CLASSIFICATION OF COSTS

The different bases of cost classification are:

(1) By time (Historical, Pre-determined).

(2) By nature or elements (Material, Labour and Overhead).

(3) By degree of traceability to the product (Direct, Indirect).

(4) 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) Relationship with accounting period (Capital, Revenue).

(8) Controllability (Controllable, Non-controllable).

(9) Cost for analytical and decision-making purposes (Opportunity, Sunk, Differential, Joint, Common, Imputed, Out-of-pocket, Marginal, Uniform, Replacement).

(10) Others (Conversion, Traceable, Normal, Avoidable, Unavoidable, Total).

1. Classification on the Basis of Time

(a) Historical Costs: These costs are ascertained after they are incurred. Such costs are available only when the production of a particular thing has already been done. They are objective in nature and can be verified with reference to actual operations.

(b) Pre-determined Costs: These costs are calculated before they are incurred on the basis of a specification of all factors affecting cost. Such costs may be:

(i) Estimated costs: Costs are estimated before goods are produced; these are naturally less accurate than standards.

(ii) Standard costs: This is a particular concept and technique. This method involves:

(a) setting up predetermined standards for each element of cost and each product;

(b) comparison of actual with standard to find variation;

(c) pin-pointing the causes of such variances and taking remedial action.

Obviously, standard costs, though pre-determined, are arrived with much greater care than estimated costs.

2. By Nature or Elements

There are three broad elements of costs:

(1) Material: The substance from which the product is made is known as material. It can be direct as well as indirect.

Direct material: It refers to those materials which become a major part of the finished product and can be easily traceable to the units. Direct materials include:

(i) All materials specifically purchased for a particular job/process.

(ii) All material acquired and latter requisitioned from stores.

(iii) Components purchased or produced.

(iv) Primary packing materials.

(v) Material passing from one process to another.

Indirect material: All material which is used for purposes ancillary to production and which can be conveniently assigned to specific physical units is termed as indirect materials. Examples, oil, grease, consumable stores, printing and stationary material etc.

(2) Labour: Labour cost can be classified into direct labour and indirect labour.

Direct labour: It is defined as the wages paid to workers who are engaged in the production process whose time can be conveniently and economically traceable to units of products. For example, wages paid to compositors in a printing press, to workers in the foundry in cast iron works etc.

Indirect labour: Labour employed for the purpose of carrying tasks incidental to goods or services provided, is indirect labour. It cannot be practically traced to specific units of output. Examples, wages of store-keepers, foreman, time-keepers, supervisors, inspectors etc.

(3) Expenses: Expenses may be direct or indirect.

Direct expenses: These expenses are incurred on a specific cost unit and identifiable with the cost unit. Examples are cost of special layout, design or drawings, hiring of a particular tool or equipment for a job; fees paid to consultants in connection with a job etc.

Indirect expenses: These are expenses which cannot be directly, conveniently and wholly allocated to cost centre or cost units. Examples are rent, rates and taxes, insurance, power, lighting and heating, depreciation etc.

3. By Degree of Traceability to the Products

Cost can be distinguished as direct and indirect.

Direct Costs: The direct costs are those which can be easily traceable to a product or costing unit or cost center or some specific activity, e.g. cost of wood for making furniture. It is also called traceable cost.

Indirect Costs : The indirect costs are difficult to trace to a single product or it is uneconomic to do so. They are common to several products, e.g. salary of a factory manager. It is also called common costs.

Costs may be direct or indirect with respect to a particular division or department. For example, all the costs incurred in the Power House are indirect as far as the main product is concerned but as regards the Power House itself, the fuel cost or supervisory salaries are direct. It is necessary to know the purpose for which cost is being ascertained and whether it is being associated with a product, department or some activity.

Direct cost can be allocated directly to costing unit or cost center. Whereas Indirect costs have to be apportioned to different products, if appropriate measurement techniques are not available. These may involve some formula or base which may not be totally correct or exact.

4. Association with the Product

Cost can be classified as product costs and period costs.

Product Costs: Product costs are those which are traceable to the product and included in inventory values. In a manufacturing concern it comprises the cost of direct materials, direct labour and manufacturing overheads. Product cost is a full factory cost. Product costs are used for valuing inventories which are shown in the balance sheet as asset till they are sold. The product cost of goods sold is transferred to the cost of goods sold account.

Period Costs: Period costs are incurred on the basis of time such as rent, salaries, etc., include many selling and administrative costs essential to keep the business running. Though they are necessary to generate revenue, they are not associated with production, therefore, they cannot be assigned to a product.

They are charged to the period in which they are incurred and are treated as expenses.

5. By Changes in Activity or Volume

Costs can be classified as fixed, variable and semi-variable cost.

Fixed Costs: The Chartered Institute of Management Accountants, London, defines fixed cost as “ the cost which is incurred for a period, and which, within certain output and turnover limits, tends to be unaffected by fluctuations in the levels of activity (output or turnover)”.

