Cost Concept
· Cost: Cost of production of a commodity is the aggregate of price paid for the factors of production used in producing that
commodity.
Classification
· By nature/element:
o
Direct Costs: Costs which are conveniently identified
with and allocated to a particular unit of final product.
Can be further as: Direct material, direct labour,
direct expenses.
o
Indirect Costs: Costs which cannot be assigned
to any particular cost unit i.e.,
job, product, or process. Usually incurred for the business as a whole. These include:
■
Indirect material such as fuel, lubricating oil, small tools etc.
■
Indirect labour which includes wages for cleaners,
store-keepers, inspectors,etc.
■
Indirect expenses such as rent, lightning, insurance, etc.
o
Indirect costs are also called
‘Overheads’, which may be further classified as:
■
Factory overheads: Indirect
expenses connected with the manufacture of a product such as
lubricants, oil, factory rent, factory insurance, work managers’s salary,
time-keeper’s salary, etc.
■
Office and administration overheads: All indirect
expenses relating to administration and management of an office such as office rent, office
lighting, salaries of executive staff, etc.
■
Selling and distributional overheads: Includes all indirect costs connected
with marketing and sales such as advertising expenses, salaries of salesmen,
indirect packaging material, etc.
· Functional classification:
o
Prime cost: Costs
of direct materials that go into the product,
the costs of direct
labour and direct expenses. Also known as direct or first cost.
■
Prime cost = Direct material
+ Direct labour
+ Direct expenses
o
Factory cost: Prime
cost plus factory
overhead or works
expenses or factory
on cost. Also known as works costs, production cost or manufacturing
cost.
■
Factory cost = Prime Cost + Factory
expenses
o
Cost of production: Also called office cost, administration cost or gross cost of production, it consists of factory cost
plus office and administrative expenses.
■
Office cost = Factory cost + Administrative and Office overheads
o
Total cost or Cost of sales: Cost of production plus selling and distribution
overheads.
■
Total cost = Office cost + Selling
and distribution overheads
·
On the basis of behaviour:
o
Variable Costs: Costs that vary almost in direct
proportion to the volume of production. Ex: Direct
material, labour and direct chargeable expenses, such as fuels, etc.
o
Fixed Costs: Costs which do not vary with the level of production. Remain constant irrespective of the level
of output.
o
Semi-variable Costs: Partly fixed and and partly
variable costs. Vary with the level of production but not in direct proportion
to the level of production. Ex: depreciation
of machinery, maintenance of equipment, administrative costs, etc.
·
Classification of Costs for Managerial Decisions and Control:
o
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. Uncontrolled costs are those which cannot be controlled or influenced.
o
Normal and abnormal
costs: Costs which are normally
incurred at a given level of output are called normal costs.
Costs which are not normally incurred at a given level of output are called
abnormal costs.
o
Avoidable and unavoidable costs: Costs which can be
escaped or avoided if some activity if some activity
of the business to which
they relate is discontinued.
Unavoidable costs are those which cannot be escaped or eliminated.
o
Shut down and sunk costs:
Fixed costs which
have to incurred
even if production or operations of an
undertaking are discontinued temporarily due to certain reasons such as strike,
shortage are called shut down costs. Costs which have been incurred and are irrelevant in a
particular situation are called sunk costs.
· Product
costs and period costs: Costs which are associated with production and which
become part of the cost of the product are called product cost. ex: 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'. ex: administration costs, rent, insurance, salesmen salaries, etc.
· 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.
· 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 buy decision is involved.
· 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.
· 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.
· 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.
· 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.
· 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'.
· Explicit
and Implicit Cost: Explicit costs are those payments which firms make to
outsiders for contributing their services
and goods. Implicit
costs may be defined as the
earning of those employed resources which belongs to the owner itself. In fact
these costs refer to the implied or unnoticed cost.
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