Understanding and Classifying

Understanding And Costs

UNIT 6 UNDERSTANDING AND Classifying Costs
CLASSIFYING COSTS

Objectives
The Objectives of this unit are:

 to familiarise you with the process of determination of costs, particularly in a

manufacturing concern

 to explain how the costing techniques are useful in the process of managerial decision-
making.

Structure
6.1 Introduction
6.2 Cost Accounting
6.3 Costs
6.4 Elements of Cost
6.5 Components of Total Cost
6.6 Cost Sheet
6.7 Classification of Costs
6.8 Some other Concepts of Costs
6.9 Summary
6.10 Keywords
6.11 Self-assessment Questions/Exercises
6.12 Further Readings

6.1 INTRODUCTION
You will recall that units 1 and 2 of this Course gave you a detailed outline of
the conceptual framework of accounting and the role the accountant is
required to play in the present commercial and industrial setup. You have
seen that he is more of an adviser to the management. He functions as the
channel through which accounting information flows to the management
efficiently and effectively. He gathers information, breaks it down, sifts it and
organises it into meaningful categories. He separates relevant information
from irrelevant and then ranks the former according to the degree of
importance to management. He also compares the actual performance with
the planned one and reports and interprets the results of operations to all
levels of management and to the owners of the business.

In performing the above multiple duties, the accountant has to make use of
different management accounting techniques. Cost techniques have
precedence over other techniques since the accounting treatment of costs is
often both complex and financially significant. For example, if a firm
proposes to increase its output by 10%, is it reasonable to expect the total cost 155
Cost Accounting to increase by less than 10%, exactly 10% or more than 10%? Such questions
are concerned with the cost behaviour, i.e., the way costs change with the
level of activity.

Answers to these questions are pertinent for the management accountant or

financial analyst, since they are basic for the firm's projections and profits,
ultimately Cost Management becomes the basis for all financial decisions. It
is, therefore, necessary for a management accountant or financial analyst to
have a reasonably good working knowledge about basic cost concepts and
patterns of cost behaviour. All these come within the range of cost
accounting.

6.2 COST ACCOUNTING

In the initial stages, cost accounting was merely considered to be a technique
for ascertainment of costs of products or services on the basis of historical
data. In the course of time it was realised, due to the competitive nature of the
market, that ascertainment of cost' was not as important as controlling costs
was. Hence, cost accounting is considered more a technique for `cost control'
than merely for cost ascertainment. Due to technological developments in all
fields, `cost reduction' has now come within the ambit of cost accounting.
Cost accounting is thus concerned with:

 Ascertaining costs.

 Controlling costs.

 Reducing costs

6.3 COSTS
Cost Accountant is concerned with costs, and hence it will be of relevance to
us to understand the meaning of the term `Cost' in a proper perspective.
In general, cost means the amount of expenditure (actual or notional)
incurred on, or attributable to a thing. For example, if you have purchased a
book for Rs. 150, it can be said that the cost of the book to you is Rs.150.
Similarly, if a furniture manufacturer makes a table by paying Rs.500 for
timber, Rs 200 as carpenter's wages and Rs.100 as the rent of the works, it
can be said that the table cost him Rs.800. It may be noted, however, that the
term cost cannot be precisely defined. Its interpretation depends on:

a) the nature of the business or industry; and

b) the context in which it issued.

In a business where selling and distribution expenses are quite nominal, the
cost of the article may be calculated without considering the selling and
distribution overheads. In a business where the nature of the product requires
heavy selling and distribution expenses, the calculation of cost without taking
into account selling and distribution expenses may prove very costly to the
business. Further, the costs may pertain to factory, office or other
establishment aspects of operations. For example, prime cost includes
156
expenditure on direct materials, direct labour and direct expenses. Money Understanding And
Classifying Costs
spent on materials is termed as cost of materials that spent on labour as cost
of labour and so on. Thus, the use of the term ‘cost’ without background
information may be quite misleading.

