Classification of Cost or Elements of Cost or Cost Concept
Cost classification is the process of
grouping costs according to their common characteristics. It is the placement
of like items together according to their common characteristics. A suitable
classification of costs is of vital importance in order to identify the cost
with cost centers or cost units.
Purposes of Classification of Costs
Classifying costs into
various categories serves several purposes:
1. It helps managers understand how costs behave: By classifying costs as fixed, variable, or mixed, managers can understand how costs change as the level of output changes. This can be valuable information when making decisions about pricing, production, and other aspects of business strategy.
2. It helps managers
assign costs to specific products or departments: By classifying costs as
direct or indirect, managers can assign costs to specific products or
departments. This can be useful for product costing, budgeting, and decision
making.
3. It helps managers
identify costs that can be controlled: By classifying costs as controllable or
uncontrollable, managers can identify costs that can be influenced or managed
by a specific individual or department. This can help managers make better
decisions about how to allocate resources and control costs.
4. It helps managers
identify relevant costs: By classifying costs as relevant or sunk, managers can
identify costs that will be incurred as a result of a decision and are
therefore relevant to that decision. This can help managers make better
decisions by focusing on the costs that will actually be affected by a
particular decision.
5. It helps managers
understand the level of predictability of costs: By classifying costs as
committed or discretionary, managers can understand the level of predictability
of costs. This can help managers make better decisions about how to allocate
resources and plan for the future.
Costs may be classified according to
their nature, i.e. material, labour and expenses and a number of other
characteristics. The important ways of classification are:
a)
By Nature or Element or Analytical Classification
According to this classification, the
costs are divided into three categories i.e. Materials, Labour and Expenses.
There can be further sub classification of each element; for example, material
into raw material components, and spare parts, consumable stores, packing
material etc. This classification is important as it helps to find out the total
cost, how such total cost is constituted and valuation of work in progress.
b)
By Functions
According to this classification costs
are divided as follows:
Manufacturing
and Production Cost: This is the total of costs involved
in manufacture, construction and fabrication of units of production.
Commercial
Cost: This is the total of costs incurred in the
operation of a business undertaking other than the cost of manufacturing and
production. Commercial cost may further be sub-divided into (a) administrative
cost and (b) selling and distribution cost.
c) As Direct and Indirect
According to this classification,
total cost is divided into direct costs and indirect costs.
Direct
costs are those which are incurred for and may be
conveniently identified with a particular cost centre or cost unit. Materials
used and labour employed are common examples of direct costs.
Indirect
costs are those cost which are incurred for the
benefit of number of cost centers or cost units and cannot be conveniently
identified with a particular cost centre or cost unit. Examples of indirect
cost include rent of building, management salaries, machinery depreciation etc.
d) By Variability
According to this classification,
costs are classified into three groups viz. fixed, variable and semi-variable.
Fixed
or period costs are commonly described as those which remain
fixed in total amount with increase or decrease in the volume of output or
productive activity for a given period of time. Examples of fixed costs are
rent, insurance of factory building, factory manager’s salary etc.
Variable
or product costs are those which vary in total in direct
proportion to the volume of output. Examples are direct material costs, direct
labour costs, power, repairs etc. Such costs are known as product costs because
they depend on the quantum of output rather than on time.
Semi-variable
costs are those which are partly fixed and partly
variable. For example, telephone expenses included a fixed portion of annual
charge plus variable charge according to calls; thus total telephone expenses
are semi-variable. Other examples of such costs are depreciation, repairs and
maintenance of building and plant etc.
e) By Controllability
Under this, costs are classified
according to whether or not they are influenced by the actions of a given
member of the undertaking. On this basis it is classified into two categories:
Controllable
costs are those which can be influenced by the
action of a specified member of an undertaking, that is to say, costs which are
at least partly within the control of management. Generally speaking, all
direct costs including direct material, direct labour and some of the overhead
expenses are controllable by lower level of management.
Uncontrollable
costs are those which cannot be influenced by the
action of a specified member of an undertaking that it is to say, which are
within the control of management. Most of the fixed costs are uncontrollable.
For example, rent of the building is not controllable and so are managerial
salaries.
f) By Normality
Under this, costs are classified
according to whether these are cost which are normally incurred as a given
level of output in the conditions in which that level of activity is normally
attained. On this basis, it is classified into two categories:
Normal
cost: It is the cost which is normally incurred at
a given level of output in the conditions in which that level of output is
normally attained. It is a part of cost of production.
