Basic Cost Terms

A Case Study

Case Scenario

A company has undertaken a Research & Development (R&D) project with the following cost and benefit estimates:

• Original Project Cost: ₹100 million
• Estimated Benefit (Initial): ₹160 million
• Cost Already Incurred (Year 1): ₹40 million
• Remaining Cost (Next Year): ₹60 million

However, due to changes in the market condition, the revised estimated benefit from the project has dropped to ₹90 million.

Question:- Should the company continue with the project or abandon it now?

Three key pieces of cost data:

1. Total Project Cost: ₹100 million
2. Cost Already Spent: ₹40 million
3. Future Cost to be Incurred: ₹60 million

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Rational Decision-Making

Option 1: If Abandon the Project

• Loss: ₹40 million already spent
• Future Cost Saved: ₹60 million
• Net Loss: ₹40 million (irrecoverable)

Option 2: Continue the Project

• Additional Cost: ₹60 million
• Estimated Revenue: ₹90 million
• Net Benefit: ₹90m - ₹60m = ₹30 million
• Net Loss (compared to original plan): ₹10 million (i.e., ₹40m + ₹60m - ₹90m)

Conclusion:

• Although the project is no longer profitable in total terms, continuing the project reduces the loss to ₹10 million compared to abandoning, which locks in a ₹40 million loss.
• Hence, it is rational to continue.

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Cost refers to the monetary measure of resources given up in acquiring goods or services. It represents the value of everything a company sacrifices to produce a product or deliver a service.

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Categories of Cost Classification

Costs are classified into four broad categories:

1. Based on Time
2. Based on Volume
3. For Financial Statements
4. For Decision Making

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1. Cost Based on Time

Cost Type	Description	Usage
Historical Cost	Cost incurred in the past.	Used in Financial Statements
Replacement Cost	Cost of replacing the asset or resource at current market prices.	Used in Decision Making & Insurance
Budgeted Cost	Estimated future cost used for planning.	Used for Planning & Control

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2. Cost Based on Volume

Cost behavior changes based on the level of activity or production volume.

Cost Type	Description	Example
Variable Cost	Change directly with production volume..	Material Cost in manufacturing Employee Cost in a software company
Fixed Cost	Remain constant regardless of output volume.	Rent for office space
Mixed Cost	Contain both fixed and variable components.	Salesman's salary + sales-based commission
Step Cost	Increase in steps, not gradually.	Depreciation of machines

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3. Cost Classification for Financial Statements

Financial accountants classify costs into four categories:

Cost Type	Description	Example
Expired Cost	Portion of cost that has been used.	Depreciation (shown in Income Statement)
Unexpired Cost	Portion of cost that remains unused.	Book value of a newly bought machine
Product Cost	Costs directly assigned to the product (also called Inventoriable Cost).	Raw material, labor, factory overhead
Period Cost	Costs not directly tied to production.	Rent, admin salaries, selling expenses

Note:

• Product Costs are used for inventory valuation.
• Period Costs are treated as expenses in the period incurred (non-inventoriable).

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4. Cost for Decision Making

Decision-making requires understanding which costs are relevant and which are not.

Relevant Costs

• Also called Incremental Costs or Opportunity Costs
• These costs change depending on the decision made.
• Examples:
  • Offering a discount: the reduced margin is an incremental cost.
  • Extending credit period: the lost interest income or added borrowing cost is an opportunity cost.

Sunk Costs

• Costs already incurred and cannot be recovered.
• Not relevant to future decisions.
• Example: In an R&D project, ₹40 million already spent is a sunk cost.

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