Cost Classification and Cost Concepts

Classifications of Cost – The meaning of the term ‘Cost’ is flexible depending on the purpose
for which it is being used. Depending on the need of management, cost can be classified &
interpreted in many ways. Some of the most popular interpretations are as follows –
1) Relationship based classification – Cost can be divided on the basis of how it relates to the
products or processes of the organization.
Direct cost is the one incurred specifically for a particular product or service. It is charged as
prime cost of such product or service. Direct material, labour & expenses are examples of
this cost.
Indirect cost is the one that cannot be conveniently charged to or identified with specific
products or services. The total of such indirect costs is called as overheads. It is charged
systematically over & above the prime cost on a suitable basis

2) Element wise classification – On the basis of elements of cost, it can be divided into
material cost, labour cost & expenses. As stated above, each of these elements can be
further sub divided into direct & indirect costs
Material is the substance from which a product is made or which is consumed in the process
of various business activities. Material cost is the most prominent of all the various costs
included in the total costs. It forms 50 to 70% of total cost.
Labour refers to the cost incurred on account of human skill, efforts, loyalty, time etc. used
by an organization in business activities. It firms 30 to 40% of total cost. But from control
point of view, it is the most complex & difficult cost.
Expenses are those items of cost, which are neither material, nor labour, but are part of the
business activities.

3) Functional classification – This is the most popular & commonly used classification of cost.
The various costs incurred are classified on the basis of the functions or activities that they
are incurred for. Generally, the overheads or indirect cost are presented in this classification
format. Different types of organizations may have different functions & their associated
costs. But the common types are
Production or factory costs are costs associated with the production activity or activity of
converting material into finished product. Direct costs incurred in factory like material &
labour and factory overheads like factory rent, depreciation, fuel etc are part of this cost.
Office & Administration costs are those which are incurred in course of general
administration & office work. Salaries of management & directors, office rent/ rates/
depreciation & taxes, legal & banking expenses, stationery costs etc are included under this
type.
Marketing & selling costs are incurred while making sales of product or services of a
business. Salaries of sales staff, sales commission, traveling expenses & entertainment
expenses are included in this type
Distribution costs are those costs that are incurred in fulfilling the sales orders & ensuring
that the finished products reach the customers in right quantity. Carriage outwards,
commission to distributors, showroom expenses are some of the expenses covered under
this category
Research & development costs are incurred for development of new products or processes
or for improving the existing products or processes. They may be treated as capital or
revenue costs depending on their periods of incurrence & benefits.

4) Behavior-wise classification – This is the classification of cost done on the basis of how it
behaves in response to the changes in volume or capacity utilization of the organization.
Fixed costs are those which remain unaffected by the changes in the volume of output. They
are mainly dependent on the effusion of time & remain constant in totality for a given
period irrespective of fluctuations in output level. The per unit fixed cost for the given cost
unit varies inversely with the level of capacity utilization. They can be subdivided in to
committed costs, managed costs & discretionary costs depending on the purpose behind
them
Variable costs are those that vary directly & proportionately with the output even if the per
unit cost remains the same. All the direct costs are variable by nature. They can be
influenced by output decisions as majority of these costs are by nature engineered costs.
Semi-variable costs OR Semi-fixed costs are those which contain both fixed & variable
elements. They neither vary directly in relation to changes in output, nor do they remain
completely fixed. They may change as slab rates over a period of time.
5) Control based classification – A cost which can be influenced by the action of a specific
decision of member of an undertaking is called as a ‘Controllable cost’. The cost which
cannot be influenced in this manner is called as an ‘Uncontrollable cost’. In practice,
majority of costs are partly controllable.

6) Normalcy based classification- The costs that are incurred at optimum capacity in normal
course of running of a business are called as normal costs. When the costs deviate from the
normal parameters due to any known or unknown reasons, the reasons are analyzed & such
costs are called abnormal costs. It is necessary for a business to continuously monitor &
correct abnormal costs.

7) Decision-making related classification – In this category, all costs that are used by
management time & again for different decision making are included. Some of them are as
follows – a) Opportunity costs are the costs of selecting one course of action & losing the
opportunity to carry out another (most probably the next best) course of action.
b) Sunk costs are those which are already incurred & can not be avoided by a decision taken
in future. They are also known as unavoidable costs.
c) Differential costs are defined as the increase or decrease in total cost resulting out of -
producing or distributing few more or few less products, change in method of production or
distribution, addition or deletion of a product or territory, selection of an additional sales
channel etc.
d) Joint costs are incurred if from one single process 2 or more joint products are produced
simultaneously.
e) Common costs are those costs which are incurred commonly for more than one product,
job, territory etc. They are not related to individual products & are therefore apportioned.
f) Out of pocket costs are the cash outlays required for an activity. The management is
interested in knowing that at least out of pocket costs are covered from cash inflows of a
project
g) Uniform costs are not distinct costs as such. They signify common costing principles &
procedures adapted by a number of firms & are the basis of inter firm comparison.
h) Marginal costs are the aggregate of variable costs. They are represented by the addition
made to cost by production of one extra unit of output at a given capacity
i) Replacement costs are costs of replacing an asset at current market value
j) Conversion costs are costs of finished product or WIP. They are defined as production
costs less costs of raw materials but including gains or losses in weight or volume of material
due to production

