Cost Cncept and Cllasification

8/9/2019 Cost Cncept and Cllasification

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CONCEPT OF COST :

In common use, the word cost means price. But inmanagement terminology, the term cost refer to expenditure

not the price. It also refer to something that must be

sacrificed to obtain a particular thing.

To make the concept clear, some important definitions about

cost as follow :

Acc. to British Institute of Cost and Work Accountants, ³cost

is the amount of expenditure incurred on or attributable to agiven thing,´

Acc. to AICPA committee refer to of cost as, ³the amount

measured in money of cash expended or other property

transferred, capital stock issued, services performed, or a



liability incurred, in consideration of goods or services

received or to be received.´

Raymond J. Chamber distinguishes three different sensesin which the term cost is used as, a) the expected cost of a

particular action, b) the cost of something purchased, and

c) the cost of attaining some end, i.e., the sacrifices actually

made to attain it.

Thus, it is clear from the above definitions that the meaning

and concept of cost is very broad and flexible.



ELEMENTS OF COST :

The elements of cost are:

a) Material,

b) Labour, and

c) Expenses.

MATTERIALS COST :³The material cost is the cost of commodities supplied toan undertaking.´ -I.C.M.A.

Thus, material cost consist of the material consumed in

the production of a product or service.



Material cost is of two types, viz., a) Direct Material Cost,

and b) Indirect Material Cost.

D IRECT MATERIAL COST :Direct material cost is the cost of those materials which

enter into and form major part of the product, e.g., timber in

furniture making, clay in brick making,cement¶ stone, etc.,in building etc.

The material cost consist the cost of purchase of

material, cost of transport, indirect cost, indirect taxes &

duties payable etc. Direct material are also known as µProcess

Material¶, µPrime Cost Materials¶, µProductive Materials¶ .



IN D IRECT MATERIAL COST :

Indirect material cost is the cost of those material which do

not form major part of the product but which help the

production and which can be conveniently assigned to

specific physical unit, for example :

(a) lubricant oil, fuel, cotton waste etc., required for

operating and maintaining plant and machinery;

(b) small tools;

c) stores used for repairs and maintenance.



LABOUR COST :

The labour cost is the cost of remuneration (wages, salaries,

commission, bonus etc.) of the employee of an undertak ing.

labour cost isub-divided into :

(a) Direct Labour Cost, and (b) Indirect Labour Cost.

D IRECT LABOUR COST :Wages paid to workers who are engaged in production

process e.g. engaged in converting the shape of raw material,

whose time can be convenientiy and economically traceable

to unit of product or services can be referred to as direct

wages on direct labour cost for, e.g., carpenters for furniture

making, workmen engaged in assembling parts, etc. in a motoe

car manufacturing concern. Direct labour cost is also known

as Process Labour Cost, Prime or Productive Labour Cost.



IN D IRECT LABOUR COST :

It is the cost of labour not directly engaged in the productionoperation bat engaged to assist or help the production

operations, e.g., watchman, store keepers, inspectors, repair

and maintenance workers, etc.

A storekeeper issues materials to several jobs and so hiswages are not identified to a particular job only, hence his

wages are indirect labour cost in a job.

EXPENSES :³The cost of the services provided to an undertaking and the

notional cost of the use of owned assets´ -I.C.M.A.

Expenses are of two types:(a) Direct and (b) Indirect Expenses



D IRECT EXPENSES :

The direct expenses are those expenses which are directlyidentified with a particular job, process or operation. These

expenses are incurred specially on a specific or particular

job or process are in no way connected with some other job

or processes. These expenses are also known as chargeableexpenses, process expenses, prime cost expenses, productive

expenses. The examples are :

a) cost of railway freight, carriage etc., incurred on the

materials purchased only for a specified job or process.

b) cost of operating a machine used on a particular job.



IN D IRECT EXPENSES :

Indirect expenses are those other than indirect material costand indirect labour cost which cannot be directly identified

with a particular job, process or work order but are common

to jobs or processes. These expenses include :

a) Factory expenses,

b) Office and Administration expenses, and

c) Selling and Distribution expenses.



CLASSIFICATION OF COST :

The cost classification is the process of grouping cost

according to their characteristics. The cost can be classified

into the following:

1. According to Elements,2. According to Functions or Operations,

3. According to Nature or Behaviour,

4. According to Controllability,

5. According to Normality,

6. According to Relevance to Decision-making and Control,

7. Other Cost.



ACCOR D ING TO ELEMENTS :

The cost is classified into - Direct Cost, and Indirect Cost according to

elements, viz, Materials, Labour and Expenses, the description of

which occur in the earlier

A) D IRECT COST :

Direct cost is the cost which can be directly identified

with the final product or service. It is a cost which is easily and

economically be attributed to the cost unit directly.

