MA1

SECTION 2
This section is all about costs. First, we will study about cost units for different businesses, then
we will study cost classification in detail. Finally, we will study about how costs are coded into Page | 1
an organization’s accounting system.

A) COST UNITS
Cost unit is a unit of output (product or service) to which costs are related.
Examples of cost units where output is product:

• Batch of sweets for bakery

• Unit of car for car manufacturer
• Unit of table for furniture manufacturer
• Batch of t-shirts for t-shirt maker, etc.
Examples of cost units where output is service:

• Chargeable hour of professional for clinic, consulting firm, or law firm

• Kilogram carried per mile for a goods transport company (such as train)
• Passenger per mile for passenger transport company (such as train)
• Student per day for schools, colleges, universities
• Room per night for hotel, etc.
Note that in service organizations, cost unit is usually made up of two parts (e.g. passenger per
mile). These type of cost units are called composite cost units.
How is cost unit information used? Cost per unit is calculated which tells how much it costs to
produce the unit (or provide in case of service unit). This is used in following ways:

• to help with cost control (business can control and monitor it’s cost per unit)
• to determine a selling price (a selling price can now be set that covers the full cost of
producing the product or providing the service)
• to compare different cost units (which product is more profitable)
• to plan (budget) and to measure performance
• in reporting

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MA1

B) COST CLASSIFICATION
For any organization, controlling its costs is a very important objectives and sometimes leads to
important competitive advantages. So, in this chapter, we will study different ways of classifying
costs to understand them better.
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Classification by Element / Type

Here all costs will be divided into THREE categories: Material, Labor or Expense.
Material
Costs related to materials used in production
E.g.

• Raw materials (wood, steel, plastic, etc.)

• components
• goods purchased for resale (for trading business)
• indirect materials used in production (cleaning supplies, nails, screws, glue, etc.)
Labor
Costs related to employees
E.g.

• Salaries / wages
• Cost of benefits provided
• Training costs, etc.
There are TWO types of workers:

• Employees: Part of the organisation. Are hired for a role. E.g. managers, production line
workers, security guards, etc. All costs related to employees are included in Labor
category.
• Independent Contractors: NOT part of the organisation. Are hired for a task. E.g.
freelancer hired for designing company’s app, auditor, electrician, plumber, etc. All
costs related to independent contractors are included in Expense category.
Expense
Costs that are neither material nor labor.
E.g.

• Bought-in services (services bought from another individual or business)

o From independent contractors
o Outsourced functions

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MA1

• Rent
o Building
o Equipment
• Royalty
• Depreciation, insurance and maintenance of machinery / equipment
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• Utility bills, etc.
Depreciation
Reduction in value of a non-current asset.
For example, an asset is bought for $1000 at the start of the year. By the end of this year its
value dropped down to $800. $200 would be the depreciation.
Royalty
Paid as a fee for using intellectual property of another business or individual.
Intellectual property: could be of one of following types:

• Copyright: For content, videos, movies, writing, design, songs, music, etc.
• Patent: For inventions
• Trademark: For company’s logo

Classification by Function
Here you ask: The cost has incurred in performing which function?
Production
Costs incurred in production of goods or provision of service. Includes:

• Materials
• Factory rent, bills
• Machine depreciation, etc.
Non-production
All costs incurred other than production. Includes:

• Sales
o Rent / bills of sales outlet
o Salaries of employees working there, etc.
• Purchase
o Salaries of employees working there
o Cost of stationery used, etc.
• Accounts / Finance

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o Salaries of employees working there (management and financial accountant would

be included here)
o Subscription fees of software used, etc.
• Administration, etc.
o Salaries of management, company’s secretory
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o Cost of stationery used
o Office furniture depreciation, etc.

