Classification of Cost by Function
Chapter Two
Syllabus topic 1, "Classify and ascertain Cost on the basis of function"
Pages 3 to 6 of 82
In one line
Cost is classified by function into four cumulative stages - prime cost, factory cost, cost of production and cost of sales - each adding the costs of one part of the business.
Why classify at all
The same rupee can be described in several ways. Wages are a labour cost by nature, a direct cost by traceability, a variable cost by behaviour, and a factory cost by function. None of those is more correct than the others; each answers a different question.
Classification by function is the one that builds the cost sheet, because it follows the product through the business: it is made, then administered, then sold.
CAS-1 Classification of Cost is the standard on this. Its requirement, stated in our own words, is that costs be classified consistently and on a stated basis, so that cost statements can be compared between periods and between entities. It sets out the bases - by nature, by traceability, by behaviour, by function - and the elements of cost.
The three elements, first
Before the functional stages there are three elements:
| Element | What it is |
|---|---|
| Material | The physical inputs |
| Labour | The human effort |
| Expenses | Everything else |
Each element splits into direct and indirect.
Direct means traceable to the cost object economically and without apportionment. Indirect means it must be shared out.
The four stages
Stage 1: Prime cost
Prime cost = Direct material + Direct labour + Direct expenses
All three direct elements, and nothing indirect. Prime cost is the part of the cost that could be traced to the unit without any judgement.
Stage 2: Factory cost
Factory cost = Prime cost + Factory overhead
Also called works cost. Factory overhead is the indirect material, indirect labour and indirect expenses of the factory - the foreman's salary, factory rent, power, depreciation of plant, consumable stores.
Two adjustments belong here and students forget them: the opening and closing work-in-progress, because a factory cost is the cost of what was completed, not of what was worked on.
Stage 3: Cost of production
Cost of production = Factory cost + Administration overhead
Office and administrative overhead: the accountant's salary, office rent, audit fee, printing and stationery.
The adjustment here is finished goods stock, which converts cost of production into cost of goods sold.
Stage 4: Cost of sales
Cost of sales = Cost of goods sold + Selling and distribution overhead
Advertisement, salesmen's salaries and commission, carriage outward, warehouse cost of finished goods, bad debts.
And then:
Profit = Sales - Cost of sales
The four stages as one table
| Stage | Add | Adjust for |
|---|---|---|
| Prime cost | Direct material, direct labour, direct expenses | Opening and closing raw material stock, inside direct material |
| Factory cost | Factory overhead | Opening and closing work-in-progress |
| Cost of production | Administration overhead | - |
| Cost of goods sold | - | Opening and closing finished goods |
| Cost of sales | Selling and distribution overhead | - |
Classification of Cost by Function
Three stocks, three different places. Raw material inside direct material, work-in-progress after factory overhead, finished goods after administration overhead. Putting a stock adjustment at the wrong stage is the commonest error in the whole module.
The other bases, briefly
MU's concept is function, but a question can name another basis and the reader should recognise it.
| Basis | Classes |
|---|---|
| By nature or element | Material, labour, expenses |
| By traceability | Direct, indirect |
| By function | Production, administration, selling and distribution |
| By behaviour | Fixed, variable, semi-variable |
| By controllability | Controllable, uncontrollable |
| By normality | Normal, abnormal |
Behaviour matters even here, because an abnormal loss is excluded from cost and charged to profit and loss - which is one of the causes of difference in the reconciliation chapter.
Classification by behaviour, in full
MU sets this as a short note of its own, so the three classes are worth stating properly rather than listing.
| Class | The TOTAL, as output rises | The cost PER UNIT, as output rises | Examples |
|---|---|---|---|
| Fixed | Stays the same | Falls | Factory rent, insurance, the works manager's salary, depreciation on the straight line |
| Variable | Rises in proportion | Stays the same | Direct material, direct wages on piece rate, power used by machines, royalty per unit |
| Semi-variable | Rises, but not in proportion | Falls, but not to nothing | Telephone with a rental and a call charge, a supervisor for each shift added, repairs |
The per-unit column is where the marks are. A fixed cost is fixed in total and variable per unit; a variable cost is variable in total and fixed per unit. The statement "fixed cost per unit remains fixed whatever the output" is false, and it is a favourite true-or-false question.
Fixed only within a range. Rent is fixed until a second factory is needed, and then it steps up. A cost that behaves this way is a stepped fixed cost, and it is fixed only within the range of output it was set for.
