CHAPTER ONE

COST TERMS AND CLASSIFICATIONS

1.1. Introduction

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ll organizations have two things in common. First, every organization has a set of goals or
objectives. Second, in pursuing an organization's goals, managers need information. The
information needs of management range across financial production, marketing, legal, and
environmental issues.

In pursuing an organization's goals, managers engage in four basic activities: decision making, planning,
directing operations, and controlling. For all of these managerial activities, managers need information.
The information comes from various sources, including economists, financial experts, marketing and
production personnel, and the organization's managerial and cost accountants. There are also individuals
and institutions that need information about the organization like suppliers, banks, insurances, customers,
investors, taxing authorities, regulatory bodies, and so forth.

1.2. Definition and Classification of Costs

Definition of Costs
The word ‘cost’ is usually used in our day to day conversation. It is a generic term that anyone needs to
know. Cost is the amount of resource given up in exchange for some present and future benefits. The
resource given up is always expressed in terms of money. Cost plays a significant role in managerial
functions such as planning, controlling, decision-making, and directing operation activities. To guide
decisions, managers want to know the cost of something. This ‘something’ may be a product, a service, a
department, or any activity. We call this ‘something’ cost object and is defined as anything for which a
separate measurement of cost is desired. Always activities consume resources and resources involve
costs.

Cost, Expense, and Loss

Cost accounting involves the use of, the control of, and the planning of costs. The term cost differs from
expense and loss, as seen by their definitions:

A) Cost: The benefit given up to acquire goods or services, measurable in money terms by the
reduction of assets or the incurrence of liabilities.
B) Expense: A cost that has given a benefit and is now expired. When the benefits (goods or
services) are received, the cost becomes an expense. In contrast an unexpired cost is
classified as an asset because benefits are still to be received.
C) Loss: A cost that occurs when goods or services purchased are determined valueless without
having provided any benefit. This loss appears as a deduction from revenues.
Expenses and losses both reduce revenue, but are separately disclosed to highlight the
loss.

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1.3. Objectives of cost accounting

1. Ascertainment of cost: - this is the primary objective of cost accounting. For cost ascertainment,
different techniques and systems of costing are used in different industries.
2. Control of cost: - cost control aims at improving efficiency by controlling and reducing cost.
3. Guide to business policy: - cost accounting aims at serving the needs of management in
conducting the business with utmost efficiency. Cost data provide guidelines for various
managerial decisions like make or buy, selling below cost, etc
4.Determination of selling price: - cost accounting provides cost information on the basis of
selling prices of products or services may be fixed.
Advantages of Cost Accounting to Management

1. Helps in cost control - cost accounting helps in controlling costs with special techniques like
standard costing and budgetary control
2. Reveals profitable and unprofitable activities - a system of cost accounting reveals profitable and
unprofitable activities to reduce or eliminate wastage and inefficiencies.
3. Helps in decision making - it supplies suitable cost data and other related information for
managerial decision making.
4. Aids in formulating policies - costing provide such information that enables the management to
formulate production and pricing policies
5. Guides in fixing selling prices – cost is one of the most important factors to be considered while
fixing selling prices. A system of cost accounting guides the management in the fixation of
selling price.
6. Helps in inventory control – techniques like perpetual inventory system help in controlling
materials cost.
7. Helps in eliminating wastage – costing helps to check various wastage in the form of material
loss, loss of labor time (idle time), expenses like power, lighting, etc.
8. Reveals idle capacity – a concern may not be working to full capacity due to reasons such as
shortage of demand, machine break down or other bottlenecks in production. A cost accounting
system can easily work out the cost of idle capacity so that management may take immediate
steps to improve the position.
9. Checks the accuracy of financial accounts: - cost accounting provides a reliable check on the
accuracy of financial accounts with the help of reconciliation between the two at the end of the
accounting period.
10. Facilitates cost comparison: - cost accounting enables management to make cost comparisons of
various jobs, products, departments, etc so as to improve performance.
11. Helps in cost reduction: - it helps in the introduction of cost reduction program and finding out
new improved ways to reduce costs.

