COST CONCEPT

AND ITS CLASSIFICATION

 INTRODUCTION
● What is cost ?
An amount that has to be paid or given up in order to get
something.
In business, cost is usually a monetary valuation of...
(1) effort,
(2) material,
(3) resources,
(4) time and utilities consumed,
(5) risks incurred, and
(6) opportunity.
forgone in production and delivery of a good or service.
 VARIOUS COST DETERMINANT FACTORS

● PRICE OF INPUTS
● PRODUCTIVITY AND MANAGERIAL EFFICIENCY
● TECHNOLOGY
● LEVELS OF OUTPUT

Mathematical Expression :-
C = f(Q, T, pr)
Where,
C = cost, Q= output, T= technology
and pr = price.
 CONCEPTs OF COST
The kind of cost concept to be adopted in a particular situation
depends on the business decision to be made.

So defining the concept are necessary to emphasize that cost

estimates produced by traditional financial accounting are not
appropriate for all managerial uses and that different business
problems call for different kinds of costs.
 KINDS OF COST
● Accounting(Explicit) costs
Includes all such business expenses that are recorded in the book of
accounts of a business firm as acceptable business expenses.
● Implicit costs
Implicit costs do not involve actual payment or cash outflow or reduction in
assets.
● Sunk cost
A sunk cost is an expenditure made in the past that cannot be changed and
over which management has no control.
● Historical cost
Under it assets and liabilities are recorded at their values when first
acquired. They are not then generally restated for change in values.
 CLASSIFICATION OF COSTS
The numerous different costs can be classified on the
basis of :
● Behaviour
● Use
● Influence on decision making and future planning
On the basis of identifiability with cost units , there are :
● Direct costs : Costs attributed by any product or activity or jobs or
process cost. It consists of:
○ Direct material
○ Direct labour
○ Direct expenses
● Indirect costs : Costs that are not directly accountable for any
product or activity.
 DIRECT COSTS
Direct Material Direct Labour
Materials which are Cost of remuneration of
absolutely necessary for employees of an
a product. undertaking.
For example: It consists of wages paid
to the workers which
● Clay in bricks
● Paper in books can be clearly identified
● Timber in furniture with a particular job,
product or process.
Direct Expenses
Expenses which can be
identified with or
allocated to any cost
centre or unit.It is also
called chargeable costs.
For example:
● Cost of patent
rights
● Renting a special
plant
 INDIRECT COSTS
Indirect Material Indirect Labour Indirect Expenses
Cost which cannot be Indirect labour is not All indirect costs except
conveniently identified directly engaged in the indirect material and
with individual cost production operations indirect labour.
units. They do not but only assist or help in These consists of rent,
physically become a part them insurance and repairs,
of the finished product. For example: among others.
For example: ● Supervisors,
● Nuts and bolts Inspectors
● Office stationery ● Clerk, Cleaner ,
Watchmen
Prime Cost is the aggregate of all the direct
costs.
Prime cost=Direct material+Direct labour +
Direct expenses.
Overhead Cost is the aggregate of all indirect
costs.
Overhead cost= Indirect material + Indirect
labour+Indirect expenses.
 Overhead costs
Selling and
Production Overhead Office and
distribution overhead
It is also called factory administrative
overhead Cost of promoting sales
overhead or
and retaining customers.
manufacturing overhead These overheads are of
and consists of all the general character. For example:
indirect expenses in Advertisement, samples
They include stationery,
producing goods or and free gifts, salaries of
salary of office workers
services. salesmen etc.
and legal expenses ,
among others.
 Cost Classification from Managerial Economist’s
Perspective

Basic types of costs discussed above and their

understanding fnd universal application in business
function. Managerial economist’s point of view, these
costs are categorized as:
1) Fixed cost and
2) Variable costs
 Fixed Costs

These costs do not change with the change in level of

production, that is, these do not increase or decrease
when the volume of production changes.
 Variable Costs

These costs tend to change in direct proportion to the

volume of output. Simply put, when volume of output
decreases, total variable costs also decrease and vice
versa
 Marginal Cost

Marginal cost is the change in total cost due to

a unit change in output. Simply put, it is the cost of
an additional unit of production.

