Cost Terms, Concepts and

Classifica

tion 2
s

Cost, a frequently used word in all types of organizations-

manufacturing, non-manufacturing, business, service and retail. The
process of management functions involves planning, control, decision
making as well as co-ordination. One of the most important inputs in
managerial decision making is cost data. Managerial decision making is
the process of choosing among alternative courses of action; if there is no
alternatives, there is no decision to make. Before communicating
information effectively to others, management accountants must clearly
understand the differences among various types of costs, their
 School of Business
computations, and their usage. Successful managers are certainly aware
that it is the level of cost relative to revenue that determines the firm's
overall profitability. Different types of costs are used in different
situations. So in any business activity concerned with making maximum
profit from available resources, some information on cost is essential. An
important first step in studying management accounting is to gain an
understanding of the various types of costs incurred by organizations. In
this unit we will learn the widely recognized cost terms, concepts, and
their classifications that is necessary to understand and communicate cost
and management accounting information.

Blank Page # 2

Unit-2 Page-2
Lesson 1: The Concept of Cost and Third, cost
measurement is
General Cost Classification always related to a
Learning objectives purpose, that is, to
After completing this lesson, you are expected to be able to: a cost object. A
cost object is an
 Understand the concept of cost.
activity or
 Distinguish between cost, expenses and losses. resource for which
 State the importance of cost classification. a separate
 Cost classify according to natural characteristics. Cost is the amount
measured by the
 Make the cost classification according to changes in the volume of current monetary
activity. value of economic
resources given up
or to be given up in
Introduction obtaining goods and
services.
There is a controversy over the concept of costs, the definition of costs and
A cost object is an
what costs are relevant for managerial decision making. Most of the activity or
controversy disappears as soon as it is realized that cost information is resource for which
essential for various purposes and for different kinds of problems. Cost data a separate
measurement of
that are classified and recorded in a particular way for one purpose may be costs is desired.
inappropriate for another purposes. The important point is that different
cost concepts and classification are used for different purposes. Clear
understanding of the concepts of costs and their classification would enable
A cost is the value
the managerial accountant to provide useful and appropriate cost data for of assets given up,
managerial decision making. or to be given up, to
acquire other
assets,
The Concepts of Cost i.e. cost is a
sacrifice of
Cost reflects a monetary measure of the resources given up to attain some resources. Expenses
objectives such as acquiring a good or service. Cost is a monetary measures are costs that are
of the amount of resources used for a cost object. So a cost object or applicable to the
objectives is an objective where cost is measured i.e. it is an activity or item current accounting
period.
for which a separate measurement of cost is desired. Broadly speaking cost
is the amount measured by the current monetary value of economic
resources given up or to be given up in obtaining goods and services. Expense means a
decrease in owners
Economic resources may be given up by transferring cash or other equity that arises
property, issuing capital stock, performing services, or increasing liabilities. from the operation
From the above definition, it will be clear that three ideas are included in of a business during
a specified
the concept of cost. accounting period.
First, the most basic nation is that cost measures the use of resources. The
resources used in producing tangible goods or intangible services are A loss is an
physical quantities of material, hours of labour services and quantities of unplanned cost
expiration and
other services. when assets are
Second, cost measurement is expressed in monetary terms. Money provides given up for nothing
in return, the value
a common denominator that permits the amount of resources, each of the assets given
measured according to its own scale (kilograms of materials, hours of up becomes a loss.
labour) to be aggregated so that the total amount of resources used can be A more precise
definition restricts
determined. the use of the term
 School of Business

loss, stating that the cost expiration which does not benefit the revenue producing The following
activities of a firm.
figure shows the
relationship
among costs,
expenses and
losses.
Assets
Statement
Exchanged for other
assets Costs
Inventory and other
assets on
Balance
Sheet

Cost of goods sold or s

Classification is the arrangement of cost items in logical groups. other
Exchanged for
revenue
Expense
measurement of costs is desired. A cost object can be a thing, such as a
expenses on the
product or asset, it can be the provision of a service, it can be segment, such income
as parquet centre, a department, or other organizational unit, it can be the stateme
conduct of a programme or it can be the operation of an entity. nt
Costs, Expenses and Losses: It is important to distinguish costs, expenses
and losses. But before that it is necessary to understand what and asset is Exchanged nothing
Normally a cost is viewed as an asset if it can be shown that it has future in return Separate
service potential that can be identified. For example, prepayment of non-operating item
insurance premium. Now as we have already understood a cost is the value on
of assets given up, or to be given up, to acquire other assets, i.e. cost is a income statement (if
sacrifice of resources. Expenses are costs that are applicable to the current immaterial
accounting period. Expenses in its broadest sense includes all expired costs, Losses in size
often included in
i.e. costs which do not have any potential future economic benefit. The
other expenses.)
term expense is the cost of services or benefits received, or resources
consumed during an accounting period. The term "cost is not synonymous
with expense". Expense means a decrease in owners equity that arises from Figure:
the operation of a business during a specified accounting period, whereas Relationship of
cost means any monetary sacrifice whether or not the sacrifice affects the Costs, expenses and
owners equity during a given accounting period. Example, cost of good losses.
sold and selling and distribution expenses.
A loss is an unplanned cost expiration and for this reasons is often included
in the broad definition of expense. When assets are given up for nothing in
return, the value of the assets given up becomes a loss. A more precise
definition restricts the use of the term loss, stating that the cost expiration
which does not benefit the revenue producing activities of a firm.
Examples, unrecovered book value on the sale of fixed assets, the write-off
goodwill, carelessly destroyed supplies etc.

