An accounting system measures costs which are later used for a number of purposes such as: (i) profit determination, (ii) performance evaluation, (iii) inventory valuation and (iv) cost control. It is, therefore, very essential to understand what cost means and how it is calculated.
What is a cost? It is something of value given up in exchange for something else. It is price paid to acquire some goods or services. It includes money, materials, labor and time. But the term “cost” conveys multiple meanings and there are different costs for different purposes. This hub aims to provide an understanding of the cost terms and concepts that are used in literature of managerial accounting.
Difference Costs for different Purposes
Cost can be classified in terms of the functions it performs such as manufacturing costs, selling & administration costs and financial costs. Some costs can be directly and conveniently identified to a particular product such as direct material and direct labor. Others are indirect costs or shared costs or common costs.
Similarly, some costs increase or decreases in line with the volume of production but some remain fixed even if the plant is closed down. Some costs result in physical goods while others are just a service. Finally, management policy plays a great role in cost classification. Depreciation is fixed by default but not if based on units produced or sum-of-digit method or even written-down-value basis. If a company enters into a long contract with an advertising firm, the advertisement cost becomes fixed.
Classification by functions
Most common basis for classification is functional. What is this cost for? So cost is segregated into Manufacturing Costs and non-manufacturing costs (Selling, Administration and Financial expenses.) The manufacturing costs are further categorized into direct material, direct labor and overheads. This is convenient and simple way of classification.
In the annual accounts published for creditors, stockholders and others, functional format is used to facilitate inter-company comparison. Besides, the company’s law also requires disclosure of cost items in a certain manner. As a result, all annual reports look alike.
Identifiability or traceability criteria
Some costs can be traced directly and conveniently to a particular product. Often, these are result of a formula whereby one can estimate direct cost for a given product. All other costs are called indirect costs or shared cost or common cost.
In a garment factory, direct raw material and direct labor are direct costs. Some other items such as button and stitching yarn can also be traced to a particular product but it would be inconvenient besides being insignificant. So button, stitching yarn, electricity, depreciation would be indirect costs. While direct costs can be allocated straight to a product or a batch of products, some methodology is evolved for allocation of indirect costs such as machine hours, direct labor hours or raw material quantity etc.
Cost Behavior Criteria
What would be our cost next year if our production is doubled? It may remain the same or be exactly double or in between. All depends on cost behavior which refers to how a cost would respond or react to changes in production. If cost is fixed in nature as in a university, doubling the number of students would slightly increase the total cost since same teachers, same rooms, same laboratories may accommodate the additional students. But if the major cost item is the direct materials as in edible oil, doubling production would nearly double the cost. In other cases, like electric power plant, operating costs would go up while fixed cost would remain the same.
A cost which is not related to production is called fixed costs. In other words, it is a cost that remains unchanged even with variations in output.
Any cost which varies exactly in proportion to the change in activity ( production or sale) would be term as variable cost. This is sometime called engineering cost or a formula cost and can be calculated in advance.
MIXED COSTS or SEMI-VARIABLE COSTS
In ordinary life we observe that even if we do not use the telephone for a month, the bill would still be there representing fixed charges like line rent. The amount of telephone bill would vary according the calls made plus fixed charges. Likewise, there are step fixed and step variable costs.
On way of classification is whether a particular cost would become a part of a product which is physical in nature and can be stored if not sold. So some costs can be categorized as product cost or manufacturing cost which includes direct material, direct labor and factory overheads. Other costs such as selling & admn costs are not added in the cost of manufacture. Such costs are termed as period costs.
Supposing a company manufactured 1000 chairs in one year of which only 200 were sold and rest were lying in the store. What value should be assigned to these remaining 800 chairs? For this purpose, units cost of manufacture would be worked out and stock at hand valued accordingly. If suppose, the same company had incurred Rs.100,000 by way of advertisements, this would not be added to finished goods stock but charged to P&L Account of the same year.
INFLUENCE OF POLICY ON COST
A company may award a contract to an advertising company for year round advertisement of the company's product for a fixed amount. Another company may earmark 5% of the sales as selling expenses. In first case, the advertisement cost would be considered as fixed, in second case as variable.
There are lot many other terms used for a certain type of cost as given below:
Such a cost arises because of a decision of the management to incur a certain amount for some purpose like amount to be spend on R&D or donation to charitable institutions etc.
A cost which must be paid and is unavoidable like property taxes on building, depreciation and rental.
It is important to note a difference between discretionary costs and committed costs. While discretionary costs can be changed with ease, it is not that easy to change committed costs as (i) there may be limitation or restrictions under the legal agreements with some outsiders as in our-sourcing, and (ii) long term implication have to be considered by any change and its approval sought at board of directors' level.
