Everything you need to know about the classification and types of cost. Cost classification is the process of grouping costs according to their common characteristics.
It is the placement of like items together according to their common characteristics. A suitable classification of costs is of vital importance in order to identify the cost with cost centres or cost units.
Cost classification is the process of grouping costs according to their common characteristics. Cost analysis and cost classification involve grouping of costs into various logical groups on some suitable basis.
Cost analysis and classification are essential for the purpose of cost control and managerial decision making.
Costs can be classified on the basis of:
1. Nature or Element or Analytical Classification 2. Functions 3. Variability 4. Controllability 5. Normality 6. Capital and Revenue or Financial Accounting Classification 7. Time 8. Planning and Control 9. For Managerial Decisions.
Some of the types of costs are:-
1. Manufacturing and Production Cost 2. Commercial Cost 3. Fixed or Period Costs 4. Variable or Product Costs 5. Semi-Variable Costs 6. Controllable Costs 7. Uncontrollable Costs 8. Normal Cost
9. Abnormal Cost 10. Historical Costs 11. Predetermined Costs 12. Budgeted Costs 13. Standard Cost 14. Marginal Cost 15. Out of Pocket Costs 16. Differential Costs 17. Sunk Costs and a Few Others.
Cost Accounting – Cost Classification : According to Element, Functions, Nature, Controllability, Normality, Time and a Few Others
Classification of Cost – Classification by Nature, Functions, Variability, Controllability, Normality, Financial Accounting, Time, Planning and Managerial Decision
Cost classification is the process of grouping costs according to their common characteristics. It is the placement of like items together according to their common characteristics. A suitable classification of costs is of vital importance in order to identify the cost with cost centres or cost units.
Costs may be classified according to their nature, i.e. material, labour and expenses and a number of other characteristics. The same cost figures are classified according to different ways of costing depending upon the purpose to be achieved and requirements of a particular concern.
Classification # 1. By Nature or Element or Analytical Classification:
According to this classification, the costs are divided into three categories i.e. Materials, Labour and Expenses. There can be further sub classification of each element; for example, material into raw material components, and spare parts, consumable stores, packing material etc. This classification is important as it helps to find out the total cost, how such total cost is constituted and valuation of work in progress.
Classification # 2. By Functions:
According to this classification costs are divided in the light of the different aspects of basics managerial activities involved in the operation of a business undertaking. It leads to grouping of cost according to the broad divisions or functions of a business undertaking i.e., production, administration selling and distribution.
According to this classification costs are divided as follows:
(i) Manufacturing and Production Cost:
This is the total of costs involved in manufacture, construction and fabrication of units of production.
(ii) Commercial Cost:
This is the total of costs incurred in the operation of a business undertaking other than the cost of manufacturing and production.
Commercial cost may further be sub-divided into:
(a) Administrative cost and
(b) Selling and distribution cost.
Classification # 3. By Variability:
According to this classification, costs are classified according to their behaviour in relation to changes in the level of activity or volume of production.
On this basis, costs are classified into three groups viz. fixed, variable and semi-variable:
(i) Fixed or period costs are commonly described as those which remain fixed in total amount with increase or decrease in the volume of output or productive activity for a given period of time. Fixed cost per unit decreases as production increases and increases as production declines. Examples of fixed costs are rent, insurance of factory building, factory manager’s salary etc.
These fixed costs are constant in total amount but fluctuate per unit as production changes. These costs are known as period costs because these are dependent on time rather than on output. Such costs remain constant per unit of time such as factory rent of Rs. 10,000 per month remaining same for every month irrespective of output of every month.
(ii) Variable or product costs are those which vary in total in direct proportion to the volume of output. These costs per unit remain relatively constant with changes in production. Thus, variable costs fluctuate in total amount but tend to remain constant per unit as production activity changes. Examples are direct material costs, direct labour costs, power, repairs etc. Such costs are known as product costs because they depend on the quantum of output rather than on time.
(iii) Semi-variable costs are those which are partly fixed and partly variable. For example, telephone expenses included a fixed portion of annual charge plus variable charge according to calls; thus total telephone expenses are semi- variable. Other examples of such costs are depreciation, repairs and maintenance of building and plant etc.
Classification # 4. By Controllability:
Under this, costs are classified according to whether or not they are influenced by the actions of a given member of the undertaking.
On this basis it is classified into two categories:
(i) Controllable Costs:
Controllable costs are those which can be influenced by the action of a specified member of an undertaking, that is to say, costs which are at least partly within the control of management.
An organization is divided into a number of responsibility centres and controllable costs incurred in a particular cost centre can be influenced by the action of the manager responsible for the centre. Generally speaking, all direct costs including direct material, direct labour and some of the overhead expenses are controllable by lower level of management.
(ii) Uncontrollable Costs:
Uncontrollable costs are those which cannot be influenced by the action of a specified member of an undertaking that it is to say, which are within the control of management. Most of the fixed costs are uncontrollable. For example, rent of the building is not controllable and so are managerial salaries. Overhead cost, which is incurred by one service section and is apportioned to another which receives the service, is also not controllable by the latter.
