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Forms of business organization:

A business organization usually takes the following forms in India:
(1) Sole proprietorship
(2) Partnership
(3) Joint Stock Company

Sole Proprietorship from of business organisation refers to a business enterprise exclusively
owned, managed and controlled by a single person with all authority, responsibility and risk







(a) Single Ownership: The sole proprietorship form of business organisation has a single owner
who himself/herself starts the business by bringing together all the resources.
(b) No Separation of Ownership and Management: The owner himself/herself manages the
business as per his/her own skill and intelligence. There is no separation of ownership and
management as is the case with company form of business organisation.
(c) Less Legal Formalities: The formation and operation of a sole proprietorship form of business
organisation does not involve any legal formalities. Thus, its formation is quite easy and simple.
(d) No Separate Entity: The business unit does not have an entity separate from the owner. The
businessman and the business enterprise are one and the same, and the businessman is
responsible for everything that happens in his business unit.
(e) No Sharing of Profit and Loss: The sole proprietor enjoys the profits alone. At the same time,
the entire loss is also borne by him. No other person is there to share the profits and losses of the
business. He alone bears the risks and reaps the profits.
(f) Unlimited Liability: The liability of the sole proprietor is unlimited. In case of loss, if his
business assets are not enough to pay the business liabilities, his personal property can also be
utilised to pay off the liabilities of the business.
(g) One-man Control: The controlling power of the sole proprietorship business always remains
with the owner. He/she runs the business as per his/her own will.

(a) Easy to Form and Wind Up: It is very easy and simple to form a sole proprietorshipform of
business organisation. No legal formalities are required to be observed. Similarly,the business
can be wind up any time if the proprietor so decides.
(b) Quick Decision and Prompt Action: As stated earlier, nobody interferes in theaffairs of the
sole proprietary organisation. So he/she can take quick decisions on thevarious issues relating to
business and accordingly prompt action can be taken.
(c) Direct Motivation: In sole proprietorship form of business organisations. The entireprofit of
the business goes to the owner. This motivates the proprietor to work hardand run the business
(d) Flexibility in Operation: It is very easy to effect changes as per the requirements ofthe
business. The expansion or curtailment of business activities does not require manyformalities as
in the case of other forms of business organisation.
(e) Maintenance of Business Secrets: The business secrets are known only to theproprietor. He is
not required to disclose any information to others unless and until hehimself so decides. He is
also not bound to publish his business accounts.
(f) Personal Touch: Since the proprietor himself handles everything relating to business,it is easy
to maintain a good personal contact with the customers and employees. Byknowing the likes,
dislikes and tastes of the customers, the proprietor can adjust his operations accordingly.
Similarly, as the employees are few and work directly underthe proprietor, it helps in maintaining
a harmonious relationship with them, and run thebusiness smoothly.
(a) Limited Resources: The resources of a sole proprietor are always limited. Beingthe single
owner it is not always possible to arrange sufficient funds from his ownsources. Again borrowing
funds from friends and relatives or from banks has its ownimplications. So, the proprietor has a
limited capacity to raise funds for his business.
(b) Lack of Continuity: The continuity of the business is linked with the life of theproprietor.
Illness, death or insolvency of the proprietor can lead to closure of thebusiness. Thus, the
continuity of business is uncertain.
(c) Unlimited Liability: You have already learnt that there is no separate entity of thebusiness
from its owner. In the eyes of law the proprietor and the business are one andthe same. So
personal properties of the owner can also be used to meet the businessobligations and debts.
(d) Not Suitable for Large Scale Operations : Since the resources and the managerialability is
limited, sole proprietorship form of business organisation is not suitable forlarge-scale business.
(e) Limited Managerial Expertise: A sole proprietorship from of business organization always
suffers from lack of managerial expertise. A single person may not be an expertin all fields like,
purchasing, selling, financing etc. Again, because of limited financialresources, and the size of
the business it is also not possible to engage the professionalmanagers in sole proprietorship
form of business organisations.