These costs are incurred so that physical and human facilities necessary for business operations, can be provided. These costs arise due to contractual obligations and management decisions. They arise with the passage of time and not with production and are expressed in terms of time. Examples are rent, property taxes, insurance, supervisors’ salaries etc.

 (a) Committed Costs: These costs are incurred to maintain certain facilities and cannot be quickly eliminated. The management has little or no discretion in this cost, e.g., rent, insurance etc.

(b) Policy and Managed Costs: Policy costs are incurred for implementing particular management policies such as executive development, housing, etc. Such costs are often discretionary. Managed costs are incurred to ensure the operating existence of the company e.g., staff services.

(c) Discretionary Costs: These are not related to the operations and can be controlled by the management. These costs result from special policy decisions, new researches etc., and can be eliminated or reduced to a desirable level at the discretion of the management.

(d) Step Costs: Such costs are constant for a given level of output and then increase by a fixed amount at a higher level of output.

Variable Cost: Variable costs are those costs that vary directly and proportionately with the output e.g. direct materials, direct labour. It should be kept in mind 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.

Management decisions can influence the cost behaviour patterns. The concept of variability is relative. If the conditions upon which variability was determined changes, the variability will have to be determined again.

Semi-fixed (Semi-Variable) costs: Such costs contain fixed and variable elements. 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 costs change in the same direction as that of the output but not in the same proportion. Depreciation is an example; for two shifts working the total depreciation may be only 50% more than that for single shift working. They may change with comparatively small changes in output but not in the same proportion.

6. Functional Classification of Costs

A company performs a number of functions. Functional costs may be classified as follows:

(a) Manufacturing/production Costs: It is the cost of operating the manufacturing division of an undertaking. It includes the cost of direct materials, direct labour, direct expenses, packing (primary) cost and all overhead expenses relating to production.

(b) Administration Costs: They are indirect and covers all expenditure incurred in formulating the policy, directing the organisation and controlling the operation of a concern, which is not related to research, development, production, distribution or selling functions.

(c) Selling and Distribution Cost: Selling cost is the cost of seeking to create and stimulate demand e.g. advertisements, market research etc. Distribution cost is the expenditure incurred which begins with making the package produced available for dispatch and ends with making the reconditioned packages available for re-use e.g. warehousing, cartage etc. It includes expenditure incurred in transporting articles to central or local storage. Expenditure incurred in moving articles to and from prospective customers as in the case of goods on sale or return basis is also distribution cost.

(d) Research and Development Costs: They include the cost of discovering new ideas, process, products by experiment and implementing such results on a commercial basis.

(e) Pre-production Cost: When a new factory is started or when a new product is introduced, certain expenses are incurred. There are trial runs. Such costs are termed as pre-production costs and treated as deferred revenue expenditure. They are charged to the cost of future production.

7. Relationships with Accounting Period

Costs can be capital and revenue. Capital expenditure provides benefit to future period and is classified as an asset. On the other hand, revenue expenditure benefits only the current period and is treated as an expense. As and when an asset is written off, capital expenses to that extent becomes cost. Only when capital and revenue is properly differentiated, the income of a particular period can be correctly determined. It is not possible to distinguish between the two under all circumstances.

8. Controllability

Cost can be Controllable and Non-Controlable.

Controllable Cost: The Chartered Institute of Management Accountants defines controllable cost as “cost which can be influenced by its budget holder”.

Non-Controllable Cost: It is the cost which is not subject to control at any level of managerial supervision. The difference between the terms is very important for the purpose of cost accounting, cost control and responsibility accounting.

A controllable cost can be controlled by a person at a given organisational level. Controllable cost are not totally controllable. Some costs are partly controllable by one person and partly by another e.g., maintenance

cost can be controlled by both the production and maintenance manager. The term “controllable costs” is often used to mean variable costs and non-controllable costs as fixed.

Belkaoni has mentioned the following fallacies about controllable costs:

(i) All variable costs are controllable and fixed are not.

(ii) All direct costs are controllable and indirect costs are not.

(iii) All long-term costs are controllable.

Sometimes the time factor and the decision making authority can make a cost controllable. If the time period is long enough, all costs can be controlled. Proper delegation helps in establishing clear responsibility and controllability. But all costs can be controlled by one or another person. The authority and responsibility of cost control is delegated to different levels, though the managing director is responsible for all the costs.

9. Costs for Analytical and Decision Making Purposes

(a) Opportunity Costs: Opportunity cost is the cost of selecting one course of action and the losing of other opportunities to carry out that course of action. It is the amount that can be received if the asset is utilised in its next best alternative. Edwards, Hermanson and Salmonson define it as “the benefits lost by rejecting the best competing alternative to the one chosen. The benefit lost is usually the net earnings or profit that might have been earned from the rejected alternative”

Example: Capital is invested in plant and machinery. It cannot be now invested in shares or debentures. The loss of interest and dividend that would be earned is the opportunity cost. Another example is when the owner of a business foregoes the opportunity to employ himself elsewhere. Opportunity costs are not recorded in the books. It is important in decision making and comparing alternatives.

