Cost classification
Almost everything else in MA (overhead absorption, marginal costing, budgeting, variances) assumes you can sort costs quickly and correctly. This sub-area gives you the vocabulary: what a cost is attached to, where it is collected, what kind of cost it is, and how it behaves when activity changes. Exam questions ask you to classify a cost, build up a cost card, describe a cost behaviour, or calculate total cost at a new output.
Cost objects, cost units and cost centres
- A cost object is anything you want to know the cost of: a product, a service, a department, a customer, a project.
- A cost unit is a unit of product or service to which costs are attached: a chair, a batch of 1,000 bottles, a hotel room-night. Services often use a composite cost unit made of two measures, such as the passenger-kilometre for a bus company or the patient-day for a hospital.
- A cost centre is a location, function or item of equipment where costs are collected before being related to cost units: the machining department, the canteen, the stores.
Responsibility centres
A responsibility centre is a part of the organisation whose manager is accountable for its performance. The type depends on what the manager controls.
| Centre | Manager is responsible for | Information the manager needs |
|---|---|---|
| Cost centre | Costs only | Actual costs against budget, by type of cost |
| Revenue centre | Revenues only | Sales against budget, by product, region or customer |
| Profit centre | Costs and revenues, so profit | Revenues, costs and profit against budget |
| Investment centre | Profit and the capital invested to earn it | Profit plus measures relating profit to capital employed, such as return on investment |
Judge each manager only on what they can control.
Classification by function
Costs are grouped by the activity that causes them:
- Production (or manufacturing): materials, factory wages, factory rent and power.
- Administration: office salaries, accounts and head office costs.
- Selling: sales salaries and commission, advertising.
- Distribution: warehousing and delivery to customers.
- Finance: interest on loans and overdrafts.
Production costs become part of the cost of inventory. The others are non-production costs, charged against profit in the period they arise.
Direct and indirect costs
A direct cost can be traced in full to a single cost unit. An indirect cost (an overhead) is shared by many cost units and cannot be traced to any one of them.
| Direct | Indirect (overhead) | |
|---|---|---|
| Materials | Wood in a chair; fabric in a shirt | Glue, cleaning materials, lubricants |
| Labour | Wages of the workers making the product | Supervisors, maintenance staff, storekeepers |
| Expenses | A royalty paid per unit made; hire of equipment for one job | Factory rent, insurance, depreciation of machinery |
The cost of a unit is then built up in layers:
| Layer | Made up of |
|---|---|
| Prime cost | Direct materials + direct labour + direct expenses |
| Production cost | Prime cost + production overheads |
| Total cost | Production cost + administration, selling, distribution and finance costs |
Classification by behaviour
Cost behaviour describes how a cost changes as the level of activity (output, hours, sales) changes. It is essential for budgeting and decision-making.
| Behaviour | Total cost as activity rises | Cost per unit as activity rises | Typical example |
|---|---|---|---|
| Variable | Rises in proportion | Stays the same | Raw materials, piecework wages |
| Fixed | Stays the same within the relevant range | Falls | Rent, a manager's salary |
| Stepped fixed | Fixed over a range, then jumps to a new level | Falls within each step, rises at each jump | Supervisors, each able to oversee a set number of workers |
| Semi-variable (mixed) | Rises, but from a fixed base | Falls, but less steeply than a fixed cost | Electricity: a standing charge plus a rate per unit used |
On a graph of total cost against activity, a variable cost is a straight line through the origin, a fixed cost a horizontal line, a stepped cost a staircase, and a semi-variable cost a sloping line starting above zero.
A fixed cost is fixed only within the relevant range of activity and over a short period. Area B shows how to split a semi-variable cost into its fixed and variable parts.
Cost codes
A cost code is a short reference that records what a cost is and where it belongs, so the accounting system can sort and report it. In 21-410, for example, 21 might be the machining cost centre and 410 indirect materials. Good codes are unique, consistent, simple and leave room for new items; a wrong code makes every report built on it wrong.