Unit-2 Page-4
 Bangladesh Open University

General Cost Classification Industry/Product Dire

Classification of costs is the process by which costs are grouped according Garments industry - Shirt Clot
to some common characteristics. Classification is the arrangement of cost Cloth Industry - Cloth Yarn
items in logical groups having regard to their nature
Jute industry - Sack Cloth Jute
(subjective classification) or purpose (objective L
classification) to be achieved and requirement a
of an organizations. Subjective classification is b
used to indicate the nature of the expenditure, o
for example, material, labour; whereas u
objective classification indicates the cost r
centre or cost unit where the costs are to be :
charged. Cost classifications are needed for the
development of cost data and each L
classification throws light on the different a
aspects of the decision making process. In this b
lesson, cost classifications are used to define o
costs in terms of their relationships to the u
following items: r
 natural characteristics.
i
 changes in the volume/levels of activity.
s
 tractability of the product.
 association with product or period. c
 the nature of functions. o
n
 relation with accounting period.
s
 the time of cost determination. i
 the nature of data. d
 the nature of prediction. e
r
 the management policies.
e
 Managers' relevancy of decision making and analysis. d

1. Classification of Cost According to Natural a

Characteristics: According to this s
classification, costs are divided into three
categories; i.e. Material, labour and other t
costs. h
e
• Material: Material is rated as the first
element of cost because without material s
to work upon nothing can be e
manufactured. Conversion of material in c
the production process increases the utility o
of the finished product. Material can be n
divided as (a) direct material and (b) d
indirect material.
e

Management Accounting Page-5

 School of Business

lement of cost because without labour the ta s,

form, shape or nature of material cannot be x depreci
changed to increase its usefulness. This e ation
cost can also be of two types, (a) direct s (other
labour and (6) indirect labour. o than
n that
Wage which can be economically traced to
r comput
the output is known as direct labour and
e ed
on the other hand, salaries paid to
al under
supervisor, cleaner, guard and production
e the
manager are treated as indirect
st units of
labour/wages.
at producti
• Other Costs: All other manufacturing e, on
costs are classified as the third elements m method)
i.e. other costs, because, unless certain ai ,
other costs are n insuran
A fixed cost is furnished to make possible labours work upon the te ce are
that which
raw material furnished. n good
tends to a exampl
remain
unchanged
Classification of costs according to natural n es of
despite often characteristics is important because it is necessary to c fixed
wide changes know the cost of each element that enters into a e costs.
in output or product to answer to the questions relating to stock
activity. a Fixed
valuation, decision making, and controlling the n costs
incurred, organisation’s activities. d are
material
2. Classification according to changes in the r someti
cannot be
volume/levels of activity: Within a period, a particular e mes
worked
cost may be observed changing with corresponding p termed
upon by
changes in some measures of activity. Hence, costs are ai as
labour.
classified according to their behaviour in relation to rs "capacit
Example
changes in the volume of output (production), which o y cost"
s of this
others, as they are incurred in relation to time, remain f because
types of
more less fixed in amount. Accountants describe a given b fixed
costs
cost behaviour pattern according to the way its total cost u costs
include
(rather than its unit cost) reacts to changes in a related il are
tools
measure of activity. d generall
must be
i y
supplied, On this basis, costs are classified into the four categories, n incurred
supervisi viz., fixed, variable, semi-fixed and semi-variable:. g to
on must
 Fixed Costs: A cost that is not immediately affected s create
be
by changes in the cost driver. Activities that affect a facilitie
exercised
costs are often called cost driver. A fixed cost is that n s.
,
which tends to remain unchanged despite often wide d
machiner
changes in output or activity. On a per unit basis, a g
y must be
fixed cost varies inversely with changes in the level r
maintain
of activity. This means that the per unit fixed cost o
ed, a
decreases with increase in the activity level, and u
place of
increases with decrease in the activity level. The rent n
work
of buildings of an organization, supervisor’s salaries, d
must be

Unit-2 Page-6
 Bangladesh Open University

2.1 (A & B) Illustrates the Unithibit

fixed2.1
cost
behaviour of fixed cost found in (b) :
the following tabulation of fixed Graph of
cost Table # 2.1 unit
2,500
fixed
2,000 cost.
Total Fixed Cost
1,500
The graph
1,000
illustrates
500
that total
fixed cost
remains
unchange
Activity (or Cost driver) Fixed Cost per unit Total Fixed Cost 5 d
(Tk.) (Tk.) 0 irrespecti
10 2,500 25,000 ve of
1 whether
20 1,250 25,000 0 activity
100 250 25,000 0 changes.
110 227.27 25,000 When
1 activity
200 125 25,000 5 doubles
210 119.05 25,000 0 or triples,
300 83.33* 25,000 from 100
2 to 200 to
*Rounded
0 300, total
0
fixed cost
remains
2
constant
5
at
0
Tk.25,000
Tk.25000
3 .
0 However,
0 the fixed
cost per
( unit does
Activity
change
o
50 100 150 200 250 300 r level as
(or cost driver) c activity
Exhibit 2.1 (A): Graph of total fixed cost o changes.
st If activity
d level is 20
ri units, then
v the fixed
e cost per
r) unit
E declines
x to

