Classification of Cost

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Cost accounting involves collecting, classifying, recording and appropriate allocation of expenditure for determining the costs of products or services. After costs have been collected, these are properly classified for their identification with cost centers or cost units. Costs have different features or characteristics. Costs are grouped or classified according to their common characteristics. The process of grouping costs according to their common characteristics is known as ‘classification of cost‘.

Cost Classes

The various groups into which costs are classified, are known as ‘classes’. Costs may be classified according to different bases or characteristics such as element, nature, variability, controllability, normality, function etc. These bases may be given as follows:

1. Element:

Under this, costs are classified with reference to the factors on which costs are incurred. According to elements, costs may be grouped as:

(a) Material Cost,
(b) Labour Cost, and
(c) Expenses.

Material cost refers to the cost of commodities supplied to an undertaking e.g., in case of textile mill, cost of cotton or cost of yarn, cotton waste for cleaning of machinery, cost of dyes, cost of finishing material etc.

Labour cost refers to the cost of remuneration of the employees in an undertaking and includes salary, wages, commission etc.

Expenses refer to the cost of services provided to an undertaking and includes the notional cost of owned assets e.g., rent of the building, insurance premium of the building, telephone expenses, depreciation of the owned factory building, depreciation of delivery van etc.

2. Nature:

Under this, costs are classified according to their identifiability with cost centres or cost units. According to their nature, costs may be grouped as:

(a) Direct Costs, and
(b) Indirect Costs.

Direct costs refer to those costs which can be directly and easily traced to or identified with a product, process or department. Materials used and labour employed in manufacturing an article or in a particular process of production are common examples of direct costs.

Indirect costs, on the other hand, refer to those costs which are not traceable to any particular product, process or department, but are common to a number of products, processes or departments e.g., Factory Rent, Factory Insurance, Factory Manager’s Salary etc.

3. Variability or Behaviour:

On the basis of their behaviour in relation to changes in the volume of activity, costs (both direct and indirect) may be classified as:

(a) Variable Costs,
(b) Fixed Costs, and
(c) Semi-variable or Semi-fixed Costs.

Variable costs refer to those costs which vary directly in proportion to changes in the volume of output or sales. These costs tend to increase or decrease with the rise and fall in production or sales. Variable costs vary in total but their per unit cost remains constant. Direct material cost, direct wages, direct expenses, consumable stores, commission on sales etc., are the typical examples of variable costs.

Fixed costs refer to those costs which tend to remain unaffected by the changes in the volume of output or sales. In other words, fixed costs remain unchanged with the increase or decrease in output or sales. These costs remain fixed in total but their per unit cost changes with changes in output or sales.

These costs depend mainly on effluxion of time and do not vary directly with the changes in the volume of output or sales. Rent, rates, taxes, insurance charges, manager’s salary etc., are the typical examples of fixed costs.

It should be remembered that fixed costs are not absolutely fixed for all times. These are fixed only in relation to a certain level of production capacity.

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Semi-variable costs refer to costs which tend to vary with changes in the volume of output or sales, but not directly in proportion to such changes. These costs have the characteristics of both fixed and variable costs. A part of semi-variable costs remains constant in spite of changes in the volume of output or sales, while the other part varies in proportion to changes in volume of output or sales. Repairs and maintenance costs of plant, machinery and building, salary of supervisor etc., are the typical examples of semi-variable costs.

4. Controllability:

Under this, costs are classified according to whether or not these are influenced by the action of a given member of an undertaking. The classes of costs are:

(a) Controllable Costs, and
(b) Uncontrollable Costs.

Controllable costs refer to those costs which can be influenced by the action of a specified member of an undertaking. An undertaking is usually divided into a number of departments or cost centers which are placed under the direct control and supervision of specified persons. The person in charge of a particular department or cost center can control only those costs which come directly under his control.

Uncontrollable costs, on the other hand, refer to those costs which cannot be influenced by the action of a specified member of an undertaking. Costs which are controllable by a person may be uncontrollable so far as another person is concerned. Thus, the difference between controllable and
uncontrollable costs is only in relation to a particular individual or level of management.

5. Normality:

Under this, costs are classified according to whether these are costs which are normally incurred at a given level of output in the conditions in which that level of output is normally attained. According to normality, costs may be classified as:

(a) Normal or Unavoidable Costs, and
(b) Abnormal or Avoidable Costs.

Normal or unavoidable costs refer to those costs which are normally incurred at a given level of output in the conditions in which that level of output is normally attained. Such costs cannot be avoided at all. Cost of normal spoilage of materials and the cost of normal idle time are the typical examples of normal costs.

Abnormal or avoidable costs refer to those costs which are not normally incurred at a given level of output in the conditions in which that level of output is attained. Such costs can be avoided if proper care is taken. Cost of spoilage of material over and above the normal limit is an example of abnormal cost.

6. Function:

From the viewpoint of the function performed by the costs, these may be classified as:

(a) Production Costs,
(b) Administration Costs,
(c) Selling Costs, and
(d) Distribution Costs.

Production costs refer to those costs which arise in the course of production from the acquisition of raw materials till the finished products have been turned out. Production costs include cost of materials, cost of labour, other factory expenses and cost of primary packing.

Administration costs refer to those costs which are incurred for formulating the business policies, directing the organization and controlling the operations of an undertaking. These costs should not be related to research, development, production, distribution or selling activities.

Selling costs refer to those costs which are incurred to create and stimulate demand and to secure orders. Thus, these costs are incurred in connection with the marketing of the products.

