COST TERM,CONCEPTS AND

CLASSIFICATIONS

Cost: In the simplest form cost is the

sacrifice of anything to obtain or to
produce something. But the Committee on
Cost Terminology of the American
Accounting Association defined cost as, “
The foregoing, in monetary terms, incurred
or potentially to be incurred in the
realization of the objective of management
which may be manufacturing of a product
or rendering service”.
 Cost Center
• Cost Center: A Cost center is a smallest
segment of activity or areas or
responsibility for which costs are
accumulated. A cost center may be a
product center or service center. Product
center refers to a center through which a
product passes and generally
corresponds to a product department.
MBA department is the example of a
cost or product center of EWU.
 Profit Center
A profit center is that segment of activity of a
business which is responsible for both revenue
and expenses and disclose the profit of that
particular segment of activity. Profit centers are
created to delegate responsibility to individuals
and measure their performance. Profit center has
a profit target and enjoy authority to adopt such
policies as are necessary to achieve its targets.
Examples of profit centers are subsidiary
company of group of companies or division in a
company.
 Classification of Costs
Purpose of cost classification Cost classification
Preparing external financial Product costs (Direct materials,
statements Direct labor, and Manufacturing
overhead)
Period costs, Non manufacturing
costs
Predicting cost behavior in response Variable cost ,Fixed cost (Committed
to changes in activity fixed cost and Discretionary fixed
cost)
Assigning costs to cost objects Direct cost, Indirect cost
Making decisions Differential cost, Sunk cost,
Opportunity cost
Cost of quality Prevention costs, Appraisal costs,
Internal failure costs, External failure
costs
 Product Cost
• Product costs include all cost involved in
acquiring or making a product. In the case of
manufactured goods, these costs consists of
materials, labor, and manufacturing overhead.
 Raw Materials
• The materials that go into the final product are called
raw materials. Raw materials refer to any materials
that are used in the final product and the finished
product of one company can become the raw
materials of another company.
• Materials are two types:
• Direct raw materials: are those materials that become
an integral part of the finished product and whose cost
can be conveniently identified or traced to the finished
product.
• Indirect raw materials: : are those materials that are
not an integral part of the finished product and whose
cost can not be conveniently identified or traced to the
finished product.
 Direct Labor
• The term direct labor is reserved for those labor that
can be easily( i.e. physically and conveniently) traced
to individual units of product. Direct labor is
sometimes called touch labor since direct labor
workers physically touch the product while it is being
made. Examples of direct labor include assembly line
workers at Toyota, carpenter at home builder etc.
• Indirect labor: Labor costs that cannot be physically
traced to the creation of products or that can be
traced only at great cost and inconvenience are
termed indirect labor. Examples of indirect labor are
the labor cost of janitors, supervisors, materials
handlers etc.
 Manufacturing Overhead
• Manufacturing overheads are the costs which
help in manufacturing the product but can not
be conveniently identified or traced to a
particular cost object or center. Examples of
manufacturing overheads are: indirect labor ,
indirect materials, maintenance and repairs
on production equipment etc.
 Non- Manufacturing Overhead or Costs

• Non manufacturing costs: are those costs that

involve in administration and is needed for
conducting sales of an enterprise.
• Non- Manufacturing Overheads costs are two
types:
• Selling costs or selling overhead
• Administrative cost or administrative
overhead.
 Product Costs
• Product costs are the costs that include all
costs involved in acquiring or making a
product. In case of manufactured goods, these
costs consists of direct material, direct labor
and manufacturing overhead. Since product
costs are assigned to inventories, they are also
known as inventoriable costs.
 Period Costs
• Period costs are all the costs that are not
related in product costs. These costs do not
depend on the scale of production but it
depend on the expiry of time. Examples of
period costs are: Salary of the general
manager, rent of the office etc.
 Variable Costs and Fixed cost
• A variable cost is a cost that varies, in total, in direct
proportion to change in the level of activity. The activity
can be expressed in many ways such as units produced,
miles driven, beds occupied lines of print etc.
• Fixed cost: A fixed cost is a cost that does not varies, in
total, in proportion to change in the level of activity in a
relevant range. Relevant range is the range of activity
within which the assumptions about variable and fixed
costs are valid. Fixed cost also termed as period cost.
• Question: “Fixed cost per unit variable but variable cost
per unit fixed”- Justify the statement.
• Step variable cost:
• Semi variable cost:
 Direct cost and Indirect cost
• A direct cost is a cost that can be easily and
conveniently traced to a specific product or
object. Examples of direct cost are: timber of a
furniture, cloth of a shirt etc.
• Indirect cost: An indirect cost is a cost that can
not be easily and conveniently traced to a
specific product or object. Examples of
indirect cost are: Nail of a furniture, button of
a shirt etc.
 Differential cost and Revenue
• Differential cost :A difference in costs between
any two alternatives is known as differential cost.
It is known as incremental cost.
• Decremental cost: Decrease in cost in one
alternative to another is known as decremental
cost.
• Differential revenue: A difference in revenues
between any two alternatives is known as
differential revenue.
•
 Example
Retailer Sales Differential
distribution represent costs and
ative Revenues
Revenues 7,00,000 8,00,000 1,00,000
Cost of good 3,50,000 4,00,000 (50,000)
sold(variable)
Advertising (fixed) 80,000 45,000 35,000
Commissions(variable) 0 40,000 (40,000)
Warehouse 50,000 80,000 (30,000)
depreciation(fixed)
Other expenses(fixed) 60,000 60,000 0
Net operating income 1,60,000 1,75,000 15,000
 Opportunity cost and Sunk cost
• Opportunity cost: is the potential benefit that
is giving up or sacrifice when one alternative
is selected over another next best
alternatives.
• Sunk cost: Sunk cost is the cost that has
already been incurred and that can not be
changed by any decision made now or in the
future and there their is no chance to recover
it.
 Prevention cost
• Prevention cost: Support activities whose purpose is to
reduce the number of defects.
• Appraisal cost: Appraisal costs, which is sometimes called
inspection costs, are incurred to identify defective products
before the products are shipped in customers.
• Internal failure costs: are incurred when a product fails to
confirm to its design specifications. Internal failure costs
results from identifying defects before they are shipped to
customers.
• External failure costs: External failure cost result when a
defective is delivered to a customer. External failure costs
include warranty repairs and replacement.