Cost Concepts and Classification

Cost Concepts & Classifications

• Cost - total of all expenses incurred for a product
or a service- actual outgoings or ascertained
changes incurred in its production and sale
activities.

• It is amount of resources used up in exchange for

some goods or services.

• Resources are expressed in terms of money or

monetary units.
 Classification of Costs
Process of grouping costs according to
their common characteristics.

Proper classification of costs is absolutely

necessary .
 Cost Classification
According to Elements:

Under circumstances, costs are classified into three broad

categories Material, Labour and Overhead.
Further subdivision may also be made for each of them.
For example, Material may be subdivided into raw materials,
packing materials, consumable stores etc.

This classification is very useful in order to ascertain total cost

and its components.

Same classification may also be made for labour and overhead.

 Cost Classification
According to Functions:
Total costs are divided into different segments according to
purpose of firm. So they are grouped as per requirements of firm
in order to evaluate its functions properly.
Total costs include all costs starting from cost of materials to cost
of packing the product.
Cost of direct material, direct labour and chargeable expenses and
all indirect expenses fall under head Manufacturing/Production
cost.
Administration cost (relating to office and administration) and
Selling and Distribution expenses (relating to sales) are to be
classified separately and to be added in order to find out total cost
of the product.
If these functional classifications are not made properly, true cost
of product cannot accurately be ascertained.
 Cost Classification
According to Variability:

Practically, costs are classified according to their behaviour

relating to change (increase or decrease) in their volume of
activity.

These costs as per volume may be subdivided into:

(i) Fixed Cost;
(ii) Variable Cost;
(iii) Semi-variable Cost.
 Cost Classification

Fixed Costs are those which do not vary with the

change in output, i.e., irrespective of quantity of
output produced, it remains fixed ( Salaries, Rent
etc.) up to a certain limit.

If more units are product, fixed cost per unit will be

reduced, and, if less units are produced, fixed cost
per unit will be increased
 Cost Classification

Variable Costs, are those which vary proportionately

with the volume of output.

So cost per unit will remain fixed irrespective of

quantity produced.

There is no direct effect on cost per unit if there is a

change in volume of output (price of raw material,
labour etc.).
 Cost Classification

Semi-variable costs are those which are partly fixed and partly
variable (Repairs of building).

Labour might be a semi-variable cost.

If you produce more cars, you need to employ more workers;
this is a variable cost.
However, even if you didn’t produce any cars, you may still need
some workers to look after empty factory.

Total Costs (TC) = Fixed + Variable Costs

 Cost Classification
Total cost is sum of fixed and variable costs.

Variable costs change according to quantity of a good or service being

produced.
Amount of materials and labor that is needed for to make a good
increases in direct proportion to the number of goods produced.
Cost “varies” according to production.

Fixed costs are independent of quanity of goods or services produced.

Fixed costs (also referred to as overhead costs) tend to be time related
costs including salaries or monthly rental fees.

Fixed costs are only short term and do change over time.
Long run is sufficient time of all short-run inputs that are fixed to
become variable.
Total cost = Total fixed costs + Total variable costs
Short Run

Long Run
 Cost Classification
According to Controllability:
Costs may be subdivided into two broad categories according to
performance done by any member of firm.
They are:
(i) Controllable Costs; and
(ii) Uncontrollable Costs.
• Controllable Costs are those costs which may be influenced by
decision taken by a specified member of the administration of firm
or, costs which at least partly depend on management and is
controllable by them, e.g. all direct costs, direct material, direct
labour and chargeable expenses (components of Prime Cost) are
controllable by lower management level and is done accordingly.
• Uncontrollable Costs are those which are not influenced by actions
taken by any specific member of management. For example, fixed
costs, viz., rent of building, payment for salaries etc.
 Cost Classification

According to Normality:

Under this condition, costs are classified according to the normal needs
for a given level of output for a normal level of activity produced for
such output.
Divided into:
(i) Normal Costs; and
(ii) Abnormal Costs.

