Cost units, Cost

Classification and
Profit
Reporting
Introduction to costs

• Let us suppose you bought newspaper for shs 60. Why does the
newsagent charge 60 for it? In other words what does that 60
represent?
• From the newsagent's point of view the cost can be split into two.

Price paid by newsagent to Z

wholesaler
Newsagent's 'mark-up Y
60
• If the seller did not charge more for the iem than he paid for it (Y)
there would be no point in him selling it.
• The mark-up itself can be split into further categories

Pure profit X
Amount paid to shop assistants X
Expenses of owning and operating a X
Shop
(rent, electricity, cleaning and so on)
Gross profit Y
Cost units

• A cost unit is a unit of product or service to which costs can be

related.
• Examples of cost units include the following.
– Room (in a hotel)
– Batch of 1,000 shoes
– Patient night ( the cost of a patient staying in a hospital for a night)
 QUESTION
Roux Co is a furniture company which manufactures chairs, tables and
beds. There are stages (and three corresponding machines) involved in
the production of the furniture - cutting, assembly and finishing.
Which of the following costs would be classified as a cost unit of Roux
Co?
A. The cutting machine
B. All three machines
C. The supervisor of the assembly department
D. A chair
Cost classification

• Grouping of costs under common characteristics.

• Examples include;
– direct or indirect costs,
– fixed or variable costs.
 Nature and Types of Cost
Classification
• Behaviour. This is important when it comes to budgeting as it is
essential to be able to predict how costs are likely to change.
• Location. For example, costs incurred in the factory are relevant to
working out the cost of production.
• Function. For example costs related to research and development,
marketing, training, manufacturing.
• Person responsible for their control. For example, the managers
of a branch might be held responsible for the costs incurred there.
• Type. For example, material, labour, other production expenses,
such as the cost of running machinery.
• Traceability. Are they direct or indirect? Direct costs are closely
related and traceable to each item produced. Indirect costs are not
so easy to relate and trace to each unit of production.
Cost Card - Cake
Kshs Kshs

Direct material: Wheat flour x

Milk x

Direct labour: Machine operators' wages x

Manual assembly staff wages x

Other direct expenses x

Prime cost/Total direct cost X

Indirect expenses/production overhead x

Production cost/factory cost X

Non-factory cost/non-production cost X

Product cost X
Direct and indirect costs

• 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.
• Materials, labour costs and other expenses can be classified as
either direct costs or indirect costs.
1. Direct material costs

These are the costs of materials that are known to have been used in
making and selling a product (or even providing a service).
Example:
• Component parts, specially purchased for a particular job, order
or process
• 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
• Primary packing materials like cartons and boxes
2. Direct labour costs

These are the specific costs 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.
Example
• Workers engaged in altering the condition or composition of the
product
• Inspectors, analysts and testers specifically required for such
production
• Foremen, shop clerks and anyone else whose wages are
specifically identified
3. Other direct expenses

Those expenses that have been incurred in full as a direct

consequence of making a product, or providing a service, or running
a department.
Example:
• The hire of tools or equipment for a particular job
• Maintenance costs of tools, fixtures
Production overhead

• The factory will also have indirect costs or factory overheads

which are not directly traceable to the product but are still part of
the cost of making it.
– Indirect materials which cannot be traced in the finished product.
Consumable stores, e.g. material used in negligible amounts
– Indirect wages, meaning all wages not charged directly to a product.
Wages of non-productive personnel in the production department,
e.g. foremen
– Indirect expenses (other than material and labour) not charged
directly to production.
• Rent, rates and insurance of a factory
• Depreciation, fuel, power, maintenance of plant, machinery
and buildings
Analysis of total cost
• Non-manufacturing overheads;
– Also referred as non-production cost, non-factory cost.
– not included in the production cost of goods or for inventory
valuation purposes.
– An appropriate portion of these overheads is sometimes included on
the cost card so that an appropriate price can be set.
• Examples include:
– The accountant's salary (a non-manufacturing labour cost)
– The office rent (non-manufacturing expenses)
 Example

