Chapter No.02
COSTS , CONCEPTS,
USES AND
CLASSIFICATIONS
McGraw-Hill/Irwin
Copyright © 2006, The McGraw-Hill Companies, Inc.
“COST” IN COST
ACCOUNTING
Cost:The American Accounting Association
Committee on Cost concept and standards
define cost:
Cost as “forgoing measured in monetary
terms, incurred or potentially to be incurred
to achieve a specific objective.
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DISTINCTION BETWEEN COST AND
EXPENSE
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Cost: Cost represents the amount invested in
obtaining a product or service which has not yet expired,
or benefits or services of which have not yet be received
or which have not yet been utilized or consumed in
connection with the realization of revenue. Prepaid
expense, inventories of various kinds, properties and
other asset, represents examples of Cost.
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Expense: Expenses refers to that cost which has
expired or which has been charged against revenue of a
period. E.g. cost of goods sold, salaries expenses etc.
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Classification of cost:There are various way of classifying costs. Each classification
serves a different purpose. Important classifications are given
below:
Functional Classification:1 - Manufacturing cost or production cost
These are the costs which are incurred to produce
items. Eg. Direct materials, direct labour and factory
overhead.
2 - Commercial Expenses
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Distribution and selling Expenses: These are the
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Administration Expenses: These
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expenses which are incurred to sell and distribute the products to
customers .e.g. advertising expenses, transport expenses, delivery
expenses etc.
are the expenses which
are incurred to manage and supervise the overall activities of an
organization. e.g. office stationery, accounts department expenses,
office transport and delivery etc.
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Cost with the Respect to Product or Period:-
1 – Product Costs = These are the costs which
are incurred or paid with respect to produce an
item.e. g. Direct Materials, Direct Labour and
Factory overhead.
2 - Period Costs = These are the costs which are
incurred with respect to period.e.g. Salaries,
rent, telephone bills and electricity bills etc.
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Direct Costs and Indirect Costs
Material
There are Two types of Materials.
1 - Direct Material: All that materials which can be directly identified with the cost of
a product.
Examples:Timber in chair or table, cloth in shirt. Basic or essential packing
material like cartons, boxes, papers etc.
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2 - Indirect Material: Material cost which can not be allocated or identified but which
are to be absorbed by the units produced.
Example:Fuel, lubricants, tools for general use, glue, thread in shirts,
nails in shoes etc.
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Labour
There are Two types of Labour.
Direct Labour:All that labours which can be directly identified with
the cost of product. All labours expending in
converting raw material into desirable goods.
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Indirect Labour:Labour cost which can not be directly allocated or
identified, but which are to be absorbed by the units
produced.
Example: idle time wages, maintenance and repair, wages leave
pay employers contribution to fun.
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Factory overhead( FOH): -
The aggregate of indirect material cost, indirect wages
and indirect expenses.”
Component Of Factory Overhead
Factory Overhead =
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Indirect Material + Indirect Labor + Others Indirect
Cost
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Component Of Factory Overhead
Other Indirect Cost
Indirect Material
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 Factory Supplies
 Lubricants and fuel
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Indirect Labor
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 Supervision (factory supervisor
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salaries)
 Superintendence (Salary)
 Inspection team Salary
 Salaries of factory clerks
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Rent
Insurance Fire
Depreciation of Plant and
machinery
Maintenance and Repairs
(Factory machinery,
factory Building)
Power (factory)
Heat and Light of Factory
Miscellaneous Factory
overhead
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By combining the foregoing elements of
cost, the following divisions can be
secured:
1.
Prime Cost: This is generally used to
denote the sum of direct material and
direct labor cost.
2.
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Conversion Cost: This term is
generally applied to the sum of direct
labor and factory overhead cost. In
other words these are the costs which
are incurred to convert raw materials
into finished goods
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Costs in their Tendency vary with volume or
Activity
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Fixed Costs:It refers to those expenses which do not vary with increase or
decrease in production level. Total amount of fixed overhead
remains constant –with all level of production. Fixed cost per unit
change with increase or decrease of production level.
Example:Factory building rent, salary of plant manager, insurance
premium, depreciation etc.
Variable Costs:It refers to those expenses which vary with the increase or
decrease in production level. Total amount of variable overhead
changes with all level of production. Variable cost per unit fixed
with increase or decrease of production level.
Example:direct materials, direct labour, Power, overtime, maintenance cost
etc.
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
Semi – variable costs
The few part of cost is fixed and few is
variable costs.
Example: Telephone expenses consist of rent charges and call
charges. Rent charges are fixed while call charges is
variable. Total of rent and call charges become semi
– variable cost.
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USES OF COST DATA
Planning profits by means of budgets.
 Controlling costs via responsibility accounting
system.
 Measuring annual or periodic profit including
inventory costing.
 Assisting in establishing selling prices and a
pricing policy.
 Furnishing relevant cost data for analytical
process for decision making.
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COST WITH RESPECT TO DEPARTMENTS

Departmental costs:
 Which
can be directly attributable to each
department specifically.e.g. indirect materials,
indirect labour etc.
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Common costs:
 Which
can not be directly attributable to specific
department.e.g. factory rent, insurance, canteen
costs, repair and maintenance and factory
depreciation
JOINT COSTS
 These
costs occur when the production of
one product may be possible only if one or
more other products are manufactured at
the same time.e.g costs in meat industry
packing industry, oil and gas industry etc.
COSTS FOR PLANNING AND CONTROL

Budgeted costs:
 Costs
estimated for a specific period are called
budgeted costs.
 These costs are used for planning and control
purpose.

Standard costs:
 It
is the estimated cost per unit of an item. On the
basis of standard costs the budget can be
prepared.
 With the help of standards the variances can be
calculated and responsibilities are identified.
EXERCISES 01
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Classify the following costs as to fixed, variable or semi
variable. Explain the reasons for your classification of the semi
variable costs.
Depreciation- straight line method
Rent
Direct materials
Repairs to machinery
Factory insurance
FICA tax
Heat, light and power
Superintendence
Indirect labor
Washroom supplies
EXERCISES 02
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Under which subheading of the elements of cost should each
of the following costs be classified
Cutting tools
Inspector ‘s salary
Depreciation of factory
Legal expenses
Earnings of mechanist
Lubricating oil
Supervisor ‘s wages
Salary of factory store clerk
Maintenance parts for factory equipment
wages of factory crane operator
EXERCISES 03
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Classify the following items as direct or indirect materials:
Ailerons on an airplane
Seats to be installed in a railway car
1-oz, perfume bottle
Stainless steel cone that holds the mirror in a color television
set
Sanding Material in furniture making
Bags in flour mills
Milk to make ice cream
Ingots used by a foundry for making castings
EXERCISES 04
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Bid calculations. The Shepard Company is to submit a bid on
the production of 10,000 ceramic salad bowls. It is estimated
that the cost of materials will be $7,500 and direct labor, $
10,100. Factory overhead is applied at $5 per direct labor hour
in the Molding Department and at 120% of the direct labor cost
in the finishing Department. It is estimated that 800 direct
labor hours will be required in Molding and the direct labor cost
in Finishing will be $ 4,300. The company wishes a bid price
consisting of a markup of 40% of its total production costs.
Required:
Estimated cost to produce
Estimated prime cost
Estimated conversion cost
Bid price