Welcome to Accounting with Madam Mombi. Today we are going to look at cost classification, rather how costs are classified depending on certain common characteristics and behaviors. So to begin with we can start by simply defining what is cost classification. So cost classification can be defined as the arrangement of cost items in a logical sequence. having regard to their nature or characteristics and their purpose that they fulfill.
So simply we are trying to just do what you call grouping of similar items. In terms here of cost, we want to group them according to their common characteristics, behavior, their purpose and so on. So we can start with classification of costs based on the behavior or cost classification based on the behavior so based on the behavior of costs we can have variable costs versus fixed costs now variable costs these are costs that increase or decrease proportionately with the change in activity level so these are costs that start from zero they may not be incurred if there's no activity once the activity increases One unit increase in the activity will result in a certain increase in the cost, so that it increases proportionately with the changes in activity level. While fixed cost, on the other hand, from the word fixed, these are costs that are constant. They do not change with the level of output.
Now, it is important that we note that the definition of a fixed cost we have to say that the cost is fixed within a certain relevant range. So again, that would mean that the fixed costs, they are constant or do not change with the level of output within a relevant range. And from our previous class, when we were defining the cost concepts, we defined what is a relevant range of activities. So I can start by projecting how a graph would look like for a variable cost and a fixed cost. cost so we can have let's start with the variable cost so a variable cost if you have a activity level here activity level and here you have the cost and you want to draw them on a graph as you have said variable costs in total it varies directly proportional with the changes in activity level.
So this is how total variable cost is going to look like. Total variable cost. That's how it would look like on a graph.
So if there is no activity, there is no cost. An increase in activity results into an increase in, an increase in activity results into an increase in the cost. So the gradient of this line can give you the variable cost per unit all right that is how you can project variable costs you can also have fixed costs as you have defined so here again having the activity level and having the cost here within the relevant range a fixed cost in total is constant so this is it so total fixed cost total fixed cost Drawn on a graph would look like that because it does not change with the changes in level of activity. So those are the first two classifications of cost based on their behavior.
There are more. You can have another classification, again still based on behavior. You can have what you call semi-variable versus semi-fixed costs.
Again, let us start with semi-variable costs. Semi-variable costs, they are also called mixed costs, as you can see here. And that should give you an idea because mixed costs means it has both components of fixed and variable costs. That is why it is called a mixed cost. So costs that have a component of fixed and variable costs, those are the ones you're calling mixed or semi-variable costs.
For example, the electricity bill. would have a constant charge while the other charge is based on the number of units consumed. The constant fee on the bill is what you call the fixed cost. The cost that relates to the number of units that were used are the ones that you're calling the variable cost. So that is a form of a mixed cost.
Again you can have semi-fixed or step fixed costs. So this one This is a cost that we have to note first, number one, that it is a fixed cost. The fixed cost remains constant within a range of activities. Once you exceed a certain critical level, the cost steps up. That is why it is called step fixed cost to another level.
Again, it remains constant within that range of activity. If you exceed a certain critical level, the cost goes up another step. Again.
and then remains fixed at that level of activity. So there is no variability here. Rather, it is still a fixed cost that keeps on changing once or steps up to a new level once you exceed a certain critical level.
So again, to project this, we can have the projection of the two of them. Let's start with the mixed cost. mixed costs we have said having here the activity level and having here the cost a mixed cost has both components of fixed and variable so a mixed cost graph would look something like this this component here this component here is fixed Well, this component here is variable. So that is how you are going to project on a graph.
A mixed cost would give us a graph or a line that does not start now at zero, but rather starts at a point above zero because of this component here, which is the fixed cost. Meaning that there is a constant charge, if it is per period. that has to be paid whether there was activity or not and again you have to say activity level here would be the number of units produced would be the number of labor hours it is same now again we can also project the step fixed costs as you have mentioned so the step fixed cost having activity level here activity level and having the cost here we are saying this is a fixed cost that remains constant within a certain range of activities so between here and here it is constant again once you exceed this critical level the cost may go up so the cost may go up again it remains constant within a certain range of activities maybe up to here then again the cost may step up once more to a new level you So this is what you call a step fixed cost.
It keeps on stepping up. So this point... of activity here we can name them a and b this point of activities are what you are calling the critical levels critical levels so once you exceed the critical level the cost goes up so that is how you can show on a graph how a step fixed cost looks like so this point between zero and a that is a relevant range where the cost is constant Once A is a critical level, it is exceeded, then the cost steps up to a new level.
