cost classification

Contents -

1. Classification and Analysis of Cost.
2. Cost Terminology.
3. Relevant Costs.
4. Irrelevant Costs.

  • Classification and Analysis of Cost -
There are several ways in which costs may be classified, Following are the main basis of classification of cost :

According to Elements-
The cost may be classified into direct cost and indirect cost according to the elements. There are three elements of cost classified viz. material, labour and expenses.

1. Material -
Sub stances or commodities used for the producing a product are called "materials". Materials consumed may be direct or indirect.

A) Direct Material :
The materials which can be directly identified with the product are called direct material. These material can be easily measured and can be directly charged to the product. For example Steel used for producing a containers.

B) Indirect Material :
These materials are used for production but cannot be directly identified with the product. These expenses are included in overhead category main example of this category are comsumable stores and stationery.

2. Labour -
Labour can also be divided into direct and indirect category.

A) Direct Labour :
Wages and salaries paid to workers and employees directly involved in the process of manufacturing goods is known as "direct labour". Wages paid to a machine operator is an example of direct labour.

B) Indirect Labour :
Wages and salaries payable to workers and production process are included in "indirect labour". The contribution of such workers cannot be directly traced to the product. For example, wages for store keeper is included in the indirect labour category.

3. Expenses -
Expenses may also be direct or indirect.

A) Direct Expenses : 
These expenses are incurred in relation to a specific product. This category does not include direct material cost and direct wages. For example, cost of secret formula and special drawing are included in this category.

B) Indirect Expenses -
These expenses cannot be directly and completely allocated to specific product for cost centre. Office and administrative expenses are included under this category.

According to Functions or Operations -
On the basis of functions the cost may be classified as following categories.

1. Production Cost -
Production cost include all such costs which are incurred directly for producing goods either manually or through machine. It include direct material cost, direct labour cost, direct expenses and overhead expenses related to production.

2. Administrative Cost -
It include all cost associated with cost of formulating the policy and measures required for running the operations. However this cost are not directly traceable to production, selling and distribution or research and development activities. Salaries paid to managerial person and workers are included in this category.

3. Selling Cost -
This category includes cost of all the activities which are in the process of selling the goods. It includes sales promotion cost, consumer services cost and selling organisations. These cost help in increasing the revenue of the firm by ensuring customer satisfaction.

4. Distribution Cost -
This cost includes packing expenses and other expenses related to making the product available for distributing and dispatch. It includes salary of dispatch clerks and running expenses of delivery trucks.

5. Research Cost -
The research cost is incurred for the purpose of carrying out research in order to come up with new manufacturing processes for improving the quality of the product.

6. Development Cost -
This is the cost of converting research into practical mode.

7. Pre-Production Cost -
These are the cost incurred in case of new manufacturing unit. Call associated with the launch of a new product also come under this category. These costs are treated as deferred revenue expenditure as these are matched against the cost of future production.

According to Nature or Behaviour -
On the basis of nature and behaviour following are the main categories of cost.

1. Variable Cost -
This cost change operationally in response to change in volume of production direct material and direct labour cost are prime examples of variable cost and include fuel expenses, electricity expenses etc.

2. Fixed Cost -
These cost do not vary with the change in level of production up to a certain level. These cost to change in the long run but remain fixed in the short term. Fixed cost can be further divided as follows :

A) Committed Fixed Cost :
These cost arise due to procession of assets such as building and plants. The main example are depreciation, insurance premium and rent basic organisational expenses such as staff salaries are also included in this category. Such cost generally cannot be reduced without having adverse impact on the long-term performance of the concern.

B) Discretionery Fixed Cost -
These costs are incurred on the basis of decisions made by the management. This cost may arise out of regular decision about the maximum outflow such decisions are generally taken on an annual basis and these cost do not have clear co relation between input and output. These are main features of such costs.
For example, Advertising, Health care, Executives training and Technical expenses.

3. Semi-Variable Cost -
This costs are partly fixed and partly variable. These do not bear linear relationship to the level of production telephone and electricity bill are example of such costs.

According to Controliability -
According to control ability the cost may be divided as following categories.

