Module 4

Understanding Cost Structures

Entrepreneurship Training for CSC Academy
Cost and cost classifications
• Cost is the monetary value of resources, like material, labour and
overheads, used in the making of a product or delivery of a service.
• Usually, there may be no material involved in the delivery of a service.
• There are different ways in which cost may be classified:
• Based on association with cost object (Direct vs indirect costs).
• Based on reaction to changes in activity (Fixed vs variable costs).
• Based on classification on financial statements (Expired vs unexpired costs).
• We will discuss these classifications and related terminologies in
greater detail in this module.
Cost object
• Direct vs indirect costs are based their association with different cost
objects.
• A cost object is an item or object for which costs are measured separately.
• Some common types of cost objects are:
• Output: This is the most common way of defining cost objects. It is based on a
business’ output because a business would want to know the cost of producing or
creating its output.
• Operational: This is based on a department within the business or a specific
operation or process. For example, a business could measure the cost of a customer
service call.
• Business relationship: This is based on an entity outside the business. For example,
cost could be aggregated for each supplier or customer.
Cost objects for Raju the thelawala
• Cost object for Raju the thelawala (based on output) could be
seasonal vegetables and non-seasonal vegetables or green vegetables
(beans, lady’s fingers, etc.), root vegetables (potatoes, carrot, etc.)
and other types of vegetables.
• If he starts selling fruits also, cost objects could be vegetables and fruits.
Direct vs indirect costs
• Direct costs are those that can directly and easily be traced to a cost object
or objects.
• Indirect costs are those that cannot be economically traced to a cost object
and hence must these costs must be allocated to a cost object or objects.
• Let’s say that Raju the thelawala buys tea during winter and nimbu paani
during summer while working at his thela.
• The cost of the fruits and vegetables are direct costs because they can be traced to
the two cost objects fruits and vegetables, respectively.
• The costs of tea and nimbu paani are indirect costs because their costs cannot be
traced back to the two cost objects fruits and vegetables.
• So the costs of tea and nimbu paani must be allocated to the two cost objects, which we will
discuss later in the module.
Fixed vs variable costs
• To understand how costs change with output, it is useful to classify costs as
fixed vs variable costs.
• Costs that do not vary in the short term, regardless of changes in output
levels, are called fixed costs.
• Costs that vary with the output levels are called variable costs.
• For Raju the thelawala,
• the cost of his thela is fixed because it does not depend on how much fruits and
vegetables he sells.
• the costs of tea and nimbu paani are also fixed because they do not depend on how
much fruits and vegetables he sells.
• the cost of fruits and vegetables sold is variable because it varies with how much
fruits and vegetables he sells.
Expired vs unexpired costs
• To determine if a cost should appear on the balance sheet or income
statement, it is useful to think of costs as expired and unexpired costs.
• Expired costs are those that have been completely consumed or the
benefits from which have been received by the business.
• Unexpired costs are those that have not been consumed fully as yet
and have some residual value.
• Typically, all expenses on the P&L statement represent expired costs,
where assets on the balance sheet represent unexpired costs.
Raju’s expired and unexpired costs
• For Raju the thelawala,
• the cost of fruits and vegetables sold are expired costs as they will show up as
cost of goods sold (COGS) on the P&L statement.
• the cost of fruits and vegetables not sold as yet are unexpired costs as they
will show up under inventory on the balance sheet.
• the annual depreciation cost of his thela will be expired cost and hence
recorded on the P&L statement.
• the value of his thela, net of depreciation cost, will be the unexpired cost and
hence recorded on the balance sheet.
• This unexpired cost of the thela will reduce by the annual depreciation cost every year
on the balance sheet (assuming a ten-year useful for the thela and an initial cost of ₹
10,000, its unexpired cost will be ₹ 9,000 after one year, ₹ 8,000 after two years, etc.)
and its unexpired cost will be zero after ten years.
Degrees of conversion
• Almost all businesses convert or modify inputs to a sellable output.
• Inputs typically consist of raw material, labour and overheads.
• The cost of conversion is dependent on the degree of conversion done by a
business.
• You could think of three degrees of conversion:
1. Low: Providing convenience to customers in terms of location, timing and variety with
almost no physical conversion of inputs. Raju the thelawala provides ease of access (in
terms of location and timing) to fruits and vegetables for his customers.
2. Moderate: Some amount of visible conversion to the output. Raju the thelawala removes
unnecessary leaves, roots and stalks, washes and packs the fruits and vegetables in plastic
before selling them to his customers.
