Cost Classification

Learning Outcomes
• Appraise the process of categorization of different costs
involved in the business process.

• Apply the cost categorization concepts in preparation of

cost sheet of the companies.
 Basis of Cost Classification

Degree of Degree of Costs related

Element Traceability to Cost Behavior Association to decision Control
product with product making
1.) On the basis of ‘Element’ of Cost

Material

Labor

Expenses
Natural Classification of Costs
 1.1) Direct Material
• Materials that are consumed in the manufacturing
process and
• physically incorporated in the finished product.
Direct material in Tyre, Steel & Furniture Industry
 1.2.) Indirect Materials
• Materials which are used in production process but which
are not directly traceable to a product or job.
 1.3) Direct labor
• Labor involved in the production of the product.

For example:
• Assembly line workers
• Machine operators
 1.4) Indirect Labor
• Workers who are not directly involved in conversion of
raw materials into finished goods.
 1.5) Direct expenses

• All the expenses incurred by the company in manufacturing of

the product.

For example:
• Custom duty paid for importing the raw material from US to
factory site in India.
• Carriage inwards paid for transporting the raw material from
different state to the factory site.
• Fuel, heating, lighting expenses and factory electricity
expenses incurred in manufacturing of product.
 1.6.) Indirect expenses
• Incurred to operate a business as a whole and cannot be directly
related to a specific product or service.

For example
• Rent
• Rates
• Taxes
• Insurance
• Maintenance
• Depreciation
Direct Expenses Vs. Indirect Expenses
Direct Expenses Indirect Expenses
Wages Salaries
Freight Office rent
Octroi Office lighting
Carriage Inwards Telephone expenses
Import duty Insurance
Gas, Fuel & Power Advertisement expenses
Factory Rent Packing charges
 Poll – II
• Raymond Ltd. is engaged in manufacturing of
garments.
• Identify which of the following costs will be
termed as an ‘overhead’ of this company?
a) Labor engaged in manufacturing of shirts $4000
b) Wool and silk used in manufacturing woolen
clothes $5500
c) Rent paid for the factory land $1200
d) Carriage paid for transporting raw materials to
factory site $400
 Activity
Classify the following cost items
a) Depreciation on factory building
b) Depreciation on office equipment
c) Salaries paid to CEO
d) Advertisement expenses
e) Boiler charges
f) Salaries paid to clerical staff
g) Paper used in textbook production
h) Paper used in central office computer
i) Wages paid to assembly line workers
j) Maintenance cost of machine
2.) On the basis of ‘Degree of traceability’ to product

Direct
costs Indirect
costs
 2.1.)Direct Costs of BMW X5

Cost of
Steel

Labor
cost

Cost of
Tires
 Direct Costs in BMW X5 – An Analysis
• The cost of the steel or tires can be easily traced to
or identified with the BMW X5.

• Workers on the BMW X5 line request materials

from the warehouse and the material requisition
document identifies the cost of the materials
supplied to the X5.

• In a similar way, individual workers record the time

spent working on the X5 on time sheets.

• The cost of this labor can easily be traced to the X5.

 2.2) Indirect Costs of BMW X5 – An
Analysis
• Salaries of plant administrators who oversee
production of the many different types of cars
produced at the plant are an indirect cost of
the X5s.

• Plant administration costs are related to the

cost object (X5s) because plant
administration is necessary for managing the
production of X5s.

• Plant administration costs are indirect costs

because plant administrators also oversee the
production of other products, such as the Z4
 Direct Costs Indirect Costs
Related to the particular Related to the particular
cost object and cost object but
can be traced to it in an cannot be traced to it in
economically feasible an economically
way. feasible way.
 Poll – III
• Hi Life Furniture company is engaged in production
of furniture and designer sofa sets.
• Identify which of the following can be termed as the
‘indirect costs’ of the company?
a) Worker’s wages who are engaged in conversion of
wood into furniture $1400
b) Cost of buying special kind of synthetic wood $500
c) Cost of varnish, glue and paints on furniture $70
d) Custom duty paid on importing wood from Canada
$200
3.) On basis of cost ‘behavior’
 2.1) Fixed Costs

• Do not change in relation to number of units produced.