It may also be noted that there is no such thing as an exact cost or a true cost
because no figure of cost is true in all circumstances and for all purposes.
Many items of cost of production are handled in an optional manner which
may give different costs for the same product or job without going against the
accepted principles of cost accounting Depreciation is one such item. Its
amount varies in accordance with the method of depreciation being used.
However, the endeavour should be made to obtain the accurate cost of a
product or service as far as possible.

6.4 ELEMENTS OF COST

In order to understand the correct interpretation of the term cost, it will be
appropriate for us to learn about the basic elements of cost. There are broadly
three elements of cost.

Material
The substance from which the product is made is known as material. It may
be in a raw or a manufactured state. It can be direct as well as indirect.

Direct Materials: All material that becomes an integral part of the finished
product and can be conveniently assigned to specific physical units is termed
‘Direct Material’. The following are some of the examples of direct material:

 All material or components specifically purchased, produced or requisitioned from

stores.

Understanding and Classifying Costs

 Primary packing material (e.g., carton, wrapping, cardboard, boxes, etc.)

 Partly produced or purchased components.

Indirect Material: All material that is used for purposes ancillary to the
business and which cannot conveniently be assigned to specific physical units
is termed as ‘indirect material’. Consumable stores, oil and waste, printing
and stationery material, etc., are a few examples of indirect material costs.

Labour
For the conversion of materials into finished goods, human effort is needed.
Such human effort is called labour. Labour can be direct as well as indirect.

Direct Labour: Labour that takes an active and direct part in the production
of a particular commodity is called direct labour. Direct labour costs are,
therefore, specifically and conveniently traceable to specific products.
Indirect Labour: Labour employed for the purpose of carrying, but tasks
incidental to goods produced or services provided is indirect labour. Such
labour does not alter the construction, composition or condition of the
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Cost Accounting product. It cannot be practically traced to specific units of output. Wages of
store-keepers, foremen, time-keepers, directors' fees, salaries of salesmen,
etc, are all examples of indirect labour costs.

Expenses
Expenses may be direct or indirect.

Direct Expenses: These are expenses that can be directly, conveniently and
wholly allocated to specific cost centres or cost units. Examples of such
expenses are the hire of some special machinery required for a particular
contract, cost of defective work incurred in connection with a particular job
or contracted.

Indirect Expenses: These are expenses that cannot be directly, conveniently

and wholly allocated to cost centres or cost units. Examples of such expenses
are rent, lighting, insurance charges, etc.

Cost Management

Chart 6.1: Element of Cost

Overheads
The term overhead includes indirect material, indirect labour and indirect
expenses. Thus, all indirect costs are overheads.

A manufacturing organisation can broadly be divided into three divisions:

 Factory or Works, where production is done.

 Office and administration, where routine as well as policy matters are decided.

 Selling and distribution, where products are sold and finally despatched to the
customers.

Overheads may be incurred in the factory or office or selling and distribution

divisions. Thus, overheads may be of three types.

Factory Overheads: They include;

 Indirect material used in the factory such as lubricants, oil, consumable stores, etc.

 Indirect labour such as gate-keeper's salary, time-keeper's salary, manager's salary, etc.

 Indirect expenses such as factory rent, factory insurance, factory lighting, etc.
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Office and Administration Overheads: They include: Understanding And
Classifying Costs
 Indirect material used in the office such as printing and stationery material, rooms and
dusters, etc.

 Indirect labour such as salaries payable to office manager, office accountant, clerks, etc.
 Indirect expenses such as rent, insurance, lighting of the office.

Selling and Distribution Overheads: They include:

 Indirect material used such as packing material, printing and stationery material, etc:

 Indirect labour such as salaries of salespersons and sales manager, etc.

 Indirect expenses such as rent, insurance, advertising expenses, etc.