Classification # 5. By Normality:
Under this, costs are classified according to whether these are cost which are normally incurred as a given level of output in the conditions in which that level of activity is normally attained.
On this basis, it is classified into two categories:
(a) Normal Cost:
It is the cost which is normally incurred at a given level of output in the conditions in which that level of output is normally attained. It is a part of cost of production.
(b) Abnormal Cost:
It is the cost which is not normally incurred at a given level of output in the conditions in which that level of output is normally attained. It is not a part of cost of production and charged to Costing Profit and Loss Account.
Classification # 6. By Capital and Revenue or Financial Accounting Classification:
The cost which is incurred in purchasing assets either to earn income or increasing the earning capacity of the business is called capital cost. For example, the cost of a rolling machine in case of steel plan, such cost is incurred at one point of time but the benefits accruing from it are spread over a number of accounting years.
It any expenditure is done in order to maintain the earning capacity of the concern such as cost of maintaining an asset or running a business it is revenue expenditure e.g. cost of materials used in production, labour charges paid to convert the material into production, salaries, depreciation, repairs and maintenance charges, selling and distribution charges etc.
The distinction between capital and revenue items is important in costing as all items of revenue expenditure are taken into consideration while calculating cost whereas capital items are completely ignored.
Classification # 7. By Time:
Cost can be classified as:
(i) Historical Costs:
The cost which is ascertained after their incurrence is called historical costs. Such costs are available only when the production of a particular thing has already been done. Such costs are only of historical value and not at all helpful for cost control purposes.
Basic characteristics of such costs are as follow:
(a) They are based on recorded facts.
(b) They can be verified because they are always supported by the evidence of their occurrence.
(c) They are mostly objective because they relate to happenings which have already taken place.
(ii) Predetermined Costs:
Such costs are estimated costs i.e. computed in advance of production taking into consideration the previous period’s costs and the factors affecting such costs. Predetermined cost determined on scientific basis becomes standard cost. Such costs when compared with actual costs will give the reasons of variance and will help the management to fix the responsibility and to take remedial action to avoid its recurrence in future.
Classification # 8. According to Planning and Control:
Planning and control are two important functions of management. Cost accounting furnishes information to the management which is helpful is the due discharge of these two functions. According to this, costs can be classified as budgeted costs and standard costs.
(i) Budgeted Costs:
Budgeted costs represent an estimate of expenditure for different phases of business operations such as manufacturing, administration, sales, research and development etc. coordinated in a well-conceived framework for a period of time in future which subsequently becomes the written expression of managerial targets to be achieved.
Various budgets are prepared for various phases, such as raw material cost budget, labour cost budget, cost of production budget, manufacturing overhead budget, office and administration overhead budget etc., Continuous comparison of actual performance (i.e. actual cost) with that of the budgeted cost is made so as to report the variations from the budgeted cost to the management for corrective action.
(ii) Standard Cost:
Budgeted costs are translated into actual operation through the instrument of standard costs. The Institute of Cost and Management Accountants, London defines standard cost as follows: “Standard cost is the predetermined cost based on a technical estimate for materials, labour and overhead for a selected period of time and for a prescribed set of working conditions”. Thus, standard cost is a determination, in advance of production of what should be the cost.
Classification # 9. For Managerial Decisions:
On this basis, costs may be classified into the following costs:
(i) Marginal Cost:
Marginal cost is the total of variable costs i.e. prime cost plus variable overheads. It is based on the distinction between fixed and variable costs. Fixed costs are ignored and only variable costs are taken into consideration for determining the cost of products and value of work in progress and finished goods.
(ii) Out of Pocket Costs:
This is that portion of the cost which involves payment to outsiders i.e., gives rise to cash expenditure as opposed to such costs as depreciation, which do not involve any cash expenditure. Such costs are relevant for price fixation during recession or when make or buy decision is to be made.
(iii) Differential Costs:
The change in costs due to change in the level of activity or pattern or method of production is known as differential costs. It the change increases the cost; it will be called incremental cost. If there is decrease in cost resulting from decrease of output, the difference is known as decremental cost.
(iv) Sunk Costs:
A sunk cost is an irrecoverable cost and is caused by complete abandonment of a plant. It is the written down value of the abandoned plant less its salvage value. Such costs are not relevant for decision making and are not affected by increase or decrease in volume.
(v) Imputed Costs:
These costs are those costs which appear in cost accounts only e.g. national rent charged on business premises owned by the proprietor, interest on capital for which no interest has been paid. These costs are also known as notional costs. When alternative capital investment projects are being evaluated it is necessary to consider the imputed interest on capital before a decision is arrived as to which is the most profitable project.
(vi) Opportunity Cost:
It is the maximum possible alternative earning that might have been earned if the productive capacity or services had been put to some alternative use. In simple words, it is the advantage, in measurable terms, which has been foregone due to not using the facility in the manner originally planned. For example, if an owned building is proposed to be used for a project, the likely rent of the building is the opportunity cost which should be taken into consideration while evaluating the profitability of the project.
(vii) Replacement Cost:
It is the cost at which there could be purchased an asset or material identical to that which is being replaced or revalued. It is the cost of replacement at current market price.
