Elements of Cost / Different types of cost / Classification of cost
ELEMENTS OF COSTS
Classification of cost:
Cost can be broadly classified into variable cost and overhead cost. Variable cost varies with the volume of production while overhead cost is fixed, irrespective of the production volume.Classification of variable cost:
Variable cost can be further classified into direct material cost, direct labour cost, and direct expenses.Direct material cost:
Direct material costs are those costs of materials that are used to produce the product.
Example: The cost of cotton used in production of cloth and the cost of lime in the production of chalk.
Direct labour cost:
Direct labour cost is the amount of wages paid to the labour who directly involved in the production activities.
Example: Wage of a workman engaged in assembling parts and wage of carpenter engaged in furniture making.
Direct expenses:
Direct expenses are those expenses that vary in relation to the production volume, other than the direct material costs and direct labour costs.
Example: Royalty cost of a product and cost of a pattern
Overhead cost:
Overhead cost is sum of all indirect costs. Overhead cost the sum of indirect material costs, indirect labour costs and indirect expenses.Classification of overhead cost:
The overhead cost can be classified into factory overhead, administration overhead, selling overhead and distribution overhead.
Factory overhead:
Factory overhead is the costs incurred during the manufacturing process, not including the costs of direct labor and direct materials.
Example: Factory rent, Equipment setup costs and equipment maintenance cost.
Administration overhead cost:
Administration overhead includes all the costs that are incurred in administering the business.
Example: Salaries of offices staff, rent of office building, stationary expenses incurred in the office etc.
Selling overhead cost:
Selling overhead is the total expense that is incurred in the promotional activities and the expenses relating to sales force.
Example: Salaries of salesman, Advertising etc.
Distribution overhead cost:
Distribution overhead is the total cost of shipping the items from the factory site to the customer sites.
Example: Rent of delivery vans, maintenance of delivery vans etc.
The selling price of a product is derived as shown below:
(a) Prime cost = Direct material costs + Direct labour costs + Direct expenses
(b) Factory cost = Prime cost + Factory overhead
(c) Costs of production = Factory cost + Office and administrative overhead
(d) Cost of goods sold = Cost of production + Opening finished stock – Closing finished stock
(e) Cost of sales = Cost of goods sold + Selling and distribution overhead
(f) Sales = Cost of sales + Profit
(g) Selling price per unit = Sales/Quantity sold
(In the above calculations, if the opening finished stock is equal to the closing finished stock, then the cost of production is equal to the cost of goods sold.)
Other Costs / Revenues
The following are the costs/revenues other than the costs which are presented in the previous section:• Marginal cost
• Marginal revenue
• Sunk cost
• Opportunity cost
1. Marginal Cost
Marginal cost of a product is the cost of producing an additional unit of that product. Let the cost of producing 20 units of a product be Rs. 10,000, and the cost of producing 21 units of the same product be Rs. 10,045. Then the marginal cost of producing the 21st unit is Rs. 45.Calculation of Marginal cost:
Marginal Cost = Total cost – fixed cost
Marginal Cost = Overhead cost + total variable
2. Marginal Revenue
Marginal revenue of a product is the incremental revenue of selling an additional unit of that product. Otherwise, the revenue that can be obtained from selling one more unit of product is called marginal revenue.Let, the revenue of selling 20 units of a product be Rs. 15,000 and the revenue of selling 21 units of the same product be Rs. 15,085. Then, the marginal revenue of selling the 21st unit is Rs. 85.
3. Sunk Cost
A cost of product in past and it is not relevant to the particular decision making is known as Sunk cost. This is also known as the past cost or sunk loss of an equipment/asset.Let us assume that an equipment has been purchased for Rs. 1,00,000 about three years back. If it is considered for replacement, then its present value is not Rs. 1,00,000. Instead, its present market value should be taken as the present value of the equipment for further analysis. So, the purchase value of the equipment in the past is known as its sunk cost.
4. Opportunity Cost
Opportunity costs represent the benefit that is given up when choosing one alternative over another. This cost is very important for decision making.In practice, if an alternative (X) is selected from a set of competing alternatives (X,Y), then the corresponding investment in the selected alternative is not available for any other purpose. If the same money is invested in some other alternative (Y), it may fetch some return. Since the money is invested in the selected alternative (X), one has to forego the return from the other alternative (Y).
The amount that is foregone by not investing in the other alternative (Y) is known as the opportunity cost of the selected alternative (X). So the opportunity cost of an alternative is the return that will be foregone by not investing the same money in another alternative.
Consider that a person has invested a sum of Rs. 50,000 in shares. Let the expected annual return by this alternative be Rs. 7,500. If the same amount is invested in a fixed deposit, a bank will pay a return of 18%. Then, the corresponding total return per year for the investment in the bank is Rs. 9,000.
This return is greater than the return from shares. The foregone excess return of Rs. 1,500 by way of not investing in the bank is the opportunity cost of investing in shares.