This is ascertained after task analysis whereby any product is dismantled and its cost worked out part by part. This shows what is the actual cost now and not what it was in the past.
SUNK COST; A cost that has incurred in the past and cannot be now changed.
OPPORTUNITY COSTS : Benefit foregone when alternative is selected over another.
DIFFERENTIAL COSTS: Cost and revenues that differ among alternatives.
MARGINAL COSTS: Cost of producing an additional unit.
RELEVANT COSTS : A cost relevant to a particular decision.
A deep understanding of cost behavior is a must for anticipating costs when the organization's level of activity changes. This facilitates cost management, planning and decision making.
There are a variety of cost behavior pattern extending from simple variable and fixed costs to more complicated patterns like curvilinear, semi-variable, step variable and step fixed. Also for control purposes, one should have a fair idea what are avoidable costs or discretionary costs. Also what are the repercussions in changing committed costs or un-avoidable costs. For example, if a company is incurring losses and wants to close down the plant, it should know before hand what are (i) shut-down costs, (ii) what are fixed costs which would continue to be paid, (iii) what are re-start cost, and finally (iv) what would affect on employees, suppliers and clients with the shutdown decision.
suleiman hatamleh on March 23, 2016:
deep and simple .....
Mustafa on February 16, 2015:
I am doing MBA, I found your article, a very informative piece.
hafeezrm (author) from Pakistan on November 26, 2011:
Thanks @Khadija Al-baulchy for visiting my page.
Costs are classified in various ways. Same cost may appear in more than two classifications. These classification are done through use of logic and prevailing environment. There are no GAAP in cost accounting which is done for internal purpose.
Period costs are non-inventoriable costs such as selling and administration expenses. In this category, there are both fixed costs (salaries of permanent salespersons) and non-manufacturing variable costs (commission to salesperson). So period cost maybe fixed or variable or semi-variable.
I hope this answers your question.
Khadija Al-baluchy on November 26, 2011:
Thanks Hafeez just iwould like to know how period cost can be regarded as a fixed cost
hafeezrm (author) from Pakistan on October 16, 2011:
Thanks @htodd for your appreciation.
htodd from United States on October 15, 2011:
gigi on August 30, 2011:
3. Companies are often faced with the need to make changes in the level and mix of their business activities due to the dynamic nature of business. What cost concepts and techniques apply for management to plan a company’s activities intelligently and control its costs effectively? Discuss the relationship of cost incurrence to changes in production, marketing and administrative activities.
flameater on February 28, 2010:
Thanks for your reply.
The services and contracting industries have become very complex areas specifically in terms of accounting. For example, in insurance, the determination of cost and matching it to revenue is becoming very complex with the introduction of new, hybrid insurance products that combine features of life insurance, investments and general - period-based, products.
Similarly, determining contract costs is becoming an open field for interpretation due to the complex nature of contract agreements - such as those for the construction of oil rigs and vessels where input costs are hedged against fluctuations in input costs and oil prices, and contracts may be terminated with options.
hafeezrm (author) from Pakistan on February 27, 2010:
Order costing, job costing and contract costing belong to the same category. Please go to my hub on Job costing. hub:https://hubpages.com/education/Managerial-Accounti...
In service industry, there is no physical product. Hence expect raw materials all other costs are like in industry.
In services, all costs are treated as period costs and are charged to the P&L account in the same year they were ‘produced’.
Value added has been covered in another hub:
Thanks for your comments. I would certainly write in details some time in future.
flameater on February 27, 2010:
Thank you very much. You have spent a lot of effort and time (drawing the charts etc) to bring an understanding of the concept of costs succinctly and clearly to us.
If I may suggest. Can you expand your hub to illustrate to us how your concept of costs relate to the services and contracting industries, seeing that the services industry plays an ever increasing role in the global economy, and much business is transacted in contract mode.
Also, it would be great if you can elaborate on the concept of costs vis-a-vis the concept of value-add, since it is the value-add and not the cost (in a manner of looking at it) that brings well-being to the population.
hafeezrm (author) from Pakistan on February 23, 2010:
Thanks Shaikha Al Suwaidi for your comments.
Work-in-process is an account where all related costs ( raw material, labour and overheads) are combined. Later, cost relating to finished goods is taken out from this account and added to finished goods inventory.
Please go through my hub on this topic:
Shaikha Al Suwaidi on February 23, 2010:
Thanks Hafeez ,,, its great ..
Just i would like to know about the work in process that related to manufacturing cost, could you bereif me plz about it