TOPIC 11

ELEMENTS OF COST AND CLASSIFICATION OF COST

Cost comprises of three elements

i. Materials
ii. Labour
iii. Expenses

1. Materials

It’s divided into 2

a) Direct materials

This is material which enters into production process and becomes part of product. It’s material that
can be measured and charged directly into cost of products e.g. leather in shoes.

b) Indirect

It’s the ma

terial used in the course of manufacturing but cannot be traced as part of product e.g. threads, glue etc.

2. Labour

a) Direct labour

It consists of wages paid directly to the workers engaged in converting raw materials into finished
products.

b) Indirect labour

This is labour that does not alter the composition or condition of a product but contribute generally to
such work e.g. supervision, inspectorate etc.

3. Expenses

This include an expenditure other than material cost and labour cost.

a) Direct expenses

It an expense which can be identified to have occurred because of cost unit.

 b) Indirect expenses

This is an expense that cannot be identified with a specific cost unit, process or department.

These costs are incurred for the benefit of number of cost unit. It may be caused by the following
reasons:

i. Expense was incurred for the cost unit and is not convenient to allocate it to one cost unit.
ii. The management chooses to do so and classify the item of cost as indirect.

PRIME COST

It’s the aggregate of all direct costs i.e. direct materials, direct labour and direct expenses.

OVERHEAD COST

It’s the aggregate of all indirect cost i.e. indirect materials, indirect labour and indirect expenses.

Overhead is divided into:

a) Production overhead (factory overhead, manufacturing overhead)

These are overheads concerned with manufacturing/production function e.g. factory rent, repair and
maintenance of factory machinery, depreciation etc.

b) Administration overhead

It refers to cost of overhead incurred in managerial and administration function of the firm e.g. office
rent, salaries for accountancy services etc.

c) Selling and distribution overhead

These are included in securing orders and marketing products e.g. warehouse cost, salesmen salaries,
advertisement, delivery van expenses etc.

CLASSIFICATION OF COST

Classification cost is the process of grouping costs according to their formal characteristics.

i) Classification according to functions

On the basis of function we can classify cost into:

a) Manufacturing cost

Include material cost, factory, rent, depreciation on P.P.E, factory power, lighting etc
 b) Administration cost

These are costs that are generally administrative e.g. office expenses, audit fees, legal costs, office
salaries etc.

c) Selling and distribution cost

This Includes advertising, show room expenses, samples etc.

d) Research and development cost

These are costs for searching a new or improved products or methods. It comprises of wages and
salaries of research staff, materials used in laboratory departments, rent on research department etc.

ii) Classification according to identifiability with unit cost

These are costs that can be identified with a particular cost unit.

a) Direct cost

It is a cost that can be identified with particular direct cost e.g. direct materials.

b) Indirect cost

They are costs that cannot be specifically or conveniently identified with a specific cost unit.

iii) Classification according to type

a) Historical costs

These are costs ascertained when they have been incurred.

They are actual costs in that they have already been incurred.

b) Predetermined /future cost

These are future costs ascertained in advance of production on the basis of assumption or behavious of

a factor that affect this cost.

iv) Classification according to behavior /variability

a) Fixed cost
This cost remain fixed or unchanged and are not affected by production units. Fixed cost per unit
decreases as production increases and vice versa.

Cost fixed cost

Unit cost

Level of activity

Characteristics of Fixed Cost

i. Remain fixed within a relevant output range.

ii. Increase/decrease per unit of fixed cost when the quantity of output changes
iii. They are apportioned to products/departments on arbitrary basis.
iv. It cannot be controlled by to level management.

Variable cost

These costs vary in direct proportion to the volume of output such that when output increases variable
cost increases and vice versa.

When there is no production the variable cost will always be zero e.g. material cost, direct wages etc.

Cost V.C

Level of activity

Characteristics of a variable cost

 i. Variability of the total amount is in direct proportion to output level.
ii. Unit variable cost remains fixed irrespective of volume of output.
iii. Variable costs are controlled by functional managers.
iv. Variable costs are easily and reasonably allocated to departments or units.

Semi fixed /semi variable costs/mixed costs

These are costs that contain fixed and variable characteristic. They are partly affected by fluctuations in
production output and partly by fixed e.g. for electricity we pay a standing charge and other we stand.

v) Classification according to controllability

Controllable cost

These are costs which are directly regulated or controlled at a given level of management. This means
that the managers have the authority to incur or not to incur the expenditure.

a) Uncontrollable cost

These are costs which cannot be influenced by actions of a specified member of an enterprise. Fixed
costs are generally uncontrolled.

COST BEHAVIOUR

Break – even analysis /cost volume profit analysis

Managers are constantly faced with decisions about selling price and cost behavior. Unless they make
accurate predictions about behavior of cost and helps the management to make sound decisions.