Abnormal
cost: It is the cost which is not normally incurred
at a given level of output in the conditions in which that level of output is
normally attained. It is not a part of cost of production and charged to
Costing Profit and Loss Account.
g) By Capital and Revenue or Financial Accounting Classification
The cost which is incurred in
purchasing assets either to earn income or increasing the earning capacity of
the business is called capital cost. For example, the cost of a rolling machine
in case of steel plan. Such cost is incurred at one point of time but the benefits
accruing from it are spread over a number of accounting years.
It any expenditure is done in order to
maintain the earning capacity of the concern such as cost of maintaining an
asset or running a business it is revenue expenditure e.g. cost of materials
used in production, labour charges paid to convert the material into
production, salaries, depreciation, repairs and maintenance charges, selling
and distribution charges etc.
h) By Time
Cost can be classified as (i)
Historical costs and (ii) Predetermined costs.
i)
Historical costs: The cost which is ascertained after their
incurrence is called historical costs.
ii)
Predetermined costs: Such costs are estimated costs i.e.
computed in advance of production taking into consideration the previous period’s
costs and the factors affecting such costs. Predetermined cost determined on
scientific basis becomes standard cost.
i)
According to Planning and Control
Planning and control are two important
functions of management. Cost accounting furnishes information to the
management which is helpful is the due discharge of these two functions.
According to this, costs can be classified as budgeted costs and standard
costs.
i)
Budgeted costs: Budgeted costs represent an estimate of
expenditure for different phases of business operations such as manufacturing,
administration, sales, research and development etc. coordinated in a well-conceived
framework for a period of time in future which subsequently becomes the written
expression of managerial targets to be achieved.
ii)
Standard Cost: Standard cost is the predetermined cost based
on a technical estimate for materials, labour and overhead for a selected
period of time and for a prescribed set of working conditions.
j) For Managerial Decisions
On this basis, costs may be classified
into the following costs:
i)
Marginal cost: Marginal cost is the total of variable costs
i.e. prime cost plus variable overheads.
ii)
Out of pocket costs: This is that portion of the cost
which involves payment to outsiders i.e., gives rise to cash expenditure as
opposed to such costs as depreciation, which do not involve any cash
expenditure.
iii)
Differential costs: The change in costs due to change in
the level of activity or pattern or method of production is known as
differential costs.
iv)
Sunk costs: A sunk cost is an irrecoverable cost and is
caused by complete abandonment of a plant. It is the written down value of the
abandoned plant less its salvage value.
v)
Imputed costs: These costs are those costs which appear in
cost accounts only e.g. national rent charged on business premises owned by the
proprietor, interest on capital for which no interest has been paid. These
costs are also known as notional costs.
vi)
Opportunity cost: It is the maximum possible alternative earning
that might have been earned if the productive capacity or services had been put
to some alternative use.
vii) Replacement cost: It is the cost at which there could be purchased an asset or material identical to that which is being replaced or revalued. It is the cost of replacement at current market price.
viii) Avoidable and unavoidable cost: Avoidable costs are those which can be eliminated if a particular product or department, with which they are directly related, is discontinued. Unavoidable cost is that cost which will not be eliminated with the discontinuation of a product or department.
Also Read: Important Questions for Upcoming Exams
Unit – 1: Basic Concept of Cost Accounting (Part A) and Cost Sheet (Part B)
(These Questions are subject to modification, if necesary. Download DTS Application for complete notes)
Q. What are the advantages and limitations of cost accounting? 2019
Q. “Cost accounting is an essential tool to the Management” –Comment. 2011, 2012
Q. Distinguish and also mention the relationship between
Ø Cost accounting and Financial accounting 2013SN,2016SN, 2018SN
Ø Cost accounting and Management Accounting
Q. Explain the role and functions of cost accountant.
Q. Explain the purposes of classification of costs. Distinguish between direct cost and indirect cost. 2022, 2023
Q. Write Short notes on:
Ø Cost sheet or Statement of Cost 2017SN
Ø 4 Methods of Cost accounting
Ø 4 Techniques of Cost accounting 2019SN
Ø Characteristics of an Ideal Costing System
Or
Unit 1: Part B (Practical)
Practical Problems:
a) Cost sheet focusing on valuation of stock of finished goods, keep in mind expenses ignored in cost accounts, preparation of cost sheet from financial records (refer unit 4 – Reconciliation), profit percentages given on cost price or sale price. Every year
b) Follow 28 solved questions uploaded on my blog
c) Follow examples of BASU AND DAS COST ACCOUNTING BOOK.
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