Chapter 2: Calculation And Classification Of Cost ✓ Solved

Chapter 2 Calculation and Classification of Cost

Cost classification is the process of grouping costs according to their common characteristics. They are to be classified suitably to identify with cost Centre or cost unit. Following are some of the costs:

Direct and Indirect cost: Direct costs are those which can be identified with the cost Centre or cost unit, and can conveniently be wholly connected with any cost unit whereas expenses incurred on those items which are not directly chargeable to production are known as indirect costs. Salaries of timekeeper, storekeeper, and foreman are paid; expenses for running the administration are incurred. They are called indirect cost.

Historical and budgeted: Budgeted cost is determined and recorded before actual performance while historical cost is recorded after the actual performance. Budgeted cost is pre-determined cost related to future while historical cost is related to the past. Budgeted cost serves as a measure of evaluation of efficiency. Historical cost does not provide any such technique; it only indicates the total cost of product or service. Budgeted cost is more important for cost control.

Relevant and sunk cost: The term relevant means pertinent to decision at hand. Costs are relevant if they guide the executive towards the decision that harmonizes with top management’s objectives. On the other hand, a cost which was incurred in the past and is not relevant to the particular decision making is a sunk cost. It may be variable or fixed or both.

Imputed (hypothetical) and opportunity cost: These types of costs are not actually incurred but are to be considered in making decision. But in costing, they are charged while ascertaining the cost of a product. Opportunity cost means the expected return or benefit foregone in rejecting one course of action for another.

Overheads Cost Allocation: Overheads cost are allocated under various heads as follows:

• Prime Cost: The prime cost of any product comprises all direct costs. It includes direct material, direct labor, and direct expenses.
• Works Cost: Works cost represent the total of all items of expenses incurred in the manufacturing of an article.
• Cost of Production: Cost of production means prime cost plus works cost plus administrative expenses.
• Total Cost: Total costs mean the sum of all items of expenditure incurred in producing, manufacturing, and selling & distribution expenses.

Cost behavior, and Cost-volume-profit relationship: Cost behavior: Costs are defined as variable or fixed with respect to a specific activity and for a given time period. 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 period despite wide changes in the related level of total activity or volume.

Cost-Volume-Profit Analysis: The cost volume-profit analysis is the analysis of three variables, viz., cost, volume and profit. In CVP analysis an attempt is made to measure variations of costs and profit with volume. The cost volume profit analysis helps the management in profit planning.

Paper For Above Instructions

The classification and calculation of costs is a foundational concept in accounting and financial management, serving as a basis for cost control, budgeting, and financial analysis. Properly classifying costs into direct, indirect, fixed, variable, and other categories is essential for effective business decision-making and operational efficiency.

Direct and Indirect Costs

Direct costs can be specifically traced to a product, department, or project and are typically variable in nature, including expenses such as direct materials and direct labor. In contrast, indirect costs, or overheads, cannot be directly traced to a specific cost object and may include administrative salaries, rent, utilities, and equipment depreciation (Horngren et al., 2013). Proper allocation of indirect costs is critical for determining the true cost of production and profitability of products or services.

Historical and Budgeted Costs

Historical costs represent the actual costs incurred in the past periods, while budgeted costs are future projections based on past performance and estimated changes in costs and activities. Budgeted costs play a significant role in strategic planning and performance evaluation. They allow management to set financial targets and benchmarks for efficiency and cost control (Drury, 2018).

Relevant and Sunk Costs

Relevant costs are future costs that will be affected by a decision and are crucial for decision-making processes. Sunk costs, conversely, are past costs that cannot be recovered and should not influence future decision-making (Garrison et al., 2018). Understanding the distinction between these two types of costs is vital for making sound financial choices.

Opportunity Cost

Opportunity costs represent the potential benefits an individual, investor, or business misses out on when choosing one alternative over another. The concept emphasizes the cost of the next best alternative forgone when making decisions, making it essential for resource allocation and strategic planning (Mankiw, 2021).

Cost Allocation

Cost allocation is a systematic approach to dividing indirect costs among various cost objects. Allocation methods can include direct labor hours, machine hours, or predetermined overhead rates, depending on the business context (Bhimani et al., 2012). Accurately allocating costs is crucial for determining product profitability and overall business performance.

Cost-Volume-Profit Analysis

Cost-volume-profit (CVP) analysis is a crucial managerial accounting technique that helps businesses understand the relationship between costs, volume, and profits. By analyzing different cost behavior patterns, management can make informed decisions about pricing, production levels, and operational efficiencies (Turney, 2020).

Break-even Point and Profit-Volume Ratio

The break-even point (BEP) illustrates the level of sales at which total revenues equal total costs, resulting in neither profit nor loss. It is a critical metric for businesses to determine minimum sales levels required to avoid incurring losses. The calculation of BEP can be expressed in units or sales revenue, while the profit-volume ratio measures the relationship of contribution margin to sales and highlights the impact of sales changes on profitability (Noreen et al., 2014).

In summary, the chapters on cost calculation and classification provide essential insights into how businesses can manage and strategize their financial performance. Understanding these concepts allows for better forecasting, resource allocation, and overall enterprise growth.

References

• Bhimani, A., Horngren, C. T., Datar, S. M., & Rajan, M. (2012). Management and Cost Accounting. Pearson.
• Drury, C. (2018). Management and Cost Accounting. Cengage Learning.
• Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2018). Managerial Accounting. McGraw-Hill Education.
• Horngren, C. T., Sundem, G. L., & Stratton, W. O. (2013). Introduction to Management Accounting. Pearson.
• Mankiw, N. G. (2021). Principles of Economics. Cengage Learning.
• Noreen, E., Brewer, P. C., & Garrison, R. H. (2014). Managerial Accounting. McGraw-Hill Education.
• Turney, P. B. B. (2020). Common Sense Budgeting and Cost Control. Industrial Press.