The above classification of overheads can be shown by means of Chart 6.2

Chart 6.2: Classification of Overheads

6.5 COMPONENTS OF TOTALCOST

Understanding and Classifying Costs

Prime cost: It consists of costs of direct material, direct labour, and direct
expenses. It is also known as basic, first or flat cost.

Factory Cost: It comprises prime cost and, in addition, works or factory

overheads, which include costs of indirect material, indirect labour and
indirect factory expenses. This cost is also known as works cost, production
or manufacturing cost.

Office Cost: It comprises factory cost and office and administration

overheads. It is also termed as the total cost of production.

Total Cost: It comprises of cost of production and selling and distribution

overheads. It is also termed as Cost of Sales.

Various components of the total cost can be depicted by means of Chart 6.3.
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Cost Accounting Direct material
Direct labour
Direct expenses Prime Cost or Direct cost or First
cost or Flat Cost
Prime cost plus
Works overheads Works or Factory cost or Production
cost or Manufacturing cost
Works cost plus Office and
Administration overheads Office cost or Total cost of
production
Office cost plus Selling and
Distribution overheads Cost of Sales or Total Cost

Chart 6.3: Components of Total Cost

It may be noted that some accountants do not use the term office cost at all.
They prefer to use the term total cost after adding office and administration
overheads and selling and distribution overheads to works cost. However,
while framing Chart 6.3, we have presumed that office and administration
overheads exclusively relate to production. The selling and distribution
overheads are inclusive of any office and administration overheads that may
have been incurred, in respect of sales.
6.6 COST SHEET
The elements/ components of the total cost can be presented in the form of a
statement, popularly known as the ‘Cost Sheet’. The cost sheet may be
prepared separately for each cost centre. It may have columns to show the
total cost, cost per unit, together with the relevant figures of the previous
period.

The techniques of preparing a cost sheet can be understood with the help of
an Illustration.

Illustration 6.1
Let us prepare a cost sheet for a company showing different components of
cost for 2021 from the following details

Raw Materials Consumed, Wages Rs Rs:

paid to labourers, Directly chargeable 80,000
expenses, Oil & Waste 20,000
Wages of Foremen 4,000
Storekeeper's Wages Electric Power 200
2,000
1,000
400
Lighting: Factory 1,000
Office 400 1,400
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Rent: Factory 4,000 Understanding And
Classifying Costs
Office 2,000 6,000
Repairs and Renewals:
Factory Plant 1,000
Machinery 2,000
Office premises 400 3,400
Depreciation: Office premises 1,000
Plant and Machinery 400 1,400
Consumable stores 2,000
Manager's Salary 4,000
Director's Fees 1,000
Office Printing & Stationery 400
Telephone Charges 100
Postage and Telegrams 200
Sales men's Commission and Salary 1,000
Travelling expenses 400
Advertising 1,000
Warehouse charges 400
Carriage outwards 300

Cost Sheet for January 2021

Rs. Rs. Rs.
Direct Material: Raw materials consumed 80,000
Direct Labour: Wages paid to laborers 20,000
Direct Expenses: Directly 4,000
chargeable expenses
PRIME COST 1,04,000
Add: Factory overheads:
Indirect Materials:
Consumable stores 2,000
Oil & Waste 200
Indirect Labour: 2,200
Wages of foremen 2,000
Storekeeper Wages 1,000 3,000
Indirect Expenses:
Electric Power 400
Factory lighting 1,000
Factory rent 4,000
Repairs and Renewals:
Plant 1,000
Machinery 2,000 3,000
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Cost Accounting

Depreciation:
Plant and machinery 400 8,800 14,000

Factory or Works Cost

1,18,000

Add: Office or Administrative Overheads:

Indirect material
Office Printing and Stationery 400
Indirect labour:
Manager's salary 4,000
Director's fees 1,000 5,000
Indirect expenses:
Office lighting 400
Office rent 2,000
Repairs and Renewals premises 400
Depreciation on premises 1,000
Telephone charges 100
Postage and Telegrams 200 4,100

