TOPIC TWO

COST CLASSIFICATION AND ESTIMATION

COST CLASSIFCATION
Cost classification is the logical grouping of the various categories of cost items according to
particular parameter, yardstick or basis. Costs can therefore be classified in different ways
according to the purpose for which they are to be used. Cost may therefore be classified
according to:
 Behaviour (Behavioural classification)
 Traceability classification
 Nature or element of cost classification
 Degree of control (Controllability classification)
 Functional classification
 Responsibility centre classification
 Economic characteristic/ Decision-making classification
BEHAVIOURAL CLASSIFICATION
This is the classification of cost according to cost behaviour. Cost behaviour is way in which
total costs or costs per unit are affected by fluctuations in the level of activity. Understanding
cost behaviour is essential in forecasting and for controlling costs and monitoring
performance and management decisions will often be based on how costs and revenue vary at
different activity levels. Examples of such decision are: what should the planned activity
level be for the next period? Should the selling price be reduced in order to sell more units?
Cost behaviour patterns can be classified into
1. Variable cost: This is an item of cost which tends to vary in direct proportions to changes
in the volume of activity or output. As output increases sot also increases and vice versa. It
could be linear or Non-linear/curvilinear.
Linear Variable cost: the relationship between variable cost and activity level is shown as a
straight line. While the variable cost varies at different levels of activity, the average variable
cost or variable cost per unit must remain constant.

Non-linear or curvilinear: Where the relationship between variable cost and output is not
linear i.e while the total variable cost varies at different activity level, the average variable
cost or variable cost per unit is not constant. It could be convex or concave.
In graph (a), an extra unit of output will only cause a less than proportionate increase in cost
item. For (b), each extra unit of output cause a more than proportionate increase in cost.
2. Fixed Cost: This is cost that remains constant irrespective of change in the level of
activity. When with certain output or turnover limits, the cost remain unaffected with the
level of activity, it is called long run fixed cost. With increase or decrease in activity, this
cost tends to be unaffected. On the other hand, a cost that is fixed in nature but only within
certain levels of activity is called stepped fixed cost. These costs remain constant for a range
of activity and rise to a new constant level once that range of activity is exceeded.

3. Mixed Cost (Semi – variable or Semi – Fixed cost): This is a cost containing both fixed
and variable cost components and which is thus partly affected by a change in level of
activity.

There are several factors that affect cost behaviour namely; Volume of output or level of
activity, nature of the cost, nature of the production process, the existence of spare capacity,
the effect of learning

TRACEABILITY CLASSIFICATION
This involves tracing costs item to the product, service or department that is been costed. It
involves direct and indirect cost. This cost classification is an extension of the behavioural
cost classification. This is because cost can be direct and variable, direct and fixed, indirect
and variable, indirect and fixed.
Direct costs: this cost can be directly identified with a specific cost unit or cost centre. It
includes direct material, direct labour and direct expenses. The addition of these costs is
called prime cost.
Indirect costs: These costs are incurred but cannot be traced directly and in full to the
product, service or department. It is referred to as overheads.

NATURE OR ELEMENTS OF COST CLASSIFICATION

This is when the physical features of cost item are used for classification. It includes material
cost, Labour cost and Overheads.
This classification is relevant for preparing income statement.
CONTROLLABILITY CLASSIFICATION
The degree of influence that an operating manager is able to exert on a particular item of cost
can be used to classify cost. It includes;
Controllable cost: Item of cost that an operating manager can control or manipulate. Extent
of these costs is within the influence of the manager.
Uncontrollable cost: This category of cost items are not within the influence or control of
the operating manager.
This type of cost classification can assist in performance evaluation.

FUNCTIONAL CLASSIFICATION
Costs in this category are classified on the basis of the function they or specific role they
perform. E.g production costs, marketing costs, selling and distribution costs, administrative
costs etc.
This classification assists in the area of cost allocation.