A) IN D IRECT COST :An indirect cost is the cost which cannot be

economically traced directly with the final product, i.e., it is associated

with the manufacture of two or more units of finished product. These

are also known as common cost.



ACCOR D ING TO FUNCTIONS :

The cost is classified into the following:

a) Production Cost, or Manufacturing Cost, or

Factory Cost,

b) Administration Cost,

c) Selling Cost, and

d) Distribution Cost

Below is given a brief description only along with

definition of each as these items as follow:



A) PRO DUCTION COST :

Production Cost is ³the cost of sequence of operationwhich begins with supplying materials, labour and

services and ends with primary packing of the product.´ It

is also known as Manufacturing or Factory Cost.

-By I.C.M.A

B) A D MINISTRATION COST :Administration Cost is ³the cost of formulation the policy,

directing the organisation and controlling the operationsof an undertaking, which is not related directly to a

production, selling, distribution, research or development

activity or function.´ -By I.C.M.A.

Administration cost comprise Office and Administration expenses.



C) SELLING COST :

Selling cost is ³the cost of seeking to create and stimulatedemand (sometimes termed µmarketing¶) and securing orders.´

- I.C.M.A.

It is also known as selling expenses or selling overheads which

include all the expenses of Selling Department.

D ) D ISTRIBUTION COST :

distribution cost is ³the cost of sequence of operations which begins with making the product available for despatch and

ends with making the re-conditioned returned empty package,

if any, available for use.´



It is known as Distribution expenses or overheads which

include warehouse expenses,cost of freight, shipping

charges and also the expenses of reconditioning thereturned empty packages for using them again.

ACCOR D ING TO NATURE :Accounting to nature or behaviour, cost is

classified into:

a) Fixed Cost

b) Variable Cost and

c) Semi-fixed or Semi-variable Cost.



A) FIXE D COST :

Fixed cost is ³a cost which tends to be unaffected byvariations in volume of output. Fixed cost mainly depend

on the effluxion of time and do not vary directly with

volume or rate of output. Fixed cost are sometimes referred

to as period costs in system of direct costing.´ -I.C.M.AFixed Cost or Period Cost are those expenses which do not

change within a given time period despite the increase or

decrease in the quantum of production. They are period

costs, e.g., Rent of Building, salaries etc.fixed cost per unit varies due to change in output. If

production decreases, fixed cost per unit increases and if

production increases fixed cost per unit decreases.



B) VARIBLE COST :Variable Cost is ³a cost which tends to vary directly with

volume of output. Variable costs are sometimes referred to

as direct costs in systems of direct costing.´

- I.C.M.A.

Variable cost or product costs are those which increase in

direct proportion with the increase in production or which

decrease in direct proportion with the decrease in

production, e.g., Direct Materials, Direct Labour, Power,fuel etc. They are also known as Product Costs.

Variable cost tend to change proportionately with the

change in quantum of production but per unit variable cost

remains the same.



SEMI-FIXE D OR SEMI -VARABLE:

Semi-Fixed or Semi-variable cost is ³a cost which is partlyvariable.´ -I.C.M.A.

This is a cost which change but not in direct proportion to

the increase or decrease in the production-output, e.g.,

Repairs and Maintenance, Electricity bill, Telephone bills,etc. These cost are made up of fixed and variable

elements. A part of the cost tends to remain constant for a

specific period (fixed) and other part tends to change

proportionately with change in output.



ACCOR D ING TO CONTROLLABILITY :

The cost can be divided into : a) Controllable Cost, and b)Uncontrollable Cost.

A) CONTROLLABLE COST :

The cost of a particular department or center are guided by person-in-charge of the department. ³The cost which can

be controlled by a µspecified member¶ who is generally an

imported link in the management are the controllable costs´

The Head of a cost center or a department has control over variable cost only which include Prime cost and other

variable overheads. So the controllable cost are the variable

costs.



B) UNCONTROLLABLE COST :It is the cost which cannot be influenced by the action of a

specified member of an undertaking.uncontrollable cost are

generally the fixed costs, the control of which does not lie

with in the province of a member of the undertaking. The

change in the fixed cost is a matter is to be decided at the

top level of management depending upon the policy of the

undertaking.

E

xample: suppose the cost of power department isshared by the machine department the cost of this share is

uncontrollable to the machine department as it has no

control over the cost of other department, viz., the power

department.



ACCOR D ING TO NORMALITY :

The cost is classified into a) Normal Cost b) Abnormal cost

A) NORMAL COST :It is the cost of at a given level of output in the

condition at which that level of output is normally attained.

B) ABNORMAL COST :It is a cost which is beyond normal cost.

