Cost Classification

A) Controllable vs. Non-controllable:

1. Controllable costs are those that are under the discretion of a particular manager.
2. Noncontrollable costs are those to which another level of the organization has committed, removing the manager's discretion.

In other words, controllability is determined at different levels of the organization ; it is not inherent in the nature of a given cost.

B) Avoidable vs. Committed:

1. Avoidable costs are those that may be eliminated by not engaging in an activity or by performing it more efficiently. An example is direct materials cost, which can be saved by ceasing production.
2. Committed costs arise from holding property, plant, and equipment. Examples are insurance, real estate taxes, lease payments, and depreciation . They are by nature long-term and cannot be reduced by lowering the short-term level of production.

C) Incremental vs. Differential:

1. Incremental cost is the additional cost inherent in a given decision.
2. Differential cost is the difference in total cost between two decisions.

EXAMPLE: A company must choose between introducing two new product lines.

1. The incremental choice of the first option is the initial investment of $1.5 million; the incremental choice of the second option is the initial investment of $1.8 million.
2. The differential cost of the two choices is $300,000.

D) Engineered vs. Discretionary:

1. Engineered costs are those having a direct, observable, quantifiable cause-and effect relationship between the level of output and the quantity of resources consumed. Examples are direct materials and direct labor.
2. Discretionary costs are those characterized by an uncertainty in the degree of causation between the level of output and the quantity of resources consumed. They tend to be the subject of a periodic (e.g., annual) outlay decision. Examples are advertising and R&D costs.

E) Outlay vs. Opportunity:

1. Outlay costs require actual cash disbursements. Also called explicit, accounting, or out-of-pocket costs. An example is the tuition payment required to attend college .
2. Opportunity cost is the maximum benefit forgone by using a scarce resource for a given purpose and not for the next-best-alternative. Also called implicit cost. An example is the wages foregone by attending college instead of working full-time .
3. Economic cost is the sum of explicit and implicit costs.
4. Imputed costs are those that should be involved in decision making even though no transaction has occurred that would be routinely recognized in the accounts. They may be outlay or opportunity costs. An example is the profit lost as a result of being unable to fill orders because the inventory level is too low.

F) Relevant vs. Sunk:

1. Relevant costs are those future costs that will vary depending on the action taken. All other costs are assumed to be constant and thus have no effect on (are irrelevant to) the decision. An example is tuition that must be spent to attend a fourth year of college.
2. Sunk costs are costs either already paid or irrevocably committed to incur. Because they are unavoidable and will therefore not vary with the option chosen, they are not relevant to future decisions. An example is three years of tuition already spent. The previous three years of tuition make no difference in the decision to attend a fourth year.
3. Historical cost is the actual (explicit) price paid for an asset. Financial accountants rely heavily on it for balance sheet reporting. Because historical cost is a sunk cost, however, management accountants often find other (lrnpliclt) costs to be more useful in decision making.

G) Joint vs. Separable:
Often a manufacturing process involves processing a single input up to the point at which multiple end products become separately identifiable, called the split-off point.

1. Joint costs are those costs incurred before the split-off point, i.e., since they are not traceable to the end products, they must be allocated.
2. Separable costs are those incurred beyond the split-off point, i.e., once separate products become identifiable.
3. By-products are products of relatively small total value that are produced simultaneously from a common manufacturing process with products of greater value and quantity (joint products).

An example is petroleum refining:

1. Costs incurred in bringing crude oil to the fractionating process are joint costs. The fractionating process is the split-off point.
2. Once the oil has been refined into its separately identifiable end products (asphalt, diesel fuel, kerosene, etc .), all further costs are separable costs.
3. If selling costs are lower than disposal costs, the sludge left over after the high value products have been processed may be sold as a cheap lubricant. It is considered a by-product.

H) Normal vs. Abnormal Spoilage:

1. Normal spoilage is the spoilage that occurs under normal operating conditions. It is essentially uncontrollable in the short run. Since normal spoilage is expected under efficient operations, it is treated as a product cost, that is, it is absorbed into the cost of the good output.
2. Abnormal spoilage is spoilage that is not expected to occur under normal, efficient operating conditions. The cost of abnormal spoilage should be separately identified and reported to management. Abnormal spoilage is typically treated as a period cost (a loss) because of its unusual nature.

I) Rework, Scrap, and Waste:

1. Rework consists of end products that do not meet standards of salability but can be brought to salable condition with additional effort. The decision to rework or discard is based on whether the marginal revenue to be gained from selling the reworked units exceeds the marginal cost of performing the rework.
2. Scrap consists of raw material left over from the production cycle but still usable for purposes other than those for which it was originally intended. Scrap may be used for a different production process or may be sold to outside customers, usually for a nominal amount.
3. Waste consists of raw material left over from the production cycle for which there is no further use. Waste is not salable at any price and must be discarded.

J) Other Costs:

1. Carrying costs are the costs of storing or holding inventory. Examples include the cost of capital, insurance, warehousing, breakage, and obsolescence.
2. Transferred-in costs are those incurred in a preceding department and received in a subsequent department in a multi-departmental production setting.
3. Value-adding costs are the costs of activities that cannot be eliminated without reducing the quality, responsiveness, or quantity of the output required by a customer or the organization.

K) Manufacturing Capacity:

1. Normal capacity is the long-term average level of activity that will approximate demand over a period that includes seasonal, cyclical, and trend variations. Deviations in a given year will be offset in subsequent years.
2. Practical capacity is the maximum level at which output is produced efficiently. It allows for unavoidable delays in production for maintenance, holidays, etc. Use of practical capacity as a denominator value usually results in underapplied overhead because it always exceeds the actual level of use.
3. Theoretical (ideal) capacity is the maximum capacity assuming continuous operations with no holidays, downtime, etc.