Management Accounting

Cost Classification – Part 3

Functional/Departmental costs

Production and non-production costs are the major categories in this area. However, if an organisation does not produce but only buy and sell then it will not incur production costs.

Production costs

Production costs are those costs which are incurred when raw material is converted into finished and part-finished products. The followings are the sub-categories in this area.

-Direct Material

-Direct Labour

-Direct expenses

-Variable production overheads

-Fixed production overheads

We have already discussed direct material, labour and expenses so we will look at the last two items now.

Variable overheads and fixed overheads are the two elements of overheads. Their composition i.e., what costs are included in these expenses will depend upon

-the size of the business,

-if the business sells goods or services and

-which industry/sector a business is operating in.

However, in all cases some expenses will change in value (£,$ etc) on regular basis called “variable overheads” while others’ value will not change (at least in the short-medium term) called “fixed overheads”.

Variable production overheads

These are the indirect expenses which are incurred in the production facilities e.g., factories. These are called variable as the amount changes regularly usually due to the change in production level. For example, if production lines run for longer then more electricity will be consumed, machines will require more lubrication and maintenance, hence more oil (indirect material) and more engineers’ time (indirect labour) will be needed. There will be more machinery breakdown requiring more parts replacements. Higher production will also require more quality testing and more batches produced will require more batch related activities including machine set ups, lines cleaning and clearing, test runs and sample testing etc.

Fixed production overheads

These are the indirect expenses which do not change in the short-medium term and the amount spent on those expenses does not depend on the volume of production. The followings are few examples of fixed production overheads;

-Factory rent & rates

-Factory insurance

-Factory building’s maintenance

-Fixed salary staff who are not directly involved with production for example cleaning and security staff, supervisors and managers, store rooms and canteen staff etc

Non-Production overheads

Followings are the sub-categories in this area

Administrative costs

These are the costs incurred to run general admin of the business including head office rent and other building related expenses, head office staff salaries including directors and senior management, accountancy and legal department etc.

Selling costs

These costs are associated with promotion, marketing and sales related expenses including salaries for shop and supermarkets’ rent and other building related expenses, shop managers and staff salaries, sales reps, order receiving costs etc.

Distribution costs

If you have travelled on motorways in the UK, you would have noticed massive buildings around motorway areas with the names of well-known UK businesses including Tesco, Sainsbury’s, DHL etc. These buildings are distribution centres for these businesses where they receive deliveries from their suppliers (often directly from manufacturers), store and maintain those stock and deliver to shops and end customers. All expenses incurred to run those warehouses, for example, rent and other building related expenses, managers, drivers and staff salaries, lorries leases and fuel costs are all included in the distribution costs.

Finance Cost

In the modern economy, businesses often borrow money to establish i.e. building a new factory, warehouse or a shop and to run their operations. These loans require a payment of interest which is called finance cost. However, there are many businesses, especially the one following Islamic financing principles, do not take loans and hence will not have this type of cost.

This article is written by Raja Mizan who is a senior lecturer in accounting & finance in a UK university. He is an ACCA member and also runs his own accountancy practice RMR Accountants & Business Advisors.

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