COST CONCEPTS AND CLASSIFICATION

CONCEPT OF COST
The term cost has a wide variety of meanings. Some use the word ‘price’ for cost, though
cost is not the same as price. In management terminology, cost refers to expenditures and not
price. Some important definitions of cost are given below to make the concept clear:
According to the British Institute of Cost and Works Accountants “Cost is the amount of
expenditure (actual or notional) incurred on or attributable to a given thing.”
W.M. Harper: “Cost is the value of economic resources used as a result of producing or doing
the thing costed.”
Raymond J. Chambers: The term cost is used in three different senses- 1) the expected cost of
a particular action, 2) the cost of something purchased, and 3) the cost of attaining some end,
ie., the sacrifices actually made to attain it.
The Institute of Cost and Management Accountants (ICMA), England: “Costing is the
technique and process of ascertaining costs.” Costing relates to the ascertainment of cost of a
product produced or service rendered.
ICMA, England defines cost accounting as “the process of accounting for cost from the point
at which expenditure is incurred or committed to the establishment of its ultimate relationship
with cost centres and cost units.” Thus cost accounting is a formal accounting procedure to
ascertain cost of production.
Cost accountancy is defined as “the application of costing and cost accounting principles,
methods and techniques to the science, art and practice of cost control and ascertainment of
profitability. It includes the presentation of information derived there from for the purpose of
managerial decision making.”
Cost accountancy is thus a wide term which includes both costing and cost accounting. Its
main
purposes are cost control and ascertainment of profitability. It is an important tool of
managerial decision-making.
CLASSIFICATION OF COST
Classification of cost is the process of grouping costs according to their common
characteristics.
Classification is done on the following bases:
1. On the basis of elements of cost
2. On the basis of function
3. On the basis of behavior or variability
4. Classification for managerial decisions and control.
1. Classification by Nature or Elements of Cost
Under this head cost can be broadly classified as : a) Direct costs and b) Indirect Costs
a) Direct Costs: Direct Costs are the costs which can be easily identified with and allocated
to a particular product. Such costs are treated as the cost of the unit produced. For eg. Cost of
raw materials, labour and other direct expenses incurred for the production of a particular job,
product or process.
b) Direct costs can be further classified in to:
i) Direct Material: all those materials specifically consumed for the production of the unit,
including all primary packing materials. ii) Direct Labour: Wages paid to workers directly
engaged in the manufacturing process of a product, a job or an operation can be stated as
direct labour.
iii) Direct Expenses: All expenses other than direct material and direct labour that are
specifically incurred for a particular job, product or process are called direct expenses or
chargeable expenses. Cost of special tools, patterns etc., made for a particular job, product or
process, hire charges of special equipment, excise duty, royalties, freight and insurance on
special materials etc. are other examples.
b) Indirect Costs: Indirect costs are those which cannot be assigned to any particular cost
unit, ie., job, product or process, but can be apportioned on a reasonable basis. These costs
are of general character and are incurred for the business as a whole or for several cost
centres at a time. Such costs are apportioned to those cost centres on the basis of benefits
received by each. Indirect costs include:
i) Indirect Material such as fuel, lubricating oil, small tools, material consumed for repairs
and maintenance, miscellaneous stores used in the factory, etc.
ii) Indirect Labour which includes wages of general supervisors, inspectors, workshop
cleaners, store-keepers, time-keepers, etc.
iii) Indirect Expenses such as rent, lighting, insurance, canteen, hospital, welfare expenses,
etc.
Indirect costs are also called “Overheads” which can be further classified into:
a) Factory Overheads which include all indirect costs related with the manufacture of a
product such as lubricants, oil, consumable stores, works manager’s salary, time keeper’s
salary, factory rent, factory insurance, etc.
b) Office and Administration Overheads which include all indirect expenses relating to
administration and management of an office such as office rent, office lighting, insurance,
salaries of clerical and executive staff, etc.
c) Selling and Distribution Overheads which include all indirect costs connected with
marketing and sales such as advertising expenses, salaries of salesmen, indirect packing
materials, etc.
2. Functional Classification
On the basis of functions cost can be classified as follows:
a) Prime Cost: It consists of cost of direct materials, direct labour and direct expenses. It is
also known as direct cost or first cost.
b) Factory Cost: It is prime cost plus factory overhead or works overhead. Also known as
works cost, production cost or manufacturing cost.
c) Cost of Production: It is factory cost plus office and administration overheads. Also known
as office cost, administration cost or gross cost of production.
d) Total Cost or Cost of Sales: It comprises of cost of production plus selling and distribution
overheads.
Functional classification of cost can be summarized as below:
1. Prime Cost = Direct Material + Direct Labour + Direct Expenses
2. Factory Cost or Works Cost = Prime Cost + Works Expenses.
3. Office Cost or Cost of Production = Factory Cost + Office & Administrative Overheads.
4. Total Cost or Cost of Sales = Cost of Production + Selling & Distribution Overheads.