Classification by Traceability / Nature

Here costs are divided into ONLY two categories: Direct and Indirect.
Direct
Costs that CAN be easily and economically traceable in production of a specific unit.
For a cost to be direct it must go through 3 filters:
1. It must be in production
2. It must be traceable to a specific unit / or units.
o A cost is traceable if the exact cost per unit can be found.
o A cost is NOT traceable if the cost per unit needs to be estimated
3. It must have some good value (compared to unit)
Indirect (Overheads)
Costs that CANNOT be easily and economically traceable in production of a specific unit.
Includes:
1. All non-production costs
2. Production costs items which are NOT traceable
3. Production costs items which are LOW value
Question: Give examples for each cost item for following organizations:

Production Non-production
Costs costs
All Direct Costs (Prime Costs) Production Overheads Non-production
DM DL DE IM IL IE Overheads
Furniture
Manufacturer

Car
Manufacturer

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Tailor

Hospital

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Classification by Behavior
Here costs are divided according to how they behave if the activity level (production) changes.

Variable
Costs that change with change in activity level. E.g.

• Material cost
• Hourly wages of workers, etc.

Activity Level Total Cost Cost per unit

10 $100
20 $200
30 $300
40 $400
50 $500

Total Cost Cost per unit

Fixed
Costs DONOT change with change in activity level. E.g.

• Rent
• Salaries of employees
• Machine depreciation, etc.

Activity Level Total Cost Cost per unit

10 $5000
20 $5000

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30 $5000
40 $5000
50 $5000

Total Cost Cost per unit

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Semi-Variable / Semi-Fixed / Mixed

These costs contain both variable and fixed elements. Hence, ONLY part of cost change with
change in activity level. E.g.

• Utility bills (normally there’s a connection charge per month which is fixed)
• Commission based pay
• Machine / vehicle rental

Activity Level Total Cost Cost per unit

0 $1000
5 $1200
10 $1400
20 $1600
30 $1800

Total Cost Cost per unit

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MA1

Stepped Fixed
These costs remain fixed over a range of activity but steps up when activity level increases from
that range. E.g.

• Additional supervisor hired

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• Additional equipment hired
• Additional warehouse space needed, etc.

Activity Level Total Cost Cost per unit

10 $1000
20 $1000
21 $2000
30 $2000
40 $2000
41 $3000
50 $3000

Total Cost Cost per unit

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MA1

C) RESPONSIBILITY CENTERS

Responsibility Accounting
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In responsibility accounting, capital, revenue and costs are divided into areas of personal
responsibility to monitor and assess the performance of each part of an organisation.
Principle of Responsibility Accounting

This principle states that managers should only be judged or held accountable for costs /
revenues / investments that they are able to influence or control.

It can be very demoralizing for managers who feel that their performance is being judged based
on something over which they have no influence.
Responsibility Centers
A responsibility center is any specific unit of an organisation that is assigned to a manager who
is held responsible for its operations and resources. Responsibility center could be:

• Cost Center
• Profit Center
• Revenue Center
• Investment Center

Cost Centers
This is any section of an organisation which generate costs.

Cost center manager is responsible for costs only. Cost center could be:

• A department; finance department, personnel department

• A project; development of new product
• A person or team
• Any process / activity; quality control activity, planning
• Production or service location; head office, production lines
• Item of machinery or equipment
The purpose of establishing cost centers within a business is so that those costs that cannot be
directly allocated to a cost unit (i.e., the overheads of the business) can be controlled. A cost
center acts as a 'collecting place' for costs before they are analyzed further.
Cost codes are used to charge actual costs to a cost center. For example, a project of
development of new product is given a cost code of 054; now all the costs related to this project
can be traced using this code.

