Chapter 2
• Cost Classification and Analysis
Cost Classification and Analysis
2.1. The elements of cost
2.2. Classification of cost: overhead cost, prime cost
2.3. Cost variance analysis
2.4. Job and process costing
2.1. The elements of cost
In Engineering Economics, the term "elements of cost" refers to the various components or
categories of costs that are incurred during the production of goods or services and are essential
to understand when analyzing the economic viability of engineering projects. These elements are
typically divided into the following main categories:
[Link] Costs:
1. Direct Materials
2. Direct Labor
[Link] Costs (or Overhead Costs):
1. Factory Overhead
2. Administrative Overhead
[Link] Costs:
[Link] Costs:
[Link]-variable Costs:
[Link] Costs:
[Link] Costs:
[Link] Costs:
1. Direct Costs:
These are costs that can be directly traced to the production of a specific
product or service. Examples include:
• Direct Materials: The raw materials or components used in manufacturing
the product.
• Direct Labor: The wages and salaries of workers directly involved in
producing the product.
2. Indirect Costs (or Overhead Costs):
These are costs that cannot be directly traced to a specific product but are
necessary for the production process. They are distributed over multiple
products or projects. Examples include:
• Factory overhead: Expenses like utilities, equipment maintenance, and
depreciation of machines.
• Administrative overhead: Costs related to administrative functions, such
as salaries of management and office staff.
3. Fixed Costs:
These costs do not change with the level of production or output. They remain
constant regardless of the volume of goods or services produced. Examples
include:
• Rent for factory space
• Salaries of permanent staff
• Depreciation on equipment or facilities
4. Variable Costs:
These costs vary directly with the level of production or output. The more you
produce, the higher these costs. Examples include:
• Raw materials costs
• Direct labor costs tied to production output
• Utility costs related to production
5. Semi-variable Costs:
These costs contain both a fixed component and a variable component. For
example, a machine operator may have a fixed salary but could also earn overtime
pay based on production volume.
6. Opportunity Costs:
The cost of forgoing the next best alternative when making a decision. While not
always a direct out-of-pocket cost, opportunity cost reflects the economic trade-offs
involved in choosing one option over another.
7. Sunk Costs:
These are costs that have already been incurred and cannot be recovered. Since they
cannot be altered by future decisions, sunk costs should not factor into decision-
making about future projects.
8. Marginal Costs:
The additional cost incurred when producing one more unit of a good or service. It
helps businesses determine the most efficient level of production.
2.2. Classification of cost: overhead cost, prime cost
Aspect Overhead Cost Prime Cost
Definition Indirect costs not directly tied to production or Direct costs associated with production or
construction, necessary for operations. construction, including labor and materials.
Classification in Indirect cost; not easily traceable to a specific Direct cost; directly attributable to each unit of
Costing product or service, often fixed or semi-fixed. production or project, usually variable.
Impact on Pricing Spread across multiple projects or units; affects Directly affects unit pricing and is crucial for break-
& Profitability overall profitability but not unit pricing. even analysis and profit margins.
Control and Managed through operational efficiency Managed by optimizing resource usage; variable
Management improvements, hard to reduce short-term. based on project scope and production level.
Role in Decision- Influences strategic decisions, such as Influences tactical decisions, such as material
Making expansions or equipment investment. selection or labor adjustments.
Examples in Site office expenses, project management On-site labor wages, construction materials,
Engineering salaries, general liability insurance. equipment rental for specific tasks.
2.3. Cost variance analysis
• It is the calculation process by which differences is analyzed . it is also simply
known as variances analysis.
• Variance analysis provides a framework for business managers to breakdown
the overall performance of an organization, so that each individual element of
the business can be isolated and analysed in turn.
• Actual cost< standard cost => Favorable
• Actual cost> standard cost => Adverse
• Variance
• Variance is defined as the difference between an actual amount of something and the
amount it was supposed to be according to the budget. Variance is use to: assist
managers in planning and control, evaluate performance, and suggest changes in
strategies. So, Variance analysis is to measure performance, correct inefficiencies, and
deal with the accountability function.
• Variance Fall into two Categories
➢ Adverse variances that arise when the standard allowance is exceeded by actual
expenditure. Adverse/ Unfavorable variances are debits, and they increase production
costs.
➢ Favorable variances are due to actual expenditure being less than the standard
allowance. Favorable variances are credits, and they reduce production costs.
