Cost Classification

Cost Classification

There are different types of costs that are incurred on various activities carried out in a firm. The costs are classified depending on their nature, functions and behavior. Table presents broad classification of various costs. Now let us understand the significance of various cost classifications.

Basis of Classification	Types of Costs
Components of cost	Material, labor, overheads and other expenses
Nature of cost	Direct and indirect
Behavior of cost	Fixed, variable and semi-variable, stepped fixed cost
Functions of cost	Production or manufacturing, administrative, selling and distribution, research and development, pre-production, conversion
Controllability	Controllable and uncontrollable
Normality	Normal and abnormal
Management decision	Marginal, differential, imputed or notional, opportunity, relevant, discretionary, sunk, replacement, abnormal, shutdown, committed, capacity, urgent
Periodicity	Historical and future
Expiry	Expired and unexpired
Product/ period cost	Product/period

Classification of Cost According to Its Components

Material Cost

It is the cost of acquiring raw materials to be used for a finished product or the materials consumed in the process. This helps to produce a product for sale. It can be direct material that is consumed in the manufacturing process and physically used for the finished product. It can be traced out to the product. It can also be indirect material cost.

This is also required for the production process, but cannot be directly attributed to the product. The expenses on cotton waste, lubricating oil, etc., can be classified as indirect materials. If the cost of material is insignificant, it can also be classified as indirect.

Labor Cost

The amount paid to workers as wages and salaries are classified as labor cost. It also involves all the benefits passed on by the firm to the workers when wages are paid to the workers who are directly involved in the production process, that is, converting raw materials into finished products is called direct labor cost.

This involves all kinds of workers, skilled and unskilled. There is another component which may include salary/wages being paid to workers who do not work directly on the product, but their services are necessary for the production process. This is termed as indirect labor cost. Wages and salaries paid to supervisors, security guards, purchase and store staff, etc., are indirect labor costs.

Expenses

The amount spent for completion of manufacturing process other than materials and labor cost are categorized as expenses. Direct expenses can be directly allocated to the specific process, product or service. The expenses that cannot be attributed directly to a product are called indirect expenses, such as, factory rent, store expenses, etc.

Some of the examples of direct expenses that are directly charged to the products may include:

• Cost of patents, royalty, license fees, etc.
• Cost of tools, cores, patterns, designs, etc.
• Components and spare parts purchased for a special job.

Classification of Cost According to Nature

The costs can be classified as direct and indirect costs. The costs that are identifiable or attributable to a particular product/unit are direct costs. The costs such as purchase of materials, wages to labor and direct expenses associated with a product or process are direct costs.

Indirect costs are not identifiable or attributable with the product/unit. These are allocated, apportioned and absorbed in the production cost on the basis of their use.

Classification of Cost According to Behavior

This classification is based on how changes occur in cost on account of changes in output level. Some costs do not change up to a particular level of production while others change.

Fixed Costs

The costs that remain fixed up to a particular level of production irrespective of changes in the production volume are known as fixed costs. The peculiarity of fixed cost is that the total costs remain same while per unit fixed cost comes down with the increased level of production. Examples of fixed costs are depreciation, salaries, insurance, rent, etc.

Variable Costs

These costs change according to the volume of production. If the production volume is higher, the variable cost will be more and vice versa. This change occurs in proportion. The features of variable costs are that per unit variable cost remains the same whereas the total variable cost will change with production. Some of the examples of variable costs are direct materials, direct labor and direct expenses.

Semi-Variable Cost

When certain components of the total cost of a unit/activity are fixed and remaining components depend on the use of that activity, it is called semi-variable cost. In other words, semi-variable cost contains the features of both, fixed and variable costs. In this case, the fixed part does not change while the variable component depends on the use. Telephone bill, electricity bill, contractual salaries to supervisors, etc., can be examples of semivariable costs.

Stepped Fixed Cost

When costs are fixed up to a certain level of activity and then increased by fixed amount with further rise in the level of activities, it is called stepped fixed cost. For example, the fixed cost up to 1,000 units of output of a product is Rs. 5,000 and thereafter for the next level up to 1,000 units, the cost will rise by Rs. 2,000.