Partnership is an association of two or more persons who pool their financial and
managerialresources and agree to carry on a business, and share its profit. The persons who form
apartnership are individually known as partners and collectively a firm or partnershipfirm.


(a) Two or More Persons: To form a partnership firm atleast two persons are required.The
maximum limit on the number of persons is ten for banking business and 20 forother businesses.
If the number exceeds the above limit, the partnership becomesillegal and the relationship among
them cannot be called partnership.
(b) Contractual Relationship: Partnership is created by an agreement among the personswho have
agreed to join hands. Such persons must be competent to contract. Thus,minors, lunatics and
insolvent persons are not eligible to become the partners. However,a minor can be admitted to
the benefits of partnership firm i.e., he can have share in theprofits without any obligation for
(c) Sharing Profits and Business: There must be an agreement among the partners toshare the
profits and losses of the business of the partnership firm. If two or morepersons share the income
of jointly owned property, it is not regarded as partnership.
(d) Existence of Lawful Business: The business of which the persons have agreed toshare the
profit must be lawful. Any agreement to indulge in smuggling, black marketingetc. cannot be
called partnership business in the eyes of law.
(e) Principal Agent Relationship: There must be an agency relationship between thepartners.
Every partner is the principal as well as the agent of the firm. When a partnerdeals with other
parties he/she acts as an agent of other partners, and at the same timethe other partners become
the principal.
(f) Unlimited Liability: The partners of the firm have unlimited liability. They are jointlyas well
as individually liable for the debts and obligations of the firms. If the assets ofthe firm are
insufficient to meet the firms liabilities, the personal properties of thepartners can also be
utilised for this purpose. However, the liability of a minor partneris limited to the extent of his
share in the profits.
(g) Voluntary Registration: The registration of partnership firm is not compulsory. Butan
unregistered firm suffers from some limitations which makes it virtually compulsoryto be
registered. Following are the limitations of an unregistered firm.
(i) The firm cannot sue outsiders, although the outsiders can sue it.
(ii) In case of any dispute among the partners, it is not possible to settle the disputethrough court
of law.
(iii) The firm cannot claim adjustments for amount payable to, or receivable from, anyother


(a) Easy to Form: A partnership can be formed easily without many legal formalities.Since it is
not compulsory to get the firm registered, a simple agreement, either in oral,writing or implied is
sufficient to create a partnership firm.
(b) Availability of Larger Resources: Since two or more partners join hands to startpartnership
firm it may be possible to pool more resources as compared to soleproprietorship form of
business organisation.
(c) Better Decisions: In partnership firm each partner has a right to take part in themanagement
of the business. All major decisions are taken in consultation with andwith the consent of all
partners. Thus, collective wisdom prevails and there is lessscope for reckless and hasty decisions.
(d) Flexibility: The partnership firm is a flexible organisation. At any time the partnerscan decide
to change the size or nature of business or area of its operation after takingthe necessary consent
of all the partners.
(e) Sharing of Risks: The losses of the firm are shared by all the partners equally or asper the
agreed ratio.
(f) Keen Interest: Since partners share the profit and bear the losses, they take keeninterest in the
affairs of the business.
(g) Benefits of Specialisation: All partners actively participate in the business as pertheir
specialisation and knowledge. In a partnership firm providing legal consultancyto people, one
partner may deal with civil cases, one in criminal cases, another inlabour cases and so on as per
their area of specialisation. Similarly two or moredoctors of different specialisation may start a
clinic in partnership.
(h) Protection of Interest: In partnership form of business organisation, the rights ofeach partner
and his/her interests are fully protected. If a partner is dissatisfied withany decision, he can ask
for dissolution of the firm or can withdraw from the partnership.
(i) Secrecy: Business secrets of the firm are only known to the partners. It is not requiredto
disclose any information to the outsiders. It is also not mandatory to publish theannual accounts
of the firm
A partnership firm also suffers from certain limitations. These are as follows:
(a) Unlimited Liability: The most important drawback of partnership firm is that theliability of
the partners is unlimited i.e., the partners are personally liable for the debtand obligations of the
firm. In other words, their personal property can also be utilized for payment of firms liabilities.
(b) Instability: Every partnership firm has uncertain life. The death, insolvency, incapacityor the
retirement of any partner brings the firm to an end. Not only that any dissentingpartner can give
notice at any time for dissolution of partnership.