(viii) Avoidable and Unavoidable Cost:
Avoidable costs are those which can be eliminated if a particular product or department, with which they are directly related, is discontinued. For example, salary of the clerks employed in a particular department can be eliminated, if the department is discontinued. Unavoidable cost is that cost which will not be eliminated with the discontinuation of a product or department. For example, salary of factory manager or factory rent cannot be eliminated even if a product is eliminated.
Classification of Cost – Cost Classification According to Elements, Functions, Behaviour, Controllability, Normality and Relevance to Decision Making and Control
Cost classification is the process of grouping costs according to their common characteristics.
The following are the bases on which costs can be classified:
(I) According to elements
(II) According to functions
(III) According to nature or behaviour
(IV) According to controllability
(V) According to normality, and
(VI) According to relevance to decision making and control.
(I) Cost Classification According to Elements:
Based on elements, cost is classified into material, labour and expenses. They are subdivided into direct and indirect material, labour and expenses. The total direct cost is termed as prime cost. Indirect material, indirect labour and indirect expenses, together are termed as indirect cost or ‘overheads’. Overhead is subdivided into factory overhead, office overhead and selling and distribution overhead.
(II) Cost Classification According to Functions:
Here the classification is under four major functions of the business:
(a) Production cost
(b) Administration cost
(c) Selling cost, and
(d) Distribution cost.
(a) Production Cost:
Production cost is “the cost of sequence of operations which begins with supplying materials, labour and services and ends with primary packing of the product”-I.C.M.A.
It is also known as manufacturing or factory cost incurred in converting raw material into finished product.
(b) Administration Cost:
Administration cost is “the cost of formulating the policy, directing the organisation and controlling the operations of an undertaking, which is not related directly to a production, selling, distribution, research or development activity or function”- I.C.M.A.
Administration cost is incurred for overall planning, organising and control of the enterprise.
(c) Selling Cost:
Selling cost is “the cost of seeking to create and stimulate demand (sometimes termed ‘marketing’) and of securing orders” – I.C.M.A.
Selling costs are also known as selling expenses and selling overheads which comprise of all the expenses of selling department including product promotion and advertising.
(d) Distribution Cost:
Distribution cost is “the cost of sequence of operations which begin with making the packed product available for dispatch and ends with making the reconditioned, returned empty package, if any, available for reuse” – I.C.M.A.
It is also known as distribution expenses or overheads which comprises of packing, warehouse expenses, cost of freight, etc.
(III) Cost Classification According to Nature of Costs:
Based on nature or behaviour, cost is classified into fixed, variable and semi-variable costs.
(a) Fixed Cost:
“A cost which tends to be unaffected by variations in volume of output. Fixed costs depend mainly on the affluxion of time and do not vary directly with volume or rate of output. Fixed costs are sometimes referred to as period costs in systems of direct costing” – I.C.M.A. Thus, fixed costs are those which do not change with increase or decrease in quantum of production but remain static.
(b) Variable Cost:
Variable cost is “A cost which tends to vary directly with volume of output. Variable costs are sometimes referred to as direct costs in systems of direct costing”. – I.C.M.A.
Variable costs increase or decrease in direct proportion to increase or decrease in production.
(c) Semi-Fixed or Semi-Variable Cost:
Semi-fixed or semi-variable cost is “A cost which is partly variable” – I.C.M.A.
This is a cost which changes but not in direct proportion to the increase or decrease in output.
(IV) Cost Classification according to Controllability:
On the basis of controllability, cost can be classified into:
(a) Controllable cost, and
(b) Uncontrollable cost.
(a) Controllable Cost- This is the cost which can be influenced by the action of a specified member of an undertaking. E.g., direct material, direct labour, etc.
(b) Uncontrollable Cost- This is the cost which cannot be influenced by the action of any specified member of an undertaking. E.g., direct material’, direct labour, etc.
(V) Cost Classification According to Normality:
This is the cost incurred in the conditions in which the output is normally attained. Normal cost is included in cost of production. Abnormal costs are not usually incurred at a given level of output in the conditions in which that level of output is normally produced. Abnormal cost is excluded from cost of production.
(VI) Cost Classification According to Relevance to Decision Making and Control:
Based on the requirement of decision making the following is the classification:
(a) Shut-Down Cost:
A cost which is incurred irrespective of plant is in operation or is shutdown, e.g., the cost of rent, rates, depreciation, maintenance expenses, etc.
(b) Sunk Cost:
A cost which is incurred in the past and is not relevant to the current decision making, e.g., written down value of plant is irrelevant for replacement of machinery.
(c) Opportunity Cost:
“The net selling price, rental value or transfer value which could be obtained at a point-in time if a particular asset or group of assets were to be sold, hired or put to some alternative use available to the owner at that time, is the opportunity cost”. I.C.M.A.
The costs which are related to the sacrifice made or the benefits foregone are opportunity costs.
(d) Imputed Cost:
It is the notional cost to be considered for making costs comparable. For example – rent of own building, interest on own capital, etc., are not actually paid but may be taken as costs notionally.
