MODULE 3 Cost and Classification

BUSINESS ECONOMICS
MODULE III: COST ANALYSIS

Cost
Cost is the monetary value of goods and services that producers and consumers purchase.
The concept of cost is a key concept in Economics. It refers to the amount of payment made to
acquire any goods and services. In a simpler way, the concept of cost is a financial valuation of
resources, materials, undergone risks, time and utilities consumed to purchase goods and services.
Concept of Cost:
Cost, a key concept in economics, is the monetary expense incurred ‘by organizations for various
purposes, such as acquiring resources, producing goods and services, advertising, and hiring workers.
In other words, cost can be defined as monetary expenses that are incurred by an organization for a
specified tiling or activity.
According to Institute of Cost and Work Accountants (ICWA), cost implies “measurement in
monetary terms of the amount of resources used for the purpose of production of goods or rendering
services.” In terms of manufacturing, costs refer to sum total -of monetary value of resources used in
producing or manufacturing a product. These resources can be raw material, labour, and land.
A cost comprises a number of elements, which are shown in Figure-1:
The different elements of cost (as shown in Figure-1) are explained as follows:
i. Material:
Helps in producing or manufacturing goods. Material implies a substance from which a product is
made For example, an organization requires materials, such as bricks and cement for constructing a
building.
Material is divided into two categories, which are as follows:
a. Direct Material:
Refers to a material that is directly related to a specific product, job, or process. Direct material
becomes an integral part of the finished product.
Some of the examples of direct material are as follows:
1. Timber is raw material for making furniture
2. Sugarcane for making sugar.
3. Textile for garment industry
4. Gold for making jewellery
5. Cans for tinned food and drink
b. Indirect Material: Refers to a material that is not directly related to a particular product or
activity. Such materials cannot be easily identified with the product.
The examples of indirect material are as follows:
1. Oils for lubricating machines
2. Printing and stationary items for publishing books
3. Nails for making furniture
4. Threads for manufacturing garments
ii. Labour:
Acts as an important part of production. An organization requires labour to convert raw materials into
finished goods. Labour cost is the main element of cost.
Labour can be of two types, which are discussed as follows:
a. Direct Labour:
Refers to labour that takes an active part in manufacturing a product. This type of labour is also
known as process labour, productive labour, or operating labour. The costs related to direct labour are
called direct labour costs. These costs vary directly with the change in the level of output, thus it is
referred as a variable expense.
b. Indirect Labour:
Refers to labour that is not directly related to the manufacturing of a product. The indirect labour cost
may or may not vary with the change in the volume of output. This type of labour is used in the
factory, office, and selling and distribution department.
iii. Expenses:
Refer to costs that are incurred in the production of finished goods other than material costs and
labour costs.
Expenses are further divided into two parts:
a. Direct Expenses:
Imply the expenses that are directly or easily allocated to a particular cost centre or cost units. These
expenses are called chargeable expenses. Some of the direct expenses of an organization include
acquiring machinery for special processes, fees paid to architects and consultants, and costs of patents
and royalties.
b. Indirect Expenses:
Refer to expenses that cannot be allocated to specific cost center or cost units. For example, rent,
depreciation, insurance, and taxes of building.
Classification of cost
1. Accounting costs
Accounting costs are those for which the entrepreneur pays direct cash for procuring resources for
production. These include costs of the price paid for raw materials and machines, wages paid to
workers, electricity charges, the cost incurred in hiring or purchasing a building or plot, etc.
Accounting costs are treated as expenses. Chartered accountants record them in financial statements.
2. Economic costs
There are certain costs that accounting costs disregard. These include money which the entrepreneur
forgoes but would have earned had he invested his time, efforts and investments in other ventures.
Economic costs help the entrepreneur calculate supernormal profits, i.e. profits he would earn above
the normal profits by investing in ventures other than his services to others instead of working on his
own business
3. Opportunity costs
Opportunity cost are the loss of earning due to lost opportunities.
Opportunity costs are incomes from the next best alternative that is foregone when the entrepreneur
makes certain choices.
For example, the entrepreneur could have earned a salary had he worked for others instead of
spending time on his own business. These costs calculate the missed opportunity and calculate income
that we can earn by following some other policy.
4. Direct costs
Direct costs are related to a specific process or product. They are also called traceable costs as we can
directly trace them to a particular activity, product or process.
They can vary with changes in the activity or product. Examples of direct costs include manufacturing
costs relating to production, customer acquisition costs pertaining to sales, etc.
5. Indirect costs
Indirect costs, or untraceable costs, are those which do not directly relate to a specific activity or
component of the business. For example, an increase in charges of electricity or taxes payable on
income. Although we cannot trace indirect costs, they are important because they affect overall
profitability.
6. Differential costs
The difference in total cost between two alternative is termed as differential costs.
7. Incremental costs
Cost which vary with the decision in case the choice of an alternative result in increase in total costs is
known as incremental cost. These costs are incurred when the business makes a policy decision. For
example, change of product line, acquisition of new customers, upgrade of machinery to increase
output are incremental costs.
8. Decremental costs
In case the choice results in decrease in total costs such decrease in total costs is termed as
decremental costs
9. Sunk costs
Suck costs are costs which the entrepreneur has already incurred and he cannot recover them again
now. These include money spent on advertising, conducting research, and acquiring machinery.
10. Fixed costs
Fixed costs are those which do not change with the volume of output. The business incurs them
regardless of their level of production. Examples of these include payment of rent, taxes, interest on a
loan, etc.
Examples of fixed costs
 Rent
 Interest on loans
 Insurance
 Depreciation
Fixed costs can be represented graphically and this would appear as follows:
11. Variable costs

These costs will vary depending upon the output that the business generates. Less production will cost
fewer expenses, and vice versa, the business will pay more when its production is greater. Expenses
on the purchase of raw material and payment of wages are examples of variable costs.
Example of variable costs
 Direct labour
 Raw materials and components
 Packaging costs
 Heating and lighting
Variable costs can be represented on a graph and this would appear as follows:
12. Semi variable costs - A semi-variable cost, also known as a semi-fixed cost or a mixed cost, is a
cost composed of a mixture of both fixed and variable components. Costs are fixed for a set level of
production or consumption, and become variable after this production level is exceeded. If no
production occurs, a fixed cost is often still incurred.
13. Explicit costs- explicit costs are normal business costs that appear in the general ledger and
directly affect a company's profitability. Examples of explicit costs include wages, lease payments,
utilities, raw materials, and other direct costs.
14. Implicit costs- An implicit cost is any cost that has already occurred but not necessarily shown or
reported as a separate expense. Also called imputed or implied costs .
These costs may be defined as the earnings of those employed resources which belong to owner
himself.
15. Short run costs - costs which vary with output when fixed plant and capital equipment remain the
same are short run costs
16 .Long run costs- those which vary with output when all input factors including plant and
equipment vary.

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BUSINESS ECONOMICS

MODULE III: COST ANALYSIS

11. Variable costs

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