(c) Limited Capital: Since the total number of partners cannot exceed 20, the capacityto raise
funds remains limited as compared to a joint stock company where there is nolimit on the
number of share holders.
(d) Non-transferability of share: The share of interest of any partner cannot betransferred to other
partners or to the outsiders. So it creates inconvenience for thepartner who wants to transfer his
share to others fully and partly. The only alternativeis dissolution of the firm.
(e) Possibility of Conflicts: You know that in partnership firm every partner has anequal right to
participate in the management. Also every partner can place his or heropinion or viewpoint
before the management regarding any matter at any time. Becauseof this, sometimes there is
friction and quarrel among the partners. Difference of opinionmay give rise to quarrels and lead
to dissolution of the firm.


Active Partners
Sleeping Partners
Nominal Partners
Limited Partners
General Partners
Secret partners.


The following steps are to be taken in order to form a partnership firm:
(a) Minimum two members are required to form a partnership. The maximum limit is tenin
banking and 20 in other businesses.
(b) Select the like-minded persons keeping in view the nature and objectives of thebusiness.
(c) There must be an agreement among the partners to carry on the business and sharethe profits
and losses. This agreement must preferably be in writing and duly signed bythe all the partners.
The agreement, i.e., the partnership deed must contain the following:
The following steps are to be taken in order to form a partnership firm:
(a) Minimum two members are required to form a partnership. The maximum limit is tenin
banking and 20 in other businesses.
(b) Select the like-minded persons keeping in view the nature and objectives of thebusiness.
(iii) The filled in form along with prescribed registration fee must be deposited in theoffice of the
Registrar of Firms.
(iv) The Registrar will scrutinise the application, and if he is satisfied that all formalitiesrelating
to registration have been duly complied with, he will put the name of thefirm in his register and
issue the Certificate of Registration.

(c) There must be an agreement among the partners to carry on the business and sharethe profits
and losses. This agreement must preferably be in writing and duly signed bythe all the partners.

Private Limited Companies

Private Limited Companies have separate legal identities to their owners, and thus their owners have limited
liability. The company has continuity, and can sell shares to friends or family, although with the consent of all
shareholders. This business can now make legal contracts. Abbreviated as Ltd (UK), or Proprietary Limited,
(Pty) Ltd.

The sale of shares make raising finance a lot easier.

Shareholders have limited liability, therefore it is safer for people to invest but creditors must be
cautious because if the business fails they will not get their money back.

Original owners are still able to keep control of the business by restricting share distribution.

Owners need to deal with many legal formalities before forming a private limited

o The Articles of Association: This contains the rules on how the company will be managed. It states the rights
and duties of directors, the rules on the election of directors and holding an official meeting, as well as the
issuing of shares.
o The Memorandum of Association: This contains very important information about the company and directors.
The official name and addresses of the registered offices of the company must be stated. The objectives of the
company must be given and also the amount of share capital the owners intend to raise. The number of shares
to be bought b each of the directors must also be made clear.
Public Limited Companies
Public limited companies are similar to private limited companies, but they are able to sell shares to the public.
A private limited company can be converted into a public limited company by:
A statement in the Memorandum of Association must be made so that it says this company is
a public limited company.

All accounts must be made public.


The company has to apply for a listing in the Stock Exchange.

A prospectus must be issued to advertise to customers to buy shares, and it has to state how the capital raised
from shares will be spent.

