Question

Give examples of situations in which it may be challenging to classify costs. Evaluate the role that Activity-Based Costing can play in cost classification. Give numerical examples.

Answer 1

The usual classification of costs by fixed, variable and step costs may not necessarily correspond to relevant and not relevant, but they are useful in breakeven analysis, and some other decision making techniques.

You might think fixed costs are not relevant to a decision but many decisions do involve adding costs which will be fixed or reducing them. Anything to do with headcount, capex or rents of premises usually means a new fixed or step cost. In the case of batch processing even material inputs can be of a step cost rather than a purely variable or incremental nature. So don't fall into the trap of worrying about fixed and variable, instead consider logically all the costs, whether fixed or variable, that are expected to appear, disappear or change as a result of the decision.

Beyond this, you should consider opportunity cost, which is the cost of lost opportunity involved in taking the opportunity. If by choosing one project I have to not chose another, then the profit of the other project is an opportunity cost of my decision. While other costs will be reflected in the books in some way, opportunity cost will not be so it is easier to overlook.

We always need to take account of the time value of money, so the relevant costs of the project need to be placed in a discounted cash flow calculation, for which you need to know your cost of capital. The expected net present value of your decision is your basic criterion.

Activity-based costing (ABC costing) is a method used to arrive at a cost price for a product – the total of direct and indirect costs required for production by identifying and costing all associated business activities.

A brief example of how to conduct ABC costing:

1. Identify the businesses main activities.
2. Identify the activities’ cost drivers -- processes and activities that determine what a given activity costs the business, such as the number of orders.
3. Assess the costs that go into each activity.
4. Assign product costs based on rates of use of each activity.

ABC costing management software is available from a number of vendors including Acorn Systems, proDaCapo and QPR CostControl. Activity-based costing is also a component of many enterprise resource planning (ERP) and corporate performance management (CPM) products.

ABC costing is considered a supplemental costing method rather than sufficient unto itself