1. Controllable Cost -
A cost which cab be influenced by the action of a specified member of an undertaking. This costs may be controlled by a specific authority within a specific period of time. These are variable cost and can be affected in a time period which is sufficiently long. It requires proper delegation authority for effective cost control.

2. Uncontrollable Cost -
These cost cannot be controlled at any level of management. These cost are defined as the cost which cannot be influenced by the action of in a specified member of an undertaking.

According to Normality -
According to normality basis the classification of cost is as under.

1. Normal Cost -
These are the usual cost which are incurred for a given level of output under the given conditions. These cost are charged to costing profit and loss account.

2. Abnormal Cost -
These cost occur over and above normal cost and are not usually cost for a given level of production. These are also charged to costing profit and loss account.

According to Time or Periodicity -
These cost may be classified as below.

1. Historical Cost -
These are the actual cost which are determined after their occurrence. These cost may be calculated using financial records and accounts. However, these figures may not be appropriate for future projections during the time with frequent changes. These costs form the basis of financial accounting.

2. Future Cost -
These are the cost which are likely to be incurred in the future. This is an important category of cost as this can be easily controlled by the management. These cost are also important for control, projection, budgeting and appraisal.

According to Association with Product -
On the basis of association with product the cost may be classified as follows.

1. Product Cost -
These cost can be directly traced back to a product. Product cost are the cost which are assigned to a particular product or a line of product. Under marginal costing, product cost would include variable manufacturing cost while in the case of absorption costing, product cost will include total manufacturing costs.

2. Period Cost -
These costs are incurred during a specified period of time and are not assigned to a product. The main example of such cost are general and administrative expenses. These cost are charged against revenue of that particular period. While fixed factory overheads are treated as period cost under marginal costing, these may be considered product cost under absorption costing.

According to Relevance to Decision Making and Control -
According to relevance to decision making control following are main categories of Cost.

1. Marginal Cost -
It is the amount by which total cost change in response to increase and decrease in volume of output by one unit. In other words, this is the amount which could not be avoided if that particular unit was not produced.

2. Programmed Cost -
These costs are incurred for long-term survivor and have less importance to current processes. These cost are incurred at the discretion of management and can be controlled accordingly. Advertising cost is an example of such cost. Sales promotion expenses and Research and Development expenses involve under this category.

3. Opportunity Cost -
These are the economic resources which are required to be given up for accepting one proposal over another. For example, if firm could sell its land for rupees 5,00,000 but decided to retain it for setting up a factory, in such case rupees 5 lakh is opportunity cost. Opportunity cost is the value of a benefit sacrificed in favour of an alternative course of action.

4. Out of Pocket Cost -
These are the cost which require an actual outflow of cash. These costs are important for managerial decision making process and for determining the profitability of a project. It includes historical cost as well as future cost. Most of the expenses fall under this category. Many fixed cost and most of the variable and semi variable cost fall under this category.

5. Differential Cost -
Management is expected to compare the cost of alternative praposal in order to make decisions. Thus, a diffrensial cost is the diffrence in cost among various alternatives. Incremental cost is the increase in cost due to the decision while decresmental cost is the decrease in total cost.

6. Replacement Cost -
These cost needs to be incurred for replacing a product with a idencial one on the date of valuation. This cost is diffrent from the actual aquisition cost of the asset. It includes change in cost due to improvement in the product. It represent the outflow required for replacing an asset at present or at some point in future time.

7. Joint Cost -
These are the cost incurred upto the point till the product cannot be seprately identified. These costs are apportioned among concerned product. Same raw material used for producing two diffrent products is an example of joint cost.

8. Imputed or National Cost -
These are the costs which are implicit in the product and are not physicallyrecorded in the account. Interest on capital is an example of such costs as no actual payment is required to be made. Although, no actual payment are made, but an estimation of earning, had the funds been invested elsewhere is made. These costs are hypothetical in nature and do not require actual cash outflow.

