Classifying costs

Management accounting produces information for people inside the business — managers deciding what to make, what to charge and where to cut. Unlike financial reporting, it isn't governed by IFRS or any other reporting framework: a company can classify, allocate and report costs however best supports its decisions. Professional bodies such as CIMA and the IMA set out common terminology and good practice, and that is what this track follows. (One link to the published accounts remains: inventory in external financial statements must be measured under IAS 2, which requires production overheads to be included in inventory cost — so product costing matters to financial reporting too.)

The same cost can be classified three different ways, depending on the question being asked.

1. By behaviour — how does total cost respond to activity? - Variable cost: total changes in proportion to activity; cost per unit stays constant (wood in a chair, sales commission per unit). - Fixed cost: total stays the same within the relevant range of activity; cost per unit falls as output rises (factory rent, a supervisor's salary). - Mixed (semi-variable) cost: a fixed element plus a variable element (a power bill with a standing charge plus a rate per kWh). - Step-fixed cost: fixed over a band of activity, then jumps to a new level (one inspector for every 4,000 units).

Behaviour depends on the contract and the time horizon, not on the type of cost. Corbel's carpenters are paid only for hours booked to jobs, and the hours flex with output, so their wages are treated as variable. Salaried production staff on guaranteed hours are a fixed cost in the short run, even though they are direct labour — a common real-world trap when building a budget or a CVP model.

2. By traceability — can it be traced to a cost object? A cost object is anything you want a cost for: a product, a job, a department, a customer. Direct costs can be traced to it economically (the oak in a table, the hours a carpenter books to a job). Indirect costs (overheads) are shared and must be allocated (factory rent, the maintenance team).

3. By treatment — product or period? - Product (inventoriable) costs are the costs of making the goods: direct materials, direct labour and manufacturing overhead. They sit in inventory until the goods are sold, then become cost of sales. - Period costs — selling, distribution and administration — are expensed in the period incurred, never inventoried.

Two useful sub-totals: prime cost = direct materials + direct labour; conversion cost = direct labour + manufacturing overhead. Direct labour belongs to both, so prime cost + conversion cost does not equal total manufacturing cost.