Cost Classification

• Cost classification is the logical process of

categorizing the different costs involved in a
business process according to their type,
nature, frequency and other features to fulfill
accounting objectives and facilitate economic
analysis. 
Classification according to nature
Classification according to nature
Material: Material cost is the cost of the raw material and its
related cost such as procurement cost, taxes, insurance, freight
inwards, etc.
Labor: Labor cost is the salary and wages paid to the
employees, i.e. permanent, temporary or contractual
employees working in an organization. It also
includes Provident Fund contribution, bonus, commission,
incentives, allowances, overtime pay, etc.
Other Expenses: All the other overheads excluding material
and labor comes under this head. Some of these are packaging,
promotion, job processing charges, etc.
 Classification by Relation to Cost Centre

The cost classification by nature are used under this category to

further sub-categorize the elements of this category. 

The basis of differentiating the costs is categorizing them by

their allocation in the production process of goods or services. 
 Classification by Relation to Cost Centre

Direct Cost: Direct cost is the significant cost immediately

associated with a production process. It can be seen as a prime
cost for any business. It is sub-divided into direct material cost,
direct labour cost and other direct expenses.

Indirect Cost: Indirect cost is the cost which cannot be directly

allocated to a particular process of production. It is a secondary
cost and is majorly seen as of three types – indirect material
cost, indirect labour cost and other indirect expenses.
. 
 Cost Classification by Functions
Cost can also be classified by the business functions for which
the resources have been used.
 Cost Classification by Functions
• Production: Production cost comprises of all the direct and indirect costs
incurred in the production of goods and services.
• Administration: The costs involved in the management activities of an
organization like electricity, stationery, telephone expenses, rent etc. These
are also known as administrative overheads.
• Selling: The indirect costs incurred on the sales function of the goods and
services like an advertisement, promotion, research, customer service, etc.
are clubbed under selling cost.
• Distribution: Distribution cost refers to the cost incurred for making the
goods or services available to the customers. These are warehousing, delivery
service, transportation, etc.
• Research and Development: Research is essential to develop a new product
or modify an existing one. The cost incurred on the research team, research
implementation, findings, etc. comes under this category.
 Classification according to behaviour
Cost involved in any business process can be differentiated on the grounds of its volatility concerning the
fluctuation in business activity in the short run.

• i.Fixed Costs :- Out of the total costs, some costs remain fixed irrespective of changes in the production volume.
These costs are called as fi xed costs. The feature of these costs is that the total costs remain same while per unit
fixed cost is always variable. Examples of these costs are salaries, insurance, rent, etc.

• ii.Variable Costs :- These costs are variable in nature, i.e. they change according to the volume of production.
Their variability is in the same proportion to the production. For example, if the production units are 2,000 and
the variable cost is Rs. 5 per unit, the total variable cost will be Rs. 10,000, if the production units are increased to
5,000 units, the total variable costs will be Rs. 25,000, i.e. the increase is exactly in the same proportion of the
production.

Another feature of the variable cost is that per unit variable cost remains same while the total variable costs will
vary. In the example given above, the per unit variable cost remains Rs. 2 per unit while total variable costs
change. Examples of variable costs are direct materials, direct labor etc.

• iii. Semi-variable Costs :- Certain costs are partly fixed and partly variable. In other words, they contain the
features of both types of costs. These costs are neither totally fixed nor totally variable. Maintenance costs,
supervisory costs etc are examples of semi-variable costs. These costs are also called as ‘stepped costs’.
 Behavior of Cost (within the relevant range)
Cost In Total Per Unit

Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.
 Classification according to time
• Costs can also be classified according to time. This classification is explained
below :

I. Historical Costs :- These are the costs which are incurred in the past, i.e. in
the past year, past month or even in the last week or yesterday. The historical
costs are ascertained after the period is over. In other words it becomes a post-
mortem analysis of what has happened in the past. Though historical costs have
limited importance, still they can be used for estimating the trends of the future,
i.e. they can be effectively used for predicting the future costs.