9. Sunk Cost -
These costs are considered irrelevant for the purpose of decision making. These are the cost which have already been incurred and cannot be recovered. This cost may be defined as, an expenditure for equipment or productive resourses which has no economic relevance to the present decision making process. Sunk cost may also be non-incremental costs.

10. Shut-down Cost -
These costs are important to make decision regarding continuing operations during off-season. These are the cost which are incurred even if the firm completely stos production office rent, insurance premium are example of such costs. In general, it is decided to remain open as long as the revenue is sufficient to meet variable costs and a part of fixed costs.

  • Cost Terminology -
Following are terminology involved in cost accounting.

1. Cost Unit -
Cost unit may be defined as, quantity of output for which cost are expressed or ascertain. A company may have more than one cost unit. A cost Centre is defined as the organisational sub unit for which cost are collected. Similarly, a unit of output for which separate cost is ascertained is known as cost unit.
For the purpose of effective analysis, it is important to identify proper cost unit. In certain cases, it may be necessary to select more than one cost unit. It is also important to consider the quality, quantity and order characteristic for the proper evaluation and selection of the cost unit.

2. Profit Centre -
Performance of a profit Centre is expressed in term of profit which is defined as, the difference between revenue and expenses. The activity in which both costs and revenue may be ascertained come under the segment as profit centre. A manager is deemed responsible for all the activities of the centre. A manager has to motivate employees for higher sales which leads to an increase a profit and better performance of the employees as well as company.

3. Cost Centre -
Cost centre important department for of a business organisation, which apprarently do not make any different contribution in the profitability. Although they do contribute to the cost of running the organisation. Example of cost centre are Research and Development Department, Marketing department, help desks, customer service or contact centre etc. It is noteworthy that although the cost centre do not make any direct contribution to the revenue generation of the company, their indirect contribution can't be undermined. Years of hard work and efforts made by the research and development department may one day reserve is involvation. Which may lend to huge revenue generation or heavy cost saving for the organisation. Similarly, Customer Service Department May, over a period of time, help in image building of the company, which may ultimately attract more business for the company.

4. Cost Object -
Sometimes management is interested in knowing the cost of some things which is called as cost object. Cost object refer to any activity for which a separate measurement of cost is desired. A cost object may be a product, service, process for area.

5. Resposibility Centre -
The main purpose behind the creation of responsibility centre is to ascertain the cost, evaluate the performance, control the cost and to fix responsibility. A responsibility centre is a unit of an organisation which is managed by an executive who is responsible for all the activities and performance. A responsibility centre may be a cost centre or profit centre. It may also contain multiple cost or profit centre. Identification of responsibility centre is important for the purpose of control. Responsibility centre are more concerned with the planning and cost control aspect of the business.

6. Cost Ascertainment -
The process of cost ascertainment is possible by applying different method of costing. It is the process of ascertaining actual cost. It computes the cost of those which have been incurred. This make the process variable and objective in nature.

7. Cost Reduction -
The process of cost reduction is concerned with bringing about real and permanent reduction in the unit cost of producing goods or services without negatively impacting their utility for the intended use. Such reduction in cost should also not reduce the quality of the product. Cost reduction is done by altering the production environment.

8. Cost Estimation -
Cost estimation involves pre-determination of cost of product or services. This cost is viewed as futuristic cost for the business. It is done before the cost is actually incurred. Such estimation is done on the basis of the average of past actual figure.

9. Cost Control -
Cost control is the regulation by executive action of the first of operating an undertaking particularly where such action is guided by cost accounting. It sets up the objectives to be made and then compares the actual performance with it. Cost control is involved with the process of setting limits and reducing wastage.

10. Cost Allocation -
This process charges full cost to be concerned cost Centre cost. Allocation is the allotment of whole item of cost to cost centre or cost unit. Allocation is possible only when the cost is easily identifiable with a particular cost centre.

11. Cost Apportionment -
In certain cases, it is not possible to directly identify the cost with specific cost centre. For such situation, the cost are apportioned on some suitable basis. Cost apportionment is the allotment of proportions of items of cost to cost centre or cost units. This process is used in cases where serval costs are common among various cost centres.