RESPONSIBILITY CENTRE CLASSIFCATION

Costs in this category are classified according to the various responsibility centres that
incurred such cost. A responsibility centre is a department or organisational function whose
performance is the direct responsibility of a specific manager. They are;
Cost centre: this is a location, person, item or equipment for which costs may be ascertained
and used for the purposes of cost control. When costs are determined, they are then related to
cost units.
Profit centre: It is a production or service location, function or activity for which costs and
revenue can be ascertained. It is similar to a cost centre, but has identifiable revenues and
costs.
Investment centre: It is a profit centre with additional responsibilities for capita; investment
and possibly for financing, and whose performance is measured by its return on investment.

ECONOMIC CHARACTERISTIC/ DECISION-MAKING CLASSIFICATION

Costs can possibly be classified according to the effect or impact of a cost item on a
particular decision to be taken. They are;
Relevant Costs/Irrelevant Costs
Relevant costs these are those future costs and revenues that can be altered by a given
decision. These costs can change by a decision. E.g. Future costs, Opportunity costs,
Avoidable costs, Incremental costs etc.
Irrelevant costs are these are those costs/revenues that will not be affected by a given
decision. Irrespective of what decision is taken, the cost will not alter. E.g. Sunk costs,
Unavoidable costs etc.
Avoidable/Non-Avoidable Costs
Avoidable costs are costs that may be saved by the adoption of a given alternative option.
These Non-avoidable costs are costs that cannot be saved or eliminated by the adoption of a
given alternative line of action.
Sunk Costs
These are the costs of resources already acquired. They are costs created by decisions made
in the past and cannot be altered by decisions to be made in the future. For example the
written down value of plant previously acquired.
Opportunity Costs
These are the values of benefits forgone or sacrificed in favour of alternative courses of
action.
Incremental Costs
They are the additional costs or revenues that arise from the production or sale of a group of
additional units. These are sometimes termed differential costs.

OTHER COSTS CATEGORIES include;

Period and product costs
Period costs are costs that do not benefit future periods and as a result are treated as expenses
written off in the period in which they are incurred. Hence, period costs are not included in
the inventory valuation. Expensing these costs immediately best matches expenses to
revenues. For manufacturing concerns, period costs include all non-manufacturing costs e.g
R & D costs, distribution costs etc. For a merchandising company, they are costs not related
to the cost of goods purchase for resale.
Product costs are costs that are attached to the product and are include in the inventory
valuation for the finished goods, or work-in-progress, hence they are not written off or
expensed immediately but are carried in the product until they are sold, and at that time they
are then recorded as expenses and matched against sales for calculating profit.
Budgeted costs: These are costs estimated and planned for a given activity level, function or
segment of the organisation within a specified time horizon.
Actual costs: These are the cost actually incurred in the production process. Actual costs are
not estimates but are historical or past costs.
Difference between Costing Methods and Costing Techniques
Costing Methods
It is a method of cost ascertainment that centres on the nature of the business. The use of a
given method is dictated by such factors as: the nature of cost units, the production process,
the mode of cost accumulation, the duration of work etc. The following are the well
established methods of costing.
Job/Batch costing: Job costing applies to business which carries out individual jobs of works
in accordance with customers specific requirements while batch costing is a form of job
costing in which each job is manufactured in a batch of identical articles, either for sale or for
use within the company.
Contract costing: It involves some form of costing method used in the constructing activity,
possibly at a site and in which the job is for a long period.
Process costing: It relates to products that are produced from a continuous process. It relates
to standardized goods.
Service costing applies to services that are repetitive in operation. It relates to standardized
services.
Costing Techniques
It refers to the methods used to determine the value of finished goods. Irrespective of the type
of costing method being applied there are various approaches that could be adopted. These
are:
Absorption costing: it is a costing technique that charges both the fixed and variable costs to
the product.
Marginal costing: It is the accounting systems in which variable costs are charged to cost
units and fixed costs of the period are written off in full against the attributed contribution. It
charges only variable cost to cost unit.
Standard costing: This is a costing technique that determines the cost estimated and
expected to be incurred per unit of activity under efficient production conditions. It uses;
a. absorption costing
b. marginal costing