Worked example
Jos Furniture Co makes wooden chairs. In March it made 2,000 chairs and incurred these costs:
| Item | $ | Classification |
|---|---|---|
| Timber used in production | 84,000 | Direct material |
| Glue, screws and polish | 3,200 | Indirect material: production overhead |
| Wages of the carpenters | 56,000 | Direct labour |
| Factory supervisor's salary | 6,500 | Indirect labour: production overhead |
| Royalty to the chair's designer, per chair made | 2,800 | Direct expense |
| Factory rent | 12,000 | Production overhead |
| Depreciation of factory machinery | 4,500 | Production overhead |
| Factory electricity | 3,100 | Production overhead |
| Office salaries | 15,000 | Administration |
| Sales commission | 5,600 | Selling |
| Delivery van running costs | 3,400 | Distribution |
| Interest on bank loan | 2,000 | Finance |
Step 1: build the cost.
| $ | Per chair $ | |
|---|---|---|
| Direct materials | 84,000 | 42.00 |
| Direct labour | 56,000 | 28.00 |
| Direct expenses | 2,800 | 1.40 |
| Prime cost | 142,800 | 71.40 |
| Production overheads (3,200 + 6,500 + 12,000 + 4,500 + 3,100) | 29,300 | 14.65 |
| Production cost | 172,100 | 86.05 |
| Administration | 15,000 | 7.50 |
| Selling and distribution (5,600 + 3,400) | 9,000 | 4.50 |
| Finance | 2,000 | 1.00 |
| Total cost | 198,100 | 99.05 |
Step 2: predict behaviour at 3,000 chairs. Timber is variable at $42 a chair. Rent is fixed. One supervisor can oversee up to 2,500 chairs a month, so a second is needed above that. Electricity is semi-variable: $1,500 a month plus $0.80 a chair.
| Cost | Behaviour | At 2,000 chairs $ | Per chair $ | At 3,000 chairs $ | Per chair $ |
|---|---|---|---|---|---|
| Timber | Variable | 84,000 | 42.00 | 126,000 | 42.00 |
| Factory rent | Fixed | 12,000 | 6.00 | 12,000 | 4.00 |
| Supervision | Stepped fixed | 6,500 | 3.25 | 13,000 | 4.33 |
| Electricity | Semi-variable | 3,100 | 1.55 | 3,900 | 1.30 |
Notice the per-unit column: only the variable cost stays constant per chair. The stepped cost per chair actually rises here, because output crossed a step.
Common mistakes
- Calling factory rent or a supervisor's salary a direct cost. If it cannot be traced to one unit, it is an overhead.
- Including production overheads in prime cost. Prime cost is direct costs only.
- Saying a fixed cost per unit is constant. Total fixed cost is constant; the cost per unit falls as output rises.
- Treating a cost as fixed at any output. Fixed costs are fixed only within the relevant range.
- Confusing a cost centre (where costs are collected) with a cost unit (what costs are attached to).
Exam technique
For classification questions, ask two questions in order: can this cost be traced to one unit (direct or indirect)? Which function causes it (production or non-production)? For behaviour questions, check what happens to the total and to the cost per unit separately, because options often describe one correctly and the other wrongly. When asked for total cost at a new output, list each cost with its behaviour first, then calculate.
Study with AI
I am studying ACCA Management Accounting (MA), cost classification. Give me twelve
costs from a manufacturing or service business, one at a time. For each, ask me to
say whether it is direct or indirect, which function it belongs to, and whether it
is fixed, variable, semi-variable or stepped. Wait for my answer, then correct me
with a one-line reason.AI assistants can misclassify borderline costs: check every answer against the definitions in these notes.
Lecturer's note: Keep two questions apart. "Direct or indirect?" is about traceability to one unit; "fixed or variable?" is about behaviour as activity changes. They are independent: a royalty per unit is direct and variable, factory rent is indirect and fixed, electricity is indirect and semi-variable. Students who merge the two ideas ("overheads are fixed, direct costs are variable") get caught every time.
Key points
- A cost unit is what costs are attached to; a cost centre is where costs are collected; services often use composite cost units.
- Cost, revenue, profit and investment centres differ in what the manager controls, and so in the information they need.
- Prime cost is direct costs only; production cost adds production overheads; total cost adds non-production costs.
- Variable costs are constant per unit; fixed costs are constant in total within the relevant range; stepped and semi-variable costs combine the two patterns.
- Cost codes let the system sort and report costs; wrong codes mean wrong reports.
Quick check
- Classify each cost for a clothing manufacturer: fabric used in shirts; the factory cleaner's wages; a salesperson's commission.
- A semi-variable cost is $14,000 at 5,000 units and $20,000 at 8,000 units. What will it be at 6,000 units?
- A manager is responsible for a division's revenues, costs and decisions to buy new equipment. What type of responsibility centre is this?
Answers
- Fabric: direct material (production). Cleaner's wages: indirect labour, so production overhead. Commission: selling cost (non-production).
- Variable cost per unit = ($20,000 − $14,000) ÷ (8,000 − 5,000) = $2. Fixed element = $14,000 − (5,000 × $2) = $4,000. At 6,000 units: $4,000 + (6,000 × $2) = $16,000.
- An investment centre: the manager controls profit and the capital invested.