Lesson 2 : Classification of costs

2.0 Introduction
It is very important to know the various classifications of costs and revenues for
effective application of cost and management accounting techniques for various
purposes within an organization. Successful application of cost accounting techniques
requires a very clear distinction of different cost terms used in business operations and
how costs are classified. This lesson looks into those aspects very deeply and intends
to provide a lucid picture about them.

2.1 Basic terms used in cost accounting:

2.1.1 Cost:
Cost measures the resources used or foregone to achieve a particular objective. The
total costs consist of the expenditure actually incurred or notional (estimated or
hypothetical) charges. Example for notional charge is the rent for the firm’s own
building.
CIMA has defined the cost as follows:

Cost:
“The amount of expenditure (actual or notional) incurred on, or
attributable to, a specified thing or activity” – CIMA definition.

2.1.2 Cost Object

Any firm needs resources to carry out any activity or business operations. These
resources can be measured in monetary terms. However, the traceability of such
utilization of resources will be difficult. The term cost object is used with respect to the
traceability of costs. Cost object is defined as anything to which costs can be traced.
For example, a bakery produces number of food items, such as bread, buns, cake,
rusks etc. If the bakery wants to know the cost of each item separately, the each item
is known as a cost object. Therefore, cost object must be identified by the user of
information and it could be a product, service, department, division etc.
Cost object is sometime referred in the old literature as cost objective also. For
instance, Drury (1995: p-18) defined it as follows:

BBA224 CDCE‐University Of Peradeniya Page 1

“A cost objective is any activity for which a separate measurement of costs is desired.
In other words, if the users of accounting information want to know the cost of
something, this something is called a cost objective”

Some Examples for a cost object:

¾ Cost of a good produced
¾ Cost of a service rendered
¾ Cost of running a division of a firm
¾ Cost of maintaining a particular sales area

2.1.2 Cost unit:

Cost unit is a specific type of cost object (or cost objective). It is used for the purpose
of cost ascertainment. There can be one or more cost units in a firm. If any firm wants
to ascertain cost for its products or services, it is necessary that the firm should be
able ascertain (determine, establish or find out) costs to those products or services.

Cost unit:
“A quantitative unit of product or service in relation to which
costs are ascertained” – CIMA definition.

2.1.3 Cost centre:

A cost centre is also a specific type of cost object. It is one of the responsibility
centres. Responsibility centre is an individual areas of responsibility as specified in a
firm’s organization structure. It is headed by a manager who is responsible for the
activities of that unit. There are three types of responsibility centre.
i. Cost Centre
ii. Revenue Centre
iii. Investment Centre

Cost Centre is a unit or department or location or function for which cost is ascertained
before attributing to a specific cost unit.

Cost centre:
“A location, function or items of equipment in respect of which costs may be
ascertained and related to cost units for control purposes” – CIMA definition

BBA224 CDCE‐University Of Peradeniya Page 2

2.2 Elements of costs:
In measuring the product cost the following cost elements can be identified. :
1. Materials
2. Labour
3. Expenses

All these elements can be separated into direct cost and indirect cost. Direct costs are
the costs which can be traced or charged directly to the products or services whereas
the costs which cannot be traced or charged directly to the products or services are
known as indirect costs. Therefore, costs are classified into direct and indirect costs
depending on their traceability to the cost object. All direct costs form prime costs and
the all indirect costs are known as overheads. This is presented in the figure given
below.

Materials = Direct materials + Indirect materials

Labour = Direct labour + Indirect labour
Expenses = Direct expenses + Indirect expenses
Total Cost = Prime cost + Overheads

2.2.1 Prime costs:

Prime costs are said to be variable costs. This statement is not true when any element
of the prime costs consist of any fixed costs. For example, if the part of direct labour
costs consists of monthly salary for labourers, then the prime costs will become semi-
fixed or semi-variable costs.

2.2.2 Overhead costs:

Overhead costs can be divided into the following categories based on the functions of
any manufacturing firm and they may consist of variable as well as fixed components:

Production/(manufacturing) overheads (POH/MOH)= Variable POH + Fixed POH

Administration overheads (AOH) = Variable AOH + Fixed AOH
Selling & distribution overheads(SDOH) = Variable SDOH + Fixed SDOH
Research
Total & take
costs can development overheads (RDOH)
various forms: = Variable RDOH + Fixed RDOH

BBA224 CDCE‐University Of Peradeniya Page 3

Therefore, total costs can be written many ways. For example:

Total costs = Variable costs + Fixed costs.

Total costs = Manufacturing costs + Non-manufacturing costs
Total costs = Prime costs + Overheads

Note:
Variable costs= Variable material costs + Variable labour costs + Variable expenses
Fixed costs = Fixed material costs + Fixed labour costs + Fixed expenses
Manufacturing costs = Prime costs + Production overhead costs
Non-manufacturing costs = Total costs – manufacturing costs

Cost of production = Prime costs + Production overheads

Relevant range, Fixed costs and variable costs:

Relevant range is the range of activity within which costs behave as predicted. Outside
this level of activity, costs behave differently. This is not a concept that can be
determined from a textbook. Observation of the actual costs must be done in order to
determine this range.

