CHAPTER 2 COST CLASSIFICATION

Question 1

what types of cost summaries do management often require

Answer 1

• management require a variety of different cost summaries, including
  o costs for a particular product – a cost unit or cost object
  o costs for use in the preparation of external financial reports
  o costs for a particular department – a cost centre
  o costs to be used for decision making
  o costs that are useful for planning and control
• to be able to produce these summaries the type of cost and the cost behaviour will need to be analysed

Question 2

what are cost objects

Answer 2

cost objects
- a cost object is any activity for which a separate measurement of cost is undertaken
- examples include cost of a product, cost of a service, cost of running a department, cost of running a regional office

Question 3

what are cost units

Answer 3

cost units
- is a unit of product or service in relation to which costs are ascertained
- examples include a room in a hotel, an in patient in a hospital

Question 4

what are cost centres

Answer 4

cost centres
- a production or service location, function, activity or item of equipment for which costs can be ascertained
- examples include a department, a project etc

Question 5

what are cost cards

Answer 5

cost cards
- used to show the breakdown of the costs of producing output based on the classification of each cost.
- Can be produced for one unit or a planned level of production

Question 6

what are the costs brought together and recorded on a cost card

Answer 6

• The following costs are brought together and recorded on a cost card
  o Direct materials
  o Direct labour
  o Direct expenses
  o Prime cost
  o Variable production overheads
  o Fixed production overheads
  o Non production overheads

Question 7

what are the 4 ways which costs are classified

Answer 7

costs can be classified in a number of ways
- Element
o Whether they relate to material, labour or expenses, useful for cost control
- Nature
o How they relate to production – are they directly involved in the production of the product/service or indirectly involved in production, useful for cost accounting
- Function
o Based on whether they are production costs or non production costs, useful for financial accounts
- Behaviour
o Based on how they change in relation to levels of output or activity, useful for budgeting and decision making

Question 8

how are cost classified by element

Answer 8

To classify by element it must be decided if a cost is material, labour or an expense
- Materials
o All costs of materials purchased fr production or non production activities e.g. raw materials, maintenance, stationary
- Labour
o All staff costs relating to employees on the payroll
- Expenses
o Other costs which are not material or labour, includes rent, bought in services, depreciation of equipment

Question 9

how are costs classified by nature

Answer 9

Direct costs
- Can be directly identified with a specific cost unit or cost centre
o 3 main types
 Direct materials – cloth for making shirts
 Direct labour – the wages of the workers stitching the cloth to make the shirts
 Direct expenses – the royalties paid to a designer
- The total of direct costs is known as the prime cost

Indirect costs
- Costs which cannot be identified with a specific cost unit or cost centre
- 3 indirect costs include
o Indirect materials – cannot be traced to an individual item for example cleaning fluids for machinery
o Indirect labour – for example a supervisor who supervises the shirt makers
o Indirect expenses – cost of renting the factory where the shirts are manufactured
- The total of indirect costs is known as overheads

Question 10

how are cost classified by function

Answer 10

5 classification by function

Production costs
- Costs that relate to the manufacture of a product or provision of a service
o Found in the cost of sales section of the statement of profit and loss
o Production costs, such as direct materials, direct labour, direct expenses and production overheads, are included in the ‘valuation of inventory’

Non production costs
- Costs that are not directly associated with the production of the business output
- Non production costs, such as administrative costs, selling costs and finance costs, are charged to the statement of profit and loss as expenses for the period in which they are incurred.
- Non production costs are not included in the ‘valuation of inventory’

Question 11

how are costs classified by behaviour

Answer 11

Costs may be classified according to the way that they behave in relation to changes in levels of activity
- Cost behaviour classifies costs as one of the following
o Variable cost
o Fixed cost
o Stepped fixed cost
o Semi variable cost

Question 12

what are variable costs

Answer 12

Variable costs
- Costs that vary in direct proportion with the level of activity. As activity levels increase then total variable costs will also increase
- Note that as total costs increase with activity levels, the cos per unit of variable costs remains constant
- Examples of variable costs include direct costs such as raw materials and direct labour