II. Predetermined Cost :- These costs relating to the product are computed in
advance of production, on the basis of a specification of all the factors affecting
cost and cost data. Predetermined costs may be either standard or estimated.
 Classification according to time
• Standard Cost is a predetermined calculation of how much cost is to
be accounted under specific working conditions. It is based on
technical studies regarding material, labour and expenses.

The main purpose of standard Financial Accounting, Cost Accounting

and Management Accounting cost is to have some kind of benchmark
for comparing the actual performance with the standards.

On the other hand, estimated costs are predetermined costs based on

past performance and adjusted to the anticipated changes. It can be
used in any business situation or decision making which does not
require accurate cost.
 Classification of costs for Management
decision making
One of the important function of cost accounting is to present information to the Management for the purpose of
decision making. For decision making certain types of costs are relevant which are classified as follows

• I. Marginal Cost :- Marginal cost is the change in the aggregate costs due to change in the volume of output by one
unit.
For example, suppose a manufacturing company produces 10,000 units and the aggregate costs are Rs. 25,000, if 10,001
units are produced the aggregate costs may be Rs. 25,020 which means that the marginal cost is Rs. 20.
Marginal cost is also termed as variable cost and hence per unit marginal cost is always same, i.e. per unit marginal cost
is always fixed. Marginal cost can be effectively used for decision making in various areas.

• II. Differential Costs :- Differential costs are also known as incremental cost. This cost is the difference in total cost that
will arise from the selection of one alternative to the other. In other words, it is an added cost of a change in the level of
activity. This type of analysis is useful for taking various decisions like change in the level of activity, adding or dropping a
product, change in product mix, make or buy decisions, accepting an
export offer and so on.

• III. Opportunity Costs :- It is the value of benefit sacrificed in favour of an alternative course of action. It is the
maximum amount that could be obtained at any given point of time if a resource was sold or put to the most valuable
alternative use that would be practicable. Opportunity cost of goods or services is measured in terms of revenue which
could have been earned by employing that goods or services in some other alternative uses.
 Classification of costs for Management
decision making
• IV. Relevant Cost :- The relevant cost is a cost which is relevant in various decisions of management.

Decision making involves consideration of several alternative courses of action. In this process, whatever
costs are relevant are to be taken into consideration.

In other words, costs which are going to be affected matter the most and these costs are called as relevant
costs. Relevant cost is a future cost which is different for different alternatives. It can also be defined as any
cost which is affected by the decision on hand. Thus in decision making relevant costs play a vital role.

• V. Replacement Cost :- This cost is the cost at which existing items of material or fixed
assets can be replaced. Thus this is the cost of replacing existing assets at present or at a
future date.

• VI. Abnormal Costs :- It is an unusual or a typical cost whose occurrence is usually not
regular and is unexpected. This cost arises due to some abnormal situation of production.
Abnormal cost arises due to idle time, may be due to some unexpected heavy breakdown
of machinery. They are not taken into consideration while computing cost of production
or for decision making.
 Classification of costs for Management
decision making
• VII. Controllable Costs :- In cost accounting, cost control and cost reduction are extremely important. In fact, in the
competitive environment, cost control and reduction are the key words. Hence it is essential to identify the
controllable and uncontrollable costs. Controllable costs are those which can be controlled or influenced by a
conscious management action.
For example, costs like telephone, printing stationery etc can be controlled while costs like salaries etc cannot be
controlled at least in the short run.
Generally, direct costs are controllable while uncontrollable costs are beyond the control of an individual in a given
period of time.

• VIII. Shutdown Cost :- These costs are the costs which are incurred if the operations are shut down and they will
disappear if the operations are continued. Examples of these costs are costs of sheltering the plant and machinery
and construction of sheds for storing exposed property. Computation of shutdown costs is extremely important for
taking a decision of continuing or shutting down operations.

• IX. Capacity Cost :- These costs are normally fixed costs. The cost incurred by a company for providing production,
administration and selling and distribution capabilities in order to perform various functions. Capacity costs include
the costs of plant, machinery and building for production, warehouses and vehicles for distribution and key
personnel for administration. These costs are in the nature of long-term costs and are incurred as a
result of planning decisions.