2.2.3 Variable cost

Variable cost (VC) is a function of number of units produced/sold.
i.e., VC = ∫ (output)
Total variable costs vary in direct proportion to changes in number of units within the
relevant range of level of activity whereas variable cost per unit remains unchanged.
Variable costs consist of variable material costs, variable labour costs, and variable
expenses. The other categories of variable costs are prime costs, variable production
overheads, variable administration overheads, variable selling, & distribution overheads
etc. As mentioned earlier, prime cost is basically known as variable costs. The other
name of the variable cost is marginal cost.

BBA224 CDCE‐University Of Peradeniya Page 4

2.2.4 Fixed cost
Fixed cost (FC) is a function of time. i.e., FC = ∫ (relevant range of activity). Relevant
range of activity is the range of output in which the total fixed costs is constant.
Therefore, fixed costs per unit decreases when output increases within the relevant
range of output. In economics, fixed costs means the costs incurred on the fixed assets
whereas in accounting, fixed costs means the costs which do not change within the
relevant range of activity. For examples: fixed monthly salary to the factory supervisor,
monthly rent for factory building, annual insurance premium etc.

2.3 Classification of costs:

Costs are broadly classified for the following purposes.

™ Costs for stock valuation and profit measurement

™ Costs for decision -making
™ Costs for controlling

2.3.1 Costs for stock valuation and profit measurement:

¾ Product costs and Period costs

¾ Manufacturing costs (Prime costs +Production overhead costs)
¾ Job costs and process costs

2.3.1.1 Product cost and period cost

Product cost or Inventoriable costs are all costs of a product. These costs are
direct materials, direct labor, and factory overhead. They become a part of the cost of
the product and are assets until sold, when they become cost of goods sold.
Period costs are all costs on the income statement other than cost of goods sold.
Period costs are treated as expenses of the period in which they are incurred.

2.3.1.2 Job costing and process costing

A job-costing is used by a company to distinctly ascertain the cost of the product or
service which is called a job. The product or service is often a single unit. The job is
frequently the cost object. Costs are accumulated separately for each job or service.

BBA224 CDCE‐University Of Peradeniya Page 5

A process-costing is used by a company that makes a large number of identical
products. Costs are accumulated by department and divided by the number of units
produced to determine the cost per unit. It is an average cost of all units produced
during the period. The cost object is masses of similar units of a product or service.

2.3.2. Costs for decision -making

¾ Costs related to their behavior (Variable costs, Fixed costs, Semi-

fixed or Semi variable costs)
¾ Relevant costs and Irrelevant costs
¾ Avoidable costs and unavoidable costs
¾ Sunk costs
¾ Opportunity costs

2.3.2.1 Relevant cost and irrelevant cost

A relevant cost is a cost that differs, in total, between the alternatives. Any cost that
does not differ between the alternatives is irrelevant and can be ignored. Relevant
costs are also known as differential costs.

2.3.2.2 Avoidable costs and unavoidable costs

Avoidable costs are those costs that can be eliminated in whole or in part by choosing
one alternative over another. Avoidable costs are relevant costs.

2.3.2.3. Sunk costs

Sunk costs are the cost that has been already incurred before making the decision.
Therefore sunk cost has no relevance to the decisions alternatives and does not cause
for incremental costs. Hence sunk cost becomes irrelevant for decision making. For
instance, if a firm wants to decide between two uses of a building constructed by it
such as either to rent it out or to use as the stores, the cost of building has been
already incurred and therefore that cost is irrelevant for any of the decisions.

2.3.2.4 Opportunity costs

This is basically the cost of next best forgone opportunity and therefore it is relevant
for the decision making. However, the opportunity cost is not accounted in the books
as an expense but is considered for decision making.

BBA224 CDCE‐University Of Peradeniya Page 6

2.3.2.5 Marginal costs and incremental costs (differential costs)
Marginal cost:
The term “marginal cost” is used in economics and accounting. Though the marginal
cost is conceptually the same in the both field of study, there is a significant difference
between them. In accounting, marginal costs means the costs that arise due to a extra
single or a group of additional production or sale whereas, in economics, marginal
costs represent the costs that arise from an extra single unit of production or sale.
Marginal cost of production = Prime costs + variable production overhead costs
Marginal total costs = Prime costs + all variable overhead costs

2.3.3 Cost for controlling

¾ Costs related to their behavior (Variable costs, Fixed costs,

Semi-fixed or Semi variable costs)
¾ Controllable costs and uncontrollable costs

2.3.3.1 Controllable costs and uncontrollable costs

Controllable costs are costs that can be controlled by the decision maker. For
example, cost of labour is a controllable cost as managers can decide what type of
labourers and how many labour hours are used. Therefore controllable costs are
relevant for decisions.
Uncontrollable costs are the cost which cannot be controlled by the decision maker.
For instance, income tax expense imposed or any unexpected cost that would occur
due to a natural hazard.

Go to the PowerPoint presentation of this lesson

BBA224 CDCE‐University Of Peradeniya Page 7

 3.0 Summary:
Total Costs can be classified into forms. When dividing costs, it is
necessary to know for which purpose the total costs are
separated/ divided. Basically, costs are classified into various
forms based on the three cost objectives, namely stock valuation,
decision-making and controlling.

THE END

BBA224 CDCE‐University Of Peradeniya Page 8