Question

Discuss the various classifications of costs and cite relevant examples of their applicability in the contemporary business environment (Use of diagrams and relevant examples is highly encouraged).

Answer 1

Definitions:

Cost : Cost is a measurement, in monetary terms, of the amount of resources used for the purpose of production of goods or rendering services.

Cost Centre : Any unit of Cost Accounting selected with a view to accumulating all cost under that unit. The unit may be a product, a service, division, department, section, a group of plant and machinery , a group of employees or a combination of several units. This may also be a budget centre.

Cost Centre or Cost Object is the logical sub-unit for collection of cost. Cost Centre may be of two types – personal and impersonal cost centers. Personal cost centre consists of a person or a group of persons. Cost centres which are not personal cost centres are impersonal cost centers. Again Cost centers may be divided into broad types i.e. Production Cost Centres and Service Cost Centres. Production Cost Centres are those which are engaged in production like Machine shop, Welding shop, Assembly shop etc. Service Cost centers are for rendering service to production cost centre like Power house, Maintenance, Stores, Purchase office etc

Basic Rules for Classification of Costs

1 Classification of cost is the arrangement of items of costs in logical groups having regard to their nature (subjective classification) or purpose (objective classification).

2 Items should be classified by one characteristic for a specific purpose without ambiguity.

3 Scheme of classification should be such that every item of cost can be classified.

4 Basis of classification : i) Nature of expense ii) Relation to object – traceability iii)Functions / activities iv) Behaviour fixed, semi-variable or variable v) Management decision making vi) Production Process vii) Time period

Classification of Costs

1 By Nature of expense: .

Costs should be gathered together in their natural groupings such as material, labour and other expenses. Items of costs differ on the basis of their nature. The elements of cost can be classified in the following three categories : i) Material ii) Labour iii) Expenses

1 . Material Cost : Material Cost is the cost of material of any nature used for the purpose of production of a product or a service. Material cost includes cost of procurement, freight inwards, taxes & duties, insurance etc directly attributable to the acquisition. Trade discounts, rebates, duty drawbacks, refunds on account of modvat, cenvat, salex tax and other similar items are deducted in determining the costs of material.

2. Labour Cost : means the payment made to the employees, permanent or temporary, for their services.Labour cost include salaries and wages paid to permanent employees, temporary employees and also to employees of the contractor. Here, salaries & wages include all fringe benefits like Provident Fund contribution, gratuity, ESI, overtime, incentives, bonus , ex-gratia, leave encashment, wages for holidays and idle time etc.

3. Expenses : Expenses are other than material cost or labour cost which are involved in an activity. Expenditure on account of utilities, payment for bought out services, job processing charges etc. can be termed as expenses.

2 By Relation to Cost Centre

Direct cost has three components – direct material cost, direct labour cost and direct expenses and indirect cost has three components- indirect material, indirect labour cost and indirect expenses. Sum of all direct costs is called prime cost .Direct material Cost is the cost of material which can be directly allocated to a cost centre or a cost object in a economically feasible way.Direct Labour Cost is the cost of wages of those workers who are readily identified or linked with a cost centre or cost object.Direct Expenses are the expenses other than direct material or direct labour which can be identified or linked with the cost centre or cost object.

  Indirect Material is the cost of material which can not be directly allocable to a particular cost centre or cost object.Indirect labour cost is the wages of the employees which are not directly allocable to a particular cost centre.Indirect expenses are the expenses other than of the nature of material or labour and can not be directly allocable to a particular cost centres..Indirect expenses are not be allocable to a particular cost centre. Examples – insurance, taxes and duties,

3 By functions/activities

  Costs should be classified according to the major functions for which the elements are used into the following four major functions : Production; Administration; Selling; Distribution; and Research & Development Expenditure.

1, Production Cost : the cost of all items involved in the production of a product or service. It includes all direct costs and all indirect costs related to the production. Production overhead is the indirect costs involved in the production process.Production overhead is also termed as factory overhead or manufacturing overhead. Examples of Production overhead : Salaries for staff for production planning, technical supervision, factory administration etc , normal idle time cost , expenses for stores management , security expenses in the factory.

