2.

Cost Classification and Analysis

2.1 The Element of cost
2.2Classification of Cost: Overhead
cost, Prime Cost
2.3 Cost Variance Analysis
2.4 Job and Process Costing
 Cost Terminologies
Cost
• A measure of what must be given in order to
obtain something
• The amount of money paid for a thing is called
a cost or cost is the amount of expenditure
incurred on a given things.
Total cost
• It is the sum of fixed costs and variable costs.
• It is also called sum costs.
Fixed cost
• The cost which are associated with fixed factors of
production like plant, land, building, equipment etc.
• It remains constant in the production process for
certain level of output capacity.
Variable costs
• Those cost which are associated with variable
factors of production and vary with change in level
of output like labour, raw materials, fuel etc.
• The difference between fixed cost and variable may
be found in only short run production process.
Sunk cost
• All the previous past cost which can not be
recovered when a firm leaves from an
industry.
• Sunk cost have no relevance to decision
making in future.
• Cost of engineering design,wages,registeraton
,license ,decoration ,depreciation etc are the
example of sunk cost.
 Opportunity cost
• The cost of best rejected opportunity to earn
return.
• It is hidden or expected cost but important for
decision making process.
• Opportunity cost is appeared due to
possibility of alternative use of scarce
resources i.e. factor inputs.
2.1 Elements of Cost
 Material cost
• The substance which is used for the
production of any things is known as material.
• The cost of raw materials, spare parts,
consumable materials (fuel, electric
,water),packing materials (carton, wrapping
paper, cardboard boxes) etc are called
material cost.
 Labor cost
• Human effort is indispensable for the
conversion of materials into final goods and
such effort is known as labor.
• Hence, all the cost of skilled and unskilled
labor employed in construction or production
process are called labor cost.
 Expenses
• Expenses include all the costs which have not
covered by material cost and labor cost.
• Therefore, it includes the cost of special design,
drawings or layouts, cost of purchasing or hiring
tools and equipments for a particular job and
maintenance cost of such tools and equipments.
• Similarly, royalty fee, training expenses,rent,
insurance, depreciation, tax, stationary, etc are
fall under this category.
 2.2 Classification of cost: Prime cost
and overhead cost
Prime cost (Direct cost)
• It is those cost which can be reasonably measured
and allocated with specific output or work
activity.
• Thus it is the aggregate of direct material cost,
direct labor cost and direct expenses.
• The labor cost, material cost and expenses costs
directly associated with a product or service or
construction activities are prime cost.
Prime cost = direct material + direct labor+ direct
expenses.
 Direct material
• it refers to material by which a product is to be
produced or manufactured. The cost of direct
material is varying according to the level of
output. For example: milk is the direct material of
butter .
• Material including component parts, specially
purchased or requisitioned(special order) for a
particular job, order or process.
• Paper in book, wood in furniture, steel in bridges,
cloth in shirts.
 Direct Labor
It refers to the amount to the workers who are
directly engaged in production of goods. It varies
directly with the output.
✔ Labor engaged in altering the condition,
conformation and composition of the product.
✔ Inspector, analysis etc. especially required for
such production,
✔ If specially identified, the wage of foremen, shop
clerks, the wages of internal transport personnel
etc.
 Direct Expenses
It refers to the expenses that are specifically
incurred by the company to produce the product.
A product cannot be produced without incurring
such expenses. It varies directly with the level of
output.
✔ Cost of special design, drawings or layout.
✔ Hire of special tools and equipments for a
particular job.
✔ Maintenance costs of such tools and equipments.
 Overhead cost (Indirect cost)
It is the indirect cost that cannot be reasonably
measured and allocated to a specific output or
work activity.
Overhead cost = indirect material cost + indirect
labor cost+ indirect expenses.
It consists all costs other direct material, direct
labor and direct expenses.
The term overhead cost is used to mean all
expenditure that are not direct cost.
 Indirect Material
• It refers to the material required to produce a product
but not directly and does not form a part of finished
product. For example: nails are used in furniture. The
cost of indirect material is not varying in direct
proportion of product.
• In strict sense, indirect material is the material that
cannot be traced in finished product like lubricants,
cotton waste, grease oils, small tools etc.
• However some minor items which enter Into
production and form part of it are conveniently
treated as indirect material such as cost of thread in
shirt making, cost of glue In card board boxes etc.
 Indirect Labor
• It refers to the amount paid to the workers who
are indirectly engaged in the production of goods.
It does not vary directly with the output.
• Labor costs that do not charged directly are
indirect labor cost. In general salaries or wages of
the following are treated as indirect labor cost;
foremen, supervisors, general labor, overtime
pay, maintenance labor charge etc.
 Indirect Expenses
• It refers to the expense that are incurred by the
organization to produce a product. But, these
expenses cannot be easily found out accurately.
For example: power used for production. It
includes;
a) Rent, rates and insurance in relation of factory.
b) Depreciation, power and fuel, repair and
maintenance of plants, machinery and buildings.
c) Others sundry expenses like first aid, light and
heating etc.
