Meaning of Cost

C I M A Terminology defines cost as resources sacrificed or forgone to achieve a specific objective. Cost is generally measured in monetary terms. Cost is the amount of expenditure (actual or notional) incurred on or attributable to, a specified thing or activity.

Thus, material cost of a product will mean the expenses incurred in procuring, storing and using materials in the product.

Similarly, labour cost will represent that part of payment made to the workmen for time spent on the product during its manufacture.

The dictionary meaning of cost is a loss or sacrifice or an amount paid or required in payment for a purchase or for the production or up keep of something, often measured in terms of effort or time expended .

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Various Elements of Cost

The various elements of cost can be broadly classified into three categories.

• Material : It is the cost of raw materials purchased by the firm.
  
  
• Labour : It is the amount of remuneration paid to the employees in the form of wages, salaries, bonus, commission, etc.
  
  
• Expenses : It is the cost of various services availed by the firm e.g., electricity, rent, stationery, etc.
  The above classification of cost is broad based and general. For cost accounting purposes, these cost need to be further sub classified. These costs are explained below.

Materials

The original product from which the final product is manufactured is the material. It may be in raw or semi manufactured state. Material may be Direct and Indirect. Direct material is material identified with or allocated to cost centers and cost units. It is the raw or semi finished material out of which a product is manufactured.

For example

leather shoes are produced out of leather, butter is produced out of milk, and steel utensils are produced out of stainless steel and so on. Thus, leather, milk and stainless steel are the direct materials for the manufacture of shoes, butter and steel utensils respectively.

Unlike direct material, another kind of material may be required for manufacturing. For example,machines used for production require lubricants, jute and cotton wastes etc. which are indirect materials.Direct material is a component of prime cost and indirect material is a component of factory overhead. Direct material directly varies with the output whereas indirect material does not.

Labour

To convert the raw materials into finished goods, human effort is required which is called labour. Labour can be Direct and Indirect. Direct wages are the wages which are allocated to cost centres and cost units. They are wages paid to the workers who produce goods. In manual work, the worker is the one who produces goods.

When work is done by a machine, the person who collects input and output and in whose Depreciation Accounting, Final Accounts and Elements of Cost account the output is credited for the purpose of payment of wages is direct worker. Other workers help direct workers in supplying materials, power, supervision and maintenance.

These are indirect workers and wages of indirect workers at different stages of production are indirect wages. Direct wage is a part of prime cost while indirect wage is a part of factory overhead. The former directly varies with the output whereas the latter may not vary so.

Expenses

Cost incurred on items apart from materials and labour is grouped under the heading of expenses. Apart from direct material and direct labour, there are expenses that might be necessary for a particular production. This expense is called direct expense and can be easily identified with or allocated to cost centres or cost units.

For example

When an order is received, a manufacturer will have to prepare a mould exclusively for this purpose. The cost of the mould will be direct expense of the production. Similarly, the charge for hiring a special plant for production is also direct expense and it can be and allocated to cost centres or cost units.

The cost of preparing blue print for a production is another example of direct expense. The expenses which cannot be related with indirect material or indirect labour are called indirect expenses. These are expenses which cannot be identified or linked with a particular cost centre or cost unit.

For example

Rent, rates, depreciation on fixed assets, insurance, etc. overhead is the indirect expense incurred at different levels of activities of an enterprise. These expenses cannot be conveniently identified with or allocated to cost centres or cost units. For a manufacturing concern, overheads can be grouped under three categories.

Factory overheads

Factory or works overhead refers to all indirect expenses of a factory. It includes the following :

• Wages of all factory staff excluding those of direct workers
  
  
• Indirect material
  
  
• Rent
  
  
• Rates
  
  
• Taxes of factory
  
  
• Depreciation of factory assets
  
  
• Excise duty
  
  
• Canteen expenses
  
  
• Labour welfare expenses
  
  

Office and administrative overheads

All expenses related to general administration. In administrative building, following things are included:

• Salary of administrative staff
  
  
• Rent
  
  
• Rates
  
  
• Taxes of administrative accommodation
  
  
• Postage
  
  
• Telegram and telephone
  
  
• Stationery
  
  
• Lighting of administrative building
  
  
• Depreciation of office appliances
  
  
• Depreciation of office appliances, etc. is included in administration overhead.
  
