ACC 211 COST AND MANAGEMENT ACCOUNTING 1

BAF II

TOPIC 2: Cost classification

Cost classification involves the separation of a group of expenses into different categories. A
classification system is used to bring to management's attention certain costs that are considered
more crucial than others, or to engage in financial modeling. Several types of cost classifications are
noted below.

1. By Nature or Elements

There are three broad elements of costs:

(i) Material: The substance from which the product is made is known as material. It can be direct as
well as indirect.

Direct material: It refers to those materials which become a major part of the finished product and
can be easily traceable to the units. Direct materials include:

(i) All materials specifically purchased for a particular job/process.

(ii) All material acquired and latter requisitioned from stores.
(iii) Components purchased or produced.
(iv) Primary packing materials.
(v) Material passing from one process to another.

Indirect material: All material which is used for purposes ancillary to production and which can be
conveniently assigned to specific physical units is termed as indirect materials. Examples, oil, grease,
consumable stores, printing and stationary material etc.

(ii) Labour: Labour cost can be classified into direct labour and indirect labour.

Direct labour: It is defined as the wages paid to workers who are engaged in the production process
whose time can be conveniently and economically traceable to units of products. For example, wages
paid to compositors in a printing press, to workers in the foundry in cast iron works etc.

Indirect labour: Labour employed for the purpose of carrying tasks incidental to goods or services
provided, is indirect labour. It cannot be practically traced to specific units of output. Examples, wages
of store-keepers, foreman, time-keepers, supervisors, inspectors etc.

(iii) Manufacturing overheads: include the cost of indirect material, indirect labour and indirect
expenses.

2. By Degree of Traceability to the Products

Cost can be distinguished as direct and indirect.

Direct Costs: The direct costs are those which can be easily traceable to a product or costing unit or
cost center or some specific activity, e.g. cost of wood for making furniture. It is also called traceable
cost.

Indirect Costs : The indirect costs are difficult to trace to a single product or it is uneconomic to do
so. They are common to several products, e.g. salary of a factory manager. It is also called common
costs.

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Costs may be direct or indirect with respect to a particular division or department. For example, all the
costs incurred in the Power House are indirect as far as the main product is concerned but as regards
the Power House itself, the fuel cost or supervisory salaries are direct. It is necessary to know the
purpose for which cost is being ascertained and whether it is being associated with a product,
department or some activity.

Direct cost can be allocated directly to costing unit or cost center. Whereas Indirect costs have to be
apportioned to different products, if appropriate measurement techniques are not available. These
may involve some formula or base which may not be totally correct or exact.

3. Association with the Product

Cost can be classified as product costs and period costs.

Product Costs: Product costs are those which are traceable to the product and included in inventory
values. In a manufacturing concern it comprises the cost of direct materials, direct labour and
manufacturing overheads. Product cost is a full factory cost. Product costs are used for valuing
inventories which are shown in the balance sheet as asset till they are sold. The product cost of goods
sold is transferred to the cost of goods sold account.

Period Costs: Period costs are incurred on the basis of time such as rent, salaries, etc., include
many selling and administrative costs essential to keep the business running. Though they are
necessary to generate revenue, they are not associated with production, therefore, they cannot be
assigned to a product. They are charged to the period in which they are incurred and are treated as
expenses.

Selling and administrative costs are treated as period costs for the following reasons:

(i) Most of these expenses are fixed in nature.

(ii) It is difficult to apportion these costs to products equitably.

4. According to Behaviour

Costs can be classified as fixed, variable and semi-variable cost.

a. Fixed Costs: the cost which is incurred for a period, and which, within certain output and
turnover limits, tends to be unaffected by fluctuations in the levels of activity (output or
turnover)”.

These costs are incurred so that physical and human facilities necessary for business operations, can
be provided. These costs arise due to contractual obligations and management decisions. They arise
with the passage of time and not with production and are expressed in terms of time. Examples are
rent, property- taxes, insurance, supervisors’ salaries etc.

It is wrong to say that fixed costs never change. These costs may vary depending on the
circumstances. The term fixed refer to non-variability related to the relevant range. Fixed cost can be
classified into the following categories for the purpose of analysis:

i. Committed Costs: These costs are incurred to maintain certain facilities and cannot be
quickly eliminated. The management has little or no discretion in this cost, e.g., rent,
insurance etc.
ii. Policy and Managed Costs: Policy costs are incurred for implementing particular
management policies such as executive development, housing, etc. Such costs are often
discretionary. Managed costs are incurred to ensure the operating existence of the company
e.g., staff services.

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 iii. Discretionary Costs: These are not related to the operations and can be controlled by the
management. These costs result from special policy decisions, new researches etc., and can
be eliminated or reduced to a desirable level at the discretion of the management.
iv. Step Costs: Such costs are constant for a given level of output and then increase by a fixed
amount at a higher level of output.

b) Variable Cost: Variable costs are those costs that vary directly and proportionately with the
output e.g. direct materials, direct labour. It should be kept in mind that the variable cost per
unit is constant but the total cost changes corresponding to the levels of output. It is always
expressed in terms of units, not in terms of time.