Question 13

what are fixed costs

Answer 13

Fixed costs
- A cost which is incurred for an accounting period, and which, within certain activity levels remains constant
- The total costs will remain constant over a given level of activity but the cost per unit falls as level of activity increases
- Examples of fixed costs include rent, business rates, executive salaries

Question 14

what are stepped fixed costs

Answer 14

• A type of fixed cost that is only fixed within certain levels of activity, once the upper limit of an activity level is reached then a new higher level of fixed cost becomes relevant
• Examples include – warehousing costs (as more space is required), supervisor wages

Question 15

what are semi variable costs

Answer 15

• Contain both fixed and variable cost elements and are therefore partly affected by changes in the level of activity
• Examples include electricity bills (standing charge plus variable), telephone bills (fixed line rental plus variable)

Question 16

why is it useful to identify cost behaviours

Answer 16

• The behavioural characteristics of costs are used when planning or forecasting costs at different levels of production or activity.
• When producing a forecast it may be necessary to identify the type of behaviour a cost is exhibiting
• It is useful to remember the following
  o Fixed costs are constant in total
  o Variable costs are constant per unit
  o Semi variable costs are neither constant in total nor constant per unit
  o Stepped fixed costs will be constant in total within a certain range

Question 17

what is the total cost of a semi variable cost equation

Answer 17

Total cost of a semi variable cost is
Total costs = total fixed costs + (variable cost per unit x activity)

Question 18

what is the high low method used for

Answer 18

• The high low method can be used to approximate the bvariable cost per unit and the total fixed cost

Step 1
- Select the highest and lowest activity levels, and their associated costs.
Step 2
- Calculate the variable cost (VC) per unit:
Step 3
- Calculate the fixed cost by substitution, using either the high or low activity level:

Fixed cost = Total cost at activity level – (Variable cost per unit × Activity level)

Step 4
- Use the total fixed cost and the variable cost per unit values from steps 2 and 3 to calculate the estimated cost at different activity levels.

Total costs = Total fixed costs + (Variable cost per unit × Activity level)

Question 19

assumptions underlying the high low method

Answer 19

Assumption underlying the high low method
- the only thing causing any change in cost is the change in activity
- the cost under consideration is potentially semi-variable (i.e. it has both fixed and variable elements)
- the linear model of cost behaviour is valid i.e. y = a + bx (we will study this in more detail later on in this chapter).

Question 20

how does the high low method work with stepped fixed costs

Answer 20

• Sometimes fixed costs are only fixed within certain levels of activity (stepped fixed costs). The high low method can still be used to estimate fixed and variable costs.
• Choose the two activity levels where the fixed costs remain unchanged and calculate the variable cost per unit and the total fixed cost using the high low technique.
• Adjustments may need to be made to the fixed costs when calculating the total cost for a new activity level.

Question 21

how does the high low method work with changes in variable cost per unit

Answer 21

• Sometimes there may be changes in the variable cost per unit, and the high low method can still be used to determine the fixed and variable elements of semi-variable costs.
• As with the stepped fixed costs – choose activity levels where the variable costs per unit remain unchanged.

Question 22

advantages and limitations of he high low method

Answer 22

Advantages and limitations of the high low method
- The main advantage of the high low method is that it is easy to understand and easy to use.
- The limitations of the high low method are as follows:
o it relies on historical cost data and assumes this data can reliably predict future costs
o it assumes that activity levels are the only factor affecting costs
o it uses only two values (highest and lowest) to predict future costs and these results may be distorted because of random variations which may have occurred
o bulk discounts may be available for purchasing resources in large quantities.

Question 23

what are cost equations used for

Answer 23

• Cost equations are derived from historical cost data.
• Once a cost equation has been established, for example distinguishing the fixed and variable costs using the high low method, it can be used to estimate future costs.

Question 24

what is the basic formula for cost equations, and how can this relate to the high low calculation

Answer 24

• Cost equations are assumed to have a linear function and therefore the equation of a straight line can be applied: y = a + bx
• ‘a’ is the intercept, i.e. the point at which the line y = a + bx cuts the y axis (the value of y when x = 0).
• ‘b’ is the gradient/slope of the line y = a + bx (the change in y when x increases by one unit).
• ‘x’ = independent variable.
• ‘y’ = dependent variable (its value depends on the value of ‘x’).