Limited liability.


Potential to raise limitless capital.

No restrictions on transfer of shares.

High status will attract investors and customers.


Many legal formalities required to form the business.

Many rules and regulations to protect shareholders, including the publishing of annual accounts.

Selling shares is expensive, because of the commission paid to banks to aid in selling shares and costs
of printing the prospectus.

Difficult to control since it is so large.

Owners lose control, when the original owners hold less than 51% of shares.

Control and ownership in a public limited company:

The Annual General Meeting (AGM) is held every year and all shareholders are invited to attend so that they
can elect their Board of Directors. Normally, Director are majority shareholders who has the power to do
whatever they want. However, this is not the case for public limited companies since there can be millions of
shareholders. Anyway, when directors are elected, they have to power to make important decisions. However,
they must hire managers to attend to day to day decisions. Therefore:

Shareholders own the company

Directors and managers control the company

This is called the divorce between ownership and control.

Because shareholders invested in the company, they expect dividends. The directors could do things other than
give shareholders dividends, such as trying to expand the company. However, they might loose their status in
the next AGM if shareholders are not happy with what they are doing. All in all, both directors and
shareholders have their own objectives.


Break-even analysis is a technique widely used by production management and management
accountants. It is based on categorising production costs between those which are "variable"
(costs that change when the production output changes) and those that are "fixed" (costs not
directly related to the volume of production).
Total variable and fixed costs are compared with sales revenue in order to determine the level of
sales volume, sales value or production at which the business makes neither a profit nor a
loss (the "break-even point").
The Break-Even Chart
In its simplest form, the break-even chart is a graphical representation of costs at various levels
of activity shown on the same chart as the variation of income (or sales, revenue) with the same
variation in activity. The point at which neither profit nor loss is made is known as the "breakeven point" and is represented on the chart below by the intersection of the two lines:

In the diagram above, the line OA represents the variation of income at varying levels of
production activity ("output"). OB represents the total fixed costs in the business. As output
increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At
low levels of output, Costs are greater than Income. At the point of intersection, P, costs are
exactly equal to income, and hence neither profit nor loss is made.
Fixed Costs
Fixed costs are those business costs that are not directly related to the level of production or
output. In other words, even if the business has a zero output or high output, the level of fixed
costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result of
investment in production capacity (e.g. adding a new factory unit) or through the growth in
overheads required to support a larger, more complex business.
Variable Costs
Variable costs are those costs which vary directly with the level of output. They represent
payment output-related inputs such as raw materials, direct labour, fuel and revenue-related costs
such as commission.
A distinction is often made between "Direct" variable costs and "Indirect" variable costs.
Direct variable costs are those which can be directly attributable to the production of a particular
product or service and allocated to a particular cost centre. Raw materials and the wages those
working on the production line are good examples.
Indirect variable costs cannot be directly attributable to production but they do vary with output.
These include depreciation (where it is calculated related to output - e.g. machine hours),
maintenance and certain labour costs.
Semi-Variable Costs
Whilst the distinction between fixed and variable costs is a convenient way of categorising
business costs, in reality there are some costs which are fixed in nature but which increase when

output reaches certain levels. These are largely related to the overall "scale" and/or complexity of
the business. For example, when a business has relatively low levels of output or sales, it may
not require costs associated with functions such as human resource management or a fullyresourced finance department. However, as the scale of the business grows (e.g. output, number
people employed, number and complexity of transactions) then more resources are required. If
production rises suddenly then some short-term increase in warehousing and/or transport may be
required. In these circumstances, we say that part of the cost is variable and part fixed.