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 School of Business

Tk.1,250 activity levels, a variable cost must be a constant v er the

and Tk.250 amount per unit. The cost of raw materials, wages, a activity
respectively sales commission, use of machine on rental basis ri level is 100
. are the good examples of variable costs. Thus, as a units, 400
Algebraically activity changes, total variable cost increases or b units or 700
, a fixed cost decreases proportionately with the activity l units.
graphs is changes, but unit variable cost remains the same. e
Algebraicall
represented A cost that varies in total in direct proportion to changes in activity c
Exhibit 2.2: Illustrates the behaviour of variable cost found in the o y, a variable
following Tabulation of variable cost Table # 2.2. st cost line in
a
Activity (or Cost driver) Variable Cost per unit Total Variable Cost the graph is
s
(Tk.) (Tk.) s represented
100 10 1,000 o
by : y = bx
200 10 2,000 c
300 10 3,000 i where; 'y' is
400 10 4,000 a the total
t
500 10 5,000 cost
e
600 10 6,000 d 'b' is
700 10 7,000 w variable
by : y = a, levels. it cost per
where; 'y' is A mixed cost is a semi-variable cost (sometimes known as a semi- h unit; and
the total cost fixed cost) that has both a fixed and variable element to it. e
and 'a' is the a 'x' is the
fixed cost. Total variable Cost c number of
h units of
 Variable
u output.
Costs:
n Mixed
A cost
it Cost: A
that
o mixed cost
changes
f is a semi-
in
a variable
direct
c cost
proporti
ti (sometimes
on to
v known as a
changes
it semi-fixed
in the
y cost) that
cost
is has both a
driver.
T fixed and
A cost
k variable
that
. element to
varies
Exhibit 2.2: Graph of total variable cost 1 it. So a
in total
0 mixed cost
in The graph illustrates that total variable cost increases w has both a
direct proportionately with activity. When activity doubles h variable and
proporti from 100 to 200 units, total variable cost doubles, from e a fixed
on to Tk.1,000 to Tk.2,000 and so on. However, the variable t component.
changes cost per unit remains the same as activity changes. The h On a per
in

Unit-2 Page-8
 Bangladesh Open University

unit basis, a direct proportion with changes in activity nor remains 'b' is the variable
mixed cost constant with changes in activity. Telephone cost is an cost per unit, and
does not example of a mixed or semi-variable cost. This is so
'x' is the number
fluctuate in because it has
of units of output
a fixed rental charge and a varaiable cost per unit
S
of telephone time used per call. This means that
t
the total telephone cost is a mixture of fixed and
e
variable costs. Another good example of a mixed
p
cost is electricity that is computed as a flat charge
(the fixed component) for basic service plus a
C
stated rate for each kilowatt-hour of electricity
o
used (the variable component).
s
t
Exhibit 2.3: Illustrates the behaviour of mixed :
costs
A

s
t
e
p

c
o
s
t

i
s
Number of Kilowatt Hours used
Exhibit 2.3: Graph of a Mixed Cost s
o
The graph illustrates the electricity charge of a
company, which consists of a flat rate of Tk.500 c
per month plus Tk.0.010 per Kwh. If the company a
uses 80,000 Kwhs of electricity per month, its total l
electricity bill is Tk.1,300 [Tk.500 + (Tk.0.010 x l
80,000]. If 90,000 Kwhs are used, the electricity e
bill is Tk.1,400. The distance between the fixed d
cost line and the total cost line in Exhibit is the
amount of variable cost. The slope of the total cost b
line is the variable cost per unit of activity. e
Algebraically, a mixed cost (semi-variable) graph is represented by; y = a c
+ bx a
u
where; 'y' is the total cost s
'a' is the fixed cost value e

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 School of Business

the cost increases in steps (or jumps) such that over

one range of output the cost remains fixed. A step
can be variable or fixed. Step variable costs have
small steps and step fixed costs have large steps.
For example; canteen staff wages. The costs are
fixed upto a certain level of output but beyond that
level as the number of workers increases to meet
the increased production an additional member of
canteen staff is required to cater the needs of
additional workers resulting in a change in canteen
staff wages.
If steps are narrow and small the behaviour pattern
approximate pure variable cost pattern [Exhibit 2.4
(A)] is termed as step-variable costs. One the
otherhand, if the steps are wider, the step cost is
termed as 'step fixed cost'. [Exhibit 2.4 (B)].

Activity (Cost driver) Activity (Cost driver)

Exhibit: 2.4 (A): Step Variable Cost Exhibit 2.4 (B):

Step Fixed Costs
When step variable or step fixed costs exist, the
accountants must choose a specific relevant range
of activity that will allow step variable cost to be
treated as variable and step fixed costs to be
treated as fixed.

