Cost classification is an essential aspect of managerial accounting that involves grouping costs into categories based on various criteria. One way to classify costs is on the basis of their relevance to decision-making and variability. This approach helps managers understand the behavior of costs and make informed decisions about pricing, product mix, and resource allocation. In this article, we will discuss the two types of cost classification based on relevance to decision-making and variability.
Classification of costs based on relevance to decision-making:
1. Relevant Costs: Relevant costs are costs that are directly related to a specific decision and will change as a result of that decision. These costs are also known as differential costs or incremental costs. Relevant costs help managers make informed decisions about pricing, product mix, and resource allocation. Examples of relevant costs include direct materials, direct labor, variable overheads, and opportunity costs.
For example, a company is considering whether to accept a special order from a customer at a lower price than its usual price. The relevant costs in this decision would be the incremental costs, such as the cost of direct materials, direct labor, and variable overheads that will be incurred to produce the special order. The opportunity cost of using the resources for the special order instead of for regular orders is also a relevant cost.
2. Irrelevant Costs: Irrelevant costs are costs that will not change as a result of a specific decision and are therefore not relevant to that decision. These costs are also known as sunk costs. Examples of irrelevant costs include fixed overheads, depreciation, and past costs that cannot be recovered.
For example, a company is considering whether to replace an old machine with a new one. The cost of the old machine is an irrelevant cost because it is a sunk cost and will not change regardless of the decision. The relevant costs in this decision would be the incremental costs of purchasing and installing the new machine and the incremental benefits of the new machine, such as reduced maintenance costs and increased productivity.
Classification of costs based on variability:
1. Variable Costs: Variable costs are costs that vary in direct proportion to changes in the level of activity or output. These costs increase or decrease as the volume of production or sales changes. Examples of variable costs include direct materials, direct labor, and variable overheads.
For example, if a company produces more units, it will need more direct materials and direct labor, resulting in an increase in variable costs. Similarly, if the company sells more units, it will incur more variable costs in the form of selling expenses, such as commissions.
2. Fixed Costs: Fixed costs are costs that do not vary with changes in the level of activity or output. These costs remain constant regardless of the volume of production or sales. Examples of fixed costs include rent, salaries, and depreciation.
For example, if a company produces more units, it will not incur any additional fixed costs, such as rent or salaries. Similarly, if the company sells more units, it will not incur any additional fixed costs in the form of administrative expenses, such as salaries of top management.
3. Semi-Variable Costs: Semi-variable costs are costs that have both fixed and variable components. These costs increase or decrease with changes in the level of activity or output but also have a fixed component that remains constant regardless of the volume of production or sales. Examples of semi-variable costs include utilities, maintenance, and repairs.
For example, if a company produces more units, it will incur more variable costs for utilities, such as electricity and water. However, the fixed component of the utility cost, such as the monthly service fee, remains constant regardless of the level of activity.
4. Step Costs: Step costs are costs that remain constant over a range of activity or output levels but increase or decrease in a step-like manner as the activity or output level crosses a certain threshold. Examples of step costs include setup costs, inspection costs, and maintenance costs.
For example, a company may have a certain production level at which it must hire an additional supervisor or purchase a new piece of equipment. This would result in a step increase in the cost of labor or equipment, respectively. Below the production level, the cost remains constant, but once the threshold is crossed, the cost increases in a step-like manner.
In conclusion, classifying costs based on their relevance to decision-making and variability is essential for effective managerial accounting. Relevant costs help managers make informed decisions about pricing, product mix, and resource allocation, while irrelevant costs are not considered in decision-making. Variable costs vary with changes in the level of activity or output, while fixed costs remain constant regardless of the level of activity or output. Semi-variable costs have both fixed and variable components, while step costs remain constant over a range of activity levels but increase or decrease in a step-like manner as the activity level crosses a certain threshold. By understanding the behavior of costs and how they are classified, managers can make more informed decisions and improve the financial performance of their organization.
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