Management Accounting - Cost Classification

COST CLASSIFICATION ASSIGNMENT

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.

1. THE DIFFERENCE BETWEEN MANAGEMENT & 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accounting concerns using data from previous years which also means that the information which is used is generally out of date.

2. HOW ARE ALL THE COSTS CLASSIFIED?

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.

3. HOW CAN COST BEHAVIOUR BE ILLUSTRATED?