Classification of Costs







Introduction


In order to discuss the classifications of costs, it is required to know the term cost. In economics, the term cost includes opportunity cost and the explicit or accounting cost. The accounting cost is the money spent in order to receive associated benefits. However, the accounting costs or the explicit costs can be classified into seven categories. This classification can be easily described by using the following diagram.




Figure 1: Classification of Costs 


(Source: As created by the Author)






Classification on the basis of Nature of Cost:


On the basis of nature, the cost can be classified as a direct cost and indirect cost.


Direct Cost: Direct cost can be considered as the business costs, which are directly associated with the production. As the direct costs are directly associated with the production process, and an enhancement in the production results in an enhancement in the direct cost. This change occurs proportionally. Direct material cost and direct labour cost are the basic examples of direct cost. Apart from these two, carriage inward cost is also considered as direct cost as this cost is directly associated with the direct material cost.


Indirect Cost: Indirect costs are not directly associated with the production of goods however this cost is associated with the overall business process. Salary to staffs, electricity expenses and depreciation of plant are not directly related to the production of goods and therefore, there is no such proportional relation between output and indirect costs. The indirect costs are often termed as overhead cost in costing.





Classification on the basis of Elements of Cost:


By considering the elements, the cost can be classified into three subcategories such as material cost, labour cost and overhead cost.


Material Cost: The costs incurred for purchasing material for the production process is considered as the material cost. However, there are some purchases of material for the non-productive purpose. If the material is purchased for resale or further progress into finished goods, the material cost is termed as direct material cost. On the other hand, if the material cost is incurred for other purposes, this will be considered as an indirect material cost.


Labour Cost: The labour cost is to be considered as the costs, which a business has to incur to pay its workers. In this regard, it is to be stated that the labour cost can be incurred for the production purpose or it can be paid for paying the supporting staffs. Without this cost, the raw material cannot be converted into the finished cost and therefore this element cost is quite crucial for the manufacturers.


Overhead Cost:


Apart from material cost and labour cost, some costs are there, which cannot be linked directly with the production. This kind of costs can be classified as the overhead cost. In this regard, it is to be added that the indirect material cost and the indirect labour costs are considered as the overhead cost while preparing the cost sheet or the cost schedule for a manufacturing concern.





Classification on the basis of Behaviour of Cost:


As per the behaviour of costs, there can be three categories of cost, fixed cost, variable cost and semi-variable cost.


Fixed Cost:


Costs, which do not change with the change in the production level, are classified as the fixed costs. This kind of cost remains unchanged with various production levels and due to this reason, the per unit fixed cost decreases with the increase in the production level. Rent of the office premises, salary to the accountants are the examples of the fixed costs. In this regard, it is also to be noted that the fixed costs can be of two types, operating fixed cost and financial fixed cost. However, the financial fixed costs are ignored while preparing the cost schedule for a manufacturing concern.


Variable Cost:


There are some costs, which change with the production level and this kind of costs are considered as the variable costs. For example, the material cost would rise with the enhancement in the production level. The per-unit variable cost remains the same and therefore, there exists a proportional relation between the total variable cost and the output. While preparing the flexible budget, the expected number of output is multiplied by the variable cost per unit in order to calculate the total variable cost.


Semi-Variable Cost:


Costs, which carry the characteristics of fixed cost as well as the variable costs, are considered as a semi-variable cost. The cost of a semi-variable cost item increases with production if the production reaches to a certain level. In other words, this kind of costs remain constant up to a certain level of production and after this production level it increases proportionately with the production.


The semi-variable cost can be expressed through the following formula:


Y = a + bx


Y = Total semi-variable cost


a = Total fixed cost in the semi-variable cost


b = Variable cost per unit


x = Number of units produced.


As this cost is a combination of variable and fixed cost, this is often termed as semi-fixed cost or fixed cost.





Classification on the basis of Controllability:


On the basis of controllability, the cost can be of two types; controllable cost, and uncontrollable cost.


Controllable cost:


There are some costs, which can be altered in short term. This kind of costs is considered as controllable. Training cost, advertisement cost and employee compensation are examples of controllable costs. The responsible manager can put control over the stated costs.


Uncontrollable cost:


Costs, which can be controlled, are considered as the uncontrollable costs. Rent and depreciation are the expenses which cannot be controlled by the managers of business and due to this reason; these costs are recognized as uncontrollable cost.


Classification on the basis of Function:


On the basis of function, could have five subdivisions such as production cost, administrative cost, selling and distribution cost, research and development cost and conversion cost.


Production cost:


Production costs include costs, which are directly related to manufacturing. Factory related cost such as depreciation of machines and plant, lighting expenses for factory and supervisory costs are the examples of the production costs.


Administrative Cost:


Office related costs are generally considered as the administrative cost. In other words, costs, which are incurred for office related expenses are the administrative costs. This cost is an example of indirect costs. Depreciation of office equipment, office rent and salary to the administrative staffs are the example of administrative cost.


Selling and Distribution Cost:


The cost incurred for delivering the products to the buyers, advertisement expense, salary to the sales personnel are the selling and distribution costs. This is also recognized as an indirect cost and due to this reason; this cost is often termed as the Selling and Distribution Overhead.


Research and Development Cost:


Research and Development cost is also to be considered as another crucial overhead cost that is considered while preparing the cost schedule. Research and development costs have no direct impact on the current production process and therefore, costs regarding this are considered as indirect costs. Development of software is an example of research and development cost.


Conversion Costs:


Costs related to converting raw material into finished goods are termed as the conversion cost. This particular cost has a special recognition in process costing.


Classification on the basis of Normality:


Normal Cost:


Normal costs are incurred by an organization in normal conditions or situations of the production process. Repair and maintenance cost, wages, and salaries are examples of the normal costs.


Abnormal Costs:


Abnormal costs are those costs, which are incurred due to some abnormal causes. Such a situation may be shut down of machines or abnormal loss of materials.





Classification on the basis of Computation:


Sunk Costs:


Sunk costs are those costs, which have already been incurred by an organization while producing goods. Thus, it can be said that the sunk costs cannot be incurred. Moreover, these costs can be said as the actual cost that has been incurred.


Estimated Costs:


The estimated costs can be classified as the budgeted costs. The estimation can be made with the help of the sunk costs or the actual costs.





Conclusion


From the above discussions, it can be said that the costs incurred by an organization while producing goods must be classified first in order to get rid of the problem of misstatement while preparing the cost schedule or cost sheet. In this regard, it can also be said that the classification of cost must not to be arbitrary and the basis of recognition is required to be examined before making such classification.