Business / Management Accounting - Cost Classification

Management Accounting - Cost Classification

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Autor:  anton  09 June 2011
Tags:  Management,  Accounting,  Classification
Words: 2279   |   Pages: 10
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To classify the various costs would first of all require a definition between the two types of accounting that practically all businesses have to face and a number of key terms which are equally important. These are management accounting and financial accounting.


Management accounting is concerned with decision making, cost apportionment, planning and control. It is based within the organisation and is solely for the use of the managers to conduct their business dealings. The process of management accounting is proactive meaning the company is looking ahead, not backwards.

Financial accounting on the other hand is externally based and is primarily concerned with the preparation of financial statements for organisations’ stakeholders. Stakeholders would include shareholders and competitors. Unlike management accounting it has to comply with various financial legislations and standards. Financial accounting concerns using data from previous years which also means that the information which is used is generally out of date.


To classify costs would require a number of key terms to be defined; all of which should be understood fully in the concept of management accounting. These are fixed / variable costs, incremental / controllable costs, direct / indirect costs and future / past costs.

Fixed costs are costs which do not change as the level of productivity increases. An example of this would be rent as this would have to be paid irrespective of how many units of a product a company produces. In contrast, variable costs are expenses which change in relation to the output produced. An example of this can be seen in the manufacturing industry, whereby the company pays for raw materials only when it is needed. If the level of activity decreases it is likely that the spending on those raw materials will fall. There are also costs which have both variable and fixed elements, known as semi – variable costs. These types of costs are most common in telephone bills, as there is a fixed rate which must be paid. Taking BT as an example in the telecommunications industry, the service charge has to be paid regardless if phone calls are made or not. The variable costs are made up of the amount of calls/ messages which are made over the period the bill covers.

A direct cost is the term used for costs which are directly associated with a product. These costs are generally allocated to products or cost units. They do not take into account costs such as admin expenses or electricity used. An example of a direct cost would be in the production of leather sofas or other related manufacturing industries. The direct cost is the actual leather which is used to make the sofa. However, costs can be further split into indirect costs which do not affect the production process. Again taking the leather sofa example to illustrate indirect costs, the salaries that are paid to the management do not affect the cost of producing the sofa itself even though they are associated with the production of the sofa.

It is important to understand that management accounting is forward looking and so the concept of future and past costs are relevant here. Any cost which is incurred previously in the year should not be taken into account when conducting cost assignment as they are irrelevant to the present circumstances. However, it is extremely important to consider that it is inevitable that costs will be incurred for any product in the future therefore these costs must be accounted for, possibly in the form of provisions. A simple illustration of this can be insurance of machinery. If the management of a company knows how much an insurance company will charge each year, then they can set aside a sum to cover that cost.

Controllable costs are costs which can be directly influenced by a manager of an organisation. For example, a manager can choose how much direct labour is to be involved in the production process therefore they can control this cost themselves. This means that it is up to them on how many employees they would like to work on a certain process. This is also the case with direct materials and variable overheads. However, there are also costs which can be controlled up to a certain extent, such as advertising costs. In this case, a department manager would be able to control how much of the allocated advertising budget is spent in their department. However, once this budget is spread throughout the whole company, it will be difficult for that particular manager to oversee budgets in the other departments.

Incremental costs are those cost which increase or decrease because of an increase or decrease in one whole unit of output. As an example, the incremental cost of increasing the level of software packages from 10 units to 15 units is the additional cost for Microsoft of producing five extra units of software packages

Many costs within the manufacturing industry can be easily separated from fixed and variable costs. The method used to achieve this is known as Cost Separation. The calculation for this is very simple and it enables the management to work out how much an individual unit will cost so that pricing and other useful decisions such as planning and control. The following example utilizes the Hi/Low method to explain how costs can be separated:

(Hi Low Method):

Units of chocolate bar: Total Cost:

Total variable cost: Total fixed cost:

100000 50000 37500 12500

300000 125000 112500 12500

Unit change = 200000

Total cost change = 75000

So 75000 ч 200000 = 0.375

0.375 Ч 100000 = 37500

0.375 Ч 300000 = 112500

This type of cost assignment is mainly associated with manufacturing firms.




There are many different ways in which costs can be classified and allocated. Each one of these costs gives rise to a number of debates as to their accuracy, techniques, purpose and objectives. The most common types are Cost Separation, Activity Based Costing, Absorption Costing, Marginal Costing and Process Costing.


