Fundamentals of Financial and Cost Accounting · Meaning and Significance of Cost Accounting and its Relationship with Financial Accounting

Cost Concepts, Classification and Cost Centres for CMA Foundation

Updated 10 October 2026 · Fact-checked

A cost unit is the unit of product or service you measure cost for. A cost centre is a location, person or item where costs are collected. A cost object is anything you want to cost. A cost driver is the factor that causes cost. Costs are classified by nature, function, behaviour, traceability and controllability.

Understand Cost Concepts, Classification and Cost Centres

Cost accounting needs a way to collect and measure cost. Four terms do this job. You must know each one exactly, because MCQs test the difference between them.

A cost unit is the unit of quantity in which you express cost. For a steel maker it is a tonne. For a cement firm it is a bag or tonne. For a hospital it is a patient-day. For a bus service it is a passenger-km. The cost unit answers the question: cost per what?

A cost centre is a location, person or item of equipment (or a group of these) for which costs are collected and later related to cost units. Examples are a machine shop, a canteen, a store or a department. A cost centre only collects cost. It does not earn revenue. A profit centre is a segment responsible for both revenue and cost, so its profit can be measured. An investment centre is judged on profit relative to the investment made in it.

A cost object is anything for which you want a separate cost measurement: a product, a service, a job, a department, a customer or a project. Cost units and cost centres are both kinds of cost object. A cost driver is the factor that causes a cost to change. Number of machine hours drives power cost. Number of purchase orders drives purchasing cost. Number of set-ups drives set-up cost.

Costs are then classified in several ways, depending on the purpose:

By nature or element: material, labour, expenses.
By function: production, administration, selling and distribution, research and development.
By behaviour: fixed, variable, semi-variable.
By traceability: direct (traced to a cost unit) and indirect (overheads, shared).
By controllability: controllable and non-controllable, at a given level of management.
By time: historical (actual, past) and predetermined (estimated or standard).
By normality: normal (expected at usual efficiency) and abnormal (beyond normal, avoidable).

The same cost can sit in several classes at once. Factory rent is an expense by nature, a production cost by function, fixed by behaviour and indirect by traceability.

Key formulas to remember

Cost per unit: Cost per unit = Total cost ÷ Number of cost units; Use the cost unit that suits the industry, such as tonne, passenger-km or patient-day.
Direct and indirect cost: Total cost = Direct cost + Indirect cost (overheads); Direct cost can be traced to a cost unit economically. Indirect cost is shared and must be apportioned or absorbed.
Prime cost: Prime cost = Direct material + Direct labour + Direct expenses; Prime cost covers all direct costs only.
Total cost by behaviour: Total cost = Fixed cost + (Variable cost per unit × Units); Fixed cost stays constant in total within the relevant range. Variable cost per unit stays constant.
Cost behaviour rule: Fixed cost: total constant, per unit falls as output rises. Variable cost: total changes, per unit constant.; Applies within the relevant range of activity.

How to solve Cost Concepts, Classification and Cost Centres questions

Most questions ask you to match a term to its meaning or place a cost in the right class. Use the same routine each time.

1Read the stem and spot the keyword: collects cost, unit of measure, causes cost, revenue, traceable, controllable.
2If the question is a term, ask what it does. Collects cost means cost centre. Measures cost per what means cost unit. Causes cost means cost driver.
3If the question is a classification, find the basis: nature, function, behaviour, traceability, controllability or time.
4For behaviour, test what happens when output doubles. Total unchanged means fixed. Total doubles means variable.
5For traceability, ask if the cost can be economically traced to one unit. If yes, direct. If shared, indirect.
6Eliminate options that mix up cost centre and profit centre or cost unit and cost object.
7Choose the option that fits the exact definition and check it against the stem once more.

Quickest way: Keyword matching for term and classification MCQs

When to use it: Use for definition-type and classification-type MCQs where you have under a minute per question.

Link each term to one trigger phrase: cost unit = per what, cost centre = collects cost, profit centre = revenue and cost, cost driver = causes cost, cost object = anything costed.
Link each basis to one test: behaviour = what happens when output changes, traceability = can it be traced, controllability = who can influence it.
Scan options for the trigger phrase and cross out the rest.
If two options look right, pick the narrower, more exact definition.

