Classification of Cost

Chapter 1
CLASSIFICATIONS OF COST
CLASSIFICATIONS OF COST(Contd.)
SPECIAL COSTS FOR MANAGEMENT
DECISION MAKING
1. Relevant costs: Cost whose magnitude will be affected by decision being made.
2. Irrelevant costs: These are those costs that will not be affected by a decision.
3. Sunk Costs: A sunk cost is an expenditure made in the past that cannot be changed
and over which management no longer has control.
4. Differential (or Incremental) Cost: This cost may be regarded as the difference in total
cost resulting from a contemplated change.
5. Marginal Cost: Marginal cost is the additional cost of producing one additional unit.
Marginal cost is the same thing as variable cost.
6. Imputed Costs: These are hypothetical costs which are specially computed outside the
accounting system for the purpose of decision making.
7. Opportunity Cost: It is the sacrifice involved in accepting an alternative under
consideration.
8. Replacement Cost: This is the cost at which there could be purchased an asset identical to
that which is being replaced.
9. Out - of - pocket Cost (Explicit Cost and Implicit Cost ): These are those costs that
involve cash outlays or require the utilization of current resources.
10.Future Cost: Relevant costs for decision making are predetermined or future costs.
11.Conversion Cost: It is the total cost of ‘converting’ a raw material into finished
product.
ELEMENTS OF COST
 ELEMENTS OF COST (Contd.)
Material Cost: ‘The cost of commodities supplied to an
undertaking.’(CIMA)

Labour Cost: This is ‘the cost of remuneration (wages, salaries,

● commissions,
Direct bonuses,
material cost is thatetc.)
whichofcan
thebeemployees of identified
conveniently an undertaking’
with and allocated to cost units.
● (CIMA).
Indirect materials cost are those materials which cannot be conveniently identified with individual cost
units.

Expenses: ‘The cost of services provided to an undertaking and the

notional cost of the use of owned assets’ (CIMA).

●
Direct labour cost consists of wages paid to workers directly engaged in converting raw materials into
finished products.
●
Indirect labour cost It is of general character and cannot be conveniently identified with a particular cost
unit.

●
Direct expenses According to CIMA, London, ‘direct expenses are those expenses which can be
identified with and allocated to cost centres or units.’
●
Indirect expenses All indirect costs, other than indirect materials and indirect labour costs, are termed
Prime expenses.
as indirect Cost: Aggregate of direct material cost, direct labour cost and direct expenses.
 ELEMENTS OF COST (Contd.)
Material Cost: ‘The cost of commodities supplied to an undertaking.’(CIMA)
1. Direct material cost is that which can be conveniently identified with and
allocated to cost units.
2. Indirect materials cost are those materials which cannot be conveniently
identified with individual cost units.
Labour Cost: This is ‘the cost of remuneration (wages, salaries, commissions,
bonuses, etc.) of the employees of an undertaking’ (CIMA).
1. Direct labour cost consists of wages paid to workers directly engaged in
converting raw materials into finished products.
2. Indirect labour cost It is of general character and cannot be conveniently
identified with a particular cost unit.
Expenses: ‘The cost of services provided to an undertaking and the notional cost of the use of
owned assets’ (CIMA).
1. Direct expenses According to CIMA, London, ‘direct expenses are those expenses which
can be identified with and allocated to cost centres or units.’
2. Indirect expenses All indirect costs, other than indirect materials and indirect labour costs,
are termed as indirect expenses.
Prime Cost: Aggregate of direct material cost, direct labour cost and direct expenses.
 ELEMENTS OF COST(Contd.)
Overheads: These are the aggregate of indirect material cost, indirect labour
cost and indirect expenses. Thus,

Indirect material + Indirect labour + Indirect expenses = Overheads

Office and administration overheads:

These are the indirect expenditures
Production overheads: Also known
incurred in general administrative
as factory overheads, works overheads
function, i.e., in formulating policies,
or manufacturing overheads, these are
planning and controlling the functions,
those overheads which are concerned
directing and motivating the personnel of
with the production function. an organization in the attainment of its
objectives.