• It should be remembered that a favorable variance does not necessarily mean good,
nor does an unfavorable variance mean bad. Management should analyze all variances
to determine the cause
➢ determine if standard is correct
➢ consider costs vs. benefit in reviewing standards
A. Direct Material Cost Variances
• Direct Material Cost Variance is the difference between the actual expenditure and budgeted expenditure of
direct materials used in production process. It is the com pans on of what we did actually pay, or use compared to
what we should have paid or used using the standard cost per unit. Accordingly, It is the aggregate of following:
i) Direct Material Price variance (DMPV)
The proportion of the budget variance that is caused by paying more/less than the standard price for the actual
purchase
• DMPV = AQ(AR-SR)
Where
• AQ =Actual quantity consumed or purchased
• AR = Actual rate of actual price per unit
• SR = Standard rate or standard price per unit
The proportion of the budget variance that is due to using more/less material in production than the standard
quantity
• DMUV = SR (AQ-SQ)
Where,
• SR = Standard rate
• AQ =Actual quantity consumed or purchased .
• SQ = Standard quantity allowed or budgeted
B. Direct Labour Variances (or Direct wages variances)
• Direct Labour budget Variance is the difference between the actual payroll and the standard labour cost of actual
production. Direct labour budget variance is the aggregate of the following.
i. Direct Labour Wage Rate Variance (DLWRV)
• The proportion of the budget variance that is caused by paying more/less than the standard
wage for the actual labour hours used
• DLWRV = AH(AR-SR)
Where,
• AH =Actual hours worked
• AR = Actual labour rate
• SR = Standard labour rate
ii. Direct labour efficiency variance (DLEV)
• The proportion of the budget variance that is due to using more/less labour hours in production than the standard hours.
𝑆𝐻
• DLEV= AH x SR-AP 𝑈𝑛𝑖𝑡 𝑆𝑅
Where,
• AH =Actual hours worked
• AR =Actual labour rate SR= Standard labour rate
• AP = Actual production units
• SH = Standard labour hours allocated
C. Variable Overhead Variances
• Variable overhead variance is the difference between the actual variable overhead
and the standard variable overhead cost of for production. Variable overhead
variance is the aggregate of the following: ·.
i) Variable Overhead Expenditure Variance (VOExV)
• The proportion of the budget variance. that is due to using more/less labour hours
in production than the standard overhead.
• VOExV = AH(AR-SR)
• Where,
• AH =Actual hours worked ·
• AR =Actual rate of variable overhead
• SR =Standard rate of variable overhead
ii. Variable Overhead Efficiency Variance (VOEfV)
𝑆𝐻
• VOEfV= AH x SR-AP 𝑆𝑅
𝑈𝑛𝑖𝑡
• Where,
• SH = Standard hours worked
• AP = Actual production units
[Link] Overhead Variances
• Fixed overhead variance is the difference between actual fixed overhead incurred and standard cost of
fixed overhead absorbed in the actual output. It is the aggregate of the following:
i) Fixed overhead expenditure variance (FOExV)
FOExV =Actual fixed overhead - Budgeted fixed overhead
ii. Fixed overhead capacity variance (FOCV)
FOCV =Budgeted fixed overhead –AH × SR
• Where,
• AH =Actual hours worked
• SR = Standard rate of fixed overhead
iii. Fixed overhead efficiency variance (FOEN)
𝑺𝑯
FOEN = AH x SR-AP 𝑼𝒏𝒊𝒕 𝐒𝐑
Where,
• SH = Standard hours worked
• AP =Actual production units
2.4. Job and process costing
The process of determination of total cost of production and unit cost of
production is known as product costing.
• There are two basic methods for product costing:
A. Job Costing
• It allocates costs to products that are readily identified by individual units
or batches, each of which is independently identifiable. When using the
job cost system, costs are accumulated for each individual unit produced,
or ach separate order of products. This method is especially useful when
producing something that is unique or custom-made. Job costing would
be used by a caterer, a garage, a helicopter manufacturer, a construction
company, a textbook publisher etc.
General approach to job costing……
The following seven step approach is used to assign actual costs to
individual jobs:
• Identify the chosen cost object(s)
• Identify the direct cost of the job
• Select the cost-absorption base(s)
• Identify the indirect costs associated with each cost-absorption base
• Compute the rate per unit of each cost absorption base to allocate indirect
costs to jobs
• Compute the indirect costs allocated to the job
• Compute the cost of the job by adding all direct costs assigned to it.
B. Process costing
• Process costing is a method that is· applied when goods or services are
produced from a series of repetitive or continuous processes or
operations and costs of processing are charged to the process before
being averaged out over the units produced during the period. It is also
knowing as continuous operation costing.
• A process costing system involves the costs of producing similar items
being accumulated and allocated to. the products by averaging costs
over large number of nearly identical products. The average cost per
unit is. calculated by dividing the total production cost by the number
of units produced. Process costing would be used by businesses such
as food processors, household product manufacturers; chemical
processors and oil refiners.
General approach to process costing…..
• Collect cost data for the period on production cost report
• Prepare statement of physical flows and equivalent units of output for
the period
• Ascertain the total costs to be accounted for this period
• Calculate the cost per equivalent unit
• Apportion cost between finished output and work-in-progress, and.
• Check that all costs accounted for
• Thank you