(e) Out-of-Pocket Cost:
This is the cost which is payable in cash as against costs such as depreciation which do not involve cash payment.
(f) Replacement Cost:
It is the ‘current cost’ at which an asset or material can be ‘replaced’ with identical one from the market. It reflects the present market price of such asset or material.
(g) Conversion Cost:
This is the cost of production, excluding cost of direct materials. It is the aggregate of direct wages, direct expenses and overhead costs of converting raw materials into finished product.
(h) Product Costs:
Product costs are those which are identified with the product and included in inventory values. They can be charged, allocated or apportioned to the products. They include direct material, direct labour direct expenses and manufacturing or production overheads. Product costs become part of inventories like work in progress and finished goods and become part of Balance sheet. Product cost of goods sold is part of the cost of goods sold. Product costs do not affect the income till the product is sold.
(i) Period Costs:
Period costs are those costs which are not identified with product or Job. They are incurred and paid for a particular period, like rent, rates, taxes salaries. Their benefit is usually exhausted with the expiry of certain period. They are totally deducted as expenses during the period in which they are incurred. They are not included in the inventory values which are carried forward to the next period.
The period costs are necessary to generate revenue but they cannot be identified with units of product. Selling and administration costs necessary to run a business but cannot be associated with products also come under this category.
Classification of Cost – Direct or Indirect Cost, Discretionary Cost, Controllable Cost, Product Cost, Normal Cost, Fixed Cost and Predetermined Cost
Classification of cost may be studied as under:
1. Direct and Indirect Cost – Every item which can be identified is direct cost. Indirect costs are incurred for the benefit which cannot be identified with a particular cost centre. Indirect expenses cannot be ascertained accurately.
2. Committed and Discretionary Cost – Committed cost are incurred in maintaining physical facilities. These expenses are invariant in the short run.
Discretionary costs are those which can be avoided by management decisions. These cost can be avoided in the short run.
3. Controllable and Non-controllable Cost – Controllable costs are regulated at a given level of management of variable cost.
Non controllable costs are those which cannot be influenced by any action. It is difficult to control these costs.
It is presumed that variable cost are controllable and fixed cost are non-controllable.
4. Product Cost and Period Cost – Product cost are necessary for any production. This cost is absorbed to the units produced. It includes direct materials, direct labour and factory overheads.
Period cost are for a time period and they are charged to profit and loss account. Rent, salary are examples of period cost. They are not included in the value of stocks.
5. Normal and Abnormal Cost – Normal costs are incurred in production, while abnormal cost is above the normal cost, and it is not treated as a part of cost of production.
6. Fixed and Variable Cost and Semi-variable Cost – Fixed costs remain constant over a wide range of activity and they do not increase or decrease. It includes rent, municipal taxes, salary, insurance of building and managerial salaries etc.
Variable costs have a tendency to vary. If output increases the variable cost will increase and vice versa. Per unit variable cost will remain unchanged.
Semi-variable costs include both fixed and variable expenses. It has a fixed elements and the variable elements, which changes at a constant rate after a certain period.
7. Historical and Predetermined Cost – Historical costs are ascertained when they are incurred. Predetermined costs are future costs which are ascertained in advance of production. These costs are used for planning and control purpose.
Classification of Cost – Variability, Functional, Responsibility, Traceability, Product Cost and Relevance to Decision-Making Classification
Proper cost classification is essential for management. Costs can be effectively collected and used only after such a grouping. These can be classified according to their common characteristics – and in relation to some independent factor.
The principal bases on which costs are classified are:
1. Variability (behavioural classification)
2. Functional areas (functional classification)
3. Responsibility (controllable and uncontrollable costs)
4. Traceability/identifiability (direct and indirect costs)
5. The accounting period charged to revenue (product costs and period costs)
6. Relevance to decision-making (relevant and irrelevant costs).
The basis of classification here is the behaviour pattern of costs. The consideration is how the costs respond, i.e. change with a given change in the volume of production. While some costs vary with the change in the quantity of output, others do not.
Accordingly, there are three categories of costs:
(ii) Variable and
(i) Fixed Costs:
These are unaffected by variations in the volume of activity. The total fixed costs remain constant over a relevant range of output, while the fixed cost per unit varies with the output. Fixed costs have no particular relation to the volume of activity. These are incurred irrespective of production and sales.
These are usually time-based. Some typical examples are rent, insurance, taxes and supervisors’ salaries. Fixed costs are again divided into two categories. First, the committed fixed costs—costs which cannot be reduced as these are related to the long term policies and planning of the organisation. In general terms, these are sunk or irrecoverable costs in the given situation.
Charges like depreciation, rent, insurance, tax on property are committed to the period. Second, the discretionary fixed costs—costs which may be reduced partially or dropped wholly according to the policy of the management and need of the situation. Expenses like advertisement, research, fees for consultancy and costs of training the top officials abroad during the lean period of the business.
(ii) Variable Costs:
These are the costs which vary in direct proportion to changes in volume. They increase or decrease in the same proportion in which the output increases or decreases. The total amount of variable costs tends to change in respect to changes in production volume, but the variable cost per unit stays at the same level for a considerable period of time. The examples of such costs are direct material, direct labour, etc.
