Friday, January 22, 2010

Classification of Costs

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
Fixed costs are sometimes referred to as “period costs” and variable costs as “direct costs” in system of direct costing. Fixed costs can be further classified into:
  • Committed fixed costs
  • Discretionary fixed costs
Committed fixed costs consist largely of those fixed costs that arise from the possession of plant, equipment and a basic organization structure. For example, once a building is erected and a plant is installed, nothing much can be done to reduce the costs such as depreciation, property taxes, insurance and salaries of the key personnel etc. without impairing an organization’s competence to meet the long-term goals.
Discretionary fixed costs are those which are set at fixed amount for specific time periods by the management in budgeting process. These costs directly reflect the top management policies and have no particular relationship with volume of output. These costs can, therefore, be reduced or entirely eliminated as demanded by the circumstances. Examples of such costs are research and development costs, advertising and sales promotion costs, donations, management consulting fees etc. These costs are also termed as managed or programmed costs.
In some circumstances, variable costs are classified into the following:
  • Discretionary cost
  • Engineered cost
The term discretionary costs is generally linked with the class of fixed cost. However, in the circumstances where management has predetermined that the organization would spend a certain percentage of its sales for the items like research, donations, sales promotion etc., discretionary costs will be of a variable character.
Engineered variable costs are those variable costs which are directly related to the production or sales level. These costs exist in those circumstances where specific relationship exists between input and output. For example, in an automobile
industry there may be exact specifications as one radiator, two fan belts, one battery etc. would be required for one car. In a case where more than one car is to be produced, various inputs will have to be increased in the direct proportion of the output.
Thus, an increase in discretionary variable costs is due to the authorization of management whereas an increase in engineered variable costs is due to the volume of output or sales.
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.” They are included in inventory values. In financial statements, such costs are treated as assets until the goods they are assigned to are sold. They become an expense at that time. These costs may be fixed as well as variable, 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. They may also be fixed as well as variable. 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. Differences between opinions exist regarding whether certain costs should be considered as product or period costs. Some accountants feel that fixed manufacturing costs are more closely related to the passage of time than to the manufacturing of a product. Thus, according to them variable manufacturing costs are product costs whereas fixed manufacturing and other costs are period costs. However, their view does not seem to have been yet widely accepted.
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. They need not tie into routine-financial accounts. They do not and should not conform the accounting rules. Accounting costs are compiled primarily from financial statements. They have to be altered before they can be used for decision-making. Moreover, they are historical costs
and show what has happened under an existing set of circumstances. 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.
An individual may regret for purchasing or constructing an asset but this action could not be avoided by taking any subsequent action. Of course, an asset can be sold and the cost of the asset will be matched against the proceeds from sale of the asset for the purpose of determining gain or loss. The person may decide to continue to own the asset. In this case, the cost of asset will be matched against the revenue realized over its effective life. However, he/she cannot avoid the cost which has already been incurred by him/her for the acquisition of the asset. It is, as a matter of fact, sunk cost for all present and future decisions.
Jolly Ltd. purchased a machine for $. 30,000. The machine has an operating life of five yea$ without any scrap value. Soon after making the purchase, management feels that the machine should not have been purchased since it is not yielding the operating advantage originally contemplated. It is expected to result in savings in operating costs of $. 18,000 over a period of five years. The machine can be sold immediately for $. 22,000.
To take the decision whether the machine should be sold or be used, the relevant amounts to be compared are $. 18,000 in cost savings over five yea$ and $. 22,000 that can be realized in case it is immediately disposed. $. 30,000 invested in the asset is not relevant since it is same in both the cases. The amount is the sunk cost. Jolly Ltd., therefore, sold
the machinery for $. 22,000 since it would result in an extra profit of $. 4,000 as compared to keeping and using it.
7. Controllable and Uncontrollable Costs
Controllable costs are those costs which can be influenced by the ratio or a specified member of the undertaking. The costs that cannot be influenced like this are termed as uncontrollable costs.
A factory is usually divided into a number of responsibility centers, each of which is in charge of a specific level of management. The officer incharge of a particular department can control costs only of those matte$ which come directly under his control, not of other matte$. For example, the expenditure incurred by tool room is controlled by the foreman incharge of that section but the share of the tool room expenditure which is apportioned to a machine shop cannot be controlled by the foreman of that shop. Thus, the difference between controllable and uncontrollable costs is only in relation to a particular individual or level of management. The expenditure which is controllable by an individual may be uncontrollable by another individual.
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. It will simply mean that certain other products will have to absorb a large amount of such overheads. However, the salary of people attached to a product or the bad debts traceable to a product would be eliminated. Certain costs are partly avoidable and partly unavoidable. For example, closing of one department of a store might result in decrease in delivery expenses but not in their altogether elimination.
It is to be noted that only avoidable costs are relevant for deciding whether to continue or eliminate a segment of a business.
9. Imputed or Hypothetical Costs
These are the costs which do not involve cash outlay. They are not included in cost accounts but are important for taking into consideration while making management decisions. For example, interest on capital is ignored in cost accounts though it is considered in financial accounts. In case two projects require unequal outlays of cash, the management should take into consideration the capital to judge the relative profitability of the projects.
10. 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:
A company is manufacturing 1,000 units of a product. The present costs and sales data are as follows:
Selling price per unit
$. 10
Variable cost per unit
$. 5
Fixed costs
$. 4,000
The management is considering the following two alternatives:
  1. To accept an export order for another 200 units at $. 8 per unit. The expenditure of the export order will increase the fixed costs by $. 500.
  2. To reduce the production from present 1,000 units to 600 units and buy another 400 units from the market at $. 6 per unit. This will result in reducing the present fixed costs from $. 4,000 to $. 3,000.
Which alternative the management should accept?
Statement showing profitability under different alternatives is as follows:
Present situation
$.              $.