3. Classification on the basis of Behavior

On the basis of behavior or variability, costs may be classified as:
a) Variable Cost: Costs that vary in direct proportion to the volume of production are called
variable costs. For eg. Direct material, direct labor and direct expenses. Variable costs vary in
total in relation to the units produced, but remain constant per unit at all levels, unless
otherwise
stated. Variable cost is also known as product cost.
b) Fixed Cost: Costs which do not vary with the volume of production are called fixed costs.
They remain fixed in total irrespective of the level of production, but vary per unit for
different levels of activity. Fixed cost per unit decreases with increase in output and increases
with decrease in output. Fixed costs are normally based on time and hence also known as
period cost. Eg. Rent of building, office salary, insurance premium, etc.
c) Semi-variable costs: These costs are partly fixed and partly variable. These costs may vary
with the level of production but not in direct proportion to the output. Eg. Telephone charges,
repairs and maintenance, depreciation of machinery, etc.
4. Classification for Managerial Decisions and Control
a) Controllable and uncontrollable costs: Controllable costs are those costs which can be
controlled or influenced by a specified person or a level of management of an undertaking.
Costs which cannot be so controlled are known as uncontrollable costs.
b) Normal and abnormal cost: Costs which are normally incurred at a given level of output
are known as normal costs and it is charged to the cost of production. The costs which are not
normally incurred at a given level of output in the normal conditions are abnormal costs, ie.,
any cost which is in excess of normal cost is treated as abnormal cost and is charged to
costing profit and loss account.
c) Avoidable and unavoidable costs: Avoidable costs are those costs which can be escaped
if some activity of the business is discontinued. Unavoidable costs are those which cannot be
escaped or eliminated.
d) Shut down and sunk costs: Those fixed costs which have to be incurred even if
production
of an undertaking is discontinued temporarily due to some reasons such as strike, shortage of
raw material, etc., are called shut down costs. Costs which have been incurred and are
irrelevant in a particular situation are called sunk costs.
e) Out of pocket costs: It is a cost which involves actual cash payment to outsiders, like rent,
salary, interest, etc. Expenses like depreciation, goodwill written off, loss on sale of assets,
etc. do not involve cash payment and hence are not out of pocket costs.
f) Opportunity costs: It refers to the benefit forgone or sacrifice made in favor of an
alternative course of action. When one alternative is rejected in favor of another, the loss of
benefit from the rejected alternative is the opportunity cost. For e.g., if an owned building is
used for business, the rent that would have been received by letting it out is an opportunity
cost.
g) Conversion costs: It is the cost of converting or transforming raw materials into finished
products. It includes direct wages , direct expenses and factory overheads.
h) Replacement cost: Replacement cost is the cost of replacing an asset by purchasing it
from the market.
i) Imputed cost or Notional cost: Imputed cost is a hypothetical cost which does not involve
actual cash expenditure. For e.g., rent of owned building, interest on owned capital, etc.
j) Differential cost, incremental cost and decremental cost: The difference in cost due to
change in the level of activity or method of production is known as differential cost. If the
change results in increase in total cost, it is called incremental cost. If the change results in
decrease in total cost, it is called decremental cost.
k) Marginal cost: Marginal cost is the cost of producing one additional unit. Marginal cost
concept is based on the distinction between fixed cost and variable cost. Marginal cost
includes variable costs only.
l) Budgeted costs and standard costs: Budgeted costs are estimated costs prior to a defined
period of time. Standard cost is a predetermined cost based on technical estimate for
materials, labour and overheads for a selected period of time and for a prescribed set of
working conditions.
m) Relevant cost: It is a cost which has a direct influence on managerial decision-making.