And that is a step fixed cost. So we can go back to another classification. So those four classifications, as we have mentioned, that is the variable cost, the fixed cost, the semi-variable cost, or what you call the mixed cost. Also the step fixed cost, which is also called... the semi-fixed cost all these are classification number a that is based on the behavior of costs so our second classification number b it is based on the traceability on the cost object now this one the classification is either a direct cost or an indirect cost direct cost a cost that can be traced in the final product in an economically feasible way You can be able to trace them with the final product.
Examples of direct costs are direct material, direct labor, direct expenses. These are direct costs. They can be seen in the final product.
They can be quantified in the final product. They can be traced in the final product. Now, indirect costs, on the other hand, these are costs that cannot specifically be directly attributed to the specific product.
I will give you examples of indirect costs. You have like example indirect material, indirect labor. For example, in a factory, the wage that is paid directly to the laborer who is producing a product, that is a direct cost, which is direct labor.
But the supervisor has a salary. While the supervisor does not specifically... attend to any of the products directly, he supervises the work.
Then the amount paid to the supervisor, that is an indirect labor cost. Because the supervisor's salary cannot specifically be attributed to any of the products, it is general cost. Again, it also has overheads like electricity.
You can say we don't know how much of it was spent on every single product, therefore it is an indirect cost. So here we have... indirect materials, indirect labor, and other indirect costs that cannot specifically be attributed to a certain product. And that is classification number B, our second classification of costs.
Our third classification, number C, is a classification based on the cost function. What does the cost do? Again here, it is either a cost is a manufacturing cost, or the cost is a non-manufacturing cost.
This is pretty straightforward. It is either cost is incurred in the process of manufacturing or the cost is incurred for any other purpose other than manufacturing. So manufacturing costs, as you'd expect, these are costs that are incurred in the production of a product.
They include the direct materials, the direct labor, direct expenses and the manufacturing overheads. So all these costs that are incurred in the factory for production are the ones that you are calling the manufacturing costs. But let's now talk about the non-manufacturing costs.
Non-manufacturing costs on the other hand, these are costs that are not incurred in manufacturing. Not incurred in manufacturing. Then what are they incurred for?
Number one, they would be incurred for general administration, like the staff salaries. that is general administration they'll also be incurred to secure the customer's order so those costs like trying to do advertising to make the customer aware of the products and even the costs that are incurred to provide that product to the customer's door or to where the customer can easily get the product those are distribution costs all these selling and distribution costs are non-manufacturing costs. Now they incurred in selling. As we have also mentioned, we have talked about general administration costs.
In the process of administration from accounting, finance, departments, those are general... Administration departments and costs associated to them are not for manufacturing. We may also have finance costs.
This is the cost that is incurred to secure money that is required to launch and sustain the business. So all the costs relating to financing of the business, again, those are finance costs. The interest on loans are non-manufacturing costs.
Then you may also have research and development costs that are non-manufacturing. That is classification number three that is based on the cost functions. Very simple, simply manufacturing or non-manufacturing. So the next one classification number D is based on controllability. Now what is controllability of costs?
Controllability there is somebody who is put in charge or responsible for certain costs. That manager for example who is in charge of certain costs. Some of the costs to him are controllable while some of the costs to him are non-controllable. Controllable costs are those costs that he can influence. He has direct influence by his actions.
He can influence the cost. Example, by determining which method of labor or remuneration he is going to use, he can be able to influence the labor costs by choosing a certain method of remuneration. over the other he can be able to alter or to influence the wages that is in his authority but non-controllable costs uh non-controllable costs these are costs that the person in charge or to whom the authority has been given to influence the cost this time he is not able to control them for example if the government passes a law imposing a certain tax the government passes a law demanding a wage increase then the manager in this case cannot be able to control such a cost it is not in his it is not in his mandate he has to abide so if the government has introduced a new tax he has to abide to that if the labor unions have demanded an increase in wages then that increment is an uncontrollable cost to the manager so that is what we mean here by controllable costs and none controllable costs. The other classification is based on the association with the products.
Here you can have either product costs or period costs. Product costs are associated with the products. Therefore, they are the costs that are incurred either to produce or to acquire a product for resale.
So all the costs of manufacturing, those are product costs. All the costs that are incurred to buy the product, maybe from a retailer, those are product costs. So product costs are just simply costs that are incurred either to acquire or to produce a product that is needed.