• X. Urgent Costs :- These costs are those which must be incurred in order to continue operations of the firm. For
example, cost of material and labour must be incurred if production is to take place.
 Classification of costs for Management
decision making
• Imputed cost : This cost means it’s a notional cost, example,
interest on internally generated funds, had I gone to market
and borrowed fund I have to pay some interest, rather than
going outside, if I use my own funds, interest paid would be
considered as notional cost because as such I need not to pay
but it has been equated with the amount of interest that
would have been paid. This is called notional cost or imputed
cost.
 Classification of costs for Management
decision making
• Sunk cost : It is also called irrelevant cost because we
cannot change this cost for taking any decision, such
cost has already been incurred.
 COST SHEET
• For determination of total cost of production a statement showing the various
elements of cost is prepared. This statement is called as a ‘statement of cost’ or
‘cost sheet.’

• Cost sheet is a statement, which provides for the assembly of the detailed cost of
the total cost of job operation or order. It brings out the composition of total cost in
a logical order, under proper classifications and sub-divisions.

• The period covered by the cost sheet may be a week, a month or so. Separate
columns are provided to show the total cost and cost per unit. A cost sheet is
prepared under output or unit costing method.

• In case of multiple products a separate cost sheet may be prepared for each
product. Alternatively, separate columns of total cost and unit cost may be provided
for each product in the same cost sheet.
COST SHEET
 COST SHEET MEANING
• Cost sheet is a statement, which shows various components of total
cost of a product. It classifies and analyses the components of cost
of a product.

• Previous periods data is given in the cost sheet for comparative

study.

• It is a statement which shows per unit cost in addition to Total Cost.

Selling price is ascertained with the help of cost sheet.

• The details of total cost presented in the form of a statement is

termed as Cost sheet
 BASIS OF COST SHEET
• Cost sheet is prepared on the basis of :
1. Historical Cost 2. Estimated Cost

• Historical Cost : Historical Cost sheet is prepared on the basis of

actual cost incurred. A statement of cost prepared after incurring the
actual cost is called Historical Cost Sheet.

• Estimated Cost
Estimated cost sheet is prepared on the basis of estimated cost. The
statement prepared before the commencement of production is
called estimated cost sheet. Such cost sheet is useful in quoting the
tender price of a job or a contract.
 IMPORTANCE OF COST SHEET
• Cost ascertainment
The main objective of the cost sheet is to ascertain the cost of a product. Cost sheet helps in
ascertainment of cost for the purpose of determining cost after they are incurred. It also helps to
ascertain the actual cost or estimated cost of a Job.

• Fixation of selling price

To fix the selling price of a product or service, it is essential to prepare the cost sheet. It helps in
fixing selling price of a product or service by providing detailed information of the cost.

• Help in cost control

For controlling the cost of a product it is necessary for every manufacturing unit to prepare a cost
sheet. Estimated cost sheet helps in the control of material cost, labor cost and overheads cost at
every point of production.

• Facilitates managerial decisions

It helps in taking important decisions by the management such as: whether to produce or buy a
component, what prices of goods are to be quoted in the tender, whether to retain or replace an
existing machine etc.
 Purposes of cost sheet
Cost sheet serves the following purposes:

• It gives the break up of total cost under different elements.

• It shows total cost as well as cost per unit

• It helps comparison with previous years.

• It facilitates preparation of tenders or quotations.

• It enables the management to fix up selling price

• It helps in controlling of cost.

 COMPONENTS OF COST SHEET
• Prime Cost
• Factory Cost
• Cost of goods sold
• Total Cost i.e, Cost of Sales
COMPONENTS OF COST SHEET
 COMPONENTS OF COST SHEET
• Prime Cost = Direct material + Direct Wages + Direct expenses works/ factory
cost;

• Factory Cost = Prime cost + Factory overheads

• Cost of production/office cost = Factory Cost + office and administration

overheads

• Cost of production of goods sold = Cost of Production + Opening stock of

Finished’ goods – closing stock of finished goods

• Total Cost = Cost of Production of goods sold + Selling and distribution overheads

• Sales = Total Cost + Profit

 FORMAT OF COST SHEET
• Cost Sheet is a statement of cost showing the total cost of production and profit or loss from
a particular product or service. A Cost Sheet shows the cost in a systematic manner and
element wise.