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Accounting For Managers - Cost Estimation And Control-Cost Accounting

Classification Of Classification Of Cost

   Posted On :  03.05.2018 11:00 pm

1. By nature or elements (materials, labour and overheads) 2. By time (historical, pre-determined) 3. By traceability to the product (direct, indirect) 4. By association with the product (product, period) 5. By changes in activity or volume (fixed, variable, semi-variable) 6. By function (manufacturing, administrative, selling, research and development, pre-production) 7. By relationship with the accounting period (capital, revenue) 8. By controllability (controllable, non-controllable) 9. By analytical/decision-making purpose (opportunity, sunk, differential, joint, common, imputed, out-of-pocket, marginal, uniform, replacement) 10. By other reasons (conversion, traceable, normal, avoidable, unavoidable, total)

Classification Of Cost Accounting
In the process of cost accounting, costs are arranged and rearranged in various classifications. The term `classification’ refers to the process of Grouping costs according to their common characteristics. The different bases of cost classification are:

1. Elements Of Cost

The elements of costs are the essential part of the cost. There are broadly three elements of cost, as explained below:

(A) Material

The substance from which the produce is made is called material.
It can be direct as well as indirect.
I)   Direct Material: it refers to those materials which become an integral part of the final product and can be easily traceable to specific physical units. Direct materials, thus, include:
1.      All materials specifically purchased for a particular job or process.
2.      Components purchased or produced.
3.      Primary packing materials (e.g., carton, wrapping, card-board boxes etc.).
4.      Material passing from one process to another.
Ii) Indirect Material: all materials which are used for purpose ancillary to the business and which cannot conveniently be assigned to specific physical units are known as `indirect materials’. Oil, grease, consumable stores, printing and stationery material etc. Are a few examples of indirect materials.

(b)   Labour

In order to convert materials into finished products, human effort is required. Such human effort is known as labour. Labour can be direct as well as indirect.
I) Direct Labour:
It is defined as the wages paid to workers who are engaged in the production process and whose time can be conveniently and economically traceable to specific physical units. When a concern does not produce but instead renders a service, the term direct labour or wages refers to the cost of wages paid to those who directly carry out the service, e.g., wages paid to driver, conductor etc. Of a bus in transport service.

 Ii) Indirect Labour:
Labour employed for the purpose of carrying out tasks
Incidental to goods produced or services provided is called indirect labour
or indirect wages. In short, wages which cannot be directly identified with a
job, process or operation, are generally treated as indirect wages. Examples
of indirect labour are: wages of store-keepers, foremen, supervisors,
inspectors, internal transport men etc.

(C) Expenses

Expenses may be direct or indirect.
I) Direct Expenses:
These are expenses which can be directly, conveniently and wholly identifiable with a job, process or operation. Direct expenses are also known as chargeable expenses or productive expenses. Examples of such expenses are: cost of special layout, design or drawings, hire of special machinery required for a particular contract, maintenance cost of special tools needed for a contract job, etc.
Ii) Indirect Expenses:
Expenses which cannot be charged to production directly and which are neither indirect materials nor indirect wages are known as indirect expenses. Examples are rent, rates and taxes, insurance, depreciation, repairs and maintenance, power, lighting and heating etc.
The above elements of cost may be shown by means of a chart:
Element of cost
materials                                  labour                        expenses
Direct                  indirect direct                  indirect direct                  indirect


The term overheads includes, indirect material, indirect labour and indirect expenses, explained in the preceding paragraphs. Overheads may be incurred in the factory, office or selling and distribution departments/ divisions in an undertaking. Thus overheads may be of three types: factory
overheads, office and administrative overheads and selling and distribution overheads. This classification of overheads may be shown thus:

Classification Of Overheads

Factory office selling and distribution
Indirect indirect indirect indirect indirect indirect indirect indirect indir Material labour exp mat lab. Exp. Mat. Lab exp

2. Cost Classification By Time

On the basis of the time of computing costs, they can be classified Into historical and pre-determined costs.
I) Historical Costs:
These costs are computed after they are incurred. Such costs are available only after the production of a particular thing is over.
Ii) Pre-Determined Costs:
These costs are computed in advance of production on the basis of a specification of all factors influencing cost. Such costs may be:
1.                  Estimated costs: estimated costs are based on a lot of guess work. They try to ascertain what the costs will be based on certain factors. They are less accurate as only past experience is taken into account primarily, while computing them.
2.                  Standard costs: standard costs is a pre-determined cost based on a technical estimate for material, labour and other expenses for a selected period of time and for a prescribed set of working conditions. It is more scientific in nature and the object is to find out what the costs should be.


 3. Cost Classification By Traceability

As explained previously, costs which can be easily traceable to a product are called direct costs. Indirect costs cannot be traced to a product or activity. They are common to several products (e.g., salary of a factory manager, supervisor etc.) And they have to be apportioned to different products on some suitable basis. Indirect costs are also called `overheads’.

4. Cost Classification By Association With Product

Costs can also be classified (on the basis of their association with products) as product costs and period costs.
1.Product Costs: product costs are traceable to the product and include direct material, direct labour and manufacturing overheads. In other words, product cost is equivalent to factory cost.
2.Period Costs: period costs are charged to the period in which they are incurred and are treated as expenses. They are incurred on the basis of time, e.g., rent, salaries, insurance etc. They cannot be directly assigned to a product, as they are incurred for several products at a time (generally).

5. Cost Classification By Activity/Volume

Costs are also classified into fixed, variable and semi-variable on the basis of variability of cost in the volume of production.