n) Postponable cost: Postponable cost is a cost which can be postponed to a future period
without any adverse effect on the efficiency of the present operations.
These are the important classifications of cost.
Now let us move on to the next module on Variable costing and Absorption costing.
VARIABLE AND ABSORPTION COSTING
VARIABLE COSTING
An analytical study of the behavior of overheads in relation to changes in volume of output
reveals that there are some items of cost which vary directly with volume of output whereas,
there are some other costs which remain unaffected by variations in the volume of output.
Fixed and variable costs behave differently with changes in the volume of output; variable
costs tend to vary in total with increase or decrease in the level of activity, but fixed costs
tend to remain constant in total irrespective of the level of activity.
The volume of production fluctuates from one period to another due to seasonal and other
factors. But fixed costs being same during each period, fluctuations occur in unit cost of
production during different periods. The total cost per unit may vary as a result of variation in
the volume of output, because of the incidence of fixed cost in it. To prevent this uneven
incidence of fixed cost on units produced, fixed costs are treated as period costs and excluded
from product costs. The necessity for separating fixed cost from product cost in order to
eliminate the fluctuations in cost has given rise to the concept of marginal costing. The
essence of marginal costing lies in considering fixed costs as distinct from variable cost and
as such excluded from the product cost. Only variable cost is considered as relevant to
product cost and matched with revenues under different conditions of production and sales,
and hence marginal costing is also called as variable costing.
Definition: Marginal cost is the additional cost of producing an additional unit of a product.
ICMA, London defines Marginal cost as “the amount at any given volume of output by which
aggregate costs are changed if the volume of output is increased or decreased by one unit.” In
practice, this happens to be the total variable cost attributable to one unit.
Marginal cost may also be defined as the ‘aggregate of variable costs’ or “prime cost plus
variable overheads”. For e.g.: Variable cost per unit Rs.6, fixed cost for the period Rs. 5,000,
units produced during the period: 500
Cost of production = 500 x 6 = 3000 + 5000 = Rs. 8,000
If in another period, 501 units are produced, then cost of production will be:
Cost of production = 501 x 6= 3006 + 5000 = Rs. 8,006
Therefore, the change in aggregate cost per unit, ie., the marginal cost is Rs. 6, ( 8006-8000)
which is the same as the variable cost per unit.
A detailed discussion on marginal costing is done later in this text.
METHODS OF PRICING OF MATERIAL
A number of methods are used for pricing material issues. Each method has its own
advantages and disadvantages. As such, it is impossible to say which method is the best. Each
organisation should choose a particular method best suited to it. While choosing a method, it
is necessary to see that the method chosen is simple, effective and realistic. At the same time,
it is equally necessary to consider the effect of the method on production cost and inventory
valuation.
The following are the different methods of pricing the material issues:
15.6.1. First In First Out Method (FIFO)
Under this method, materials are issued in the order in which they are received in the store. It
means that the material received first will be issued first.
Advantages:
a. This method is simple to understand and easy to operate.
b. The closing stock is valued at the current market price.
c. Since issues are priced at cost, no profit or loss arises from pricing.
d. This method is more suitable in times of falling prices.
e. Deterioration and obsolescence can be avoided.
Disadvantages:
a. When prices fluctuate, calculation becomes complicated. This increases the possibility of
clerical errors.
b. During the period of price fluctuations, material charged to jobs vary. Therefore,
comparison between jobs is difficult.
c. During the period of rising prices, product costs are under stated and profits are overstated.
This may result in payment of higher dividend out of capital.

