6. Classification of Costs
6.1 By Nature of expense:
6.1.1 Costs should be gathered together in the
ir natural groupings such as material, labour a
nd other expenses. Items of costs differ on the basis of their nature. The elements of cost can be classified in the following three categories : i) Material ii) Labour iii) Expenses
Cost
Classification by nature
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Material Labour Expenses
6.1.2 Material Cost is the cost of material of any nature used for the purpose of production of a product or a service.
6.1.3 Material cost includes cost of procurement, freight inwards, taxes & duties, insurance etc directly attributable to the acquisition. Trade discounts, rebates, duty drawbacks, refunds on account of modvat, cenvat, salex tax and other similar items are deducted in determining the costs of material.
6.1.4. Labour Cost means the payment made to the employees, permanent or temporary, for their services.
6.1.5 Labour cost include salaries and wages paid to permanent employees, temporary employees and also to employees of the contractor. Here, salaries & wages include all fringe benefits like Provident Fund contribution, gratuity, ESI, overtime, incentives, bonus , ex-gratia, leave encashment, wages for holidays and idle time etc.
6.1.6 Expenses are other than material cost or labour cost which are involved in an activity.
6.1.7 Expenditure on account of utilities, payment for bought out services, job processing charges etc. can be termed as expenses.
6.2 By Relation to Cost Centre
6.2.1 Classification should be on the basis of method of allocation of cost to a cost unit. If an expenditure can be allocated to a cost centre or cost object in an economically feasible way then it is called direct otherwise the cost component will be termed as indirect. According to this criteria for classification, material cost is divided into direct material cost and indirect material cost, labour cost into direct labour cost and indirect labour cost and expenses into direct expenses and indirect expenses. Indirect cost is also known as overhead.
Cost
Classification by relation to Cost Centre
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Direct Indirect
__________________ ____________________
Material labour expenses Material labour expenses
6.2.2 Direct cost has three components – direct material cost, direct labour cost and direct expenses and indirect cost has three components- indirect material, indirect labour cost and indirect expenses. Sum of all direct costs is called prime cost .
6.2.3 Direct material Cost is the cost of material which can be directly allocated to a cost centre or a cost object in a economically feasible way.
6.2.4 Raw materials consumed for production for a product or service which are identifiable in the product or service form the direct material cost. Direct Material cost includes cost of procurement, freight inwards, taxes & duties, insurance etc directly attributable to the acquisition. Trade discounts, rebates, duty drawbacks, refunds on account of modvat, cenvat, salex tax and other similar items are deducted in determining the costs of direct material.
6.2.4 Direct Labour Cost is the cost of wages of those workers who are readily identified or linked with a cost centre or cost object.
6.2.5 Here, the wages of the workers include the fringe benefits include all fringe benefits like Provident Fund contribution, gratuity, ESI, overtime, incentives, bonus , ex-gratia, leave encashment, wages for holidays and idle time etc. for the purpose of calculation of direct labour cost.
6.2.6 Direct Expenses are the expenses other than direct material or direct labour which can be identified or linked with the cost centre or cost object.
6.2.7 Examples of direct expenses are
· expenses for special moulds required in a particular cost centre
· hiring charges for tools and equipments for a cost centre
· royalties in connection to a product
· Job processing charges etc
6.2.8 Indirect Material is the cost of material which can not be directly allocable to a particular cost centre or cost object.
6.2.9 Materials which are of small value and can not be identified in or allocated to a product/service are classified as indirect materials. Examples :
· Consumable spares and parts
· Lubricants etc.
6.2.10 Indirect labour cost is the wages of the employees which are not directly allocable to a particular cost centre.
6.2.11 Examples of indirect labour :
· Salaries of staff in the administration and accounts department
· Salaries of security staff etc
6.2.12 Indirect expenses are the expenses other than of the nature of material or labour and can not be directly allocable to a particular cost centres.
6.2.13 Indirect expenses are not be allocable to a particular cost centre. Examples – insurance, taxes and duties,
6.3 By functions/activities:
6.3.1 Costs should be classified according to the major functions for which the elements are used into the following four major functions :
Production;
Administration;
Selling;
Distribution; and
Research & Development Expenditure.
Cost
Classification by function
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Production Administration Selling Distribution Research & Development
6.3.2 Production Cost is the cost of all items involved in the production of a product or service. It includes all direct costs and all indirect costs related to the production.( Exhibit 1)
6.3.3 Production overhead is the indirect costs involved in the production process.
6.3.4 Production overhead is also termed as factory overhead or manufacturing overhead. Examples of Production overhead :
§ Salaries for staff for production planning, technical supervision, factory administration etc
§ normal idle time cost
§ expenses for stores management
§ security expenses in the factory
§ labour welfare expenses
§ dispensary and canteen expenses
§ depreciation of plant and machineries
§ repair and maintenance of factory building and plant & machineries
§ insurance
§ quality control etc.