Cost Behavior
Cost behavior refers to how the activities of an organization affect its costs. For example, if one or more
patient is added (admitted) for a 3-day stay, the costs of a hospital changes. Addition of one more flight to
the schedule will affect the cost of airlines. A decision to add one program by educational institution will
affect its costs. An increase in one unit of output will affect the total costs.

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 Knowledge of the patterns of cost behavior offers valuable insights in planning and controlling short-and
long-run operations.

The behavior of costs is depicted in the following graphs. Figure 1 shows that variable costs change as
activity level changes. Figure 2 shows that fixed costs remain constant, in total, over a certain range.
Figure 3&4 shows the characteristics of mixed costs.

Figure 1 Figure 2 Figure 3 Figure 4

C CC

Q QQQ

Variable Fixed Semi-variable Semi-Fixed

(Step) costs

1.4. Common cost related terminologies

A cost system typically accounts for costs in two basic stages:

Stage 1.It accumulates costs by some “natural” classification such as: Materials, labor, fuel, advertising,
etc. Manufacturing costs are accumulated as labor, materials and factory overhead.

Stag 2.It assigns these costs to cost objects.

Cost accumulation is the collection of cost data in some organized way (such as material, labor, fuel,
etc) through accounting system.

 Cost assignment is the general term that encompasses both tracing and allocating
accumulated costs to a cost object. Cost tracing is the assigning of direct costs to the chosen
cost object, and cost allocation is the assigning of indirect costs to the chosen cost object.
Direct costs are costs that are related to the particular cost object whereas indirect costs are
costs that are common to two or more cost objects. Cost assignment is a general term that
include both:
1. Tracing accumulated costs to a cost object.
2. Allocating accumulated costs to a cost object.

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Costs that are traced to cost object are direct costs and costs that are allocated to a cost object are indirect
costs.

Cost Object: Any thing for which a separate measurement of costs is desired. To guide decisions,
managers often want to know how much a certain thing (such as a new product, a machine, a service, or a
process) costs. All these things are called cost objects.

1.5. Cost Tracing and Cost Allocation

 Cost tracing: is the assignment of direct cost to the chosen cost object.
 Cost allocation: is the assignment of indirect costs to the chosen cost object.

Direct

Cost
Cost Tracing

Cost Cost Object

Assignment Indirect

Cost

Cost allocation

1.6. Classification of costs

Different cost concepts and classifications are used for different purposes. Understanding these concepts
and classifications enables the cost accountant to provide appropriate costs data to the managers who need
it. The purpose of the classification determines how the classification should be done. Cost data classified
and recorded in a particular way for one purpose could be inappropriate for another use.

For example, classification of costs for purposes of determining inventory valuations and cost of goods
sold for external reports differs from the classification of costs that would be carried out to aid decision-
making.

It is important to note that the classifications of costs are not mutually exclusive. That is, a particular cost
may be classified in many different ways—depending upon the purpose of the classification.

Cost accountants classify costs to meet the particular information need at hand.  In practice, the following
classifications are used extensively.  More than one may be used in any given circumstance.  You may
encounter other classifications in practice.

Cost classifications are needed for the development of cost data that will help (aid) management in
achieving its objectives.

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These classifications are based on the following:

1. Relationship of the cost to the product.

2. The department where the cost is incurred.
3. The major Functional areas.
4. Relationship of the cost to the production process.
5. The period to which the cost is charged to income.
6. Relationship of the cost to volume of production.
7. The ability to be traced
8. Relationship of cost to planning, controlling, and decision making.
1. Relationship of the cost to the product
Based on the relation ship of costs to the product, costs can be classified as direct material, direct labor,
and overhead costs. This classification provides management with information necessary for income
measurement and product pricing. The elements of a product cost are: -Materials, Labor and Others
facilities (called factory overhead costs)

I. MATERIALS: - are the principal substances used in production that are transformed into finished
goods by the addition of direct labor and factory overhead. The cost of materials may be divided into
direct and indirect.

Direct materials cost: -These are cost of all materials used in the production process that can be
identified with the finished product, that can be easily and economically traced to the product and that
represent a major material cost of producing that product. They are the integral part of finished products.

