Cost Concepts

Semester II

Basic Terms
Cost is the amount of expenditure, actual (incurred) or notional (attributable), relating to a specific thing or activity. The specific thing or activity may be a product, job, service, process or any other activity Expenses are expired costs, incurred and totally used up in generation of revenue Loss is lost cost. The term loss is used to describe mainly two accounting events. In traditional financial accounting it is used to denote a situation where expenses exceed revenues for an accounting period. Secondly, a loss arises due to the cost of an asset being more than the sale proceeds when the asset is sold. Loss is unrelated to revenue generation and is only offset against revenue of the period in which the loss occurred

Classification of Costs
The achievement of the objectives of cost accounting requires that cost should be ascertained, classified and grouped Cost classification may be defined as the process of grouping costs according to their common characteristics There are many objectives of cost classifications depending on the requirements of management Determining product costs for stock valuation and profit measurement  Planning  Decision Making  Control

Natural classifications of costs

1. Direct material refers to the cost of materials which are conveniently and economically traceable to specific units of output. Examples of direct materials are: raw cotton in textiles, crude oil to make diesel, steel to make automobile bodies. Items, such as import duties, dock charges, transport cost of materials, storing of materials, cost of purchasing and receiving materials are properly added to their invoiced price and thus, the materials are charged out at this increased cost.

 Direct labour - Direct labour is defined as the labour of those workers who are engaged in the production process. Examples are the labour of machine operators and assemblers. Direct expenses - These include any expenditure other than direct material and direct labour directly incurred on a specific product or job. Such special necessary expenses can be identified with product or job and are charged directly to the product as part of the prime cost. Examples of direct expenses are fees paid to architects, surveyors and other consultants, cost of special moulds, designs and patterns.

 Factory overhead also called manufacturing overhead or factory burden, may be defined as the cost of indirect materials, indirect labour and indirect expenses. Relation with the product is so small or complex that it would not be appropriate to treat it as prime cost Selling and distribution and administrative overheads are generally incurred when the product is in saleable condition. Selling and distribution overheads covers the cost of making sales and delivering/despatching products. These costs include advertising, salesmen salaries and commissions, packing, storage, transportation, and sales administrative costs. Administrative overhead includes costs of planning and controlling the general policies and operations of a business enterprise.

Total Cost
Direct Material + Direct Labour + Direct Expenses = Prime Cost Indirect Materials + Indirect Labour + Indirect Expenses = Factory Overhead Prime Cost + Factory Overhead = Factory Cost Factory Cost + Selling and Distribution and Administrative overhead = Total Cost

Cost behaviour
1. Fixed cost - Fixed cost is a cost which does not change in total for a given time period and capacity despite wide fluctuations in output or volume of activity. They accrue or are incurred with the passage of time and not with the production of the product or the job. Examples of fixed costs are rent, property taxes, supervising salaries, depreciation on office facilities, advertising, insurance, etc.

2. Variable cost - Variable costs are those costs that vary directly and proportionately with the output. There is a constant ratio between the change in the cost and change in the level of output. Direct materials cost and direct labour cost are the costs which are generally variable costs 3. Mixed cost ( Semi-variable and Semi-fixed cost) Mixed costs are costs made up of fixed and variable elements. They are a combination of semi-variable costs and semi-fixed costs. Because of the variable component, they fluctuate with volume; because of the fixed component, they do not change in direct proportion to output.

Degree of Traceability to the Product

1. Direct costs can be conveniently and economically traced to a cost pool or a cost object 2. Indirect costs cannot be traced conveniently or economically to a cost pool or a cost object. Indirect costs are those costs which cannot be identified with, or traced to a single product because they are incurred for several products. The examples of indirect costs are: indirect materials (lubricants and scrap materials), salary of factory supervisors (indirect labour), rent, rates and depreciation (indirect expenses). Indirect costs, often referred to as overheads, have to be apportioned to different products

Functional Classification of Costs

1. Manufacturing costs are all production costs incurred to manufacture the products and to bring them to a saleable condition, including direct materials, direct labour and indirect manufacturing (or factory overhead) costs 2. Selling and distribution cost covers the cost of making sales and delivering/despatching products. These costs include advertising, salesmen salaries and commissions, packing, storage, transportation, and sales administrative costs 3. Administrative cost includes costs of planning and controlling the general policies and operations of a business enterprise

 Functional classification is important because it provides an opportunity to the management to evaluate the efficiency of departments performing different functions in the organisation

Relationship with the Accounting Period

1. Capital cost - A capital expenditure provides benefit to future periods and is classified as an asset 2. Revenue cost A revenue expenditure is assumed to benefit the current period and is classified as an expense A capital expenditure will flow into the cost stream as an expense when the asset is used up or written off The distinction between capital and revenue expenditures is vital to the proper matching of costs and revenue and to the accurate measurement of periodic net income

Costs for Decision Making and Planning

1. Opportunity cost is the cost of opportunity lost. It is the cost of selecting one course of action in terms of the opportunities which are given up to carry out that course of action 2. Sunk cost is the cost that has already been incurred. Generally known as unavoidable cost, it refers to all past costs since these amounts cannot be changed once the cost is incurred 3. Relevant costs are those future costs which differ between alternatives. Relevant costs may also be defined as the cost which are affected and changed by a decision. On the contrary, irrelevant costs are those costs which remain the same and not affected by the decision whatever alternative is chosen

4. Differential cost is the difference in total costs between any two alternatives. Differential costs are equal to the additional variable expenses incurred in respect of the additional output, plus the increase in fixed costs, if any. Differential cost is a broader term, encompassing both cost increases (incremental costs) and cost decreases (decreasing costs) between alternatives 5. Out-of-pocket cost signify the cash cost incurred on an activity. Non-cash costs such as depreciation are not included in out-of-pocket costs 6. Shutdown costs are those costs which have to be incurred under all situations in the case of stopping manufacture of a product or closing down a department or a division. Shut down costs are always fixed costs

Costs for Control

1. Controllable and uncontrollable cost Controllable cost is a cost which can be influenced by the action of a specified member of an undertaking. It is the cost over which a manager has direct and complete decision authority. It is contended that two factors: (i) the time period factor, and (ii) the decisionmaking authority, can make a cost controllable or uncontrollable

2. Standard costs are those costs which are planned or predetermined cost estimates for a unit of output in order to provide a basis for comparison with actual costs. Standard costs are used to prepare budgets. Standard cost is a unit concept and indicates standard cost per unit of output, per labour hour etc. On the contrary, the term Budgeted Cost is a total concept and indicates total budgeted cost of an item at some activity level or output level such as budgeted cost of material is Rs. 8,00,000 if 8000 units are manufactured.

Other Costs
1. Joint costs relate to two or more products produced from a common production process or element-material, labour, or overhead or any combination thereof, or so locked together that one cannot be produced without producing the other(s). Joint costs are total costs incurred up to the point of separation/ split-off point.

2. Common costs are those which are incurred for more than one product, job, territory or any other specific costing object. Common costs are not easily identifiable with individual products and, therefore, are generally apportioned. For example, the salary of a manager of a production department which is manufacturing three products is an example of common cost with respect to the products. But his salary is direct cost to the departments located in the factory. The basic point is that a particular (common) cost may be direct to one object and common as far as other objects are concerned.