2. Administration costs : expenses incurred for general management of an organization. These are in the nature of indirect costs and are also termed as administrative overhead.Examples of items to be included in Administrative overhead : Salaries of administrative and accounts staff ,general office expenses like rent, lighting, rates and taxes, telephone, stationery, postage etc

3. Selling costs : indirect costs related to selling of products or services and include all indirect cost in sales management for the organization. Selling Costs include all costs relating to regular sales and sales promotion activities. Examples of expenses which are included in selling cost are : Salaries, commission and traveling expenses for sales personnel , advertisement cost , Legal expenses for debt realization.

4. Distribution Costs : the cost incurred in handling a product from the time it is completed in the works until it reaches the ultimate consumer. Distribution costs are the costs incurred for distribution of product to customers. Examples of distribution costs : • Transportation cost • cost of warehousing salable products

5. Research & Development Costs : the cost for undertaking research to improve quality of a present product or improve process of manufacture, develop a new product, market research etc and commercialization thereof. Research Cost comprises the cost of development of new product and manufacturing process; improvement of existing products, process and equipment; finding new uses for known products; solving technical problem arising in manufacture and application of products etc.

4 By Behaviour

Costs are classified based on behaviour as fixed cost, variable cost and semi-variable cost depending upon response to the changes in the activity levels.

1. Fixed Cost : the cost which does not vary with the change in the volume of activity in the short run. These costs are not affected by temporary fluctuation in activity of an enterprise. These are also known as period costs. Examples for fixed cost : salaries, rent, audit fees, depreciation etc.

2. Variable Cost : the cost of elements which tends to directly vary with the volume of activity. Variable cost has two parts – (a) Variable direct cost; and (b) Variable indirect costs. Variable indirect costs are termed as variable overhead. Examples of variable cost are materials consumed, direct labour, sales commission, utilities, freight, packing, etc.

3. Semi Variable Costs contain both fixed and variable elements. They are partly affected by fluctuation in the level of activity. Examples of semi-variable cost : Factory supervision, maintenance, power etc.

5 For Management Decision Making

1. Marginal cost :  the aggregate of variable costs, i.e. prime cost plus variable overhead. Marginal cost per unit is the change in the amount at any given volume of output by which the aggregate cost changes if the volume of output is increased or decreased by one unit.Marginal cost is used in Marginal Costing system. For determining marginal cost, semi-variable costs, if any, are segregated into fixed and variable cost. Then, variable costs plus the variable part of semi-variable costs is the total marginal cost for the volume of production in consideration.

2. Differential Cost :  the change in cost due to change in activity from one level to another. Differential Cost is found by using the principle which highlights the points of differences in costs by adoption of different alternatives. This technique is used in export pricing, new products and pricing goods sought to be promoted in new markets, either within the country or outside. The algebraic difference between the relevant cost at two levels of activities is the differential cost. When the level of activity is increased, the differential cost is known as incremental cost and when the level of activity is decreased, the decrease in cost is known as decremental cost.

3. Opportunity Cost : the value of the alternatives foregone by adopting a particular strategy or employing resources in specific manner.It is the return expected from an investment other than the present one. The opportunity cost is considered for selection of a project or justification of investment, studying viability of an investment option. Example : A machine is currently being used to produce product P. It can also be used to produce product Q which can fetch Rs 60,000 profit. Then the opportunity cost of using the machine is Rs 60000.

4. Replacement Cost :  the cost of an asset in the current market for the purpose of replacement. Replacement cost is generally used for determining the optimum time of replacement of an equipment or machine in consideration of maintenance cost of the existing one and its productive capacity

5. Relevant Costs are costs relevant for a specific purpose or situation. In the context of decision making relating to a specific issue, only those costs which are relevant are considered. A particular cost item may be relevant in a decision making and may be irrelevant in some other decision making situation. For example, present depreciated cost of machine is relevant in case of decision of its sale but it is irrelevant in case of decision of its replacement.

