Session Objectives:

 The basis of classifying costs

 The various types of costs

 An introduction to the concept of cost Centers and cost units; and

 The various techniques used in costing

The bases of classifying costs are the nature of cost, function, direct/indirect, variability,
controllability, normality, capital/revenue, time, planning and control, managerial decisions etc.
The classification of costs is done based on these factors. The concept of cost center refers to the
smallest segment of activity or area of responsibility for which costs are accumulated. A cost unit
is nothing but a unit of output in the production of which the costs are incurred. The techniques of
costing can be classified as historical costing, absorption costing, marginal costing, direct costing,
standard costing and uniform costing
Different Basis for classification of
Cost

The nature of cost is the basis on which costs are classified. Depending on the nature of costs,
costs can be classified into material cost, labor cost and overheads. Each of these costs can
further be classified. Materials can be classified under raw material components, spare parts,
consumable stores etc. Likewise, labor and Others can also be classified.
Costs can also be classified based on the functions of a business undertaking or basic
managerial activities. The various functions can be production, administration, selling etc.
We can classify the costs considering the cost, whether direct or indirect. Direct costs are those
incurred for and may be conveniently identified with a particular cost centre or cost unit.
Indirect costs are incurred for the benefit of number of cost centres or units and cannot be
conveniently apportioned to a particular cost unit or centre.
As per the basis of variability, the behavior of costs is considered in relation to the changes in
the levels of activity or volumes of production.
On the basis of controllability, costs are classified as controllable costs and uncontrollable costs.
Controllable costs can be brought down through proper management intervention where as
uncontrollable costs lie beyond the control of the cost managers.
On the basis of normality, costs are classified into normal costs and abnormal costs.
Costs can be incurred for purchasing a fixed asset which can be used for a longer period of
time. There can be other expenditure incurred to maintain the earning capacity of the
organization like the cost incurred for maintaining an asset or running a business. Thus, on this
basis, costs are classified as capital expenditure and revenue expenditure.
On the basis of Time costs can be classified into historical costs and predetermined costs.
Planning and control classifies costs into budgeted costs and standard costs.
On the basis of managerial decisions, costs can be marginal cost, out of pocket cost, differential
cost, sunk cost, imputed cost, opportunity cost , replacement cost and avoidable and
unavoidable cost.
There exist other classifications like future cost, programmed cost, joint cost, conversion cost,
discretionary cost and committed cost.
A bird’s view of the different classification of
Cost

The different types of costs are identified with reference to the bases on which the costs are
classified. The various types of costs are:

 Nature

 Material costs

 Labor costs

 Overhead

 Function

 Manufacturing cost

 Commercial cost

 Direct or indirect

 Variability

 Fixed costs

 Variable cost; and

 Semi-variable cost

 Controllability

 Controllable cost; and

 Uncontrollable cost

 Normality

 Normal cost

 Abnormal cost

 Capital or revenue

 Time

 Historical cost

 Predetermined cost

 Planning and control

 Budgeted costs

 Standard costs
 Managerial decisions

 Marginal Cost

 Out of pocket cost

 Differential Costs

 Sunk Costs

 Imputed Costs

 Opportunity Costs

 Replacement Costs

 Avoidable/Unavoidable Costs

 Other costs

 Future Costs

 Programmed Costs

 Joint Costs

 Conversion Costs

 Discretionary Costs

 Committed Costs
Classification of cost on basis of nature and
Function
By nature, costs can be classified into three components –material, labor and manufacturing
overheads.
 Direct material cost refers to the cost of all the important materials used in the
production process. Small items like thread in the stitching of a suit is not to be
considered as material, since the cost of these items is small in comparison to other
important materials.
 Direct labor costs refer to the costs on important labor performed on the product itself.
Here also, only the material amount spent for the labor is to be considered.
 Manufacturing overheads refer to all costs necessary for the production of a product
except direct material costs and direct labor cost.

Manufacturing Overhead = Cost of Production- direct material cost -direct labor cost
By function, costs can be classified as Manufacturing Costs or Production Costs and Commercial
Costs.
 Production Costs refer to the total cost incurred to complete the manufacturing process.
 Commercial Costs refer to the total cost incurred in the operation of the business undertaking other than the
cost of production. For e.g. administrative or selling expenses are not directly related with the manufacturing
process of a product.