When unit variable costs have an explicit relationship with physical volume of production, the cost is termed as engineered to such volume. Hence, the term engineered cost. Assume that variable costs for direct materials are Rs.100 per unit of output. Each time output increases by one unit, variable costs will increase by Rs.100. For 3000 units, the total variable costs for material will be Rs.3,00,000, for 5000 units Rs.5,00,000, and for 1,900 units it will be Rs.1,90,000.
(iii) Semi-Variable Costs:
Also known as ‘mixed costs’, these are neither wholly variable nor wholly fixed in nature. They have the characteristics of both fixed and variable costs. The fixed part of semi-variable costs represents a minimum fees for making a particular item or service available. The variable portion is the fee charged for actually using the service each time.
Examples of such costs are- telephone charges, repairs and maintenance, electricity, depreciation, etc. For the purpose of planning and control, these costs must be separated into their fixed and variable elements. The main methods used for splitting such costs are- Scalter graph, high-low, simultaneous equation and least squares.
Classification of costs according to behaviour is essential for:
i. Effective cost control
ii. Marginal costing and break-even analysis
iii. Formulation of budget
iv. Managerial decision-making.
In terms of the volume related classification, the total cost of an item can be expressed in the form of the following cost function:
Fixed costs in general remain fixed over a range of activity and then jump to a new level as activity changes. It is assumed that the firm plans to operate at a level of activity between points X and Y resulting in fixed costs of OA. The horizontal line above points X and Y is extended to the right and left signifying the planned fixed costs for the period.
Costs classified according to managerial functions are accumulated according to the activity performed. The costs of a typical organisation may be divided into manufacturing, marketing, administrative and financing groups.
These are discussed below:
i. Manufacturing Costs:
These are related to the production of an item. These are the sum of direct materials, direct labour and factory overhead. In other words, these include all the costs incurred in the factory up to that stage when the goods are ready for dispatch. Examples are- salaries of factory manager, supervisors and foremen, rent, rates and insurance of the factory, power and fuel used in the factory, depreciation, maintenance and repairs of building, plant, machinery tools, etc.
ii. Administrative Costs:
These include all expenditures incurred in formulating the plans, directing the organisation and controlling the operations. A major portion of these costs are policy costs which are of fixed nature and, therefore, uncontrollable. These include salaries paid to management and clerical staff, rent, rates and insurance of general offices, their lighting, heating and air-conditioning, depreciation of office buildings, furniture, machinery, etc.
iii. Selling and Distribution Costs:
a. Selling Costs:
These are incurred to create and stimulate demand and to secure orders. These include salaries, commission and travelling expenses of salesmen and technical representatives and sales managers, advertising, catalogues, price lists, bad debts and collection charges, cost of market research, etc.
b. Distribution Costs:
These are the costs incurred in moving the goods from the point of production to the point of consumption. These include- warehouse expenses, carriage outwards, depreciation and upkeep of delivery vans, wages of packers, van drivers, etc.
iv. Financing Costs:
These are costs incurred for raising and using capital, e.g. interest on loans and debentures, commission or brokerage on issue of shares and debentures, discount on the issue of shares and debentures, etc.
v. Controllable and Uncontrollable Costs:
Costs are also classified in terms of responsibility over them. Responsibility carries the authority of the manager to influence costs—increase or decrease their amount.
As such, there are two groups:
a. Controllable and
a. Controllable Costs:
Costs are said to be controllable when the amount of the cost incurred can be influenced by the action of a specified member (manager or supervisor) of an undertaking.
b. Uncontrollable Costs:
Costs which cannot be influenced by the action of a specified member (manager or supervisor) of an undertaking are known -as uncontrollable costs. The distinction between controllable and uncontrollable costs depends upon a point of reference. An item of cost may be uncontrollable at one level of management but the same item may be controllable at another level of management.
Almost all costs are controllable at some level of management. Segregation of costs into controllable and uncontrollable categories will help the management in fixing responsibilities of different executives for unfavourable cost variances. An executive should be held responsible only for those costs which are under his control.
vi. Product Costs and Period Costs:
Costs are also classified as to when they are charged against revenue. The basis is the period benefitted by the particular cost. This is essential in matching expenses against revenues in the relevant period. Such a grouping helps management in income measurement for the preparation of financial statements. Here, two categories are product costs and period costs.
a. Product Costs:
These are the costs directly identified with the product. These are the cost of goods produced and kept ready for sale. They are direct materials, direct labour, and variable factory overheads. These costs provide no benefit till the product is sold, and are, therefore, inventoried. When the products are sold, the total product costs are recorded as an expense, and is called ‘cost of goods sold’. It is matched against revenue for the period in which products are sold.
b. Period Costs:
These are not directly related to the product and, therefore, not inventoried. If the period costs benefit only one accounting period, it is called a revenue expenditure. If they benefit two or more accounting periods, they are treated as assets till they are charged as expenditure for the relevant years.
