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Classification of Costs: Explained

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Meaning of Cost

The term cost means the economic value of expenditures for raw materials, equipment, supplies, services, labour, products, etc. It is an amount that is displayed as an expense classification in bookkeeping records.


Different Types of Cost

Any business requires an investment of capital or money. The investor or owner of the business has to keep a record of the total money he has spent for the various operations in the business. It can be for anything required to start and establish any enterprise up to gaining of the final profit. Under this topic, we will learn and identify various expenditures that are incurred while running any business endeavor. There are also different formats and categories for the classification of all costs.


First classification is in relation to the resources that the money has been spent on. It can be for raw materials, land, labour, transportation, marketing, infrastructure, communication, management, and everything else. However, all these expenses are broadly put under three types such as Labour cost, Material cost, and Expenses. It can be easily recognized by understanding the nature of the commodities obtained through the expenses. Materials are the raw materials used for the production of any final product. It includes all the expenses of packaging and value addition too. The salary and wages paid to the persons working for the manufacturing of the product is termed as Labour cost. It includes both permanent and temporary workers. However, only producing a product does complete the job of running a business. It has to be marketed and transported to the market for getting selled and returning a profit. All these expenses are categorized under expenses.


All in all the expense for producing a final product is known as Production cost. And all other expenses are termed as commercial costs.  Some have also categorized the costs into direct costs and indirect costs. The other classification is Normal cost versus Abnormal cost. Other than that there are several other costs which do not pertain to commercial operations so will be included in the subsequent chapters.


Classification of Costs

Classification of cost in economics is the classification of cost based on various factors which are discussed below. The following will be the types of cost classification.


Classification by Nature

This classification of cost is based on the nature of the expenditure, which are the three broad categories as per this, namely Labor Cost, Materials Cost, and Expenses. This cost makes it easier to classify them on a cost sheet. They help in estimating the total cost and also to estimate the work-in-progress cost.

  • Material Costs: These are the costs of any materials that are used in the production of goods. This is further divided into further costs. For instance, we can classify material costs into spare parts, raw material cost, packaging material cost, etc.

  • Labour Costs: This cost includes the salary and wages paid to temporary and permanent employees for the manufacturing of the goods.

  • Expenses: It includes all other expenses associated with manufacturing and selling the services or goods.


Classification by Functions

This is the classification based on functional costs. The cost classification by function flows the pattern of basic managerial activities. So, this cost is classified as production, administration, selling, etc. 

  • Production Costs: These costs are related to the real construction or manufacturing of the goods. 

  • Commercial Costs: This cost includes the operation of an enterprise except for the manufacturing costs. It consists of the admin costs, distribution and selling cost, etc.


Classification by Traceability

This cost is classified into direct costs and indirect costs. This classification is classified on the degree of traceability to the final product of the firm.

  • Direct Costs: These are the costs that are easily related to a specific cost unit. The most significant examples are the materials used to manufacture a product or the labour involved in the production process.

  • Indirect Costs: These costs are used for many purposes, which are between many cost centers or units. So we cannot put them to one specific cost center—for instance, the rent of the place or the manager's remuneration. We will not be able to identify how to estimate costs to a specific cost unit.


Classification by Normality

This classification is based on the costs as the normal costs and abnormal costs. The normal costs are the costs that happen at a given point of output, under the same set of conditions in which this point of output occurs.

  • Normal Costs: The cost of production and also the part of the costing profit and loss. These are the type of costs that the organization incurs at the standard level of output under normal conditions.

  • Abnormal Costs: These costs are not normally occurring at a particular level of output in conditions in which normal levels of output happen. These costs are calculated according to the profit and loss account; they are not a part of the production cost.

