6. cost classification

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Basic cost concepts and classification


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A cost may be defined as a sacrifice or giving up

of resources for a particular purpose.

Costs are frequently measured by the monetaryunits that must be paid for goods and services.

An actual cost is the cost incurred (a historical

cost) as distinguished from budgeted costs.

A cost object is anything for which a separate

measurement of costs is desired.


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Cost unit and Cost centre

Cost estimation and cost ascertainment

Cost objective and cost accumulation

Cost allocation and cost apportionment

Cost reduction and cost control


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Cost Centres

Parts of the business to which particular costs can be

attributed. Cost centre is the smallest organisational

sub-unit for which separate cost collection is

attempted.

In large businesses this can be:

a particular location, section of the business, capital

asset or human resource/s

Enable a business to identify where costs are arising

and to manage those costs more effectively


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Cost unit

Once the cost of various cost centres is ascertained,

the need arises to express the cost of output (product

/ service).

A cost unit is defined as a unit of quantity of product,

service or time (or a combination of these) in relation

to which costs may be ascertained or expressed.

Cost units are usually units of physical measurementlike number, weight, time, area, length, volume etc.


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Cost estimation and cost ascertainment

Cost Estimation is the process of pre determining the

costs of certain product, job or order for the purpose

of budgeting, measuring performance efficiencies,

make or buy decisions etc.

Cost Ascertainment is the process of determining cost

on the basis of actual data.

Computation of historical cost is Cost Ascertainmentwhile computation of future costs is Cost Estimation


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Cost allocation Vs Cost apportionment.

Cost allocation - Cost allocation refers to the allotment ofwhole items of costs to cost centres. For example, if aworker is employed in department "A", then the wagespaid to the worker are allocated or charged to department

"A". This process of charging the entire wages (beingcost) of the worker to department "A" is termed as costallocation.

Cost apportionment - It is the process of distributing an

item of cost over several cost centres or cost units. Thus,one item of cost is charged to two or more cost centres orcost units. Normally overheads (indirect costs) are chargedto cost centres or cost units by way of apportionment inproportion to the anticipated benefits.


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Cost reduction and cost control

Cost Reduction: It is concerned with real and permanent

reduction in the unit cost of goods manufactured or

services rendered. It is done by variety of techniques like

value analysis, design analysis, technological forecasting,

standardization etc.

Cost control: The ascertainment of cost as well as

furnishing such information to the management so as to

control the cost of operating the business. It is done by

variety of techniques like standard costing, budgetarycontrol, quality control etc.


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Basic Cost Terms:

Cost Object: Any activity or item for which a

separate measurement of costs is desired.

Cost Assignment: Direct costs are traced to a

cost object. Indirect costs are allocated or

assigned to a cost object.


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Cost Drivers

The cost driver of variable costs is the level

of activity or volume whose change causesthe (variable) costs to change proportionately.

EXAMPLE: SealBicycles incurred Rs. 94,500 in a given year for theleasing of its plant. (This is an example of fixed costs with respect to

the number of bicycles assembled.)

Q1. What is the leasing (fixed) cost per bicycle when SealBicyclesassembles 1,000 bicycles?Ans: Rs. 94,500 1,000 = Rs. 94.50

Q2. What is the leasing (fixed) cost per bicycle when SealBicyclesassembles 3,500 bicycles?Ans: Rs. 94,500 3,500 = Rs. 27

The number of bicycles assembled is a cost driver

of the cost of handlebars.


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COST

Direct

Material

Factory O/h

Indirect

material

Indirect

labor

Indirect

expenses

Indirect

material

Office &admin O/h Selling &Distrb. O/h

Direct

Labor

Direct

ExpensesOverheads

Indirect

expenses

Indirect

labor

Indirect

expenses

Indirect

labor

Indirect

material


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Direct costs can be identified specificallyand exclusively with a given cost

objective in an economically

feasible way.

What are direct costs?


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Indirect costs cannot be identifiedspecifically and exclusively with a

given cost objective in an economically

feasible way.

What are indirect costs?