Cost concepts


The term cost means the amount of expenses [actual or notional] incurred on or attributable to
specified thing or activity. As per Institute of cost and work accounts (ICWA) India, Cost is
measurement in monetary terms of the amount of resources used for the purpose of production
of goods or rendering services.
Elements of cost
Cost of production/manufacturing consists of various expenses incurred on
production/manufacturing of goods or services. These are the elements of cost which can be
divided into three groups: Material, Labour and Expenses.
To produce or manufacture material is required. For example to manufacture shirts cloth is
required and to produce flour wheat is required. All material which becomes an integral part of
finished product and which can be conveniently assigned to specific physical unit is termed as
Direct Material. It is also described as raw material, process material, prime material,
production material, stores material, etc. The substance from which the product is made is known
as material. It may be in a raw or manufactured state. Material is classified into two categories:
Direct Material
Indirect Material
Direct material
Direct Material is that material which can be easily identified and related with specific product,
job, and process. Timber is a raw material for making furniture, cloth for making garments,
sugarcane for making sugar, and Gold/ silver for making jewellery, etc are some examples of
direct material.
Indirect material
Indirect Material is that material which cannot be easily and conveniently identified and related
with a particular product, job, process, and activity. Consumable stores, oil and waste, printing
and stationery etc, are some examples of indirect material. Indirect materials are used in the
factory, the office, or the selling and distribution department.
Labour is the main factor of production. For conversion of raw material into finished goods,
human resource is needed, and such human resource is termed as labour. Labour cost is the main
element of cost in a product or service. Labour can be classified into two categories:
Direct Labour, and
Indirect labour

Direct labour
Labour which takes active and direct part in the production of a commodity. Direct labour is that
labour which can be easily identified and related with specific product, job, process, and activity.
Direct labour cost is easily traceable to specific products. Direct labour costs are specially and
conveniently traceable to specific products. Direct labour varies directly with the volume of
output. Direct labour is also known as process labour, productive labour, operating labour, direct
wages, manufacturing wages, etc. Cost of wages paid to carpenter for making furniture, cost of a
tailor in producing readymade garments, cost of washer in dry cleaning unit are some examples
of direct labour.
Indirect labour
Indirect labour is that labour which can not be easily identified and related with specific product,
job, process, and activity. It includes all labour not directly engaged in converting raw material
into finished product. It may or may not vary directly with the volume of output. Labour
employed for the purpose of carrying out tasks incidental to goods or services provided is
indirect labour. Indirect labour is used in the factory, the office, or the selling and distribution
department. Wages of store-keepers, time-keepers, salary of works manager, salary of salesmen,
etc, are all examples of indirect labour cost.
All cost incurred in the production of finished goods other than material cost and labour cost are
termed as expenses. Expenses are classified into two categories:
Direct expenses, and
Indirect expenses (An item of overheads)
Direct expenses
These are expenses which are directly, easily, and wholly allocated to specific cost center or cost
units. All direct cost other than direct material and direct labour are termed as direct expenses.
Direct expenses are also termed as chargeable expenses. Some examples of the direct expenses
are hire of special machinery, cost of special designs, moulds or patterns, feed paid to architects,
surveyors and other consultants, inward carriage and freight charges on special material, Cost of
patents and royalties.
1. Cost center means a location, person, or item of equipment or group of these for which costs
may be ascertained and used for the purpose of cost control.
2. Cost object is anything for which a separate measurement of cost is desired. It may be a
product, service, project, or a customer.
Indirect expenses
These expenses cannot be directly, easily, and wholly allocated to specific cost center or cost
units. All indirect costs other than indirect material and indirect labour are termed as indirect
Indirect Expenses = Indirect cost Indirect material Indirect labour.
Indirect expenses are treated as part of overheads. Rent, rates and taxes of building, repair,
insurance and depreciation on fixed assets, etc, are some examples of indirect expenses.
The term overhead has a wider meaning than the term indirect expenses. Overheads include the
cost of indirect material, indirect labour and indirect expenses. This is the aggregate sum of
indirect material, indirect labour and indirect expenses.
Overhead = Indirect material + Indirect labour + Indirect expenses
Overheads are classified into following three categories:
Factory/works/ production overheads


