Management Notes

Reference Notes for Management

Classification of Costs – Introduction to Cost Accounting | Management Notes

Classification of Costs

A) Classification on the Basis of Time

i) Historical Costs: Costs are determined after they are incurred. These costs are available only after the production of a particular item has been completed. They are objective in nature and can be verified using actual data.

ii) Pre-determined Costs: In order to calculate these costs, all factors affecting their amount are specified before they are incurred. The following costs may be incurred:

  1. Estimated costs: It is possible to estimate costs before goods are manufactured; however, this is less precise than standards
  2. Standard costs:These are unique concepts and techniques. The method involves the following:
  • defining predetermined standards for each cost element and for each product;
  • comparing actuals to standards to find variations;
  • determining the causes of these differences and taking appropriate actions.
    Although predetermined, standard costs are derived with a great deal more care than estimated costs.

B) Classification By Nature or Elements

i) Material: Material refers to the substance from which a product is made. This can be direct or indirect. Direct materials are those components that form a large part of the product and can be easily traced back to the unit. For example, direct materials include:

  • Materials purchased specifically for a particular job/process.
  • Materials acquired and later requisitioned from stores.
  • Purchased or produced components.
  • Main packing materials.
  • Material that passes from one process to another.

The term indirect material refers to materials used for purposes ancillary to production and can be conveniently assigned to specific physical units. For example, oil, grease, consumable stores, printing and stationary material.

ii) Labour:  There are two types of labour costs: direct labour and indirect labour. Direct labour refers to labor that is engaged in a production process whose time can be traced economically and conveniently to units of production. For example, wages paid to compositors in a printing press, to workers in a foundry in a cast iron company, etc. Indirect labour refers to workers employed for the purpose of carrying out tasks related to the goods or services provided. It is not assigned a specific unit of production. Examples include wages for storekeepers, foremen, time keepers, supervisors, inspectors, etc.

iii) Expenses: The expenses may be direct or indirect. Direct expenses are incurred on a specific cost unit and are attributed to that cost unit. Examples of special layout, design, or drawing costs, hiring of a particular tool or equipment for a job, consulting fees charged in connection with the job, etc. Indirect expenses are those that cannot be directly, conveniently and wholly attributed to a particular cost center or unit. For example, rent, rates, and taxes, insurance, electricity, lighting, and heating, and depreciation. Overheads have a broader meaning than indirect expenses. Indirect material, indirect labor, and indirect expenses are included in overhead. There are four types of overheads: production overheads, administration overheads, selling overheads, and distribution overheads.

C) Classification By Degree of Traceability to the Products

i) Direct Costs: Direct costs are those that can easily be traced to a specific product, costing unit, cost center, or activity, e.g. cost of wood for making furniture. Traceable costs are also known as direct costs.

ii) Indirect Costs : Indirect costs cannot be traced to a single product or are uneconomical to do so. They are common to several products, for example, a factory manager’s salary. These costs are also known as common costs.

Depending on the department or division, costs may be direct or indirect. As an example, all the costs incurred in the Power House in relation to the main product are indirect, but in terms of the Power House itself, the fuel costs and supervisory salaries are direct. Costs need to be associated with products, departments, or activities in order to know where they are being used. Direct costs can be allocated directly to costing units or cost centers. If appropriate measurement techniques are not available, indirect costs have to be allocated to the different products. There may be some formulas or bases involved that aren’t entirely accurate or precise.

D) Classification by Association with the Product

i) Product Costs: The product costs are those which can be traced to the item and are included in inventory values. Cost of direct materials, direct labour and manufacturing overheads are included in a manufacturing concern. Product costs are full factory costs. Product costs are used to value the inventories on the balance sheet, which are shown as assets until sold. In the cost of goods sold account, the product cost of goods sold is transferred.

ii) Period Costs: The period costs are those that are incurred according to a set timetable such as rent, salaries, and include sales and administrative costs essential to the business’s survival. The reason they cannot be assigned to a product is that, while they are necessary to generate revenue, they are not associated with production. They are charged to the period in which they are incurred and are considered expenses.

