Financial Management & Cost Accounting

Lesson 45. CLASSIFICATION OF COSTS

Module 8. Costing

Lesson 45

CLASSIFICATION OF COSTS

45.1 Concept of Cost and Classification of Costs

Cost Centre

A Cost-centre is defined as a location, person or item of equipment (or the group of these), for which costs may be ascertained and used for the purpose of cost control.

Cost centre are primarily of two types.

(i)Impersonal cost centre

(ii)Personal cost centre

Impersonal cost centre consist of location, Equipment or group of machines, for which costs may be ascertained. Whereas Personal cost centers refer to person (or group) eg – Factory Manager, Sales Manager, Purchase Manager etc.

From Functional point of view, a cost center may be classified as:

(i) Productions cost centre

(ii) Service cost centre

Production cost centre are those cost centers which are primarily engaged in production activities. ( e.g. production, packing, processing, etc)

Service cost centers do not involve production but are essential and supportive for production and existence of business. E.g. Administration, Canteen, Transportation, repairs and maintenance, etc

Other type of cost centers are:

(i) Operation cost centre.

(ii) Process cost centre

Operation cost centre is one in which a group of machines (or person) perform the same operation. When a cost centre is such that it contains a specific process or a continuous sequence of operations, it is called a process cost centre.

Identification of cost centers is very important because it provides a base (person/equipment/department etc) for which costs may be ascertained, controlled and reduced.

Cost Unit

The institute of cost and management accountants, England defines a cost unit as follows:"A unit of quality of product, services of time (or a combination of these) in relation to which costs may be ascertained or expressed “It may also be defined as the "Unit of quantity of output in relation to which costs are ascertained or expressed".

For example

Industry		cost Units are
1	Brick Industry	Per 1000 bricks
2	Electricity generating co.	per unit of electricity generate
3	Steel industry	per tonne of steel
4	Paper industry	Reams
5	Cable	per meter
6	Transportation Industry	per tonne – km or per passenger – km
7	Automobile industry	Number
8	Chemical Industry	per kg/ or tonne or pounds

45.2 Classification of Costs

It is always recommended that the word "cost" should be used with adjective or phrase for its proper meaning. Cost classification is defined as the process of grouping costs according to their common characteristics. Costs can be classified on several basis such as time of ascertaining the costs, degree of traceability, on the basis of function, on the basis of nature of expenses etc.

The most commonly used classification of costs is as under:

1. On the basis of behavior of cost w.r.t. changes in output, or volume – The cost can be classified into

• Fixed Cost
• Variable Cost
• Semi-Variable cost ( or Mixed Cost)

Fixed Cost

Those costs which do not vary with the amount of units produced remain constant for a given period of time. Hence fixed cost has no relation with the level of output. Examples are-e.g. Rent, Insurance, Property taxes, Depreciation office facilities, executive's salary etc.

Variable Cost

Those costs which proportionately vary with the level of output is variable cost. For example: cost of raw material components etc. If one unit of a product requires material worth Rs. 20, then 100 Unit would require material worth 20 x 100 Rs. 2000, hence the cost of material here is variable cost and increases or decreases with the level of output. It should be further noted that, when there is no-production, there is no variable cost.

Semi variable (Mixed Cost)

The costs which are not fully constant and not fully variable with the amount of production (level of output) are called semi variable costs. Semi variable costs consist of two components – Fixed and Variable.

Example :

(a) If a worker is paid on the basic of output for eg. Rs.100 per unit. Then for making 20 units in month, he will get payment of Rs. 2000.

This cost in variable cost.

(b) If the same worker was hired at a monthly salary of Rs. 1500/- then, irrespective of the output, he will receive of the output, he will receive Rs. 1500 at month

This cost is Fixed cost.

(c) If the payment to the worker was structured in following manner

The worker gets fixed salary of Rs. 100 per month and incentive Rs. 50 per unit.

If the worker produces 8 unit in a month his earning at the end of more are

Fixed component = 1000

Variable (8×50) = 400

1400

Similarly, calculation are made for, different level of output

Output of worker
	8 units	10 units	16 units	20 units
Fixed Rs.	1000	1000	1000	1000
Variable	8*50 = 400	10 * 50 = 500	800	1000
Total	1400	1500	1800	2000

It can be interpreted that, the earnings of the workers is variable unable the output but it is not directly proportionate to the output.