  

Selling overhead

All expenses related to sales. In selling overhead, following things are included:

• Salary of sales staff
  
  
• Traveller s commission
  
  
• Advertisement
  
  
• Rent
  
  
• Rates
  
  
• Taxes of sales office
  
  
• Depreciation of sales office appliances
  
  
• Cost of participation in industrial fares and exhibitions
  
  
• Cost of free gifts
  
  
• Cost of free after sales service
  
  
• Normal bad debt
  
  

Distribution Overhead

All expenses related to the delivery of a product after the sale is done. In distribution overhead, following things are included:

• Delivery van expenses
  
  
• Fright and insurance
  
  
• Packing for delivery loading and unloading
  
  
• Salary of the delivery men
  
  
• Customs duty
  

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Classification of Cost

The different costs can be grouped according to their common characteristics. They are :

1. Nature/Elements
   
   
2. Functions
   
   
3. Research and development cost
   
   
4. Behaviour
   
   
5. Controllability
   
   
6. Normality
   
   
7. Time
   
   
8. Capital and revenue
   
   

Nature/Elements

On the basis of nature or elements, costs can be classified into three categories i.e. materials, labour and expenses. These costs are further sub classified as direct and indirect. This classification of cost has already been discussed in the earlier paragraphs.

Functions

In an organization which manufacture and sell goods, four main costs are incurred i.e. manufacturing, office and administration, selling and distribution and research and development. The first three types of cost have already been discussed. Research and development cost is explained below.

Research and development cost

Research cost is the cost incurred for the improvement of the existing product or development of new product of methods of new application of materials. Development cost involves the cost of putting the research results on commercial basis.

Behaviour

Due to change in the volume of production, there are changes in the level of cost. Such costs can be classified as fixed cost, variable cost and semi variable cost. Fixed costs are the ones which have to be paid for any level of production.

Example, rent of the factory building. Variable costs vary with the change in the production level. Example direct material cost. Semi variable costs are the ones which partly vary and partly remain fixed with the changes in the volume of production.

For example

Electricity bill. If the volume of production is increased the use of electricity will also increase which would result in the increased electricity bill. If the volume of production decreases the use of electricity will also decrease which would result in the reduced electricity bill.

If there is zero production, still a fixed amount of electricity rental has to be paid. Thus, the rent portion of the electricity bill is fixed cost and the usage of the power is a variable cost.

Controllability

Costs can be either controllable or uncontrollable. Controllable cost is affected by the actions of the people associated with it. Such costs are within the control of management. The management can decide how much is to be spent on the particular cost.

Examples are direct material, direct labour and direct expenses. Uncontrollable costs are beyond the control of management. Most of the fixed costs are uncontrollable in nature. For example the rent of the factory premises is fixed and has to be paid whether there is production or not.

Normality

Costs which are normally incurred to produce a certain level of output is referred to as the normal cost. However, in abnormal situation where cost need to be incurred even if there is no production, is referred to as the abnormal cost.

For example, payment of wages to workers even when they have gone on strike. Abnormal cost is not included in cost of production, but recorded in the costing profit and loss account.

Time

Costs can be historical or predetermined. Historical cost is the one, which is ascertained after its occurrence. Example, after purchasing the raw materials, the cost of materials consumed is ascertained. Predetermined or estimated costs are the ones which are computed in advance. They can also be referred to as the forecasted cost.

Capital and revenue

Any cost incurred for buying an asset is referred to as the capital cost. Example cost of heavy machinery purchased to produce goods. Capital cost is incurred to increase the earning capacity of the business. In order to maintain the machinery certain costs need to be incurred like repairs, renewals and overhauling. These costs are referred to as the revenue cost.

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