit of output than

it will cost to produce 1,000 units.

Cost Behaviour Pattern

• Fixed cost

• A fixed cost is a cost which tends to be unaffected

by increases or decreases in the volume of output.

Cost Behaviour Pattern

• Examples of fixed cost include:

• The salary of the MD (per month or per annum)

• The rent of a single factory building (per month or

per annum)

• Straight line depreciation of a single machine

(per month or per annum)

Cost Behaviour Pattern

• Step cost

• A step cost is a cost which is fixed in nature but

only within certain level of activity.

Cost Behaviour Pattern

• Examples of step cost include:

• Basic pay of employees is nowadays usually

fixed, but as output rises, more employees are

required.

• Royalties

Cost Behaviour Pattern

• Variable cost

• A variable cost is a cost which tends to vary

directly with the volume of output. The variable

cost per unit is the same amount for each unit

produced.

Cost Behaviour Pattern

• Semi Variable cost

• A semi-variable/semi-fixed/mixed cost is a cost

which contains both fixed and variable

components and so is partly affected by changes

in the level of activity.

Cost Behaviour Pattern

• Examples of these costs include the following:

• Electricity and gas bill

• FC = standing charges

• VC = charge per unit of electricity used

• Cost of running car

• FC = road tax, insurance

• VC = petrol, oil, repair

Cost Behaviour Pattern

• Cost behaviour and cost per unit

• The following tables relates to different level of

production of the zed. The variable cost of

producing a zed is $5. Fixed costs are $5,000.

Cost Behaviour Pattern

• What happen when activity level rise can be

summarised as follows:

Cost Behaviour Pattern

• The variable cost per unit remain constant.

• The fixed cost per unit falls

• The total cost per unit falls

Determining the fixed & variable

elements of semi-variable cost

• The fixed & variable elements of semi variable

cost can be determined by the high low method.

• Steps in high low method are as follows:

Determining the fixed & variable

elements of semi-variable cost

Linear Equation

• A linear equation is a straight line and has the

general form

y = a + bx

• where

• y = is the dependent variable

• x = is the independent variable

• a = is a constant, that is fixed amount

• b = is also constant, being coefficient of x

Questions & Answers

Thank You

Ibrahim Sameer Seek knowledge from cradle to grave