Normal Costs are those costs which are normally required for a normal
production at a given level of output and which is a part of production.
Abnormal Costs, on the other hand, are those costs which are not
normally required for a given level of output to be produced normally,
or which is not a part of cost of production.
 Cost Classification
According to Time:
Costs may also be classified according to time element in it.
Accordingly, costs are classified into:
(i) Historical Costs; and
(ii) Predetermined Costs.

Historical Costs are those costs which are taken into consideration
after they have been incurred. This is possible particularly when
production of a particular unit of output has already been made. They
have only historical value and cannot assist in controlling costs.

Predetermined Costs are estimated costs. Such costs are computed in

advanced on basis of past experience and records. It becomes
standard cost if it is determined on scientific basis. When such
standard costs are compared with actual costs, reasons of variance
will help management to take proper steps for reconciliation.
 Cost Classification
According to Traceability:
Costs can be identified with a particular product, process,
department etc. They are divided into:
(i) Direct (Traceable) Costs; and
(ii) Indirect (Non-Traceable) Costs.
Direct/Traceable Costs are those costs which can directly be
traced or allocated to a product, (it includes all traceable
costs, viz., all expenses relating to cost of raw materials,
labour and other service utilised which can be traced easily).
Indirect/Non-Traceable Costs are those costs which cannot
directly be traced or allocated to a product(it includes all
non-traceable costs, e.g. salary of store-keepers, general
administrative expenses, i.e. which cannot properly be
allocated directly to a product. )
 Cost Classification
According to Planning and Control:
Costs may also be classified into:
(i) Budgeted Costs; and
(ii) Standard Costs.
Budgeted Costs refer to expected cost of manufacture computed
on basis of information available in advance of actual production
or purchase. Practically, budgeted costs include standard costs,
both are predetermined costs and their amount may coincide but
their objectives are different.
Standard Costs, is a predetermination of what actual costs should
be under projected conditions serving as a basis of cost control
and, as a measure of product efficiency, when ultimately aligned
actual cost.
It supplies a medium by which effectiveness of current results can
be measured and responsibility for derivations can be placed.
 Cost Classification
Standard Costs are predetermined for each element, viz.,
material, labour and overhead.
Standard Costs include:
(i) Cost per unit is determined to make an estimated total
output for future period for:
Material;
Labour; and
Overhead.
(ii) Cost must depend on past experience and experiments and
specification of technical staff.
(iii) Cost must be expressed in terms of currency/ money value.
 Cost Classification

(i) According to Management Decisions: Costs may also be

classified as:
(a) Marginal Cost:
Marginal Cost is the cost for producing additional unit or units by
segregation of fixed costs (i.e., cost of capacity) from variable cost
(i.e. cost of production) which helps to know the profitability.
Moreover, we know, in order to increase the production, certain
expenses (fixed) may not increase at all, only some expenses
relating to materials, labour and variable expenses are increased.

Thus, the total cost so increased by the production of one unit or

more is the cost of marginal unit and the cost is known as marginal
cost or incremental cost.
 Cost Classification
(b) Differential Cost:

Differential Cost is that portion of cost of a function

attributable to and identifiable with an added
feature,
i.e. change in costs as a result of change in level of
activity or method of production.
 Cost Classification
(c) Opportunity Cost:
Prospective change in cost following adoption of an alternative
machine, process, raw materials, specification or operation.
Maximum possible alternative earnings which might have been
earned if existing capacity had been changed to some other
alternative way.

(d) Replacement Cost:

Cost, at current prices, in a particular locality or market area,
of replacing an item of property or a group of assets.
 Cost Classification
(e) Implied Cost:
Cost used to indicate presence of arbitrary or subjective
elements of product cost having more than usual
significance. Also called notional cost, e.g., interest on
capital —although no interest is paid. This is particularly
useful while decisions are taken regarding alternative
capital investment projects.
(f) Sunk Cost:
Past cost arising out of a decision which cannot be revised
now, and associated with specialised equipment’s or other
facilities not readily adaptable to present or future
purposes. Such cost is often regarded as constituting a
minor factor in decisions affecting future.
 Cost Classification
Economic Cost- Economic cost includes both actual
direct costs (accounting costs) plus opportunity
cost.

