Classification of Cost
The idea of cost accounting is to collect, classify, record, and suitably allocate expenditures to determine the costs of products or services. After collecting costs, these are classified to ensure their identification with cost centers or cost units.
Costs have different features or characteristics, and they are grouped or classified based on their common characteristics. The process of grouping costs based on their common characteristics is known as the classification of cost.
Different Classes of Cost
The groups that costs are classified into are known as classes.
Costs can be classified using different bases or characteristics, including element, nature, variability, controllability, normality, and function. The main classes of cost are shown in the image below.
Classification of Cost by Element
In this class, costs are categorized based on the factors they are incurred for. Based on their elements, costs may be grouped as:
- Material cost
- Labor cost
Material cost refers to the cost of commodities supplied to an undertaking (e.g., in the case of a textile mill, the cost of cotton or yarn, the cost of cotton waste to clean the machinery, the cost of dyes, the cost of finishing material, and so on).
Labor cost refers to the cost of paying employees in an undertaking, which includes salary, wages, and commission.
Expenses refer to the cost of services provided to an undertaking and include the notional cost of owned assets (e.g., rent for a building, telephone expenses, depreciation of the owned factory building, depreciation of delivery van, and so on).
Classification of Cost by Nature
In this class, costs are classified based on their identifiability with cost centers or cost units. Costs can be grouped as follows based on their nature:
- Direct costs
- Indirect costs
Direct costs are costs that can be directly and easily traced to (or identified with) a product, process, or department. Common examples of direct costs include the materials used and labor employed in manufacturing an article or in a production process.
Indirect costs, on the other hand, are costs that are not traceable to any particular product, process, or department, but which are common in a number of products, processes, or departments.
Examples of indirect costs are factory rent, factory insurance, and the salary of the factory manager.
Classification of Cost by Variability or Behavior
Costs (both direct and indirect) can also be classified into the following groups based on their behavior relative to changes in the volume of activity:
Variable costs are costs that vary in a directly proportional way to changes in the volume of output or sales. These costs tend to increase or decrease with the rise and fall in production or sales. Variable costs vary in total but their per-unit cost stays the same.
Examples of variable costs are direct material cost, direct wages, direct expenses, consumable stores, and commission on sales.
Fixed costs are costs that generally remain unaffected by changes in sales volume/output. Fixed costs remain unchanged when output or sales increase or decrease. These costs remain fixed in total but their per-unit cost changes with output or sales.
These costs depend mainly on the passage of time and do not vary directly with the changes in the volume of output or sales. Typical examples of fixed costs include rent, rates, taxes, insurance charges, and salaries for managers.
It is worth remembering that fixed costs are not absolutely fixed for all of time. In fact, fixed costs are fixed only in relation to a particular level of production capacity.
Semi-variable costs are costs that tend to vary with changes in the volume of output or sales, but which do not vary in a directly proportional way relative to such changes. These costs have the characteristics of both fixed and variable costs.
One part of semi-variable costs remains constant irrespective of changes in the volume of output or sales. By contrast, the other part varies in proportion to changes in the volume of output or sales.
Typical examples of semi-variable costs include repairs and maintenance costs for plants, machinery, and buildings and supervisor salaries.
Cost Classification by Controllability
Under this category, costs are classified based on whether or not they are influenced by the action of a given member of an undertaking. The classes of costs are:
- Controllable costs
- Uncontrollable costs
Controllable costs are costs that an entity in an undertaking can influence through their action. An undertaking is usually divided into several departments or cost centers that are placed under the direct control and supervision of specified persons.
The person in charge of a particular department or cost center can control only those costs that come directly under their control.
Uncontrollable costs, on the other hand, are costs that cannot be influenced by the action of a specified member of an undertaking. Costs that are controllable for one person may be uncontrollable for another person.
Therefore, the issue of whether a cost is controllable or uncontrollable is determined by the individual or level of management in question.
Cost Classification by Normality
In this category, costs are classified based on whether they are normally incurred at a particular level of output under the conditions for which that level of output is normally attained. Based on normality, costs may be classified as:
- Normal or unavoidable costs
- Abnormal or avoidable costs
Normal or unavoidable costs are normally incurred at a given level of output under the conditions for which that level of output is normally attained. Costs of this kind cannot be avoided at all.
The cost of normal spoilage of materials and the cost of normal idle time are typical examples of normal costs.
Abnormal or avoidable costs are costs that are not normally incurred at a given level of output under the conditions for which that level of output is attained.
It is possible to avoid such costs if proper care is taken. The cost of spoilage of material over and above the normal limit is an example of an abnormal cost.
Cost Classification by Function
Costs can also be classified based on their perceived function. The following types of cost exist by function:
- Production costs
- Administration costs
- Selling costs
- Distribution costs
Production costs refer to costs that arise in the course of acquiring, processing, and using raw materials. Production costs include the cost of materials, cost of labor, other factory expenses, and the cost of primary packing.
Administration costs are the costs incurred in formulating business policies, directing the organization, and controlling the operations of an undertaking. Administration costs are not related to research, development, production, distribution, or selling activities.
Selling costs are incurred to create and stimulate demand and secure orders. As such, these costs are incurred in connection with the marketing of products.