Normally, expense of fixed nature like depreciation of assets, insurance premium, rent and rates are treated as fixed costs. These costs represent non-operating items and are related to passage of time and not to the production and sales of the period.
In a manufacturing organisation all manufacturing costs are regarded as product costs and non-manufacturing costs are regarded as period cost. In retailing and wholesaling organisations goods are purchased for resale without changing their basic form. The cost of goods purchased is regarded as product cost and all other costs such as administration and selling and distribution are considered to be period costs.
vii. Direct and Indirect Costs:
Costs are classified as direct and indirect costs on the basis of their identification with particular jobs, products or processes.
a. Direct Cost:
It is a cost which can be directly identified with a product, process or department. Materials used and labour employed in manufacturing an article or in a particular process of production, are common examples of direct costs.
b. Indirect Costs:
These costs are not traceable to any particular product, process or department, but are common to different products, processes or departments. Factory manager’s salary, factory rent, depreciation of machinery, etc., are typical examples of indirect costs.
The distinction between direct and indirect costs depends upon whether or not the cost can be identified with the activity or other relevant unit. A cost such as the plant superintendent’s salary can be readily identified with the plant and hence is a direct cost of the plant.
However, it is an indirect cost of any department within the plant or of any line of product manufactured. This nature of business and cost unit chosen will determine which are direct and which indirect costs are.
Direct costs are allocated whereas indirect costs are apportioned to different jobs, products or services on a reasonable basis. It may be noted that the more the share of the direct costs in relation to the total cost of the product, the greater is exactness in costing. The reason for this is that indirect costs are apportioned on an arbitrary basis.
viii. Relevant and Irrelevant Costs:
For managerial decision-making, costs are sub-divided under:
(a) Relevant costs; and
(b) Irrelevant costs.
(a) Relevant Costs:
These are costs which are relevant for decision-making (for the future) such as differential or incremental costs, opportunity costs, out-of-pocket costs, etc.
These are discussed below:
1. Differential Costs:
Management is expected to make decisions and in doing so compares alternatives. In making a decision, management compares the costs of the alternatives. The costs that remain the same in any case can be disregarded but the difference in cost between alternatives is relevant to decision-making.
A difference in cost between one course of action and another is differential cost. If a decision results in an increased cost, the differential cost may be called incremental cost. If the cost is decreased, the differential cost may be referred to as a decremental cost. A decision in favour of an alternative is taken only when the incremental revenue between two levels of output is greater than differential cost of those levels of activity.
This differential cost is the difference in net costs and benefits between two or more alternative courses of action. If the selection of an alternative involves changes in variable costs only, marginal cost and differential costs are the same. However, a decision may involve changes in fixed costs also.
2. Opportunity Costs:
In choosing between alternatives, management has to select the best alternative but in doing so, has to give up the returns that could have been derived from the rejected alternatives. The sacrifice of a return or benefit from a rejected alternative is known as the opportunity cost of the alternative accepted. Opportunity costs are not entered in the accounting records, yet they are used in decision-making.
Often management is confronted with alternatives, each having its advantages. For example, there may be an opportunity to make only one of the two different products with the present facilities. It may be estimated that product A will contribute Rs.56,000 a year to profits and that product B will contribute Rs.71,000 a year to profits. Product B should be selected and the opportunity cost of selecting product B is the sacrifice of Rs.56,000 that could be earned by product A.
3. Out-Of-Pocket Costs:
An out-of-pocket cost signifies the relevant cash expenditure which is involved in a particular situation. Management decisions are directly affected by such costs. Thus, an out-of-pocket cost is the present or future cash expenditure connected with a certain decision which will change according to the nature of the decision made.
For example, if it is proposed to replace the company’s delivery trucks by an arrangement to deliver goods through public carriers, the depreciated value of the trucks is irrelevant (being a sunk cost) to decide upon the proposal. But, the cost of fuel, driver’s salary and maintenance expenditure involved in using the truck should be relevant costs in deciding whether the delivery system should be changed. These are out-of-pocket costs.
b. Irrelevant Costs:
Are those which are not pertinent to a decision? These are the costs that will not be changed by a decision. Because irrelevant costs will not be affected, they may be ignored in decision-making process. An example of irrelevant cost is that of sunk cost.
It is a cost incurred as a result of decision made in the past which cannot be reversed or altered by any decision in the future. Sunk costs are irrelevant for decision-making. The written down values of assets previously purchased are sunk costs. Let us suppose the management of a company is considering the desirability of replacing an existing machine by a new one.
Suppose, an old machine originally costs Rs.20,000 and it has been depreciated to the extent of Rs.15000 so far. If it is scrapped (no value being realisable on sale) there will be an accounting loss of Rs.5000. It would be wrong to recognise this loss as a cost for deciding upon the proposed replacement.
The book value of the existing machine is really a sunk cost and the decision to replace or not to replace the machine will not make any difference to its undepreciated value. It is irrelevant to the question of replacing the existing machine. The difference in income which will result from the installation of new machine and expected return on capital investment should be the deciding factor.
1. Shut down cost – These are the costs which will still be incurred although a plant is shut down temporarily, e.g. rent, rates, depreciation, maintenance of plant, etc.
