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Classification Of

Cost


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Cost classification is the process of grouping costsaccording to their common characteristics. Asuitable classification of costs is of vital importancein order to identify the cost with cost centers or cost

units. Cost may be classified according to theirnature, i.e., material, labor and expenses and anumber of other characteristics. The same costfigures are classified according to different ways of

costing depending upon the purpose to be achievedand requirements of particular concern. Theimportant ways of classification are:


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On the basis of Identity: According to thisclassification, the costs are divided into threecategories i.e., Materials, Labor and Expenses. There

can be further sub-classification of each element; forexample, material into raw material components, andspare parts, consumable stores, packing material etc.

This classification is important as it helps to find totalcost, how such total cost is constituted and valuation

of work-in-progress.


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On the basis of Function: Production, Administration, Selling &Distribution are three important functions of a business concern.Taking these functions into consideration, costs have been classifiedby:(a) Production or Manufacturing Cost: Manufacturing costs are thosecosts which are incurred in the course of manufacture. It includescost of raw material, cost of labour, other direct cost and factoryindirect cost. Example of production or manufacturing costs may bepower, lighting, heating, rent, depreciation etc.(b) Office and Administration Cost: These costs are incurred for the

general administration of the enterprise. It includes office costs aswell as administration cost. For example, salary of office staff, rent ofoffice building, electricity charges, audit fee, printing and stationeriesetc.(c) Selling and Distribution Cost: It includes both selling cost as well

as distribution cost. Selling costs are those costs which are incurredin connection with the selling of goods and services Distribution costsare those costs which are incurred on dispatch of finished goods tothe consumers. Example of selling and distribution costs are: salesmen salary, packing charges, carriage, out ward, advertisement,

ware house charges etc.


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On the basis of controllability: From the point of

view of controllability, the cost has been classified into two categories as controllable cost anduncontrollable cost.

(a)Controllable Cost: These costs are regulated orcontrolled by specified member of an organization.Most of the variable costs are controllable. Generallydirect material, direct labor and direct expenses arecontrolled by the lower level of the management.

(b) Uncontrollable Cost: These costs can not beregulated or controlled by specified member of anundertaking. Most of the fixed costs are

uncontrollable. Example of uncontrollable costs are,


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On the basis of normality: On this basis the costshave been classified in to two categories as

(a)Normal cost: It is the cost which is normallyincurred at a given level of out put. These costs arepart of cost production.

(b) Abnormal cost: It is the cost which is notnormally incurred at a given level of out put. Thesecosts are not charged to the cost of production. It is

transferred to the costing profit and loss account.


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On the basis of Time: On this basis the costshave been classified as

(a) Historical Cost: These costs are ascertained

after they have been incurred such costs are

available only when the production of a particular

thing has already been done.

(b) Pre-determined Cost: Pre-determined costs

are estimated costs which are set in advance on a

scientific way. It becomes standard cost and

compared with the actual for adopting controlling


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On the basis of cost center: On the basis of cost centre


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On the basis of cost center: On the basis of cost centrecosts are classified into direct and indirect cost. Direct costsare the costs which are identifiable with the product unit orcost center while indirect costs are not identifiable with the

product unit or cost center and hence they are to be allocated,apportioned and then absorb in the production units. Allelements of costs like material, labor and expenses can beclassified into direct and indirect.

They are mentioned below:

i. Direct and Indirect Material :- Direct material is thematerial which is identifiable with the product. For example,Timber in furniture, Cloth in garments, Bricks or cementin building .Indirect material cannot be identified with the

product, for example, lubricants, fuel, oil, cotton wastes etccannot be identified with a given unit of product and hencethese are the examples of indirect materials.

ii i d di b i l b b id ifi d i h


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ii. Direct and Indirect Labor :- Direct labor can be identified with agiven unit of product, for example, when wages are paid according tothe piece rate, wages per unit can be identified. Similarly wages paidto workers who are directly engaged in the production can also beidentified and hence they are direct wages. Ex. Weaver in weavingunit, Carpenter in furniture unit. On the other hand, wages paidto workers like sweepers, gardeners, maintenance workers ,Engineers, managersetc are indirect wages as they cannot beidentified with the given unit of production.iii. Direct and Indirect Expenses :- Direct expenses refers to

expenses that are specifically incurred and charged for specific orparticular job, process, service, cost center or cost unit. Theseexpenses are also called as chargeable expenses. Examples of theseexpenses are cost of drawing, design and layout, royaltiespayable on use of patents, copyrights etc, consultation fees paid

to architects, surveyors etc. Indirect expenses on the other handcannot be traced to specific product, job, process, service or costcenter or cost unit. Several examples of indirect expenses can begiven like insurance, electricity, rent, salaries, advertising etc.It should be noted that the total of direct expenses is known as Prime

Cost while the total of all indirect expenses is known as Overheads.


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O th b i f V i bilit Th b h i f t i f


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On the basis of Variability:The behavior of cost varies from oneanother as production increases, some cost remains constant orvaries in direct proportion to the volume of out put, or others mayvary partially. Thus on the basis of variability, costs can be classifiedinto the following three categories.

(a) Fixed Cost : Fixed costs are those costs which remain fixedirrespective of the change in volume of out put. As productionincreases cost per unit of the fixed cost decreases and as productiondecreases fixed costs are, rent of the factory buildingdepreciation, salary of the office manager etc.