• Remain constant over a period of time.

• Total Fixed Costs = Always Same/Constant.

For example:
• Rent, advertising, insurance, depreciation, salaries etc.
 Fixed Costs in BMW X5

• BMW incurs a total cost of $2,000,000 per year for

supervisors who work exclusively on the X5 line.

• Fixed costs become smaller and smaller on a per unit

basis as the number of vehicles assembled increases.
 Fixed Costs in BMW X5

• Total cost remains ‘constant’

in proportion to changes in
the number of vehicles
produced.

• The per unit fixed cost

changes and become smaller
as the number of vehicles
 2.2) Variable Costs

• It changes in direct proportion to the level of production.

• Total variable cost increase when more units are produced and

• Total variable cost decreases when less units are produced. 

For example:
• Direct material, direct labor
 Variable costs in BMW X5
• BMW buys each steering wheel at $60 for
each of its BMW X5 vehicles.
 Variable costs in BMW X5

• Total cost changes in

proportion to changes in
the number of vehicles
produced.

• The cost per unit of a

variable cost is
 2.3) Semi – variable costs
• Costs which remains
constant up to a certain
level of output and after
which they become
variable.

• Mixture of both fixed costs

and variable costs.

• For example: Salesmen’s

Salary, Electricity charges,
telephone charges
 Poll – IV
• The per-unit amount of three different production costs for a
manufacturing company., are as follows:
Production Cost A Cost B Cost C
20,000 Units Rs. 12 Rs. 15 Rs. 20
80,000 Units Rs. 12 Rs. 11.25 Rs. 5

• What type of cost is each of these three costs?

a) Cost A is mixed, Cost B is variable, Cost C is mixed
b) Cost A is fixed, Cost B is mixed, Cost C is variable.
c) Cost A is fixed, Cost B is variable, Cost C is mixed.
d) Cost A is variable, Cost B is mixed, Cost C is fixed.
 News analysis:
V – mart focuses on ‘lean costs’ during pandemic

• Focus on optimizing costs; lean costs

• Major costs are ‘fixed’; such as rentals,

maintenance, logistics and employee cost.

• Challenge is to cover fixed costs as soon

pandemic goes down.

• Already cut – down variables costs such

as travelling costs.
 CASE ANALYSIS
GM collapses under the weight of its Fixed Costs

• After nearly 80 years as the world’s largest

automaker, General Motors (GM) was forced to
file for bankruptcy in 2009.

• Declining sales and the rise of Japanese

competitors, such as Toyota and Honda,
affected GM’s viability given its high fixed costs.

• Such costs that did not decrease as the number

of cars that GM made and sold declined.
 CASE ANALYSIS
GM collapses under the weight of its Fixed Costs

• To cover its high fixed costs, GM needed to sell a lot of cars.

• In 2001, it began offering sales incentives and rebates, which for a

few years were somewhat successful.

• GM also expanded aggressively into China and Europe.

• In 2005, growth efforts slowed, and GM lost $10.4 billion.

• As a result, GM closed more than a dozen plants, eliminated several

jobs, slashed retirement plan benefits, and pension programs.

• Despite these cuts, GM could not reduce its costs fast enough to
keep up with the steadily declining market for new cars and trucks.
 CASE ANALYSIS
GM collapses under the weight of its Fixed Costs

• By November 2008, GM had lost more than $18 billion

for the year, and the government loaned the company
$20 billion to continue operations.

• Ultimately, its restructuring efforts fell short, and the

weight of GM’s fixed costs drove the company into
bankruptcy.
 Learnings from GM’s case analysis
1) Managers must understand costs in order to interpret
and act on accounting information.

2) Many organizations generate reports containing a variety

of cost concepts and terms that managers need to run
their businesses.

3) Managers must understand these concepts and terms to

effectively use the information provided.