(b) Sunk Costs: A sunk cost is one that has already been incurred and cannot be avoided by decisions taken in the future. As it refers to past costs, it is called unavoidable cost. The National Association of Accountants (USA) defines a sunk cost as “an expenditure for equipment or productive resources which has no economic relevance to the present decision making process”. This cost is not useful for decision making as all past costs are irrelevant. CIMA defines it as the past cost not taken into account in decision making. It has also been defined as the difference between the purchase price of an asset and its salvage value.

(c) Differential Cost: Differential cost has been defined as “the difference in total cost between alternatives, calculated to assist decision making”. Differential cost is the increase or decrease in total costs resulting out of:

(a) Producing and distributing a few more or few less of products;

(b) A change in the method of production/distribution;

(c) An addition or deletion of a product or a territory; and

(d) The selection of an additional sales channel.

The differential cost between any two levels of production is the difference between the marginal costs at these two levels and the increase or decrease in fixed costs, if any. These costs are usually ‘specific purpose costs’ as they are determined for a particular purpose and under specific circumstances.

Incremental cost measures the addition in unit cost for an addition in output. This cost need not be the same at all levels of production. It is usually expressed as a cost per unit whereas the differential cost is measured in total. The former applies to increase in production and is restricted to the cost only, whereas the differential cost has a comprehensive meaning and application in the sense that it denotes both increase and decrease.

Differential costs are useful in planning and decision making and helps to choose the best alternative.

It helps management to know the additional profit that would be earned if idle capacity is used or when additional investments are made.

(d) Joint Costs: The processing of a single raw material results in two or more different products simultaneously. The joint products are not identifiable as different types of product until a certain stage of production known as the split-off point is reached. Joint costs are the costs incurred upto the point of separation. One product may be of major importance and others of minor importance which are called by-products.

Bierman and Djckman define it as: “Joint costs relate to a situation in which the factors of productionby their basic nature result in two or more products. The jointness results from there being more than one product, and these multi-products are the result of the methods of production or the nature of raw material and not of a decision by management to produce both”.

The National Association of Accountants defines it as follows:

“Joint costs relate to two or more products produced from a common production process or element-material, labour or overhead or any combination thereof or so locked together that one cannot be produced without producing the other”.

Joint costs can be apportioned to different products only by adopting a suitable basis of apportionment.

(e) Common Costs: Common costs are those costs which are incurred for more than one product, job, territory or any other specific costing object. They are not easily related with individual products and hence are generally apportioned.

The National Association of Accountants defines the term as “the cost of services employed in the creation of two or more outputs which is not allocable to those outputs on a clearly justified basis”.

It should be kept in mind that management decisions influence the incurrence of common costs e.g. rent of the factory is a common cost to all departments located in factory.

(f) Imputed Costs: Some costs are not incurred and are useful while taking decision pertaining to a particular situation. These costs are known as imputed or notional costs and they do not enter into traditional accounting systems.

Examples: Interest on internally generated funds, salaries of owners of proprietorship or partnership, notional rent etc.

(g) Uniform Costs: They are not distinct costs as such. Uniform costing signifies common costing principles and procedures adopted by a number of firms. They are useful in inter-firm comparison.

(h) Marginal Costs: It is the aggregate of variable costs, i.e., prime cost plus variable overheads. Thus, costs are classified as fixed and variable.

(i) Replacement Costs: This is the cost of replacing an asset at current market values e.g. when the cost of replacing an asset is considered, it means the cost of purchasing the asset at the current market price is important and not the cost at which it was purchased.

(j) Out of Pocket Cost: It involves payment to outsiders i.e. gives rise to Cash Expenditure as opposed to such costs as depreciation which don’t involve any cash expenditure. Such costs are relevant for price fixation during recession or when make or buy decision is to be made.

10. Other Costs

(i) Conversion Cost: It is the cost of a finished product or work-in-progress comprising direct labour and manufacturing overhead. It is production cost less the cost of raw material but including the Gains and losses in weight or volume of direct material arising due to production.

(ii) Normal Cost: This is the cost which is normally incurred at a given level of output in the conditions in which that level of output is achieved.

(iii) Traceable Cost: It is the cost which can be easily associated with a product, process or department.

(iv) Avoidable Costs: Avoidable costs are those costs which under the present conditions need not have been incurred.

Example: (a) Spoilage in excess of normal limit; (b) Unfavourable cost variances which could have been controlled.

(v) Unavoidable Costs: Unavoidable costs are those costs which under the present conditions must be incurred.

(vi) Total Cost: This is the sum of all costs associated to a particular unit, or process, or department or batch or the entire concern. It may also mean the sum total of material, labour and overhead. The term total cost however, is not precise, it needs to be made precise by using terms that indicate the elements of cost included.

(vii) Value Added: Strictly, it is not cost. It means the selling price of the product/service less the cost of materials used in the product or the service. Often depreciation is also deducted for ascertaining “value added”.

Reference: 

Cost Accounting by Reddy and Hari Prasad Reddy

Cost Accounting by  Jain and Narang

ICAI
ICSI