M.C. is one of the most

useful techniques available to the management. It
guides the management in pricing, decision making
and assessment of proftability. It reveals the
interrelationship between cost, volume of sales and
proft.
Total Cost
Total cost is the aggregate cost of fixed costs and
variable costs

Average Cost Concept

Average cost is cost per unit of output.
Average Fixed Cost (AFC) is fixed cost per unit of output; it is equal to
TFC divided by total units of output at each level of
production output.
 Graphical presentation of Cost-Output
Relationship

● The cost-output relationship plays an important role in determining

the optimum level of production

● Knowledge of the cost-output relationship helps the manager in

cost control,profit prediction,pricing,promotion etc
The relation between cost and its determinants is technically described
as the cost function.
C= f (S, O, P, T ….)
Where;
● C= Cost (Unit or total cost)
● S= Size of plant/scale of production
● O= Output level
● P= Prices of inputs
● T= Technology
Considering the period of cost function can be
classified as:

1. Short run cost function

2. Long run cost function
 1. Cost-Output Relationship in the Short-Run
The cost concepts made use of in the cost behavior are Total cost, Average cost, and Marginal cost.

● Total cost is the actual money spent to produce a particular quantity of output. Total Cost is the
summation of Fixed Costs and Variable Costs.

TC=TFC+TVC
● Up to a certain level of production Total Fixed Cost i.e., the cost of plant, building, equipment etc,
remains fixed. But the Total Variable Cost i.e., the cost of labor, raw materials etc., vary with the
variation in output. Average cost is the total cost per unit. It can be found out as follows.­­

AC=TC/Q
● The total of Average Fixed Cost (TFC/Q) keep coming down as the production is increased and
Average Variable Cost (TVC/Q) will remain constant at any level of output.
● Marginal Cost is the addition to the total cost due to the production of an additional unit of product.
It can be arrived at by dividing the change in total cost by the change in total output.
Example:
The short-run cost-output relationship can be shown graphically as follows.
The relationship between ‘AVC’, ‘AFC’ and ‘ATC’ can be summarized up
as follows:
1. If both AFC and ‘AVC’ fall, ‘ATC’ will also fall.
2. When ‘AFC’ falls and ‘AVC’ rises
○ ‘ATC’ will fall where the drop in ‘AFC’ is more than the raise
in ‘AVC’.
○ ‘ATC’ remains constant is the drop in ‘AFC’ = rise in ‘AVC’
○ ‘ATC’ will rise where the drop in ‘AFC’ is less than the rise in
‘AVC’
2. Cost-output Relationship in the Long-Run
● Long run is a period in which all inputs are variable including ones which are
constants in short run
● In the long run firm can change its outputs according to demand
● Over a long period, the size of the plant can be changed ,unwanted
buildings can be sold,staff can be increased or reduced
● In the long-run cost-output relationship is influenced by
the law of returns to scale.
● In the long run a firm has a number of alternatives in regards to the scale of
operations. For each scale of production or plant size, the firm has an
appropriate short-run average cost curves. The short-run average cost
(SAC) curve applies to only one plant whereas the long-run average cost
(LAC) curve takes in to consideration many plants.
 The long run cost-output relationship is shown graphically
with help of ‘LCA’ curve:

The ‘LCA’ curve drawn will be tangential to the entire family of ‘SAC’ curves i.e. the ‘LAC’ curve touches each ‘SAC’ curve at one
point, and thus it is known as envelope curve.
 Application of Costing Techniques in Various
Business Organisations

Having understood various types of cost and concepts, we shall extend our
Discussion into the utility of costs by various business organisations.
It can be stated that basic concepts and principles remain the same in all these
cases. Option and selection of costing techniques are left to the individual
company’s policy. Executives have to keep in mind several aspects and
parameters
based on demand for the product, competition, product substitutes prevailing
product’s life cycle stage and soon.
Manufacturing Companies
Managers use estimates of product to develop
budget
for production, materials, labour and overhead.
Determines the selling price or sales level required
to
cover all costs.
Retail Companies
Managers use the estimated cost of merchandise
purchases to:
• Predict the gross margin, operating income and the value of the
merchandise sold.
• Make decisions about matters such as
bidding on future business
lowering or negotiating fees
dropping a service
estimate revenue
manage the organisation’s work force
Executives of the organisations
Executives use estimated product cost to:
• predict the gross margin and operating income on
sales
• Make decisions about matters such as
Dropping of a product line
Outsourcing the manufacture of a part
Bidding on a special order
Negotiating a selling price
Other costs these organizations incur include the costs
of
• Marketing
• Distribution
• Installing and repairing
• Supporting delivery of services
Ultimately a company is profitable only when its
resources from sales or services rendered exceeds all
costs.
Conclusion
The ambit of cost and costing techniques is a wide
domain in cost accounting and managerial economics.This presentation
discussed
The basic concepts and their behavior with respect to the volume of
production;
cost and volume of output analysis are essential for profit planning and cost
fixation.
THANK YOU