Question one
Compute the missing amounts, assuming that cost behaviour patterns remain unchanged
within the relevant range of 5,000 to 8,000 units.
Hour 5,000 6,000 7,000 8,000
N N N N
Variable cost 20,000
168,00
Fixed cost 0
188,00
Total cost 0
Cost per unit N N N N
Variable cost
Fixed cost
Total cost
 COST ESTIMATION
Cost estimation is a term used to describe the measurement of historical cost with a view to
helping in the prediction of future costs for management decision making i.e historical
information is analysed to provide estimates on which to base future expectation. Cost may
be mixed and this will require segregation into mixed and variable elements. Cost estimation
is made possible on the ability of the accountant to identify cost driver. A cost deriver as any
factor whose changes causes a change in total cost of an activity. E.g direct labour hours,
machine hour, unit of output etc.
Segregation of mixed cost into its fixed and variable element can be achieved by adopting
any of the following methods;
 Engineering Method
 Inspection of the accounts or Account Classification Method
 High Low Method or Range Method
 Graphical or Scattered graph Method
 Least Square or Regression Method
Engineering method
It uses engineering analysis of technological relationship between inputs and outputs e.g
work study, work sampling. The procedure in such a study is used to make an analysis based
on direct observation of the underlying physical quantities required for an activity and then to
convert the results into cost estimates. Engineers apply the method.
Inspection of the accounts or account classification method.
It is a subjective way of segregating the mixed cost into fixed and variable element based on
the personal experience of the accountant. It involves inspecting each item of expenses and
classifying such cost as wholly fixed, variable or semi-variable.
High Low Method or Range Method
It is an objective way of segregating the mixed cost into fixed and variable element by
applying the following steps:
 Identify highest and lowest activity level
 Determine the difference between the two activity level
 Identify the corresponding costs to both the highest and lowest activity levels. where
inflation makes the costs in each period uncomparable, adjust itto same price level
through a price level index.
 Determine the difference between the two corresponding cost
 Divide difference in cost by difference in activity level in order to determine variable
cost per unit
 Use the variable cost per unit to determine total variable cost. The difference between
the total variable cost and the corresponding mixed cost will represent the total fixed
cost.
Review questions
1) ADEAYO Ltd has recorded the following total costs during the last five years

Years Outputs Total Costs

Units N
2004 65,000 145,000
2005 80,000 162,000
2006 90,000 170,000
2007 60,000 140,000
2008 75,000 160000

Required: Using the high-low point method

(i) Determine the fixed and variable cost
(ii) Calculate the total cost if output in 2009 is expected to be 85,000 units.
2) The following data are the actual costs of Adebayo Manufacturing Limited for the month
of June 2000
N
Direct material 1,800
Direct Labour 2,760
Supervisory Labour 130
Factory Rent and Rates 550
Fuel and Power 770
Costing office expenses 460
Maintenance 70
Depreciation 950
Miscellaneous 1,360
8,850
The production for the month of June was 500 units. You are required to:
(i) Determine the variable cost per unit
(ii) Determine the total fixed cost using account analysis method
(iii) Determine what the total costs would be in July, 2000, if the production is 750
units

3) The following data relate to the overhead expenditure of contract cleaners (for industrial
cleaning) at two activity levels

Square metres cleaned 12,750 15,100

Overheads N73,950 N83,585
When more than 20,000 square metres are industrially cleaned, it is necessary to have another
supervisor and so the fixed costs rise to N43, 350.
Required:
(a) What is the estimate of the overheads if 16,200 square metres are to be cleaned
(b) Calculate the estimated overhead expenditure if 22,000 square metres are to be
industrially cleaned.