9,500

1,27,500

TOTAL COST OF PRODUCTION

Add: Selling and Distribution
overheads: Indirect labour:
Salesmen's Commission 1,000
and salary
Indirect expenses:
Travelling expenses 400
Advertising 1,000
Warehouse charges 400
Carriage outward 300 2,100 3,100

COST OF SALES 1,30,600

Activity 6.1
Complete the following Cost sheet

Cost Sheet for June 2020

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Cost Accounting Opening stock of raw material 10,000
Add purchases ……..
Less: Closing stock of raw material 50,000
Raw material consumed 12,000
Direct wages ……… ……….
Other Direct expenses 30,000
2,000
……….
a) Prime Cost 6,000
Add: Factory overhead:
Indirect material
Indirect labour
Indirect expenses 1,000
9,000
b) Factory or Works Cost 17,000
Add: Office or administration Overheads

c) Cost of Production 14,000

Add: Opening stock of finished goods
Less: Closing stock of finished goods 15,000
Selling and Distribution overheads 8,000

d) Cost of goods sold 1,03,000

Sale of finished goods 1,33,000
Profit for the month ……….

6.7 CLASSIFICATION OF COSTS

Costs can be classified into different categories depending upon the purpose
for which information is required. The costs can broadly be classified into
Fixed, Variable, Semi-variable and Step Costs.
Fixed Costs: These are the costs that remain constant irrespective of the
quantum of output within and up to the capacity that has been built up.
Examples of such costs are rent, insurance charges, management salary, etc.

Fixed costs remain constant per unit of time. As a result, they decrease per
unit with every increase in output and vice versa. For example, if Rs.6,000
have been paid as rent for a factory building with an output of 1,000 units, the
cost of rent per unit is Rs.6. In case the output increases to 1,200 units, the
cost of rent per unit will decrease to Rs.5. In case the output is reduced to 800
units, the cost of rent per unit will increase toRs.7.50.
Fixed costs sometimes are also referred to as period costs. They can further
be divided into (i) committed fixed costs (ii) discretionary fixed costs.

Committed Fixed Costs Consists primarily of those fixed costs that arise
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Cost Accounting from the possession of the plant, equipment and a basic organisational
structure. For example, once a building is constructed and a plant is installed,
nothing much can be done to reduce the costs such as depreciation, property
taxes, insurance and salaries of the key personnel, etc., without impairing the
organisation's competence to meet the long-term goals.

Discretionary Fixed Costs are those which are set at a fixed amount for
specific time periods by the management in the budgeting process. These
costs directly reflect top management policies and have no particular
relationship with the volume of output. These costs can therefore be reduced
or eliminated if the circumstances so require. Examples of such costs are
research and development costs, advertising and sales promotion costs,
donations, management consulting fees, etc. These costs are also termed as
managed or programmed costs.
Figure 6.1 shows the behaviour of fixed cost graphically.

3
Cost in thousand rupees

2
Fixed Cost
line.

0 1 2 3 4

Production in thousand units

Figure 6.1: Fixed Cost behaviour

Variable Costs: These are the costs that vary in direct proportion to output.
They increase or decrease in the same proportion in which the output
increases or decreases. The examples of such costs are direct material, direct
labour, power, etc.
Variable costs may be said to be constant per unit of output. For example, if a
factory incurs Rs. 1,000 on raw material for an output of 1,000 units, the cost
of raw material per unit would amount to Re. 1. If the output increases to
2,000 units, the cost of raw material would proportionately increase to Rs.
2,000 (i.e. Re. 1 x 2,000). Similarly, if the output decreases to 800 units, the
cost of raw material would also decrease to Rs 800 (i.e. Re.1 x800)
Variable costs are also referred to as product costs. Figure 6.2 gives graphical
presentation of variable costs

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 Understanding And
Classifying Costs
Variable Costs

