Post on 07-Apr-2018
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Classification of costClassification of cost
The cost of a product can be classified as follows:Elements of a productRelationship to production
Relationship to volumeAbility to traceAccording to departmentAccording to periodAccording to functionFor managerial decision making
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A. Elements of a product: A. Elements of a product:
Material cost: Cost incurred for transforming raw materials to finishedproducts .
Example:Timber for making a furnitureMaterial cost can be classified into two
types: Direct material cost: Cost of materialsthat can be identified with production
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Indirect material cost: Cost of materials thatcannot be directly identified with production .
L abor cost: L abor cost is the cost of physical or mental efforts given in the production of anyproduct . L abor cost is of two types:
Direct labor cost: Cost of labor that can beidentified with production .
Indirect labor cost: Cost of labor that cannot bedirectly identified with production .
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F actory overhead cost: Indirect material,indirect labor and other indirect costswhich all together form factory overhead . F actory overhead costs are costs thatcannot be identified with productiondirectly .
Example:Cost of supervision in a factory, factory rentetc .
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B . Relationship to production:B . Relationship to production:
A ccording to relationship to production,costs can be classified into broad
categories:Prime cost: Directly relates withproduction .
Prime cost = Direct material + Direct labor Conversion cost: Costs incurred to
transform materials to finished products .
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Conversion cost = Direct labor + F actoryoverhead
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C . Relationship to volume:C . Relationship to volume:
There are four types of costs according tovolume:
Variable costs: Costs which change withthe change in volume, activity or outputwithin the relevant range .
Example:Mobile call, electricity bill etc
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S pecial features of vc: Total variable cost is variable Unit variable cost is fixed
F ixed cost: Costs which remains fixed or constant over the period within a relevant range .
Example:F actory rent, salary to workers etc
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S pecial features of fc: Total fixed cost is fixed Unit fixed cost is variable
S emi-variable cost: S emi-variable cost isnothing but the combination of variable and fixedcosts .
Example:Mobile bill standard line, equipment service
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S tep cost: A step cost is similar to fixedcost within a very small relevant range . S uch costs are constant for a given levelof output and then increases by a fixedamount at a higher level of output .
Example:
S upervisors salaryS emi-variable and step costs are also
known as mixed costs .
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D. A bility to trace:D. A bility to trace:
There are two types of costs based ontraceability:
Direct cost: Costs which can be directlytraceable to production, specific product or department .
Indirect cost: Costs which cannot bedirectly traceable to production, specificproduct or department .
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E . A ccording to department:E . A ccording to department:
Costs can be classified department-wise asfollows:Production department: Costs which are
directly related with the production .Example:
Costs for manual and machine operationS ervice department: These are
departments which are not directly relatedwith production .
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Example:Payroll, factory office, personnel, security
service etc.
F . A ccording to function:Costs can be categorized according tofunction as follows:
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Manufacturing costs: Total cost requiredfor production .
Manufacturing costs = DM + DL
+ FOHMarketing costs: Costs required to
promote a product
Example: A dvertising expense
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A dministrative costs: Costs required to operatea company or business activities .
Example:S alaries paid to employees
F inancing costs: Costs incurred for collectingfinance/fund for a company
Example:B ank loan, lease financing, equity financing etc .
B oth administrative and marketing costs areknown as commercial costs also .
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G . A ccording to period:G . A ccording to period:
Costs may be classified on the basis of whenthey will be charged as revenue as follows:Product costs: Costs which are directly and
indirectly identified with production, not with theperiod . When the product is sold, cost of goodssold are matched with revenue in the period theproducts are sold .
Example:Cost of goods sold
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Period costs: Costs which are not directlyor indirectly related with production, rather related with the period . There is hardly anyrelationship in between these costs andearning revenue .
Example:S alary, rent etc .
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H . F or managerial decisionH . F or managerial decision- -making:making:
They can be grouped into the followingcategories:S
tandard costs: Estimates that are usuallyused for per unit basis to direct material,direct labor and/or factory overhead .B udgeted costs: Estimates that are
usually used for total cost basis .
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A ctually, both standard and budget costs areused for the same purpose . B oth areapplied by management to plan cost for future and to control costs by comparingbetween estimated and actualperformance .
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Replacement costs: Costs to be incurredto replace or revalue any fixed asset or items at the current market value .H istorical costs: Costs that happen
already i .e . past cost or sunk costs .
Marginal costs: Total of variable costs .
Marginal costs = DM+ D L + Variable FOH
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Imputed, implicit or notional costs: Costswhich involve no cash outlay . Despitehaving no cash outlay, they are importantin managerial decision .
Example:Rent charged on the house owned by the
owner, interest on capital invested by theowner . In both the cases, no cash outlay isinvolved .
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Controllable costs: Costs which can becontrolled by the management .
Example: A cquisition or use of plant
N on-controllable costs: Costs that are notwithin management control .
Example:Cost of increased price of material or
conveyance due to strike, layout etc .
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Committed costs: A rises out of basicorganizational structure or previously committedfacilities .
Example:Plant, salaried personnel, essential property etc .
Discretionary fixed costs: These costs are at thediscretion of the management and hence subject
to control i .e . can be reduced or increased atany point of time without affecting the efficientoperation of the business .
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Example:Executive training, research, advertising and other costsresulting 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
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Irrelevant costs: Costs that have noimpact on decision making . They have thefollowing traits:
Do not differ in between alternatives Past or sunk costs Cannot be eliminated Example:Cost of a plant to be acquired in future
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Differential costs: The difference betweenthe alternative course of actions . If thecost of one alternative is increasing fromanother, its known as differential or incremental costsDecremental costs: if the cost of one
alternative is declining to another, itsDecremental cost .
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O pportunity costs: The opportunity lost is theopportunity cost . B enefits lost from rejecting thenext best alternative are the opportunity cost for the chosen alternative .
Example:Cost needed to buy a certain material
= tk . 10 per unitCost needed to make the same material
= tk . 11 per unit .N ow if the company decides to buy, tk . 10 is the
opportunity cost for the buy decision
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S hutdown costs: Costs those will be evenincurred if there is no production .
Example:S alary to staffs, insurance costs, storagecosts etc .
This costs frequently faced by seasonalbusiness in their off season .
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N ormal costs: Costs that normally happenor are expected to happen in case of agiven production level .
Example:L eakage, evaporation etc .
A bnormal costs: Costs which are not
expected in a given level of output .Example:
F ire, strike, natural disaster, theft etc .