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# Basic cost concepts and classification

A cost may be defined as a sacrifice or giving up of resources for a particular purpose. Costs are frequently measured by the monetary units that must be paid for goods and services. An actual cost is the cost incurred (a historical cost) as distinguished from budgeted costs. A cost object is anything for which a separate measurement of costs is desired.

Cost

unit and Cost centre Cost estimation and cost ascertainment Cost objective and cost accumulation Cost allocation and cost apportionment Cost reduction and cost control

Cost Centres

Parts of the business to which particular costs can be attributed. Cost centre is the smallest organisational sub-unit for which separate cost collection is attempted.
In large businesses this can be: a particular location, section of the business, capital asset or human resource/s Enable a business to identify where costs are arising and to manage those costs more effectively

Cost unit

Once the cost of various cost centres is ascertained, the need arises to express the cost of output (product / service). A cost unit is defined as a unit of quantity of product, service or time (or a combination of these) in relation to which costs may be ascertained or expressed. Cost units are usually units of physical measurement like number, weight, time, area, length, volume etc.

## Cost estimation and cost ascertainment

Cost Estimation is the process of pre determining the costs of certain product, job or order for the purpose of budgeting, measuring performance efficiencies, make or buy decisions etc.
Cost Ascertainment is the process of determining cost on the basis of actual data.

Computation of historical cost is Cost Ascertainment while computation of future costs is Cost Estimation

## Cost allocation Vs Cost apportionment.

Cost allocation - Cost allocation refers to the allotment of whole items of costs to cost centres. For example, if a worker is employed in department "A", then the wages paid to the worker are allocated or charged to department "A". This process of charging the entire wages (being cost) of the worker to department "A" is termed as cost allocation. Cost apportionment - It is the process of distributing an item of cost over several cost centres or cost units. Thus, one item of cost is charged to two or more cost centres or cost units. Normally overheads (indirect costs) are charged to cost centres or cost units by way of apportionment in proportion to the anticipated benefits.

## Cost reduction and cost control

Cost Reduction: It is concerned with real and permanent reduction in the unit cost of goods manufactured or services rendered. It is done by variety of techniques like value analysis, design analysis, technological forecasting, standardization etc.
Cost control: The ascertainment of cost as well as furnishing such information to the management so as to control the cost of operating the business. It is done by variety of techniques like standard costing, budgetary control, quality control etc.

## Basic Cost Terms:

Cost

Object: Any activity or item for which a separate measurement of costs is desired.

Cost

Assignment: Direct costs are traced to a cost object. Indirect costs are allocated or assigned to a cost object.

Cost Drivers
The cost driver of variable costs is the level of activity or volume whose change causes the (variable) costs to change proportionately.
EXAMPLE: Seal Bicycles incurred Rs. 94,500 in a given year for the leasing of its plant. (This is an example of fixed costs with respect to the number of bicycles assembled.)

Q1. What is the leasing (fixed) cost per bicycle when Seal Bicycles assembles 1,000 bicycles? Ans: Rs. 94,500 1,000 = Rs. 94.50
Q2. What is the leasing (fixed) cost per bicycle when Seal Bicycles assembles 3,500 bicycles? Ans: Rs. 94,500 3,500 = Rs. 27

COST

Direct Material

Direct Labor

Direct Expenses

Factory O/h

## Selling & Distrb. O/h

Indirect material

Indirect material

Indirect material

Indirect labor
Indirect expenses

Indirect labor
Indirect expenses

Indirect labor
Indirect expenses

## What are direct costs?

Direct costs can be identified specifically and exclusively with a given cost objective in an economically feasible way.

## What are indirect costs?

Indirect costs cannot be identified specifically and exclusively with a given cost objective in an economically feasible way.

Managers prefer to classify costs as direct rather than indirect whenever it is economically feasible or cost effective.
Other factors also influence whether a cost is considered direct or indirect. The key is the particular cost objective. Any raw material, labor, or other input used by any organization could, in theory, be identified as a direct or indirect cost depending on the cost objective.

include the acquisition costs of all materials that are physically identified as a part of the manufactured goods and that may be traced to the manufactured goods in an economically feasible way.

include the wages of all labor that can be traced specifically and exclusively to the manufactured goods in an economically feasible way.

or factory overhead, include all costs associated with the manufacturing process that cannot be traced directly to the manufactured goods in an economically feasible way.

Manufacturing Costs
Manufacturers

make the products they sell. They must keep records of their factory costs so that they can control those costs and set selling prices that will produce a net income instead of a net loss.

Direct Labor

Conversion Costs

Indirect Labor

Indirect Materials

Other

## Prime cost / Basic, first or flat cost

= Direct Material + Direct labour + direct expenses

Factory cost or Works cost = Prime cost + Factory overheads Office cost or cost of production = Factory cost + Office and admin. overheads Total cost or cost of sales = cost of production of goods sold + selling and distribution overheads

Factory Costs
Raw materials: The costs of materials which are used in manufacturing and which become part of the finished product. Direct labor costs: The wages of all the workers who work directly on the products as they move through the factory.

Factory overhead: The expenses that cannot be directly tied to producing a product. For example, it includes salaries and wages of the factory managers, supervisors, inspectors, and other workers who do not work directly on the manufactured products. It also includes building rent, depreciation of equipment, heat, power, insurance, and factory supplies.

Direct material refers to cost of direct material consumed. However not all material purchased as well as in stock are consumed during the period.
Cost of Direct material = opening stock + purchases closing stock

## Distribute Factory Overhead to Units

A

manufacturer needs to know the costs of running each of its divisions, departments, or other units. So, factory expenses, or overhead, are often distributed or charged to each unit.

