This series will cover different facets of cost accounting and cost management. The concepts discussed here will be beneficial not only for entrepreneurs but also for investors who want to analyse a company’s cost structure.
We will start with the different classifications of costs and then move to other concepts in later posts.
There are different ways to classify costs and we will cover some major ways in this post.
DIRECT AND INDIRECT COSTS
The classification of direct and indirect costs is based on the traceability of the source of the costs.
Raw material, direct labour costs are easier to track for a particular product or a business function whereas administrative costs, rent etc. are difficult (and/or expensive) to distribute to the products or service units. This is why raw material, direct labour can be classified as direct costs whereas administrative costs and rent as an indirect cost.
FIXED AND VARIABLE COSTS
To evaluate whether a cost is a fixed or a variable cost ask yourself a question - “ Will this cost change with the output volume of product or service?”
Costs which increase or decreases with the level of output are called variable cost. Costs which are not correlated with output volume are called fixed costs.
Note: it will be wrong to assume that fixed costs never change. Certain fixed costs are pretty unaffected to the production volume but certain fixed costs can increase in steps depending on the level of output. For example, if the production volume increases significantly, a company may have to hire new administrative personnel or lease new factory space to manage the higher production volume.
PRODUCT AND PERIOD COSTS
Product costs are costs which are part of the production process- they are included in the inventory costs, and at the end, in the Cost of Goods Sold in the Profit and Loss statement. Landed cost of raw materials, raw material storage and handling costs, labour costs associated with the production process etc. are product costs.
Period costs are costs which cannot be traced to the production process but with the time period. These costs are required to keep the business running. Examples of such costs are rent, salaries of employees who are not part of the production process, management cost etc. Most of these costs are fixed in nature i.e. they do not increase or decrease with output volume to a certain extent.
CAPITAL AND REVENUE COSTS
The idea between capital and revenue costs is whether the benefit of the cost is received in one accounting period or multiple.
If a company buys a machine which will be used for years in the production process, it does not make sense to consider the cost of the machine in one year. Rather the cost of the machine is capitalised and depreciated over several years. How long the cost of the machine can be depreciated and how the depreciation can be calculated depends on relevant tax and accounting laws.
Benefits of costs such as rent, electricity bills and salaries etc. cannot be justified to be creating benefits for more than one period. Such costs are thus expensed on one financial period.
What costs can be capitalised and which ones cannot depend on the accounting laws followed.