Chapter 2

Costs
Costs Concepts,
Concepts, Uses
Uses
and
and Classifications
Classifications

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 Concept of Cost

 The amount of expenditure incurred or attributable

to a given thing. (CIMA London)
 An exchange price, a foregoing, a sacrifice made to
secure a benefit.
 The price paid for something.
 Utilization of economic resources for achieving the
goal of the business organization.

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 Cost vs Expense
 Expenses are those costs which have been
applied against revenue of a particular
accounting period in accordance with the
principle of matching costs to revenue.
 “An expired cost resulting from a productive
usage of an asset”
 Unexpired part of cost as an asset
 Expired part of cost as an expense
 Example

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 Cost Centre
 “A location (a department, a sales area), person (a
salesman, a machine operator), or item of equipment
(a machine, a delivery van) for which the costs may
be ascertained and used for the purpose of control”
 Main purpose of ascertainment of cost of cost centre
is control of cost.
 Cost centres are of two types:
1. Personal Cost Centre (Person or Group of Persons)
2. Impersonal Cost Centre (Location and Item of
equipment)
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 Cost Centre

 From the functional point of view, the cost centre is of

following types:
1. Production Cost Centre: Where actual production
work take Place. Examples are melting shop, machine
shop, welding shop, and finishing shop etc.
2. Service cost Centre: which are ancillary to and render
services to production cost centres. Examples are
power house, store department, repair shop, and
canteen etc.

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 Cost Unit

“A unit of product, service, or time in relation to

which cost may be ascertained or expressed”
For example in a sugar mill, the cost per ton of
sugar may be ascertained, in a textile mill the cost
per meter of cloth may be ascertained. Thus a ton of
sugar and a meter of cloth are the cost units.
In simple, cost unit is unit of measurement of cost.

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 Classifications of Cost

 Classification is the process of grouping costs

according to their common characteristics.

 It is a systematic placement of like items together

according to their common features.

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 Classifications of Cost

 Direct Cost
Those costs which are incurred for and identified with a
particular cost unit, process or department.
Cost of Raw material used,
Cost of steel used in manufacture of machine,
wages paid to tailor in a readymade garments company,
wages of machine operator,

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 Classifications of Cost

 Indirect Cost
Those costs which are incurred for the benefit of a number
of cost units, processes or departments. These can not
be identified with a particular cost unit or cost centre.
Depreciation of machinery
Insurance
Light and Power
Rent
Managerial Salaries
Materials used in repair
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 Classification of Costs

 Classification according to behavior:

1. Fixed Cost: Out of the total cost, some cost remain fixed
irrespective of changes in volume production. For
example building rent, managerial salaries, Building
insurance, Salaries and wages of permanent staff. But
fixed cost per unit increases/decreases with the
changes of volume of production.
2. Variable Cost: These costs are variable in nature. They
change according to the volume of production. Their
variability is in the same proportion to the production.
But per unit cost remains the same. For example
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commission of salesman, Direct material and direct
 Classification of costs

 Semi variable Costs: Certain costs are partly fixed and

partly variable. They contain the features of both types
of costs.
 For example, Introduction of an additional shift in the
factory will require additional supervisors and certain
costs will increase by jumps.
In telephone, there is a minimum rent and after a specified
number of calls, the charges are according to the
number of calls made. light and power, depreciation,
telephone expense, Maintenance and repair,
11 compensation for accidents, supervision etc.
 Classification of Costs

 Classification according to time:

1. 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. These
are available until after the completion of the
manufacturing operations. These are ascertained
after the period is over. In other words, it is the post
mortem analysis of what has happened in the past.
These can be effectively used for predicting the
future costs.

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 Classification of Costs
2. 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 the cost and cost data. These costs are of
two types:
• Standard Cost: It is a predetermined calculation of
how much cost should be under specific working
conditions. The main purpose of this cost is to have
some kind of benchmark for comparing the actual
performance with the standards.

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 Classification of Costs
• Estimated Costs are predetermined costs based
on the 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.

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 Classification of Costs
 Classification according to Management
Decision Making:
1. Marginal Cost: It is the change in the aggregate
costs due to the change in volume of output by
one unit. It helps in decisions like make or buy,
pricing of products, selection of sales mix and
so on. For example a manufacturing company
produces 10,000 units and aggregate costs are
Rs. 25,000/- if 10,001 units are produced, the
aggregate costs may be Rs. 25,020/- which
means that marginal cost is of Rs. 20/-
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 Classification of Costs

2. Differential Costs: This is the difference in total

cost that will arise from the selection of one
alternative to the other. This type of analysis is
useful for taking various decisions like change in
the level of activity, adding or dropping a
product, change in the product mix, accepting an
export offer and so on.

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 Classification of Costs
3. Opportunity Cost: It is the value of benefit
sacrificed in favor of an alternative course of
action. For example, a company deposited Rs. 1
lakh in bank at 10% p.a. interest. Now it is
considering a proposal to invest this amount in
debentures where the yield is 17% p.a. If the
company decides to invest in debentures, it will
have to forego bank interest of Rs. 10,000/- p.a.,
which means the opportunity cost.

