Cost management is a complex process related to the cost and expenditure. It facilitates cost control and cost reduction. All types of organizations, whether manufacturing, service or trading, require management of cost to control various activities. Cost management is an internal reporting system and provides the detailed cost information that management needs to control current operations and for planning of the future. It helps management to understand the costs involved in running of the organization and in taking decision on the appropriate course of action which are based on cost efficiency and capability.
Modern cost management originated during the industrial revolution, when the complexities of running a large scale organization led to the development of systems for recording and tracking costs to help the management.
Cost management is the process for effective planning and controlling the costs involved in an organization. It is an integral part of the overall management. It is considered to be one of the most challenging tasks of the management since the performance of the organization depends on how effective is its cost management. The process of cost management involves cost sheets which are prepared taking into account various activities such as collecting, analyzing, evaluating and reporting cost statistics. Cost sheets aims at computing cost of production in a scientific manner and facilitate cost control and cost reduction. The information available in cost sheets is used for budgeting, estimating, forecasting and monitoring of the costs. By implementing an effective cost management system, overall budgeting of the organization can be brought under control.
In cost management, cost classification is basically based upon the basis of functions, activities, products, process and on internal planning and control as well as information needs of the organization. The basic elements of the cost include raw materials, fuel, stores and spares, power, water, utilities, maintenance and repairs, salaries and wages including incentives, works overheads, administrative overheads, depreciation and interest both on working capital as well as on capital. In the cost analysis credits are given for the by-products which are generated during the process.
Costs elements are usually fall into two categories. These are variable costs and fixed costs (Fig 1). Fixed costs and variable costs comprise total cost. Variable costs are those costs that vary depending on the production volume. These costs rise as production increases and fall as production decreases. Variable costs differ from fixed costs which tend to remain the same regardless of production output.
Fig 1 Fixed costs and variable costs
For an effective cost management usually three types of cost sheets are prepared. These are standard cost sheets, budget cost sheets and actual cost sheets. Standard costs are made on the basis of process capabilities i.e. consumption norms as well as fixed charges at cent percent capacity utilization level. Budget costs are prepared based on budgeted level of the performance. Actual cost sheets are based on actual performance. Budget costs and standard costs uses predetermined per unit costs such as landed cost of raw materials, consumables, stores and spares etc. Actual cost sheets uses actual data.
An important aspect of cost management is the variance analysis. Variance analysis can be done between actual cost and standard cost or budget cost. Variation analysis breaks down the variation in the costs into various components such as volume variation, material cost variation, and manpower cost variation etc. This helps the management to understand which factor is affecting most for the cost variation with the planned cost and in turn helps in taking appropriate corrective action to correct the situation.
Classification of costs
Classification of cost is the grouping of costs according to their common characteristics. The costs can be classified in the following ways.
- By the element of cost – The three basic elements of costing i.e. material, manpower and expenses.
- By nature or traceability – These are direct costs and indirect costs. Direct costs are directly attributable or traceable to cost object. These costs are assigned to the cost object. Indirect costs are those costs which are not directly attributable or traceable to cost object. Indirect costs are allocated or apportioned to the cost objects.
- By functions – There are various functions for which usually the cost is determined. For example these are production, administration, marketing, and R & D etc.
- By behavior – As per behavior the costs can be either fixed or variable. Costs are classified according to their behavior in relation to change in relation to production volume within given period of time. Fixed Costs remain fixed irrespective of changes in the production volume in given period of time. Variable costs change according to volume of production.
- By ability of control – The costs can be either controllable or uncontrollable costs. Controllable costs are those which can be controlled or influenced by a conscious action of the management while uncontrollable costs cannot be controlled or influenced by a conscious management action.
- By normality – As per this classification costs can be either normal costs or abnormal costs. Normal costs arise during routine day-to-day operations of the organization. Abnormal costs arise because of those abnormal activities which are not part of normal and routine operations. Example of such costs the costs arising out of accidents etc.
- By time – These costs are historical costs and predetermined costs. Historical costs are those costs which were incurred in the past. Predetermined costs are computed in advance on basis of factors affecting cost elements. Examples are standard costs and budget costs.
- Decision making costs: These costs are those costs which are used by the management for the purpose of decision making.
- Marginal costs – Marginal costs are defined as the change in the total costs due to change in the volume of output by one unit. They are the variable costs associated with increasing output in the short run.
- Differential costs – Differential cost is the difference in total cost that will arise from the selection of one alternative to the other.
- Opportunity costs – It is the cost which has been incurred due to the selection of an alternative course of action. It is the value of benefit sacrificed in favour of this alternative course of action.
- Relevant costs – These costs are those costs which are relevant in various decisions of the management.
- Replacement costs – These costs are those costs at which existing items of material or fixed assets can be replaced. This is the cost of replacing existing assets at present or at a future date.
- Shutdown costs – These costs are those costs which are incurred due to the shutdown of the operations. These costs are not there if the operations are continued.
- Capacity costs – These costs are normally fixed costs. These costs are those costs which are incurred by an organization for providing production, administration and selling and distribution capabilities in order to perform various functions.
- Other costs – These are those costs which do not come under a normal classification of costs.