COST CONCEPTS
AND
CLASSIFICATION
BY: AMAR RAVEENDRAN
DEBASIS BEHERA
Meaning of Cost Accounting
Cost accounting is concerned with recording, classifying and
summarizing costs for determination of costs of products or services,
planning, controlling and reducing such costs and furnishing of
information to management for decision making.
Classification of Cost
Cost may be classified into different categories depending upon the
purpose of classification. Some of the important categories in which the
costs are classified are as follows:
1. Fixed, Variable and Semi-Variable Costs
The cost which varies directly in proportion with every increase or
decrease in the volume of output or production is known as variable
cost. Some of its examples are as follows:
Wages of laborers
Cost of direct material
Power
The cost which does not vary but remains constant within a given period
of time and a range of activity inspite of the fluctuations in production is
known as fixed cost. Some of its examples are as follows:
Rent or rates
Insurance charges
Management salary
The cost which does not vary proportionately but simultaneously does
not remain stationary at all times is known as semi-variable cost. It can
also be named as semi-fixed cost. Some of its examples are as follows:
Depreciation
Repairs
2. Product Costs and Period Costs
The costs which are a part of the cost of a product rather than an expense
of the period in which they are incurred are called as “product costs.”
e.g., cost of raw materials and direct wages, depreciation on plant and
equipment etc.
The costs which are not associated with production are called period
costs. They are treated as an expense of the period in which they are
incurred. Such costs include general administration costs, salaries
salesmen and commission, depreciation on office facilities etc. They are
charged against the revenue of the relevant period.
3. Direct and Indirect Costs
The expenses incurred on material and labor which are economically
and easily traceable for a product, service or job are considered as direct
costs. In the process of manufacturing of production of articles,
materials are purchased, laborers are employed and the wages are paid to
them. Certain other expenses are also incurred directly. All of these take
an active and direct part in the manufacture of a particular commodity
and hence are called direct costs.
The expenses incurred on those items which are not directly chargeable
to production are known as indirect costs. For example, salaries of
timekeepers, storekeepers and foremen. Also certain expenses incurred
for running the administration are the indirect costs. All of these cannot
be conveniently allocated to production and hence are called indirect
costs.
4. Decision-Making Costs and Accounting Costs
Decision-making costs are special purpose costs that are applicable only
in the situation in which they are compiled. They have no universal
application. Accounting costs are compiled primarily from financial
statements. They have to be altered before they can be used for decision-
making. Decision-making costs are future costs. They represent what is
expected to happen under an assumed set of conditions. For example,
accounting costs may show the cost of a product when the operations are
manual whereas decision-making cost might be calculated to show the
costs when the operations are mechanized.
5. Relevant and Irrelevant Costs
Relevant costs are those which change by managerial decision.
Irrelevant costs are those which do not get affected by the decision. For
example, if a manufacturer is planning to close down an unprofitable
retail sales shop, this will affect the wages payable to the workers of a
shop. This is relevant in this connection since they will disappear on
closing down of a shop. But prepaid rent of a shop or unrecovered costs
of any equipment which will have to be scrapped are irrelevant costs
which should be ignored.
6. Shutdown and Sunk Costs
A manufacturer or an organization may have to suspend its operations
for a period on account of some temporary difficulties, e.g., shortage of
raw material, non-availability of requisite labor etc. During this period,
though no work is done yet certain fixed costs, such as rent and
insurance of buildings, depreciation, maintenance etc., for the entire
plant will have to be incurred. Such costs of the idle plant are known as
shutdown costs.
Sunk costs are historical or past costs. These are the costs which have
been created by a decision that was made in the past and cannot be
changed by any decision that will be made in the future. Investments in
plant and machinery, buildings etc. are prime examples of such costs.
Since sunk costs cannot be altered by decisions made at the later stage,
they are irrelevant for decision-making.
7. Controllable and Uncontrollable Costs
Controllable costs are those costs which can be influenced by the ratio or
a specified member of the undertaking. The costs that cannot be
influenced like this are termed as uncontrollable costs.
8. Avoidable or Escapable Costs and Unavoidable or Inescapable
Costs
Avoidable costs are those which will be eliminated if a segment of a
business (e.g., a product or department) with which they are directly
related is discontinued. Unavoidable costs are those which will not be
eliminated with the segment. Such costs are merely reallocated if the
segment is discontinued. For example, in case a product is discontinued,
the salary of a factory manager or factory rent cannot be eliminated
9. Differentials, Incremental or Decrement Cost
The difference in total cost between two alternatives is termed as
differential cost. In case the choice of an alternative results in an
increase in total cost, such increased costs are known as incremental
costs. While assessing the profitability of a proposed change, the
incremental costs are matched with incremental revenue. This is
explained with the following example:
10. Opportunity Cost
Opportunity cost refers to an advantage in measurable terms that have
foregone on account of not using the facilities in the manner originally
planned. For example, if a building is proposed to be utilized for housing
a new project plant, the likely revenue which the building could fetch, if
rented out, is the opportunity cost which should be taken into account
while evaluating the profitability of the project.
11. Traceable, Untraceable or Common Costs
The costs that can be easily identified with a department, process or
product are termed as traceable costs. For example, the cost of direct
material, direct labor etc. The costs that cannot be identified so are
termed as untraceable or common costs. In other words, common costs
are the costs incurred collectively for a number of cost centers and are to
be suitably apportioned for determining the cost of individual cost
centers. For example, overheads incurred for a factory as a whole,
combined purchase cost for purchasing several materials in one
consignment etc.
12. Conversion Cost
The cost of transforming direct materials into finished products
excluding direct material cost is known as conversion cost. It is usually
taken as an aggregate of total cost of direct labor, direct expenses and
factory overheads.
14. Production, Administration and Selling and Distribution Costs
A business organization performs a number of functions, e.g.,
production, illustration, selling and distribution, research and
development. Costs are to be curtained for each of these functions. The
Chartered Institute of Management accountants, London, has defined
each of the above costs as follows:
i. Production Cost
The cost of sequence of operations which begins with supplying
materials, labor and services and ends with the primary packing of
the product. Thus, it includes the cost of direct material, direct
labor, direct expenses and factory overheads.
ii. Administration Cost
The cost of formulating the policy, directing the organization and
controlling the operations of an undertaking which is not related
directly to a production, selling, distribution, research or
development activity or function.
iii. Selling Cost
It is the cost of selling to create and stimulate demand (sometimes
termed as marketing) and of securing orders.
iv. Distribution Cost
It is the cost of sequence of operations beginning with making the
packed product available for dispatch and ending with making the
reconditioned returned empty package, if any, available for reuse.
v. Research Cost
It is the cost of searching for new or improved products, new
application of materials, or new or improved methods.
vi. Development Cost
The cost of process which begins with the implementation of the
decision to produce a new or improved product or employ a new or
improved method and ends with the commencement of formal
production of that product or by the method.