 Example 1
• Suppose that for a future period the overhead
cost is expected to be total$1,00,000 and the total
direct labor cost is expected to be
$50,000.similarly for a unit product the direct
labor cost is expected to be $60. Calculate
overhead rate per dollar of direct labor cost and
overhead cost per unit of product.
Solutions:
Total overhead cost = $1,00,000
Total direct labor cost = $50,000
Direct labor cost/unit = $60
• Hence, overhead rate = Total overhead
cost/total direct labor cost
= $1,00,000/50,000
=$2/direct labor cost
Similarly, overhead cost/unit = overhead rate
*(direct labor cost/unit)
=$2*60
=$120
 Example 2
• Following are the cost for the production of 100 badminton
racquets;
Labor rate; Rs.40/hr
Leather ; 50 meter @ Rs. 200/meter
Gut; 300 meter @ Rs. 50/meter
Graphic; 100kg. @ Rs. 200/kg
Total labor hours needed; 200 hours
Total annual factory overhead; Rs. 50,00,000
Total annual direct labor hours; 2,50,000 hours
Break down the cost into component of prime cost and
overhead cost and find out the manufacturing cost of each
racquet.
Solution:
Direct labor cost = 40 *200hours= Rs. 8000
Direct leather cost = Rs.200*50meter =
Rs.10,000
Gut cost= Rs.50*300meter= 15,000
Graphite cost = Rs.200*100 kg = Rs.20,000
Total prime cost = Rs.53,000
For the overhead cost
Factory overhead per hour cost = Total factory annual overhead
cost/total annual direct labor hours
=Rs.50,00,000/2,50,000hours
=Rs.20/hr.
Total overhead cost = factory overhead per hour cost* Total labor
hour needed
=Rs.20*200hours = Rs. 4,000
Total cost = Total prime cost + total overhead cost
=Rs.53,000+Rs.4,000= 57,000
Manufacturing cost of each racquets = total cost/total production
units
=Rs.57000/100
Rs.570/racquets
 Cost Variance Analysis
• When actual performance are recorded and
compared with the standard set, some
deviations are observed. These deviations are
popularly called variances.
• Cost variance is a way of showing the financial
performance of a project. Specifically, it is the
mathematical difference between budgeted
cost of work performed and the actual cost of
the work performed.
 • Price variance
That portion of the variance caused by the
difference between the actual and expected
price of the goods or service acquired.
Price variance = Actual quantity *(Actual
price-Standard price)
If the actual price is higher than standard price,
there is unfavorable variance. Otherwise, the
variance is favorable.
 • Quantity Variance
Quantity variance refers to the variance
resulting from the difference in the actual
quantity used and budgeted quantity as per
scheduled.
Quantity variance = standard price *(Actual
quantity – standard quantity)
If the actual quantity used is higher than the
standard quantity, the variance is unfavorable.
 Cost variance analysis consists
following steps
(a) Direct Material Cost Variance: it is the
difference between the standard cost of
direct materials specified for the output
achieved and the actual cost of the direct
material used. This is the total material cost
variance and Is the aggregate of direct
material price variance and direct material
usage variance.
(b) Direct wage variance (Direct labor variance)
Direct wage variance is the difference between the standard
direct wage specified for the activity achieved and the
actual direct wage paid. It include two basic variances.
i) Direct wage Rate variance: it is the portion of the direct
wages variance which is due to the difference between
the standard rate of pay specified and actual rate paid.
Direct Wage Rate Variance = Actual hour worked at actual rate
– Actual hour worked at standard rate
= AH(AR-SR)
AH= actual hours worked
AR = actual labor rate
SR= Standard labor rate
ii) Direct Labor Efficiency Variance: it is that portion of
the direct wages variance which is due to difference
between the standard labor hours specified for the
activity achieved and the actual labor hour expended.
Direct labor Efficiency Variance = Actual hours worked at
standard rate – standard hours worked for the actual
production at standard rate.
= SR(AH-SH) = SR(AH-AP*SH per unit)
AP = actual production units
SH per unit = Standard hours per standard unit
production.
 c)Variable Overhead Variance : it is the difference between the
actual variable overhead and the standard variable
overhead cost for the production. It includes two basic
variance.
i) Variable Overhead Expenditure variance = AH(AR-SR)
ii) Variable Overhead Efficiency Variance =
AH*SR-AP*SH per unit * SR
AH= actual hour worked
AR= Actual rate of variable overhead
SR= Standard rate of variable overhead
SH per unit = standard hours per standard unit of production
D) Fixed Overhead Variance: it is the difference
between actual fixed overhead incurred and
standard cost of the fixed overhead absorbed in
the actual output. It includes three basic
variances.
i) Fixed Overhead Expenditure Variance: it is that
portion of the overhead variance which
represents the difference between the actual
expenditure incurred and the standard or
budgeted allowance for the output achieved.