And of course this cost is included in the value of that inventory. It is part of the value of that product. Now what again then is period costs? These are costs that are incurred on a time period basis and they have no direct association.
to the product so for example rent is incurred not because you are producing but rent is incurred due to passage of time so simply rent is not a product cost but rent is a period cost it is incurred because of passage of time and that is the distinction between a product cost and a period cost the other classification is um based on the relevance to decision making. So here we have several costs. Number one, you can start with relevant costs. This is cost, future cost that has, that changes among us decision alternatives.
A relevant cost is a cost that can influence a decision. So if you are making a decision in the future, the cost of different alternatives is a relevant cost. Then we have irrelevant costs. These are costs that do not differ among us decision alternatives.
The cost is the same between option A and option B. So being the same under the two alternatives, then it is not going to affect future decision making. So an irrelevant cost does not differ among us decision alternatives.
Then you have sunk costs. They are also called historical costs or committed costs. These are costs for resources that have already been acquired or for commitments that have already been made.
So sunk costs, we can no longer change them in the current because they were already committed in the past. So they are of asset... that have already been acquired or resources that have already been used and therefore they cannot change among us various decisions now they have already been committed or they are sunk costs the other cost is the standard cost standard cost is simply a predetermined per unit cost that is expressed in per unit based on operations so a standard cost would be now for example what is the standard material of producing one unit imagining we are producing this pen then the standard cost of producing this pen is predetermined and stated per unit so that we know per unit 80 shillings is required to produce this pen and that cost is what you're calling a standard cost it is based on analysis of previous manufacturing records for example and you're able to predict now how much is the standard cost for every unit Moving on, on this classification, you also have avoidable costs and unavoidable costs. Let's start with avoidable costs.
These are costs that can be saved by not adopting a certain given alternative or a certain decision. Let me give you an example here. If you decide to buy a product from the external supplier, then you're going to totally avoid it. variable manufacturing costs. If you decide to buy a product externally, that would mean then you're not going to be incurring the variable manufacturing costs.
So the variable manufacturing case in that example is an avoidable cost. It can be avoided by making a certain decision here by deciding to buy a product instead of making the product. Now an avoidable cost These are costs that cannot be avoided by not adopting a given decision. What we are saying, like now in my example, even if you decide to buy a product, instead of making it internally, you are still going to incur the fixed costs. You are going to incur the fixed costs, some of which like rent, has to still be paid.
So in that case, whether you decide to buy the products, or to make the product internally the rent is an unavoidable cost it cannot be avoided so that is what you mean here between avoidable and non-avoidable costs an avoidable cost they cannot be avoided they cannot be avoided by not adopting a given decision or by adopting a given decision the next one is incremental differential costs So I've kept on mentioning that you have two alternatives or three alternatives. The cost difference between the alternatives, that is alternative A and B, the cost difference between the two alternatives is what you call differential cost. So it is a difference in cost between two or more decisions. So the decision A is worth this much, decision B is worth this much.
The difference between them is what we are calling the differential cost. Finally, we can also define what is the marginal cost. Marginal cost is simply the cost of one extra unit. So if you are moving from 50 units to 51 units, the cost of that one unit, the 51 units, that cost of one extra unit is what you are calling here the marginal cost. So basically, this is a the definition of that was the cost cost that were based on relevance to decision making another classification is based on the cash flow so what do you mean by the cash flow that is in this case we're asking ourselves in terms of money did the money leave the pocket was it an implicit cost or an exp implicit costs.
Let's start with implicit costs. Implicit costs do not represent a cash movement. Example is depreciation.
Despite the fact that a building has depreciated, in the books of accounts in terms of cash flow, there was no money that was paid to anybody that is called depreciation. So it is a loss of value. It is a loss of value in an asset. It is an expense. Example here being depreciation.
But it is an implicit cost because there was no cash flow. There was no movement of money. So an implicit cost is a cost that do not represent out-of-pocket expenditure. There is no money out of the pocket. Again, opportunity costs, we consider them when you're making decisions, but they're just the cost of the foregone alternative.
They do not represent, again, a cash flow. That is what we mean by implicit cost. then explicit costs these are costs that represent out-of-pocket expenditure money leaves the pocket money leaves the bank money leaves the office to be paid for these expenses so majorly most of the expenses are explicit expenses in an organization that represent an actual cash flow advertising rent salaries and wages those are explicit costs they represent out of pocket expenditure so that is it for classification of costs if you found this video to be useful kindly like share and subscribe thank you