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Cost Concepts/ Cost Classification

Amity School of Business

Costs can be classified on the basis of: Business Functions. Element wise classification. Planning and control. Decision Making. Normality.

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Cost Concepts/ Cost Classification
Amity School of Business

On the basis of Business Function: Direct and Indirect costs. Manufacturing and Non manufacturing costs. Product and Period Costs. On the basis of normality: Normal cost and abnormal cost.

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On the basis of Decision Making: Sunk Costs. Controllable and Non-controllable. 3 . Relevant and Irrelevant costs. Out of pocket. Incremental Costs.Amity School of Business On the basis of planning and Control: Fixed and variable costs. Differential costs. Replacement costs.

Direct labor and Direct expenses. Direct labor: The cost of remuneration for employees efforts and skills applied directly to a product or saleable service. Direct expense: The cost other than material and labor which are incurred for a specific product or saleable service. Examples: Direct material.On the basis of Business Function Amity School of Business Direct costs Costs that can be easily and conveniently traced to a unit of product or other cost objective. Direct Material: The cost of material entering into and becoming constituent element of product or saleable service. 4 .

5 .Amity School of Business Indirect costs Costs cannot be easily and conveniently traced to a unit of product or other cost object. Example: Manufacturing Overhead.

Examples: maintenance workers and security guards. Examples: lubricants and cleaning supplies used in the automobile assembly plant. Materials used to support the production process. direct labor.Amity School of Business Manufacturing overheads (Indirect Costs) Included all overheads other than direct material. direct expenses. 6 . Examples: Indirect labor and indirect materials Wages paid to employees who are not directly involved in production work.

Classifications of Costs Amity School of Business Manufacturing costs are often classified as follows: Direct Material Direct Labor Manufacturing Overhead Prime Cost Conversion Cost .

Inventory Sale Cost of Good Sold Expense Balance Sheet Income Statement Income Statement . They are expensed on the income statement. direct labor. and manufacturing overhead.Product Costs Versus Period Costs Amity School of Business Product costs include direct materials. Period costs are recorded as expenses of the accounting period in which they are incurred. Period costs are not included in product costs.

Flow of Manufacturing Costs Amity School of Business Direct Materials Direct Labor Factory Overhead Work in Process (Assets) Finished Goods (Assets) Cost of Goods Sold (Expenses) 9 .

10 . Indirect labour:  Wage cost other than direct wage cost.Element Wise classification Amity School of Business According to the nature of and source of expenditure.  It cannot be allocated but can be apportioned to cost centres and cost units.  It cannot be allocated but can be apportioned to cost centres and cost units. the overheads are classified into: Indirect Material:  Materials other than direct material cost. Idle time wages. grease etc.  Example: Staff of personnel department.  Example: Oil.

11 .Element Wise classification Amity School of Business Indirect Expenses:  Expenses other the direct expenses. depreciation etc.  Example: Rent.  It cannot be allocated but can be apportioned to cost centres and cost units. rates.

Rent. Administrativ e salary Which cannot be easily or quickly eliminated. lease rentals. Eg: advertisement programmes. Property Taxes. Eg: Depreciation . Total fixed costs remain unchanged regardless of changes in cost-driver activity 12 . Fixed Costs Discretionary Fixed Costs Which can be discontinued at management discretion. Examples: Depreciation.On the Basis of Planning and Control Amity School of Business Fixed costs: That does not change with the change in the level of activity. Thumb Rule Think of fixed costs as a total. Supervisors salary.

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There is a fixed ratio between the change in cost and change in activity.On the Basis of Planning and Control Amity School of Business Variable Costs Where total varies directly and proportionally with the volume of activity. 14 . Variable Costs Thumb Rule Think of variable costs on per unit basis. The per-unit variable cost remains unchanged regardless of changes in the cost-driver activity.

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16 . Partly effected by the fluctuation in the level of activity. Types of Semi variable costs Semi variable costs Semi variable costs ‡ Variable element operates at all the levels of activity.On the Basis of Planning and Control Amity School of Business Semi Variable Cost Contains both fixed and variable elements. For example: telephone expenses include a fixed portion of annual charge plus variable charge according to calls. ‡ Variable element comes into operation after certain level of activity.

Non Controllable Costs Beyond the influence of manager because he cannot authorize it. To determine whether the cost is controllable or non. Example: Depreciation of warehouse will not be controllable by the production manager or sales manager. ‡ Point of time. Two basic characteristics: ‡ Level of Organization.On the Basis of Planning and Control Amity School of Business Controllable Costs Manager has a direct and complete decision authority.controllable. both the characteristics must be considered concurrent 17 .

On the basis of Decision Making Amity School of Business Relevant Costs Vary depending upon the alternative selected in a particular decision. Irrelevant Costs Not effected by the decision taken or by the option selected. 18 .

Example: The written down value of the fixed asset. Sunk costs cannot be changed by any decision. They are not differential costs and should be ignored when making decisions. Differential Costs Costs that differs between decision alternatives. The differential cost may be incremental or decremental.On the basis of Decision Making Amity School of Business Sunk Costs Those costs have already been incurred and spent. 19 . These costs are created by a decision in the past and no present or future decision can change such costs.

20 . The choice of one course of action is given by rejecting the other. Does not involve any flow of cash or payment.On the basis of Decision Making Amity School of Business Opportunity costs The costs that measures the next best alternative that is lost or sacrificed. Every decision maker must incorporate the expected benefits that have been sacrificed. Not found in the accounting system.

Replacement cost The cost of replacing an assets at current market value. 21 . it means the cost of purchasing a machinery at the current market price and not the price at which it was purchased. Example : cost of replacing a machinery is considered.On the basis of Decision Making Amity School of Business Out of pocket costs Signifies the cash outlay required for undertaking project. Management is interested in knowing whether the income from the particular project will at least cover the expenditure on that project.

Example: Rent of factory. 22 .On the basis of Decision Making Amity School of Business Avoidable cost Cost that can be eliminated in case of product or department is discontinued. Unavoidable cost Indirect cost that cannot be eliminated with the discontinuation of a product or department. salary of production manager.

lockouts in a factory. Example: Strikes. Abnormal cost Cost which is not normally incurred at a given level of output in the conditions in which that level of output is normally attained. 23 .On the basis of Normality Amity School of Business Normal cost Cost which is normally incurred at a given level of output in the condition in which that level of output is normally attained. Example: Idle time for factory workers.

Implicit costs are related to forgone benefits of any single transaction. Explicit cost Expense that is contractual in nature and definite in amount. salaries. obvious cash outflows from a 24 business that reduce its bottom-line profitability.Implicit & Explicit Cost Implicit cost An implicit cost occurs when one foregoes an alternative action but does not make an actual payment. such as rent. or utility bills. Explicit costs represent clear. Amity School of Business . This is considered an implicit cost because the capital could have been rented to another firm instead. Example: A firm's use of its own capital. Explicit costs are easily recognizable for classification and recording. wages.