Cost is defined as the value of the sacrifice made to acquire goods or services, measured in dollars by the reduction of assets or incurrence of liabilities at the time the benefits are acquired. At the time of acquisition, the cost incurred is for present or future benefits. When these benefits are utilized, the costs become expenses. Management is constantly faced with making choices among alternative courses of action. Information about various types of costs and their behavioral patterns is vital to effective decision making. Data can be visualized as being in one large cost accounting information pool that is routinely accessed for purposes of product costing and performance evaluation and managerial decision making.
This post overview cost classification allover categories maybe found in cost pool. Enjoy!
We can classify the cost data that may be found in the pool into various:
- Categories, according to Elements of a product [Classification-1]
- Relationship to production [Classification-2]
- Relationship to volume [Classification-3]
- Ability to trace [Classification-4]
- Department where incurred [Classification-5]
- Functional areas (activities performed) [Classification-6]
- Period charged to income [Classification-7]
- Relationship to planning, controlling, and decision making [Classification-8]
Next, let’s discuss each of these categories. Read on…
Classification-1: Elements Of A Product
The cost elements of a product, or its integral components, are direct materials, direct labor, and factory overhead as illustrated below. This classification provides management with information necessary for income measurement and product pricing.
Materials are the principal substances used in production that are transformed into finished goods by the addition of direct labor and factory overhead. The cost of materials may be divided into “direct” and “indirect materials cost“.
Direct materials are all materials that can be identified with the production of a finished product, that can be easily traced to the product, and that represent a major material cost of producing that product. An example of direct material is the lumber used to build a bunk bed.
In contrast, indirect materials are all materials involved in the production of a product that are not direct materials. Indirect materials are included as part of factory overhead.
Labor is the physical or mental effort expended in the production of a product. Labor costs may be divided into direct and indirect labor. Direct labor consists of all labor directly involved in the production of a finished product that can be easily traced to the product and that represents a major labor cost of producing that product. The work of machine operators in a manufacturing company would be considered direct labor. Indirect labor is all labor involved in the production of a product that is not considered direct labor. Indirect labor is included as part of factory overhead. The work of a plant supervisor is an example of indirect labor [Read: Labor Cost [An Overview] for more detail discussion].
Factory overhead is an all-inclusive cost pool used to accumulate indirect materials, indirect labor, and all other indirect manufacturing costs that can-not be directly identified with specific products. Examples of other factory overhead costs, besides indirect materials and indirect labor, are rental payments, utilities to operate the factory, and depreciation of factory equipment. Factory overhead costs can be further classified as fixed, variable, and fixed (definitions will be presented later in this post, keep reading…).
An Example of Production Costs
Consider an example of a company that incurs the costs shown in the manufacturing wooden table shown below:
The company’s cost of direct materials would be $260,000; direct labor is $540,000, and factory overhead is $142,800. These three figures represent the elements of the product not included as product costs are office rent of $16,000, office salaries of $80,000, and depreciation of office equipment of $8,000. These office costs are not elements of a product and usually appear as deductions on the income statement from gross profit under the caption of “general and administrative expenses”. The $942,800 of total product cost will appear as the major component in a manufacturer’s cost of goods manufactured statement.
The classification of a cost based on its relationship to the product will change as the relationship changes. For example:
- Lumber is a direct material cost when used in the manufacture of wood furniture. However, lumber is an indirect material cost when used as shipping crates for equipment.
- Maintenance personnel (e.g., janitors, custodians) in a manufacturing plant are an indirect labor cost; their function is not directly related to production. However, in a company that provides maintenance service to others, maintenance personnel would be considered a direct labor cost.
Classification-2: Costs Relationship To Production
Costs may also be classified according to their relationship to production. This classification is closely related to the cost elements of a product (i.e., direct materials, direct labor, and factory overhead) and the major objectives of planning and control.
The two categories, on the basis of their relationship to production, are prime costs and conversion costs:
- Prime costs. These costs are direct materials and direct labor. Prime costs are directly related to production.
- Conversion costs. These are costs associated with transforming direct materials into inished products. Conversion costs are direct labor and factory overhead costs.
Note that direct labor is included in both categories. This does not result in double counting because this classification is used for planning and control, not for cost accumulation.
Classification-3: Costs Relationship To Volume
Costs vary with changes in the volume of production. Understanding their behavior is vital in almost all aspects of product costing, performance evaluation, and managerial decision making. Costs in relationship to volume are classified as variable, fixed, and fixed. However, the cost behavior patterns to be discussed are applicable only within a company’s relevant range. The relevant range is defined as that interval of activity within which total fixed costs and per-unit variable costs remain constant.