Cost in thousand rupees

3

1
0
1 2 3 4
Production in thousand units
Figure 6.2: Variable Cost Behaviour

Semi-variable Costs: These are the costs that do vary but not in direct
proportion to output. They are made up of both fixed and variable cost
elements such as depreciation, repairs, light, heat, telephone, etc.
Semi–variable costs are shown graphically in Figure 6.3
Cost in thousand rupees

Semi-variable cost line

2

1 2 3 4
Production in thousand units
Figure 6.3: Semi-Variable Cost Behaviour

Identification of fixed and variable elements of semi-variable costs is

essential for the management for planning their business activities. Different
methods are available for this purpose which will be discussed in the next
unit.

Step Costs: Fixed costs, in general, remain fixed over a range of production
activity and then jump to a new level as activity changes. For example, a
foreman can supervise a given number of workers. Beyond this number, it is
necessary to hire a second foreman, then a third and so on. Similarly, the
rental cost of delivery vehicles also follows the same pattern.
The general characteristic of fixed cost rising in steps is depicted in Figure
6.4
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Cost Accounting 3

Cost in thousand rupees

2

0 1 2 3 4

Production in thousand units

Figure 6.4: Fixed Costs rising in Steps

Illustration 6.2
A company has provided the following information in respect of 10,000 units
of output. Let us calculate the total cost for 12,000 units of output and the
cost per unit with the following information:

Variable cost Rs.50,000

Fixed Cost Rs.30,000

Semi-variable Cost(50%fixed) Rs.80,000

STATEMENT OF COST

Output 12,000 units

Rs. Rs.

Variable Cost @ Rs.5 60,000

Fixed cost 30,000
Semi-variable cost:
Fixed 40,000
Variable cost @ Rs.4 48,000 88,000
Total cost 1,78,000
Cost per unit 1,78,000 Rs.14.83
= 12,000

Direct and Indirect Cost

Direct Costs: These are costs that can be directly, conveniently and wholly
traced to a product, service or job. Examples of such costs are direct material,
direct labour and direct expenses.

Indirect Costs: These are costs that cannot be directly, conveniently and
166
wholly identified with a specific product, service or job. They include all Understanding And
Classifying Costs
overhead costs such as salaries of timekeepers, stores keepers, foremen,
printing and stationery costs, etc.

Indirect or overhead costs are apportioned to different jobs, products or

services on a reasonable basis. For example, the indirect factory labour cost
may be apportioned over different jobs according to their direct labour cost.
Similarly, the selling overheads can be charged to different products
according to their sales values.

It may be noted that the more the share of the direct cost in relation to the
total cost of the product, the greater is the exactness in costing. The reason
for this is that indirect costs are allocated (or apportioned) on an estimated
basis.

Activity 6.2
In terms of your own organisation, give five examples of each of the
following:

a) Direct Costs

b) Indirect Costs
c) Fixed Costs
d) Variables costs
e) Semi-Variables Costs
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

6.8 SOME OTHER CONCEPTS OFCOSTS

Shut Down and Sunk Costs
Shut Down Costs: These represent the fixed costs that have to be incurred
even when a factory is shut down on account of some temporary difficulties,
viz., shortage of raw materials, non-availability of requisite labour force etc.
During this period, though no work is done, the fixed costs, such as rent,
insurance, depreciation, maintenance, etc., for the entire plant are still to be
incurred. Such costs of the idle plant are known as shut down costs.

Sunk Costs: These are historical or past costs or the costs incurred as a result
of a decision made in the past. Such costs cannot be reversed or revised by
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Cost Accounting subsequent decisions. Investments in plant and machinery, building, etc., are
some prominent examples of such costs. Sunk costs are considered not
relevant for decisions concerning the increase in the present profit levels. Let
us consider an example.