6.3.5 Administration costs are expenses incurred for general management of an organization. These are in the nature of indirect costs and are also termed as administrative overhead.
6.3.6 Examples of items to be included in Administrative overhead :
§ Salaries of administrative and accounts staff
§ general office expenses like rent, lighting, rates and taxes, telephone, stationery, postage etc
§ bank charges
§ audit fees
§ legal expenses
§ depreciation & repair and maintenance of office building etc.
6.3.7 Selling costs are indirect costs related to selling of products or services and include all indirect cost in sales management for the organization.
6.3.8 Selling Costs include all costs relating to regular sales and sales promotion activities. Examples of expenses which are included in selling cost are :
§ Salaries, commission and traveling expenses for sales personnel
§ advertisement cost
§ Legal expenses for debt realization
§ market research cost
§ royalty on sale
§ after sales service cost etc
6.3.9 Distribution Costs are the cost incurred in handling a product from the time it is completed in the works until it reaches the ultimate consumer.
6.3.10 Distribution costs are the costs incurred for distribution of product to customers. Examples of distribution costs :
· Transportation cost
· cost of warehousing salable products
· cost of delivering the products to customers. etc
Note
1. Primary packaging cost is included in production cost whereas secondary packaging cost is distribution cost.
2. In exceptional cases, for example in case of heavy industries equipment supply, installation cost at delivery site for heavy equipments which involves assembling of parts, testing etc is included in production cost but not distribution cost. For example. installation cost of a gas turbine at plant site is included in the cost of production of gas turbine.
6.3.11 Research & Development Costs are the cost for undertaking research to improve quality of a present product or improve process of manufacture, develop a new product, market research etc and commercialization thereof.
6.3.12 Research Cost comprises the cost of development of new product and manufacturing process; improvement of existing products, process and equipment; finding new uses for known products; solving technical problem arising in manufacture and application of products etc. Development cost includes the cost incurred for commercialization / implementation of research findings.
Exhibit 1
(1) Direct Material Cost (a)
(2) Direct Labour Cost
(3) Direct Expenses
(1)+(2)+(3) = (4) Prime Cost
(5) Production Overhead
(6) Administrative Overhead
(7) Research & Development Cost ( apportioned )
(4)+(5)+(6)+(7)= (8) Cost of Production (b)
(9) Selling Cost
(10) Distribution Cost
(8)+(9)+(10) = (11) Cost of Sales
Note :
To arrive at value at different points as indicated above adjustment with opening and closing stock is necessary at following different points :
(a) opening and closing stock of raw materials
(b) opening and closing stock of work-in-progress & finished goods
6.4 By Behaviour
6.4.1 Costs are classified based on behaviour as fixed cost, variable cost and semi-variable cost depending upon response to the changes in the activity levels.
Cost
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Fixed Variable Semi-variable
6.4.2 Fixed Cost is the cost which does not vary with the change in the volume of activity in the short run. These costs are not affected by temporary fluctuation in activity of an enterprise. These are also known as period costs.
6.4.3 Examples for fixed cost : salaries, rent, audit fees, depreciation etc.
6.4.4 Variable Cost is the cost of elements which tends to directly vary with the volume of activity. Variable cost has two parts – (a) Variable direct cost; and (b) Variable indirect costs. Variable indirect costs are termed as variable overhead.
6.4.5 Examples of variable cost are materials consumed, direct labour, sales commission, utilities, freight, packing, etc.
6.4.6 Semi Variable Costs contain both fixed and variable elements. They are partly affected by fluctuation in the level of activity.
6.4.7 Examples of semi-variable cost : Factory supervision, maintenance, power etc.
Note :
1. The characteristics of fixed costs are (1) fixed amount within an output range (2) fixed cost per unit decreases with increased output
2. The characteristics of variable Cost: (1) The variable cost varies directly with volume of activities or production (2) variable cost remains constant per unit within a range of activity .
6.5 For Management Decision Making 
6.5.1 Costs are classified for the purpose of management decision making under different circumstances as under :
6.5.2 Marginal cost is the aggregate of variable costs, i.e. prime cost plus variable overhead. Marginal cost per unit is the change in the amount at any given volume of output by which the aggregate cost changes if the volume of output is increased or decreased by one unit.
6.5.3 Marginal cost is used in Marginal Costing system. For determining marginal cost, semi-variable costs, if any, are segregated into fixed and variable cost. Then, variable costs plus the variable part of semi-variable costs is the total marginal cost for the volume of production in consideration.