For the following reasons, selling and administrative costs are treated as period costs:

  • The majority of these expenses are fixed.
  • These costs are hard to apportion to products fairly.
  • Determining the relationship between a cost and a particular product is difficult.
  • Benefits accruing from these expenses cannot easily be obtained.

Both product and period costs affect a company’s net income. Product costs are incorporated into the cost of the product and do not affect income until the product is sold. Period costs are credited to the period during which they are incurred.

E) Classification By Changes in Activity or Volume

i) Fixed Costs: The fixed costs are those which are incurred over a period and which, within certain parameters of output and turnover, are not affected by sudden changes in output and turnover. The purpose of these costs is to provide the physical and human facilities necessary for the success of a business. These costs result from contractual obligations and management decisions. These phenomena are created by the passage of time rather than by production, and they express themselves through the passing of time. Rent, property taxes, insurance, salaries of supervisors, etc. are examples. Fixed costs do not always remain the same. They can change based on the situation. They refer to costs that are not subject to variation. For the purpose of analysis, fixed costs can be divided into the following categories:

  1. Committed Costs: The costs of maintaining certain facilities cannot be eliminated immediately. Rent, insurance, etc., are costs over which management has little or no control.
  2. Policy and Managed Costs: There are policy costs associated with implementing certain management policies, such as executive development, housing, etc. Such costs are sometimes discretionary. In order to ensure the company’s operation, managed costs are incurred, such as staff services.
  3. Discretionary Costs: These are not associated with the operations and are dependent on management. Costs associated with these decisions, new research, etc., can be eliminated or reduced at the management’s discretion.
  4. Step Costs: For a given level of output, such costs are constant, and then at higher levels of output they increase by a fixed amount.

ii) Variable Cost: Direct materials and direct labor are examples of variable costs because they vary directly and proportionately with output. Remember that the variable cost per unit is constant, but the total cost varies based on output levels. This cost is always expressed in terms of units, not time. Managing the cost behavior pattern can have a significant impact on the cost behavior pattern. Variability is a relative term. The variability will have to be determined again if the conditions on which it was measured change.

iii) Semi-fixed (Semi-Variable) costs: Fixed and variable costs are included in such costs. Due to the variable element, they vary with volume, and due to the fixed element, they do not fluctuate inversely with output. In semi-variable costs, the changes in direction are the same as changes in output, but not proportionally. A simple example is depreciation; when working two shifts, the total depreciation may only be half as much as it is when working one shift. The proportion may not change in the same way when output changes comparatively little.

F) Classification By function

i) Manufacturing/production Costs: An undertaking’s manufacturing costs are included in the cost of operation. Direct material costs, direct labour costs, direct expenses, packing (primary) costs, and all overhead costs relating to production are included.

ii) Administration Costs: They are indirect and cover all expenses incurred in formulating policy, managing the organization and controlling the operations of a business, which are not directly related to research, development, production, distribution or selling.

iii) Selling and Distribution Cost: Selling cost is the cost associated with creating demand (advertising, market research, etc.). Distribution costs are incurred in order to make reconditioned packaging available for resale i.e. warehousing, transportation, etc. Expenses incurred in transporting articles to central or local storage are included. The cost of moving goods to and from prospective customers as in the case of goods on sale or return is also part of the distribution cost.

iv) Research and Development Costs: These costs include the cost of discovering new ideas, processes, and products and implementing those results commercially.

v) Pre-production Cost: Certain expenses are incurred when a new factory is opened or a new product is introduced. Trials are performed. These costs are categorized as pre-production costs and treated as deferred revenue expenditures. Costs associated with production in the future are attributed to them.

G) Classification by Relationship with accounting period

Assets are classified as capital expenditures because they provide benefits to future periods. Revenue expenditures, on the other hand, apply only to the current period and are treated as expenses. In the event of a write-off, capital expenses become cost to the extent of the write-off. Capital and revenue must be properly differentiated in order to determine earnings in a given period. Under all circumstances, it is impossible to distinguish between the two.

H) Classification by Controllability (Controllable, Non-controllable).

I) Classification by Cost for analytical and decision-making purposes (Opportunity, Sunk, Differential, Joint, Common, Imputed, Out-of-pocket, Marginal, Uniform, Replacement).

J) Others (Conversion, Traceable, Normal, Avoidable, Unavoidable, Total).

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