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Cost classification. Cost classification. Cost items are grouped according to their common features. They are related to some independent factor which could be:- Activity level- leading to fixed, variable and semi-variable costs Products, jobs or processes- leading to direct and indirect costs
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Cost classification Cost items are grouped according to their common features. They are related to some independent factor which could be:- • Activity level- leading to fixed, variable and semi-variable costs • Products, jobs or processes- leading to direct and indirect costs • Responsibility- leading to controllable and uncontrollable costs • Functions- leading to production, administration, selling and distribution, finance, research and development costs
Fixed costs • Fixed costs are costs that remain the same in total regardless of changes in the activity level. Since fixed costs remain constant in total as activity changes, therefore fixed costs per unit vary inversely with activity. • Example:-Company A leases all of its productive facilities at a cost of $10,000 per month. Total fixed costs of the facilities will remain constant at every level of activity.
Step fixed cost • Fixed cost might increase if a business approaches full capacity. • For instance a factory may have one supervisor for a certain level of activity. However, if activity and therefore number of people being supervised increases, it will become necessary to employ an additional supervisor
Variable costs • Vary in direct proportion to a change in volume or level of activity • These fluctuate in total amount as the volume of production increases or decreases • Variable costs remain the same or approximately the same in amount per unit of production • Example of variable costs- • Wages of labourers • Cost of direct material • Power
Direct cost • Are generally seen to be variable costs and they are called direct costs because they are directly associated with manufacturing. • A direct cost is a cost that can be traced in full to the product or service • Direct costs include- Direct material, direct labour and direct expenses • Total direct costs are collectively known as Prime Costs
Direct cost (Cont…) • Direct material costs are costs of materials that are known to have been used in making and selling a product • Direct labour costs are the specific costs of the work force used to make a product or provide a service. Direct labour costs are established by measuring the time taken for a job, or the time taken in direct production work • Other direct expenses are those expenses that have been incurred in full as a direct consequence of making a product or providing a service
Indirect cost • Indirect costs are those costs that are incurred in the factory but that cannot be directly associated with manufacture. • These costs are classified according to the three elements of cost, materials labour and expenses • Indirect Material- lubricants, cleaning materials. • Examples of Indirect labour- Wages of storekeepers, foremen, timekeepers, directors’ fees, salaries of salesmen etc, are examples of indirect labour costs. • Examples of Indirect expenses rent, lighting, insurance charges • Total indirect costs are collectively known as overheads
Components of Total Cost • Prime Cost Prime cost consists of costs of direct materials, direct labors and direct expenses. It is also known as basic, first or flat cost. • Factory Cost/ product cost Factory cost comprises prime cost and, in addition, works or factory overheads that include costs of indirect materials, indirect labors and indirect expenses incurred in a factory. It is also known as works cost, production or manufacturing cost. • Total Cost comprise of manufacturing/production cost and administrative and selling overheads
Production overheads • Production overheads include the following:- • Indirect materials which cannot be traced in the finished product • Consumable stores • Indirect wages • Wages of non-productive personnel in the production department (Example foreman) • Indirect expenses • Rent, rates, insurance on factory, depreciation, fuel, power, maintenance of plant
Administrative, selling and distribution overheads • Administrative overheads- represent those indirect expenses incurred in the direction, control and administration of an undertaking. • Examples:- • Depreciation of office building • Office salaries • Selling overhead is all indirect material cost, wages and expenses incurred in promotion sales and retaking customers • Distribution overhead is all indirect material costs, wages and expenses incurred in making the packed product ready for despatch and delivering to the customer
Functional costs • Production costs are costs which are incurred by the sequence of operations beginning with the supply of raw materials and ending with the completion of the product • Packaging costs are production costs where they relate to primary packaging • Administrative costs are the costs of managing an organization, that is, planning and controlling its operation
Functional costs (Cont…) • Selling costs/marketing costs are costs of creating demand for the products and securing firm orders from customers • Distribution costs are the costs of the sequence of operations with the receipt of finished goods from the production department and making them ready for despatch
Functional costs (Cont…) • Research costs are the costs of searching for new or improved products whereas development costs are the costs incurred between the decision to produce a new or improved product and the commencement of full manufacture of the product • Financing costs are costs incurred to finance the business
Other cost classification Relevant and Irrelevant Costs • Relevant costs are those which change by managerial decision. • Irrelevant costs are those which do not get affected by the decision. • For example, if a manufacturer is planning to close down an unprofitable retail sales shop, this will affect the wages payable to the workers of a shop. • This is relevant in this connection since they will disappear on closing down of a shop. • But prepaid rent of a shop or unrecovered costs of any equipment which will have to be scrapped are irrelevant costs which should be ignored.