Example :
A. Production 45,000 units
Fixed Cost Variable Cost
B. Cost Rs lakhs Rs lakhs
1. Material cost 4.50
2. Labour cost 2.45
3. Fixed Cost 4.80 -
4. Variable Production & Selling overhead 2.30
5. Semi-variable Cost 3.20 2.00
( after segregation fixed and variable part)
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C. Total Marginal Cost 11.25
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D. Marginal cost per unit Rs 25.00
6.5.4. Differential Cost is the change in cost due to change in activity from one level to another.
6.5.5 Differential Cost is found by using the principle which highlights the points of differences in costs by adoption of different alternatives. This technique is used in export pricing, new products and pricing goods sought to be promoted in new markets, either within the country or outside.
6.5.6 The algebraic difference between the relevant cost at two levels of activities is the differential cost. When the level of activity is increased, the differential cost is known as incremental cost and when the level of activity is decreased, the decrease in cost is known as decremental cost.
| Output Unit in Lakhs | Differential Unit in lakhs | Total Cost (Rs lakhs) | Differential cost ( Rs lakhs) | Differential cost per unit ( Rs) |
| (a) 1.00 | - | 30.00 | - | - |
| (b)1.20 | 0.20 ( b) –(a) | 35.00 | 5.00 | 25.00 |
| © 0.80 | 0.20 ( a) –(c) | 26.00 | - 4.00 | - 20.00 |
( +) Incremental cost
( -) Decremental cost
6.5.7 Opportunity Cost is the value of the alternatives foregone by adopting a particular strategy or employing resources in specific manner.
6.5.8 It is the return expected from an investment other than the present one. The opportunity cost is considered for selection of a project or justification of investment, studying viability of an investment option. Example : A machine is currently being used to produce product P. It can also be used to produce product Q which can fetch Rs 60,000 profit. Then the opportunity cost of using the machine is Rs 60000.
6.5.9 Replacement Cost is the cost of an asset in the current market for the purpose of replacement.
6.5.10 Replacement cost is generally used for determining the optimum time of replacement of an equipment or machine in consideration of maintenance cost of the existing one and its productive capacity.
6.5.11 Relevant Costs are costs relevant for a specific purpose or situation.
6.5.12 In the context of decision making relating to a specific issue, only those costs which are relevant are considered. A particular cost item may be relevant in a decision making and may be irrelevant in some other decision making situation. For example, present depreciated cost of machine is relevant in case of decision of its sale but it is irrelevant in case of decision of its replacement.
6.5.13 Imputed Costs are hypothetical or notional costs, not involving cash outlay, computed only for the purpose of decision making.
6.5.14. In economics, ‘imputed’ indicates an ascribed or estimated value when there is no criteria of absolute monetary value for such purpose. In national income estimation wages of housewives are imputed. Similarly, in farming operations, the wages or salaries of owner are imputed. Imputed costs are similar to opportunity costs. Interest on internally generated fund, which is not actually paid is an example of imputed cost.
6.5.15 Sunk Costs are historical costs which are incurred i.e. ‘sunk’ in the past and are not relevant to the particular decision making problem being considered.
6.5.16 Sunk costs are those that have been incurred for a project and which will not be recovered if the project is terminated. While considering the replacement of a plant, the depreciated book value of the old asset is irrelevant as the amount is a sunk cost which is to be written off at the time of replacement.
6.5.17 Normal Cost is a cost that is normally incurred at a given level of output in the conditions in which that level of output is achieved.
6.5.18 Normal cost includes those items of cost which occur in the normal situation of production process or in the normal environment of the business. The normal idle time is to be included in the ascertainment of normal cost.
6.5.19 Abnormal Cost is an unusual or a typical cost whose occurrence is usually irregular and unexpected and due to some abnormal situation of the production.
6.5.20 Abnormal cost arises due to idle time for some heavy break down or abnormal process loss. They are not considered in the cost of production for decision making and charged to profit & loss account.
6.5.21 Avoidable Costs are those costs which under given conditions of performance efficiency should not have been incurred.
6.5.22. Avoidable costs are logically associated with some activity or situation and are ascertained by the difference of actual cost with the happening of the situation and the normal cost. When spoilage occurs in manufacture in excess of normal limit, the resulting cost of spoilage is avoidable cost. Cost variances which are controllable may be termed as avoidable cost.
6.5.23 Unavoidable Costs are inescapable costs which are essentially to be incurred, within the limits or norms provided for. It is the cost that must be incurred under a programme of business restriction. It is fixed in nature and inescapable.