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Managers prefer to classify costs as direct ratherthan indirect whenever it is economicallyfeasible or cost effective.

Other factors also influence whether a cost isconsidered direct or indirect.

The key is the particular cost objective.Any rawmaterial, labor, or other input used by anyorganization could, in theory, be identified as adirect or indirect cost depending on the costobjective.


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include the acquisition costs of all materials

that are physically identified as a part of the

manufactured goods and that may be traced

to the manufactured goods in an

economically feasible way.


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include the wages of all labor that can be

traced specifically and exclusively to the

manufactured goods in an economically

feasible way.


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orfactory overhead, include all costs

associated with the manufacturing process

that cannot be traced directly to the

manufactured goods in an economicallyfeasible way.


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Manufacturing Costs

Manufacturers make the products they sell.

They must keep records of their factory costsso that they can control those costs and set

selling prices that will produce a net income

instead of a net loss.


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Direct

Labor

Manufacturing

Overhead+ =Conversion

Costs

Indirect

LaborIndirect

Materials Other


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Prime cost / Basic, first or flat cost

= Direct Material + Direct labour + direct expenses

Factory cost or Works cost = Prime cost + Factoryoverheads

Office cost or cost of production = Factory cost +

Office and admin. overheads

Total cost or cost of sales = cost of production of

goods sold + selling and distribution overheads


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Factory Costs

Raw materials: The costs of materials which are usedin manufacturing and which become part of the

finished product.

Direct labor costs: The wages of all the workers who

work directly on the products as they move through

the factory.

Factory overhead: The expenses that cannot be

directly tied to producing a product. For example, it

includes salaries and wages of the factory managers,supervisors, inspectors, and other workers who do not

work directly on the manufactured products. It also

includes building rent, depreciation of equipment,

heat, power, insurance, and factory supplies.


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Direct material refers to cost of direct material

consumed. However not all material purchased

as well as in stock are consumed during the

period.

Cost of Direct material = opening stock +

purchases closing stock


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Distribute Factory Overhead to Units

A manufacturer needs to know the costs of

running each of its divisions, departments, or

other units.

So, factory expenses, or overhead, are oftendistributed or charged to each unit.


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Examples of

Distributing Factory Overhead

The way they are distributed varies with the companyand the kind of expense.

Rent may be distributed in proportion to the floor

space used by the units. Taxes and insurance on equipment may be distributed

based on the value of the equipment in each unit.

Cleaning expenses may be distributed on the basis offloor space.

Management salaries may be distributed based on thenumber of factory workers in a unit.


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On the basis of variability the cost can be

classified as:

Fixed cost / period cost Variable cost / product cost

Semi-variable cost

Step cost


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Fixed Costs

Costs that remain unchanged for a given time periodregardless of changes in the related cost driver.

Variable Costs

Costs that change directly in proportion to changes inthe related cost driver

Other Common Functions for Cost Behavior Semi-variable costs (part variable and part fixed)

Step costs (aka semi-fixed costs, it remains constant

over a range of activity)


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Cost which become part of the cost of the

product rather than an expense of the period in

which they are incurred are called as Product

costs. Ex. Cost of raw material, depreciation on

plant.

Cost which are not associated with production

but are treated as an expense of the period in

which they are incurred are called period costs.Ex. Gen admin. Cost, salesman salaries etc.


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Product Costs: Costs that attach to the

units that are produced i.e., manufacturingcosts) and are not reported expenses until

the goods are sold.

Period costs: Costs that must be chargedagainst income in the period incurred and

cannot be inventoried e.g., selling and

administrative expenses

Unit Costs: Total cost of units divided by

units


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Decision making cost and Accounting cost Shutdown and sunk cost

Relevant and irrelevant cost

Controllable and uncontrollable cost

Imputed and hypothetical cost

Out of pocket cost

Opportunity cost

Joint cost and common cost Traceable and untraceable cost

Conversion cost


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Imputed / Notional cost - Imputed cost is that cost whichdoes not involve any cash outlay. Though it is a

hypothetical cost, it is relevant for decision making.Interest on capital, the payment for which is not actuallymade, is an example of imputed cost.

