Written by Cost classification is the process of grouping costs according to common characteristics.
It is a method of organizing costs based on specific characteristics.
In cost accounting, there are several ways in which cost can be classified. Costs may be classified:
- By nature
- By function
- By relevancy
- By controllability
- By traceability
- By behaviour
Let’s now look at the various classification of costs
Table of Contents
Cost Classification by Nature
Cost classification according to nature refers to categorizing costs based on the type of expense they represent.
It is the grouping of costs according to the natural elements of the cost.
Based on the nature of the cost, we can classify cost into material costs, labour costs and expenses.
Material costs
Material costs are the costs of materials used in the production of goods and services
They are incurred when purchasing raw materials or finished goods used in the process of producing goods and services.
Material costs are often associated with the acquisition and use of materials in the production of goods.
Examples include the cost of wood for furniture production or the cost of fabric for clothing production.
Labour costs
Labour costs are the costs of paying wages, salaries, and benefits to employees.
They are costs incurred by a company for salary and wages paid to employees involved in the production of goods and services.
Examples of labour costs include the wages paid to assembly line workers in a manufacturing plant or the salaries of the sales staff in a retail store.
Labour costs can be divided into two categories: direct labour costs and indirect labour costs.
- Direct labour costs: These are costs of workers directly involved in the production of goods or services. A good example is the wages paid to assembly line workers.
- Indirect labour costs: These are the costs of workers not directly involved in the production but are necessary for the operation of the business. An example is the salaries of administrative staff.
Expenses
Expenses include all other costs associated with making and selling goods or services that are not labour costs or material costs.
That is, they are non-labour and non-material costs incurred by a business in the course of its operations.
Examples of expenses are advertising costs, rent costs, phone costs, and insurance costs.
Cost Classification by Function
Cost classification according to function is the grouping of costs according to the functions or activities they are associated with in a business.
It is the classifying of costs according to the different functions they serve within the business.
The main categories of cost classification by functions include production costs, administration costs, selling and distribution costs, and research and development costs.
Production Costs
Production costs are real costs incurred during the production of goods and services.
They are costs incurred in the process of producing goods or services.
These costs are directly related to the production process, and they are sometimes called Manufacturing costs.
Examples of production costs are the costs of raw materials, labour costs, and factory overhead costs.
Administrative Costs
Administration costs are costs associated with the general management and administration of the organization.
These costs are crucial for the smooth running of the business, but they are not directly related to the production of goods and services.
Administrative costs include salaries of executives, accounting and legal fees, and office rent.
Marketing Costs
Marketing costs refer to the costs of promoting and selling goods or services.
They are costs associated with selling and distributing goods and services. Marketing costs are sometimes called selling and distribution costs.
Marketing costs are crucial for businesses to generate sales and revenue since they are incurred to get the products or services into the hands of the consumer.
Examples of sales and distribution expenses include salaries and commissions paid to sales representatives, transportation costs, and discounts offered to retailers and distributors.
Research and Development Costs
Research and development costs are the costs of researching and developing new products or services.
To put it in another way, R&D Costs are the costs of developing new products, and services or improving existing ones.
These costs include research expenses, salaries of research and development personnel, and costs associated with testing and prototyping.
Cost Classification by Relevancy
Cost classification according to relevancy is the categorizing of costs based on their importance or relevance to the decision-making process of the company.
So, when you classify costs according to relevancy, it means you are classifying costs based on whether or not they will be relevant to decision-making.
Based on relevancy, costs can be classified into relevant and irrelevant costs.
Relevant costs
Relevant costs are those costs that are directly related to a particular decision and will have a significant impact on the outcome.
They are future costs that will be avoided or incurred as a result of a decision.
Relevant costs are directly influenced by a decision as they change as a result of the decision or action made.
Among the best-known examples of relevant costs are costs of additional labour and costs of new equipment.
It should be noted that all variable costs are considered relevant costs, but not all fixed costs are relevant costs. Only “additional fixed costs” that happen because of a decision are considered relevant costs.
So, as long as a fixed cost remain constant within a relevant range, it is not a relevant cost.
Irrelevant Costs
Irrelevant costs are costs that do not affect the decision-making process and can be ignored.
They are costs that have already been incurred and, as a result, are considered irrelevant to decision-making.