8) Time based classification – On the basis of time of the costs’ incurrence or calculation,
they are classified as follows –
Historical costs are those which are ascertained after they are incurred. They are available
only after a particular activity is carried out or a process is completed. They are objective in
nature & can not be changed or affected in any way
Predetermined costs are those which are calculated before they are incurred. They are also
known as future costs or estimated costs as they are estimated in advance before the
activities or processes using preset norms. If such costs are established using specific
processes, techniques for the purpose of establishing cost controls then they can also be
called as standard costs.

9) Association based classification – If costs are incurred in relation to product, they are
called as ‘Product costs’. All the direct costs as well as manufacturing overheads are product
costs & they are shown as factory cost
Some costs are incurred on the basis of time for e.g. rent, salaries, taxes, insurance,
electricity etc. They are necessary for the smooth functioning of various business activities,
even though they are not related to any specific product. They are called as ‘Process costs’.
The basic elements of cost:
 Material Cost: physical substance
 Labour Cost: human efforts
 Expenses: other than material & labour cost
Meaning of Cost sheet –
It is a statement prepared in a systematic manner, showing various stages of cost as well as
total cost of any product or service. It may be prepared for any given level of output.
Sometimes cost sheet may show profit /Loss as well as sales figures.

Uses – 1) It is useful in understanding cost elements & costs in various stages of production
& sales
2) It shows profits out of operations
3) It is useful in pricing and preparation of tenders & quotations
4) It helps in preparing various functional budgets
5) It helps in locating inefficiencies & wastages by pointing out excess costs

Cost Sheet of M/S ……………………………….For the period ended …………………..

Output :……..units
Particulars Details Amount
Direct Material :
Opening Stock of Raw material ………….
(+) Purchases of Raw Material ………….
(+) Expenses on Material Purchased …………
(Carriage inwards, octroi, excise etc)
Total ……………

(-) Closing stock of Material ……………

(-) Scrap of Material ……………
(1)Cost of Material Consumed **********
Direct Labour
Actually paid (+) Outstanding ………….
Direct Expenses
Actually paid (+) Outstanding ………….
(2) Prime Cost *********
Factory / Production Overheads
Factory Rent rates & Taxes …………..
Factory Insurance …………..
Factory Depreciation …………..
Rent of machinery …………..
Insurance of Machinery …………..
Depreciation of machinery …………..
Factory or Machine Repairs & Maintenance …………..
Consumables at factory …………..
Salary of Production manager & production supervisor …………..
Fuel costs …………..
Power …………..
Cost of rectifying defectives or processing scrap …………..
Total …………..
(+) Opening Stock of WIP …………..
(-) Closing Stock of WIP …………..
(-) Sale value of scrap from production ………….. …………..
(3)Works Cost / Factory Cost *********

Office / Administration / General Overheads

Office Rent rates & Taxes ………….
Office Insurance …………..
Office Depreciation …………..
Rent of Furniture …………..
Insurance of Furniture …………..
Depreciation of Furniture …………..
Legal Expenses …………..
Printing & Stationery …………..
Salary of GM & Office staff …………..
Audit fees …………..
Electricity …………..
General Administration costs ………….. …………..

(4) Cost of Production *********.

(+) Opening Stock of Finished goods ………….
(-) Closing Stock of Finished goods ………….

(5) Cost of Goods Sold *********

Selling & distribution Overheads
Sales office Rent rates & Taxes, Insurance, Depreciation …………..
Bad Debts …………..
Traveling Expenses …………..
Salesmen’s Commission …………..
Entertainment Expenses …………..
Salary of Sales manager & Sales staff ………….
Advertisement & Publicity costs ………….
Distribution Salaries & Commissions ………….
Godown Rent rates & Taxes, Insurance, Depreciation ………….
Carriage outwards …………..
Depreciation & Maintenance of distribution vehicles …………..
General Administration costs ………….. …………..

(6) Cost of Sales / Total Cost *********

Profit/ Loss *********
Sales *********

Items excluded from Cost sheet - Financial accounting records all financial transactions &
calculates total cost of any product or service by considering all related items. However in
costing, while preparing cost sheet, all items are not considered. As the purpose of
preparing costing is to find out purely operational; costs in normal circumstances, following
items are not included in costs –
1) Interest costs or Financial charges like dividend
2) Income tax
3) Any abnormal costs or losses
4) Cash discounts
5) Transfers to reserves etc.

