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Unit 2: Cost Elements and Classification

5. Overheads may be defined as the cost of indirect materials, indirect labour and such other Notes
expenses including services as cannot conveniently be charged direct to specific cost
units.

Cost Analysis and Concepts

Cost driver

A cost driver is any activity that causes a cost to be incurred.
Cost driver is a cost accounting term. A business engages in many different activities. The
cost driver for an activity is the factor that influences the amount of the resources that will be
consumed by a particular activity. A cost driver is designed to allocate the activity cost pool
(or related costs) to the cost objects.

1. The activity is the work that is done.
2. The resource is what the activity uses to do the work, i.e., people, equipment, services.
3. Resources cost money – The cost of the activity depends on the quantity of resources used
to accomplish the activity.
4. The cost object is whatever it is you wish to cost. It could be a product, service, process, job
or customer.

Example: One part of the Ace Trucking’s business operation involves making deliveries
by truck. The activity is delivering goods. The costs of this activity include the truck drivers’
wages, fuel, depreciation of the truck, insurance, etc. The quantity of the resources that will be
consumed by this activity are influenced by the number of deliveries made per year. Hence the
cost driver could be the number of deliveries.
A cost driver is the reason why the cost is incurred—in other words, the cost is incurred in
producing the driver.
Out of Stock Cost: Economic consequences of not being able to meet an internal or external
demand from the current inventory. Such costs consist of internal costs (delays, labor time
wastage, lost production, etc.) and external costs (loss of profit from lost sales, and loss of future
profit due to loss of goodwill). Also called shortages costs.

Replacement cost policy: Type of homeowners insurance policy that covers the cost to replace or
repair the building and/or personal possessions (up to the policy’s limit) which is more than the
value covered by an actual cash value policy or a market value policy.
Idle facilities cost: Costs of idle facilities or idle capacity means costs such as maintenance, repair,
housing, rent, and other related costs; e.g., property taxes, insurance, and depreciation.

Actual Cost and Opportunity Cost

Actual costs are those costs, which a firm incurs while producing or acquiring a good or service
like raw materials, labour, rent, etc. Suppose, we pay ` 150 per day to a worker whom we employ
for 10 days, then the cost of labour is ` 1500. The economists called this cost as accounting costs
because traditionally accountants have been primarily connected with collection of historical
data (that is the costs actually incurred) in reporting a firm’s financial position and in calculating
its taxes. Sometimes the actual costs are also called acquisition costs or outlay costs. On the other
hand, opportunity cost is defined as the value of a resource in its next best use. For example,
Mr. Ram is currently working with a firm and earning ` 5 lakh per year. He decides to quit his
job and start his own small business. Although, the accounting cost of Mr. Ram’s labour to his

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