Goa Steel Ltd purchased a machine for Rs.60,000. The machine has an
operating life of five years without any scrap value. Soon after making the
investment, the management felt that the machine should not have been
purchased as it was incapable of yielding the operating advantage initially
contemplated. Originally, it was expected to result in savings in operating
costs of Rs.40,000 over a period of ten years. On the other hand, the machine
can be sold immediately for a sum of Rs. 42, 000.

In deciding whether the machine should be sold or used, the relevant amounts
to be compared are Rs. 40,000 in cost savings over ten years and Rs 42,000
that can be realised in case it is immediately disposed off. Rs 60,000 invested
in the asset are not relevant since it is the same in both cases. This amount is
sunk cost. Therefore, Goa Steels should sell the machinery for Rs. 42,000
since it will result in a gain of Rs 2,000 as compared to keeping and using it.

Controllable and Uncontrollable Costs

Controllable Costs: These are costs that can be influenced by the action of a
specified member of an organisation. For example, the foreman of a
production department can control the utilisation of power or raw materials in
his department. These are, therefore, controllable costs as far as he is
concerned.

Uncontrollable Costs: These are costs that cannot be influenced by the

action of a specified member of an undertaking. For example, the foreman of
a production department can control the wastage of power in his department,
but he cannot control the power being wasted in the powerhouse itself,
resulting in a higher cost per unit of power to him. Similarly, he cannot
control the increase in the cost of materials consumed in his department if the
purchasing department or the supplying department buys the materials at
higher prices due to its own inefficiency. Such costs are controllable at a
particular level of management while they are uncontrollable at some other
level of management.

The difference between controllable and uncontrollable costs is of particular

significance to the management. The executive concerned should be held
responsible only for those costs which are within his control and not for costs
beyond his control.

Imputed or Hypothetical Costs: These are costs that do not involve cash
outlay. They are not included in cost accounts but are important for making
management decisions. For example, interest on capital is ignored in cost
accounting though it is considered in financial accounting. If two projects
require unequal outlays of cash, the management must take into consideration
interest on capital to judge the relative profitability of the projects.

Differential, Incremental or Decremental Costs: The difference in total

costs between two alternatives is termed as differential cost. In case the
168
choice of alternative results in an increase in the total costs, such increased Understanding And
Classifying Costs
costs are known as incremental costs. If the choice decreases total costs, the
resulting decrease is known as decremental costs. While assessing the
profitability of a proposed change, the incremental costs are matched with
incremental revenues. The following illustration will demonstrate the concept
of incremental costs.

Illustration 6.3
A company is presently selling 1000 'unit @ Rs. 10 per unit. The variable
cost per unit is Rs 5, and the total fixed costs are Rs.4,000. The company
receives an order for a supply of 200 units @ Rs.8 per unit. The execution of
this export order will increase the fixed cost by Rs.200.

The cost and sales data under the existing and proposed situation can be put
as under:

Existing Proposed Incremental

situation situation Cost Revenue
Rs. Rs. Rs. Rs. Rs. Rs.
Sales 10,000 11,600 1,600
Less: Variable costs 5 000 6 000
Less : Fixed costs 4,000 9,000 4,200 10,200 1,200
Profit 1,000 1,400 400

Under the existing situation, there is a profit of Rs.1,000. If the alternative

proposal is considered, it would result in incremental revenue of Rs.1,600
against the incremental cost of Rs. 1,200. Hence the incremental profit will
be Rs.400.

Out-of-Pocket Costs: Out-of-pocket cost means the present or future cash

expenditure regarding a certain decision which may vary, depending upon the
nature of the decision made. For example, a company has its own trucks for
transporting raw materials and finished products from one place to another. It
seeks to replace these trucks by employing public carriers of goods. In
making this decision, of course, the depreciation of the trucks is not to be
considered. However, the management must take into account the present
expenditure on fuel, salary to drivers and maintenance, which have to be
incurred in cash. Such costs for arriving at a decision are termed as out-of-
pocket costs.

