Understanding Costing and Cost Classifications

Management accountants connect financial information with business analysis to advise managers creating business strategy. We explore the essential Costing knowledge for this role.

There are a number of specific management accounting topics that are covered in the AAT Accounting Qualifications including budgeting and forecasting, performance evaluation and variance analysis and decision-making. This article will focus in on another key area – costing.

Costing

‘Costing’ is the process of identifying the cost per unit of production. If I’m a manufacturer of cars (or cakes or chairs for that matter) it’s incredibly useful to know how much each unit will cost me to produce.

Knowing this, enables me to:

• Set a profitable selling price – In order to make a profit, a business must ensure that the price they charge for each unit is greater than the costs of making it.
• Value units of inventory at the end of a period – As a general rule, we value inventory at the cost of production of those units.
• Identify where cost savings can be made to improve profit – A good starting place is to understand clearly where costs are being incurred.
• Compare the profitability of different products – By looking at the price of each product and the production costs, we can work out where we make the most money.

A typical starting point of the costing process is to break down the costs of the business into sensible categories.

Classifying costs

There are a number of different ways that you can break down costs into different groups; this is the process of ‘classifying’ costs.

Classifying costs by function

When we classify costs by ‘function’ we are thinking about which location within the business they are incurred in.

• Production costs are incurred in the factory where physical production occurs.
• Non-production costs are incurred elsewhere in the business, for example:
  • Administration costs are incurred as part of the administrative function.
  • Selling costs relate to the process of stimulating demand through marketing and advertising products.
  • Distribution costs are incurred in the process of delivering finished goods to customers.
  • Finance costs would be those incurred as part of raising finance and paying interest.

Classifying costs by behaviour

When we talk about the ‘behaviour’ of a cost we mean the way that the cost is affected by changes in the volume of production.

• Fixed costs are unaffected by the volume of production so stay the same whether you make 5,000 units or 10,000 units.
• Variable costs change in line with any changes in production volume so if you double the volume of production you double the cost you incur.

One thing to note is that when we describe a cost as ‘fixed’ that doesn’t mean it will never change, just that it is not affected by changes in volume. For instance, your factory rent can go up each year, but your landlord isn’t interested in how many cars you make.

Classifying costs by element

• Material costs are the purchase of anything physical.
• Labour costs are when we pay for the time of a member of staff.
• Expenses relate to anything other than material and labour.

Classifying costs by nature

• Direct costs can be ‘traced’ to a single unit of production. The total of all direct costs is the ‘prime’ cost.
• Indirect costs cannot be traced to a single unit of production but are ‘shared’ over many units. Indirect costs are often called ‘overheads’.

You have to remember that our categories of cost overlap:

The purchase of wheels used in assembling cars can be thought of as:

• Production costs as they are used in the factory.
• Variable costs as an increase in the number of cars made will mean more wheels being bought.
• Material costs as the wheels are a physical product.
• Direct costs as you could trace four wheels to a single car assembled.

The monthly salary of a factory supervisor could be seen as:

• Production costs as the supervisor works in the factory.
• Fixed as the monthly salary paid will be the same no matter how many cars are made.
• Labour costs as they relate to paying for someone’s time.
• Indirect as you cannot trace the monthly salary paid to a single car.

The quarterly electricity bill for lighting the accounts department would be:

• Non-production costs as the accountants don’t work in the factory.
• Fixed as the bill will have no link to the number of cars being assembled in the factory.
• An expense as it is not material or labour.
• Indirect as a bill for three months will be shared over all of the production in that quart

In summary

Classifying costs is an essential process to management accountants, enabling them to translate financial costs into business strategy, so it’s important to understand the basics at this early stage of your AAT studies.

Read more study tips from AAT here:

• Study tips: What’s the difference between marginal and absorption costing?
• What actually is standard costing?
• Speed reading: revise like a pro

Gareth John is a qualified chartered accountant and tutor at First Intuition.