2. Research cost – It is the cost of searching for new or improved products, new application of materials or new or improved methods of production.
3. Development cost – It is the cost of the process which begins with the implementation of the decisions to produce a new/improved product. It ends with the commencement of production of that product or method. Thus, it is the cost of commercial exploitation of successful research. Development cost of new products is treated as an item of deferred expenditure to be spread over a number of years. It is charged to product costs when production is fully established.
4. Joint cost – These are the costs incurred up to the point in a given process where individual products can be identified. Whenever two or more products are produced out of the same basic raw material or process, the cost of material purchased and processing are called joint costs. Such costs have to be apportioned to various products on some basis.
Classification of Cost – Top 9 Classifications: Nature, By Relation to Cost Center, By Function, By Behaviour, By Time, By Controllability, By Payment and By Normality
Cost analysis and cost classification involve grouping of costs into various logical groups on some suitable basis. Cost analysis and classification are essential for the purpose of cost control and managerial decision making.
There are various methods of classification of costs. The method selected is based on the purpose for which it is needed.
Classification # 1. Nature or Element:
On the basis of nature costs are classified into three categories:
i. Materials cost
ii. Labour cost and
Materials are the physical things, articles or commodities used in production. It includes raw materials, consumable stores, spare parts and components.
It is further classified into:
a. Direct materials cost and
b. Indirect materials cost.
a. Direct Materials Cost:
Direct materials include raw materials, components and spare parts entering the body of the finished product. They become part and parcel of the finished product. They are directly identified with a product, cost centre, process or a job. Direct materials cost is allocated to a cost object in whole.
Some materials may form part of finished product but their costs may be very small. As a matter of convenience and economy in accounting they are treated as indirect materials, e.g., small screws, washers, nails and sewing threads. But primary packing materials which are essential for convenient handling of the finished products are treated as direct materials.
b. Indirect Materials Cost:
Cost of materials which do not enter the body of the finished product and which are incurred with reference to two or more products, cost centres, processes or jobs are called indirect materials cost. They cannot be charged to a specific cost object. They are to be apportioned over cost objects.
These include consumable stores, secondary packing materials, lubricants, cotton waste, stationery, advertising materials etc. Usually costs of indirect materials are small compared to direct materials cost.
Labour cost includes all remuneration paid to employees. They include all rewards provided to employees in different forms such as salary, wages, allowances, bonus, commission, fees, contribution to PF, ESI and superannuation funds, cost of perquisites like free transport, medical facilities, reading rooms etc.
Labour cost is classified into:
a. Direct labour cost and
b. Indirect labour cost.
a. Direct Labour Cost:
Direct labour cost is identified or linked wholly with a particular product, cost centre, process or job. It includes all labour engaged in changing or altering of the composition of raw materials into finished products. It also includes wages of all employees engaged in a contract work. It is allocated in full to a cost centre or a cost object.
b. Indirect Labour Cost:
It includes all labour cost incurred in relation to two or more products, processes, jobs or cost centres. Indirect labour assists or helps the direct labour in production process, e.g., works manager, supervisor, attenders, security staff, office people, staffs in stores department, time office and sales department. Indirect wages are apportioned to products, processes, jobs or cost centres.
It includes all costs other than materials and labour cost. It is the cost of various services consumed by an undertaking.
It is further classified into:
a. Direct expenses and
b. Indirect expenses.
a. Direct Expenses:
It includes cost of all services specifically incurred for a product, process, job or cost centre. They are directly identified with a particular cost object. It is conveniently allocated to a particular cost object in whole. It is also called chargeable expenses. It includes excise duty, royalty, hire charges and repairs and maintenance of special equipment required for a job; cost of special drawings, designs, moulds and patterns.
b. Indirect Expenses:
Indirect expenses are expenses incurred in relation to two or more products, processes, jobs or cost centres. It is apportioned to various cost objects. It includes rent, rates, taxes, insurance, lighting, depreciation, power, fuel, advertisement and repairs and maintenance.
On the basis of relation to cost centre, costs are classified as:
i. Direct costs and
ii. Indirect costs.
i. Direct Costs:
Direct costs are incurred in relation to a specific product, process, job or cost centre. They consists of direct materials, direct labour and direct expenses. The total of all direct costs is called prime cost.
ii. Indirect Costs:
Indirect costs are general expenses incurred for two or more products, processes, jobs or cost centres. They are apportioned to various cost objects on suitable basis. They include indirect materials, indirect labour and other indirect expenses. The total of all indirect costs is also called overheads, on cost or burden.