Normal cost is one which is considered to be normal under thenormal circumstances. If the normal cost is Rs.130, but the

actual cost is Rs.150,there is difference of Rs.20 which is an

Abnormal Cost.



ACCOR D ING TO RELEVANCE TO

D ECISION-MAKING AN D CONTROL:

The cost classified on this basis are the following :

A) SHUT- DOWN COST :

A cost which will still be required to beincurred even though the plant is closed or shut-down for a

temporary period, e.g., the cost of rent, rates, depreciation,

maintenance expenses etc., is known as shut-down cost.

B) SUNK COST :

A cost which has been incurred in the

past or sunk in the past and is not relevant to the



particular decision-making is a sunk cost. If it decided to

replace the existing plant, the written down book value of

the plant and less the sale value of the existing plant , is asunk or irrevocable cost. Sunk cost are generally historical

cost in nature.

C) OPPORYUNITY COST :³The net selling price, rental value or transfer value which

could be obtained at a point in time of a particular asset or

group of assets were to be sold, hired, or put to some

alternative use available to the owner at that time´ is theopportunity cost. -I.C.M.A.

The cost which are related to the sacrifice made or the

benefit forgone are opportunity costs.



D ) IMPUTE D COST :

It is a hypothetical cost required to be considered to make

cost comparable. If the owner of the factory charges rent of

the factory to the cost of production to make cost

comparable with that of those undertakings which run

production in rented factories, it is an imputed cost as the

rent has actually not been paid. Same is the case with

charging interest on one¶s own capital.

E) OUT-OF-POCKET COST :A cost which will have have to be paid to outsider as

against cost such as depreciation, which do not require any

cash payment. This cost is relevant in fixation of prices

during trade recession or in make or buy decisions.



F) REPLACEMENT COST :

It is a cost of replacing a material or asset, by purchase from the current

market. If a µx¶ material was originally purchased @ Rs.250 per kg andnow it can be replaced by purchase from the market at current rate of

Rs.280 per kg, the replacement cost is Rs.280 per kg.

G) MARGINAL COST :Marginal cost as defined by I.C.M.A. is ³the amount at any given

volume of output by which aggregate costs are changed if the volume

of output is increased or decreased by one unit. Thus marginal cost

refers to the increase or decrease in total cost caused due increase or

decrease in total cost caused due to increase or decrease in output by

one single unit. It comprises of direct material, direct labour, direct

expenses and variable overheads.



H) D IFFERENTIAL COST :

The difference in total costs between two alternatives istermed as differential cost. The change in total cost due to

the change in method or technique of production or charge

in level of production is called differential cost. In case, if

the choice of the choice of an alternative results in increasein total cost, then this increase is termed as incremental cost

and if the cost decrease due to change in alternative, then it

is known as decremental cost.

I) STAN D AR D COST :As per I.C.M.A., ³A predetermined cost which is calculated

from management¶s standards of efficient operation and the

relevant necessary expenditure. It may be used as a basis for



fixing and for cost control through variance analysis.

Thus, standard cost is a predetermined cost or estimate

which is compared with the actual cost in order todetermine variance and carry out an analysis of variance

for cost control.

J ) RELEVANT COST :The relevant cost are :those cost which aids to makes

specific management decisions. The cost is said to be

relevant if it help managers in taking a right decision in

furtherance of company¶s objectives.

K) OTHER COST :The following terms of cost are also included in the

µclassification of cost¶ as per terminology of I.C.M.A.



a ) RESEARCH COST :

This is the cost of searching new or improved products,new applications of materials, or new or improved

methods.

b) D EVELOPMENT COST :Having made the research, when the management decides

to produce a new or improved product or to employ a new

or improved method, the cost of the process beginning with

the implementation of the decision to do so and endingwith the commencement of formal production of that

product or by that method, is called the Development Cost.



c ) PRE-PRO DUCTION COST :

It is that part of the Development cost which is incurred in making atrial production preliminary to formal production. As such, Research

and Development costs are sometimes included in this term. This

cost is normally treated as the deferred revenue expenditure and

may be written off by charge to future production in a period of

three to five years.

d ) CONVERSION COST :This is the cost of production excluding Direct Material Cost. So it is

the sum of direct wages, direct expenses and overhead costs of converting raw material into finished goods. Conversion cost,

however, includes the cost of excess material or the loss of materials

incurred at the particular stage of production. In short it is the

Factory Cost minus Direct Material Cost.



e ) POLICY COST :

A cost incurred, in addition to the normal requirements, asa matter of policy of the undertaking is the Policy Cost.

f) I D LE FACILITIES COST :

The cost of abnormal idleness of fixed assets or availableservices is the Idle Facilities Cost.

Cost Cncept and Cllasification

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