Last In First Out Method (LIFO)

This method is opposite to FIFO. Here materials received last are issued first. Issues are made
from the latest purchases.
Advantages:
a. Issues are based on actual cost.
b. Issue price reflects current market price.
c. Product cost will be based on current market price and hence will be more realistic.
d. There is no unrealized profit or loss.
e. Simple to operate if purchases are not many and prices are steady or rising.
f. When prices are raising this method is helpful in preparation of quotation or estimates.
Disadvantages:
a. This method involves considerable clerical work.
b. Under felling price, issues are priced at lower prices and stocks are valued at higher rates.
c. Stock of material shown in the balance sheet will not reflect market price.
d. Due to variation in prices, comparison of cost of similar job is difficult.
e. This method is not accepted by the income tax authorities.

Weighted Average Method:

This is an improvement over the simple average method. This method takes into account both
quantity and price for arriving at the average price. The weighted average is obtained by
dividing the total cost of material in the stock by total quantity of material in the stock.
For Example : 20 units are purchased at Rs.10 p.u Rs. 200
30 units are purchased at Rs.20 p.u Rs. 600
 50 Rs. 800
Weight average price = Rs. 800 / 50 = Rs. 16
Advantages:
a. It gives more accurate results than simple average price because it considers both quantity
as well as price.
b. It evens out the effect of price fluctuations. All jobs are charged a average price. So,
comparison between jobs is more easy and realistic.
c. It is suitable in the case of materials subject to wide price fluctuations.
d. It is acceptable to income tax authorities.
Disadvantages:
a. Stock on hand does not represent current market price.
b. When large number of purchases are made at different rates, the calculation is tedious. So,
there are more chances of clerical error.
c. With some approximation in average price, there will be profit or loss due to over or under
charging of material cost to jobs.

Draw a stores ledger card recording the following transactions under FIFO method.
1998 July 1 Opening stock 2,000 units at Rs.10 each.
5 Received 1,000 units at Rs.11 each
6 Issued 500 units.
10 Received 5,000 units at Rs.12 each.
12 Received back 50 units out of the issue made on 6th July.
14 Issued 600 units.
18 Returned to supplier 100 units out of goods received on 5th.
19 Received back 100 units out of the issue made on 14th July.
20 Issued 150 units.
25 Received 500 units at Rs.14 each.
28 Issued 300 units.
The stock verification report reveals that there was a shortage of 10 units on 18th July and
another shortage of 15 units on 26th July.
Note:
1. G.R.N.No. – Goods Received Note Number.
2. M.R.No. – Material Requisition Number. Mat. Retd. Note = Material Returned Note.
3. Debit Note is sent to suppliers when materials are returned.
4. Shortage is treated like an issue and priced as per the method of pricing in operation.
5. Returns from departments are treated just like fresh receipts at the price at which the
original issue was made. Its reissue will be as per the method followed. An alternative
treatment is to issue the returned material as the ‘first out’ (or) irrespective of the method of
pricing, issuing it as ‘next issue’ whenever an issue is made.
6. Returns to supplier are like an issue, at the rate at which the original purchase was made.