Distribution costs are associated with the sequence of operations. This sequence starts with dispatch preparations for the packed product and ends by facilitating the availability of the reconditioned, returned, and empty packages for re-use.
Classification by Time
From the view of time, costs can be classified as:
- Historical costs
- Predetermined costs
Historical costs are costs that are identified after they have been incurred. That is to say, they are determined after goods have been manufactured or services have been rendered.
Historical costs simply represent a post-mortem of past events, and they are useful in ascertaining profitability but not in exercising cost control.
Predetermined costs are computed in advance of production based on a specification of all the factors affecting them. Predetermined costs can be further divided into:
- Estimated costs
- Standard costs.
Estimated costs are costs that, according to investigation and analysis, are most likely to be incurred.
They are estimated in advance based on the following assumptions: firstly, that costs are more or less free to move; and secondly, that what is made is the best estimate of the cost conditions that will apply when the cost is incurred.
Standard costs refer to a predetermined cost that is calculated from the management’s standards of efficient operation and the relevant necessary expenditure.
Standard cost is established based on the assumption that costs will not be allowed to move freely but will be controlled as far as possible.
This ensures that the actual cost will be as close to the standard cost as possible, and that any disparity between actual and standard cost can be reasonably explained.
The basic difference between an estimated cost and a standard cost is that an estimated cost is a more or less reasonable assessment of what a cost will be when it is incurred. A standard cost, on the other hand, is a specification of what a cost ought to be when it is incurred.
Cost Classification by Relevance to Decision-making and Control
In this category, costs are classified based on whether they are relevant to managerial decisions. These costs are as follows:
Marginal Cost: Marginal cost is defined as “the amount at any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit.”
Marginal cost refers to the increase in total cost that results from an increase in output by one unit. Marginal cost is denoted by variable cost, and it consists of direct material cost, direct labor cost, direct expenses, and variable overheads.
Sunk Costs: Sunk costs refer to costs that have already been incurred and cannot be changed by a future decision. These costs become irrelevant costs for later decisions.
For example, if a manager decides to replace an existing machine with a new one, the amount of capital invested in the existing machine (less scrap value) will be irrecoverable and, as a result, is known as a ‘sunk cost’.
Out-of-pocket Costs: These costs represent the present or future case expenditure regarding decisions, which vary based on the nature of the decision. Management decisions are directly affected by such costs because they give rise to cash expenditure.
For example, consider a firm that has its own fleet for transporting raw materials and finished goods from one place to another. It seeks to replace these vehicles by employing public carriers.
In making this decision, the depreciation of the vehicles is not to be considered but the management must take into account the present expenditure on fuel, maintenance, and driver salaries. Such costs are treated as out-of-pocket costs.
Opportunity Costs: The opportunity cost of a product or service is measured in terms of revenue that could have been earned by applying the resources to some other use. Opportunity cost can be defined as the cost of foregoing the best alternative.
Thus, the opportunity cost of yarn produced by a composite spinning and weaving mill, which is used in the weaving section, would be the price that could have been obtained by selling the yarn in the market.
Imputed Costs: Imputed costs are costs that are not included in costs but are considered for making management decisions. These costs are hypothetical in character.
Differential Costs: Differential costs refer to the difference in total costs between two alternatives. When choosing an alternative increases total costs, such increased costs are known as incremental costs.
On the other hand, if the choice results in a decrease in total costs, such decreased costs are called decremental costs.
Shut-down Costs: Shut-down costs are costs that will still be incurred when a plant is shut down temporarily. Sometimes, the normal operations of a business must be suspended temporarily due to unfavorable market conditions, strikes, or other forces.
During the suspension of production or other activities, certain costs may still need to be incurred, and these are considered ‘shut-down costs’. Examples of shut-down costs include rent for factory premises, salaries of top management, and so on.
Postponable Costs: These are the costs that can be postponed or shifted to the future with little or no effect on the efficiency of current operations. These costs are postponable but not avoidable and must be incurred at a later stage.
The concept of a postponable cost is highly significant in the railway and transport business, where it’s possible to delay the cost of repairs and maintenance for a certain period.
In manufacturing, economic crises can also be averted by postponing certain costs. This strategy was used during the depression period.
Replacement Cost: Replacement cost is the cost of replacing an asset in the current market or at the current price.
Thus, the replacement cost of an asset is the cost that would be incurred if the asset were purchased at the current market price and not at the original purchase price.
Abandonment Costs: Abandonment refers to the complete retirement or withdrawal of a fixed asset from service or use. Fixed assets are abandoned when they are no longer serviceable.
Abandonment cost refers to the cost incurred in abandoning a fixed asset (i.e., the cost that cannot be recovered or salvaged from the abandoned asset). It is also known as abandonment loss.
Other Types of Cost
Research Cost: This refers to the cost of searching for new or improved products, new applications of materials, or new or improved methods of production.
Development Cost: This refers to the cost of the process that begins with making the decision to produce a new/improved product/method and ends with the commencement of formal production of that product/method.
Pre-production Cost: This refers to the part of the overall development cost that is incurred in making a trial production run before beginning formal production.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.