Cost Classification and Responsibility Accounting Systems

Responsibility Accounting and Responsibility Centres

Responsibility accounting is a management system based on the principle of identifying individual parts of a business that fall under the direct jurisdiction and responsibility of a single manager. This structure ensures that performance can be monitored against specific targets. A responsibility centre is defined as an individual part of a business where the manager has personal responsibility for its performance.

A cost centre is a specific production or service location, function, activity, or item of equipment for which costs are identified, recorded, and accumulated. Examples include a mixing department or packaging department for a paint manufacturer, or administration and marketing departments. For an accountancy firm, cost centres might involve specific departments like audit, taxation, and the canteen, or geographical branches such as the London office, the Rome office, and the Peru office. Cost centre managers require detailed information regarding costs incurred and charged to their centres, as their performance is judged strictly on the extent to which cost targets are achieved.

A revenue centre is a part of the organisation focused on earning sales revenue. While similar to a cost centre, only revenues—not costs—are recorded. These are typically associated with selling activities; for instance, regional sales managers are responsible for regional sales revenues. For performance assessment, revenues must be traceable to individual revenue centres, allowing for the evaluation of managers based on their ability to reach specific sales targets.

A profit centre is a segment of the business for which both costs incurred and revenues earned are tracked. These are frequently found in large, divisionalised organisations where each division operates as a profit centre. Within a single profit centre, multiple cost and revenue centres may exist. The manager of a profit centre is measured by the profit made by that centre and must therefore have the authority to plan and control both costs and revenues. Data regarding both financial aspects must be accurately collected and allocated to the relevant profit centre.

Investment centres represent the highest level of responsibility. Managers here are responsible for investment decisions in addition to overseeing costs and revenues. They are accountable for the performance of the capital employed as well as profit. Performance is measured by the return on capital employed (ROCE), which is the profit earned relative to the capital invested. An example of an investment centre is the UK or European division of a multinational corporation.

Cost Objects, Cost Units, and Cost Cards

A cost object is defined as any activity for which a separate measurement of cost is undertaken. Common examples include the cost of a specific product, the cost of a service, the cost of running a department, or the cost of operating a regional office. A cost unit is a unit of product or service in relation to which costs are ascertained. Examples include a room in a hotel, a litre of paint for manufacturers, or an in-patient in a hospital setting.

To manage these costs, organisations use cost cards. A cost card provides a detailed breakdown of the costs of producing output based on cost classification, either for a single unit or a planned production level. The items recorded on a cost card include direct materials, direct labour, direct expenses, the prime cost (the sum of all direct costs), variable production overheads, fixed production overheads, and non-production overheads. Management utilizes these summaries for various purposes, such as preparing external financial reports, making decisions, planning, and control. To produce these summaries, managers must analyse cost behaviour and classification types.

Methods of Cost Classification

Costs can be classified in four primary ways to aid different management functions. Classification by Element categorizes costs based on whether they relate to materials, labour, or expenses, which is essential for cost control. Classification by Nature determines how costs relate to production—specifically whether they are directly or indirectly involved—useful for cost accounting. Classification by Function separates costs into production and non-production categories for financial accounts. Finally, Classification by Behaviour identifies how costs change in relation to activity levels, which is vital for budgeting and decision-making.

When classifying by element, costs are split into Materials (all costs of materials for production or non-production, including raw materials, components, and stationery), Labour (all staff costs for payroll employees), and Expenses (all other costs, such as rent, telephone, sub-contractors, and equipment depreciation).

Classification by Nature: Direct and Indirect Costs

Direct costs can be traced specifically to a cost unit or cost centre. The three main types are direct material, direct labour, and direct expenses. For a shirt manufacturer, direct materials include the cloth, direct labour covers the wages of workers stitching the shirts, and direct expenses include royalties paid to a designer. The summation of these direct costs is known as the prime cost.

Indirect costs, also known as overheads, are those that cannot be identified directly with a specific cost unit. Examples for a shirt manufacturer include indirect materials like cleaning fluids for machines, indirect labour such as the cost of a supervisor, and indirect expenses such as factory rent. Whether a cost is direct or indirect depends on the cost object. For example, a supervisor\'s salary is a direct cost of the machining department (the cost centre), but it is an indirect cost for each individual unit (the cost unit) processed in that department.

Classification by Function: Production and Non-Production Costs

Production costs relate to manufacturing a product or providing a service and are found in the cost of sales on the statement of profit or loss and included in inventory valuation. For a construction firm, these include direct materials like bricks and cement, direct labour like builders, direct expenses like crane hire, variable overheads like electricity, and fixed overheads like the site manager’s salary.

