Cost Concepts & Classifications

Why cost concepts, its distinction &

classifications are necessary?

These are necessary to emphasize on the followings:

(i) That cost estimates produced by conventional
accounting are not appropriate for all managerial
uses;
(ii) That different business problems call for
different kinds of cost;
(iii) That different combinations of cost ingredients
are appropriate for various kinds of management
problems.
 Direct Vs. Indirect Costs
• A Direct or Traceable Cost is one which can be identified
easily and indisputably with a unit of operation (costing
system or cost centre).
• Indirect or Common costs are those that are not traceable
to any plant, dept., operation or to any individual final
product. Eg. Salary of an Divisional Manager, when division
is a costing unit will be a direct cost, whereas the salary of
GM, when one of the division is a costing unit, would be an
indirect cost.
• For decision making, traceable of cost is important when
multiple costs with common costs differ considerably in
production or marketing.
 Fixed Vs. Variable Costs
Fixed costs are those costs which remain constant in total
regardless of changes in volume up to a certain level of
output.
• These are not affected by changes in the volume of
production. They will have to be incurred when output is nil.
• There is an inverse relationship between volume and fixed
costs per unit.
Variable costs are those costs which vary directly with the
volume of production.
• An increase in volume of output results in a proportionate
increase in the total variable cost and vice versa.
• Thus, there is a linear relationship between volume and total
variable cost, but variable costs are constant per unit.
 Average Cost, Marginal Cost & Total Cost

• Average Cost is the total cost divided by the total

quantity produced.
• Marginal Cost is the extra cost of producing one
additional unit. E.g. if a firm produces 100 metres
of cloth and the same firm when produces 101
units of cloth, the cost of producing one extra
unit is Marginal cost. The economist’s marginal
cost is same as cost accountant’s differential cost.
• Total Cost is the total combination of fixed and
variable costs
 Classification of Cost – Classification by Nature, Functions, Variability, Controllability,
Normality, Financial Accounting, Time, Planning and Managerial Decision

• Cost classification by Nature/Element: 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.

• Cost classification by Function: According to this

classification costs are divided in the light of the different
aspects of basics managerial activities involved in the
operation of a business undertaking. It leads to grouping of
cost according to the broad divisions or functions of a
business undertaking i.e., production, administration
selling and distribution.
 Cont..

• Classification By Variability: According to this

classification, costs are classified according to their
behaviour in relation to changes in the level of activity or
volume of production. On this basis, costs are classified
into three groups viz. fixed, variable and semi-variable.

• Classification 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: 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. (ii) Uncontrollable Costs: 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.
 Cont...

• Classification 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.
• Classification By Capital and Revenue
• Classification By Time – Past and Future
 Short-run & Long-run Costs
• Short-run costs are those costs that vary with output
when fixed plant and capital equipment remain the
same.
• Long-run costs are those which vary with output when
all input factors including plant and equipment vary.
• Short-run costs become relevant when a firm has to
decide whether or not produce in the immediate future.
In this case, setting up of a new plant is ruled out.
• Long-run costs become relevant when the firm has to
decide whether to set up a new plant. It can help the
businessman in planning the best scale of plant or the
best size of the firm.
 Past Costs Vs. Future Costs
• Past costs are actual costs incurred in the past
and are generally contained in the financial
accounts.
• Future costs are costs that are reasonably
expected to be incurred in some future period or
periods. Their actual occurrence is a forecast and
their management is an estimate.
• Future costs are the only costs that matter for
managerial decisions (controlled/ reduced) unlike
Past costs.
 Actual Cost Vs. Opportunity Cost
• Actual cost means the actual expenditure for
acquiring or producing a good or service. These costs
are those costs that are generally recorded in the
books of accounts. Eg. Actual wages paid, cost of
materials purchased, etc.
• Opportunity cost of a good or service is measured in
terms of revenue which could have been earned by
employing that good or service in some other
alternative uses. It can be defined as the revenue
foregone by not making the best alternative use.
 Incremental Cost (Differential Cost) & Sunk
Cost
• Incremental Cost is the additional cost due to a change in the level
or nature of business activity. Eg. Addition of a new product line,
changing the channels of distribution, replacing a machine by a
better machine, etc. The question of incremental or differential
costs would not arise when a business is to be set up afresh. It
arise only when a change is contemplated in the existing business.
• Sunk Cost is one which is not affected or altered by a change in the
level or nature of business activity. The most important example of
sunk cost is the amortization of past expenses, e.g. depreciation.
• For managerial decisions, the incremental cost will be different in
case of different alternatives whereas the sunk cost remains same
irrespective of the alternatives selected. Eg. Decision to be made
between purchasing a machine or acquiring it on rent.
 Shut-down Vs. Abandonment Costs
• Shut down costs may be defined as those costs which would be
incurred in the event of suspension of the plant operation and
which would be saved if the operations are continued. E.g.
Sheltering of plant and equipment & construction of sheds for
storing exposed property.
• Abandonment costs are the costs of retiring altogether a plant
from service. It arises when there is a complete cessation of
activities and creates a problem so as to the disposal of asset.
E.g. the costs involved in discontinuance of Tram services in
Mumbai & Delhi.
• These costs become important when management is faced
with the alternatives of either continuing the existing plant or
suspending the operations or abandoning it altogether.
 Out-of-Pocket Vs Book Costs
• Out-of-Pocket costs refer to costs that involve current cash
payments to outsiders.
• Book costs such as depreciation do not require current cash
payments.
• In concept, this distinction is quite different from
traceability and also from variability with output. E.g.
salaries paid to the administrative staff. Neither all they are
fixed, e.g. electric power bill.
• Book costs are in some cases variable and in some cases
readily traceable, hence becomes a part of direct cost. This
distinction primarily shows how costs affect the cash
position.
 Replacement Vs. Historical Costs
• Historical cost means the cost of a plant at a price
originally paid for it, whereas Replacement cost means
the price that would have to be paid currently for
acquiring the same plant. E.g. if the price of any
machine at the time of purchase is Rs. 15,000 and if the
present cost is Rs. 50,000. Then the original price is
historical cost and the present price is replacement
cost.
• The assets are usually shown in the financial accounts
at their historical costs. But during the period of
changing price levels, historical costs may not be the
correct basis for projecting the future costs.
 Cost Classification
• Level of output
• Prices of input factors
• Productivities and factors of production
• Size of the plant
• Output stability
• Lot size
• Laws of return
• Level of capacity utilization
• Period under consideration
• Technology
• Learning effect
• Breadth of product range
• Degree of vertical integration
• Geographical location
• Institutional factors
• Firm’s discretionary policies