December 24, 2012

MH0054 [Finance, Economics & Planning in HCS] Set1 Q3



The costs are classified into various categories according to the purpose and requirements of the firm. Some of the most important classifications are as follows:

1. According to functions
2. Direct and indirect cost
3. According to variability
4. According to controllability
5. According to normality
6. According to time
7. According to planning and control
8. According to managerial decisions
9. Differential, incremental or decrement cost
10. Opportunity cost
11. Relevant and irrelevant cost.

1. According to Functions: Under this methodology, the costs are classified into various divisions or functions of the enterprise viz. production cost, administration cost, selling and distribution cost and so on. The detailed classification is that total of production cost sub-classified into cost of manufacture, fabrication or construction and another classification of cost is commercial cost of operations; which is other than the cost of manufacturing and production. The major components of commercial costs are known as

administrative cost of operations and selling and distribution cost of operations.

# Production related:
o Indirect material such as oil, grease etc.
o Indirect labour such as wages of storehouse watchman.
o Indirect expenses such as hospital rent and insurance.

# Office and administration related:
o Indirect material such as general office stationery.
o Indirect labour such as salary of office staff.
o Indirect expenses such as office rent and lighting.

2. Direct and Indirect Cost:

Direct costs of a cost object are related to the particular cost object and can be traced to that cost object conveniently and in an economically feasible (cost-effective) way.

But this is possible only when the cost can be identified with a cost object or cost unit and even the exact amount incurred on the same is known. For example, the cost of the electricity. The cost of the electricity can be easily traced to the hospital activities. The term cost tracing is used to describe the assignment of direct costs to a particular cost object.

Indirect costs of a cost object are related to the particular cost object but cannot be directly traced to that cost object in a convenient and economically feasible(cost-effective) way. For example, the salary of supervisor who oversees the procurement of medicines at a hospital and the pharmacy center it runs, is an indirect cost for a hospital. Supervision costs are related to the cost object (hospital) because supervision is a must for managing the incoming of medicines at the hospital. But the supervision costs shall be termed as indirect costs because supervisor also oversees the procurement of medicines for other related centers/ activities. It is quite difficult to trace supervision costs to the hospital. The term Cost allocation is used to describe the assignment of indirect costs to a particular cost object or cost unit. So there has to be a common/joint cost and some reasonable base, and then cost allocation will take place.

Several factors affect the classification of a cost as direct or indirect such as the following:

  • Significance of the cost in question
  • Design of operation
  • Cost collection technology

3. According to Variability: Costing systems record the costs of resources acquired and track how they are then used. Recording the costs of resources acquired and used allows managers to see how costs behave. Let us first consider two basic types of cost-behavior patterns found in many accounting systems. A variable cost changes in total in proportion to changes in the related level of total activity or volume. A fixed cost remains unchanged in total for a given time period, despite wide changes in the related level of total activity or volume. Costs are defined as variable or fixed with respect to a specific cost object and for a given time period. Identifying a cost as variable or fixed helps managers in forecasting total costs and in taking many important management decisions.

Variable costs are those costs that vary in total directly and proportionately with changes in the activity level.

Fixed costs are the costs that remain the same in total regardless of changes in the activity level or quantity of the cost driver, within the relevant range. Examples include insurance, rent, property taxes, supervisory salaries etc. Because total fixed costs remain constant as activity changes, it follows that fixed costs per unit vary inversely with activity: As volume increases, unit cost declines, and vice versa.

Variable costs are generally termed as ‘product costs’, while fixed costs are known as ‘period costs’. Each of the manufacturing components (such as direct materials, direct labour, and manufacturing overhead) are product costs. Product costs are costs that are a necessary and integral part of making the finished product. However, period costs are costs that are matched with the revenue of a specific time period rather than included as part of

the cost of a product. These are mainly non-manufacturing costs such as selling and administrative expenses.