The stock of a material as on 1st April 1998 was 200 units at Rs.2 each. The following
purchases and issues were made subsequently. Prepare Sores Ledger Account showing how
the value of the issues would be recorded under (a) FIFO and
(b) LIFO methods.
1998 April 5 Purchases 100 units at Rs.2.20 each.
10 Purchases 150 units at Rs.2.40 each
20 Purchases 180 units at Rs.2.50 each
2 Issues 150 units
7 Issues 100 units
12 Issues 100 units
28 Issues 200 units
Prepare as stores ledger account using weighted average method of pricing issue of materials.
1999
March 1 Balance 1,000 units @ Rs.70 per unit.
3 Purchased 2,000 units @ Rs.80 per unit.
5 Issued 500 units.
10 Issued 1,000 units.
15 Purchased 2,000 units at Rs.80 per unit.
18 Issued 400 units.
20 Received back 25 units out of the issue made on 5th March.
22 Issued 1,500 units.
24 Returned to supplier 30 units out of the purchases made on
15th March.
25 Purchased 1,000 units at Rs.75 per unit.
30 Issued 1,000 units.
Physical verification on 21st March revealed a shortage of 15 units and 20 units shortage on
30th March.
Exercises
MEANING OF DEPRECIATION
Assets are broadly divided in to two categories- current assets (cash, debtors or customers
balances, stock of materials and goods) and fixed assets (buildings, furniture and fixtures,
machinery and plant, motor vehicles). Fixed assets are also called long term assets as they
provide benefits to the business for more than one year. Most fixed assets loose their value
over time as these are put in use and as the years pass by. The fixed assets loose their
usefulness due to arrival of new technologies and change of fashions etc. These are then
generally required to be replaced, as their useful life is over. Hence, the cost of a fixed asset is
allocated over its useful life. Each year’s allocation of the cost is charged as depreciation
expense for that year. For example an office chair is purchased for ` 2,500 and it is estimated
that after ten years it will be scraped. The useful life of the chair is ten years over which the
cost of ` 2,500 will be distributed. Each year’s allocation may be calculated as:-
Depreciation = Cost of Assets – Scarp Value / Life of Assets
= 2500/10 = 250
Thus ` 250 is the depreciation expense for each year. Thus, depreciation is an expense
charged during a year for the reduction in the value of fixed assets, arising due to:
• Normal wear and tear out of its use and passage of time
• Obsolescence due to change in technology, fashion, taste and other market conditions

METHOD OF CHARGING DEPRECIATION

Most popularly used methods for charging depreciation are:
i. Straight Line Method and
ii. Diminishing Balance Method

Straight Line Method of Depreciation

Under this method, the amount of depreciation is uniform from year to year. Suppose, if an
asset costs ` 1,00,000 and depreciation is fixed @ 10%, then ` 10,000 would be written off
every year. That is why this method is also called ‘Fixed Installment Method’ or ‘Original
Cost Method’. In this method, the amount to be written off every year is arrived at as under:
Out of the cost of the asset, its scrap value is deducted and it is divided by the number of
years of its estimated life.
For example: a machine is purchased for ` 1,20,000 and it is estimated that its useful life is 10
years. After its useful life its scrap value is ` 20,000. Depreciation of one year can be
calculated as under:

If its scrap cannot be sold or no money can be realized from its scrap, then depreciation of
one year is:

In this method the amount of depreciation is same for each year. Therefore this method is
called Straight Line Method, Fixed Installment Method or Original Cost Method.
Illustration 2 A machine was purchased on January 1, 2011 for ` 1,00,000 and its useful life is
10 years. After completing its useful life the machine will be scraped and nothing will be
realized from it. It is decided to charge depreciation on this machine @ 10% p. a. on Straight
Line Method.
Calculate amount of depreciation for each year during the useful life of this machine
Amount of depreciation is same in every year, so this method is called ‘Straight Line
Method’ or ‘Fixed Installment Method’ or ‘Original Cost Method’.
MERITS OF STRAIGHT LINE METHOD

