Cost Classification

Income Statement
Revenue (30 x 1,000,000) 30,000,000
Less:
Cost of Raw Material Consumed 8,000,000
Rent of Factory Premises 1,000,000
Depreciation:
- Machineries 1,000,000
- Office Furniture 700,000
- Office Equipments 750,000
Rent of Office Premises 1,200,000
Salaries and Wages
- Labour 2,000,000
- Production Supervisors (2 Nos.) 1,000,000
- Production Manager 1,000,000
- Office Staff 1,500,000
Advertisement and Promotion 1,000,000
Interest and other Financial Charges 800,000
Taxes 600,000
Total Cost 20,550,000
Net Profit 9,450,000
 Cost Classification

Total Costs

Product Period
Costs Costs
 Product and Period Costs
• Product Costs:
– Incurred for producing the final product
– Directly related to the manufacturing activity
– Matched on ‘product basis’ with the revenue under the
matching concept while preparing income statement
– Also known as ‘inventoriable costs’
– E.g. material, labour, rent of factory, depreciation on
machineries etc.
• Period Costs:
– Not directly related to the manufacturing activity
– Matched on ‘period basis’ with the revenue under the matching
concept while preparing income statement
– E.g. CEO’s salary, rent of office premises, depreciation on office
equipments etc.
 Overview of Cost Categories
Total Cost

Product Costs Period Costs

Manf. Overheads
Marketing and
Direct Material Direct Labour or Indirect Manf. Admin Costs
Selling Costs
Costs

Other
Indirect Material Indirect Labour Manufacturing
Overheads
 Direct Material Costs
• Comprises of the costs of raw material that goes in
manufacturing of the final product.
• The raw material is physically incorporated in the
finished product.
• However, there is need to distinguish between direct
material costs and cost of consumables, e.g. for
manufacturing a wooden table, cost of the wood is the
direct material cost whereas the cost of the glue and
nails is cost of consumables.
• Cost of consumables may not be large enough to be
economically traced to the finished product and
therefore are generally considered to as ‘Indirect
materials’.
 Direct Labour Costs
• Comprises of the cost of labour employed for the
production of finished product.
• One must be able to trace the cost of labour to
the finished product.
• For example, wages of workers manufacturing
the table.
• However, costs of any employee whose time is
not directly traceable to the single unit of the
finished product is not a direct labour costs e.g.
salary of factory supervisor, factory manager,
factory janitors etc.
 Overheads or Indirect Costs
• Indirect Material: Cost of such material that
cannot be directly traced into the product such as
glue and nails to manufacture a wooden table, oil
used to deep fry the ‘French fries’ at McDonalds
etc.
• Indirect labour: Labour used for production
purposes but whose time is difficult to trace to a
unit of a product e.g. salary of supervisor, salary
of production manager, salary of maintenance
workers, idle time etc.
 Overheads or Indirect Costs
• Other Manufacturing Overheads: For example
depreciation on machineries,
depreciation/rent on factory building, factory
insurance, general factory maintenance,
utilities for factories.
 Period Costs
• Marketing and Selling Costs: All costs associated
with the marketing of the product and sale of the
product such as sales commissions, cost of
shipping, storage of finished products,
advertisement and promotions etc.
• Admin. Costs: These are the costs that are not
related to manufacturing or marketing such as
CEO’s salary, cost of accounting and finance
department, cost of administration, depreciation
on non-manufacturing assets like office building
and office equipments etc.
Cost Terms in Manufacturing
Names for Groups of Costs
Cost Terms in Manufacturing Prime
Costs

Conversion
Costs
Flow of Costs: Service Settings
Statement of Profit and Loss
Flow of Costs in Merchandising

Transportation
in, stocking
Cost Classification based on
Variability
 Income Statement
Revenue (30 x 1,000,000) 30,000,000
Less:
Cost of Raw Material Consumed 8,000,000
Rent of Factory Premises 1,000,000
Depreciation:
- Machineries 1,000,000
- Office Furniture 700,000
- Office Equipments 750,000
Rent of Office Premises 1,200,000
Salaries and Wages
- Labour 2,000,000
- Production Supervisors (2 Nos.) 1,000,000
- Production Manager 1,000,000
- Office Staff 1,500,000
Advertisement and Promotion 1,000,000
Interest and other Financial Charges 800,000
Taxes 600,000
Total Cost 20,550,000
Net Profit 9,450,000
 Cost Classification

