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:
- Total Project Cost: ₹100 million
- Cost Already Spent: ₹40 million
- Future Cost to be Incurred: ₹60 million
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.
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.
Categories of Cost Classification
Costs are classified into four broad categories:
- Based on Time
- Based on Volume
- For Financial Statements
- For Decision Making
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 |
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 |
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).
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.