Classification of Cost 2 in Detail
Classification of Cost is the process of arranging costs according to their common characteristics. It is the logical placement of like items together according to their common features.
There are different methods of classifying costs. The methods of classification depending on the purpose to be achieved. The same cost figures are classified according to the different methods depending upon requirements. The important bases of classification are:
By nature or element.
By function.
As direct or indirect.
By variability.
By controllability.
As capital and revenue.
By normality.
By time.
For making managerial decisions.
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Cost Classified by Nature or Element
One of the bases of classification is nature or element, i.e., what they are. On this basis, it is classified into three categories:
Material
Labour
Expenses
There can be further sub-classification of these; for example, material into raw material, components, maintenance material, etc.
This classification is important as it serves to find out the different elements of the cost of a product and what is the relative importance of each element in the total cost of a product. This classification helps in the estimation of the work-in-process.
Cost Classified by Function
Here costs are classified according to functions to which they relate. There are three major functional divisions in an organization:
Production
Administration
Selling and Distribution
In the cost sheet or cost statement, the total cost is split up according to the function and element.
Direct and Indirect
Direct cost is the cost that can be conveniently determined with and is paid for a particular unit of cost, i.e., job, product or process. On the other hand, the term indirect cost means that which is of general disposition and that cannot be identified with a particular unit of cost. It has to be distributed or shared.
Costs which can be directly identified with cost centres, processes or production units are direct costs.
Example: The cost of cloth in the ready-made short, wages payable to a worker who is directly involved in the production, etc.
Costs that cannot be identified with cost centres or cost units and are to be distributed on some equitable basis are indirect costs.
Example: The cost of consumable stores, the salary of a foreman or supervisor, rent of the factory, etc.
There are certain costs that can be identified with a particular unit of cost but the process of identifying them is so costly and cumbersome that it is not worthwhile to do so and therefore, they are treated as indirect costs.
Example: In the case of thread used in stitching a shirt, though it is possible to find out the amount of thread used in a particular shirt, it would not be of much importance, hence it can be treated as an indirect cost.
Such a classification is essential for cost ascertainment and cost control. All direct costs like raw material, direct wages, and expenses are considered while preparing the cost sheet. It helps in cost control through the tools of standard costing and budgeting.
Cost Classified According to Variability
Variability of cost is estimated in relation to the volume of production. Some costs vary in accordance with production while some remain constant. Under this classification, costs are classified into three groups:
Fixed cost
Variable cost
Semi-variable cost
Fixed Cost
Fixed cost is that cost that is not affected by any variation in the volume of output. The amount of fixed cost tends to remain constant for all volumes or production within the fixed capacity of the plant.
Example: Rent of the office, the salary of the factory manager remain the same even if the
production goes up or comes down.
Variable Cost
This is a cost that varies directly with variations in the volume of output. Such cost increases when the production goes up and correspondingly the cost decreases when the production declines. However, variations may not always be in the same proportion.
Semi-Variable Cost
This cost is partly variable and partly fixed. It possesses the characteristics of both the fixed and variable.
Example: Maintenance of building and plant.
Costs Classified According to Controllability
Under this basis, costs are classified with respect to the capability of controlling or not. The concept of control of cost is influenced by a specified level of managerial authority and the action of the executive in the undertaking, and if capable of control. Costs are classified as:
Controllable
Non-controllable
Controllable Cost
Controllable cost is the direct cost that includes direct labour wage, direct material cost, direct expenses and some overheads that are usually controlled by the middle-level management.
Non-Controllable Cost
Non-controllable cost is not influenced by the action of any executive in undertaking and is beyond control.
Example: Fixed expenditures like rent, salary, insurance and taxes.
Such a classification is very important for cost control and cost reduction. It depends on the management to identify the areas where the costs can be controlled and reduced.
Costs Classified as Capital and Revenue
Capital cost is the cost incurred while purchasing some assets to increase the production capacity of the business.
Example: In a steel plant, the purchase of a rolling machine is an investment. Hence, it is the capital cost.
Revenue cost is the cost that is incurred for the maintenance of the revenue earning capacity of the business.
Example: The cost of maintaining assets of the business and the cost of running the business.
Costs Classified as Normality
There are two types of costs under this classification that display the normality characteristics. They are
Normal Cost
Abnormal Cost
Normal Cost
This cost is normally incurred at a given level of output in the conditions in which that level of output is normally attained.
Abnormal Cost
This cost is incurred at a given level of output under unfavourable conditions like destruction due to fire or shutdown or machinery, etc.
The normal cost is part of the cost of production, whereas abnormal cost is excluded from the cost of production.
Costs Classified by Time
Under this classification, there are two types of costs:
Historical Cost
Predetermined cost
Historical Cost
This cost is the actual cost that is ascertained after it has been incurred. Historical costs are available only after the completion of production. Such cost figures have only historical value.
Predetermined Cost
Predetermined costs are estimated costs. These costs are determined prior to production on the basis of actual cost and the factors affecting the cost. Predetermined costs made on a more or less scientific basis result in a standard cost.
Standard costs are compared with actual costs to find out the differences or variances. These variances are analyzed and facilitate the management to take remedial actions, if necessary.
Costs Classified for Managerial Decisions
Costs under managerial decisions are classified into the following types:
Marginal Costs.
Out of Pocket Costs.
Differential Costs.
Imputed Costs.
