Cost classification and elements of cost

“Costs” refer to the total amount of expenses incurred by a company to

produce goods or provide services. These expenses can include materials,
labor, overhead, and any other expenditures that are necessary for
production and operations. Costs are a critical component of financial
management and are categorized in various ways, such as fixed, variable,
direct, and indirect costs. Understanding and managing costs is essential
for setting prices, controlling expenditures, and maximizing profitability.
Additionally, costs are analyzed to make informed decisions about
budgeting, financial planning, and strategic initiatives. Effective cost
management can significantly impact a company’s financial health and
competitive position in the market.

Classification of Costs:
1. Classification of Cost by Nature or Element

2. Functional Classification of Cost

3. Classification of Cost on the Basis of Behaviour

4. Classification of Costs for Managerial Decisions and Control

Category # 1. Classification of Cost by Nature or Element:

According to the nature or elements of cost, costs can be broadly
classified as:

(a) Direct Costs

(b) Indirect Costs.

(a) Direct Costs:

Direct Costs are the costs which can be conveniently identified with and
allocated to a particular unit of final product. Such costs are treated as the
cost of the unit produced. The examples of direct costs are raw materials,
labour and other direct expenses which are exclusively incurred for a
particular unit of cost, i.e., job, product or process.

Hence, direct costs can be further classified as:

(i) Direct Material

(ii) Direct Labour

(iii) Direct Expenses.

All materials which become an integral part of the finished product and
which can be conveniently assigned to specific physical units is called
direct material. Direct materials include all materials specifically purchased
or requisitioned for specific cost unit, all primary packing materials.

Direct Labour cost consists of wages paid to workers directly engaged in

manufacturing or handling a product, job or process. It includes the
payment of wages to the workers engaged on the actual production of the
product or an operation or a process; and to the workers engaged in
helping such production operation or process by way of supervision,
maintenance, etc.

All expenses other than the direct material or direct labour that are
specifically incurred for a particular job, product or process are called direct
expenses. Direct expenses are also known as chargeable expenses as
they are charged directly to the particular unit of cost concerned.

Examples of direct expenses are: cost of special tools, patterns, etc., made
for a specific job, product or process, hire charges of a special equipment,
excise duty, cost of trial castings, royalties, freight and insurance on special
materials, etc.
(b) Indirect Costs:

Indirect Costs are those costs which cannot be assigned to any particular
cost unit, i.e., job, product or process. Indirect costs are, usually, incurred
for the business as a whole and are, therefore, apportioned among the
various cost units (product, job or process) on some reasonable basis.

Like direct costs indirect costs:

(i) Indirect Material such as fuel, lubricating oil, small tools, and material
consumed for repairs and maintenance work, miscellaneous stores used in
the factory, etc.

(ii) Indirect labour which includes wages of general supervisors, inspectors,

workshop cleaners, store-keepers, time-keepers, etc.

(iii) Indirect expenses such as rent, lighting, insurance, canteen, hospital,

welfare expenses, etc.

Indirect costs are also called ‘Overheads’. Overheads may be further

classified as:

(a) Factory Overheads which include all indirect expenses connected with
the manufacture of a product such as lubricants, oil, consumable stores,
works manager’s salary, time-keeper’s salary; factory rent, factory
insurance, etc.

(b) Office and Administration Overheads which include all indirect

expenses relating to administration and management of an office such as
office rent, office lighting, insurance, salaries of clerical and executive staff,
etc.

(c) Selling and Distribution Overheads which include all indirect costs
connected with marketing and sales such as advertising expenses, salaries
of salesmen, indirect packing material, etc.

Category # 2. Functional Classification of Cost:

(a) Prime Cost:

It consists of the costs of direct materials that go into the product, the costs
of direct labour and direct expenses. It is also known as direct cost or first
cost.
(b) Factory Cost:

It consists of prime cost plus factory overhead or works expenses or factory

on cost. Factory cost is also known as works cost, production cost or
manufacturing cost.

(c) Cost of Production:

Also called office cost, administration cost or gross cost of production, it

consists of factory cost plus office and administrative expenses.

(d) Total Cost or Cost of Sales:

It comprises cost of production plus selling and distribution overheads.

The various components of total cost can be presented as follows:

1. Prime Cost = Direct Material + Direct Labour + Direct Expenses

2. Factory Cost or Works Cost = Prime Cost + Works Expenses or

Factory Expenses or Works on Cost.