All indirect costs are called overheads and can be classified on functional basis into:
i. Factory overheads
ii. Office and administration overheads
iii. Selling overheads
iv. Distribution overheads.
i. Factory Overheads:
Factory overheads is also called production overheads, works overheads or manufacturing overheads. It includes all indirect expenses in relation to production activity. It includes all indirect materials used in production, indirect labour expended in production, works manager’s salary and allowances, repairs, maintenance, depreciation and insurance of factory building, plant, equipment and machinery, supervision, cost of designing and drawing, cost of fuel, power, oil, water, gas and steam and consumable stores.
ii. Office and Administration Overheads:
These include expenses incurred in connection with formulation of policies, overall administration and control of an organisation. This includes office salary, printing and stationery, repairs, maintenance, depreciation and insurance of office equipment, building and furniture, General Manager’s or managing director’s salary and allowances, postage, general travelling expenses, telephone and telegram, audit fees, bank charges, legal expenses and secretarial department expenses.
iii. Selling Expenses:
These expenses are incurred for creating and stimulating demand for a product. Sometimes it is also called ‘marketing cost’. These include advertisement, salesmanship, market research, showroom expenses, cost of free samples, commission and discount to distributors.
iv. Distribution Expenses:
These are expenses incurred to take the goods from production centre to consumers place. They include warehouse expenses, packing, carriage outward and all expenses in connection with delivery van and trucks.
Expenses respond in varying degrees to changes in production or activity level. Some expenses change in direct proportion to changes in production level, some expenses change in a lesser proportion to changes in production level and some expenses do not change at all.
On the variability basis costs are classified into:
i. Variable costs,
ii. Fixed costs and
iii. Semi-variable costs.
i. Variable Costs:
Variable costs change in direct proportion to changes in production. These include all direct materials, direct labour, direct expenses and a portion of indirect expenses. As these costs respond directly in relation to changes in production, variable cost is also called “product cost”. They change in total amount only. Variable cost per unit remains constant at all levels of activity.
ii. Fixed Costs:
Fixed costs remain constant in total or do not change even when production or activity level changes. They remain unaffected in total to changes in production level. But fixed cost per unit changes in inverse proportion to changes in production level. These expenses respond to passage of time. They are called period cost or time cost.
iii. Semi-Variable Costs:
These expenses are partly variable and partly fixed. They change but not in direct proportion to changes in production level. They remain constant up to a certain production level and rise suddenly when production increases beyond a production level. So it is also called “Step Cost”.
On time basis, costs are classified as follows:
i. Historical Costs:
These are the costs actually incurred during a certain period. These represent the cost of actual performance. It is also called “Postmortem” costs.
ii. Predetermined Costs:
Predetermined costs are costs determined in advance of production.
Predetermined cost is classified into:
a. Standard Costs and
b. Estimated Costs
a. Standard Costs – Standard costs are the desired costs or reasonable costs. These are the costs ought to be incurred for a given volume of production. They are fixed on scientific basis.
b. Estimated Costs – The cost likely to be incurred in the future is determined on the basis of past experience. It is a simple assessment of what the cost will be.
Costs are classified into:
i. Controllable costs and
ii. Uncontrollable costs.
i. Controllable Costs:
Controllable costs are those costs which can be influenced by the people within an organization. All direct expenses and variable overheads are normally controllable. They can be increased or reduced by the executive action of the management.
ii. Uncontrollable Costs:
Uncontrollable costs are those costs which cannot be influenced by the managerial action.
The distinction between controllable and uncontrollable costs is not permanent. Some expenses which are uncontrollable in the short term may be controllable in the long term. Similarly uncontrollable expenses at the lower level in an organization may be influenced by people at higher level in an organization, e.g., wages and salaries of employees.
For enabling the management in decision making, costs are classified into the following groups:
i. Marginal Cost:
It is the total of all variable expenses. It includes all direct expenses and variable overheads. Marginal cost possesses all the characteristics of variable cost.
ii. Differential Cost:
The change in the cost of two alternatives is called differential cost. The increase in the total cost due to increase in output is called ‘incremental cost’. The decrease in the total cost due to decrease in output is called ‘decremental cost’.
iii. Relevant Cost and Irrelevant Costs:
Cost items taken into consideration while making a decision are called relevant costs. Costs which are not necessary for a particular decision making are called irrelevant costs. A cost relevant for a particular decision may be irrelevant for another decision. A cost irrelevant for a decision may be relevant for another decision.
For example rent for own premises may be relevant for comparison of profitability with another firm paying rent. But it is irrelevant for computing tax liability of a firm using own building.
iv. Opportunity Cost:
The benefit foregone due to an alternative decision taken is called opportunity cost. For example, a person decides to start a business of his own. For the purpose he resigns his present employment and withdraws his savings kept in a bank deposit. Due to this decision to start a business he foregoes his salary income and interest income. The loss of salary and interest income is opportunity cost for the business.
On the basis of payment involved costs are classified as follows:
i. Out of Pocket Costs or Explicit Costs:
The costs result in actual outflow of cash, e.g., salary, wages, rent, advertisement, etc. paid.
ii. Imputed Costs or Notional Costs or Implicit Costs:
These expenses are considered for decision making purpose only. They do not result in any cash outflow, e.g., rent for own premises, interest on own capital and depreciation on fully depreciated asset.
Costs are classified into the following two groups:
i. Normal Costs:
Expenses incurred in a normal business condition is called normal costs. These costs are included in cost of production.
ii. Abnormal Costs:
These costs are occasional and occur due to the happening of some unforeseen event, e.g., loss due to fire, theft, accident etc. These costs are not included in the cost of production. They are debited to costing profit and loss account.