## Examples of Distributing Factory Overhead

The way they are distributed varies with the company and the kind of expense.
Rent may be distributed in proportion to the floor space used by the units. Taxes and insurance on equipment may be distributed based on the value of the equipment in each unit. Cleaning expenses may be distributed on the basis of floor space. Management salaries may be distributed based on the number of factory workers in a unit.

## On the basis of variability the cost can be classified as:

Fixed

cost / period cost Variable cost / product cost Semi-variable cost Step cost

Fixed

Costs

Costs that remain unchanged for a given time period regardless of changes in the related cost driver.

Variable

Costs

Costs that change directly in proportion to changes in the related cost driver

Other

## Common Functions for Cost Behavior

Semi-variable costs (part variable and part fixed) Step costs (aka semi-fixed costs, it remains constant over a range of activity)

Cost which become part of the cost of the product rather than an expense of the period in which they are incurred are called as Product costs. Ex. Cost of raw material, depreciation on plant.
Cost which are not associated with production but are treated as an expense of the period in which they are incurred are called period costs. Ex. Gen admin. Cost, salesman salaries etc.

Product

Costs: Costs that attach to the units that are produced i.e., manufacturing costs) and are not reported expenses until the goods are sold. costs: Costs that must be charged against income in the period incurred and cannot be inventoried e.g., selling and administrative expenses Costs: Total cost of units divided by

Period

Unit

units

Decision making cost and Accounting cost Shutdown and sunk cost Relevant and irrelevant cost Controllable and uncontrollable cost Imputed and hypothetical cost Out of pocket cost Opportunity cost Joint cost and common cost Traceable and untraceable cost Conversion cost

Imputed / Notional cost - Imputed cost is that cost which does not involve any cash outlay. Though it is a hypothetical cost, it is relevant for decision making. Interest on capital, the payment for which is not actually made, is an example of imputed cost. Sunk cost - Historical cost which is incurred in the past is known as sunk cost. This cost is not relevant in decision making in the current period. For eg. In the case of a decision relating to the replacement of a machine, the written down value of the existing machine is a sunk cost and hence irrelevant to decision making. Shut down cost - The fixed cost which cannot be avoided during the temporary closure of a plant is known as shut down cost. Examples of shut down cost are depreciation and rent.

Controllable cost - The cost, which can be influenced by the action of a specified person in an organisation, is known as controllable cost. In a business organisation, heads of each responsibility centre are responsible to control costs. Uncontrollable cost - The cost which cannot be influenced by the action of the person heading the responsibility centre is called uncontrollable cost. For e.g. all the allocated costs and the fixed costs.

Normal cost - It is the cost which is normally incurred at a given level of output, under the conditions in which that level of output is normally attained. Normal cost is charged to the respective product / process. 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.

Differential cost - It is the difference in the total cost between alternatives calculated to assist decision making Thus, it represents the change in total cost (both fixed and variable) due to a change in the level of activity, technology, process or method of production, etc. Where the change results in increase in cost it is called incremental cost, whereas if costs are reduced due to increase of output, the difference is called decremental costs. The differential costs are relevant costs.

Discretionary cost - It is an "escapable" or "avoidable" cost. In other words, it is that cost which is not essential for the accomplishment of a particular objective.

Standard cost - It is a pre-determined cost which is arrived at, assuming a particular level of efficiency in utilization of material, labour and other indirect services. It is the planned cost of a product and is expected to be achieved under a particular production process under normal conditions. It is often used as a basis for price fixing and cost control. Estimated Cost - It is an approximate assessment of what the cost will be. It is based on past data adjusted to anticipated future changes. Marginal cost - It is the amount at any given volume of output by which aggregate cost changes if the volume of output changes increases/decreases) by one unit.

Opportunity cost - It refers to the value of sacrifice made or benefit of opportunity forgone in accepting an alternative course of action.
Out of pocket cost - It is that portion of total cost which involves cash outlay. It is a short term cost concept and is used in short- term decision making like make or buy, price fixation during recession. Out of pocket cost can be avoided if a particular proposal under consideration is not accepted. Joint cost - It is the cost of the process which results in more than one main product. Decision-driven cost - It is that cost which is incurred following a policy decision and continues to be incurred till that decision is altered. It does not vary with changes in output or with operational activities.

Committed cost - It is a fixed cost which results from decisions of prior period and is not subject to managerial control in the present. Examples of committed cost are depreciation, insurance premium and rent. Relevant cost - CIMA defines relevant cost as " cost appropriate to a specific management decision". Replacement cost - It is the cost of replacement in the current market. Absolute cost - It is the total cost of any product or process. For e.g.: in a cost sheet, both absolute cost and cost per unit are depicted.

A Company is manufacturing 1000 unit of a product. Selling Price per unit : Rs. 10 Variable Cost per unit: Rs. 5 Fixed cost: Rs. 4000

## The management is considering following two alternatives:

(i)

(ii)

To accept an order for another 200 units at Rs.8 per unit. This will increase the fixed cost by Rs. 500. To reduce the production from present 1000 units to 600 units and buy another 400 from the market at Rs 6 per unit. This will reduce the fixed cost to Rs. 3000.

## Statement showing Profitability under different alternatives

Present situation

Proposed Situations

Rs.
Sales Less: Variable cost/ Purchase Fixed cost Profit 5000 4000 9000 1000 1000x10 10000 10000 + 1600 1200x5 4500

I
11600 1000x10

II
10000