Proposed situations
Variable purchase costs
Fixed costs Profit






  1. In the present situation, the company is making a profit of $. 1,000.
  2. In the proposed situation (i), the company will make a profit of $. 1,100. The incremental costs will be $. 1,500 (i.e. $. 10,500 - $. 9,000) and the incremental revenue (sales) will be $. 1,600. Hence, there is a net gain of $. 100 under the proposed situation as compared to the existing situation.
  3. In the proposed situation (ii), the detrimental costs are $. 600 (i.e. $. 9,000 to $. 8,400) as there is no decrease in sales revenue as compared to the present situation. Hence, there is a net gain of $. 600 as compared to the present situation.
Thus, under proposal (ii), the company makes the maximum profit and therefore it should adopt alternative (ii).
The technique of differential costing which is based on differential cost is useful in planning and decision-making and helps in selecting the best alternative.
In case the choice results in decrease in total costs, this decreased costs will be known as detrimental costs.
11. Out-of-Pocket Costs
Out-of-pocket cost means the present or future cash expenditure regarding a certain decision that will vary depending upon the nature of the decision made. For example, a company has its own trucks for transporting raw materials and finished products from one place to another. It seeks to replace these trucks by keeping public carriers. In making this decision, of course, the depreciation of the trucks is not to be considered but the management should take into account the present expenditure on fuel, salary to drive$ and maintenance. Such costs are termed as out-of-pocket costs.
12. 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. Suppose, a manufacturer is confronted with the problem of selecting anyone of the following alternatives:
  1. Selling a semi-finished product at $. 2 per unit
  2. Introducing it into a further process to make it more refined and valuable
Alternative (b) will prove to be remunerative only when after paying the cost of further processing, the amount realized by the sale of the product is more than $. 2 per unit. Also, the revenue of $. 2 per unit is foregone in case alternative (b) is adopted. The term “opportunity cost” refers to this alternative revenue foregone.
13. 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.
Joint cost is a kind of common cost. When two or more products are produced out of one material or process, the cost of such material or process is called joint cost. For example, when cottonseeds and cotton fibers are produced from the same material, the cost incurred till the split-off or separation point will be joint costs.
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:
  1. 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.
  1. 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.
  1. Selling Cost
It is the cost of selling to create and stimulate demand (sometimes termed as marketing) and of securing orders.
  1. 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.
  1. Research Cost
It is the cost of searching for new or improved products, new application of materials, or new or improved methods.
  1. 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.
  1. Pre-Production Cost
The part of development cost incurred in making a trial production as preliminary to formal production is called pre-production cost.
15. 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.
Cost Unit and Cost Center
The technique of costing involves the following:
  • Collection and classification of expenditure according to cost elements
  • Allocation and apportionment of the expenditure to the cost centers or cost units or both
Cost Unit
While preparing cost accounts, it becomes necessary to select a unit with which expenditure may be identified. The quantity upon which cost can be conveniently allocated is known as a unit of cost or cost unit. The Chartered Institute of Management Accountants, London defines a unit of cost as a unit of quantity of product, service or time in relation to which costs may be ascertained or expressed.
Unit selected should be unambiguous, simple and commonly used. Following are the examples of units of cost:
(i) Brick works
per 1000 bricks made
(ii) Collieries
per ton of coal raised
(iii) Textile mills
per yard or per lb. of cloth manufac- tured or yarn spun
(iv) Electrical companies        
per unit of electricity generated
(v) Transport companies        
per passenger km.
(vi) Steel mills
per ton of steel made

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