3. Office Cost or Gross Cost of Production = Factory Cost +

Administrative and Office Overheads

4. Total cost or Cost of Sales = Office Cost + Selling and Distribution

Overheads

Category # 3. Classification of Cost on the Basis of Behaviour:

(a) Variable Costs:

Costs that vary almost in direct proportion to the volume of production are
called variable costs. The examples of such costs are direct material, direct
labour and direct chargeable expenses, such as electric power, fuel, etc.

(b) Fixed Costs:

Costs which do not vary with the level of production are known as fixed
costs. These costs are called fixed costs because these remain constant
irrespective of the level of output. It must, however, be noted that fixed
costs do not remain constant for all times. In fact, in the long run ail costs
have a tendency to vary. Fixed costs remain fixed upto a certain level of
production.

(c) Semi-variable Costs:

Those costs which are partly fixed and partly variable are called semi-
variable costs. These costs vary with the level of production but not in
direct proportion to the level of production. The examples of such costs are
depreciation of machinery, maintenance of equipment, administrative costs,
etc.

Category # 4. Classification of Costs for Managerial Decisions and

Control:
(a) Controllable and Uncontrollable Costs:

Controllable costs are those costs which can be controlled or influenced by

a specified person or a level of management of an undertaking. Costs
which cannot be so controlled or influenced by the action of a specified
individual of an undertaking are known as uncontrollable costs. The
difference in controllable and uncontrollable costs is only in relation to a
particular person or a level of management.

(b) Normal and Abnormal Costs:

Costs which are normally incurred at a given level of output are called
normal costs while the costs which are not normally incurred at a given
level of output in the conditions at which that level is normally achieved, are
called abnormal costs.

(c) Avoidable and Unavoidable Costs:

Avoidable costs are those costs which can be escaped or avoided if some
activity of the business to which they relate is discontinued. Unavoidable
costs are those which cannot be escaped or eliminated.

(d) Shut Down and Sunk Costs:

Those fixed costs which have to be incurred even if production or

operations of an undertaking are discontinued temporarily due to certain
reasons such as strike, shortage of raw material, etc., are called shut down
costs. Costs which have been incurred and are irrelevant in a particular
situation are called sunk costs.
(e) Product Costs and Period Costs:

Costs which are associated with production and which become part of the
cost of the product are called ‘product costs’. The examples of product
costs are raw material, direct wages, etc. Costs which are not associated
with production or which are associated with period for which they are
incurred are called ‘period cost’. The examples of period costs are
administration costs, rent, insurance, salesmen salaries, etc.

(f) Differential, Incremental and Decremental Costs:

The difference-in-costs due to change in the level of activity or the method

of production is known as ‘differential cost’. In case, the change increases
the cost, it is called incremental cost and in case, the change decreases
the cost, it is called decremental cost.

(g) Out of Pocket Costs:

It is that cost which gives rise to costs expenditure as opposed to that cost
which do not involve any costs expenditure, e.g., depreciation of an asset
owned is not an out of pocket cost. Out of pocket costs are important for
price fixation during recession and where make or duydecision is involved.

(h) Marginal Costs:

Marginal cost is the cost of producing one additional unit. The marginal cost
concept is based on the distinction between fixed and variable costs.
Marginal cost is the total of variable cost only and fixed costs are ignored
for the purpose of marginal cost. The concept of marginal cost is very
useful in making many managerial decisions such as price fixation, make or
by decisions, etc.

(i) Opportunity Costs:

Opportunity costs refer to the advantages foregone as a result of adopting

one course of action and not the other. For example, if an owned building is
proposed to be used for a project, the expected rent of the building is the
opportunity cost that must be taken into consideration while evaluating the
profitability of the project.

(j) Conversion Cost:

It is the cost of converting or transforming raw materials into finished
products. Conversion cost can be calculated as the total of direct labour,
direct expenses and chargeable factory overheads.

(k) Budget Costs and Standard Cost:

Budget costs are estimated costs prior to a defined period of time.

Standard cost is a ‘predetermined cost based on technical estimate for
materials, labour and overheads for a selected period of time and for a
prescribed set of working conditions’. Standard costs are based upon
technical assessments whereas budgets are based on historical costs
adjusted to future trends.

(i) Imputed or Hypothetical Costs:

These costs do not involve any expenditure in real sense. They are
included in cost accounts only for taking managerial decisions. For
example, the rent of owned building or interest on owned capital should be
taken into consideration while evaluating the profitability of a project. These
costs are also called ‘notional costs’.