Cost Classification by Element, Function and Behaviour

Before a business can control or plan its costs, it has to be able to say what its costs are, what they are for, and how they behave when activity changes. This topic sets the foundation for the whole course.

It explains why organisations need cost information, defines the key terms (cost object, cost unit and unit cost), and shows the main ways of classifying costs: by element, by function and by behaviour.

Examiners test these ideas with definitions, short classification questions (“state whether each cost is a production, administration or selling cost”), small calculations with fixed, variable, mixed and stepped costs, and a functional income statement. This page covers every point the syllabus makes, with worked numbers, so that you can answer any question in this area with confidence.

Types of organisation and their costing systems

It helps to start by sorting organisations into two groups: manufacturing organisations and service organisations. The kind of output decides which costing system fits best.

Manufacturing organisations

Service organisations

Service organisations include training and education, healthcare, travel and tourism, financial services, and entertainment and leisure. The main difference from manufacturing is tangibility. Manufactured goods can be touched and stored. A service is usually intangible and is consumed at the time it is delivered, as when a patient receives a consultation from a doctor.

Some work-in-progress may still exist. An accountant who has spent 10 hours on a tax advice project that will take 20 hours in all has 10 hours of work-in-progress at that point.

Costing systems found in service organisations include standard costing (for example, the standard cost of a doctor’s consultation, a package holiday or a flight between Lagos and London) and job costing (for example, a bespoke consultancy project in financial services, or an architect designing a ship). In job costing, the professional normally charges a standard hourly rate, while the number of hours on each job varies.

Why organisations need cost information

Every organisation needs to know how much it costs to make its products or to provide its services.

Key terms: cost object, cost unit and unit cost

• Cost object: any activity for which a separate measurement of cost is needed. It could be a product, a service, a department or a project.
• Cost unit: a unit of product or service for which costs are determined. It is the basic unit of output for which cost is measured.
• Unit cost: the cost of producing, storing and selling one unit of a particular product. It includes all the fixed and variable costs involved.

Do not confuse cost unit (the unit we measure, such as a tonne of steel) with unit cost (the amount of cost per unit, such as ₦180,000 per tonne). Cost objects and cost units should be chosen so that they give management the information it needs.

One organisation can have several cost objects. A juice company that makes orange juice and pineapple juice has two cost objects, and its cost units are the production cost per carton of each. A courier firm might measure its cost in three ways: per vehicle per month (cost object: vehicles), per delivery route per month (cost object: routes), and per rider employed (cost object: riders).

Ways of classifying costs

Costs can be grouped in several ways, and the groupings are not mutually exclusive.

• By element: material, labour and other expenses.
• By function: production, and non-production (selling, distribution, administration and finance).
• By behaviour: how cost changes with the level of activity, as fixed or variable.
• By traceability: whether the cost can be attributed directly to units of production (direct or indirect). The next topic covers this.
• By treatment in the accounts: whether the cost is charged in this period (a period cost) or carried forward in inventory (a product cost). The next topic covers this too.

Take the steel used by a car maker. Steel is a material. It is a production cost because you cannot make a car without it. It is a variable cost, because more cars need more steel. It is a direct cost, because it can be traced to a particular car. And it is a product cost. One item, five labels.

Classification by element

There are three basic elements of cost.

A cost accounting system must record all these items in an organised way, and similar items must be grouped into categories.

Classification by function

A manufacturer splits costs into production (manufacturing) costs and non-production (non-manufacturing) costs.

Production costs

These are the costs of making finished goods, up to the point where manufacture is complete and the goods are moved to finished goods inventory or delivered straight to the customer. They include raw materials and components, the labour of everyone working in manufacturing (machine operators, supervisors, the factory manager), and other factory expenses such as factory rent, energy and depreciation of machinery.

Non-production costs

Finance costs may be treated as part of administration costs. Alternatively they may be left out of the cost accounting system altogether, because they matter for financial reporting but not for measuring the cost of products.

Costs shared between functions

Some costs belong partly to production, partly to administration and partly to selling and distribution. The salary of the managing director is an example, because the managing director spends time on every part of the business. So is the rent of a building shared by administration and sales staff. Such costs are divided between the functions on a fair basis.