Accounting Costs –monetary outlay for producing a

certain good. Accounting costs will include your
variable and fixed costs you have to pay.
 Cost Classification
Private costs are ‘A producer's or supplier's cost of
providing goods or services.
It includes internal costs incurred for inputs, labor,
rent, and depreciation but excludes external costs
incurred as environmental damage (unless the
producer or supplier is liable to pay for them).’

Private costs for a producer of a good, service, or

activity include costs firm pays to purchase capital
equipment, hire labor, and buy materials or other
inputs.
 Cost Classification
Private costs to firms or individuals do not always
equate with total cost to society for a product,
service, or activity.

Difference between private costs and total costs to

society of a product, service, or activity is called an
external cost; (pollution is an external cost of many
products.)

Private Costs + External Costs = Social Costs

If external costs > 0, then private costs < social costs.

 Cost Classification
External costs, are not reflected on firms' income statements or in
consumers' decisions.
However, external costs remain costs to society, regardless of who pays
for them.
Consider a firm that attempts to save money by not installing water
pollution control equipment.

Because of firm's actions, cities located down river will have to pay to
clean water before it is fit for drinking, public may find that
recreational use of the river is restricted, and fishing industry may be
harmed.

When external costs like these exist, they must be added to private
costs to determine social costs and to ensure that a socially efficient
rate of output is generated.
 Cost Classification
Social costs include both private costs and any other
external costs to society arising from production or
consumption of a good or service.

Social costs will differ from private costs, for example,

if a producer can avoid cost of air pollution control
equipment allowing the firm's production to imposes
costs (health or environmental degradation) on other
parties that are adversely affected by air pollution.
 Cost Classification
Social costs include all these private costs (fuel, oil, maintenance,
insurance, depreciation, and operator's driving time) and also
cost experienced by people other than operator who are exposed
to congestion and air pollution resulting from the use of car.

Social cost refers to cost of producing a commodity to society as a

whole.
It takes into consideration all those costs, which are borne by
society directly or indirectly.
Social cost is not borne by firm.
It is rather passed on to persons not involved in activity in the
direct way.
Social cost is a much broader concept.
 Cost Control
A process which focuses on controlling total cost through competitive
analysis. It is a practice which works to maintain actual cost in
agreement with established norms. It ensures that cost incurred on
an operation should not go beyond pre-determined cost.

A chain of functions, which starts from preparation of budget in

relation to operation, thereafter evaluating actual performance, next
is to compute variances between actual cost & budgeted cost and
further, to find out reasons for same, finally to implement necessary
actions for correcting discrepancies.

Major techniques used in cost control are standard costing and

budgetary control.
It is a continuous process as it helps in analysing causes for variances
which control wastage of material, any embezzlement and so on.
 Cost Reduction
Cost Reduction is a process, aims at lowering the unit cost of a product
manufactured or service rendered without affecting its quality by using new and
improved methods and techniques.
It ascertains substitute ways to reduce the cost of a unit.
It ensures savings in per unit cost and maximisation of profits of the organisation.

Cost Reduction aims at cutting off the unnecessary expenses which occur during
the production, storing, selling and distribution of the product.

To identify cost reduction, following are major elements:

•Savings in per unit cost.

•No compromise with quality of the product.
•Savings are non-volatile in nature.

Tools of cost reduction are Quality operation and research, Improvement in

product design, Job Evaluation & merit rating, variety reduction, etc.
 Cost Control and Cost Reduction

Major concern of enterprise is to maximize profit, which is

possible only through decreasing the cost of production.

Two efficient tools are used by management, i.e. cost

control and cost reduction.
Cost Control is a technique which provides necessary
information to management that actual costs are aligned
with budgeted costs or not.
Conversely, Cost Reduction is a technique used to save the
unit cost of product without compromising its quality.
While cost control, regulates action to keep the cost
elements within set limits, cost reduction refers to actual
permanent reduction in unit cost.
 Cost Control and Cost Reduction
These are two different concepts
Cost control is achieving the cost target as its objective while cost
reduction is directed to explore the possibilities of improving the
targets or company profitability.