Classification of Cost According to Function

The costs under this category are classified according to the functions on which they are incurred.

Production or Manufacturing Cost

All costs incurred in the production process and producing a finished product are called production costs. The elements of production cost mainly include direct materials, direct labor, direct expenses and overheads in connection with the production or manufacturing activities.

Administration Cost

Costs that are incurred in managing general administration activities and that cannot be directly related to production, marketing and other activities are called administration cost.

Selling and Distribution Costs

The cost incurred on publicity, advertising, salesman salaries and traveling expenses, etc., are examples of selling costs. Costs incurred on delivering products and other related activities are called distribution costs. Distribution cost involves transport cost, packaging, etc. Sometimes in case of electricity and gas, the distribution cost includes cost of distribution of pipes, etc.

Finance Cost

The costs associated with external borrowed funds such as interest paid or accrued on borrowed funds.

Research and Development Cost

The costs incurred on research and development activities for new innovation and techniques, which result in increased efficiency of the products and processes, are called research and development costs.

Pre-Production Cost

The preliminary cost incurred on trial, testing and production before regular and normal production is called preproduction cost. This is different from research and development cost and basically incurred on testing a product before going into a final product.

Classification of Cost Based on Conversion

Conversion Costs

The total of direct wages, direct expenses and overhead costs for converting raw materials into finished products or converting materials from one stage of production to the next stage are called conversion costs. These do not include material costs.

Classification of Cost by Controllability

Under this category, costs are classified as controllable and uncontrollable. The costs that can be influenced by decisions of management and can be controlled are known as controllable costs. It means the management can reduce, minimize or avoid this cost base on its own decisions. Direct costs generally fall under this category. The costs that cannot be influenced by the decisions of the management are uncontrollable costs. Short-term commitments such as salaries and maintenance are uncontrollable costs.

Classification of Cost by Management Decisions

Costs are also classified for taking different types of managerial decisions in the following manner.

Marginal Cost

The cost incurred in producing one additional unit is called marginal cost. It is total variable cost as when we produce one additional unit, variable cost alone is incurred as the fixed components remain the same. A firm produces 100 units and the total cost to produce the units is Rs. 1,000. Suppose one more (101th) unit is produced and the cost increases to Rs. 1,005, the marginal cost will be Rs. 5 in this case.

Likewise, there is a concept of marginal revenue that provides additional revenue by selling one more unit. Marginal revenue and marginal cost both are significant for taking a decision to produce or not to produce. The rule is as long as marginal revenue is equal or more than the marginal cost, a firm goes on producing.

Opportunity Cost

The amount sacrificed or foregone to achieve a better option is called opportunity cost. It is used when a firm needs to make a choice between more than one option and have to choose the best. If a firm has surplus funds for a short-term period, it has different options to invest in. It chooses the best one by sacrificing or foregoing the others (Box 4.1).

Differential Cost

It is also known as incremental cost, which is required to be incurred if a firm needs to choose other alternatives of production or any other changes in the level of production, etc. What will be the difference in the total cost if the firm wants to add or drop out a product? Such decisions are taken keeping in view the increased costs. Even vital decisions to buy a product from market or to produce on its own are also influenced by the differential cost concept.

Imputed or Notional Cost

When a firm utilizes its own resources such as building and capital, the cost of these components is not accounted for. For example, rent on own building or interest on own capital in not considered when we prepare profit and loss account. But these kinds of costs are considered while taking managerial decisions because in that scenario alternative investment decisions can be considered. Therefore, the cost that does not appear in financial accounting but is considered only for managerial decisions is called imputed or notional cost.

Discretionary Cost

This cost is fixed in nature and incurred on the basis of policy decisions of the management. It does not affect the current level of production. The examples of discretionary costs are providing training to employees, additional research and development activities, advertisement costs, etc. Since all these costs to be incurred or not to be incurred depend on the discretion of management, they are called discretionary costs. These are also known as programmed costs or managed costs or policy costs.

Out-of-Pocket Cost

All costs that involve cash outflow are called outof-pocket costs. There are certain costs like depreciation that does not require any cash outflow and therefore is not termed out-of-pocket cost. The significance of this cost is that it helps management in deciding the level of cash to be arranged at different intervals.