Office and administrative overheads

Selling and distribution overheads

Factory/works overheads
All indirect costs incurred in the factory for production of goods is termed as factory/works
overheads. Such costs are concerned with the running of the factory or plant. These include
indirect material, indirect labour and indirect expenses incurred in the factory. Some examples
are as follows:
Indirect materials:
(i) Grease, oil, lubricants, cotton waste etc.
(ii) Small tools, brushes for sweeping, sundry supplies etc.
(iii) Cost of threads, gum, nails, etc.
(iv) Consumable stores
(v) Factory printing and stationery
Indirect wages
(i) Salary of factory manager, foremen, supervisors, clerks etc.
(ii) Salary of storekeeper
(iii) Salary and fee of factory directors and technical directors
(iv) Contribution to ESI, PF., Leave pay etc. of factory employee.
Indirect expenses
(i) Rent of factory buildings and land
(ii) Insurance of factory building, plant, and machinery

Municipal taxes of factory building

(iv)Depreciation of factory building, plant and machinery, and their repairs and maintenance
(v) Power and fuel used in factory
(vi)Factory telephone expenses.
Office and administrative overheads
These expenses are related to the management and administration of the business. They are
incurred for the direction and control of an undertaking. These represent the aggregate of the cost
of indirect material, indirect labour, and indirect expenses incurred by the office and
administration department of an organisation. Some examples are as follows:
Office printing and stationery, Cost of brushes, dusters etc. for cleaning office building and
equipments, Postage and stamps. Salary of office manager, clerks, and other employees, Salary
of administrative directors, Salaries of legal adviser, Salaries of cost accountants and financial
accountants, Salary of computer operator. Rent, insurance, rates and taxes of office building,
Office lighting, heating and cleaning, Depreciation and repair of office building, furniture, and
Equipment etc., Legal charges, Bank charges, Trade subscriptions, Telephone charges, Audit fee
Selling and distribution overheads
Selling and distribution overheads are incurred for the marketing of a commodity, for securing
order for the articles, dispatching goods sold or for making efforts to find and retain customers.
These expenses represent the aggregate of indirect material, indirect labour, and indirect

expenses incurred by the selling and distribution department of the organisation. These
overheads have two aspects (i) procuring orders (ii) executing the order. Based upon this concept
the selling and distributions are studied separately.
I. Selling overheads
Indirect costs incurred in relation to the procurement of sale orders are termed as selling
overheads. Some of the examples of selling overheads are as follows:
Indirect material
(i) Catalogues, price list (ii) Printing and stationery
(iii) Postage and stamps (iv) cost of sample
Indirect wages
(i) Salaries of sales managers, clerks and other employees
(ii) Salaries and commission of salesmen and technical representatives
(iii) Fees of sales directors
Indirect expenses
(i) Advertising
(ii) Bad debts
(iii) Rent and insurance of showroom
(iv) Legal charges incurred for recovery of debts
(v) Travelling and entertainment expenses
(vi) Expenses of sending samples
(vii) Market research expenses.
II. Distribution overheads
Indirect costs incurred in relation to the execution of the sales order is termed as distribution
overheads. Some of the examples of distribution overheads are as follows:
Indirect material
(i) Cost of packing material
(ii) oil, grease, spare parts etc. for maintaining delivery vans
Indirect wages
(i) Salaries of godown employees
(ii) Wages of drivers of delivery vans
(iii) Wages of packers and dispatch staff.
Indirect expenses
(i) Packing expenses
(ii) Godown rent, insurance, depreciation, and repair etc.
(iii) Freight carriage outwards and other transport charges.
(iv) Running expenses of delivery vans, repair, and depreciation.
(v) Insurance in transit etc.
Costs are classified into following categories:
1. Cost behavior basis
(a) Fixed Cost
(b) Variable cost
(c) Semi-variable cost