This formula can be related to the results of the high low calculation as follows
- ‘a’ is the fixed cost per period (the intercept)
- ‘b’ is the variable cost per unit (the gradient)
- ‘x’ is the activity level (the independent variable)
- ‘y’ is the total cost = fixed cost + variable cost (dependent on the activity level)

Question 25

what is a cost code

Answer 25

- A code is a system of symbols designed to be applied to a classified set of items, to give a brief accurate reference, which helps entry into the records, collation and analysis. - A cost code is a code used in a costing system. - The first step in creating a cost code will be to determine the cost centre to which the cost relates and then to allocate the correct cost centre code.

Question 26

what are generic or functional codes

Answer 26

- Once a cost has been allocated its correct cost centre code then it may also be useful to know the particular type of expense involved. Therefore some more digits might be added to the cost centre code to represent the precise type of cost.

Question 27

what are specific codes

Answer 27

- Finally it may be necessary for cost allocation, decision making or accounting purposes to allocate a code which specifically identifies the item of cost. - A cost code is designed to analyse and classify the costs of an organisation in the most appropriate manner for that organisation. - Therefore there are no set methods of designing a cost code and the cost code of a particular organisation will be that which best suits the operations and costs of that business.

Question 28

what is a sequential code system

Answer 28

Sequential code - This is the most basic type of code. It simply means that each code follows a numerical or alphabetical sequence. Planning is needed to determine how many codes might be needed in total. - For example, let's assume we are making a coding list for different types of expenses. We could give our first category, say Motor Expenses, code 001. Our next type of expense, say Electricity, would get code 002. Each expense would then follow in sequence. This allows us to have as many as 999 different types of expenses as we are using a three digit sequential code.

Question 29

what is a block code system

Answer 29

Block code - Block codes are often used to categorise sequential codes together. For example, an accounting system might have the following block codes: - The 3000 "Block" is allocated to Current assets. This means that it is possible to classify up to 1,000 different current assets (such as different types of inventories and bank accounts) using this block.

Question 30

what is a hierarchical code system

Answer 30

Hierarchical code - Each digit in the code represents a classification. As the code progresses from left to right each digit represents a smaller subset. For example, codes for sales for an international electronics retailer could have the hierarchy: 1 represents revenue 1.1 Revenue from the UK (.1) 1.2 Revenue from the USA (.2) 1.3 Revenue from China (.3) This allows for infinite expandability. For example, it can be expanded as: 1.1.1 Revenue in the UK from laptop sales (.1) 1.1.2 Revenue in the UK from photocopier sales (.2) 1.2.1 Revenue in the USA from laptop sales (.1) 1.3.2 Revenue in China from photocopier sales (.2) Each sub-category simply gets a further decimal coding

Question 31

what is a significant digit code

Answer 31

A significant digit code is a code that contains individual digits and letters that are used to represent features of the coded item. The example given is one used to describe packs of paper file dividers: 2000 is the code for the dividers and then the 10, 20, 30 represents the number of dividers in a pack.

Question 32

what is a faceted code

Answer 32

A faceted code is one that is broken down into a number of facets or fields, each of which signifies a unit of information. Consider the following simplified table which has been extracted as a sample from the faceted code used by a large international manufacturer: In this example, there are three facets, or fields, to the code: Facet 1 is the region, and is 2 digits long Facet 2 is the department, and is 2 digits long Facet 3 is the type of expense, and is 4 digits long If we wanted to post an expense for a bonus paid to the production department of the USA region, the code would be 03020247. That is: 03 (for USA), 02 (for Production) and 0247 (for Bonus payments). It can be seen that a faceted system is a complicated one and requires lots of training and possibly a table such as the one above to be used for interpretation of codes. But it does allow for more sub-divisions and a greater number of codes.

Question 33

what is a mnemonic code

Answer 33

Mnemonic means something that aids the memory or understanding. This uses an alphabetical coding rather than a numerical coding system. It is often used to abbreviate or simplify information. For example, in accounting we might use: NCA non current asses EXP expenses Mnemonic codes are a way of quickly expressing information and making that information easily understood. However, this coding method makes it very difficult to use sub-categories or to have too much information. Mnemonic coding is likely to struggle to categorise 999 different types of expenses.