Break even analysis is a system used to determine probable profit or loss at any given level of output. A
breakeven chart is a graph that shows profit or loss at any point of activity. Breakeven points are
volume of output or sales volume where total sales revenue is equal to total costs

It’s the point of zero profit or zero loss.

Total revenue
 Cost/revenue profit
Total cost curve

Breakeven point (s.h) -----------------------------

--
-- Fixed cost
loss --
--
--
Q1
Breakeven point-- (unit) No of unit
--
Level of activity

Production level of Q 1 units, the costs and revenue are equal signifying break even points.

TR = FC Total revenue =Fixed cost

TR = F.C + V.C Total revenue = Fixed cost + Variable cost

FC = T.R-V.C Fixed cost =Total revenue – Variable cost

Contribution level of Q 1 is the difference between the total revenue and total variable cost. In any
given organization, contribution shows the amounts available for fixed cost and profits.

B.e points in units

(Units) Breakeven point = Fixed cost

Contribution per unit

BEP = F.C

Contribution/unit (T.R – T.r.c)

B.e.p in sh = BEP (sh) = F.C x selling price (sh)

Contribution/unit

Breakeven point = Fixed cost x selling price

Contribution per unit

The following information was extracted from Brookside ltd. Selling price/unit is shs 12, fixed cost shs
12,000, variable cost/unit shs 9.

Required: Breakeven point in shs and in units

BEP in units = F.c

Contribution /unit

Contribution /unit = selling price – variable cost/unit = 12-9 =3

12000 = 4000 units

BEP in sh = FC x selling price = 4000 x 12 = 48000

Contribution /unit
Sales 4000 at 12 = 48000

Less variable cost at 9 = 36,000

Contribution 12,000

Less fixed cost 12,000

Net profit0

MARGIN OF SAFETY

It’s the difference between actual sales and sales at a breakeven point. It represents the extra sales that
a company can be able to make to safeguard against any loss.

Margin of safety = sales –Breakeven point (sales)

Margin of safety = sales – BEP (sales)

It’s expressed as a % by

M.O.S x 100 margin of safety x 100

Sales sales

Angle of incidence

- This is the angle that shows the rate at which profit are earned once breakeven points has been
achieved.
- It’s the angle between the total revenue curve and total cost curve at breakeven points.
- The wider the angle the greater the rate of profits and sales increase.
- It’s very important since it represents the expansion of the market.

T.R Angle of incidence

T.C

----
----
Cost/revenue ---------------------- ----
----
----
F.C
----
----
---
 Quantity
Q1 M.O.S sales Q 2

BEP/unit

Assumptions of Breakeven analysis (limitations/weakness)

i. All costs can be separated into fixed and variable components.

ii. Variable cost per unit remains constant and total variable costs varies in direct proportion with
output level.
iii. Fixed cost remain constant over a given output range of the breakeven charts.
iv. Price of factors of production remains constant.
v. Efficiency, productivity methods and techniques remain constant.
vi. Stock level are zero or do not change in periods under consideration.
vii. Volume is the only relevant factor affecting cost and revenue.
viii. There is only one product in the firm.
ix. Selling price remains constant over time.

Limitations of Breakeven Analysis

1. The assumption that all costs can be separated into fixed and variable components does not
hold some costs are mixed.
2. Assumption that fixed costs remain constant is unrealistic. Fixed costs are only constant within
a limited range of output thereby getting step up cost.

Cost set up cost

 3. The assumption regarding selling price being constant is very simplistic since at high production
level there are economies of scale that tend to bring price down.
4. Assumption for breakeven analysis that it can’t be used when we have more than one product is
unrealistic as most of companies engage in variety of commodities with the aim of minimizing
risk.
5. Ignores consideration of capital employed which will be an important factor in the study of
profit analysis.
6. Assumes that variable costs gives a straight line which is very simplistic, in real sense variable
cost tends to change with volume of production but not necessarily in direct production.

IMPORTANCE OF BREAKEVEN ANALYSIS

i. Helps to determine breakeven points and hence the number of units below which we should not
produce giving a zero profit.
ii. Helps to determine the selling price giving a desirable profit.
iii. Helps to fix the sales volume to give return for capital employed.
iv. Helps to determine cost and revenue at different levels of output.
v. Helps in the study of effects of changes in selling price or price differentiation in different
markets.
vi. Shows the impacts of an increase/decrease in selling price, fixed cost/variable cost on profit.
vii. It’s used as an aid to management decision e.g. make or buy decision with the help of cash
breakeven points.
viii. Used to determine cash requirement at different levels of operation with the help of cash
breakeven points.
ix. Helps to find out safety level at which we are operating.

Profit volume chart

It’s a graph that shows profits at different levels of sales. It’s an alternative presentation of the facts
illustrated in a breakeven chart.
Profit

Cost
B.E.P
Fixed cost loss unit