Indirect materials costs: - These are all materials used in the production of a product, that can not be
easily and conveniently traced to the product, and that do not represent significant material cost of the
product. It is difficult to determine such costs on a per unit basis as a result these will be considered as
part of the factory overhead.

II. LABOR: - is the physical and/or mental effort expended in the production of a product. Labor costs
are divided into direct and indirect.

Direct labor cost: - It represents the cost of all labor actually involved in the production of a product, that
can be easily and economically traced to the product in an economically feasible way and that represent a
major labor cost of producing that product.” Economically feasible” means “cost effective “, in the sense
that managers do not want cost accounting to be too expensive in relation to expected benefits. It is the
wage cost of employees working directly on the product as assemblers, machinists, painters, welders, and
some machine operators. Direct labor is sometimes referred to as "touch labor" since it consists of the
costs of workers who "touch" the product as it is being made. Direct labor is declining as a percentage of
total manufacturing cost as automation increases in manufacturing facilities.

Indirect labor cost: -It is cost of labor expended in the production process indirectly and that can not be
easily traced to the product and is part of the manufacturing overhead. Indirect labor include factory line
supervisors, factory department heads, factory clerical workers, time keepers, janitors and factory, guards,
receiving clerks (material handlers), maintenance persons, fringe benefits to both direct and indirect
laborers

III. FACTORY OVERHEAD (FOH)

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 It consists of all manufacturing costs other than direct materials and direct labor. It is an all-inclusive cost
pool used to accumulate all indirect manufacturing costs, which cannot be directly identified with specific
cost object. These costs cannot be easily and conveniently traced to products. All indirect material and
labor and many other costs including depreciation on manufacturing facilities are synonymous with
indirect manufacturing cost. Overhead benefits some or all manufacturing activities but cannot be related
to individual products. FOH is sometimes called manufacturing overhead, factory burden, and indirect
manufacturing expenses.

Examples of FOH include indirect materials cost, indirect labor cost, factory rent, factory insurance, heat,
light and power, factory depreciation etc.

Therefore, the following equations hold true

FOH costs = Indirect Material + Indirect Labor + Other Indirect Manufacturing Costs

Manufacturing Cost = Direct Material Cost + Direct Labor Cost + FOH

Here is a partial listing of the most common costs in a typical factory operation.

Indirect materials Indirect labor Other manufacturing overheads

- Shop supplies - Factory line supervisors - Employee fringe benefits

- Lubricants - Factory clerical workers - Payroll taxes

- Factory office supplies - Timekeepers - Workers’ compensation insurance

- Small tools - Factory superintendents - Factory utilities

- Packaging materials - Janitors - Rent of factory building, warehouse, and

equipment
-Items used in small amounts - Receiving clerks
in the manufacturing process -Depreciation of factory building
- Storeroom supervisors/clerks &equipment
- Purchasing employees - Fire and casualty insurance
-Idle-time costs of direct workers - Property taxes
- Overtime premiums of direct - Group insurance for factory employees
workers
- Repairs and maintenance

- Spoiled goods

2. The department where the cost is incurred

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In manufacturing businesses departments can be classified into manufacturing (or producing) and non-
manufacturing (or service) departments. The manufacturing/non-manufacturing cost classification is
important in all cost accounting functions. 

Producing department costs: are costs incurred in departments that contribute directly to the production
of the item and include costs of departments in which conversion and production process takes place.

Service department costs: are costs incurred in departments which are not directly related to the
production of the item but provide services to other departments. The cost of maintenance, accounting,
health and other departments are considered as non-manufacturing or service department costs.

3. Major Functional areas

Costs can also be classified based on the functional areas of an organization. All costs of a manufacturing
organization may be divided into manufacturing, marketing, administrative and financing.

Manufacturing costs: are costs related to the manufacturing or production process of an item. It is the
sum of direct material, direct labor, and factory overhead.

Marketing costs: are costs incurred in promoting or selling a product or service. Examples include
advertisement costs, transportation costs, etc.

Administrative costs: are incurred in directing, controlling and operating a company. The salary of the
general manager is an example.

Financing cost: are costs related to obtaining funds to operate the company. Example is interest expense.