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FAQs on Classification of Costs: Explained

1. On what different bases are costs typically classified in cost accounting?

In cost accounting, costs are classified on several bases to aid in decision-making, control, and financial reporting. The primary bases for classification include:

  • By Nature or Element: This groups costs into Material, Labour, and Expenses.
  • By Function: Costs are categorised as Production, Administration, or Selling & Distribution costs.
  • By Behaviour: This classification depends on how costs change with the level of activity, dividing them into Fixed, Variable, and Semi-Variable costs.
  • By Traceability: Costs are classified as Direct or Indirect based on whether they can be easily traced to a specific cost unit.
  • By Normality: This distinguishes between Normal costs (expected during production) and Abnormal costs (unexpected losses).

2. What are the main types of costs when classified by their behaviour?

Classification by behaviour analyses how costs respond to changes in production volume or business activity. The three main types are:

  • Fixed Costs: These are costs that do not change in total, regardless of the level of output. Examples include factory rent, insurance, and salaries of administrative staff.
  • Variable Costs: These costs change in direct proportion to the level of output. The cost per unit remains constant, but the total cost increases as production increases. An example is the cost of raw materials.
  • Semi-Variable Costs: Also known as mixed costs, these have both a fixed and a variable component. A part of the cost remains fixed, while the other part varies with production. A common example is a telephone bill with a fixed monthly rental plus charges based on usage.

3. What is the key difference between a Direct Cost and an Indirect Cost? Please provide an example.

The key difference lies in traceability. A Direct Cost is an expense that can be directly and wholly attributed to a specific product, department, or 'cost object'. In contrast, an Indirect Cost (also called overhead) is incurred for the benefit of multiple cost objects and cannot be easily traced to a single one. For example, in a furniture workshop, the cost of wood used to make a specific table is a direct cost. The factory supervisor's salary, however, is an indirect cost because it benefits the production of all furniture, not just one table.

4. Why is the proper classification of costs so important for a business?

Properly classifying costs is crucial for effective management and strategic decision-making. Its importance stems from several key functions:

  • Cost Control: By classifying costs, management can identify areas of high expenditure, set budgets, and monitor performance to keep costs in check.
  • Pricing Decisions: Understanding the total cost (including fixed, variable, direct, and indirect costs) of a product is essential for setting a competitive and profitable selling price.
  • Performance Evaluation: Management can assess the efficiency of different departments by comparing actual costs against standard or budgeted costs.
  • Managerial Decisions: Classification helps in decisions like 'make or buy', accepting a special order, or discontinuing a product line by enabling analyses like marginal costing and break-even analysis.

5. How are costs classified according to their business function?

Functional classification groups costs based on the business operation for which they are incurred. The main categories are:

  • Production or Manufacturing Costs: These are all costs related to the manufacturing of a product, including direct materials, direct labour, and factory overheads.
  • Administration Costs: These are costs incurred for general management and administrative functions of the organisation, such as office salaries, rent, and printing expenses.
  • Selling and Distribution Costs: These are costs incurred to create demand and deliver the product to the customer. Examples include advertising costs, sales commissions, and delivery charges.

6. What is the difference between a Normal Cost and an Abnormal Cost in cost accounting?

Normal Cost is the cost that is expected to be incurred under normal operating conditions at a given level of output. It is considered a part of the total cost of production. For example, a small amount of material wastage during the cutting process is a normal cost. On the other hand, an Abnormal Cost is an unexpected or unusual cost that is not part of the normal production process. It arises from unforeseen events like accidents, fire, theft, or machinery breakdown. This cost is not included in the cost of production but is charged directly to the Costing Profit and Loss Account.

7. How does the concept of 'Product Costs' versus 'Period Costs' relate to other classifications?

Product Costs are costs that are directly associated with the production of goods. They are 'inventoriable', meaning they are included in the cost of inventory and are only expensed (as Cost of Goods Sold) when the product is sold. These costs include direct materials, direct labour, and manufacturing overhead. Period Costs are all other costs that are not product costs, such as selling and administrative expenses. They are not attached to the product and are expensed in the accounting period in which they are incurred. The key relationship is that product costs are essentially manufacturing costs (both direct and indirect), while period costs are non-manufacturing costs.