Question

How are cost classified on the financial statements, and why are such classifications useful?

How do managers use flexible budgets to set predetermined overhead rates?

Answer 1

• Cost classification can be done in various ways depending on its nature and a specific purpose. There are various types of costs classified into logical groupings. These groups are such that each and every item of cost can be classified. These classifications of costs make the cost information meaningful. It is of most importance to the management of a manufacturing concern. It is the first step towards their decision-making process relating to costs and costing.

==>> There can be various bases on which classification of costs can be done. Following are the important ones,

1. Nature of Expense: By nature of expenses, costs are classified into material, labor and expenses.

2. Relation to Cost Object – Traceability: This classification is based on the relation of cost element with the cost object. The classification is done into direct and indirect costs. The basis is cause and effect relationship between cost element and cost object or traceability of costs to its cost object.

3. Functions / Activities: Costs can also be classified into various functions / activities.

4. The behavior of Costs: The behavior of costs is seen with respect to the change in volume. On this basis, costs are classified into Fixed Costs, Variable Costs, and Semi-variable Costs.

5. The purpose of Decision Making by Management: For decision-making purpose of management, costs can be classified into various types such as opportunity cost, marginal cost, differential cost, relevant cost, imputed cost, replacement cost, sunk cost, normal/ abnormal cost, avoidable/ unavoidable costs, etc.

6. Production Process: It’s an important classification for cost accounting of different manufacturing industries. Based on the production process of the industry, costs can be classified.

-->> cost classifications useful :-

1. Profit Planning 2. Effective Cost Control 3. Fixation of Selling Prices 4. Marginal Costing and Break-Even Analysis 5. Budgetary Control 6. Proper Absorption of Overheads 7. Helpful in Decision-Making.

==>> managers use flexible budgets to set predetermined overhead rates :-

Flexible budgets are used by managers to help set predetermined OH rates by:

- allowing managers to identify the manufacturing H costs to be incurred and what the behaviors (variable, fixed, or mixed) or those costs are.

-allowing managers to separate mixed costs into their variable and fixed elements

- providing information on the budgeted costs to be incurred at various levels of activity

- providing the impacts on the predetermined fixed OH rate (or on a plant wide rate) from changing the denominator level of activity.

If an organization's departments use significantly different types of work effort or material processing, flexible budgets and predetermined OH rates generally should be computed using departmental rather than plant wide information.