Unit-2 Page-10
 Bangladesh Open University

Assignments  D policies
(a) Objective type and multiple choice questions e .
s
1. True or Fales  Make
c
cost
2. Fill in the blanks r
classifi
i
3. Select the most suitable answer cation
b
accordi
(b) e
ng to
t
Desc relevan
h
cy of
ripti e
decisio
ve r
n
o
quest making
l
and
ion e
analysi
o
(c) s.
f
Prob v
lems a
I
r
: i n
(d) Cases: o t
u r
s o
c d
o u
s
c
t
Direct costs t
are those
Lesson 2: Other General s
t i
which can be Cost Classification o
identified as o
part of the Learning objectives t n
cost of a given
product. After completing this lesson, you are expected to be able h
to: e
One of the
m
 Explain the classification of costs according to important
a
traceability to the product inputs in
n
 Distinguish between period costs and product costs managerial
a
decision-
 Describe and give examples of manufacturing costs, g making is
administrative costs, marketing costs and research e cost data.
and development costs. m
There is,
e
 Classify cost according to relation with accounting n however,
period. no single
t
concept of
 Distinguish between cost classifications according cost which
to the time of incurrence and nature of data. can cater to
 Explain cost classification according to the nature of all
production. managemen

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 School of Business

t needs. An 3. Classification according to D nters and

i indirect
important traceability to the product r costs are
objective of e not
managerial Cost control is facilitated by tracing costs to the c controllable
department or work center in which the cost was t .
accounting is c
to assist incurred. It is usually possible to determine the cost of o
managers in raw materials, labour inputs with production of each s
unit. Other items cannot be easily and accurately t
controlling s
costs. In this separated and attributed to individual units of output.
process, For the purpose of traceability of costs to product, costs a Period costs
costs are are classified as either direct or indirect. r refer to
e those items
classified in of cost
• Direct Cost: Direct costs are those which are
various c which are
incurred for a particular cost unit, and can be recognized
ways, and, at o
conveniently linked with that particular cost unit. n as expenses
different for the
Direct costs are those incurred primarily for, and t
steps in r period in
which can be identified as part of the cost of a given which they
managerial o
product. So once the cost object is specified, any l are
accounting, incurred
costs that are distinctly traceable to it are called l
some cost a and are
direct costs. Examples of direct costs include cost of charged
figures may b
direct material, direct labour, direct charges (special l against the
be placed in revenue for
tool used for product) etc. e
different the period.
classification • Indirect Cost: Indirect costs are those of a more c
. In the final general nature which cannot be identified primarily o
lesson of this as part of the cost of a given product but without s
t
unit we have which the product could not be manufactured. So s
already these costs that can not be traced are called indirect
discussed the or common costs and are allocated or assigned to the f
o Product
final two cost object using one on more appropriate r costs are
types of cost predictions or arbitrarily chosen bases. Examples of those costs
classification indirect costs include supervisors' salary, rent, rates v that are
. This lesson and taxes, lighting etc. a assigned to
r inventory
is concerned i because
with the The build-up of total cost showing how direct and o they are
other cost indirect costs are related is shown in the following u closely
classification figure: s associated
with
s mentioned Indirect costs are those which cannot be identified primarily as part
r production
in the of the cost of a given product. activities
e
s rather than
preceding with the
p
lesson. o passage of
n time.
s mentioned
i
b that direct
i costs are
l controllable
i
t costs for
y various
responsibili
c ty centers
e

Unit-2 Page-12
 Bangladesh Open University

and indirect cost which are recognized as expenses for the period sify period
Merchandise
costs are not in which they are incurred and are charged against costs and Inventory
purchases
controllable. the revenue for the period. So period costs are product
charged in the profit and loss account in the period costs with
4.
in which they are incurred because they relate to the due and
Marketing care.
Classificatio
passage of time, rather then being associated closely As shown
administrative costs
n according
with the manufacturing process. It should be in the
to
remembered that period costs are not assets, because M above flow
association
they are not expected to provide any future e diagram,
with product
economic benefits to the organization. Examples of r marketing
of period:
period costs are salaries of sales personnel, sales c and
An important
representatives’ commission, administrative h administrati
issue in both
expenses, selling expenses, distribution expenses, a ve costs are
managerial
depreciation of the office equipment, and finance n not product
and financial
expenses etc. d costs either
accounting is
i in
the timing
with which • Product Costs: Product costs refer to those items of s merchandis
cost that are included in the costs of inventory and ing or
the costs and i
become expenses when the product is sold manufacturi
services are n
subsequently. So product costs are those costs that ng
recognized as g
are assigned to inventory because they are closely companies.
expenses.
associated with production activities rather than with Merchandis
Costs are M
the passage of time. It should be remembered that e company
also a
product costs are considered assets when incurred, inventory
classified by n
because they are resources that are expected to represents
time period a
provide future economic benefits to the merchandis
to provide g
organization. Product costs associated with making e purchase
some bases i
or acquiring inventory are also called “inventoriable for sale
of n
costs”, which means the amount of inventory while
comparison
remains unsold that is the portion of product cost g manufacturi
of the firm's
stored. During the time period of sale the product ng
financial
costs are recognized as an expense called “cost of It company
position from
goods sold”. For examples, the cost of direct i inventory
period to
materials, direct labour, and manufacturing s consists of
period. Costs
overhead consist product costs for manufactured i cost of
related to
goods. m material,
time periods
p labour and
are either The following flow diagram gives a general picture of
o manufacturi
period costs how to determine whether a cost is period cost or
r ng
or product product cost.
t overhead
costs.
that
a Statement are
Outlay Balance Sheet Income
n used to
• Period (Product or Inventoriable Costs)
manufactur
Costs: Costs) t
t e product.
Period So if the
costs o
c period costs
refer to and product
those l
a costs are
items of classified
s