Dividing common costs fairly is called apportionment. For example, the managing director’s salary might be split equally into three: manufacturing, administration and sales and distribution.

Classification practice

Why classify by function?

Functional costs show managers what each function is expected to spend (budget) and what it actually spends. They also show how profit is made up. A functional income statement for a firm with sales of ₦750m looks like this:

Why production and non-production costs must be kept apart

A manufacturer must value its closing inventory, which consists of finished goods not yet sold and work-in-progress (partly finished goods). The cost of both is made up of production costs only. Total production cost in a period has therefore to be shared between goods made and sold, goods made but unsold, and work-in-progress. Non-production costs are never included in the cost of inventory.

How profit is reported: the manufacturing account

A manufacturer’s cost of sales is built from the cost of goods made, not from purchases. The cost of goods made is found in a manufacturing account. It combines direct materials used, direct labour and production overheads, adjusted for the change in work-in-progress. The result is then carried to the statement of comprehensive income (income statement). A typical layout, with sample figures, is:

In the income statement that follows, with sales of ₦600,000, opening finished goods of ₦40,000 and closing finished goods of ₦55,000, the cost of sales is ₦40,000 + ₦227,000 − ₦55,000 = ₦212,000. Gross profit is ₦388,000. After administration costs of ₦70,000 and selling and distribution costs of ₦85,000 (total ₦155,000), net profit is ₦233,000.

Classification by cost behaviour

Cost behaviour is the way costs change when the volume of activity changes. The measure of activity depends on the situation. It may be sales volume, production volume, labour hours, machine hours, units inspected, or journeys and deliveries. In general, total costs rise as activity rises.

Managers need to understand cost behaviour in order to forecast what costs ought to be and to compare actual costs with what they should have been. The most important division for cost estimation is into fixed and variable costs.

Fixed costs

A fixed cost stays the same in total during a period, whatever the volume of activity. A fixed cost is stated for a period and scaled up for longer periods. Rent of ₦65,000 a month is ₦780,000 a year. A salary of ₦30,000 a month is ₦360,000 a year. As activity rises, the total stays fixed but the cost per unit falls, because the same amount is spread over more units.

Variable costs

A variable cost rises, usually by the same amount, for each extra unit of product or service. The variable cost of a unit is also called its marginal cost. Total variable cost rises in direct proportion to activity, while cost per unit stays constant. Examples:

• Cement at ₦9,000 a bag: 200 bags cost ₦1,800,000 and 500 bags cost ₦4,500,000.
• Hourly paid labour at ₦200 an hour: 250 hours cost ₦50,000 and 400 hours cost ₦80,000.
• A product needing 6 minutes of labour at ₦200 an hour has a direct labour cost per unit of ₦200 × 6/60 = ₦20.
• Bulk text messages at ₦4 each: 5,000 messages cost ₦20,000.

Semi-variable (mixed) costs

A semi-variable cost is partly fixed and partly variable. It has a fixed minimum amount each period plus a variable amount for every unit of activity. A phone plan that costs ₦3,000 a month plus ₦5 a minute costs ₦3,000 + (2,400 × ₦5) = ₦15,000 for 2,400 minutes. In management accounting it is often assumed that total costs, or total selling and distribution costs, are mixed costs.

If so, they can be separated into a fixed part and a variable part, which makes cost forecasting simple. For example, if a factory’s costs are ₦180,000 fixed per month plus ₦45 per unit, then for 80,000 units next month total cost is (80,000 × ₦45) + ₦180,000 = ₦3,600,000 + ₦180,000 = ₦3,780,000.

Stepped costs

A stepped fixed cost is fixed within a limited range of activity and then goes up or down in steps when activity passes certain levels. For example, security guards paid ₦25,000 a month each:

Cost behaviour graphs

The syllabus also asks students to sketch graphs for nine cost items.