Total Costs

Variable Mixed
Fixed Costs Step Costs
Costs Costs
 Variable Costs
• Variable Cost
– Any cost that directly varies with the production/ sales volume
– Total Variable costs increase/ decrease in the same proportion
as that of the volume
– Per unit variable costs remain constant with
increase/decrease in the volume
– Includes direct material, direct labour , variable overheads and
variable selling overheads
– E.g. wood consumed to manufacture a wooden table (Direct
material), wages paid to carpenter for manufacturing the table
(direct labour), glue and nails consumed (variable overheads),
selling commission paid to sell the table (variable selling
overheads)
 Variable Cost Behavior

Total Variable
Cost

Number of units
 Fixed Costs
• Fixed Costs
– Any costs that remain fixed, in total, with
increase/decrease in the volume
– Total fixed costs does not change with the change in
the volume
– Per Unit fixed costs decreases with increase in
volume
– Examples include depreciation on machinery, rent of
the factory, depreciation of office equipment, salary of
managers etc.
 Fixed Cost Behavior

Total Fixed
Cost

Number of units
 Fixed Cost
Fixed Cost

Committed Discretionary
Fixed Costs Fixed Costs

Committed Fixed Costs: Those costs which cannot be reduced

without curtailing organisation’s operations substantially e.g.
depreciation on plant and machineries, rent of factory etc.

Discretionary Fixed Costs: Those fixed costs that can be reduced

in difficult times e.g. R&D cost, Advertisement and Promotion
costs, etc.
 Fixed Costs – Relevant Range
• Fixed costs remain fixed within a range of
volume only, called as ‘Relevant range’
• The relevant range is generally determined by
the capacity of the company.
• In order to increase the volume, the company
is required to invest into assets leading
increase in total fixed cost.
• In other words, the fixed cost is also subject to
change if the relevant range changes.
Fixed Cost and Relevant Range
Relevant Range

Total Fixed
Cost

Number of units
 Mixed Costs
• Mixed Costs contains elements of both fixed and
variable cost behavior
• The fixed cost element remains unchanged over
the range of volume
• The variable cost element varies proportionately
with volume.
• Mixed Costs take the following form:
Mixed Costs = FC + (VC p.u. x N)
• A simple example of mixed cost is your postpaid
mobile phone bill.
 Mixed Cost Behavior

Total Mixed VC p.u.

Cost

Fixed
Element

Number of units
 Step Cost
• Step costs are those costs that change
abruptly at intervals of volume because the
resources and their cost come in indivisible
chunks.
• E.g. the cost of a factory supervisor who can
manage 20 workers.
 Step Cost Behavior

StepCost

Number of units
Cost Classification based on
Traceability
 Cost Classification

Total Costs

Direct Indirect
Costs Costs
 Cost Object
• Cost Object is any thing for which the cost
needs to be measured.
• It can be a output, product lines, department,
factories, customers etc.
 Cost Object Examples
Situation Cost Object
A company wish to measure the cost Output
per unit of its product
A company wish to measure the Product Line
performance the three products it
produces
A company wish to measure the Departments
performance of its three
departments
A company wish to measure which Customers
customer is more profitable
 Direct Costs
• Direct Cost is any cost which is directly
attributable to the cost object.
• In other words, a cost that is traced directly to a
specific cost object is a Direct Cost.
• Direct costs does not require allocation as they
can be identified with one cost object.
• E.g. Depreciation of a machinery which solely
used to produce Product A, is a direct cost for
Product A.
 Indirect Cost
• Indirect costs are those costs that cannot be
traced to one cost object.
• For example, if a machinery is used to produce
Product A as well as Product B, depreciation
on that machine will be an indirect cost to
both the products.
• Indirect costs require allocation.
 Example
Classify the cost between direct and indirect if the Cost object is
•Product, or,
•Site
(Rs. in Lakhs)
Site 1 Site 2
Product 1 Product 2 Total Product 3 Product 4 Total Total

Sales 3,000 2,500 5,500 2,000 650 2,650 8,150

Material 560 440 1,000 500 185 685 1,685

Labour 540 360 900 400 200 600 1,500

Depreciation on Equipments 1,500 500 2,000

Site overheads 675 250 925
Corporate General
Overheads 850
Corporate R&D 650
Profit 540