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 School of Business

incorrectly, of an undertaking i.e. this costs include the A tion as a

d whole.
the financial transformation of material into finished products m
statement for through the use of labour and factory facilities. This i
the period cost is also termed as “production cost” or “factory n
i
will be cost”, which is the sum of direct material, direct s
inexact. labour, and factory overhead. The portion of t
manufacturing costs which represent work r
Marketing
5. completed is transferred to finished goods to offer a
costs also
Classificatio t
for sale while incomplete works remain in work-in- i known as
n according selling costs
process.  Administrative Costs: Administrative
v
incurred
to the nature e
when
of functions: costs refer to all costs of running the organization as manufacturi
a whole. So it includes all expenditure incurred in c
According to o
ng process
formulating the policy, directing the organization is
this s completed
classification and controlling its operations, which is not directly t and the
related to production, selling, distribution, research s
costs are finished
and development costs. Examples of such costs product is
classified r ready for
relating to include salaries of top management personnel, e sale.
the number general accounting, secretarial, cost of legal and f
public relation activities, general administration etc. e
of functions r
performed by
a business • Marketing Costs: Marketing costs also known as t
enterprise. It selling costs incurred at the point where o
leads to manufacturing costs end that is, when
a Research
grouping of manufacturing process is completed and the finished l cost is the
costs product is ready for sale. So the marketing costs l cost of
according to include the cost of selling goods or services and also researching
c for new or
the broad the cost of distribution. This cost is often termed as o improved
division of “order-getting” and “order-filling” cost. Order- s products
activity i.e. getting costs also known as selling costs include t methods,
s processes,
functional salaries, commissions, travel costs of sales systems or
costs may be representatives, and cost of advertising and o services.
classified promotion. On the other hand, order filling costs f Capital
into the also known as distribution costs include costs of expenditure
r is the
following storing, handling and shipping finished products. outflow of
u
types. Taking together, marketing cost is well known as n funds to
“selling and distribution cost.” n acquire an
asset that
• Manufac i
n will benefit
turing • Research and Development Costs: Research cost g the
Costs: is the cost of researching for new or improved enterprise
t more than
These products, new application of materials or new or one
h
refer to improved methods, processes, systems or services. e accounting
the costs period.
Manufacturing costs refer to the costs of operating the
of manufacturing division of an undertaking. o
operating r
g
the a
manufact n
uring i Revenue
z expenditure
division a is the

Unit-2 Page-14
 Bangladesh Open University

outflow of or technical knowledge to produce a new or f fiable

funds to meet
the running improved product or to employ a new or improved i in
expenses of method, process, system, etc., and ends with the n quantiti
an enterprise commencement of commercial production of that a es for
and that will
be of benefit product or by that method. n income
for the c stateme
current
6. Classification according to relation with accounting
i nt and
period only. period: The concepts of capital and revenue are of
a balance
fundamental importance to the connect determination of
l sheet
accounting profit for a period. In addition to the costs
a valuati
discussed earlier other costs relate to its efficiency or
c ons. It
capacity are incurred from time to time during its service
c is a
life. For the purpose of costs related to accounting
o postmo
period, costs are classified as either capital cost or
u rtem of
revenue cost.
n the
Historical t costs.
costs or • Capital Expenditure: Capital expenditure is the
i Howev
actual cost
refer to the
outflow of funds to acquire an asset that will benefit n er,
costs actually the enterprise more than one accounting period. A g historic
incurred and capital expenditure takes place when an asset or . al costs
ascertained service is acquired or improvement of a fixed asset
after they T are
have been is affected. These assets are expected to provide h frequen
incurred. benefits to the business in more than one accounting e tly not
period and are not intended for resale in the ordinary s so
course of business. For example, the cost of Plant e useful
and Machinery in case of a manufacturing company, c for
A replacement Buildings, Vehicles, Patents etc. o decisio
cost is an s n
amount that a
firm would
• Revenue Expenditure: Revenue expenditure is the t making
currently have outflow of funds to meet the running expenses of an s because
to pay to enterprise and that will be of benefit for the current a conditi
replace an period only. A revenue expenditure is incurred to
asset. r ons
carry on the normal course of business or maintain e may
the capital asset in good condition. Examples o have
include raw materials used, labour changes, b change
Develop electricity, stationery, rent, insurance etc. j d since
ment
Correct classification between capital and revenue e the
cost is
expenditure is crucial. Incorrect classification may c costs
the cost
affect reported income. t were
of the
i incurre
process 7. Classification according to the time of cost v d.
which determination: Costs classified in relation to the time of e
begins incidence include historical costs, replacement costs and
with the budgeted costs.
a • Replac
n ement
impleme
d Costs:
ntation • Historical Costs: Historical costs or actual costs v A
of the refer to the costs actually incurred and ascertained e replace
decision after they have been incurred. Historical costs were r ment
to use incurred in the past and are normally used in i cost is
scientific