Other cost classification (Cont…) • Sunk costs are historical or past costs. • These are the costs which have been created by a decision that was made in the past and cannot be changed by any decision that will be made in the future. • Investments in plant and machinery, buildings etc. are prime examples of such costs. • Since sunk costs cannot be altered by decisions made at the later stage, they are irrelevant for decision-making.
Other cost classification (Cont…) • Opportunity cost refers to an advantage in measurable terms that have been foregone on account of not using the facilities in the manner originally planned. • For example, if a building is proposed to be utilized for housing a new project plant, the likely revenue which the building could fetch, if rented out, is the opportunity cost which should be taken into account while evaluating the profitability of the project. • Differential costs are additional costs of manufacturing and marketing extra production.These would not be incurred if the firm does not take up the project.
Cost Estimation and Cost Ascertainment • Cost estimation is the process of pre-determining the cost of a certain product job or order. Such pre-determination may be required for several purposes. Some of the purposes are as follows: • Budgeting • Measurement of performance efficiency • Preparation of financial statements (valuation of stocks etc.) • Make or buy decisions • Fixation of the sale prices of products
Cost Estimation and Cost Ascertainment (Cont…) • Cost ascertainment is the process of determining costs on the basis of actual data. • Hence, the computation of historical cost is cost ascertainment while the computation of future costs is cost estimation. • Both cost estimation and cost ascertainment are interrelated and are of immense use to the management. • In case a concern has a sound costing system, the ascertained costs will greatly help the management in the process of estimation of rational accurate costs which are necessary for a variety of purposes stated above. • Moreover, the ascertained cost may be compared with the pre-determined costs on a continuing basis and proper and timely steps be taken for controlling costs and maximizing profits.
Cost Allocation and Cost Apportionment • Cost allocation and cost apportionment are the two procedures which describe the identification and allotment of costs to cost centers or cost units. • Cost allocation refers to the allotment of all the items of cost to cost centers or cost units whereas cost apportionment refers to the allotment of proportions of items of cost to cost centers or cost units.
Cost Allocation and Cost Apportionment (Cont…) • Thus, the former involves the process of charging direct expenditure to cost centers or cost units whereas the latter involves the process of charging indirect expenditure to cost centers or cost units. • For example, the cost of labor engaged in a service department can be charged wholly and directly but the canteen expenses of the factory cannot be charged directly and wholly. • Its proportionate share will have to be found out. • Charging of costs in the former case will be termed as “allocation of costs” whereas in the latter, it will be termed as “apportionment of costs.”
Cost centre and cost unit • The area of an organization where costs are collected for the purposes of cost ascertainment, planning, decision making, and control. • Cost centers are determined by individual organizations; they may be based on a function, department, section, individual, or any group of these. • Cost centers are of two main types: production cost centers in an organization are those concerned with making a product, while service cost centers provide a service (such as stores, or canteen) to other parts of the organization.
Cost centre and cost unit (Cont…) • Cost centers are divisions that add to the cost of the organization, but only indirectly add to the profit of the company. • Typical examples include Research and Development, Marketing and Customer service • Cost unit - Is the quantitative unit of product or service in relation to which costs can be ascertained. • Examples: Jobs, contracts, kilowatt hours, cost per patient day, kilometers
Cost objects • A cost object is any activity for which a separate measurement of costs is desired • If the user of management information wish to know the cost of something, this something is called a cost object • Examples include the following:- • The cost of a product • The cost of a service • The cost of operating a department
Profit centers and revenue centers • Profit centers are similar to costs centers but are accountable for costs and revenues • Profit costs managers should normally have control over how revenue is raised and how costs are incurred. • Revenue centers are similar to costs and profit centers but are accountable for revenues only • A revenue center manager is not accountable for costs. He would be aiming purely to maximize sales.
Investment centers • An investment center is a profit center with additional responsibilities for capital investment and possibly for financing, and whose performance is measured by its return on investment • Cost centers, revenue centers, profit centers and investment centers are also known as responsibility centers