The key shapes are:

• an annual rates bill (fixed, flat)
• direct labour (variable, straight line from zero)
• an annual telephone bill (semi-variable, with a fixed line rental plus charges for calls)
• direct materials with a bulk discount on all purchases once a level is passed (a rising line that drops back or becomes flatter at the discount point)
• supervisory costs (stepped)
• labour paid a fixed weekly wage for a 35-hour week with overtime at time and a half (flat up to 35 hours, then rising more steeply)

A mixed cost with a step: worked case

Suppose a cost graph shows total cost of ₦9,000 at zero output and ₦15,000 at 3,000 units, and then a jump to ₦19,000 at 3,000 units just after a step, with the same slope afterwards. The item is a mixed cost. Up to 3,000 units, fixed costs are ₦9,000 and variable cost per unit is (₦15,000 − ₦9,000) ÷ 3,000 = ₦2. At 3,000 units fixed costs step up by ₦4,000 (from ₦15,000 to ₦19,000 total), so fixed costs become ₦13,000 while the variable cost per unit stays at ₦2. At 7,000 units total cost is variable (7,000 × ₦2 = ₦14,000) plus fixed ₦13,000 = ₦27,000.

The ideas in more depth

Fixed cost per unit falls, variable cost per unit stays put

The most common exam error is confusing total cost with unit cost. Take rent of ₦40,000 a month and a variable cost of ₦150 per unit.

Fixed cost per unit halves each time output doubles, which is why higher output usually lowers the full unit cost. Total variable cost doubles when output doubles.

Fixed does not mean fixed forever

A cost is fixed only within a time period and a relevant range of activity. If the factory must be enlarged to double output, rent will rise. That is why the stepped cost idea matters. For short-term decisions managers normally treat costs as fixed within the planned range.

Why the three element headings are not enough

The element classification tells you what was bought. The functional classification tells you why the firm spent it, and so it controls whether the cost is placed in inventory. The behaviour classification tells you how it responds to activity, which is what forecasts and budgets require. Good cost accounting uses all three at once.

Estimating the cost of a service

Service businesses apply the same ideas. A training college has fixed costs (building, permanent lecturers) and variable costs (printed materials per student). Its cost unit might be cost per student. As student numbers rise, cost per student falls until a new classroom or lecturer is needed, which is a step.

Worked example: classify, then build the profit statement

1. Raw materials consumed:
   ₦18,000 + ₦120,000 − ₦14,000 = ₦124,000.
2. Prime cost:
   ₦124,000 + ₦80,000 wages = ₦204,000.
3. Production overheads:
   ₦30,000 + ₦26,000 = ₦56,000.
4. Manufacturing cost:
   ₦204,000 + ₦56,000 = ₦260,000.
5. Cost of goods made:
   ₦260,000 + ₦20,000 opening work in progress (WIP) − ₦15,000 closing WIP = ₦265,000.
6. Cost of sales:
   ₦30,000 + ₦265,000 − ₦25,000 = ₦270,000.
7. Gross profit:
   ₦400,000 − ₦270,000 = ₦130,000.
8. Net profit:
   ₦130,000 − (₦40,000 + ₦35,000) = ₦130,000 − ₦75,000 = ₦55,000.

Common mistakes in the exam

• Mixing up cost unit and unit cost.
• Saying fixed costs are fixed per unit. Fixed costs are fixed in total. Per unit they fall as output rises.
• Saying variable cost per unit changes with output. It is the total that changes. Per unit it is normally constant.
• Putting selling, distribution or administration costs into inventory valuation. Only production costs go into inventory.
• Forgetting to apportion shared costs such as the managing director’s salary or a building shared by several functions.
• Treating warehouse wages as always production or always distribution. It depends on what the warehouse stores.
• Forgetting that the classifications overlap, and giving only one label to a cost when asked for several.
• Adding the step to variable cost instead of fixed cost in stepped cost questions.

Quick revision

• Organisations: manufacturing (tangible, storable) and service (intangible, consumed on delivery). Output type guides the costing system: batch/standard, process, job.
• Cost object = what we measure cost for. Cost unit = unit of output costed. Unit cost = cost of one unit.
• Elements: material, labour, other expenses. Functions: production; selling and distribution; administration; finance.
• Production costs go into inventory. Non-production costs never do. Shared costs are apportioned fairly.
• Behaviour: fixed (constant total, falling unit cost), variable (constant unit cost, rising total), semi-variable (fixed + variable), stepped (jumps at activity levels).
• Cost of goods made = prime cost + production overhead ± change in WIP. Cost of sales = opening FG + goods made − closing FG.

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer.

Section A style: multiple choice

Section B style: written questions

A further written question

Model answers

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