4. Relationship of the cost to the production process

Based on the relationship of the costs to the production process, we can classify costs into prime costs and
conversion costs.

Prime costs are costs which are directly related to the production of a product. Prime cost is the sum of
direct material costs and direct labor costs.

Conversion costs, called processing costs, are costs concerned with transformingdirect materials into
finished products. They are the sum of direct labor and factory overhead costs. Therefore, the following
equations hold true:

Prime cost = DM + DL

Conversion Cost = DL + FOH

Manufacturing Cost = Direct Material Cost + Direct Labor Cost + FOH

5. The period to which the cost is charged to income

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Costs may also be classified on the basis of the time or accounting period they are to be charged against
revenue. Some costs are first recorded as assets and then expensed as they are used or expired. Other
costs are immediately expensed in the year of incurrence. Product costs and periodic costs are the two
categories according to this classification.

Product costs: are costs directly and indirectly identifiable with the product. These costs provide no
benefit until the product is sold and are therefore inventoriable, i.e. it is part of the finished product.
Product costs are added to units of product (i.e., "inventoried") as they are incurred and are not treated as
expenses until the units are sold. This can result in a delay of one or more periods between the time in
which the cost is incurred and when it appears as an expense on the income statement. Product costs are
also known as inventoriable costs.

Periodic costs: are neither directly nor indirectly related to the product. They are expensed (charged
against revenue) immediately and are therefore non- inventoriabl. All selling and administrative costs are
typically considered to be periodic costs. These costs are also called non-inventoriabl costs. Product costs
become periodic cost when products are sold.

6. Relationship of the cost to volume of production

Taking the response of a cost to changes in production volume as a base we can classify costs into
variable, fixed, and mixed.

Variable costs: are costs that change in direct proportion to changes in volume of output, whereas the
unit cost remains constant. Variable costs are easily traceable to units of output and are controlled by the
department head responsible for incurring them.

Fixed cost: are costs remain constant over a relevant range of output, whereas the fixed cost per unit
varies inversely with output. Relevant range is the range over which total fixed costs remains constant.
But beyond the relevant range, the fixed costs will change in total. Thus, fixed costs will not be affected
immediately by changes in the output (cost driver). These costs are usually controlled by top
management.

Mixed costs: These are costs that contain both fixed and variable characteristics over various relevant
ranges of operation. Telephone bill can be an example.

For costs to be variable, fixed or mixed, they must have a linear relationship to production in units (or
some other measure of activity-output is by far the most commonly used activity measure). The following
table summarizes unit costs and total costs:

As output increases:

In TotalUnit Cost

Variable Cost ....................Increases Remains Constant

Fixed Cost..........................Remains Constant Decreases

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The challenge of identifying costs as variable or fixed (or mixed) is common to many cost accounting
issues. In many real-world situations, approximations can be made without much loss in benefit. We will
discuss variable, fixed and mixed costs in detail latter.

7. The ability to be traced

A cost may be classified as direct and indirect based on management ability to trace it to specific jobs,
departments and units or generally to specific cost objects.

Direct costs: are costs that management is capable of tracing them to specific items or areas in an
economically feasible way. These are costs that could be traced to specific units in a cost-effective
manner. Direct material and direct labor costs are example of direct cost of products.

Indirect costs: are costs that are common to many items and are therefore not directly traceable to any
specific item (cost object). These costs are usually charged to items (cost objects) through allocation
techniques. For a product indirect material, indirect labor, other FOH costs are indirect costs. There are
two reasons why a cost would be considered indirect: either it is impossible or it is impractical to trace the
cost to the cost object.

For example, it is impossible to trace the factory managers’ salary in a multi-product plant to any
particular product made in the plant. Even if a product were dropped entirely, we would ordinarily expect
the factory manager’s salary to remain the same. This is an example of a "common cost".

On the other hand, other costs are treated as indirect costs because it would not be practical to treat them
otherwise. For example, it would be possible to measure the precise amount of varnish used on each
armchair produced at a house furniture factory, but it wouldn’t be worth the effort. Instead, varnishes
would typically be considered an indirect material and would be included in overhead.

