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Friday, May 09, 2014

Classification of Cost

Types of Cost:
Cost classification is the process of grouping costs according to their common characteristics. It is the placement of like items together according to their common characteristics. A suitable classification of costs is of vital importance in order to identify the cost with cost centers or cost units. Costs may be classified according to their nature, i.e. material, labour and expenses and a number of other characteristics. The important ways of classification are:
a)      By Nature or Elements
b)      By Functions
c)       As Direct and Indirect
d)      By Variability
e)      By Controllability
f)       By Normality
g)      By Capital or Revenue
h)      By Time
i)        According to Planning and Control
j)        For Managerial Decisions.


By Nature or Element or Analytical Classification
                According to this classification, the costs are divided into three categories i.e. Materials, Labour and Expenses. There can be further sub classification of each element; for example, material into raw material components, and spare parts, consumable stores, packing material etc. This classification is important as it helps to find out the total cost, how such total cost is constituted and valuation of work in progress.
By Functions
According to this classification costs are divided as follows:
                Manufacturing and Production Cost: This is the total of costs involved in manufacture, construction and fabrication of units of production.
                Commercial Cost: This is the total of costs incurred in the operation of a business undertaking other than the cost of manufacturing and production. Commercial cost may further be sub-divided into (a) administrative cost and (b) selling and distribution cost.
As Direct and Indirect
According to this classification, total cost is divided into direct costs and indirect costs.
                Direct costs are those which are incurred for and may be conveniently identified with a particular cost centre or cost unit. Materials used and labour employed are common examples of direct costs.
                Indirect costs are those cost which are incurred for the benefit of number of cost centers or cost units and cannot be conveniently identified with a particular cost centre or cost unit. Examples of indirect cost include rent of building, management salaries, machinery depreciation etc.
By Variability
According to this classification, costs are classified into three groups viz. fixed, variable and semi-variable.
                (i) Fixed or period costs are commonly described as those which remain fixed in total amount with increase or decrease in the volume of output or productive activity for a given period of time. Examples of fixed costs are rent, insurance of factory building, factory manager’s salary etc.
                (ii) Variable or product costs are those which vary in total in direct proportion to the volume of output. Examples are direct material costs, direct labour costs, power, repairs etc. Such costs are known as product costs because they depend on the quantum of output rather than on time.
                (iii) Semi-variable costs are those which are partly fixed and partly variable. For example, telephone expenses included a fixed portion of annual charge plus variable charge according to calls; thus total telephone expenses are semi-variable. Other examples of such costs are depreciation, repairs and maintenance of building and plant etc.
By Controllability
                Under this, costs are classified according to whether or not they are influenced by the actions of a given member of the undertaking. On this basis it is classified into two categories:
                (i) Controllable costs are those which can be influenced by the action of a specified member of an undertaking, that is to say, costs which are at least partly within the control of management. Generally speaking, all direct costs including direct material, direct labour and some of the overhead expenses are controllable by lower level of management.
                (ii) Uncontrollable costs are those which cannot be influenced by the action of a specified member of an undertaking that it is to say, which are within the control of management. Most of the fixed costs are uncontrollable. For example, rent of the building is not controllable and so are managerial salaries.
By Normality
                Under this, costs are classified according to whether these are cost which are normally incurred as a given level of output in the conditions in which that level of activity is normally attained. On this basis, it is classified into two categories:
                (a) Normal cost: It is the cost which is normally incurred at a given level of output in the conditions in which that level of output is normally attained. It is a part of cost of production.
                (b) Abnormal cost: It is the cost which is not normally incurred at a given level of output in the conditions in which that level of output is normally attained. It is not a part of cost of production and charged to Costing Profit and Loss Account.
By Capital and Revenue or Financial Accounting Classification
                The cost which is incurred in purchasing assets either to earn income or increasing the earning capacity of the business is called capital cost. For example, the cost of a rolling machine in case of steel plan. Such cost is incurred at one point of time but the benefits accruing from it are spread over a number of accounting years.
                It any expenditure is done in order to maintain the earning capacity of the concern such as cost of maintaining an asset or running a business it is revenue expenditure e.g. cost of materials used in production, labour charges paid to convert the material into production, salaries, depreciation, repairs and maintenance charges, selling and distribution charges etc.
By Time
Cost can be classified as (i) Historical costs and (ii) Predetermined costs.
                i) Historical costs: The cost which is ascertained after their incurrence is called historical costs.
                ii) Predetermined costs: Such costs are estimated costs i.e. computed in advance of production taking into consideration the previous period’s costs and the factors affecting such costs. Predetermined cost determined on scientific basis becomes standard cost.
According to Planning and Control
                Planning and control are two important functions of management. Cost accounting furnishes information to the management which is helpful is the due discharge of these two functions. According to this, costs can be classified as budgeted costs and standard costs.
                i) Budgeted costs: Budgeted costs represent an estimate of expenditure for different phases of business operations such as manufacturing, administration, sales, research and development etc. coordinated in a well conceived framework for a period of time in future which subsequently becomes the written expression of managerial targets to be achieved.
                ii) Standard Cost: Standard cost is the predetermined cost based on a technical estimate for materials, labour and overhead for a selected period of time and for a prescribed set of working conditions.
For Managerial Decisions
On this basis, costs may be classified into the following costs:
                i) Marginal cost: Marginal cost is the total of variable costs i.e. prime cost plus variable overheads.
                ii) Out of pocket costs: This is that portion of the cost which involves payment to outsiders i.e., gives rise to cash expenditure as opposed to such costs as depreciation, which do not involve any cash expenditure.
                iii) Differential costs: The change in costs due to change in the level of activity or pattern or method of production is known as differential costs.
                iv) Sunk costs: A sunk cost is an irrecoverable cost and is caused by complete abandonment of a plant. It is the written down value of the abandoned plant less its salvage value.
                v) Imputed costs: These costs are those costs which appear in cost accounts only e.g. national rent charged on business premises owned by the proprietor, interest on capital for which no interest has been paid. These costs are also known as notional costs.
                vi) Opportunity cost: It is the maximum possible alternative earning that might have been earned if the productive capacity or services had been put to some alternative use.
                vii) Replacement cost: It is the cost at which there could be purchased an asset or material identical to that which is being replaced or revalued. It is the cost of replacement at current market price.

                viii) Avoidable and unavoidable cost: Avoidable costs are those which can be eliminated if a particular product or department, with which they are directly related, is discontinued. Unavoidable cost is that cost which will not be eliminated with the discontinuation of a product or department.