Management Accounting Page-15

 School of Business

an could be, but is not necessarily, the same amount as w ich are
amount the replacement cost. h a sort
that a i of
Historical costs are indispensable to determine product
firm c commo
costs for inventories and other financial accounting
would h n costs
purposes because in financial statement amounts must
currently r exist
be objective and verifiable. On the otherhand,
have to e when
replacement, budgeted, and other version of current
pay to s units of
costs are normally more appropriate to provide useful
replace u differen
information to management.
an asset l t goods
or to buy 8. Classification according to the nature of data: Costs t are
one that classified according to the nature of data include explicit s produc
performs costs and implicit costs. i ed out
functions n of one
similar to • Explicit Costs: In general, costs refer only to m and the
an asset explicit costs. In fact, historical costs are explicit o same
currently costs of the firm for which explicit payment had r materia
held. It is been made sometime in the past or for which the e l or
the cost firm is committed to make future payments. t process
of Examples of such costs are wages and salaries, rent, h .
replacem cost of materials, depreciation, the amount paid for a a
ent at machine, and interest payments. n • Com
current o mon
Cost:
market • Implicit Costs: Implicit costs are those which do n
Comm
price. So not involve actual payment by a firm to factors of e
replacem m on cost
production, but nevertheless represent costs to the
ent cost a refers
firm in the sense that in order to use certain inputs in
valuation i to those
the production process, opportunities for the firm to
states the n costs
use them else where have been foregone. Example,
costs at p which
the value of the firm owners’ time is used to manage
prices r are
the business also component of total implicit costs.
that o incurre
would 9. Classification according to the nature of production: d d
have to Fundamentally depending on the nature of production, u collecti
be paid there are two major groups of costing methods; process c vely for
currently costing, and job costing. There is also a flux method t. a
. combining features of both into one usually called a S number
batch costing method. Costs classified according to the o of cost
• Budgete nature of production include separable cost, joint cost, , centres
d Costs: and common cost. t and are
A h require
budgeted • Separable Cost: A separable cost refers to any cost e d to be
cost is a that can be attributed to exclusively and wholly to a c suitable
planned particular product, process, division or department. o apporti
future s oned
expendit • Joint Cost: In costing of joint products, difficulty t for
ure. A arises in apportioning joint costs, that is the cost s determi
budgeted incurred up to the spilt-off point between individual w ning
cost joint products. So a joint cost is the cost of a process h the cost

Unit-2 Page-16
 Bangladesh Open University

of Historical costs are explicit costs of the firm for which explicit C An
payment had been made. o engi
individua m neer
l cost m ed
centres. i cost
Implicit costs are those which do not involve actual payment by a t is
Common t any
firm to factors of production.
costs are e cost
costs of d that
has
maintaini an
c
ng o expli
common s cit,
t speci
facilities. fied,
s
10. physi
a cal
Classificatio relati
A separable cost refers to any cost that can be attributed to r
n according e onshi
exclusively and wholly to a particular product, process, division or p
to the department. with
management t a
policies: h selec
Joint cost incurred up to the spilt-off point between individual joint e ted
Another products. meas
dimension to r ure
the e of
classification Common cost refers to those costs which are incurred collectively s activ
for a number of cost centres. u ity.
l
commitmen
 Committed Fixed Costs: Committed costs are the result of t
t in fixed
o costs and
f
other long-
e term
Committed costs are the result of earlier commitment. activities.
of costs a
debate is that r Consequent
l
of i ly, these are
management e mostly
policy. r fixed costs.
Management Committed
c
policy on o fixed costs
cost m are those
behaviour is m which arise
i
important, t from
otherwise  m
e
creation of
A budgeted capacity
n
cost is a t and the size
planned future . of such
expenditure.
costs
depends
upon the
technology.
 Committed
costs are
 sometimes
known as

Management Accounting Page-17

 School of Business

non- are those costs that are incurred or reduced or eliminated d res a
controllable as needs arise and they are dependent upon management e sacrific
costs. They policy. Labour overtime cost is a good example. for c e of
become non- further example; if the management policy is to spend a i alternat
controllable specified percentage of sales revenue achieved on s ives,
once the research, and on advertisement, these two items of i i.e.,
commitment variable costs would fit in the discretionary o unless
is made. classification. n it is an
Examples of m opportu
committed a nity
fixed costs k cost.
Discretionary Fixed Costs: They are costs which are
are, i Opport
not the result of output but which are at the discretion of
depreciation n unity
management. The good examples of discretionary fixed
and g cost is
costs include advertising costs, training expenses,
insurance, , the cost
management consultancy services, sales promotion
property a of
costs, research expenses, charitable and political
taxes, rent, c selectin
donations. These costs are also known as programmed
rates, and o g one
costs or managed costs because these costs are caused
supervisory s course
by management policy decisions. The most important
salaries. t of
characteristics of these costs is that it is very difficult, if
Such costs i action
not impossible, to determine whether the services or
are s in
resources acquired through these costs have been used
committed n terms
effectively and as a result the need and amount of such
because o of the
expenses are decided afresh everytime.
short-term t opportu
management Engineered Variable Costs: As the term indicates, are r nities
decisions the costs which have a scientific relationship with the e which
cannot output level. An engineered cost is any cost that has an a are
change these explicit, specified, physical relationship with a selected l given
costs and measure of activity. Such relationship is known with l up to
they are experience and could be established scientifically to set y carry
incurred even the standards. The best known examples of engineered a out that
11. Classification according to manager’s relevancy of decision c course
making and analysis: Although costs are accumulated for cost as o of
curtailment and cost control, one of the main purposes of cost s action;
accounting is to provide detailed information for managerial decision t that is,
making. In fact, the fixed-varible classification cannot deal with all cost u an
when output n opportu
variable costs include direct material, direct labour, sales l nity
is zero; that
commissions, distribution expenses etc. Variable costs e cost is
is, they do
are normally engineered. s the cost
not change as
activity relationships involved in managerial decisions. So it is s of an
changes. necessary at this stage to discuss a wider range of cost i opportu
concepts. Each classification throws light on manager’s t nity
Discretionar relevancy of decision making and analysis. r foregon
y Variable e e. The
Costs: • Opportunity Cost and Outlay Cost: The term q concept
Discretionary u recogni
opportunity cost, used by accountants is borrowed
variable costs i zes that
from economists. We know that, in managerial