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MA1

Information will be collected for:

• Costs
o Actual costs
o Budgeted costs
o Cost Variances Page | 9
Impact of cost centers
Because cost center only incurs costs this leads to cost centers being:

• targeted for cutbacks

• perceived negatively
• managers find it difficult to justify expansion
It is important to realize that cost centers do add value to organisation. If a business must be
successful, it must provide quality in product or service it offers, which is not possible without
investing resources in cost centers also.
Directly Attributable Costs / Direct Costs
Costs that can be directly attributed to a single cost center. For example, rent of a warehouse
that is directly attributed to that warehouse; it isn’t shared between two or more cost centers.
These are the costs, that the manager can be held responsible for.
Shared Costs / Indirect Costs
Costs that cannot be directly attributed to a single cost center. For example, rent of the whole
business premises cannot be directly attributed to a single cost center, it is shared by multiple
departments (cost centers) in the premises.
Service Cost Centers
These are areas of the business that provide necessary services to the production cost
centers such as stores, maintenance or a canteen.
Controllable and Uncontrollable costs
When evaluating the performance of a cost center and of the person (or people) responsible for
the cost center performance (such as a manager), a distinction should be made
between controllable and uncontrollable costs.
A controllable cost is 'a cost that can be controlled, typically by a cost, profit or investment
center manager'.

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MA1

Profit Centers
Any section of the organisation which generate both costs and revenues.

Profit center manager is responsible for costs and revenue generated. Examples include:
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• Sales division / After sales service
• individual shops in a retail chain
• local branches
• a team or person - sales team, salesman, team of equipment installers
Information will be collected for:

• Costs (same information collected as for cost centers)

• Revenues
o Actual sales and budgeted sales
o Market share for different products
o Profitability of different products
o Cost to sales ratio + Gross profit margin + net profit margin etc.
Internal and External Profits
Revenue can be generated internally or externally. For example, IT support department inside
an organization may start charging other departments for its services. This department will now
be a profit center.

Revenue Centers
Any section of organization which is made responsible solely for generating revenue.

Revenue center manager is only responsible for the revenue generated and not the costs
incurred. This is useful when organization wants a manager to focus on maximizing sales only
and not making them accountable for the costs incurred.
Information will be collected for:

• Revenues only
o Actual sales and budgeted sales
o Market share for different products

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MA1

Investment Centers
Any section of the organisation which generate both costs and revenue and is also responsible
for capital investment.

Investment center managers are responsible for costs, revenues and investment decisions. Page | 11
Examples include:

• Subsidiary companies
o Instagram, WhatsApp owned by Meta
o Ufone is a subsidiary of PTCL
• can be based on products – Coca Cola owns Sprite, Fanta
Information could be collected for:

• Costs and Revenues (same information collected as for profit centers)

• Capital Employed
o Return on capital employed (comparison of profit made to capital invested)
o Asset turnover (comparison of revenue made to capital invested) etc.
Responsibility Centers and Organizational Hierarchy
In organization hierarchy (as shown by organization chart), investment centers managers are
the most senior under whom many profit center managers and cost center managers are
placed. Similarly, profit centers require more experienced and senior managers as compared to
cost centers.

Investmennt
Centers

Profit Centers

Cost Centers

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MA1

D) CODING SYSTEMS

Code Page | 12
A code is a unique set of characters used to identify an item. An example is barcode.
Characters could be numbers, letters or symbols
Item could be customers, suppliers, source documents, assets, inventory items, costs /
expenses, cheques
Coding system: System by which codes are created, managed and used.
Characteristics of an effective coding system

• Concise: should be brief, simple and easy to understand

• logical and understandable: should contribute to the efficiency of the organization
• Consistent and uniform: coding system should be structured so that it can be applied
uniformly (in the same way) and consistently
• Unique: each code should be unique
• Potential to expand should include room for expansion
Primary reason for using codes is to identify transactions. Using codes helps entry into
accounting records, collation and analysis. Each expense can be classified (using codes)
according to its responsibility center and type of expense.
Types of Coding Systems
The coding system used by an organisation is often determined by the computerized
accounting software package (QuickBooks for example), which may come with a ready-
made chart of accounts and suggested codes.
A coding system may be made up of a combination of multiple types of coding systems.

