Cost Analysis and Classification Systems

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Chapter 2

• Cost Analysis and Classification Systems

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What is cost?

• 'the resources consumed or used up to achieve a
  certain objective'

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Cost classification systems

• Cost analysis involves classifying costs
  according to their common characteristics. There
  are a number of different classification systems,
  each differing according to the purpose to which
  the cost data is to be used.
• Cost classification by element.
• Cost classification for control (direct and
  indirect).
• Cost classification by cost centre.
• Cost classification by behaviour.

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Classifying costs by element
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Cost classification for control

• One of the responsibilities of management is to
  ensure costs are minimised without a loss of
  quality to the product or service provided. To
  control costs, one must be able to trace costs to
  either a product line or a department. This can
  help management identify where cost over-runs
  have occurred, identify the problems and decide
  on appropriate solutions. The process of tracing
  costs to departments or product lines involves
  classifying costs according to whether they are
  direct costs or indirect costs.

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Direct cost

• expenditure that can be attributed to a specific
  cost unit
• CIMA Official Terminology

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Indirect cost

• expenditure on labour, materials or services
  that cannot be economically identified with a
  specific saleable cost unit.
• CIMA Official Terminology

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Direct v indirect cost
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Example - Hotel
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Example 2.1 Calculation of direct material cost
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Example 2.1 Solution
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Example 2.2 Calculation of direct labour cost
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Example 2.2 Solution
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Example 2.3 Calculation of direct expenses
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Example 2.3 Solution
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Prime cost

• The prime cost can be established as follows

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Cost classification by cost centre

• This is an extension of cost classification for
  control purposes. A cost centre is a location or
  person or item of equipment for which costs may
  be ascertained, and for which an individual is
  responsible.

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Cost classification by cost centre
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Cost classification by behaviour

• Cost classification by behaviour is primarily
  used for management planning decisions. It is a
  crucial classification in that it allows an
  insight into how costs react to different
  circumstances. In trying to predict and plan for
  the future, it is essential to understand costs
  and what drives and creates costs. In particular,
  this classification looks at the relationship
  between costs and sales volume / production
  output. When planning to increase output (sales
  volume), it is important to understand and
  appreciate how costs will react to this.

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Cost classification by behaviour

• 'the way in which cost per unit of output is
  affected by fluctuations in the level of
  activity'. 
• Variable cost
• Fixed cost

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Example 2.4 Cost behaviour
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Example 2.4 Solution
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Variable cost

• Variable costs are costs that increase as sales
  or production volume increases.
• Examples would include direct materials (cost of
  food or beverages for a restaurant or toys in a
  toyshop)
• Variable costs in total change in response to
  changes in activity levels.
• Variable cost per unit will remain constant in
  relation to changes in sales activity.

The graph illustrates the variable cost of
producing a meal in a restaurant is 2 and, as
sales volume increases, the variable costs
increase. The variable cost graph shows that the
variable cost of producing 2,000 meals is 4,000
and the variable cost of producing 4,000 meals is
8,000.
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Fixed cost

• Fixed costs are costs that are a function of time
  rather than sales activity and thus are not
  sensitive to changes in sales volume.
• Examples of fixed costs would include rent,
  rates, insurance and management salaries.
• Fixed costs in total do not change in response
  to changes in sales activity levels.
• Fixed cost per unit will change in relation to
  changes in sales activity.

The graph shows that fixed costs are 2,000 per
week.
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Relevant range

• In some situations increases in activity (volume)
  can affect the cost structure.
• For example a significant increase in volume
  could result in an increase in fixed costs, if
  the activity increases to a level where
  additional fixed resources are required then
  there will be can be a significant increase in
  fixed cost.

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Step cost

• Some costs are called step costs due to the fact
  that they are fixed for a given level of activity
  but they eventually increase by a significant
  amount at some critical point.
• Examples include renting an additional warehouse
  unit or hiring an additional supervisor when
  activity reaches a critical point.