Non-production costs are not associated with output production and are treated as period expenses in the statement of profit or loss; they are not included in inventory valuation. These consist of Administrative costs (e.g., the accounts department), Selling costs (e.g., sales department and marketing), Distribution costs (e.g., warehousing and delivery), and Finance costs (e.g., loan interest).

Classification by Behaviour: Cost Dynamics

Cost behaviour describes how costs react to changes in activity levels. Variable costs vary in direct proportion to activity; as activity increases, the total variable cost increases, but the cost per unit remains constant. Examples include raw materials and direct labour. In a widget factory example, if it takes $4\,m^2$ at $\$2$ per square metre to make one widget, the material cost is $\$8$ per unit. Making $50$ widgets costs $\$400$, and $100$ widgets costs $\$800$. While total cost rises with volume, the $\$8$ per unit remains fixed.

Regarding materials, two discount scenarios exist. In the first, discounts apply only to additional purchases above a certain quantity. In the second, discounts apply to all units once total purchases exceed a threshold. In both cases, the data line on a cost graph will return to the origin.

Fixed costs remain constant over an accounting period regardless of activity levels within a certain range. Examples include rent and executive salaries. If factory rent is $\$5,000$, it remains $\$5,000$ whether production is $2$ widgets or $200$. Consequently, fixed cost per unit falls as activity increases: at $2$ widgets, the cost is $\$2,500$ per unit, while at $200$ widgets, it is $\$25$ per unit. The cost per unit falls at a reducing rate but never reaches zero.

Stepped Fixed and Semi-Variable Costs

Stepped fixed costs are constant only within specific activity ranges. Once an upper limit is surpassed, the cost jumps to a new level. Examples include warehousing costs and supervisor wages. For instance, one supervisor costing $\$18,000$ per annum might manage production up to $50$ widgets. If production increases to between $50$ and $100$ units, a second supervisor is required, increasing the fixed cost to $\$36,000$.

Semi-variable costs contain both fixed and variable elements, meaning they are partly affected by activity levels. Examples include electricity and telephone bills, which consist of a fixed standing charge or line rental plus a variable charge based on usage or calls. For cost planning, it is vital to remember: fixed costs remain constant in total, variable costs remain constant per unit, semi-variable costs are neither constant in total nor per unit, and stepped fixed costs are constant only within certain ranges.

The High-Low Method and Cost Equations

The high-low method is used to separate the fixed and variable elements of a semi-variable cost using the formula: $\text{Total costs} = \text{Total fixed costs} + (\text{Variable cost per unit} \times \text{Activity level})$. The process involves four steps: 1. Select the highest and lowest activity levels and their costs. 2. Calculate variable cost (VC) per unit using $\text{VC per unit} = \frac{\text{Cost at high level} - \text{Cost at low level}}{\text{High level activity} - \text{Low level activity}}$. 3. Calculate fixed cost by substitution: $\text{Fixed cost} = \text{Total cost} - (\text{VC per unit} \times \text{Activity level})$. 4. Formulate the total cost equation to predict costs at other levels.

This method assumes that activity is the sole cause of cost changes, the cost is semi-variable, and the linear model $y = a + bx$ is valid. In this equation, $y$ is the dependent variable (total cost), $a$ is the intercept (fixed cost), $b$ is the gradient (variable cost per unit), and $x$ is the independent variable (activity level). The method can be adapted for stepped fixed costs or changing variable costs per unit by selecting ranges where those specific elements remain constant. While easy to use, it is limited by its reliance on only two data points and historical data, which may be distorted by random variations or bulk discounts.

Principles of Cost Coding

A cost code is a system of symbols used to provide a brief, accurate reference for items within a costing system, aiding in record entry and analysis. Coding typically begins with identifying the cost centre (e.g., code 07 for Machine Group 7 or 16 for the Canteen), followed by generic or functional codes to identify the expense type (e.g., 23 for indirect materials or 02 for food purchases). Specific codes may be added for precise identification, such as 072304 for oil used by Machine Group 7 or 160219 for frozen peas bought for the canteen.

There are several popular coding systems: Sequential codes follow a numerical or alphabetical sequence (e.g., 001 for Motor Expenses, 002 for Electricity). Block codes categorise sequences into groups (e.g., 3000 block for Current Assets). Hierarchical codes use digits where each represents a sub-classification (e.g., 1 for revenue, 1.1 for UK revenue, 1.1.1 for UK laptop sales). Significant digit codes use digits to represent specific features (e.g., 2000 for dividers, 2010 for a 10-pack). Faceted codes break codes into fields (e.g., using a region field, a department field, and an expense field like 03020247 for a USA production bonus). Mnemonic codes use alphabetical abbreviations to aid memory (e.g., NCA for Non-current assets), though they struggle with complex sub-categorisation.