Sunk cost - Historical cost which is incurred in the past isknown as sunk cost. This cost is not relevant in decisionmaking in the current period. For eg. In the case of adecision relating to the replacement of a machine, thewritten down value of the existing machine is a sunk costand hence irrelevant to decision making.

Shut down cost - The fixed cost which cannot be avoidedduring the temporary closure of a plant is known as shutdown cost. Examples of shut down cost are depreciationand rent.


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Controllable cost - The cost, which can be influenced

by the action of a specified person in an organisation, is

known as controllable cost. In a business organisation,

heads of each responsibility centre are responsible to

control costs.

Uncontrollable cost - The cost which cannot be

influenced by the action of the person heading the

responsibility centre is called uncontrollable cost. For

e.g. all the allocated costs and the fixed costs.

Normal cost - It is the cost which is normally incurred

at a given level of output, under the conditions in which

that level of output is normally attained. Normal cost is

charged to the respective product / process.

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.


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Differential cost - It is the difference in the total cost

between alternatives calculated to assist decision makingThus, it represents the change in total cost (both fixed andvariable) due to a change in the level of activity,technology, process or method of production, etc.

Where the change results in increase in cost it is called

incremental cost, whereas if costs are reduced due toincrease of output, the difference is called decremental

costs. The differential costs are relevant costs.

Discretionary cost - It is an "escapable" or "avoidable"cost. In other words, it is that cost which is not essentialfor the accomplishment of a particular objective.


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Standard cost - It is a pre-determined cost which is arrivedat, assuming a particular level of efficiency in utilization

of material, labour and other indirect services. It is theplanned cost of a product and is expected to be achievedunder a particular production process under normalconditions. It is often used as a basis for price fixing andcost control.

Estimated Cost - It is an approximate assessment of whatthe cost will be. It is based on past data adjusted toanticipated future changes.

Marginal cost - It is the amount at any given volume of

output by which aggregate cost changes if the volume ofoutput changes increases/decreases) by one unit.


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Opportunity cost - It refers to the value of sacrifice madeor benefit of opportunity forgone in accepting analternative course of action.

Out of pocket cost - It is that portion of total cost whichinvolves cash outlay. It is a short term cost concept and isused in short- term decision making like make or buy, pricefixation during recession. Out of pocket cost can beavoided if a particular proposal under consideration is not

accepted.

Joint cost - It is the cost of the process which results inmore than one main product.

Decision-driven cost - It is that cost which is incurredfollowing a policy decision and continues to be incurred tillthat decision is altered. It does not vary with changes inoutput or with operational activities.


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Committed cost - It is a fixed cost which results from

decisions of prior period and is not subject to managerial

control in the present. Examples of committed cost aredepreciation, insurance premium and rent.

Relevant cost - CIMA defines relevant cost as " cost

appropriate to a specific management decision".

Replacement cost - It is the cost of replacement in the

current market.

Absolute cost - It is the total cost of any product orprocess. For e.g.: in a cost sheet, both absolute cost and

cost per unit are depicted.


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A Company is manufacturing 1000 unit of a product.

Selling Price per unit : Rs. 10

Variable Cost per unit: Rs. 5

Fixed cost: Rs. 4000

The management is considering following two alternatives:

(i) To accept an order for another 200 units at Rs.8 per

unit. This will increase the fixed cost by Rs. 500.

(ii) To reduce the production from present 1000 units to 600

units and buy another 400 from the market at Rs 6 per

unit. This will reduce the fixed cost to Rs. 3000.

What alternative the management should adopt?


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Statement showing Profitability under different alternatives

Present situation Proposed Situations

Rs. I II

Sales

Less:

Variable cost/

Purchase

Fixed cost

1000x10

5000

4000

10000

9000

10000 +

1600

1200x5

4500

11600

10500

1000x10

(3000 +

2400)

3000

10000

8400

Profit 1000 1100 1600

6. cost classification

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