The graph shows that fixed costs are 2,000 up to
an activity level of 2,000 meals. At this point
the fixed costs increase significantly. Again at
4,000 meals another critical point is reached and
fixed costs increase again.
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Semi-variable cost
This graph shows the fixed and variable elements
of a typical landline telephone charge as
described above.
This graph shows the fixed and variable elements
of a mobile phone charge where the user pays a
fixed charge for a required level of usage
(number of minutes) after which the user pays for
each phone call.
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Separating semi-variable cost

• Accounts analysis method
• High-low method
• Scatter-graph method
• Linear regression

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Accounts analysis method

• Under this method each cost is examined and,
  using judgement and experience, classified into
  fixed, variable and semi-variable categories. The
  semi-variable category is further apportioned
  individually into its fixed and variable
  components, normally on a percentage basis. This
  method is based mainly on experience and personal
  judgement and thus can be quite subjective.
  Management can however, reduce this level of
  subjectivity as follows.
• Asking a person associated with the cost item who
  knows its behavioural pattern and can give a best
  estimate of the variable and fixed components to
  the cost.
• Analysing how the cost item has responded to
  sales volume levels in past periods before
  categorising the cost.

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Accounts analysis method

• The main advantages of the accounts analysis
  method is that it is quick and inexpensive,
  however the subjectivity involved can lead to
  inaccuracies. Where the cost item is immaterial
  and is largely fixed or variable, then the
  accounts analysis method is acceptable. However
  if this is not so, other more scientific methods
  should be used with the accounts analysis method
  providing the first stage of a more analytical
  approach to cost behaviour analysis.

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High-low method

• The high-low method is a statistical method that
  establishes a cost to sales volume relationship
  based on past observations of how the cost
  reacted to changes in sales volume.
• This relationship is expressed in terms of the
  cost function y a b (x).
• The high-low method focuses on the highest and
  lowest levels of activity (sales volume) within
  the relevant range over a period of time.
• The total cost at these two extreme levels of
  activity is recorded and the difference is
  attributed to the behaviour of the variable cost
  element, which changes as activity levels change.
  The process seeks to calculate this variable
  element. The fixed element can then be calculated
  to complete the cost function.

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High-low method the steps

1. Identify the high and low activity levels and
   record the cost at each level.
2. Calculate the difference in activity levels and
   the difference in costs.
3. Divide the cost difference by the difference in
   activity levels. This gives us the variable cost
   per room sold (b).
4. Take either the high or the low activity level
   and input the data including (b) as calculated in
   step 3 and solve the equation by finding the
   fixed cost element.

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Example 2.5 High-low method
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Example 2.5 Solution
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Scatter-graph method

• The scatter-graph approach is a statistical
  method that uses historical data to determine
  cost behaviour. The scatter-graph approach plots
  on a graph, all the historic observations of the
  cost items in relation to the activity levels of
  the business, within the relevant range. A line
  of best fit is then drawn visually through the
  data on the graph. As with the high-low method,
  the form of the line is assumed linear. The angle
  or gradient of the line represents the variable
  cost per unit and the fixed cost is the point
  where the fitted line intersects the vertical
  axis.

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Example 2.6 Scatter-graph method
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Example 2.6 Solution
The data is plotted on the graph and a line of
best visual fit is drawn and extends down to the
Y (total cost) axis. The point of intersection
with the Y axis represents the estimated fixed
costs in this cost equation, which amounts to
2,900. The variable costs can be calculated by
inputting the fixed cost and the total cost
figures into a cost function based on any
activity point on the line of best fit.
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Linear regression least squares method

• This method is a statistical approach to
  determine the line of best fit for a given set of
  data. It is an extension of the scatter-graph
  approach and is based on the principle that the
  sum of the squares of the vertical distances from
  the regression line to the plots of the data
  points is less than the sum of the squares of the
  vertical distances from any other line that may
  be determined. In other words a truly objective
  line of best fit is calculated which minimises
  the squared deviations between the regression
  line and the observed data.

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Linear regression least squares method
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Example 2.7 Linear regression
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Example 2.7 Linear regression
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Example 2.7 Linear regression
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Separating semi-variable cost

• Each method will give a different cost function.

Of the three methods, the linear regression model
is considered to have the least number of
limitations. The cost function can be used in the
intelligent prediction of future costs based on
forecast sales activity