A semi-variable cost can be split into its fixed and variable parts, and where a question gives the cost at two levels of output the variable part per unit is the change in cost divided by the change in output, the fixed part being the balance.
The cost terms an examiner uses
These are not classes of cost so much as ways of describing one, and MU examines them in the objective questions.
| Term | What it means | The trap |
|---|---|---|
| Cost centre | A location, person or item of equipment for which cost is collected | It may be a PERSON - a salesman, a foreman - not only a place |
| Cost unit | The unit of product or service in which cost is expressed - a tonne, a metre, a passenger-kilometre | It is not the same as a cost centre |
| Out-of-pocket cost | Involves a present or future cash outlay | Depreciation is NOT one; the cash went out when the asset was bought |
| Book, notional or imputed cost | A charge made in the accounts with no cash outlay - depreciation, rent on owned premises, interest on the proprietor's own capital | Notional and imputed mean the same thing |
| Sunk cost | Already incurred and irrecoverable, so irrelevant to any decision now | The written-down value of a useless machine is sunk, however large |
| Opportunity cost | The benefit given up by choosing one course over another | It is never recorded in the books |
| Postponable cost | Can be deferred without immediate loss of output - building maintenance, painting | Deferring it is not saving it |
| Controllable cost | Can be influenced by the manager at that level | The same cost is controllable to one manager and not to another |
Classification of Cost by Function
Two of these appear in almost every objective paper. Depreciation is a book cost and not an out-of-pocket cost, and a cost centre may be a person.
Worked example
Classify each and say which stage it enters.
| Item | Class | Stage |
|---|---|---|
| Timber used in making furniture | Direct material | Prime cost |
| Glue used in small quantities | Indirect material | Factory overhead |
| Wages of the carpenter | Direct labour | Prime cost |
| Salary of the factory supervisor | Indirect labour | Factory overhead |
| Hire of a special machine for one job | Direct expense | Prime cost |
| Factory rent | Indirect expense | Factory overhead |
| Audit fee | Indirect expense | Administration overhead |
| Carriage outward | Indirect expense | Selling and distribution overhead |
| Carriage inward on raw material | Direct material | Prime cost |
The last two rows are the pair MU sets. Carriage inward is part of the cost of getting material in and belongs to direct material; carriage outward is a cost of delivering to the customer and belongs to selling and distribution.
What it does NOT mean
Direct is not the same as variable. A direct expense can be fixed, and a variable cost can be indirect - power, for instance.
Overhead is not waste. It is the cost that cannot be traced economically, not the cost that need not be incurred.
The stages are cumulative. Factory cost contains prime cost; cost of sales contains everything.
Quick revision
- Elements: material, labour, expenses, each direct or indirect.
- Prime cost = direct material + direct labour + direct expenses.
- Factory cost = prime cost + factory overhead, adjusted for work-in-progress.
- Cost of production = factory cost + administration overhead.
- Cost of goods sold = cost of production adjusted for finished goods.
- Cost of sales = cost of goods sold + selling and distribution overhead.
- Profit = sales less cost of sales.
- Three stocks at three different stages: raw material, work-in-progress, finished goods.
- CAS-1 Classification of Cost requires a consistent, stated basis of classification.
Classification of Cost by Function
Test yourself
1. Define prime cost. The aggregate of direct material, direct labour and direct expenses.
2. At which stage is work-in-progress adjusted? After factory overhead has been added, in arriving at factory cost, because factory cost is the cost of production completed.
3. Under which heading does carriage outward fall, and carriage inward? Carriage outward is selling and distribution overhead; carriage inward is part of direct material cost.
4. Is a direct cost always variable? No. Traceability and behaviour are different bases; a direct expense may be fixed.
5. What does CAS-1 require? That costs be classified on a consistent and stated basis so that cost statements are comparable, setting out the bases of classification and the elements of cost.
Answer in one sentence
How is cost classified by function? Into four cumulative stages: prime cost, being direct material, direct labour and direct expenses; factory cost, being prime cost plus factory overhead adjusted for work-in-progress; cost of production, being factory cost plus administration overhead; and cost of sales, being the cost of goods sold after adjusting finished goods stock plus selling and distribution overhead.
The rest of this subject
These notes are cut from the University's printed syllabus. Open the syllabus itself, or the past papers, for the same subject.