Variable costs are those in which the total cost changes in direct proportion to changes in volume, or output, within the relevant range, while the unit cost remains constant. Variable costs are controlled by the department head responsible for incurring them. For example, if variable costs for direct materials are $100 per unit of output, each time output increases by one unit, the variable cost for direct material increases by $100.
The implication for management in its planning and controlling of variable costs is as follows: With all other factors held constant, such as selling price per unit and total fixed cost, each desired per-unit expansion of productive activity triggers an incremental change in total variable costs equal to a constant amount per unit. As long as the selling price per unit exceeds the variable cost per unit, productive activity should be expanded.
Fixed costs are those in which total fixed cost remains constant over a relevant range of output, while the fixed cost per unit varies with output. Beyond the relevant range of output, fixed costs will vary. Upper-level management controls the volume of production and is, therefore, responsible for fixed costs. For example:
Assume that the total fixed cost for rent on a warehouse is $20,000 a year if production is between 5 and 14.99 units. If production is expected to be less than 5 units, a smaller warehouse can be rented at $15,000 a year. Therefore, two relevant ranges exist in this situation: relevant range a, covering from 0 to 4.99 units of output, and relevant range b, covering from 5 to 14.99 units of output.
The implication for management in its planning and controlling of fixed cost is as follows: With all other factors held constant, such as selling price per unit and variable cost per unit, productive activity should be expanded as far as possible, which will reduce the fixed cost per unit to its lowest amount. This is the very essence of the important concept of fully utilizing productive capacity.
There exists a potential misuse of unitized fixed cost. The fact that fixed cost per unit changes as production changes does not mean that fixed cost should be treated like variable costs. Increasing production volume (within the relevant range) will decrease fixed cost per unit, but total fixed costs will not change. For example:
Assume that at the beginning of year 1, a $40,000 computer was purchased to service Departments C and D. The computer was expected to last four years with no salvage value and was to be depreciated using the straight-line method. It was projected that 10,000 total computer hours would be used in year 1 with Department C requiring 6,000 hours and Department D requiring 4,000 hours. The $40,000/4 years = $10,000 annual depreciation was to be allocated to each department on the basis of computer hours used. The cost per computer hour in year 1 was $1.00, computed as follows:
$10,000 = $1.00 per hour for each of 10,000 hours
During year 1 the following computer hours were used:
Department C = 6,000 hours
Department D = 4,000 hours
The computer depreciation costs allocated to Departments C and D were computed as follows:
Department C (6,000 hours × $1.00) = $ 6,000
Department D (4,000 hours × $1.00) = $ 4,000
Total depreciation allocated = $10,000
This method of handling the allocation of the fixed depreciation costs of the computer appears to be sound. However, consider year 2. During year 2 the following computer hours were used:
Department C = 6,000 hours
Department D = 2,000 hours
The manager of Department C used the computer for the same amount of hours as in year 1 and therefore expects that $6,000 will again be allocated to Department C. Instead, Department C is charged with $7,500. Department C used the same number of hours with no change in costs and yet $1,500 more was allocated to it. This ludicrous situation resulted because a fixed cost (i.e., depreciation) was improperly allocated as if it were a variable cost. Department C was allocated $7,500 because the total computer hours used in year 2 were only 8,000 (6,000 hours for Department C plus 2,000 hours for Department D).
The cost per computer hour in year 2 was $1.25, computed as follows:
$10,000 = $1.25 per hour × 8,000 hours
This avoidable error is, unfortunately, all too common in practice. Managers must understand ixed cost behavior from a total and per-unit viewpoint so as not to misuse fixed costs, especially in decision making.
Continuing our computer cost allocation problem, the annual fixed cost of depreciation should have been allocated using a fixed percentage based on the projected long-run average use by each department. For example: If it was projected that Department C would use the computer 75% of the time and Department D 25% of the time, then the fixed costs should be allocated 75% to Department C ($7,500 each year) and 25% to Department b ($2,500 each year) regardless of actual use.
If Department D used the computer less than planned, it still should be charged with 25% of the cost because the “capacity” of the computer originally acquired was based on each department’s projected long-run average needs; therefore Department D should be made to bear, in this situation, the full cost of the underutilized computer capacity.
In summary, I can say the following about the relationship between cost and volume within the relevant range:
- Total variable costs change in proportion to changes in volume.
- Per-unit variable costs remain constant when volume changes.
- Total fixed costs remain constant when volume changes.