2. Cost inventory basis

(a) Product cost and
(b) Period cost
3. Cost Relation to Cost Centre basis
(a) Direct and
(b) Indirect costs
4. Cost Classifications for Decision-Making
(a) Differential cost
(b) Opportunity cost
(c) Sunk cost
1. Cost behavior basis
(a) Fixed Cost
A cost that remains constant within a given period of time and range of activity in spite of
fluctuations in production. Per unit fixed cost varies with the change in the volume of
production. If the production increases, fixed cost per unit decreases and as there is decrease in
production, the fixed cost per unit increases. Rent and insurance of building, depreciation on
plant and machinery, salary of employees etc., are some examples of fixed costs.
(b) Variable cost
Variable costs are those cost which vary directly in proportion to change in volume of
production/output. The cost which increases or decreases in the same proportion in which the
units produced is termed as variable cost. Direct material, direct labour, direct expenses, variable
overheads are some examples of variable cost.
(c) Semi-variable cost
A cost contains both fixed and variable component and which is thus partly affected by
fluctuations in the level of activity. Semi-variable costs is that cost of which some part remains
fixed at the given level of production and other part varies with the change in the volume of
production but not in the same proportion of change in production
2. Costs by inventory:
Product cost and period cost
Product costs are those cost which are charged and identified with the product and included in
stock value. In other words, the costs that are the cost of manufacturing a product are called
product cost. Product cost includes direct material, direct labour, direct expenses, and
manufacturing overheads. Period costs are those costs which are not charged to products but are
written off as expenses against revenue of the period during which these are incurred. They are
not transferred as a part of value of stock to the next accounting year. They are charged against
the revenue of the relevant period. Period costs include all fixed costs and total administration,
selling and distribution costs.
3. Cost Relation to Cost Centre:
Direct and Indirect costs
All costs are subdivided into direct and indirect costs. The concept of direct and indirect cost is
of basic importance in costing. Costs which are easily and directly allocated to products or units
are termed as direct cost. Direct costs include all traceable costs. In the process of manufacturing
of a product, materials are purchased, wages are paid to labour, and certain other expenses are
also incurred directly. All these expenses are called as direct costs. The expenses incurred on
those items which are not directly charged to a single product because they are incurred for many
products are termed as indirect Costs. The example of indirect costs are Oil and scrap materials,

[indirect materials], salary of factory supervisors [indirect labour],rent rates and depreciation
[indirect expenses]. Indirect costs, often referred to as overheads have to be apportioned to
different products on suitable criterion/criteria.

4. Cost Classifications for Decision-Making. Every decision involves choosing from among at
least two alternatives. Only those costs and benefits that differ between alternatives are relevant
in making the selection. This concept is explored in greater detail in the chapter on relevant
costs. However, decision-making contexts crop up from time to time in the text before that
chapter, so it is a good idea to familiarize students with relevant cost concepts.
1. Differential Costs. A differential cost is a cost that differs between alternatives. The cost may
exist in only one of the alternatives or the total amount of the cost may differ between the
alternatives. In the latter case, the differential cost would be the difference between the cost
under one alternative and the cost under the other. Differential costs are also called incremental
costs. Differential costs and opportunity costs should be the focus of decision-making. They are
the only relevant costs and all others should be ignored.
2. Opportunity Costs. An opportunity cost is the potential benefit that is given up by selecting
one alternative over another. The concept of an opportunity cost is rather difficult for students to
understand because it is not an actual expenditure and it is rarely (if ever) shown on the
accounting books of an organization. It is, however, a cost that must be considered in decisions.
3. Sunk Cost. A sunk cost is a cost that has already been incurred and that cannot be changed by
any decision made now or in the future. Since sunk costs cannot be changed and therefore cannot
be differential costs, they should be ignored in decision making. While students usually accept
the idea that sunk costs should be ignored on an abstract level, like most people they often have
difficulty putting this idea into practice.