COST TERMS, CONCEPTS AND CLASSIFICATIONS
Costs are classified according to needs of management. Each different use of cost data demands a different classification and definition.
Manufacturing Costs:
Manufacturing Costs are (A.) Direct Materials (B.) Direct Labor and (C.) Manufacturing Overhead.
Direct Materials:
Direct materials are those materials that become an integral part of the finished products and whose costs can be easily traced to the finished product.
Direct labor:
Direct labor it consists of labor costs that can be easily traced to the individual units of product. Direct labor is also called touch labor.
Manufacturing Overhead:
It includes all costs of manufacturing except direct materials and direct labor.
Manufacturing overhead includes indirect materials, indirect labor, maintenance and repair expenses of production equipment, heat and light, property taxes, depreciation and insurance on manufacturing facilities.
All costs related with operating the factory are included in manufacturing overhead.
Non Manufacturing Costs:
These are divided into two categories:- (1). Selling costs (2). Administrative costs.
Selling Costs:
Include all costs which are incurred to get customer orders and to deliver finished goods to customers. Such as advertising, shipping, sales travel, sales commissions, sales salaries, costs of warehouses of finished goods.
Administrative Costs:
Include all executive and clerical costs associated with the general management salaries, general accounting, secretarial, public relations etc.
Product Costs Versus Period Costs:
Product Costs:
Product costs include all costs involved in acquiring or making a product.
In case of manufacturing goods, these costs consist of direct material, direct labor and manufacturing overhead.
Product costs are initially assigned to and inventory account on the balance sheet.
When goods are sold, the costs are released from inventory as cost of goods sold and matched against sales revenue. Product costs are also called inventoriables cost. These are shown on balance sheet as work-in-process inventory. Product costs are treated as expense when goods are sold.
Period Costs:
Period costs are all the cost which are not product costs. All selling and Administrative expenses are considered to be period costs.
Prime Costs:
Prime cost is the total of direct material cost and direct labor cost.
Conversion Cost:
Conversion cost is the sum of direct cost and manufacturing overhead cost.
Cost Classification for Predicting Cost Behavior:
Cost behavior means how a cost changes in the level of activity. As the activity level rises or falls, a particular cost may rise and fall or remain constant.
Variable Cost:
A variable cost varies in total in direct proportion to change in the level of activity. E.g. batteries in vehicles.
Variable cost is constant if expressed on a per unit basis.
In a manufacturing company, variable costs include items such as direct materials, shipping cost, sales commission and some elements of manufacturing overhead such as lubricants, tin most situations direct labor is also a variable cost.
Fixed Cost:
A fixed cost is a cost that remains constant in total regardless of changes in the level of activities. Rent is good example of fixed cost. When you say a cost is fixed, we mean it is fixed within some relevant range.
The relevant range is the range of activity within which the assumptions about variable and fixed costs are valid.
Average fixed cost per unit increases or decreases inversely with changes in activity.
Cost classification for Assigning Cost to Cost Objects:
Cost Object:
Cost objects is anything for which cost data are desired including products, jobs, customers and departments of organization.
Direct Cost:
A direct cost is cost which can be easily traced to a specified cost object. Direct material and direct labor are the example of direct cost.
Indirect Cost:
An indirect cost is a cost that cannot be easily traced to a specified cost object. It is also called a common cost.
A common cost is a cost that is incurred to support a number of cost objects, but cannot be traced to them individually.
Cost Classification for Decision Making
Differential Cost and Revenue:
Decisions involve choosing between alternatives. Each alternative will have its costs and benefits.
A difference in costs between any two alternatives is known as differentials cost.
A difference in revenues between any two alternatives is known as differential revenue.
Opportunity Cost:
Opportunity cost is the potential benefit that is given up when one alternative is selected over another.
Opportunity costs are not found in accounting records. But must be considered whenever a decision is made by manager.
Sunk Cost:
A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future.
Sunk costs are ignored while making decisions.
INTERNATIONAL FINANCIAL MANAGEMENT