As mentioned earlier production overheads cannot be directly identified with a specific product so instead it is apportioned throughout the whole department(s) through the method of absorption costing. The purpose of Absorption costing is to allocate a share of all the production costs which include variable manufacturing and fixed manufacturing costs that are incurred by a business to either its products or services. Another term that is commonly used to describe this process is apportioning costs. The primary basis for this method is to use direct costs such as materials or labour. This effectively gives a better picture of an organisations’ cost structure although it is up to the manager to decide which technique to use. Also prices can be set based on total cost, which may be useful when demand is uncertain as it is better to consider the the final profit figure and not just the contribution.

One of the main problems with absorption costing is that the method is prone to manipulation by managers as they can increase the rate of production wihout due regard for the level of sales. By achieving this, all extra costs can be deffered until the following year by which time the management will show higher profits on the accounts but only for their own personal gain (i.e rewards and bonuses).

A worked example of Absorption Costing:

This answer means that for every chair produced by the assembly department, an extra Ј1.50 must be added so that each chair carries an equal share of the assembly department overheads.


One of the main discussion points between absorption costing and marginal costing is how the costs can be organized and presented in a way so as to identify products and services and also the total profits of the business. Marginal costing distinguishes between fixed and variable costs unlike absorption costing which charges both fixed and variable cost elements to the product. An advantage of marginal costing is that it helps decision making by providing a method of charging variable costs to cost units and the remaining fixed costs for that specific period are written off in full against the total contribution. It also enables the management to work out easily the profit or loss at a certain level of output if the break-even point and the contribution per unit are already worked out. This is because for every unit sold above the break even point the profit will equal the contribution per unit. If the units sold are less than the break-even point then the contribution will fall.

Problems with marginal costing - Under the Financial Reporting Standards, it is necessary for all companies to produce a true and fair of their accounts. Under marginal costing all of the stocks and work in progress tend to be understated which could mean that it affects the overall profits in a way which does not completely reflect the companies true value.

Furthermore, many costs to the business such as director’s remunerations cannot be related, or assigned to the products, customers or service departments because there is actually no effective way of accurately doing this. However, it should be noted that this sum must still be recognised through contributions from each of the products.


This method of costing is concerned with the allocation of costs to a company’s products and services. Activity based costing is a tool for managers to help them plan and control business activities. The main purpose of this cost method is to identify all the directly attributable costs of a particular activity and then dispense those costs to each product to the extent that the product uses the activity. ABC is extremely useful in this context because it can identify an area which has high overhead costs per unit, meaning that further attention can be directed towards finding ways of reducing costs or charging extra for products which cost more to make.

ABC accomplishes the most complex task of identifying discrete activities and then identifying the primary output measure for each activity. Many companies have decided against using absorption and marginal costing because they see ABC as a more powerful tool for measuring business performance because it allows them to identify opportunities to improve business process, effectiveness and efficiency. Also, ABC provides a better basis for cost reduction because it gives an accurate reflection of the effort put into each product and it is also a better basis for identifying the costs of each unit.

Problems: Many companies have abandoned the use of ABC because they feel that it is too complicated and puts managers under pressure with the extra workload. The pioneer for ABC costing, Kaplan, suggested that it was effective within a “limited setting”, but the approach became increasingly difficult when it was applied to a larger scale because of the fact there is more data and information to collect on. Companies such as Coca Cola or Wal-mart are good examples. As a result this information quickly becomes out of date and therefore somewhat unreliable.


There are many ways to classify costs but the method used depends entirely on the type of business and what the managers of the company want to achieve from the information they will gain. The main uses are to reduce the price of individual units, identify which departments are performing to high standards and those which are not so that loss centres can be disposed of and resources can be concentrated on the profitable ones. All businesses have their preferences on which technique to use but it is the information that these methods generate that determines which one is most useful for the management of an organisation.

Both absorption and marginal costing allow businesses to determine which costs are allocated to a specific department. If a company wanted to determine the costs of a continuous work process then they are more likely to use marginal costing because of the benefits of cost/volume/profit analysis. However, absorption costing will be more relevant if it is for a specific unit because that individual unit can be referred back to the total costs.

Another factor for why businesses choose one approach over the other could be due to the fact that normally, the value of the closing stock is higher when the absorption costing approach is used. The reason for this is because stock is valued to include a certain amount of fixed overheads, whereas in the marginal costing approach the costs take account only the variable overheads of production. This could be reflected on the Balance sheet and Income statement in the form of increased or decreased profits.

The concept of ABC costing provides a different angle to managing costs. Apart from working out the various costs, many businesses have found it useful to mix elements of marginal, absorption and ABC costing so that they can identify the most beneficial information from which they can set budgets.



Bendry, M et al, 2003, Essentials of Management Accounting in Business, printed in UK, published by Thompson Learning

Drury, C, 2001, Management Accounting For Business Decisions, Second Edition, Published by Thompson Learning

Drury, C, 2003, Cost & Management Accounting: An Introduction, Fifth Edition, Published by Thompson Learning

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