- Per-unit fixed costs increase (decrease) when volume decreases (increases).
Fixed costs contain both fixed and variable characteristics over various relevant ranges of operation. Two types of fixed costs exist: semi-variable costs and step costs.
Semi-variable costs contain both fixed and variable costs. The fixed part of a semi-variable cost usually represents a minimum fee for making a particular item or service available. The variable portion is the cost charges for actually using the service. For example, most telephone service charges are made up of two elements: a fixed charge for being allowed to receive or make a phone call, plus an additional or variable charge for each phone call made.
Telephone charges are relatively simple to separate into fixed and variable costs; however, in some situations, the variable and fixed components must be approximated.
Assume that a company rents a delivery truck at a flat fee of $2,000 per year plus $0.15 for each mile driven. The fixed component is the $2,000 annual rental fee; the variable component is the $0.15 for each mile driven. If 10,000 miles are driven during the year, the total annual cost of the delivery truck is $3,500, computed as follows:
Flat fee (fixed component) $2,000
Mileage charge (variable component)
(10,000 miles × $0.15) $ 1,500
Total Cost $3,500
The fixed part of step costs jumps abruptly at various activity levels because these costs are acquired in indivisible portions. An example of a step cost is the salary of supervisors. If one supervisor is needed for every 10 workers, then two supervisors would be required if, for example, 15 workers are used. If an additional worker is hired (increasing the number of workers to 16), still only two supervisors would be needed. However, if the number of workers increases to 21, three supervisors would be needed. A step cost is similar to a fixed cost within a very small relevant range.
Although fixed costs are neither wholly fixed nor wholly variable in nature, they must ultimately be separated into their fixed and variable components for purposes of planning and control. When a relationship is found to exist between two variables, statistical techniques are available to divide a fixed cost into its fixed and variable components.
Classification-4: Management’s Ability To Trace
A cost may be considered direct or indirect depending on management’s ability to trace it to specific jobs, departments, sales territories, and so forth. Direct costs are costs that management is capable of tracing to specific items or areas. Examples of direct costs are direct materials and direct labor costs for a specific product. Indirect costs are costs that are common to many items and are therefore not directly traceable to any one item or area. Indirect costs are usually charged to items or areas on the basis of allocation techniques. For example, indirect manufacturing costs are allocated to products after first being accumulated in a factory overhead cost pool.
Classification-5: Department Where Incurred
A department is a major functional division of a business. Costing by departments helps management to control overhead costs and to measure income.
The following types of departments are found in manufacturing companies:
Production departments. These contribute directly to the production of the item and include departments in which conversion or production processes take place. They include manual and machine operations directly performed on the product manufactured.
Service departments. These are departments that are not directly related to the production of an item. Their function is to provide services for other departments. Examples of service departments are payroll, factory office personnel, cafeteria, and plant security. The costs of service departments are usually allocated to production departments since they benefit from the services provided.
For example, Company one has only one production department and all the machinery in that department is kept in operating condition by the maintenance department. The maintenance department is also required to provide janitorial and maintenance services to the rest of the company. Therefore, a portion of the maintenance department’s cost should be allocated to the production department and will become part of product cost. The portion not allocated to the production department may be allocated to another service department or to a non-plant department, such as the sales department, and will be an expense of that department for the current period.
The basis for allocating service department costs usually varies according to the service provided. For example, two common bases for allocating service department costs are square feet serviced for a building and grounds service department and number of employees for a personnel service department.
Classification-6: Functional Areas
Costs classified by function are accumulated according to activity performed. All costs of a manufacturing organization may be divided into manufacturing, marketing, administrative, and financing, defined as follows:
- Manufacturing costs are related to the production of an item. They are the sum of direct materials, direct labor, and factory overhead costs.
- Marketing costs are costs incurred in promoting a product or service.
- Administrative costs are cost incurred in directing, controlling, and operating a company and include salaries paid to management and staff.
- Financing costs are costs related to obtaining funds for the operation of the company. They include the cost of interest that the company must pay on loans, as well as the cost of providing credit to customers.
If the controller or CFO wants to analyze the current period’s operations, one method would be to classify costs by functions and compare them to parallel costs for a previous year. Knowing that a company had $400,000 total operating costs for year 1 and $500,000 total operating costs for year 2 would not provide sufficient information for the controller to determine the cause(s) of the increase. a further detailed analysis by functions would be necessary in order to explain why total costs increased by $100,000.
This analysis reveals that the increase in total operating costs resulted from manufacturing and administrative functions. These functions should be examined by the controller to determine if the increases were appropriate. The decrease in financing costs should also be analyzed to determine its cause, especially when the decrease was totally unexpected and the amount was significant.