1.Fixed Cost:

Fixed cost is a cost which tends to be unaffected by variations in volume of output. Fixed cost mainly depends on the passage of time and does not vary directly with the volume of output. It is also called period cost, e.g., rent, insurance, depreciation of buildings etc. It must be noted here that fixed costs remain fixed upto a certain level only. These costs may also vary after a certain production level.


 2.Semi-Variable Cost:

These costs are partly fixed and partly variable. Because of the variable element, they fluctuate with volume and because of the fixed element, they do not change in direct proportion to output. Semi-variable or semi-fixed costs change in the same direction as that of the output but not in the same proportion. For example, the expenditure on maintenance is to a great extent fixed if the output does not change significantly. Where, however, the production rises beyond a certain limit, further expenditure on maintenance will be necessary although the increase in the expenditure will not be in proportion to the rise in output. Other examples in this regard are: depreciation, telephone rent, repairs etc.

3.Variable Cost:

Cost which tends to vary directly with volume of outputs is called `variable cost’. It is a direct cost. It includes direct material, direct labour, direct expenses etc. It should be noted here that the variable cost per unit is constant but the total cost changes corresponding to the levels of output. It is always expressed in terms of units, not in terms of time.

6. Cost Classification By Function

On the basis of the functions carried out in a manufacturing concern,
Costs can be classified into four categories:
1.Manufacturing/Production Cost: it is the cost of operating the manufacturing division of an enterprise. It is defined as the cost of the sequence of operations which begin with supplying materials, services and ends with the primary packing of the product.
2Administrative/Office Cost: it is the cost of formulating the policy, directing the organisation and controlling the operations of an undertaking, which is not directly related to production, selling, distribution, research or development. Administration cost, thus, includes all office expenses: remuneration paid to managers, directors, legal expenses, depreciation of office premises etc.
3.Selling Cost: selling cost is the cost of seeking to create and stimulate demand e.g., advertisements, show room expenses, sales

 promotion expenses, discounts to distributors, free repair and servicing expenses, etc.
4.Distribution Cost: it is the cost of the sequence of operations which begins with making the packed product, available for despatch and ends with making the reconditioned returned empty package, if any, available for re-use. Thus, distribution cost includes all those expenses concerned with despatching and delivering finished products to customers, e.g., warehouse rent, depreciation of delivery vehicles, special packing, loading expenses, carriage outward, salaries of despatch clerks, repairing of empties for re-use, etc.
5.   Research And Development Cost: it is the cost of discovering new ideas, processes, products by experiment and implementing such results on a commercial basis.
6.Pre-Production Cost: expenses incurred before a factory is started and expenses involved in introducing a new product are preproduction costs. They are treated as deferred revenue expenditure and charged to the cost of future production on some suitable basis.

7. Cost Classification By Relationship With Accounting Period

On the basis of controllability, costs can be classified as controllable or uncontrollable.
1.Controllable Cost: a cost which can be influenced by the action of a specified member of an undertaking is a controllable cost, e.g., direct materials, direct labour etc.
2.Uncontrollable Cost: a cost which cannot be influenced by the action of a specified member of an undertaking is an uncontrollable cost, e.g., rent, rates, taxes, salary, insurance etc.
The term controllable cost is often used in relation to variable cost and the term uncontrollable cost in relation to fixed cost. It should be noted here that a controllable cost can be controlled by a person at a given organisation level only. Sometimes two or more individuals may be involved in controlling such a cost.

8. Cost Classification By Decision-Making Purpose

Costs may be classified on the basis of decision-making purposes for which they are put to use, in the following ways:
1.Opportunity Cost: it is the value of the benefit sacrificed in favour of choosing a particular alternative or action. It is the cost of the best alternative foregone. If an owned building, for example, is proposed to be used for a new project, the likely revenue which the building could fetch, when rented out, is the opportunity cost which should be considered while evaluating the profitability of the project.
2.Sunk Cost: a cost which was incurred or sunk in the past and is not relevant for decision-making is a sunk cost. It is only historical in nature and is irrelevant for decision-making. It may also be defined as the difference between the purchase price of an asset and its salvage value.
3.Differential Cost: the difference in total costs between two alternatives is called as differential cost. In case the choice of an alternative results in increase in total cost, such increase in costs is called `incremental cost’. If the choice results in decrease in total costs, the resulting decrease is known as decremental cost.
4.Joint Cost: whenever two or more products are produced out of one and the same raw material or process, the cost of material purchased and the processing are called joint costs. Technically speaking, joint cost is that cost which is common to the processing of joint products or by-products upto the point of split-off or separation.
5.Common Cost: common cost is a cost which is incurred for more than one product, job territory or any other specific costing object. It cannot be treated to individual products and, hence, apportioned on some suitable basis.
6.Imputed Cost: this type of cost is neither spent nor recorded in the books of account. These costs are not actually incurred (hence known as hypothetical or notional costs) but are considered while making a decision. For example, in accounting, interest and rent are recognized only as expenditure when they are actually paid. But in costing, they are charged on a notional basis while ascertaining the cost of a product.

7.Out-Of-Pocket Cost: it is the cost which involves current or future expenditure outlay, based on managerial decisions. For example a company has its own trucks for transporting goods from one place to another. It seeks to replace these by employing public carriers of goods. While making this decision, management can ignore depreciation, but not the out-of-pocket costs in the present situation, i.e., fuel, salary to drivers and maintenance paid in cash.
8.Marginal Cost: it is the aggregate of variable costs, i.e., prime cost plus variable overheads.

9.Replacement Cost: it is the cost of replacing a material or asset in the current market.

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