Selling and distribution overheads:

Selling overheads are the costs of promoting
sales and retaining customers. They are
defined as ‘the cost of seeking to create and
stimulate demand and of securing orders.’
STEPS OF INSTALLATION OF A COSTING SYSTEM
1 ●
Preliminary investigations should be made relating to technical aspects of the business.

2 ●
The organization structure should be studied to ascertain scope of authority.

3 ●
Methods of purchase, storage or issue of materials should be modified as required.

4 ●
Methods of remunerating labour should be examined to introduce any incentive plans.

5 ●
Forms and accounting records should be designed to involve minimum clerical labour.

6 ●
The size and layout of the factory should be studied.

7 ●
The system should be effective in cost control and cost reduction.

8 ●
Costing system should be simple and easy to operate.

9 ●
The installation and operation of the system should be economical.

10 ●
The system should be introduced gradually.
ADVANTAGES OF COST ACCOUNTING
Advantages to Management: Reveals profitable and
unprofitable activities, Helps in cost control, Helps in
decision making, Guides in fixing selling prices, Helps in
inventory control, Aids in formulating policies, Helps in cost
reduction, Reveals idle capacity, Checks the accuracy of
financial accounts, Prevents frauds and manipulation.

Advantages to Workers: Workers are benefited

by introduction of incentive plans which are an
integral part of a cost system bringing higher
productivity and higher earnings for them.

Advantages to Society: An efficient cost system

is bound to lower the cost of production, the
benefit of which is passed on to the public at large,
in the form of lower prices of products or services.

Advantages to Government Agencies and Others: A cost

system produces ready figures for use by government, wage
tribunals, chambers of commerce and industry trade unions,
etc., for use in problems like price fixing, wage level fixing,
settlement of industrial disputes, policy matters, etc.
 LIMITATIONS OR OBJECTIONS AGAINST COST ACCOUNTING
It is unnecessary

●
It is argued that maintenance of cost records is not necessary and involves duplication of work. It is based
on the premise that a good number of concerns are functioning prosperously without any system of costing.

It is expensive

●
It is pointed out that installation of a costing system is quite expensive which only large concerns can afford. It is also argued
that installation of the system will involve additional expenditure which will lead to a diminution of profits.

It is inapplicable

●
Another argument sometimes put forward is that modern methods of costing are not applicable to
many types of industry.

It is a failure

●
The failure of a costing system in some concerns is quoted as an argument against its introduction
in other undertakings.
 ESSENTIALS OF A GOOD COST ACCOUNTING SYSTEM

Suitability The method of costing adopted should be suitable to the

●

industry and serve the objectives of installing the system.

Specially designed A readymade costing system cannot be suitable for every business. The cost
●

accounting system should be tailor-made according to the requirements of a

system business.

Support of If a costing system is to be successful, it must be fully supported by

●

executives of various departments and everyone should participate in it.

executives
●
The cost of installing and operating the system
Cost of the system should be justified by the results produced.

Clearly defined cost In order to derive maximum benefits from a costing system, well-defined cost
●

centres and responsibility centres should be identified within the organization.

centres
 ESSENTIALS OF A GOOD COST ACCOUNTING SYSTEM (Contd.)
●
Controllable and non-controllable costs of each
Controllable costs responsibility centre should be separately shown.

Integration with There should be cooperation and coordination between cost accounting and
●

financial accounting departments. In order to avoid duplication of accounts, cost

financial accounts and financial accounts may be integrated.

Continuous Well-trained and educated staff should be employed to operate the system. In
●

order to educate the costing staff, written manuals and meetings, etc. should be
education arranged on a continuous basis.

Prompt and The cost accounting department should prepare accurate reports and promptly
●

submit the same to appropriate level of management so that action may be

accurate reports taken without delay.

Avoid unnecessary ●
Resources should not be wasted on collecting and
details compiling cost data that is not required.