Unit-2 Page-18
 Bangladesh Open University

resources if fixed deposits in the banks are proposed to be O aterials and

u other
are scare withdrawn for financing a project, the opportunity t productive
and have cost would be the loss of interest on the deposits. l facilities.
alternativ Since the opportunity cost represents only sacrificed a
y
e uses. alternatives, they are never recorded as such in the
For financial accounts. c
example, o Any cost
On the contrary, the concept of cost which normally s which is
assume
enters into the accounts of a business is known as t relevant in
that a s making a
outlay cost. Outlay costs refer to the actual
manufact decision is
expenditures incurred on raw materials and other relevant cost.
urer can r
productive facilities. e
sell his
f
work-in- Costs
process
• Relevant Costs and Irrelevant Costs: Any cost e
r which are
to which is relevant in making a decision is relevant not
cost. Costs or revenues are relevant when they are affected by
t
outside o a decision
market logically related to a decision and vary from one are
for decision alternative to another. Any cost which is irrelevant
t costs.
Tk.1,00, relevant in making a decision is relevant cost. Costs h
00. They that will be incurred as a result of a decision and e

decide, thus appropriate to a specific managerial decision

are known as relevant costs. These costs are relevant a When the
however, c cost of an
to keep it for future decision making. On the contrary, costs t option is
and which are not affected by a decision are irrelevant u shown as
costs, that is costs that have already been incurred a additional
finish it. l to that
The irrespective of what is being done by the enterprise under
opportun at present are irrelevant costs. e another
x option it is
ity cost Relevant costs for decision making reflect the following p called an
of the two important features: e incremental
workin- n cost.
process • They must be expected future costs and  They d
i
is must differ among alternatives. t
Tk.10,00 u Differential
For example; when plant replacement is being r cost is the
0 e difference in
because considered, the present depreciated cost of the plant to s the total
this is the be replaced would be irrelevant but its sale value would cost of two
amount be relevant since this will go to reduce the cost of i options
capital investment. Similarly, if a company wants to n compared.
of c
economi make components that was purchased from outside u
c market, the relevant cost will be the cost of material and r
direct labour and fixed costs that will be required for r
resources e
foregone creating new facilities to make the components. d
by the Opportunity cost is the cost of selecting one course of action in
terms of the opportunities which are given up to carry out that o
manufact course of action. n
urer to
complete r
the a
w
product.
Further, m

Management Accounting Page-19

 School of Business

Sunk costs are cost of an option is shown as additional to that under e s

costs that
have been another option it is called an incremental cost. On x estimat
incurred in the otherhand, differential cost is the difference in a ed
the past the total cost of two options compared. The option m scrap
cannot be
changed by may involve change in production, introduction of p value is
any current new machinery on new product, marketing on any l Tk.75,0
or future other business activity. It is noteworthy here that, e 00; the
action.
although technically an incremental cost should refer , net
only to an increase in cost from one alternative to if book
another; decrease in cost should be refereed to as t value of
decrement cost. Differential cost is a broader term, h the
encompassing both cost increases (incremental e machin
costs) and cost decreases (decremental costs) b e i.e.,
between alternatives. o Tk.9,25
o ,000
For example; that a company is considering two
k (Tk.10,
competing sites for a new factory. If the northern site is
v 00,000
chosen, the annual cost of transporting raw materials to
a -
the site is estimated Tk.1,85,000. If the southern site is
l Tk.75,0
selected, annual transportation charge is estimated to be
u 00)
Out-of-pocket Tk.1,50,000. The annual differential cost of transporting
costs refer to e should
raw material is calculated as follows:
costs that o be
involve Annual cost of transporting raw materials to northern f conside
current
payments to site a red as
outsiders. m sunk
Annual cost of transporting raw materials to southern
a cost.
site
c Alterna
Annual differential cost h tively,
 i the
Increme n book
ntal Cost It may be noted that differential cost calculation is
e value of
and generally done for facilitating managerial decisions and
i Tk.10,0
Different is not generally incorporated in accounting records.
s 0,000
ial Cost: T can also
For most • Sunk Cost: A sunk cost is a cost that has already k be
practical been incurred at the time that a decision is being . conside
decision considered and is therefore not of importance for the 1 red
problems new decision under consideration. So sunk costs are 0 sunk
, the two costs that have been incurred in the past and , cost
terms consequently they do not affect future costs and 0 while
incremen cannot be changed by any current or future action. 0 Tk.75,0
tal cost Such costs are irrelevant in a decision-making , 00
and situation because there is nothing that can be done to 0 should
differenti undo the decision to invest in them. 0 be
al cost 0 taken as
are used Some argue that the total cost of a fixed asset is not a a opportu
synonym sunk cost, but sunk cost is the difference between n nity
ously. the purchase price of a fixed asset and the net d cost.
When the amount that could be realized from its sale. For it