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 Classification of Costs
4. Relevant Cost: It is future cost which is different for
different alternatives. Management can not change
the cost of plant and machinery purchased in 1995.
It can change the future costs by its current
decisions.
5. Replacement Cost: This is the cost at which existing
item of material or fixed assets can be replaced.
Thus, this is the cost of replacing existing assets at
present or at a future date. A machinery purchased
in 1990 at Rs. 10,000 is discarded in 1998 and a new
machinery of same type is purchased for Rs. 15,000.

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 Classification of Costs
6. 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. These costs
arise due to idle time, may be due to some
unexpected heavy breakdown of machinery. They
are not taken into consideration while computing
the cost of production or for decision making.

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 Classification of Costs
7. Shutdown Cost: These 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 the exposed property.
Computation of shutdown costs is extremely
important for taking a decision of continuing or
shutting down operations.

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 Classification of Costs
8. Urgent Costs: These are the costs which must ne
incurred in order to continue operations of the
firm. For example, cost of material and labor must
be incurred if production is to take place.
9. Controllable Costs: These are the costs which
can be controlled like costs of telephone,
stationery can be controlled while the costs like
the salaries can not be controlled in the short run
hence these costs are called non controllable
costs.

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 Classification of Costs
10. Sunk Cost
It is an expenditure made in the past that can not be
changed and over which management no longer
has control. These costs are not relevant for
decision making about the future.
The book value of an asset currently being used is
not relevant in making decision to replace it. The
cost of land purchased in 1958 is not relevant in
deciding whether to sell the land or hold it.

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 Classification of Costs

11. Imputed Cost

Those which are specially computed outside the
accounting system for the purpose of decision
making. Interest on capital invested is a common
example.
Project A requires a capital investment of Rs.
50,000/- and project B Rs. 40,000/- Both the
projects are expected to yield Rs. 10,000 as
additional profit. These two projects are not
equally profitable since project B requires less
investment and it should be preferred
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 Classification of Costs

12. Out of Pocket Cost

These are costs which require cash payments to be
made such as wages, rent, whereas many costs
do not require cash outlay such as depreciation.
It involves cash outlays or requires utilization of
current resources.
It may be either fixed (manager Salary) or variable
(Raw materials and direct wages).

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 Product vs. Period
Costs
 Product costs are those costs which are
necessary for the production and which will not
be incurred if there is no production. These
consist of direct material, labor, and some of the
factory overhead.
 Period costs are those costs which are not
necessary for the production and are written off
as expenses in the period in which these are
incurred. Rent, salary of company executives,
and travel expenses are the examples of these
costs.
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 Capital vs. Revenue
Costs
 The cost which is incurred in purchasing the
assets either to earn income or increasing the
earning capacity of the business is called capital
cost. For example, the cost of rolling machine in
case of steel plant. Such cost is incurred at one
point of time but the benefits accruing from it are
spread over a number of accounting years.

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 Capital vs. Revenue
Costs
 If any expenditure is done in order to maintain the
earning capacity of the concern such as
maintaining an asset or running a business is
called revenue expenditure. For example, cost of
materials used in production, labor charges paid
to convert the material into production, salaries,
repairs & maintenance charges, selling and
distribution charges.

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 Factory Overhead (FOH)
 This is the aggregate of indirect material cost,
indirect labor cost, and indirect expenses.
Overhead = Indirect material cost + Indirect Labor cost + Indirect expenses
 Overhead is divided into three groups:
• Factory Overhead
• Office and administrative overhead
• Selling and Distribution overhead

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 Factory Overhead (FOH)
 Factory Overhead: These are those overheads
which are concerned with the production
function. It is also known as manufacturing or
work overheads.
Indirect Material: Coal, Oil Grease, Cotton waste,
sweeping broom.
Indirect Labor: Salary of factory office staff, salary
of inspector, wages of sweepers and watchman.
Indirect Expenses: Factory Rent, Repair &
Maintenance of plant, Insurance of factory
building, Internal transport expenses.
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 Factory Overhead (FOH)
 Office and Administrative overhead: This is the
indirect expenditure incurred in general
administrative function in formulating policies,
planning and controlling the function, directing
and motivating the personnel of an organization
in the attainment of its objectives.
(a) Stationeryused in general administrative office,
postage, sweeping broom and brush.
(b) Salary of office staff, salary of managing director
and directors of company.
(c) Legal expenses, office lighting and power.
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 Factory Overhead (FOH)
 Selling overhead is the cost of promoting sales and
retaining the customers. “The cost of seeking to
create and stimulate demand and of securing orders”
Examples are advertisement, samples, free gifts, and
salaries of salesman.
 Distribution Overhead: “The cost of sequence of
operations which begins with making the packed
product available for dispatch and ends with making
the reconditioned returned empty packages if any
available for use” Examples are insurance of goods,
rent of warehouse, Traveling expenses, and
Showroom expenses.
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 Prime Cost vs
Conversion Cost
 Prime cost is the sum of direct material cost and
direct labor cost.
Prime cost = Direct Material Cost + Direct Labor Cost

 Conversion cost is the sum of direct labor cost

and factory overhead cost.
Conversion cost = Direct Labor Cost + FOH

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