Cost Concepts and Their Application - Essay Example

Examples are number of units of output and direct labour hours (Datar, Horngren, & Foster 1999, p. 27 - 58). Costs are classified so that data obtained from them will be useful to management. Costs can be classified (1) by the nature of the cost items, (2) with respect to the accounting period, (3) by their tendency to vary with the level of activity, (4) by their relation to the product (product costing), and (5) for analysis or decision making (Datar, Horngren, & Foster 1999, p. 27 - 58; The Hong Kong University of Science and Technology 2000).

In a manufacturing concern, the two main types of cost items are manufacturing costs or factory costs and commercial expenses. Examples of manufacturing costs include direct material costs, direct labour costs, and factory overheads. Examples of commercial expenses include selling and distribution costs, administration costs, and financial costs. With respect to the accounting period, costs could be capital expenditure or revenue expenditure. Capital expenditure is intended to benefit future periods and classified as an asset.

For example, the purchase of fixed asset is a capital expenditure. Revenue expenditure benefits the current period and is classified as an expense. The distinction between capital expenditure and revenue expenditure is essential for proper matching of costs and revenues to accurately determine periodic profits. By their tendency to vary with the level of activity, costs could be classified as variable costs, fixed costs, semi-fixed costs or step costs, and semi-variable costs. Variable costs are costs that vary directly in proportion to change in activity or volume of a chosen cost object.

Fixed costs are costs that do not change with changes in level of activity or output over a certain time period or relevant range. Relevant range is defined as the range of activity over which the amount of fixed expenses and rate of variability remain unchanged. This applies to all expenses, whether they are fixed, variable, or semi-variable. Semi-fixed costs or step costs are costs fixed over a certain range of output but jump to a new level when the range is exceeded. Semi-variable costs show characteristics of both fixed and variable costs.

A minimum of some expenses has to be maintained in order to maintain operational readiness. At this level of maintenance costs are fixed. Beyond this level costs become variable. By their relation to the product (product costing), costs can be divided into direct costs and indirect costs. Direct costs are costs that can be easily traced to the cost objects. Indirect costs are costs that cannot be easily traced to the cost objects. For the purpose of analysis and decision making, costs are classified into incremental costs, differential costs, sunk costs, avoidable costs, unavoidable costs, marginal, and opportunity costs.

Incremental costs is the difference in totals between two alternatives or the addition cost of making a change, such as increasing the activity level or adding a new product line. Differential costs are costs that change in response to an action. Sunk costs are costs that have been incurred in the past and that cannot be changed. It is therefore irrelevant for decision making. Avoidable costs are costs that may be avoided if an activity is discontinued or if another alternative is adopted.

Unavoidable costs are