Sunk Cost

The cost committed in the past that may be by wrong managerial decisions does not yield any revenue in the present is called sunk cost. Suppose a young engineer entrepreneur, who is enthusiastic and optimistic, wishes to establish a unit of production. For this purpose, he avails a piece of land at a rent of Rs. 2 lakh per annum. Later on, he realizes that half piece of the land is sufficient to continue the required production for the next 3 years.

But the land is leased for 5 years. In this case, the rent being paid on the vacant piece of land is called sunk cost. Sunk cost is not considered as the cost while taking future decisions.

In the example, suppose only half of the land is lying vacant, for which an annual rent of Rs. 1 lakh is being paid, and the engineer gets an offer from a third party for taking the vacant piece of land for one year at a rent of Rs. 50,000, he should not consider that he is paying Rs. 1 lakh, instead he is getting only Rs. 50,000 as rent from the third party because it is a sunk cost. Therefore, whatever he gets is additional revenue for him as otherwise also it is a committed cost that is to be paid.

Relevant Cost

All costs may not be relevant for taking future decisions as under different alternatives and scenarios certain existing costs may not be relevant. We can think of a firm deciding about acquiring an automated plant that may not have any manual work. In this case, all existing costs relating to manual operations become irrelevant. Therefore, the management decides which of the costs are relevant and they alone are considered for future decisions.

Replacement Cost

The cost associated with replacing a present asset is called replacement cost. Suppose a firm wishes to replace its existing machinery and plant and if the cost is Rs. 20 lakh and the present machine has a saleable value of Rs. 4 lakh, the replacement cost will be Rs. 16 lakh.

Abnormal Cost

When a cost occurs on account of reasons or circumstances beyond control, not in normal or routine course, it is called abnormal cost. There may be instances of additional production cost due to fire in the plant, breakdown of machinery, power failure, etc., that may cause an increase in the cost. The abnormal cost is not included in the production cost but is adjusted in profit and loss account. It is because of the responsibility that the production manager is responsible for normal loss only.

Shutdown Cost

Sometimes a unit remains shut without any operations for a temporary period on account of strikes by the workers, recession in demand or any other reason. After some time, the unit starts functioning again. The costs, such as wages to security, depreciation and sheltering of plant, that are incurred during this period when the unit remains closed and the cost, such as oiling and overhauling of machines and parts, incurred again when the unit starts functioning are called shutdown costs.

Capacity Cost

A fixed cost in nature that is incurred in creating certain facilities on long-term basis for smooth functioning of various operations, such as plant, machinery, building warehouses and distribution arrangements, is called capacity cost.

Classification of Cost Based on Expiry

All historical costs are classified either as expired costs or unexpired costs. Unexpired costs are the costs incurred in acquiring resources and creating facilities and capacities to generate revenues for a firm in future. These costs are a part of assets in the balance sheet of a firm. The examples of unexpired costs are costs of machinery and equipment. This cost becomes expired cost when measured in terms of expenses to compare revenue.

Therefore, as long as an inventory of finished stock remains as closing inventory in the balance sheet, it is unexpired cost but the moment it generates revenue for the firm, the historical cost becomes expired cost. Remember while explaining the meaning of cost in Chapter 1, we described cost as resources sacrificed to achieve a goal. Therefore, cost incurred in creating facilities is unexpired cost.

Product and Period Costs

All costs that are accounted for in a particular time period and not carried over to another time period with the product are called period costs. These are recorded in the current year’s profit and loss account. Product costs are attached to and carried over with the particular product.

For example, closing inventory, it remains product cost till the finished goods inventory remains unsold and is shown in the balance sheet. This concept will be explained better when we deal with absorption and marginal costing concept in Chapter 5 of this book.

Methods of Costing

Different firms are engaged in a variety of product operations. Therefore, there are different kinds of costing systems followed for different purposes. The main methods of costing include unit costing, batch costing, job costing, contract costing, process costing, service costing, joint costing and multiple costing. We will be covering these methods in different units of this book in detail