Classification-7: Period Charge In Income
Costs may also be classified on the basis of when they are to be charged against revenue:
Some costs are first recorded as assets (for example, capital expenditures) and then expensed (that is, charged as an expense) as they are used or expire. Other costs are initially recorded as expenses. The classification of costs into categories relating to the periods they benefit aids in measuring income, in preparing financial statements, and in matching expenses to revenue in the proper period.
Two categories used are product costs and period costs:
- Product costs are costs directly and indirectly identifiable with the product. They are direct materials, direct labor, and factory overhead. These costs provide no benefit until the product is sold and are, therefore, inventoried upon completion of the product.
- When the products are sold, the total product costs are recorded as an expense, called the cost of goods sold. Cost of goods sold is matched against revenue for the period in which the products are sold.
Classification-8: Relationship To Planning, Controlling, And Decision Making
Costs that aid management in its planning, controlling, and decision-making functions are briefly defined as follows. The classification of costs into various categories as I have done below is not to be construed as definitive. That is, the boundaries that separate the categories are not very clear cut.
Standard and Budgeted Costs
Standard costs are those that should be incurred in a particular production process under normal conditions. Standard costing is usually concerned with per-unit costs for direct materials, direct labor, and factory overhead; it serves the same purpose as a budget (A budget is a quantitative expression of management objectives and a means of monitoring progress toward achievement of those objectives). Budgets, however, usually provide forecasted activity on a total cost basis rather than on a unit cost basis. Standard costs and budgets are used by management first to plan upcoming performance and second to control actual performance through variance analysis (i.e., the difference between expected and actual amounts).
Controllable and Non-controllable Costs
Controllable costs are those that may be directly influenced by unit managers in a given time period. For example: where managers have the authority of acquisition and use, the cost may be considered to be controllable by them.
Non-controllable costs are those costs that are not directly administered at a given level of management authority.
Committed and Discretionary Fixed Costs
A committed fixed cost arises, of necessity, from having a basic organizational structure (i.e., essential property, plant, equipment, salaried personnel, etc.). It is a long-run phenomenon that usually cannot be adjusted down-ward without adversely affecting the ability of the organization to operate at even a minimum level of productive capacity.
A discretionary fixed cost arises from yearly appropriation decisions for repairs and maintenance costs, advertising costs, executive training, and so on. It is a short-run phenomenon that usually can be adjusted downward, thereby permitting the organization to operate at any desired level of productive capacity provided for by the committed fixed costs.
Relevant and Irrelevant Costs
Relevant costs are expected future costs that differ among alternative courses of action and may be eliminated if some economic activity is changed or deleted.
Irrelevant costs are unaffected by management’s actions. Sunk costs are an example of irrelevant costs. sunk costs are past costs that are now irrevocable, such as depreciation on machinery. When confronted with a choice, they are not relevant and should not be considered in a decision-making analysis, except for possible tax effects upon their disposition and painful lessons to be learned from past mistakes.
Relevancy is not an attribute of a particular cost; the identical cost may be relevant in one circumstance and irrelevant in another. The specific facts of a given situation will dictate which costs are relevant and which are irrelevant.
A differential cost is the difference between the costs of alternative courses of action on an item-by-item basis. If the cost is increasing from one alternative to another, it is called an incremental cost; if the cost is decreasing from one alternative to another, it is called a decremental cost.
When analyzing a specific decision, the key is the differential effects of each option on the company’s profits. Frequently, variable costs and incremental costs are the same. However, should a special order, for example, extend production beyond the relevant range, both variable and total fixed costs would increase. In that event, the differential in fixed costs should be included in the decision-making analysis along with the differential in variable costs.
Where a decision to pursue one alternative is made, the benefits of other options are forgone. Benefits lost from rejecting the next best alternative are the opportunity costs of the chosen action. Since opportunity costs are not actually incurred, they are not recorded in the accounting records. They are, however, relevant costs for decision-making purposes and must be considered in evaluating a proposed alternative.
Shutdown costs are those fixed costs that would be incurred even if there were no production. In a seasonal business, management is often faced with decisions of whether to suspend operations or remain open during the off-season. In the short run, it is advantageous for the firm to remain open as long as sufficient sales revenue can be generated to cover variable costs and contribute to the recovery of fixed costs. Typical shutdown costs that must be considered when deciding whether to close or stay open are rent, severance pay for employees, storage costs, insurance, and salaries for the security staff.
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