Classification of cost

The cost of a product can be classified as follows:  Elements of a product  Relationship to production  Relationship to volume  Ability to trace  According to department  According to period  According to function  For managerial decision making

A. Elements of a product:
Material cost: Cost incurred for transforming raw materials to finished products. Example: Timber for making a furniture Material cost can be classified into two types: Direct material cost: Cost of materials that can be identified with production

Indirect material cost: Cost of materials that cannot be directly identified with production. Labor cost: Labor cost is the cost of physical or mental efforts given in the production of any product. Labor cost is of two types: Direct labor cost: Cost of labor that can be identified with production. Indirect labor cost: Cost of labor that cannot be directly identified with production.

Factory overhead cost: Indirect material, indirect labor and other indirect costs which all together form factory overhead. Factory overhead costs are costs that cannot be identified with production directly. Example: Cost of supervision in a factory, factory rent etc.

B. Relationship to production:
According to relationship to production, costs can be classified into broad categories: Prime cost: Directly relates with production. Prime cost = Direct material + Direct labor Conversion cost: Costs incurred to transform materials to finished products.

Conversion cost = Direct labor + Factory overhead

C. Relationship to volume:
There are four types of costs according to volume: Variable costs: Costs which change with the change in volume, activity or output within the relevant range. Example: Mobile call, electricity bill etc

Special features of vc: Total variable cost is variable Unit variable cost is fixed Fixed cost: Costs which remains fixed or constant over the period within a relevant range. Example: Factory rent, salary to workers etc

Special features of fc: Total fixed cost is fixed Unit fixed cost is variable Semi-variable cost: Semi-variable cost is nothing but the combination of variable and fixed costs. Example: Mobile bill standard line, equipment service

Step cost: A step cost is similar to fixed cost within a very small relevant range. Such costs are constant for a given level of output and then increases by a fixed amount at a higher level of output. Example: Supervisors salary Semi-variable and step costs are also known as mixed costs.

D. Ability to trace:
There are two types of costs based on traceability: Direct cost: Costs which can be directly traceable to production, specific product or department. Indirect cost: Costs which cannot be directly traceable to production, specific product or department.

E. According to department:
Costs can be classified department-wise as follows: Production department: Costs which are directly related with the production. Example: Costs for manual and machine operation Service department: These are departments which are not directly related with production.

Example: Payroll, factory office, personnel, security service etc.

F. According to function:
Costs can be categorized according to function as follows:

Manufacturing costs: Total cost required for production. Manufacturing costs = DM + DL + FOH Marketing costs: Costs required to promote a product Example: Advertising expense

Administrative costs: Costs required to operate a company or business activities. Example: Salaries paid to employees Financing costs: Costs incurred for collecting finance/fund for a company Example: Bank loan, lease financing, equity financing etc. Both administrative and marketing costs are known as commercial costs also.

G. According to period:
Costs may be classified on the basis of when they will be charged as revenue as follows: Product costs: Costs which are directly and indirectly identified with production, not with the period. When the product is sold, cost of goods sold are matched with revenue in the period the products are sold. Example: Cost of goods sold

Period costs: Costs which are not directly or indirectly related with production, rather related with the period. There is hardly any relationship in between these costs and earning revenue. Example: Salary, rent etc.

H. For managerial decision-making: decisionThey can be grouped into the following categories: Standard costs: Estimates that are usually used for per unit basis to direct material, direct labor and/or factory overhead. Budgeted costs: Estimates that are usually used for total cost basis.

Actually, both standard and budget costs are used for the same purpose. Both are applied by management to plan cost for future and to control costs by comparing between estimated and actual performance.

Replacement costs: Costs to be incurred to replace or revalue any fixed asset or items at the current market value. Historical costs: Costs that happen already i.e. past cost or sunk costs. Marginal costs: Total of variable costs. Marginal costs = DM+ DL + Variable FOH

Imputed, implicit or notional costs: Costs which involve no cash outlay. Despite having no cash outlay, they are important in managerial decision. Example: Rent charged on the house owned by the owner, interest on capital invested by the owner. In both the cases, no cash outlay is involved.

Controllable costs: Costs which can be controlled by the management. Example: Acquisition or use of plant Non-controllable costs: Costs that are not within management control. Example: Cost of increased price of material or conveyance due to strike, layout etc.

Committed costs: Arises out of basic organizational structure or previously committed facilities. Example: Plant, salaried personnel, essential property etc. Discretionary fixed costs: These costs are at the discretion of the management and hence subject to control i.e. can be reduced or increased at any point of time without affecting the efficient operation of the business.

Example: Executive training, research, advertising and other costs resulting from policy decisions. Relevant costs: Costs which are relevant (important) in managerial decision-making. Relevant costs are costs that are for future differ in between alternative course of actions subject to eliminate if decision is changed. Example: Cost of a plant acquired tk. 10,000

Irrelevant costs: Costs that have no impact on decision making. They have the following traits: Do not differ in between alternatives Past or sunk costs Cannot be eliminated Example: Cost of a plant to be acquired in future

Differential costs: The difference between the alternative course of actions. If the cost of one alternative is increasing from another, its known as differential or incremental costs Decremental costs: if the cost of one alternative is declining to another, its Decremental cost.

Opportunity costs: The opportunity lost is the opportunity cost. Benefits lost from rejecting the next best alternative are the opportunity cost for the chosen alternative. Example: Cost needed to buy a certain material = tk. 10 per unit Cost needed to make the same material = tk. 11 per unit. Now if the company decides to buy, tk. 10 is the opportunity cost for the buy decision

Shutdown costs: Costs those will be even incurred if there is no production. Example: Salary to staffs, insurance costs, storage costs etc. This costs frequently faced by seasonal business in their off season.

Normal costs: Costs that normally happen or are expected to happen in case of a given production level. Example: Leakage, evaporation etc. Abnormal costs: Costs which are not expected in a given level of output. Example: Fire, strike, natural disaster, theft etc.