Cost classification means grouping costs into different categories based on common features. This helps managers understand how costs behave, how they can be controlled and how they affect decisions. Cost classification is very important in cost accounting and management accounting because it provides useful information for planning, budgeting, pricing, cost control and performance evaluation. A manufacturer, service provider or trader can take better decisions when costs are properly classified.
Classification of Costs by Behaviour:
Cost behaviour explains how a cost changes when the level of activity changes. Activity level means output, production, sales volume or any other business operation. Behaviour helps managers estimate future costs and prepare budgets.
1. Fixed Costs
Fixed costs remain constant within a given level of activity. These costs do not change even if production increases or decreases. Examples include rent of factory building, salary of permanent staff and insurance premium. These costs are time related and are not affected by short term changes. Even if a company produces nothing during a month, fixed costs must still be paid. Managers study fixed costs to understand the minimum financial commitment of the business.
2. Variable Costs
Variable costs change in direct proportion to the level of activity. When production increases, variable cost increases and when production decreases, variable cost decreases. Examples include direct materials, direct labour and power used for operating machines. The cost per unit usually remains the same, but the total cost changes. This behaviour helps managers calculate marginal cost, contribution and break even point. Study of variable costs helps in decisions related to accepting special orders and choosing profitable products.
3. Semi Variable Costs
Semi variable costs contain both fixed and variable elements. A part of the cost remains fixed while the remaining part changes with activity. For example, a telephone bill may include a fixed charge and additional charges based on usage. Similarly, machine maintenance may have a fixed amount plus a usage based amount. These costs are also called mixed costs. Managers separate the fixed and variable portions for accurate budgeting and cost analysis. Several methods like high low method and scatter graph method are used for separation.
4. Step Costs
Step costs remain constant for a certain range of activity but increase by a fixed amount when activity crosses a certain limit. For example, one supervisor may handle twenty workers. If the number of workers becomes twenty one, one more supervisor must be appointed and the cost increases suddenly. Step cost analysis helps managers know capacity limits and plan expansion in advance.
Classification of Costs by Traceability:
Traceability means how easily a cost can be identified with a specific product, department or job. It is important for cost control, pricing and profit measurement.
1. Direct Costs
Direct costs can be clearly traced to a product or job. These costs are directly related to production. Examples include direct materials used for making a product and direct labour involved in manufacturing. Direct costs vary with production and are included directly in the cost of goods. Accurate identification of direct costs helps in fixing the selling price and analysing product profitability.
2. Indirect Costs
Indirect costs cannot be directly traced to a single product. They support production but are related to more than one product or department. Examples include factory rent, maintenance expenses, indirect materials and indirect labour. These costs are also called overheads. They are collected and then allocated or distributed among different products using suitable bases like labour hours or machine hours. Proper allocation helps managers understand the true cost of production.
3. Joint Costs
Joint costs arise when more than one product is produced from the same process. For example, during the refining of crude oil, petrol, diesel and kerosene are produced together. The cost incurred till the point where products become separate is known as joint cost. It is difficult to trace it to individual products. Managers use methods like physical units method or sales value method to divide joint costs.
4. Common Costs
Common costs are incurred for the benefit of many departments or activities but cannot be identified with one specific unit. For example, salary of the factory manager is a common cost for all departments in the factory. These costs are allocated among departments using a suitable basis. Common cost study helps in departmental cost control and performance evaluation.
Classification of Costs by Controllability:
Controllability means whether a cost can be influenced by a manager or not. This classification helps evaluate performance and responsibility.
1. Controllable Costs
Controllable costs can be regulated by managers within a specific time. These costs depend on managerial decisions. Examples include direct materials, direct labour, overtime and use of supplies. Managers have power to reduce waste and increase efficiency in these costs. Controllable costs are important for responsibility accounting because managers are held responsible for controlling them.
2. Non Controllable Costs
Non controllable costs cannot be regulated by a manager in the short term. These costs depend on policies or factors beyond the manager’s control. Examples include rent, insurance and depreciation. The manager must accept these costs and cannot reduce or influence them. These costs are not used for judging a manager’s performance. Understanding these costs helps maintain fairness in performance evaluation.
3. Partially Controllable Costs
Some costs can be controlled to some extent by the manager but not fully. For example, electricity cost may depend on machine usage which the manager can control, but the rate per unit is fixed by the electricity board which cannot be controlled. Managers try to reduce such costs by improving efficiency. Identifying partially controllable costs helps in planning better control systems.
Classification of Costs by Relevance:
Relevance means whether a cost is useful for decision making. Relevant cost analysis helps managers choose the best alternative.
1. Relevant Costs
Relevant costs are costs that affect the future and differ among alternatives. These costs help in decisions like make or buy, accept or reject an order, choose a product mix and shut down or continue production. Examples include variable costs, specific fixed costs and incremental costs. Relevant costs are always future costs and linked to the decision being considered. Managers study relevant costs to choose the option that gives the best financial benefit.
2. Irrelevant Costs
Irrelevant costs are costs that do not affect decision making. These costs will remain the same regardless of the option selected. An example is rent of factory building which must be paid whether production continues or not. These costs are not considered while making decisions because they do not influence the result. Distinguishing between relevant and irrelevant costs helps avoid confusion and ensures smart decision making.
3. Sunk Costs
Sunk costs are costs that have already been incurred and cannot be recovered. These costs are past costs. For example, money spent on a machine that has already been purchased cannot be changed. Sunk costs are irrelevant for decision making. Managers should avoid being influenced by sunk costs and focus on future costs and benefits.
4. Opportunity Costs
Opportunity cost is the benefit lost when one option is chosen over another. For example, if a building is used for business, the opportunity cost is the rent that could have been earned by giving it on lease. Opportunity cost is not recorded in accounts but is important for decision making. It helps managers understand the real cost of choosing an option.
5. Differential Costs
Differential cost is the difference in total cost between two alternatives. It can be an increase or decrease. Managers use this concept while choosing between selling or further processing, replacing a machine or changing a product mix. Differential cost analysis helps understand the financial impact of each choice.
Classification of Costs by Function:
1. Manufacturing or Production Costs
Manufacturing costs are costs related to producing goods. These include direct materials, direct labour and factory overheads. The aim is to convert raw materials into finished goods. Manufacturing costs help managers understand the cost of output and maintain control over wastage and inefficiency. These costs appear in the cost of goods manufactured statement.
2. Administration Costs
Administration costs relate to the general management of the organisation. These include salaries of administrative staff, office rent, stationery, audit fees and communication expenses. These costs are necessary for overall control and smooth functioning of the business. They are indirect costs and do not directly relate to production. Managers study these costs to maintain discipline in administrative spending.
3. Selling and Distribution Costs
Selling costs are incurred for promoting and selling the product. These include advertising, sales commission and showroom expenses. Distribution costs relate to delivering products to customers. These include packing, transport, warehouse charges and loading expenses. Selling and distribution costs help increase sales and deliver goods safely to customers. Managers analyse these costs to decide pricing and control excess spending.
4. Research and Development Costs
Research and development costs are incurred for improving products and developing new products. These include expenses on experiments, product testing and research facilities. These costs help companies remain competitive and meet customer needs. Managers study these costs to understand the long term benefits of innovation.
5. Finance Costs
Finance costs relate to arranging and using funds. These include interest on loans, bank charges and other financial expenses. Companies incur these costs to run operations and make investments. Managers study finance costs to maintain proper borrowing levels and avoid excess interest burden.