Distribution costs refer to the costs of the sequence of operations which starts with making the packed product available for despatch and ends with making the reconditioned returned empty packages available for re-use.

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7. Time:

From the viewpoint of time, costs can be grouped as:

(a) Historical Costs, and
(b) Pre-determined Costs.

Historical costs refer to costs ascertained after these have been incurred. These costs are determined after goods have been manufactured or services have been rendered. Historical costs simply represent post-mortem of past events and help in ascertaining the profitability but not in exercising cost control.

Pre-determined costs refer to costs which are computed in advance of production on the basis of a specification of all the factors affecting them. Pre-determined costs can be further divided into:

(i) Estimated Costs, and (ii) Standard Costs.

Estimated costs refer to costs which, as per studies made, are most likely to be incurred. These are estimated in advance on the basis of the assumption that costs are more or less free to move and that what is made is the best estimate of the cost conditions which will apply when the cost is incurred.

Standard cost refers to a pre-determined cost which is calculated from management’s standards of efficient operation and the relevant necessary expenditure. Standard cost is established on the basis of the assumption that costs will not be allowed to move freely but will be controlled as far as possible so that actual cost will be as close to standard cost as possible and any variation of actual from the standard cost will be capable of reasonable explanation.

The basic difference between an estimated cost and a standard cost is that, an estimated cost is a more or less reasonable assessment of what a cost will be when it is incurred. A standard cost, on the other hand, is a specification of what a cost ought to be when it is incurred.

8. Relevance to Decision-Making and Control:

Under this, costs are classified on the basis of their relevance to the decisions to be taken by the management. These costs are as follows:

(a) Marginal Cost: Marginal cost is defined as “the 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.” Marginal cost is the increase in total cost resulting from increase in output by one unit. Marginal cost is denoted by variable cost comprising direct material cost, direct labour cost, direct expenses and variable overheads.

(b) Sunk Costs: Sunk costs refer to those costs which have already been incurred and cannot be altered by any decision in the future. These costs become irrelevant costs for later decisions. For example, if the management decides to replace an existing machine by a new one, the amount of capital invested in the existing machine less scrap value will be irrecoverable and hence it is known as ‘Sunk Cost’.

(c) Out of Pocket Costs: These refer to those costs which signify the present or future case expenditure regarding a certain decision that will vary depending upon the nature of decision made. Management decisions are directly affected by such costs since they give rise to cash expenditure. For example, a firm has its own vehicles for transporting raw materials and finished goods from one place to another. It seeks to replace these vehicles by the employment of public carriers. In making this decision, the depreciation of the vehicles is not to be considered but the management must take into account the present expenditure on fuel, maintenance and salary to drivers. Such costs are treated as out of pocket costs.

(d) Opportunity Costs: Opportunity cost of a product or service is measured in terms of revenue which could have been earned by employing the resources in some other alternative uses. Opportunity cost can be defined as the cost of the best alternative foregone. Thus, the opportunity cost of yarn produced by a composite spinning and weaving mill and used in the weaving section would be the price that could have been obtained by selling the yarn in the market.

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(e) Imputed Costs: Imputed costs refer to those costs which are not included in costs but are considered for making management decisions. These costs are hypothetical in character. For example, interest on capital, though not actually payable, is often required to be included in order to judge the relative profitability of two products involving unequal outlays of cash.

(f) Differential Costs: Differential costs refer to the difference in total costs between two alternatives. In case, the choice of alternative results in an increase in total costs, such increased costs are known as incremental costs. On the other hand, if the choice results in a decrease in total costs, such decreased costs are called decremental costs.

(g) Shut-down Costs: These are the costs which will still be incurred although a plant is shut down temporarily. Sometimes, it so happens that the normal operations of a business have to be suspended temporarily due to unfavorable market conditions or strike etc. There are some costs which have to be incurred even during the suspension of production or other activities. These are treated as ‘Shut-down costs’. Examples of such costs are rent of factory premises, salaries of top management etc.

(h) Postponable Costs: These are the costs which can be postponed or shifted to the future with little or no effect on the efficiency of current operations. These costs are postponable but not avoidable and have to be incurred at a later stage. The concept of postponable cost is very significant in railways and transport undertakings in which cost of repairs and maintenance can be postponed for a certain period. In manufacturing concerns also, during the depression period, economic crisis can be averted by postponing certain costs.

(i) Replacement Costs: Replacement cost refers to the cost of replacement of an asset in the current market or at the current price. Thus, the replacement cost of an asset means the cost which would be
incurred if the asset was to be purchased at the current market price and not the cost at which it was originally purchased.

(j) Abandonment Costs: ‘Abandonment’ refers to complete retirement or withdrawal of a fixed asset from service or utilization. A fixed asset is abandoned when it is no longer serviceable. Abandonment cost refers to the cost incurred in abandoning a fixed asset i.e., the cost which cannot be recovered or salvaged from the abandoned asset. It is also known as ‘Abandonment Loss’.

Other Types of Cost:

(a) Research Cost: The cost of searching for new or improved products, new applications of materials, or new or improved methods of production, is known as Research Cost.

(b) Development Cost: The cost of the process, which begins with the implementation of the decision to produce a new or improved product or to employ a new or improved method and ends with the commencement of formal production of that product or by that method, is known as ‘Development Cost’.

(c) Pre-production Cost: It refers to that part of development cost which is incurred in making a trial production run preliminary to formal production.

(d) Conversion Cost: Conversion costs refer to costs which are incurred for converting raw materials into finished goods and comprise direct labour cost, direct expenses and factory overhead.

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