Classification on the basis of Traceability, Variability and

Controllability
Costs can be classified as direct costs and indirect costs.
 A direct cost is a cost that can be specifically identified with a cost object.
 An indirect cost is that type of cost that is incurred for different cost centers.
Costs can be classified according to their variability also. In that process costs are classified
under- fixed cost, variable cost and semi-variable cost.

 Fixed costs refer to costs that are stable independent of any

 changes in the volume of activity.

 Variable costs refer to costs that change in direct proportion to changes in volume of
activity.

 Semi-variable costs refer to costs which are partly variable and partly fixed.

Based on the control mechanism, costs can be classified as controllable costs and uncontrollable
costs.
 Controllable cost- if a cost item is dependent on the decision or activity of a manager
then this cost can be termed as controllable cost.
  Uncontrollable cost is a cost that is beyond the control of a manager.

The distinction between controllable and uncontrollable costs is not always very clear and thus it
may be left to individual judgment also. Some expenditure which may be uncontrollable in the short-
term, may not be so in the long-term. Thus a careful analysis is required to be done before
classifying costs on the basis of controllability.
Classification on basis of Normality, Financial Accounting classification & On the basis
of time.

Normal cost is the cost, which is normally incurred at a given level of output under conditions in
which that level of output is normally attained. It is a part of cost of production.
Abnormal cost is the cost, which is not normally incurred at a given level of output under
conditions in which that level of output is normally attained. It is not a part of cost of
production and is charged to costing profit and loss account.
Capital cost refers to the cost incurred in purchasing a capital asset and revenue expenditure
refers to the cost incurred in maintaining the earning capacity of an organization.
Historical cost is the actual cost, determined after the event. Historical cost valuation states
about costs of plant and materials. Historical costs are advised to be adjusted to reflect current
or future price levels.

Predetermined costs are estimated costs. These are computed in advance of production, taking into
consideration the previous period costs and factors affecting such costs.
Classification on the basis of Planning & Control and For Managerial
Decisions

Budgeted costs represent an estimate of expenditure for different phases of business

operations. Various budgets are prepared for various phases in the process of production.
Standard cost refers to the predetermined cost based on a technical estimate for materials,
labor and OH for a selected period of time and for a prescribed set of working conditions.
Marginal cost is the variable cost of one unit of a product or a service. In short, MC is a cost
that is avoided if the unit was not produced or provided. Marginal cost is the amount at any
given volume of output by which aggregate costs are changed if the volume of output is either
increased or decreased.
Out of pocket cost is a cost that will necessitate a corresponding outflow of cash. These costs
involve cash outlays or payments to other parties. Out of pocket costs are relevant in some
decision-making problems such as fluctuation of prices during recession, make or buy decisions
etc.
Differential cost is the extra cost of taking one course of action against another alternative. It is
also called as incremental cost. It is the additional cost due to a change in the level or nature of
business activity.
Sunk costs are those costs that have been invested in a project and which will not be recovered
if the project is terminated. The sunk cost is the cost for which the expenditure has already
taken place in the past. This cost is not affected by a particular decision that is under
consideration.
Imputed cost is a cost that doesn’t involve actual cash outlay, which is used only for the
purpose of decision-making and performance evaluation. It is a hypothetical cost from the point
of view of financial accounting. Interest on capital is a common type of imputed cost.
Opportunity cost refers to the value of a benefit that is sacrificed in favor of an alternative
course of action. It is the maximum amount that could be obtained at any given point of time if
a resource was sold or put to the most valuable alternative practicable use.
Replacement cost is the purchase cost of an asset or material identical to that which is being
replaced or revalued.

Avoidable cost refers to the cost that will be incurred if an activity is not undertaken or discontinued.
Avoidable costs often correspond with variable costs. They can be identified with an activity or
sector of a business and are avoided if that activity or sector did not exist. Unavoidable cost is that
cost which will not be eliminated with the discontinuation of a product or department.
Other types of cost not falling under the above
classifications

Future costs are those costs that are expected to be incurred in the future.
Programmed costs are those costs which are incurred as a result of the policies taken by the
top management which results in periodic appropriations.
Joint cost is the cost which is common to the processing of joint products and by-products till
the point of separation and cannot be traced to particular products before the point of split-off.
Conversion cost is the cost incurred for converting the raw material into finished products. It is
referred to as the production cost excluding the cost of direct materials.
Discretionary costs are those costs that are not essential for the decisions under consideration
or for the accomplishment of management objectives.
Committed cost is a cost over which management has little discretion, like the cost that is
primarily associated with maintaining the organization’s legal and physical existence. The
committed cost is a fixed cost which results from decisions of a prior period. The amount of
committed cost is fixed by decisions that are made in the past and not subject to managerial
control in the short run.