Management decisions can influence the cost behaviour patterns. The concept of variability is
relative. If the conditions upon which variability was determined changes, the variability will
have to be determined again.

c) Semi-fixed (Semi-Variable) costs: Such costs contain fixed and variable elements. Because
of the variable element, they fluctuate with volume and because of the fixed element; they do
not change in direct proportion to output. Semi-variable costs change in the same direction as
that of the output but not in the same proportion. Depreciation is an example; for two shifts
working the total depreciation may be only 50% more than that for single shift working. They
may change with comparatively small changes in output but not in the same proportion.

5. Functional Classification of Costs

A company performs a number of functions. Functional costs may be classified as follows:

(a) Manufacturing/production Costs: It is the cost of operating the manufacturing division of an

undertaking. It includes the cost of direct materials, direct labour, direct expenses, packing (primary)
cost and all overhead expenses relating to production.

(b) Administration Costs: They are indirect and covers all expenditure incurred in formulating the
policy, directing the organisation and controlling the operation of a concern, which is not related to
research, development, production, distribution or selling functions.

(c) Selling and Distribution Cost: Selling cost is the cost of seeking to create and stimulate demand
e.g. advertisements, market research etc. Distribution cost is the expenditure incurred which begins
with making the package produced available for dispatch and ends with making the reconditioned
packages available for re-use e.g. warehousing, cartage etc. It includes expenditure incurred in
transporting articles to central or local storage. Expenditure incurred in moving articles to and from
prospective customers as in the case of goods on sale or return basis is also distribution cost.

(d) Research and Development Costs: They include the cost of discovering new ideas, process,
products by experiment and implementing such results on a commercial basis.

(e) Pre-production Cost: When a new factory is started or when a new product is introduced, certain
expenses are incurred. There are trial runs. Such costs are termed as pre-production costs and
treated as deferred revenue expenditure. They are charged to the cost of future production

6. Controllability

Cost can be Controllable and Non-Controlable.

Controllable Cost: “cost which can be influenced by its budget holder”.

Non-Controllable Cost: It is the cost which is not subject to control at any level of managerial
supervision. The difference between the terms is very important for the purpose of cost accounting,
cost control and responsibility accounting.

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A controllable cost can be controlled by a person at a given organisational level. Controllable cost are
not totally controllable. Some costs are partly controllable by one person and partly by another e.g.,
maintenance cost can be controlled by both the production and maintenance manager. The term
“controllable costs” is often used to mean variable costs and non-controllable costs as fixed.

7. Costs for Analytical and Decision Making Purposes

(a) Opportunity Costs: Opportunity cost is the cost of selecting one course of action and the losing
of other opportunities to carry out that course of action. It is the amount that can be received if the
asset is utilised in its next best alternative.

Example: Capital is invested in plant and machinery. It cannot be now invested in shares or
debentures. The loss of interest and dividend that would be earned is the opportunity cost. Another
example is when the owner of a business foregoes the opportunity to employ himself elsewhere.

Opportunity costs are not recorded in the books. It is important in decision making and comparing
alternatives.

(b) Sunk Costs: A sunk cost is one that has already been incurred and cannot be avoided by
decisions taken in the future. As it refers to past costs, it is called unavoidable cost. It is an
expenditure for equipment or productive resources which has no economic relevance to the present
decision making process”. This cost is not useful for decision making as all past costs are irrelevant.

(c) Differential Cost: Differential cost has been defined as “the difference in total cost between
alternatives, calculated to assist decision making”. Differential cost is the increase or decrease in total
costs resulting out of:

i. Producing and distributing a few more or few less of products;

ii. A change in the method of production/distribution;
iii. An addition or deletion of a product or a territory; and
iv. The selection of an additional sales channel.

The differential cost between any two levels of production is the difference between the marginal
costs at these two levels and the increase or decrease in fixed costs, if any. These costs are usually
‘specific purpose costs’ as they are determined for a particular purpose and under specific
circumstances.

Incremental cost measures the addition in unit cost for an addition in output. This cost need not be the
same at all levels of production. It is usually expressed as a cost per unit whereas the differential cost
is measured in total. The former applies to increase in production and is restricted to the cost only,
whereas the differential cost has a comprehensive meaning and application in the sense that it
denotes both increase or decrease.

Differential costs is useful in planning and decision making and helps to choose the best alternative. It
helps management to know the additional profit that would be earned if idle capacity is used or when
additional investments are made.

Other Costs

i. Conversion Cost: It is the cost of a finished product or work-in-progress comprising direct

labour and manufacturing overhead. It is production cost less the cost of raw material but
including the gains and losses in weight or volume of direct material arising due to production.

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 ii. Normal Cost: This is the cost which is normally incurred at a given level of output in the
conditions in which that level of output is achieved.
iii. Traceable Cost: It is the cost which can be easily associated with a product, process or
department.
iv. Avoidable Costs: Avoidable costs are those costs which under the present conditions need
not have been incurred. Example: (a) Spoilage in excess of normal limit; (b) Unfavourable
cost variances which could have been controlled.
v. Unavoidable Costs: Unavoidable costs are those costs which under the present conditions
must be incurred.
vi. Total Cost: This is the sum of all costs associated to a particular unit, or process, or
department or batch or the entire concern. It may also mean the sum total of material, labour
and overhead. The term total cost however, is not precise, it needs to be made precise by
using terms that indicate the elements of cost included