Cost control will end the exercise when achieved the organization
target or objective. While cost reduction is a continuous process and
it has no visible end.

Cost control tries to attain the lowest possible cost under existing
conditions whereas cost reduction does not recognize any condition
as permanent since a change will result in lowering the cost.

Cost control emphasis is on past and present, while the cost

reduction emphasis is on the present and future.
 Cost Control and Cost Reduction
Cost control ensuring costs is in accordance with
established standards

Cost reduction is concerned with try to improve cost

by continuous and without accordance with any of
standard
 Cost Function
Considering time period cost function can be
classified as

(1) short-run cost function and

(2) long-run cost function.

Short-run is defined as that period during which the

physical capacity of the firm is fixed and the output
can be increased only by using the existing capacity
 Cost Function
Cost-Output Relation in Short Run or
Short Run Cost Curves:
Time element plays an important role in price
determination of a firm.
During short period two types of factors are employed.
One is fixed factor while others are variable factors of
production.
Fixed factor of production remains constant while with
the increase in production,
we can change variable inputs only because time is
short in which all the factors cannot be varied
 Short Run Total Costs
Short run total costs of a firm

(1) Total Costs:

(2) Total Variable Costs
(3) Total Fixed Costs
 Short Run Total Costs
Total fixed cost remain constant when the
production is zero or its is increasing while total
variable cost is zero when production is zero and
it changes with the change in output and total
cost is the aggregate of total fixed cost and total
variable cost
[Total cost (TC) = Total fixed cost (TFC) + Total
variable cost (TVC) ]
Total costs change due to change in the total
variable costs only during short period because
total fixed costs (TFC) remain constant.
 Short Run Costs
During short period average costs or per unit costs
can be divided into following categories:

(1) Average fixed costs (AFC)

(2) Average variable costs (AVC)
(3) Average Costs (AC)

(4) Marginal Cost (MC).

 A. Short Run Total Costs
Short run costs are accumulated in real time throughout
the production process.
Fixed costs have no impact of short run costs, only variable
costs and revenues affect the short run production.
Variable costs change with the output.
Examples of variable costs include employee wages and
costs of raw materials.
Short run costs increase or decrease based on variable cost
as well as the rate of production.
If a firm manages its short run costs well over time, it will
be more likely to succeed in reaching the desired long run
costs and goals
 Marginal Cost and Average Cost
Average Total Cost is sum of average variable cost and average fixed
cost.
Average cost is equal to total cost divided by the number of units
produced. (ATC = TC/Q )

Marginal Cost is addition made to total cost by producing 1

additional unit of output.

Marginal Cost = Total cost of nth unit - Total cost of (n-1)th unit.
MC = TCn – TCn-1
(e.g. – MC of 6 th unit = Total cost of 6th unit – Total cost of 5th unit)

Marginal cost - change in total cost (∆TC) due to change in quantity

produced(∆Q). MC = ∆TC/∆Q
 Total, Marginal Cost and Average Cost
Quantity of Total Cost MC = TCn – TCn- AC = TC/ Q
Output 1
0 20 20 -
1 30 10 30
2 38 8 19
3 45 7 15
4 50 5 12.5
5 57 7 11.4
6 68 11 11.3
7 80 12 11.45
8 96 16 12
9 114 18 12.7
10 135 21 13.5
Relationship between Marginal , Average and Total Cost

Whenever marginal cost is less than average total

cost, average total cost is falling.
Whenever marginal cost is greater than average
total cost, average total cost is rising.
Marginal-cost curve crosses average-total-cost
curve at efficient scale. (Efficient scale is quantity
that minimizes average total cost
Three Important Properties of Cost Curves are
1. Marginal cost eventually rises with quantity of
output.
2. Average-total-cost curve is U-shaped.
3. Marginal-cost curve crosses average-total-cost
curve at minimum of average total cost.
Short Run Costs-Marginal , Average and Total Cost

Units of TFC AFC AVC ATC (AFC MC

Output TVC TC (TFC + (TFC/0P) (TVC/0P) + AVC) or  
      TVC)     (TC/0)  
  (RS.) (RS.) (RS.) (RS.) (RS.) (RS.)  
(RS.)