Mixed costs are the costs that contain both a variable element and a fixed element. Sometimes called semi-variable costs, mixed costs change in total but not proportionately with changes in the activity level. These costs do not change within the units of a small range of activity but may change when the output reaches a new level. It is also known as semi-fixed cost or semi-variable cost.

Example 1:

Make a classification of the different costs given below related to a particular product:
Amount ( in Rs )
Direct Material
Salary Expenses
Electricity Power
Rent – Hospital Building
Direct Wages
Warehouse Charges

We know the following:
Direct cost include: Direct material + Direct labour + Direct expenses
Indirect expenses include: Factory overhead + Administration overhead + selling overhead
Classification of Expenses

Type of Cost
Direct material
Direct Wages
Direct Expenses
Total Direct cost or prime cost
Hospital Overhead :
Electricity power
Rent – Hospital Building
Administration Overhead :
Selling Overhead
Warehouse Charges
Total Indirect Expenses

4. According to Controllability: The costs are classified into two categories in accordance with controllability, as follows:
- Controllable costs: Cost, which can be controlled through some measures known as controllable costs. All variable costs are considered to be controllable in segment to some extent.
- Uncontrollable costs: Costs, which cannot be controlled, are known as uncontrollable costs. All fixed costs are very difficult to control or bring down; they rigid or fixed irrespective to the level of production.

5. According to Normality: Under this methodology, the costs which are normally incurred at a given level of output in the conditions in which that level of activity normally attained.

- Normal cost: It is the cost, which is normally incurred at a given level of output in the conditions in which that level of output is normally achieved.
- Abnormal cost: It is the cost, which is not normally incurred at a given level of output in the conditions in which that level of output is normally attained.

6. According to Time: According to this classification, the costs are classified into historical costs and predetermined costs:

- Historical costs: The costs are accumulated or ascertained only after the incurrence known as past cost or historical costs.
- Predetermined costs: These costs are determined or estimated in advance to any activity by considering the past events, which are normally affecting the costs.

7. According to Planning and Control: The following are the two major classifications viz. standard cost and budgetary control:

- Standard Cost: Standard cost is a cost scientifically determined by way of assuming a particular level of efficiency in utilization of material, labour and indirect expenses.

The prepared standards are compared with the actual performance of the firm in studying the variances in between them. The variances are studied and analysed through an exclusive analysis.

- Budget: A budget is detailed plan of operation for some specific future period. It is an estimate prepared in advance of the period to which it applies. It act as a business barometer as it is complete programme of activities of the business for the period covered.

The control is exercised through continuous comparison of actual results with the budgets. The ultimate aim of comparing with each other is to either to secure individuals’ action towards the objective or to provide a basis for revision.

8. According to Managerial Decisions: The major classifications are sunk cost and marginal cost:

- Marginal cost is the amount at any given volume of output by which aggregate costs are changed if the volume of output is decreased or increased by one unit.
- Sunk costs are costs incurred in the past. They are the results of past decisions, and cannot be changed by future decisions. Since they do not influence future decision-making, they are irrelevant costs.

9. Differentials, Incremental or Decrement Cost: The difference in total cost between two alternatives is termed as differential cost. In case the choice of an alternative results in an increase in total cost, such increased costs are known as incremental costs. While assessing the profitability of a proposed change, the incremental costs are matched with incremental revenue.

10. Opportunity Cost: Opportunity cost refers to an advantage in measurable terms that have foregone on account of not using the facilities in the manner originally planned.

For example, if a building is proposed to be utilized for developing a new project plant, that of a super-specialty hospital, should be compared with the opportunity cost of the same land if it was used for developing a hospital with general facilities.

11. Relevant and Irrelevant Costs: Relevant costs are those which change by managerial decision. Irrelevant costs are those which do not get affected by the decision. For example, if a proprietor is planning to close down an unprofitable healthcare center, this will affect the wages payable to the staff of the center. This is relevant in this connection since they will disappear on closing down of a center. But prepaid rents of a center or unrecovered costs of any equipment which will have to be scrapped are irrelevant costs which should be ignored.

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