Costing

Costing is a key element of management accounting. This page is an introduction to the topic but further detail can be explored using the above navigation bar.

Terminology - cost units and cost centres

Cost units

To help with the above purposes of planning, control and decision making, businesses often need to calculate a cost per unit of output.

A key question, however, is what exactly we mean by a “unit of output”, or “cost unit”. This will mean different things to different businesses but we always looks at what the business produces.

• A car manufacturer will want to determine the cost of each car and probably different components as well.
•  In a printing firm, the cost unit could be the specific customer order. 
•  For a paint manufacturer, the unit could be a litre of paint.
•  An accountancy firm will want to know the costs incurred for each client. To help with this it is common to calculate the cost per hour of chargeable time spent by staff.
• A hospital might wish to calculate the cost per patient treated, the cost of providing a bed for each day or the cost of an operation, say.

Cost centres

A cost centre is a small part of a business for which costs are determined.  This varies from business to business but could include any of the following:

• The Research and Development department
• The Human Resources function
•  A warehouse
• A factory in a particular location

It is important to recognise that cost centre costs are necessary for control purposes, as well as for relating costs to cost units. This is because the manager of a cost centre will be responsible for the costs incurred.

Cost, profit and investment centres

Some businesses use the term “cost centre” in a more precise way than that given above:

• A cost centre is when the manager of the centre (department or division or location or...) is responsible for costs but not revenue or investment. This is usually because the centre has no revenue stream.
  For example, a research and development department.
• A profit centre is when the manager of the centre (department or division or location or...) is responsible for costs and revenues but not investment.
  For example, a local supermarket where investment decisions are made by the main Board.
• An investment centre is when the manager of the centre (usually a division) is responsible for costs and revenues and the level of investment in the division.
  For example, the US subsidiary of a global firm. The CEO would usually have authority to open new factories, close others and so on.

Cost classification

Costs can be classified (collected into logical groups) in many ways.  The particular classification selected will depend upon the purpose for which the resulting analysed data will be used, for example:

Classification by function

For financial accounting purposes costs are split into the following categories:

• Cost of sales – also known as production costs. This category could include production labour, materials, supervisor salaries and factory rent.
• Distribution costs – this includes selling and distribution costs such as sales team commission and delivery costs.
• Administrative costs – this includes head office costs, IT support, HR support and so on.

Note that some costs impact each of the above - e.g. depreciation. This is a measure of how much an asset is wearing out or being used up. The classification will depend on which asset is being depreciated. For example,

• Cost of sales – depreciation on a machine in the production line
• Distribution – depreciation of a delivery van
• Admin – depreciation of a computer in the accounts department

Cost classification by element

The simplest classification is splitting costs according to element as follows:

• Materials - includes raw materials for a manufacturer or alternatively the cost of goods that are to be resold in a retail organisation
•  Labour - Labour costs can consist of not only basic pay but overtime, commissions and bonuses as well.
• Other expenses – also known as overheads.  This includes electricity, depreciation, rent and so on.

Cost classification by nature - direct and indirect

Direct costs

Direct costs are costs which can be directly identified with a specific cost unit or cost centre. There are three main types of direct cost:

• direct materials - for example, cloth for making shirts
• direct labour - for example, the wages of the workers stitching the cloth to make the shirts
• direct expenses - for example, the royalties paid to a designer, or the freight charges for imported special materials.

The total of direct costs is known as the prime cost.

Indirect costs

Indirect costs are costs which cannot be directly identified with a specific cost unit or cost centre. Examples of indirect costs include the following:

• indirect materials - these include materials that cannot be traced to an individual shirt, for example, cotton
• indirect labour - for example, the cost of a supervisor who supervises the shirt makers
• indirect expenses - for example, the cost of renting the factory where the shirts are manufactured.

The total of indirect costs is known as overheads.

Cost classification by behaviour

Costs may be classified according to the way that they behave. Cost behaviour is the way in which input costs vary with different levels of activity. Cost behaviour tends to classify costs as one of the following:

• Variable costs are costs that tend to vary in total with the level of activity. As activity levels increase then total variable costs will also increase
• A fixed cost is a cost which is incurred for an accounting period, and which, within certain activity levels remains constant.
• A stepped fixed cost 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
• Semi-variable costs contain both fixed and variable cost elements and are therefore partly affected by fluctuations in the level of activity

Cost cards

Once costs have been analysed, management may wish to collect the costs together on a cost card. A cost card (or unit cost card) lists out all of the costs involved in making one unit of a product.

COST CARD - statement of the total cost of one unit of a product

Understanding a cost card

• The total production cost is the marginal production cost (total direct costs) plus any fixed production overheads.
• It is important that the total production cost of a product is clearly identified as being such. Non-production costs must be analysed separately. This is because when finished products are transferred to the warehouse as finished goods, they are transferred at a value that reflects the direct manufacturing costs that were involved in producing them, i.e. total production cost.
• When finished goods are transferred to the warehouse, this is where they remain until they are sold to customers or held as inventory. When inventory is sold, it is important that it is given a value that reflects the 'cost of sale' of the product, so that a profit can be calculated and reported in the income statement.
• Similarly, at the end of an accounting period, inventory is valued and reported in the balance sheet of an organisation at its total production cost.
• It is important, therefore, that the production costs and the non-production costs are clearly distinguished for the purposes of valuing output and inventories.

Standard costing

Many businesses will determine an expected or standard cost at the start of a period and then use this as the basis for evaluating actual costs.

Determining the components of a cost card.

For any business the elements of a cost card that require the most work are the following (click on the links to explore in more detail):

• materials costs
• labour costs
• overhead costs

Marginal and absorption costing

Different businesses have different approaches to whether or not they include fixed overheads in their cost per unit calculation. Marginal costing (MC) excluded fixed overheads but total absorption costing (TAC) includes fixed production overheads.

Costing in different industries

Different organisations have different types of production, which impacts on their costing systems:

• Specific order costing is the costing system used when the work done by an organisation consists of separately identifiable jobs or batches.
• Continuous operation costing is the costing method used when goods or services are produced as a direct result of a sequence of continuous operations or processes, for example process and service costing.

To explore the implications of this further please click on the following links:

• Job costing
• Batch costing
• Process costing
• Service and operations costing
• Joint and by-product costing

Cost control and cost reduction

Cost control and cost reduction are priorities for many businesses. To explore these aspects further click on the following links:

• Cost control
• Cost reduction techniques

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