i) Simplicity :Calculation of depreciation under this method is very simple and

therefore the method is widely popular. Once the amount of depreciation is
calculated, the same amount is written off as depreciation each year. Hence this
method is simple and calculations are easier to understand.
ii) Asset is completely Written Off : Under this method, the book value of an asset is
reduced to net scrap value or zero value. In other words, in the books of accounts
the value of the asset at the end of its useful life is equal to zero or its residual
value.
LIMITATIONS OF STRAIGHT LINE METHOD
i) Difficulty in Computation : When there are various machines having different
life-spans, the computation of depreciation becomes complicated because the
depreciation on each machine will have to be calculated separately for each asset.
ii) Illogical :It is well known that the expense on its repairs and maintenance
increases as the asset becomes older. Thus, the total burden on Profit and Loss
Account, depreciation plus repair expenses, is more in later years in comparison to
earlier years. This is illogical because the efficiency and productivity of the asset
is more in earlier years and less in later years.
On 1st January, 2003 a Company purchased a plant for ` 20,000. On 1st July in the same year,
it purchased additional plant worth ` 8,000 and spent ` 2,000 on its erection. On 1st July,
2004, the plant purchased on 1st jan., 2003 having become obsolete, was sold off for `
12,500. On 1st October, 2005, fresh plant was purchased for ` 28,000 and on the same date,
the plant purchased on 1st July, 2003 was sold at ` 6,000. Depreciation is provided at 10% per
annum on original cost on 31st December every year. Show the plant account for 2003 to
2005.
DIMINISHING BALANCE METHOD
Under this method, as the value of asset goes on diminishing year after year, the amount of
depreciation charged every year goes on declining. The amount of depreciation is calculated
as a fixed percentage of the diminishing value of the asset shown in the books at the
beginning of each year. Under this method the value of an asset never comes to zero.
Suppose, the cost of the asset is ` 40,000 and the percentage to be written off each year is
10%. In the first year the amount of the depreciation will be ` 4,000 i.e., 10% of ` 40,000.
This will reduce the book value to ` 36,000 i.e. ` 40,000 – ` 4,000. Now, at the beginning of
the next year the book value is ` 36,000. The amount of the depreciation for the next year will
be ` 3,600, i.e., 10% of ` 36,000. Thus, every year the amount of the depreciation will go on
reducing. This method of charging depreciation is also known as Reducing Balance Method
or written down value method.
For Example: A machine was purchased on January 1, 2011 for ` 1,00,000 and its useful life
is 10 years. After completing its useful life the machine will be scraped and ` 4,000 will be
realized from it. It is decided to charge depreciation on this machine @ 10% p. a. on
Diminishing Balance Method. Calculate amount of depreciation for each year during the
useful life of this machine.

Amount of depreciation is decreased year after year in this method that is why this method is
called ‘Diminishing Balance Method’ or ‘Reducing balance method’ or ‘written down value
method’.
MERITS OF DIMINISHING BALANCE METHOD
i) Equal Burden on Profit & Loss Account The productivity of the asset is more hence
its contribute to profit is also relatively greater. Therefore the cost charged in terms of
depreciation should also be greater. In the initial year, the depreciation charges are
more and repair expenses are less. In later years, depreciation charges are less and
repair expenses are more. Hence the total burden, depreciation plus repair expenses,
is some what equal on Profit & Loss Account for each year.
DEMERITS OF DIMINISHING BALANCE METHOD
i) Asset cannot be completely written off : Under this method, the value of an asset is
not reduced to zero even when there is no scrap value.
ii) Complexity : Under this method, the rate of depreciation cannot be determined easily.

Example: Widson enterprise purchases Plant and Machinery for ` 1,00,000 on 1st October
2012. It decides to write off depreciation 20% per annum on Written Down Value Method.
On 1st January, 2015 purchases additional Machinery for ` 40,000. Show Machinery Account
upto the year ending 31st March, 1996. The accounting year ends on 31st March.
Example: On April 1, 2009 Ganga Bros. purchased two machines for ` 75,000 each.
Depreciation at the rate of 10% on diminishing balance method was provided. On March 31,
2011, one machine was sold for ` 55,000. An improved model with a cost of ` 80,000 was
purchased on the same day. You are required to show the Machinery Account for 2009-10 to
2010-11.
Example: On October 1, 2008, the Akash Transport Company purchased a Truck for `
8,00,000. On April 1, 2010, this Truck was involved in an accident and was completely
destroyed and ` 6,00,000 were received from Insurance Company in full settlement. On the
same date another Truck was purchased by the company for ` 10,00,000. The company writes
off 20% depreciation p. a. on written down value method. Give the Truck Account from 2008
to 2010.