Opportunity Costs: Opportunity cost refers to the advantage, in measurable

terms, which has been foregone on account of not using the facilities in the
manner originally planned. For example, suppose an owned building is
proposed to be utilised for housing a new project plant. In that case, the likely
revenue that the building could fetch if rented out is the opportunity cost that
should be considered while evaluating the profitability of the project.
Suppose you have a sizeable deposit in a bank that is fetching you a return of
10% per annum. When your deposit is nearing maturity (but can be renewed),
your friend approaches you with a business proposal that is likely to earn you 169
Cost Accounting a return of 18% (after-tax). After careful consideration of the factors relating
to risk and return, you decide to go in for the proposal. Obviously, you have
to give tip to the existing alternative in view of the limited funds you have.
Thus you will no longer have the bank deposit. The sacrifice in the form of
10% interest on your deposit in the bank that you have to forego if you go in
for a business proposal, is the opportunity cost for the new alternative.

Traceable, Untraceable and Joint Costs

Traceable Cost: These are costs that can be easily identified or traced to
specific products, services or units of the company, such as raw material and
labour.

Untraceable Cost: These are costs that cannot be identified with a

department, process or product. Such costs are also termed as common costs,
as they are incurred collectively for a number of products or cost centres, e.g.,
overheads incurred for the factory as a whole. As such, they are apportioned
among various products or cost centres using suitable criteria.

Joint Costs: Whenever two or more products are produced out of the same
raw material or process, the cost of material purchased and the processing
costs are called joint costs. Take the example of an oil refinery where a range
of products such as bitumen, petrol, kerosene, diesel, are derived in the
process of refining crude oil. All these products have joint costs comprising
the cost of crude and the cost incurred in the course of refining. These joint
costs are then apportioned to various products on some basis.

Conversion Cost: The cost of transforming direct materials into finished

products, exclusive of direct material cost, is known as conversion cost. It is
usually taken as the aggregate of the cost of direct labour, direct expenses and
factory overheads.

The above classification concepts of cost help the management in the

decision making process. For example, the segregation of cost into fixed and
variable elements will help the management in analysing the total cost.
Similarly, the segregation of costs into controllable and uncontrollable
categories will help the management fix the responsibilities of the different
executives for unfavourable cost variances. Numerous other examples can be
given, highlighting the usefulness of the above classification of costs.

6.9 SUMMARY
In order to maximise a firm's wealth, ascertaining and controlling costs is
necessary. Cost control involves controlling different elements of costs, viz.
material, labour and expenses. Each of these elements of costs can further be
classified into direct and indirect. The term overhead is used for all indirect
costs. Costs can be classified into different categories: direct and indirect
costs; fixed, variable and semi- variable costs; controllable and
uncontrollable costs; differential incremental or decremental costs, out-of-
pocket costs and opportunity costs, etc. Each classification of costs has its
significance in the managerial decision-making process.
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 Understanding And
6.10 KEYWORDS Classifying Costs

Cost: The amount of expenditure (actual or notional) incurred on or

attributable to a given thing.

Conversion Cost: The Cost of converting direct materials into finished

products, i.e., direct wages, direct expenses and factory overheads.
Controllable Cost: Costs chargeable to a job or cost centre which can be
influenced by the actions of the persons in whom the control of such a centre
is vested.
Differential Cost: The difference in total cost between two alternatives.
Fixed Cost: The cost which remains fixed irrespective of the quantum of
output over a given capacity of the organisation.
Opportunity Cost: The value of the benefit sacrificed in favour of choosing
a particular alternative or action.
Uncontrollable Cost: The costs chargeable to a job or cost center which
cannot be influenced by the action of the person in whom the control of the
center vests.
Variable Cost: The cost which tends to vary in direct proportion to changes
in the volume of output or turnover.