We can thereby deduce as below:

The cost elements are divided as follows:
Direct Material Indirect Material
(+)Direct Labour (+)Indirect Labour
(+)Direct Expenses (+)Indirect Expenses
= PRIME COST = OVERHEADS

Problems on Cost Sheet

1. From the following information, prepare a cost sheet showing the prime cost, factory
cost, cost of goods produced, cost of goods sold, cost of sales and profit per unit and in
total.
1. Cost of materials @Rs.13 p.u.
2. Labour cost @ Rs. 7.50 p.u.
3. Factory overheads are absorbed @60% of labour cost
4. Administration overheads are absorbed @ 20% of factory cost.
5. Selling overheads are charged @ 2.50 p.u. sold.
6. Opening stock of finished goods – 500 units @ 19.75/-
7. Closing stock of finished goods – 250 units
8. Sales – 10250 units at profit of 20% on sales.

(Profit Rs. 82,000/- @ Rs. 8/-p.u.)

2. From the following information, prepare a cost sheet.

3.
Particulars Opening Closing
Raw material 29,500 36,000
Work in progress
Materials 13,600 12,000
Wages 11,000 16,500
Works overheads 6,600 9,900
Finished Goods 200 units @ Rs. 84/- 1,600 units
Other Information:
 1. Purchases of raw material Rs. 1,90,000, Carriage on purchases Rs. 1,500/-, Sale of
scrap of raw materials Rs.5,000/-
2. Wages Rs.2,97,000
3. Works overheads are absorbed @ 60% of direct labour cost.
4. Administration overheads are absorbed @ Rs. 12 p.u. produced.
5. Selling & distribution overheads are absorbed @ 20% of selling price.
6. Sales – 7600 units at a profit of 10% on sales price.

(Profit Rs.91,200/- @ Rs. 12/- p.u.)

4. Below is the enumerated expenditure in the manufacture of A product.

Particulars Rs. Particulars Rs.

Raw material 28000 Fuel 6900
Electric power 1340 Process and general wages 63500
Repairs 2400 Haulage 1060
Light & Water 400 Rent 2000
Rates & insurance 300 Office salaries & general 7000
expenses
Administration (office) 5000 Depreciation on machinery 2500
Quintals manufactured: 17,200
(Cost of goods produced Rs.1,20,400/- @ Rs. 7/-p.u.)
4. Mr. A furnishes the following data relating to the manufacture of a standard product
during the month of January, 2009.

Particulars Amount Rs.

Raw materials purchase 15000
Opening stock of raw materials 4000
Closing stock of raw materials 5000
Direct labour cost 9000
Machine hours worked 900 hrs
Machine hour rate 5
Carriage inwards 1000
Administrative overheads 20% on works cost
Selling overheads 0.50 per unit sold
Units produced 17100
Opening stock of finished products 2000 units @
 Rs.1.50/- p.u.
Units sold 16000 units
Selling price per unit 4

Prepare:
Cost sheet (prime cost Rs.24000/-, works cost Rs.28, 500/-, Cost of goods produced
Rs.34,200 i.e. Rs.2/- p.u.)
A statement showing profit for the period. (Profit Rs.25, 000/-)

5. From the following data prepare cost sheet and find out the amount of profit:

Particulars Rs.
Raw materials purchased 24000
Works overheads 20000
Stock as on 1 st Jan, 2009:
Raw material 4000
Finished goods (800 quintals) 3200

Work in progress:
Opening 960
Closing 3200

Office & administrative overheads 1600

Sales (Finished goods) 60000

Advertising, discount allowed and selling cost is Re.0.40/- per quintal. During the
month 12,800 quintals of the commodity were produced.

6. Surat Diamond Exporters Ltd. Produced 500 units of finished product ‘Solitaire’
during the month of June 2009. Following details are available for the same. You
are required to prepare Cost Sheet.
Particulars Amt.(Rs.)
Opening Stock : Raw Materials 3000
Work in Progress 2400
Finished Goods 18000
Closing Stock : Raw Materials 2600
 Work in Progress 3000
Finished Goods 36000
Purchases of Raw Material 17000
Carriage Inward 600
Direct Wages 24000
Unproductive Wages 600
Power 9000
Royalty 12000
Interest on Debentures 6000
Rent and Rates : Factory 2400
Office 2200
Insurance : Factory 600
Office 800
Lighting : Factory 800
Office 1000
Repairs to machinery 400
Indirect Material 1600
Supervision 3800
Depreciation of Plant 400
Office Salaries 9200
Sundry office expenses 1800
Repairs of Office Building 400
Depreciation of Building 600
Carriage Outward 400
Travelling Expenses 1200
Advertising 2400
Agent’s Commission 3000
Bad Debts 200
Delivery Van Expenses 600
Sales 104000
Salesman’s Commission 2000
Counting House Salaries 1000
Drawing Office Salaries 1000
Advance Income Tax 12000
Sale of Scrap 1000
Manager’s Salary 15000
Manager spends one third of his time in factory and the remaining in office.