Note on Fixed Costs

It is to noted that fixed costs are "Fixed" for the "given period" under consideration, for example "Rent", it is fixed for the given period and does not depend upon the output. For example, a ice-cream vendor takes a shop rent for one month in a fair, then the cost of rent, is fixed for the month, it has no relation with the amount of ice – cream sold. Even if no ice – cream is purchase or sold, the amount of rent remains same. Hence fixed cost is always expressed in terms of "time” such as per day, per month, per annum. Sometimes, fixed costs can be further classified into

- Committed fixed cost and

- Discretionary fixed costs

Committed Fixed Costs

Fixed costs which are incurred primarily to maintain the company's facilities (plant, equipment and basis organizations structure) and its physical existence are called committed fixed costs. Hence, it is clear that commuted fixed cost arise because of decisions of possession of plant, building, equipment etc. Once the building is constructed, plant and equipment are installed the company has to been certain fixed costs – Depreciation, taxes, insurance, rent etc. The management has little or no control over there costs, they can not reduce / change there costs without impairing the organization's ability to achieve its long term objectives.

Discretionary Fixed Costs

Discretionary costs are also called "programmed cost / policy costs ". These are the costs which are a result of special policy decision. These decisions are taken by the top management. The basic feature of discretionary fixed cost is that it has no particular relationship with the volume of output.

Examples- R and D costs, marketing programs, donations, sales promotion costs etc.

In case of committed fixed cost, there is negligible control of the management the Discretionary fixed costs, are greatly controllable by the management. Discretionary fixed costs can be reduced or even eliminated entirely if the circumstances so require.

45.3 Direct Cost and Indirect Costs

1. Direct cost:

The costs which can be easily traceable identifiable (and fully chargeable) to a given product are called direct cost e.g. direct material, direct labour etc.

2. Indirect Costs:

The costs which can not be wholly and usefully associated or traced or identified with a given product are called indirect cost. Indirect costs are costs which are not incurred for a single product only rather they are incurred for several products. Hence these costs can not be charged fully to any one product in particular.

Hence, indirect costs are charged on the basis of some proportion to each product.

Ex. – Salary of supervisor, Depreciation, Rents, Taxes, lubricants and salary of store keepers, foreman etc. for e.g. a supervisor who look after production of 5 different products, his salary can not be charged to one product (rather charged proportionately to all 5 products).

Direct or Indirect cost

The fact that whether a cost is "direct or indirect" depends upon the cost centre / cost object whose cost we want to ascertain. If a company dealing in diversified product has sales department, which consist of 20 sales manager looking after automobile division , electrical appliance division etc, the salary of sales managers looking after automobile division is an indirect cost to the scooter because if can not be fully charged to scooter only. If we wish to ascertain to cost – department will – i.e. cost of sales department cost of purchase depend cost of customer service dept. etc. then the salary of the sales manager is a Direct Cost to the sales department.

Hence, the problem of direct and indirect, depends upon the associate or identifiability of the cost with the given cost centre. For example, the salary of sales manager can be fully identified with sales department (and not with any other Department) it is a direct cost to the department. (But the salary of general manager who controls all departments can not be fully associated with only one department and hence if is an indirect cost to each department.

Product Cost and Period Cost

Certain costs (like material, labour, expenses and indirect manufacturing overheads) which become the part of cost of the product are called product costs. That is it includes all the costs involved in manufacturing the final product. A typical feature of "product cost" is that if the product is not sold, then it continues to be shown as inventory (at product costs) in the balance sheet, hence these cost (product costs) are not charged as expenses in the current year's income – expenditure statement.(They are called inventoriable costs, and hence carried forward to next period).Subsequently the year / period in which the product is finally sold in that year the product cost are charged in the P and L account as cost of goods sold. So product cost can be carried forward to future account period.

Period Cost

Certain costs like Depreciate of office premises, selling and Distribute expenses – etc which are not a part of product costs, are called period – costs, the “Period costs" are charged as an expense in the same period in which they are incurred. They are not being carried forward to next accounting period.

On the basis of a cost's relationship with the accounting period – costs may be divided into

1. Capital Expenditure

2. Revenue Expenditure

a. Revenue Expenditure – The cost whose entire benefit will be received in the current year (current accounting period), is classified as Revenue Expenditure. Revenue Expenditure is treated as Expense and charged fully in the current year itself. (E.g. rent, lubricant, Raw materials etc.)

b. Capital Expenditure – In the situation, where a cost is incurred (such as for long – term equipment, Building, license, etc), such that it provides benefit for more than one accounting period (accounting year) (i.e. future accounting period).Then, it is classified as Capital expenditure.(Clearly, as the entire benefit of a capital expenditure can not be received in the current accounting can not be treated as an expense of the current period only : Rather, the capital expenditure is charged suitably in the future accounting period also)e.g. Amortization, depreciation etc. The capital expenditure is shown as an asset in the balance sheet.