Common mistakes in Cost Concepts, Classification and Cost Centres

Treating a cost centre and a cost unit as the same thing.
Both appear in cost sheets and sound alike.
Fix: A cost centre is where cost is collected. A cost unit is what cost is measured per. Machine shop is a centre. Tonne is a unit.
Saying a profit centre only collects costs.
Students blur it with a cost centre.
Fix: A profit centre has both revenue and cost, so its profit can be measured. A cost centre has cost only.
Saying fixed cost per unit is constant.
The word fixed is read as fixed everywhere.
Fix: Total fixed cost is constant. Fixed cost per unit falls as output rises. Variable cost per unit is constant.
Calling every factory cost direct.
Students mix up function (factory) with traceability (direct).
Fix: Factory rent and supervisor salary are production costs but indirect. Direct means traceable to the cost unit.
Confusing cost driver with cost unit.
Both are measures of activity.
Fix: A cost driver explains why a cost changes. A cost unit is the unit you report cost per. Purchase orders drive purchasing cost, but the product cost unit may be a tonne.
Treating abnormal cost as part of normal product cost.
Students assume all costs incurred go into the cost of output.
Fix: Abnormal costs are beyond normal and avoidable, so they are kept out of product cost and shown separately in costing profit and loss.

Worked examples

Example 1

A factory makes 5,000 units. Fixed cost is ₹2,00,000 and variable cost is ₹60 per unit. Find the total cost and the cost per unit at 5,000 units, and the cost per unit if output rises to 8,000 units (within the relevant range).

Show the solution

Variable cost at 5,000 units = 5,000 × ₹60 = ₹3,00,000.
Total cost = ₹2,00,000 + ₹3,00,000 = ₹5,00,000.
Cost per unit = ₹5,00,000 ÷ 5,000 = ₹100.
At 8,000 units, variable cost = 8,000 × ₹60 = ₹4,80,000.
Total cost = ₹2,00,000 + ₹4,80,000 = ₹6,80,000.
Cost per unit = ₹6,80,000 ÷ 8,000 = ₹85.

Answer: Total cost at 5,000 units is ₹5,00,000 (₹100 per unit). At 8,000 units the cost per unit falls to ₹85, because fixed cost is spread over more units.

Example 2

Which one of these is correct? (A) A cost centre earns revenue. (B) A cost unit is the place where costs are collected. (C) A cost driver is the factor that causes a cost to change. (D) A profit centre collects only costs.

Show the solution

Option A is wrong: a cost centre collects cost and does not earn revenue.
Option B is wrong: the place where costs are collected is a cost centre, not a cost unit.
Option C matches the definition: a cost driver causes cost to change, such as machine hours for power cost.
Option D is wrong: a profit centre has both revenue and cost.

Answer: Option C is correct.

Exam tips

Learn the one-line definition of cost unit, cost centre, profit centre, investment centre, cost object and cost driver. Most questions are direct.
For each basis of classification, memorise two or three examples, so you can place any cost quickly.
Watch for tricky wording on fixed cost: total versus per unit.
When two options seem right, check whether one confuses a centre (a place) with a unit (a measure).
Do these questions first. They are quick, and there is no negative marking, so always mark an answer.

Practice questions from Meaning and Significance of Cost Accounting and its Relationship with Financial Accounting

Cost Concepts, Classification and Cost Centres in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Cost Concepts, Classification and Cost Centres: frequently asked questions

What is the difference between a cost centre and a cost unit?

A cost centre is a location, person or equipment where costs are collected, such as a machine shop. A cost unit is the unit of product or service you measure cost per, such as a tonne or a passenger-km. One collects cost, the other measures it.

What is the difference between a cost centre and a profit centre?

A cost centre is responsible only for cost. A profit centre is responsible for both revenue and cost, so its profit can be measured. An investment centre goes further and is judged on profit against the investment it uses.

What is a cost driver? Give an example.

A cost driver is the factor that causes a cost to change. For example, the number of machine hours drives power cost, and the number of set-ups drives set-up cost. It is used mainly in activity-based costing.

How are costs classified in cost accounting?

Costs are classified by nature (material, labour, expenses), function, behaviour (fixed, variable, semi-variable), traceability (direct, indirect), controllability and time. The same cost can belong to several classes at once.