1. Sequential Code
This system allocates a standard numeric code to each item in a sequence. There is no obvious
connection between an item and its code.
For example:

001 Bread roll, small, white

002 Bread roll, small,
wholegrain
003 Bread roll, large, white
004 Bread roll, large,
wholegrain

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2. Block Code
This system group similar items together in a block. This system is often applied to chart of
accounts in an accounting system. Normally block codes are used to categorize sequential
codes together.
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For example:

1000 Non-current assets

2000 Current assets
3000 Non-current liabilities
4000 Current liabilities
5000 Equity
6000 Revenue
7000 Expenses
This code structure can accommodate 999 items within each category. Further blocks can also
be made within each category:

Non-current asset
1001 – 1099 plant and machinery
1100 land and building
1200 Cars

3. Faceted Code
A faceted code is broken down into facets (or groups), each of which represents a different
category characteristic.
For example, consider a furniture manufacturer using a three-faceted coding system.

Facet 1 is two digits long and represents the department, function or cost center.
Facet 2 is three characters long and represents different types of cost.
Facet 3 is four digits long and represents the cost item.

Facet 1: Function Facet 2: Cost Facet 3: Cost item

Classification
01 Production DM Direct materials 0001 - 0100 Direct material
descriptions
02 Inspection DL Direct Labor 0101 - 0150 Direct labour activities
03 Delivery DE Direct expenses 0151 - 0200 Production overhead cost
items
IC Indirect costs 0201- 0250 nonproduction overhead
Now for example code for leather could be 01DM0070. Similarly, fuel for distribution could be
given the code 03IC0205.

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MA1

4. Hierarchical
Under this system, each digit in the code represents a classification or an item. And each
classification (on the right) represents a subset of the previous classification (on the left). The
code grows in length as more detail is provided.
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For example:

1 represent revenue 1.1 revenue from USA 1.1.1 revenue from USA from laptop
sales
1.2 revenue from China 1.1.2 revenue from USA from ps4 sales
1.3 revenue from UK

5. Mnemonic
This system uses an abbreviation or other memory trigger to help identify the meaning of the
code.
An example is the three-letter system used to identify airports in the travel industry:

BNE Brisbane
LHE Lahore
LAX Los Angeles
LHR London Heathrow
SIN Singapore

Can also be used for chart of accounts:

NCA Non-current asset

EXP Expenses
CA Current Assets

The use of Codes in an Accounting System

Accounting systems capture transactions and other information, process them according to a
set of rules and produce outputs such as financial statements and management accounting
information and reports.
This process relies on transactions being classified correctly and being directed to the correct
location in the accounting system. Coding helps to facilitate this process.
Timing of Coding
Code should be inputted into system when expense incurs, normally when invoice is received.
When code is given to an item of expense, it can also be written on the front of invoice to which
it relates.

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MA1

Creating Cost Codes

A cost code is a code used in a costing system. The first step in creating a cost code will be to
determine the cost center to which the cost relates and then to allocate the correct cost center
code.
Problems with Coding Page | 15

Deciding cost center or cost classification may be difficult

if unable to find correct code

• Refer to policy manual in organisation

• Ask supervisor
Apportionment

• Directly attributable costs are coded in according their relevant cost center
• Shared costs are normally coded in as indirect costs
• indirect costs need to be apportioned carefully
Identifying and Correcting Coding Errors
Errors are usually detected via the internal controls of the company or through the activities of
internal and external auditors. For example:

• Reconciling accounts
• Built in Logic checks
• Sampling of Invoices
For Correction
1. Reversing the entries
2. Repost correct entries using correct codes
Advantages of Coding
• Help in tracking of expenses
• Help in classification of costs
• Increased Efficiency
o Data entry is more efficient
o Analysis of data is more efficient. All costs can be sorted according to cost
center
o Processing of data is more efficient using simple and brief codes
o Reduces confusion
• Can incorporate check codes: for example, cannot put nonproduction expense in
system in production department

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