Introduction and Classification of Cost

Concept of Cost

Cost means price; the price that is paid for something. That is the general meaning of cost. But, in Cost accounting, it is considered to be different from price. In cost accounting, the amount of resources that is given up in exchange for some goods or services is known as cost. Generally, the given up resources are in terms of money or monetary units.

According to Horngren, Sundem and Stratton, “Cost may be defined as the sacrifice or giving up resources for the particular purpose. Cost is frequently measured by monetary units that must be paid for goods and services.”

The term ‘cost’ is always used with a phrase or an adjective conveying the intended meaning like direct, indirect, variable, fixed, marginal, replacement, etc. as it does not have any significant meaning by itself.

Cost Centre:

Cost centre is an individual or group of similar activities for which costs are accumulated. According to ICMA, “a production or service, function, activity or item of equipment whose costs may be attributed to cost units. A cost centre is the smallest organizational subunit for which separate cost allocation is attempted.”

Cost Unit:

A cost unit refers to the cost imposed upon by a company from the production to the manufacturing, storing and finally selling a product or service in per unit case. Simply, it is a cost per unit of any service or product including fixed and variable costs during its production phase. For example:

(Koirala & Acharya, 2006)

Classification of Cost

On the basis of different characteristics, cost is classified into various groups. Such as:

1. On the basis of production and process

   During the production of products and services, a factory is incurred with several types of costs. These costs can be sub-divided into 2 types. They are:

• Direct expenditure:
  This expenditure contains direct expenses, material expenses and labor expenses which are easily identified wholly with a unit of cost. For example, cloth and labor are direct expenses for a garment manufacturer.
  
  
• Indirect expenditure: These expenditures refer to such expenses which are not easy to identify as they tend to occur as an extra expense in a production process. For example, fabric softener and colour are indirect expenses for a garment manufacturer.

Differences between Direct and Indirect expenditure:

2. On the basis of element

   On the basis of element, cost is divided into 3 parts: material, labour and expense.
   
   
   
   Material: Material is the most important component for the production of goods or to provide services. They are classified as follows:
   
   
   • Direct material:
     It refers to the materials which have huge part in the product formation and that can be easily identified through the finished product. For example; wood, adhesive, plywood, etc. for furniture manufacture; metal, steel, rubber, etc. for bicycle manufacture, etc.
   • Indirect material:
     Other expenses or material costs that occur during the production process but cannot be easily traced as the part of the product are indirect materials. For example; dusters and chalks in teaching purposes in schools, oil and grease for the maintenance of machinery, etc.
   
   
   Labour: For the conversion of raw materials into finished goods and even after the production phase, for the proper supply and distribution of goods, labour is needed. It can be divided into following types:
   
   
   • Direct labour: It is the labour cost which cost centres and cost units can identify and allocate. It is the workforce directly involved in the production process of the products. For example: wages paid to a mason by a building contractor for the construction of a building, wages paid to carpenters for a wooden table, etc.
   • Indirect labour: Salary paid to the general manager or sales managers, salary paid to foreman or supervisor, etc. are some examples of indirect labour.
   
   
   Expenses: These are the expenses that incur in the process of production and distribution of the products but not in terms of material and labour. Its types are :
   
   
   • Direct expense: Also called Chargeable expenses, these are those expenses which incur for each unit of manufacture specifically. For example; Royalties paid, carriage and freight on direct materials purchased, an amount payable to the sub contractor, etc.
   • Indirect expenses: Rent, taxes, insurance of factory building, repairs to factory building, depreciation to plant and machinery, etc. are some examples of indirect expenses.

3. On the basis of function

   The cost can be classified into 4 areas on this basis. They are:
   
   Production cost: As the name says, it refers to the costs concerned with production activity. From the supply of material to the primary packing of the product, production covers all. It includes direct material, direct expenses, direct labour and manufacturing expanses.
   
   Administration cost: Also called the office cost, this is the type of cost which does not include production, distribution, research, development or selling activities. It incurs while administrative functions of the organization are carried, such as; policy formulation cost and its implementation to attain the objectives of the organization.
   
   Selling and Distribution cost: Selling and Distribution cost refers to the cost of maintenance and creation of demand for product and making them available in the customers’ hands. They are also called total cost or cost of sales.
   
   Research and Development cost: The research cost is the cost for searching new products, manufacturing process, improvement of existing products, equipment, services and processes and the Development cost is the cost of putting those research results on the commercial basis.
   
   

4. On the basis of variability

   On the basis of variability or behavior, cost is classified into 3 types: fixed, variable and semi-variable.
   
   Fixed cost: Also called the capacity cost, fixed cost remains unchanged and constant no matter what, up to a certain capacity. With the level of production, per unit cost changes to its accordance but the total amount of fixed cost remains constant. But, while its costs remain unchanged, it’s per unit cost changes with changes in sales or output.
   
   

   
   
   
   

   Some of its features are:

   • The amount of fixed cost is never Zero, even though the production is zero.
   • Fixed costs’ amount remains constant, up to a certain range.
   • These costs are uncontrollable costs.
   • Per unit fixed cost changes in vice versa to the production activity.
   
   
   
   Variable cost: These costs are the costs that change in proportionate to the change in output. Unlike fixed costs, the total amount of variable cost is zero, if the production is zero. But, on the other side, the variable cost per unit is always constant.
   
   

   
   
   
   

   
   Some of its features are:

   • It is a controllable cost.
   • Its total amount changes in accordance with production level changes.
   • It is also called marginal cost, pocket costs, direct cost, etc.
   
   
   
   Semi-variable cost: Semi-variable cost has both fixed and variable costs’ characteristics. It is neither absolutely fixed nor variable in relation to changes in the volume. Telephone charges, water supply charges, electricity charges, etc. are some of its examples.

Its features are:

• It can never be zero.
• Its total amount increases with the increase in production level but it’s per unit cost decreases and vice versa.
• Its total amount and per unit cost never remain constant.

5. On the basis of controllability

   On the basis of controllability, cost is divided into 2 parts. They are:
   
   Controllable cost: These are the costs that can be controlled; as in changed or altered by the action of an individual or a specific manager.
   
   Uncontrollable cost: These costs are not influenced by anyone’s actions. These are unchangeable.

ILLUSTRATION:

The following cost data are available for the production of 5000 and 10000 units of a product.

Required: (i) Fixed cost (ii) Variable cost and (iii) Semi-variable cost.

Solution:

Fixed cost

Variable cost

Semi-variable cost

References:

Koirala, Madhav et.al., Principles of Accounting -XII, Buddha Prakashan, Kathmandu

Shrestha, Dasharatha et.al., Accountancy -XII, M.K. Prakashan, Kathmandu

Bajracharya, Puskar, Principle of Accounting-XII, Asia Publication Pvt. Ltd., Kathmandu