How can costs be classified? Explain in detail.

Cost can be defined as the expenditure (actual or notional) incurred on or attributable to a given thing. It can also be described as the resources that have been sacrificed or must be sacrificed to attain a particular objective. In other words, cost is the amount of resources used for something which must be measured in terms of money. For example – Cost of preparing one cup of tea is the amount incurred on the elements like material, labor and other expenses, similarly cost of offering any services like banking is the amount of expenditure for offering that service.

Thus cost of production or cost of service can be calculated by ascertaining the resources used for the production or services.

Classification of Costs :- An important step in computation and analysis of cost is the classification of costs into different types. Classification helps in better control of the costs and also helps considerably in decision making. Classification of costs can be made according to the following basis.

There are three broad elements of cost:-

(a)    Material

(b)    Labour

(c)    Expenses

(a)       Material: - The substance from which the product is made is known as material.  It may be in a raw or a manufactured state.  It can be direct as well as indirect.

Direct Material: - All material which becomes an integral part of the finished product and which can be conveniently assigned to specific physical units is termed as “Direct Material”.

Following are some of the examples of direct material:-

(i)                 All material or components specifically purchased produced or requisitioned from stores.

(ii)               Primary packing material (e.g. – cartoon, wrapping, cardboard, boxes etc.)

(iii)             Purchased or partly produced components.

Direct material is also described as raw-material, process material, prime material, production material, stores material, constructional material etc.

Indirect Material: - All material which is used for purposes ancillary to the business and which cannot be conveniently assigned to specific physical units is termed as “Indirect Material”.

Consumable stores, oil and waste, printing and stationery etc. are a few examples of indirect material

Indirect material may be used in the factory the office or the selling and distribution division.

(b)       Labour: - For conversion of materials into finished goods, human effort is needed such human effort is called labour.  Labour can be direct as well as indirect.

Direct labour: - Labour which takes    an active and direct part in the production of a particular commodity is called labour.  Direct labour costs are, therefore specially and conveniently traceable to specific products.

Direct labour is also described as process labour, productive labour, operating labour, manufacturing labour, direct wages etc.

Indirect labour:- labour employed for the purpose of carrying out tasks incidental to goods or services provided, is indirect labour such labour         does not alter the construction, composition or condition of the product.  It cannot be practically traced to specific units of output wages of store – keepers, foreman, time – keepers, directors, fees, salaries of salesmen, etc. are all examples of indirect labour costs.

Indirect labour may relate to the factory the office or the selling and distribution division.

(c)    Expenses: - Expenses may be direct or indirect.

Direct expenses: - These are expenses which can be directly, conveniently and wholly allocated to specific cost centers or cost units.  Examples of such expenses are: hire of some special machinery required for a particular contract, cost of defective work incurred in connection with a particular job or contract etc.

Direct expenses are sometimes also described as “chargeable expenses”.

Indirect expenses:- these are expenses which cannot be directly, conveniently and  wholly allocated to cost centers or cost units.

OVERHEADS:- It is to be noted that the term overheads has a wider meaning than the term indirect expenses overheads include the cost of indirect material, indirect labour besides indirect expenses.

Indirect expenses may be classified under the following three categories:-

(a)   Manufacturing (works, factory or production) expenses:-

Such indirect expenses which are incurred in the factory and concerned with the running of the factory or plant are known as manufacturing expenses.  Expenses relating to production management and administration are included there in.  Following are a few items of such expenses:

Rent, rates and insurance of factory premises, power used in factory building, plant and machinery etc.

(b)   Office and Administrative expenses

These expenses are not related to factory but they pertain to the management and administration of business such expenses are incurred on the direction and control of an undertaking example are :- office rent, lighting and heating, postage and telegrams, telephones and other charges; depreciation of office building, furniture and equipment, bank charges, legal charges, audit  fee etc.

(c)    Selling and Distribution Expenses:-

Expenses incurred for marketing of a commodity, for securing orders for the articles, dispatching goods sold, and for making efforts to find and retain customers are called selling and distribution expenses examples are:-

Advertisement expenses cost of preparing tenders, traveling expenses, bad debts, collection charges etc.

Warehouse charges packing and loading charges, carriage outwards, etc.

The above classification of different elements of cost can be presented in the form of the following chart:

Items excluded from cost accounts

There are certain items which are included in financial accounts but not in cost accounts.  These items fall into three categories:-

Appropriation of profits

(i)                 Appropriation to sinking funds.

(ii)               Dividends paid

(iii)             Taxes on income and profits

(iv)              Transfers to general reserves

(v)                Excess provision for depreciation of buildings, plant etc.  and for bad debts

(vi)              Amount written off – goodwill, preliminary expenses, underwriting commission, discount on debentures issued; expenses of capital issue etc.

(vii)            Capital expenditures specifically charged to revenue

(viii)          Charitable donation

Matters of pure finance

(a)  Purely financial charges:-

            (i)         Losses on sale of investments, buildings, etc.

            (ii)        Expenses on transfer of company’s office

            (iii)       Interest on bank loan, debentures, mortgages, etc.

     (iv)    Damages payable

     (v)     Penalties and fines

     (vi)    Losses due to scrapping of machinery

(vii)            Remuneration paid to the proprietor in excess of a fair reward for services rendered. 

(b)  Purely financial incomes:-

(i)      Interest received on bank deposits

(ii)        Profits made on the sale of investments, fixed assets, etc.

(iii)       Transfer fees received

(iv)       Rent receivable

(v)        Interest, dividends, etc. received on investments.

(vi)       Brokerage received

(vii)            Discount, commission received

Abnormal gains and losses:-

(i)                 Losses or gains on sale of fixed assets.

(ii)               Loss to business property on account of theft, fire or other natural calamities.

In addition to above abnormal items (gain and losses) may also be   excluded from cost accounts.  Alternatively, these may be taken to costing profit and loss account.

b. Classification according to behavior :- Costs can also be classified according to their behavior. This classification is explained below.

i.           Fixed Costs :- Out of the total costs, some costs remain fixed irrespective of changes in the production volume. These costs are called as fixed 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’.

C Classification according to functions :- Costs can also be classified according to the functions/ activities. This classification can be done as mentioned below.

iv.        Production Costs :- All costs incurred for production of goods are known as production costs.

v.          Administrative Costs :- Costs incurred for administration are known as administrative costs. Examples of these costs are office salaries, printing and stationery, office telephone, office rent, office insurance etc.

vi.        Selling and Distribution Costs :- All costs incurred for procuring an order are called as selling costs while all costs incurred for execution of order are distribution costs. Market research expenses, advertising, sales staff salary, sales promotion expenses are some of the examples of selling costs. Transportation expenses incurred on sales, warehouse rent etc are examples of distribution costs.

vii.      Research and Development Costs :- In the modern days, research and development has become one of the important functions of a business organization. Expenditure incurred for this function can be classified as Research and Development Costs.

c. 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. Pre determined costs may be either standard or estimated. Standard Cost is a predetermined calculation of how much cost should be under specific working conditions. It is based on technical studies regarding material, labor and expenses. The main purpose of standard 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.

D .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. Classification of costs based on the criteria of decision making can be done in the following manner

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 favor 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.

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.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.

VII.      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.

VIII.    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.

IX.       Urgent Costs :- These costs are those which must be 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.