3. High: A major transformation from input to output. An example of this would be a two-
wheeler company like Bajaj Motors or Hero Motocorp. They take inputs consisting of
various parts of a two-wheeler made out of metal, plastic and glass and convert it to two-
wheelers.
Degrees of conversion … contd.
• Retail companies like Reliance Fresh, D-Mart, Big Bazaar have low to
moderate degree of conversion.
• Manufacturing companies like Bajaj Auto, Hero Motocorp, Amul,
Asian Paints, Bombay Dyeing, etc. have a high degree of conversion.
Product costs
• Product costs are the key determinants of the cost of goods sold
(COGS), which appears on the P&L statement.
• They represent the cost of items or services used to generate
revenues.
• The three main components are:
1. Direct material
2. Direct labour
3. Overheads
• We will discuss these in detail over the next few slides.
Direct material costs
• It is the cost of any material directly used in the production of the
output.
• For example, for a two-wheeler, it would include the costs of engine, fuel
tank, shock absorbers, mirrors, handlebar, wheels, tyres, etc.
• Direct material costs are significant for manufacturing companies like
Hero Motocorp, Amul, Asian Paints, etc.
• Direct material costs are low or insignificant for service companies
like Infosys, Wipro, State Bank of India, ICICI Bank, etc.
Direct labour costs
• It refers to the cost of individuals involved in manufacturing a product
or delivering a service.
• The cost includes salaries, bonuses, insurance, pension benefits, earned leave
paid to the individuals involved.
• It typically does not include overtime costs paid to the individuals.
• Overtime costs are included in overheads, which we will discuss on the next slide.
• It also does not include salaries of executive, salespersons, commissions paid
to the sales team, advertising, utilities paid for the administrative building,
etc.
• These are not directly involved in the manufacturing of a product or delivery of a service.
Overheads
• While direct material cost and direct labour costs are direct costs,
overheads include indirect costs incurred in the manufacturing of a
product or delivery of a service.
• For example, in the manufacture of a two-wheeler, it will be very
difficult to keep track of the exact amount (and cost) of glue and exact
number (and cost) of screws used.
• The cost of glue and screws will be indirect costs.
• But the cost of these must still be included under product costs, which we will
discuss next.
Cost allocation
• Indirect costs like overheads cannot be easily traced back to a product
or service.
• Hence, businesses need to allocate these costs to each product or
service or broadly each cost object.
• Cost allocation is a method through which a business allocates or
distributes an indirect cost across various cost objects.
Cost allocation … contd.
• There are four parts to cost allocation:
1. Cost pool: This is the total indirect cost that needs to be allocated across cost
objects.
2. Cost objects: Defined earlier.
3. Cost driver: Some attribute or characteristic that we can measure for each cost
object.
4. Allocation volume: This is the aggregate of the cost driver amounts across all cost
objects.
• The steps in cost allocation are as follows:
1. Determine the allocation rate (called the overhead rate): The overhead rate is the
amount in the cost pool divided by the allocation volume.
2. Allocate the cost: Multiply the overhead rate by the number of cost driver units in
each cost object.
Cost allocation for Raju the thelawala
• We had seen earlier that tea and nimbu paani are indirect costs that Raju
incurs.
• How does he allocate the costs of tea and nimbu paani to the cost of fruits
and vegetables sold?
• Let’s start by identifying the four parts of cost allocation:
1. Cost pool: Let’s say that he spends a total of ₹ 20 on a given day to tea or nimbu
paani.
2. Cost objects: Raju has two cost objects – fruits and vegetables.
3. Cost driver: Raju takes the total kilograms of cost object sold as his cost driver. Cost
drivers are the number of kilograms of fruits and vegetables sold.
4. Allocation volume: This is the total kilograms of fruits and vegetables sold. Let’s say
that he sold 10 kilograms of fruits and 15 kilograms of vegetables. So allocation
volume is 25 kilograms.
Cost allocation for Raju the thelawala …
contd.
• The overhead rate is the amount in the cost pool divided by the
allocation volume.
• 20 divided by 25, which is ₹ 0.80 per kg.
• Cost allocated to each cost object:
• Fruits: 0.80 multiplied by 10 = ₹ 8.
• Vegetables: 0.80 multiplied by 15 = ₹ 12.
• So the ₹ 20 indirect cost has been allocated as ₹8 to fruits and ₹ 12 to
vegetables cost objects.
Key takeaways
• What is a cost object and what the different types of cost objects?
• Explain what direct and indirect costs are with examples.
• Explain what fixed and variable costs are with examples.
• Explain what expired and unexpired costs are with examples.
• What are the main components of product costs?
• Allocate indirect costs (or overheads) across different cost objects.