Note that a cost that is not direct with respect to a product may be direct with respect to another cost
object such as a department. For example the salary of a production department's manager is not direct
with respect to a product but it is a direct cost for the production department. In general the classification
of a certain cost item as direct or indirect is affected by the following factors:

a) The materiality of the cost in question:

For costs that are immaterial, tracing will not be cost effective (or not as such relevant) even if the cost
has direct relation with cost object. For example, glues and invoice papers sent with the product usually
are classified as indirect (not traced) as they are immaterial.

b) Available information-gathering technology:

Improvements in the information technology will make cost tracing simpler and more cost effective and
make more costs to be direct.

c) The cost object selected:

For example, consider the salary of supervisor in the maintenance department of a textile factory. If the
cost object is the department, the supervisor’s salary is a direct cost. In contrast, if the cost object is a

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service (product), the supervisor’s salary is an indirect cost. Thus, a particular cost may be simultaneously
be direct and indirect, depending on the type of cost objective/object.

8. Relationship of cost to planning, controlling, and decision making

Every decision involves choosing from among at least two alternatives. Only those costs and benefits that
differ between alternatives are relevant in making the selection.

A. Relevant and Irrelevant Costs

A relevant cost is a future cost that differs among alternatives. Relevant costs also are called differential
or incremental costs.   Restricting attention to relevant costs greatly simplifies the decision making
process.  When deciding among alternatives, only those costs and revenues that change need be
considered.  Managers appreciate simplified reports that include only the information they need to make
decisions. An irrelevant cost is one that is the same for all decision alternatives.  These costs need not to
be considered.  
A direct or variable cost is not necessarily a relevant cost.   For example, direct material is a variable cost
and is a direct cost with respect to output in units.  But in a decision concerning whether to increase
automation to reduce direct labor in the production process, direct material is not a relevant cost.   The
amount of material per unit is the same regardless of how units are produced.

B. Controllable and Uncontrollable Costs

Controllable costs are those which may be directly influenced by unit managers in a given time period.
Non-controllable costs are those costs which are not directly administered at a given level of management
authority.
Primarily used for the evaluation of the segment management, this classification seeks to separate costs
into those that can be influenced by management, and those that cannot be.  Managers perceive the
evaluation process to be more fair if they are evaluated only over those activities and costs they can
influence. For example, depreciation on existing equipment is not controllable because the cost of the
equipment is sunk.  Again, a controllable cost is not necessarily direct or variable.

C. Standard and Budgeted costs:

Standard costs are those costs which should be incurred in a particular production process under normal
conditions. Standard costing is usually concerned with per-unit costs of direct material, direct labor and
FOH, whereas budgeted costs usually provide forecasted activity on a total cost basis.

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D. Opportunity Costs.
An opportunity cost is the potential benefit that is given up by selecting one alternative over another. An
opportunity cost is not an actual expenditure and it is rarely (if ever) shown on the accounting books of an
organization. It is, however, a cost that must be considered in decisions.

E. Sunk Cost.
A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now
or in the future. Since sunk costs cannot be changed and therefore cannot be differential costs, they should
be ignored in decision-making. While students usually intellectually accept the idea that sunk costs should
be ignored, they often have difficulty putting this idea into practice. A sunk cost is an amount of cash that
has been spent and it cannot be recovered. For example, if you are considering selling a used car, the
amount you paid for it two years ago is sunk.  It should not influence the amount you accept when you
sell the car.   The value of a used car is set by the market.  There is an active market for all types of used
cars.  A sunk cost is by definition irrelevant because it cannot differ across decision alternatives.  The two
alternatives here are:  (1) sell the car, or (2) keep the car.  The amount paid for the car in the past is the
same either way and cannot influence the decision.

F. Shutdown costs: - are fixed costs that would be incurred even if there were no production.
G. Committed Vs Discretionary costs.
Committed costs are costs that will continue even if an organization shuts down for a short time. These
costs cannot be eliminated without endangering an organization's overall health and existence. Examples
are the cost of facilities and top management. Discretionary costs are costs that exist as the result of a
management decision. In comparison with committed costs, such costs are more easily changed in bad
economic times without doing serious long-run harm to the entity. Examples are a training program, an
advertising campaign, and corporate contributions.

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