(b) Variable Cost : Variable costs are those costs which very in directproportion to the volume of out put. As production increases totalcost increases but also per unit remains constant. As productiondecreases total cost decreases and cost per unit also decreases.Example of variable costs are, cost of raw materials, labor etc.

(c) Semi-Variable Cost / Semi-Fixed cost: These costs are partly fixedand partly variable. Examples of variable costs are telephone rent.It includes partly fixed charge up to a certain level and then variesaccording to the calls.


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On the basis of inventory : On the basis ofinventory costs areclassified into period cost and product cost.

Product costs are costs assigned to the manufacture of

products and recognized for financial reporting whensold. They include direct materials, direct labor, factorywages, factory depreciation, etc.

Period costs are on the other hand are all costs otherthan product costs. They include marketing costs andadministrative costs, etc.


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Cl ifi ti f t f M t d i i ki


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Classification of costs for Management decision making :-One of the important function of cost accounting is to preseninformation to the Management for the purpose of decision making. Fodecision making certain types of costs are relevant. Classificationcosts basedon the criteria of decision making can be done in the following mannerI. Marginal Cost :- Marginal cost is the change in the aggregate costdue to change in the volume of output by one unit. For examplsuppose a manufacturing company produces 10,000 units and thaggregate costs are Rs. 25,000, if 10,001 units are produced th

aggregate costs may be Rs. 25,020 which means that the margincost is Rs. 20. Marginal cost is also termed as variable cost andhence per unit marginal cost is always same, i.e. per unit marginal cosis always fixed. Marginal cost can be effectively used for decisiomaking in various areas.

II. Differential Costs :- Differential costs are also knownas incremental cost. This cost is the difference in total cost that wiarise from the selection of one alternative to the other. In other wordit is an added cost of a change in the level of activity. This typeanalysis is useful for taking various decisions like change in the level

activity, adding or dropping a product, change in product mix, make obuy decisions, accepting an export offer and so on.

III Opportunity Costs : It is the value of benefit sacrificed in


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III. Opportunity Costs :- It is the value of benefit sacrificed infavor of an alternative course of action. It is the maximum amountthat could be obtained at any given point of time if a resource wassold or put to the most valuable alternative use that would bepracticle.

Opportunity cost of goods or services is measured in terms ofrevenue which could have been earned by employing that goods orservices in some other alternative uses.IV. Relevant Cost :-Relevant costs are costs that will be differentwhen two or more alternatives are involved. Relevant cost or

expenses attributable or chargeable to one or more activities onthe basis of benefits received or some other logical relationship.Relevant costs are subject to change depending uponthe decisions that are made. It is a managerial accounting term thatdescribes costs that are specific to management's decisions. The

relevant costs eliminate unnecessary data that could complicatethe decision-making process. A relevant cost may be important inone situation and irrelevant in another. For example whenmanagement uses relevant costs can be seen when itis determining whether to sell or keep a business unit, make or buyan item, or accept a special order.

V Replacement Cost : This cost is the cost at which existing items


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V. Replacement Cost :-This cost is the cost at which existing itemsof material or fixed assets can be replaced. Thus this is the cost ofreplacing existing assets at present or at a future date.

VI. Shutdown Cost :-These costs are the costs which are incurred

if the operations are shut down and they will disappear if theoperations are continued. Examples of these costs are costs ofsheltering the plant and machinery and construction of sheds forstoring exposed property. Computation of shutdown costs isextremely important for taking a

decision of continuing or shutting down operations. Ex. Rent &Insurance of building

VII. Capacity Cost :-These costs are normally fixed costs. The costincurred by a company for providing production, administration and

selling and distribution capabilities in order to perform variousfunctions. Capacity costs include the costs of plant, machinery andbuilding for production, warehouses and vehicles for distribution andkey personnel for administration. These costs are in the nature oflong-term costs and are incurred as a result of planning decisions.

VIII Urgent Costs : These costs are those which must be


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VIII. Urgent Costs :-These costs are those which must beincurred in order to continue operations of the firm. Forexample, cost of material and labor must be incurred ifproduction is to take place.

IX. Imputed Cost:These are the notional costs which do notinvolve any cash outlay. Imputed costs consist of theopportunity costs of time and capital that the manager hasinvested in producing the given quantity of production and the

opportunity costs of making a particular choice among thealternatives being considered. Ex. Interest on capital

X. Sunk Costs:Sunk costs are costs that were incurred in the past. Sunk costs

can not be changed by later decision, these are not relevant fordecision making.Ex. In case of a decision relating to the replacement of oldmachine, WDV of old machine is sunk cost.


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XI. Committed costs:These are costs that will occur inthe future, but that cannot be changed once the decisionto incur them has been taken.

Ex. Depreciation on Plant & Machinery

XII. Discretionary Cost:These are those costs whichcan be avoided by managerial decisions. Ex. Advertising ,R& D costs.

XIII. Conversion Cost: It is the cost of converting a rawmaterial into finished goods. It is aggregate of directlabour, direct expenses and production overheads.

XIV. Out of Pocket Cost:These are cost requiring cashdisbursements in the current accounting period. Forexample, the wages of the person setting up a machine

for a new production run are an out-of-pocket cost.


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THANKYOU

Date post:	14-Apr-2018
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