Opportunity Costs.
Replacement Costs.
Avoidable and Unavoidable Costs.
Sunk Costs.
Conversion Costs.
Marginal Cost
It is the variable cost that comprises the major cost and variable cost. It is incurred when there is an increase in the volume of production. When there is an increase in one unit of output, the total cost is increased and this resultant increase in the total cost from the existing level to the new level is known as marginal cost.
Out of Pocket Cost
This cost arises depending upon the managerial decision to do cash expenditure for a particular operation. Example: A decision taken in order to make price fixation during trade recession or a decision taken for buying any asset.
Differential Cost
This cost is the difference in total cost that arises as result from any variation in operation. This cost is incurred when there is a change in the level pattern, method of production. It could be increment or decrement depending upon whether the operations increase cost or decrease in cost.
Imputed Cost
This cost does not involve any cash outlay and as a consequence, it is not included in the financial records. It is a hypothetical cost that is estimated only for the purpose of decision-making. For example interest on capital not payable, rent on own banking, etc.
Opportunity Cost
This cost arises when one alternative is rejected or sacrificed to use another alternative. It depends upon the managerial decision to give up on one alternative to choose something else.
Replacement Cost
This cost is incurred when an asset is purchased at the current market rate and not at the earlier market cost at which it was purchased. So this cost is related to the current market.
Avoidable and Unavoidable Cost
Avoidable costs are the costs that could have been escaped or eliminated under any given condition of performance efficiency. Unavoidable costs are the costs that are essential and could not have been escaped or eliminated from its occurrence.
Sunk Cost
This is the cost that is already acquired and which is not affected by the decision-making process. This is a historical cost and is sunk in the past. For example: when the management decides to replace old machinery then the depreciation value of the old machine is not taken into account during the decision-making process.
Conversion Cost
This cost is incurred during the process of converting raw materials into finished products. It includes both direct labour cost and manufacturing overheads.
FAQs on Cost Classification Explained
1. What is meant by cost classification in accounting?
Cost classification is the process of logically grouping costs based on their common features or characteristics. The primary purpose is to arrange cost data in a way that supports management in key functions like planning, cost control, and decision-making. Costs are categorised differently depending on the objective, for instance, by their behaviour, function, or traceability.
2. What are the primary ways to classify costs for a business?
Costs can be classified on several bases depending on the information required. The most important classifications include:
- By Nature or Element: Material, Labour, and Expenses.
- By Function: Production, Administration, and Selling & Distribution costs.
- By Behaviour or Variability: Fixed, Variable, and Semi-Variable costs.
- By Traceability: Direct and Indirect costs.
- By Controllability: Controllable and Uncontrollable costs.
- For Managerial Decisions: Opportunity Cost, Sunk Cost, Imputed Cost, etc.
3. How are costs classified based on their behaviour in relation to production volume?
Based on their behaviour, costs are classified into three types:
- Fixed Costs: These costs remain constant regardless of changes in the volume of production, like factory rent or a manager's salary.
- Variable Costs: These costs change in direct proportion to the volume of output. For example, the cost of raw materials increases as more units are produced.
- Semi-Variable Costs: These costs have both fixed and variable components. A common example is an electricity bill, which often includes a fixed monthly charge plus a variable charge based on consumption.
4. What is the difference between a direct cost and an indirect cost? Please provide an example.
The key difference lies in traceability. A direct cost can be easily and conveniently traced to a specific product or cost unit. For example, the cost of wood used to make a specific table is a direct cost. An indirect cost, often called an overhead, cannot be traced to a single product and must be allocated on a reasonable basis. An example is the salary of a factory supervisor who oversees the production of many different products.
5. How does understanding the difference between fixed and variable costs help a business manager in decision-making?
Distinguishing between fixed and variable costs is critical for several managerial decisions. It forms the basis for Break-Even Analysis, which helps determine the sales volume needed to cover all costs. This understanding also aids in setting product prices by calculating the contribution margin (Sales - Variable Costs) and in making 'make or buy' decisions by comparing the relevant costs of production versus outsourcing.
6. Why is it crucial to distinguish between controllable and uncontrollable costs for performance evaluation?
This classification is fundamental to the principle of responsibility accounting. When evaluating a manager's performance, it is fair and effective to assess them only on the costs they have the authority to influence, which are the controllable costs. Holding a manager accountable for uncontrollable costs, such as a company-wide rent increase decided by top management, would be demotivating and would not accurately reflect their operational efficiency.
7. What is the key difference between a sunk cost and an opportunity cost, and which is relevant for future decisions?
A sunk cost is a cost that has already been incurred and cannot be recovered, such as the purchase price of an old machine. It is irrelevant for future decisions. In contrast, an opportunity cost is the potential benefit that is given up when one alternative is chosen over another. For example, if you use a building you own for your business, the opportunity cost is the rent you could have earned by leasing it out. For decision-making, managers must always consider opportunity costs, while sunk costs must be ignored.
8. What are imputed costs and why are they considered in decision-making if no cash is actually spent?
Imputed costs are hypothetical or notional costs that do not involve any cash outlay but are considered to reflect the true profitability of a project. For instance, if a business operates from a building owned by the proprietor, no rent is paid. However, to assess the project's real performance, a hypothetical rent (an imputed cost) is charged to the project. This ensures that the profit figure is not overstated and allows for a fair comparison with other projects that might have to pay rent.