Irrelevant costs have already been incurred, and including or excluding them from the analysis will not change the outcome of the decision.
Examples of irrelevant costs include sunk costs (costs that have already been incurred and cannot be recovered), and overhead costs that do not change based on production levels.
It’s important to note that fixed costs within a relevant range are also considered irrelevant costs.
However, any additional fixed costs that will be incurred once the relevant range is exceeded are not considered irrelevant costs.
Cost Classification by Controllability
Cost classification by controllability refers to categorizing costs based on the level of control an organization has over them.
It means classifying costs according to the degree to which they can be controlled by managers.
The two types of costs under this classification are controllable and uncontrollable costs:
Controllable Costs
Controllable costs are costs that can be influenced or controlled by the management of an organization.
They are costs that can be adjusted or modified by the management to achieve certain objectives
The main feature of controllable costs is that managers have the power to control or authorize the costs.
That is, managers can make decisions to increase or decrease them.
Controllable costs are generally related to the day-to-day operations of the organization.
Examples of controllable costs are labour and material costs.
Uncontrollable Costs
Uncontrollable costs are costs that are beyond the control of the management of an organization
They are costs that cannot be adjusted or modified by the management of an organization
These costs are generally related to external factors such as economic conditions or government regulations.
Managers cannot make decisions to increase or decrease these costs.
A good example of uncontrollable cost is tax.
Cost Classification by Traceability
Cost classification according to traceability is a method of categorizing costs based on the ease with which they can be traced to a specific product, service, or project.
There are two types of costs based on traceability, namely; direct costs and indirect costs.
Direct Costs
Direct costs are costs that can be directly traced to a specific product, service, or project.
They are directly incurred in the production or provision of a specific product or service.
Direct costs can be easily traced to a particular good, service or project.
They are typically variable costs that change in proportion to the level of production or output
Examples of direct costs are raw materials costs and labour costs.
Indirect Costs
Indirect costs are costs that cannot be directly traced to a specific product, service, or project.
These costs are necessary for the business to operate, but they are not directly related to the production or provision of a specific product or service.
Indirect costs are not directly related to the production or provision of a specific product or service.
For example, the salary of a supervisor in a manufacturing plant is an indirect cost because it cannot be directly traced to a specific product.
Similarly, administrative costs are indirect costs because they are necessary for the business to operate, but they cannot be directly linked to a specific product or service.
Cost Classification by Behaviour
Cost classification by behaviour is a method of categorizing costs based on how they change in response to changes in the level of activity of a business or organization.
In other words, it is a method of classifying costs based on how they change in relation to the level of activity or production.
According to behaviour, Costs can be classified into fixed costs, variable costs, and mixed costs.
Fixed Costs
In cost accounting, fixed costs are costs that do not change within a relevant range.
They are costs that do not vary with changes in the level of activity within a given range.
Fixed costs are incurred irrespective of the level of production or sales volume. As such, they are not directly affected by changes in the level of activity.
An example of fixed costs is the rent paid on the factory building, which remains constant within a given range, regardless of whether the company is producing or not.
However, It is important to note that fixed costs are only fixed within a given range.
Once the relevant range is attained, fixed costs increases or “step up”.
To illustrate. The rent of a factory building is usually fixed. But, if the factory expands its production capacity so that it needs to rent additional space, then the rent of the factory building will increase.
Variable Costs
Variable costs are costs that change proportionally to the level of output or production.
As production increases, the total variable costs increase, and as production decreases, variable costs decrease.
A common example of a variable cost is the cost of direct labour used to produce goods or services.
As production levels increase, more direct labour is required to produce the additional output, and the cost of direct labour increases accordingly.
Other examples of variable costs are the costs of raw materials and sales commissions.
Mixed Costs
Mixed are costs that have both fixed costs and variable costs components.
They are sometimes called semi-variable costs or semi-fixed costs
These costs change with production levels, but they also include a fixed portion that does not vary with changes in activity.
Mixed costs arise when a business incurred a cost that includes both a fixed-rate charge and an additional activity-based charge.
An example of a mixed cost is the cost of sales personnel, which includes a fixed salary and a variable commission.
The fixed salary is a constant cost that does not change regardless of the level of sales, while the commission is a variable cost that increases as sales increase.