45.4 Costs used in Decision Making

(A) Opportunity Cost

It is the cost of rejecting the "second best alternative" and selecting one alternative. For ex. out of a several choices available, we can make a choice of one alternative, but by doing so we reject all other alternatives, and also reject the benefits of other alternatives. So it implies that, we are selecting on a particular alternative, at the cost of rejecting other alternatives. Opportunity cost represents, the cost (Benefits costs) associated with the rejecting of second best alternative.

a. For ex. if a doctor works in hospital and earns salary of Rs. 30,000 p.m. decides to start his own clinic, then he loses the opportunity to earn Rs. 30,000 p. m. Hence, he has an opportunity cost of Rs. 30,000 p.m.

b. Inventory:- If a person / firm decides to invest Rs. 5 lakhs in inventories. The other option was to invest Rs. 5 lakhs in bank. But by selecting to posses inventory worth Rs. 5 lakhs, the firm has to fore go, the interest which can be earned on Rs. 5 lakhs (by keeping it in bank).

c. Hence, the opportunity cost of keeping inventories, is the amount of interest lost on the capital blocked in inventory.

(B) Relevant Cost and Irrelevant Costs

Relevant costs are those costs, which are affected by selecting different managerial decision – Hence they are affected by managerial decision. On the contrary, irrelevant costs are those costs, which remain the same, do not change, and are unaffected whatever decision (alternative) has been taken. These are unaffected by any managerial decision. Irrelevant costs are historic and unavailable any future decision, taken by management can not alter the irrelevant costs. Hence, irrelevant costs should be ignored in decision making( since, they are not going to be affected by any decision and remain same for all decisions alternative). Relevant costs are always "future costs", they may increase / decrease / or totally avoided by a particular managerial decision.

(C) Sunk Cost

Sunk costs are historical or past costs. (e.g. land, building, equipments, etc).These costs have been incurred by a decision in the past, no future decision can alter these costs. Hence they are historical and an avoidable costs and are irrelevant, they should be ignored for decision making.

(D) Differential Cost and Marginal Costs

Marginal Cost: -It is cost of producing one more (additional unit).(so, it can calculated from finding the (a) total cost of n units, (total cost of (n+1) unit, and then calculating b-a = m. c)

Differential costs: It is difference between total costs associated with the different alternatives.

Differential costs may be further classified into

1. Incremental costs

2. Decremental costs

While selecting alternative a instead of alternative b, if the net result is increase in cost, then the differential cost is called incremental cost and if the net result is "decrease" in cost, then the differential cost is termed as "decremental cost".

(E) Joint Costs and Common Costs

Joint cost

Many times, out of the same manufacturing operations (or from the raw material), two or more products are produced. The cost incurred till the split – off point of these products called the joint – cost.

The National Association of Accountants define joint costs as, "Joint Costs relates to two or more products produced from a common production process or element – material labour or overhead or any combination of these of or so locked together that one can not be produced without producing the other(s). For e.g. while refining crude, oil – kerosene, fuel oil, gasoline, was etc are produced. The total cost incurred up to the point of separation is called joint cost.

Common Cost

Common costs are the costs which are incurred for more than one product, job, territory or any other specific costing object. Common costs are common to two or three products and they are apportioned among the products on some suitable basis. For example the sales manager who looks after three different products, his salary is common to three products and apportioned among them. The basic different between Joint Cost and common costs is that – "Joint costs are incurred only in Process Industries where a product can not be independently produced". Common cost is not the result of any manufacturing compulsion.

Conversion Cost

The cost of converting raw material into finished goods is called conversion cost. It excludes the cost of direct materials. It includes cost of direct labour, direct expenses and factory overheads (Hence, it is also referred as "production cost – excluding the cost of direct materials").

Cost Estimation and Cost Ascertainment

Cost Estimation

It is the process of estimation (predetermination the cost of certain – product, job, activity, etc.)Such cost – estimation is useful for planning, budgeting, measuring of performance efficiency, fixation of selling of products, etc. Hence, it represents the computation of future costs.

Cost Ascertainment

On the basis of the data of actual costs which have been incurred, the process of determining the cost of product, process, job, etc is called cost ascertaining. Hence, cost ascertainment is essentially the computation of historical costs.

Cost Allocation and Cost Apportionment

Cost allocation refers to the process of "allotment of whole items of cost to cost centre on cost unit." whereas cost apportionment refers to the "allotment of proportions of items of cost to various cost centre / cost unit."Hence cost allocation is a process of charging direct costs, whereas cost apportionment is process of charging indirect costs to various cost centers.

Cost Reduction and Cost Control

Cost Control

It refers to controlling costs at the pre – established standards (cost targets). So, the main aim of cost control is to control costs and ensure that costs do not exceed the targets.

Cost Reduction

It refers to try and reduce the cost – target itself. Hence, it means continuously exploring various possibilities of reducing the cost targets. It can be done even in a situation where efficient cost – control is in existence.