  • Relevant Costs -
Cost which differ from one option to another are called relevant costs. This cost are affected by a decision and are changed accordingly. Many cost such as differential cost, incremental cost, opportunity cost and out of pocket cost are included in this category.
Following are the two main features of relevant costs.
a) Relevant cost are also incremental in nature. This cost may be avoided by taking appropriate decision. Incremental cost are the changes in a cost among various alternatives.
b) Relevant cost are future cost and are yet to be incurred. The cost such as sunk cost, which have already been incurred, are not relevant cost as this cannot be altered by any new decision.

Incremental or Differential Costs -
The change in a cost item owing to change in decisions is termed as differential costs. Any cost which remains the same for different projects or alternative is called irrelevant cost.
For example, a piece of land may be used for constructing a Mall. The cost of land is irrelevant for the purpose of decision making as it would be incurred in either case.
For example, a company may decide to sell its product online using a website or through opening a shop. The cost associated with online selling are rs.10 Millions, while the cost for opening a shop are rs.12 million, this difference of rs. 2 million is relevant for making decisions.
Differential cost are match against differential revenue for the purpose of making decisions. If in the above, differential cost of rs.2 Millions is able to generate additional rs.5 million in sale, then it would be beneficial to sale on offline than online.

Out of Pocket Cost -
These costs are the relevant expenses which are paid in cash. Such cost have direct impact on managerial decisions. This type of cost is associated with certain decisions and changes with difference in decisions.
For example, if a company need a make decisions between using own vehicle or public transport for delivering goods, then depreciated value of owned trucks is irrelevant as it is sunk cost. However, other cause such as driver wages and fuel cost are relevant as these are out of pocket cost.

Opportunity Cost -
When a management chooses a specific course of action, it involved rejecting all other alternative. The benefits which could have been obtained from the rejected options are known as opportunity cost. This cost are not recorded in the accounts books. However, these costs are important for the purpose of decision making. Management is often faced with different alternative, all with their pros and cons.
For example, product A is expected to bring net profit of rupees 50,000 while product B is likely to bring rupees 40,000 in net profit. In such case, product A should be chosen. The net profit of rupees 40,000 which has been forgone on account of rejecting product B is known as opportunity cost.

  • Irrelevant Costs -
These are the cost which do not affect the process of decision making. These costs are not altered by any change in the alternative chosen. This costs are ignored while taking a decision. Sunk cost is the prime example of irrelevant cost.
For example, if firm spend rupees 5 lakh on buying a machine. The machine has current book value rupees 3,00,000. It cannot be sold in the market on account of obsolescence. However, if it is modified then it can be sold, for rupees 1,00,000. The costs associated with modification are rupees 40,000. In such scenario, cost of modification is a relevant expenditure. The expected sales value rupees 1,00,000 is also relevant. However cost and book value of the machine are irrelevant cost as the actual cost is sunk cost and will not change irrespective of decisions made.

Sunk Cost -
These are historical cost which have already been incurred. The cost were incurred for implementing past decisions and future decisions will have no impact on them. Purchase of fixed assets like building, machine etc. are example of such costs. These cost are irrelevant for the purpose of decision making as future decision do not have any impact on them. A firm cannot change its past cost with any future decisions. However the firm may decide to sell their assets for tecouping some of the investment made in them. Alternatively they may decide to continue holding the assets. In such cases the relevant drived will be matched against the cost incurred for them. Such cost which cannot be changed are known as sunk cost.

For example, company A brought a machine rupees 5 lakh with a working life of 10 years and Nil scrap value. However after a year, the management decide that the machine is not appropriate for their use. The machine is likely to result in Rupees 20,000 in operating expenses each year for next 4 years. It may be sold for rupees 50,000 immediately.
In the above scenario, the relevant factor are rupees 20,000 p.a. in operating expenses and immediate sale price of rupees 50,000. The money spent on purchasing the machine is not relevant as it is a sunk cost. The firm should make the decisions based on the relevant cost rupees 20,000 p.a. for next 4 years and the immediate sale price. In this case, the expected cost are rupees 80,000 for the life span of the machine while it can obtain rupees 50,000 by selling the machine.