What are Cost Centers?

What are the different types of Cost Centers?
Cost centers refer to the smallest segments of activity or area of responsibility for which costs
are accumulated. It can be a person, location or item of equipment for which cost may be
ascertained and used for the purpose of cost control.
From a functional point of view, a cost centre may be relatively easy to be established, because
a cost centre is any unit of the organization to which costs can be separately attributed.
Example of cost centers are a production department, a machine or group of machines with in a
department or a work group etc.
The different types of cost centers are

a. personal and impersonal

b. production and service; and
c. process cost centre
A cost centre that consists of a person or group of persons is called personal cost centre. A cost
centre that consists of a location or item of equipment is called impersonal cost centre.
Production cost centers, are engaged in production activities through conversion of raw material
into finished products. Service cost centers are ancillary centers and render service to other
production and service cost centers.

Process cost centre is one in which a specific process or a continuous sequence of operations is
carried out.
Cost Unit

Cost unit refers to the costs incurred for the production of a unit of output. It is a unit of
quantity of product, service or time or a combination of these in relation to which costs are
expressed or ascertained.

The relation between cost centre and cost unit is that the costs of a function or activity are allocated
to the cost centre. The cost units that pass through the cost center, the direct and indirect costs of the
cost centre are charged to the units of production by means of an absorption rate. The unit of output
in relation to which costs are incurred by a cost centre is expressed as cost unit. It is useful
measurement of costs for comparative purposes.
Techniques of
Costing

Historical costing- Under this approach, actual costs are ascertained after they have been
incurred. This is a conventional method of cost ascertainment.
Absorption Costing – is also known as full costing. This refers to a system in which all the
fixed manufacturing overheads are allocated to products.
Marginal Costing – is the process of ascertaining marginal costs and of the effects of changes
in volume or type of output on profit by differentiating between fixed and variable costs.
Direct Costing – refers to the ascertainment of direct costs in respect of department, process
or product. This is marginal cost plus fixed cost which is directly chargeable to the department,
process or product.
Standard Costing – refers to the ascertainment and use of standard costs and measurement
and analysis of variances. It is a scientifically pre-determined cost which is fixed in advance of
production for each element of costs.

Uniform Costing – refers to the use of the same costing principles and practices by several
undertakings with a view to achieve uniformity in approach and system.
Statement of Cost or Cost Sheet
Cost Sheet is a statement, which provides for assembly and depiction of the detailed cost in
respect of cost centers and cost units. Data is collected from various sources to incorporate in the
cost sheet. Cost sheet is only a statement. It is not a part of double entry cost accounting
records.

Specimen of Cost Sheet

Particulars Total Cost (Rs.) Cost per unit (Rs.)

Direct Materials
Direct Labor
Prime Cost
Add: Works Overheads
Works Cost
Add: Administration Overheads
Cost of Production
Add: Selling and Distribution Overheads
Total Cost or Cost of Sales
Profit
Sales

Items Excluded from Cost

The following items are not included while preparing a cost sheet
 a. Interest Paid
b. Dividends Paid

c. Transfer to Reserves

d. Donations Paid

e. Preliminary Expenses Written Off

f. Goodwill Written Off

g. Cash Discount Paid

h. Provision for Taxation

i. Provision for Income Tax

j. Profit/loss on Sale of Fixed Assets etc.

The proforma of the Comprehensive Cost Sheet, i.e., with stocks, is as under:

Opening Stock Raw Materials

Add: Purchases (including Carriage Inwards, Transit Insurance
etc.)
Less: Closing Stock of Raw Materials
– Direct Materials Consumed
– Direct Labor
– Direct Expenses
Prime Cost
Add: Factory Overheads (Works OH / Manufacturing OH /
Production OH)
Add: Opening Stock of Work in Progress
Less: Closing Stock of Work in Progress
Factory Cost / Work Cost
Add: Administration Overheads
Cost of Production
Add: Opening Stock of Finished Goods
Less: Closing Stock of Finished Goods
Cost of Goods Sold
Add: Selling and Distribution Overheads
Cost of Sales
Add: Profit/Loss (Balancing Figure)
Sales

SUMMARY
:
 What are the bases on which costs can be classified ?
 Trace the classification of costs
 Explain cost center and cost unit
 Different techniques of costing