Unit-2 Page-20
 Bangladesh Open University

• Out of by management. Out of pocket costs could also be i ng

Pocket like sunk cost and irrelevant if the firm is not in a s authorit
Costs position to save them, otherwise these costs are c y.
and relevant costs. o
Book Book costs can be converted into out-of-pocket costs by
n • Escapa
Costs: tr ble
selling assets and leasing them back from the buyer.
Out-of- o Costs
For example, A firm can sell own factory building
pocket ll and
but can continue to use it by paying rent to the new
costs a Inesca
owner. The rental payment then replaces the
refer to b pable
depreciation charge and interest cost of owned
costs that l Costs:
capital.
involve e Whethe
current o r
• Past Costs and Future Costs: Most of the
r
payments certain
important managerial decisions using cost n
to costs
information requires forecast of future costs, rather o
outsiders are
than actual costs, i.e., unadjusted records of past t
as escapab
costs. Actual costs incurred in the past and recorded s
opposed le or
in the books of account are known as past costs. On h
to book inescap
the contrary future costs are those that are likely to o
cost, able
be incurred in a future period. They are not recorded u
such as varies
in the books of account, and hence, have to be l
depreciat accordi
estimated. Since managerial decisions are forward d
ion, that ng to
looking, it centres round future costs and not past b
do not the
costs for expenditure control, projection of future e
require decisio
income statements, capital investment decisions, d
current n.
pricing etc. e
cost Escapa
expendit • Controllable Costs and Uncontrollable Costs: c ble
ures. The The controllability of a particular cost depends upon i costs
payments the level of management, that is, it is related to a d refer to
for special centre of managerial responsibility. e these
manage Controllable costs are those which can be influenced d costs
ment in by the decisions and actions of a specified member b that
deciding of an undertaking and uncontrollable costs are those y may
whether which cannot be influenced by a specified member t not
or not a of an undertaking. The distinction is not absolute h only be
particular because many costs are not completely under the e postpon
project control of one individual. In classifying costs as d ed but
will at controllable or uncontrollable, managerial e may
least accountants generally focus on a manager’s ability c also be
return to influence costs. Examples of controllable costs i avoided
the are indirect labour, lubricants, power costs while s entirely
expendit depreciation, rent, and property tax are i as a
ures uncontrollable costs. o result
associate n of
The time period factor and the decision making m contrac
d with
authority can make a cost centrollable or a tion of
the
uncontrollable. If the time period is long enough, all k busines
project
costs can be controllable. Similarly, whether a cost i s
reelected

Management Accounting Page-21

 School of Business

activity. Actual costs incurred in the past and recorded in the books of O rom a
account are known as past costs.
For n permanent
example; t cessation of
Future costs are those that are likely to be incurred in a future
A period. h business
portion e activities.
of o In other
depreciat t words,
ion Controllable costs are those which can be influenced by the h when a
decisions and actions of a specified member of an undertaking.
which e fixed asset
varies r is retired
with the Uncontrollable costs are those which cannot be influenced by a h from
use of a specified member of an undertaking. a service and
machine n is to be
can be d disposed of,
avoided , the costs
by a connected
reducing b with
output. a disposal an
Therefor n known as
e, the d abandonme
part that o nt costs.
continues Escapable costs refer to these costs that may not only be postponed n
but may also be avoided entirely as a result of contraction of
regardles business activity. m
s of Inescapable or unavoidable costs are those that must be met even if e
output is there is contraction of business activity. n
escapabl t
e only if Shutdown costs are those costs which have to be incurred under all c
the situations in the case of stopping manufacture of a product or o
machine closing down a department or a division. s
or t
building Abandonment costs are those that result from a permanent cessation s
is sold of business activities. a
and if, of On the contrary, inescapable or unavoidable costs are r
course, those that must be met even if there is contraction of e
there is a business activity. For example, manufacturing plants t
ready must incur minimum power costs regardless of the h
market volume of sales. o
for the  Shut-down Costs and Abandonment Costs: s
asset. e
Shutdown costs are those costs which have to be
Book costs t
incurred under all situations in the case of stopping
refer to cost h
that that do manufacture of a product or closing down a
a
not require department or a division. Shut down costs are
current cost t
always fixed costs. For example, in case of a
expenditures. r
manufacturing company, if a product manufacturing
e
is stopped, then a part of fixed costs associated with
s
the product like rent, watchman’s salary, property
u
taxes will be incurred. Such fixed costs are
lt
unavoidable.
f

Unit-2 Page-22