Canine Co makes dog leads. It buys in leather, thread and metal clips to
make them, employs people to operate stitching machines and assemble
the finished leads and has various running costs (overheads) for the
rented factory space it uses.
Which of the following costs would be classified as indirect labour?
A. Dog lead clip
B. Factory rent
C. Wages for machine operator
D. Wages for factory manager
Cost Behaviour

• Cost behaviour patterns demonstrate the way in which costs are

affected by changes in the level of activity.
• It is the way that costs change as the level of activity changes.
• 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.
• A variable cost is a cost which tends to vary with the level of
activity.
1. Variable costs

• These are directly proportional to the level of activity/units of

production.
• If the number of units produced doubles, then variable production
costs will double also.
• An example;
– The cost of raw materials
– Direct labour costs
– Sales commission
Graph of total variable cost
 ii. Fixed costs

• It’s a cost which tends to be unaffected in total by increases or

decreases in the volume of output.
• Fixed costs are a period charge, in that they relate to a span of time; as
the time span increases, so too will the fixed costs
• Examples;
– The salary of the managing director (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)
Graph of total fixed cost
iii. Stepped-fixed costs

• Costs which are fixed in nature within certain levels of activity.

• Rent will increase if a new factory is leased.
Graph of total stepped-fixed
cost
Mixed costs (or semi-variable costs
or semi-fixed costs)
• Mixed costs (semi-variable/semi-fixed costs) are partly fixed and
partly variable, and therefore only partly affected by changes in
activity levels.
Example: KPLC electricity bill
Graph of total semi-variable
cost
 Example
Hans has a fleet of company cars for sales representatives. Running costs have
been estimated as follows.
a) Cars cost $12,000 when new, and have a guaranteed trade-in value of $6,000
at the end of two years. Depreciation is charged on a straight-line basis.
b) Petrol and oil cost 15 cents per mile.
c) Tyres cost $300 per set to replace; replacement occurs after 30,000 miles.
d) Routine maintenance costs $200 per car (on average) in the first year and $450
in the second year.
e) Repairs average $400 per car over two years and are thought to vary with
mileage. The average car travels 25,000 miles per annum.
f) Tax, insurance, membership of motoring organisations and so on cost $400 per
annum per car.
Required
Calculate the average cost per annum of cars which travel 15,000 miles per annum
and 30,000 miles per annum.
Functional costs

• Costs can also be analysed according to their function.

– Production,
– distribution and selling,
– administration and
– financing costs.
Calculating the cost of a
product
• The cost of a product or service can be built up on a cost card,
which identifies:
– Direct costs
• Prime cost (sum of direct costs)
– Production overheads
• Production costs
– Non-production overheads
• Total cost/product cost
 QUESTION 5
Skeggy Co makes 20,000 Braces per year.
Each Brace requires ½ hour of labour at $5 per hour and 3 bought-in
components, costing $1.25, $2 and 40c each respectively.
The packaging for the Brace costs $16 for 100 boxes.
The business incurs fixed production costs of $4,000 per annum, and the
cost of selling, administration and distribution works out at 50c per item
sold.
Calculate the production cost and the total cost of a Brace and record this
information on a cost card.
Example

A product that a company manufactures requires:

― 3kg of material A costing $6.20 per kg and
― 4kg of material B costing $5.60 per kg.
The product requires 2 hours of labour at a cost of $7.40 per hour.
The product is sold in packs of 10 and the packaging for 10 units costs $22.
Fixed production costs are $60,000 per annum and selling, distribution and
administration costs are $24,000 per annum.
The company makes 15,000 units of the product each year.
Calculate:
– Prime cost
– Production cost
– Product cost
Analyses of Costs

• The fixed and variable elements of semi-variable costs can be

determined by the high-low method.
• It is generally assumed that costs are one of the following.
– Variable
– Semi-variable
– Fixed
High-low method
Example
Example