6.11 SELF-ASSESSMENT
QUESTIONS/EXERCISES
1. What do you understand by cost accounting? State its objectives.
2. What do you understand by cost? Explain its different elements.
3. All controllable costs are direct costs; not all direct costs are controllable.
Explain with the help of suitable examples.
4. "Fixed costs are variable per unit, while variable costs are fixed per
unit". Comment.
5. How would you differentiate between `Direct cost' and `Variable Costs'?
Give suitable illustrations.
6. State whether each of the following statements is `True' or ‘False'.

7. Select the most appropriate answer for each of the following cases:
i) Cost accounting mainly helps the management in:
a) earning extra profit: 171
Cost Accounting b) providing information to management for decision-making, and
c) fixing prices of the products.
ii) Variable cost per unit:
a) remains fixed;
b) fluctuates with the volume of production; and
c) varies in sympathy with the volume of sales.
iii) Fixed cost per unit increases when:
a) production volume decreases;
b) production volume increases; and
c) variable cost per unit decreases
iv) Opportunity cost helps in:
a) ascertaining cost,
b) controlling cost, and
c) making managerial decisions.
v) Conversion cost is the sum total of:
a) direct material cost and direct wages cost
b) direct wages, direct expenses and factory overheads, and
c) indirect wages and factory overheads.
8. Prepare a cost sheet from the following details:
Raw Materials :
Opening stock Purchases Closing 20,000
1,00,000
40,000
Direct wages 40,000
Chargeable Expenses 8,000
Machine hours worked 16,000
Machine hour rate Rs. 2
Office overheads 10% of works cost
Selling Overheads Rs. 1.50 per unit
Cash discount allowed 1,000
Interest on capital 2,000
Units produced 4,000
Units sold 3,600 @ Rs. 50 each

(Hint: Cash discount and interest on capital are to be excluded from costs).
9. Calculate
(a)Value of raw material consumed,
(b)Total cost of production,
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 (c) Cost of production of goods sold, and Understanding And
Classifying Costs
(d) The amount of profit from the following particulars:
Opening Stock: Rs.
Raw materials 5,000
Finished goods 4,000
Closing stock
Raw materials 4,000
Finished goods 5,000
Raw materials purchased 40,000
Octroi paid on raw materials 4,000
Carriage inward 6,000
Direct wages paid 20,000
Direct expenses 2,000
Rent, rats and taxes 5,000
Power 2,000
Factory heating and lighting 2,000
Factory insurance 1,000
Experimental expenses 500
Office management salaries 4,000
Office printing and stationary 2,000
Salary of salesman 600
Advertising 300
Carriage outwards 100
Sales 1,00,000

Answers to Self-assessment Questions/ Exercises

6. (i) F; (ii)F; (iii) F; (iv) T; (v)F.

7 (i) b; (ii)a; (iii) a; (iv) c; (v)b.

8. Prime Cost Rs. 1,28,000; Works cost Rs.1,60,000Cost of production Rs.

1,76,000; Cost of sales Rs. 1,63,800; Profit Rs. 16,200

9 (a) Rs.51,000; (b) Rs. 89,500; (c) Rs. 89,500 and (d) Rs.10,500

6.12 FURTHERREADINGS
Horngren, C.T.; DatarSrikant M and Foster George M, 2002, Cost
Accounting: A Managerial Emphasis, Prentice Hall of India: New Delhi (
Chapters 2 and 9 )

Bhattacharyya, S.K., Dearden John, 2002, Costing for Management (Part I),
173
Cost Accounting Vikas Publishing House: New Delhi

Dopuch, N Birnberg, J.G. and Demiski ,Joel,1982,Cost Accounting, (2nd Ed.)

Harcourt Brace Javanovich: New York. (Chapter2)

Glautier, M.W.E. and B. Underdown, 1982, Accounting Theory and Practice,

ELBS, London: Bombay ( Chapter 27)

Maheshwari, S. N. 1987, Management Accounting and Financial Control,

5th Edition, Mahavir Book Depot, Delhi (Section A, Chapter 3).

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