1 200 180 380 200 180 380 180

2 200 300 500 100 150 250 120
3 200 400 600 66.7 133.3 200 100
4 200 520 720 50 130 180 120
5 200 650 850 40 130 170 130
6 200 820 1020 33.3 136.7 170 170
7 200 1060 1260 28.6 151.4 180 240
8 200 1400 1600 25 175 200 340
 Short Run Costs- Average
Cost-output relationship can also be shown better by short
run output cost curves.

Average fixed cost curve (AFC Curve) falls as output rises

from lower levels to higher levels.

Average variable cost curve (AVC curve), First falls and then
rises so also that average total cost curve (ATC curve).

However, AVC curve starts rising earlier than the ATC curve.
 Relation between Average and Marginal
When average declines,
Marginal is less than
average.

Marginal When average increases,

Marginal Marginal is greater than

Average
average.

Marginal When average remains

constant (minimum or
maximum),
Marginal cost equals the
average cost.
 Short Run Costs-Marginal and Average
Another important point to be noted is that in Figure, marginal cost
curve (MC curve) intersects both AVC curve and ATC curve at their
minimum points.

Explanation
If marginal cost (MC) is less than the average cost (AC), it will pull AC
down.
If the MC is greater than AC, it will pull AC up.
If the MC is equal to AC, it will neither pull Ac up nor down.

Hence MC curve tends to intersect the AC curve at its lowest point.

Similar is position about average variable cost curve.

It will not make any difference whether MC is going up or down

Marginal and Average Costs
Total cost = Total fixed costs + Total variable costs
Short Run

Long Run
 Long Run Cost

Long period gives sufficient time to business managers

to change the scale of production.

All factors of production are variable.

All costs are variable costs and there is no fixed cost.

Supply of goods can be adjusted to the firms demand

because scale of production and factors of production
can be changed.
 Long Run Costs
Long run costs are accumulated when firms change production levels
over time in response to expected economic profits or losses.
In long run there are no fixed factors of production.
Land, labor, capital goods, and entrepreneurship all vary to reach long
run cost of producing a good or service.

Long run is a planning and implementation stage for producers.

They analyze current and projected state of market in order to make
production decisions.
Efficient long run costs are sustained when combination of outputs
that a firm produces results in the desired quantity of the goods at the
lowest possible cost.
Examples of long run decisions that impact a firm’s costs include
changing the quantity of production, decreasing or expanding a
company, and entering or leaving a market.
 Long Run Total Cost

Long run Total Cost (LTC) refers to minimum cost at which

given level of output can be produced.

“Long run total cost of production is the least possible cost

of producing any given level of output when all inputs are
variable.”

LTC represents least cost of different quantities of output.

LTC is always less than or equal to short run total cost, but
it is never more than short run cost.
Long Run Total Cost

As shown in Figure, short run

total costs curves; STC1, STC2,
and STC3 are shown depicting
different plant sizes.

LTC curve is made by joining

the minimum points of short
run total cost curves.

Therefore, LTC envelopes STC

curves.
 Long Run Average Cost
Long run Average Cost (LAC) is equal to long run total costs divided
by level of output.
Derivation of long run average costs is done from short run
average cost curves.
In short run, plant is fixed and each short run curve corresponds to
a particular plant. The long run average costs curve is also called
planning curve or envelope curve as it helps in making
organizational plans for expanding production and achieving
minimum cost
 Long Run Marginal Cost:
Long run Marginal Cost (LMC) is added cost of producing an
additional unit of a commodity when all inputs are variable.
This cost is derived from short run marginal cost.
On graph, LMC is derived from points of tangency between
LAC and SAC.

Relation between LMC and LAC:

When LMC < LAC, LAC falls
When LMC = LAC, LAC is constant
When LMC > LAC, LAC rises