6. Imputed Costs : hypothetical or notional costs, not involving cash outlay, computed only for the purpose of decision making. . In economics, ‘imputed’ indicates an ascribed or estimated value when there is no criteria of absolute monetary value for such purpose. In national income estimation wages of housewives are imputed. Similarly, in farming operations, the wages or salaries of owner are imputed. Imputed costs are similar to opportunity costs. Interest on internally generated fund, which is not actually paid is an example of imputed cost.

7. Sunk Costs : historical costs which are incurred i.e. ‘sunk’ in the past and are not relevant to the particular decision making problem being considered. Sunk costs are those that have been incurred for a project and which will not be recovered if the project is terminated. While considering the replacement of a plant, the depreciated book value of the old asset is irrelevant as the amount is a sunk cost which is to be written off at the time of replacement

8. Normal Cost : a cost that is normally incurred at a given level of output in the conditions in which that level of output is achieved. Normal cost includes those items of cost which occur in the normal situation of production process or in the normal environment of the business. The normal idle time is to be included in the ascertainment of normal cost.

9. Abnormal Cost :  an unusual or a typical cost whose occurrence is usually irregular and unexpected and due to some abnormal situation of the production. Abnormal cost arises due to idle time for some heavy break down or abnormal process loss. They are not considered in the cost of production for decision making and charged to profit & loss account.

10. Avoidable Costs :  those costs which under given conditions of performance efficiency should not have been incurred. . Avoidable costs are logically associated with some activity or situation and are ascertained by the difference of actual cost with the happening of the situation and the normal cost. When spoilage occurs in manufacture in excess of normal limit, the resulting cost of spoilage is avoidable cost. Cost variances which are controllable may be termed as avoidable cost.

11. Unavoidable Costs are inescapable costs which are essentially to be incurred, within the limits or norms provided for. It is the cost that must be incurred under a programme of business restriction. It is fixed in nature and inescapable.

.6. By nature of production process

Costs are also classified on the basis of nature of production or manufacturing process as follows :

1.Batch Cost : the aggregate cost related to a cost unit which consist of a group of similar articles which maintain its identity throughout one or more stages of production.

2. Process cost : When the production process is such that goods are produced from a sequence of continuous or repetitive operations or processes, the cost incurred during a period is considered as process cost. The process cost per unit is derived by dividing the process cost by number of units produced in the process during the period.

3. Operation Cost is the cost a specific operation involved in a production process or business activity.When there are distinctly separate operations involved in a process, cost for each operation is found out for effective control mechanism.

4. Operating Cost :  the cost incurred in conducting a business activity. Operating costs refer to the cost of undertakings which do not manufacture any product but which provide services.

5. Contract cost :  the cost of a contract with some terms and condition of adjustment agreed upon between the contractee and the contractor.Contract cost usually implied to major long term contracts as distinct from short term job costs. Escalation clause are sometimes provided in the contract in order to take care of anticipated change in material price, labour cost etc.

6. Joint Costs are the common cost of facilities or services employed in the output of two or more simultaneously produced or otherwise closely related operations, commodities or services.

7. Classification by time

A cost item is related to a specific period of time and cost can be classified according to the system of assessment and specific purpose as indicated in the following ways:

1. Historical Costs :  the actual costs of acquiring assets or producing goods or services.They are ‘postmortem’ costs ascertained after they have been incurred and they represent the cost of actual operational performance. Historical costing system follows a system of accounting to which all values ( in revenue and capital accounts) are based on costs actually incurred or as relevant from time to time.

2. Pre-determined Costs : The Pre-determined Costs for a product are computed in advance of production, on the basis of a specification of all the factors affecting cost and cost data. Pre-determined costs may be either standard or estimated.

3. Standard Costs : A predetermined norm applied as a scale of reference for assessing actual cost, whether these are more or less. The standard cost serves as a basis of cost control and as a measure of productive efficiency when ultimately posed with an actual cost.

4.Estimated Costs : Estimated Costs of a product are prepared in advance prior to the performance of operations or even before the acceptance of sale orders.  Estimated cost is found with specific reference to product in question, and activity level of the plant. It has no link with actual and hence it is assumed to be less accurate than the standard cost.