Lecture -5
Classification of Costs
1] Classification by Nature
This is the analytical classification of costs. Let us divide as per their natures. So
basically there are three broad categories as per this classification, namely Labor Cost,
Materials Cost and Expenses. These heads make it easier to classify the costs in a cost
sheet. They help ascertain the total cost and determine the cost of the work-in-
progress.
Material Costs: Material costs are the costs of any materials we use in the production
of goods. We divide these costs further. For example, let’s divide material costs into
raw material costs, spare parts, costs of packaging material etc.
Labor Costs: Labor costs consists of the salary and wages paid to permanent and
temporary employees in the pursuit of the manufacturing of the goods
Expenses: All other expenses associated with making and selling the goods or
services.
2] Classification by Functions
Under this classification, costs are divided according to the function for which
they have been incurred. It includes the following:
Direct Material Cost
Direct Employee (labour) Cost
Direct Expenses
Production/ Manufacturing Overheads
Administration Overheads
Selling Overheads
Distribution Overheads
Research and Development costs etc.
3] Classification by Traceability
This aspect one of the most important classification of costs, into direct costs and
indirect costs. This classification is based on the degree of traceability to the final
product of the firm.
Direct Costs: So these are the costs which are easily identified with a specific cost
unit or cost centres. Some of the most basic examples are the materials used in the
manufacturing of a product or the labour involved with the production process.
Indirect Costs: These costs are incurred for many purposes, i.e. between many cost
centres or units. So we cannot easily identify them to one particular cost centre. Take
for example the rent of the building or the salary of the manager. We will not be able
to accurately determine how to ascertain such costs to a particular cost unit.
4] Classification by Normality
This classification determines the costs as normal costs and abnormal costs. The
norms of normal costs are the costs that usually occur at a given level of output, under
the same set of conditions in which this level of output happens.
Normal Costs: This is a part of the cost of production and a part of the costing profit
and loss. These are the costs that the firm incurs at the normal level of output in
standard conditions.
Abnormal Costs: These costs are not normally incurred at a given level of output in
conditions in which normal levels of output occur. These costs are charged to the
profit and loss account, they are not a part of the cost of production.
5] By Variability or Behaviour
Based on this classification, costs are classified into three groups viz., fixed,
variable and semi-variable.
Fixed costs– These are the costs which are incurred for a period,
and which, within certain output and turnover limits, tend to be
unaffected by fluctuations in the levels of activity (output or
turnover). They do not tend to increase or decrease with the
changes in output. For example, rent, insurance of factory
building etc., remain the same for different levels of production
Variable Costs– These costs tend to vary with the volume of
activity. Any increase in the activity results in an increase in the
variable cost and vice-versa. For example, cost of direct material,
cost of direct labour, etc.
Semi-variable costs– These costs contain both fixed and
variable components and are thus partly affected by fluctuations in the
level of activity. Examples of semi variable costs are telephone bills,
gas and electricity etc.
6] By Costs used in Managerial Decision Making or relevant cost
According to this basis, cost may be categorized as follows:
1. Pre-determined Cost - A cost which is computed in
advance before production or operations start, on the basis of
specification of all the factors affecting cost, is known as a pre-
determined cost.
2. Standard Cost - A pre-determined cost, which is
calculated from managements ‘expected standard of efficient operation’
and the relevant necessary expenditure. It may be used as a basis for
price fixation and for cost control through variance analysis.
3. Marginal Cost - The amount at any given volume of
output by which aggregate costs increases if the volume of output is
increased or decreased by one unit.
4. Estimated Cost - Kohler defines estimated cost as “the
expected cost of manufacture, or acquisition, often in terms of a unit of
product computed on the basis of information available in advance of
actual production or purchase”. Estimated costs are prospective costs
since they refer to prediction of costs.
(i) Opportunity Cost - This cost refers to the value of sacrifice
made or benefit of opportunity foregone in accepting an alternative
course of action. For example, a firm financing its expansion plan by
withdrawing money from its bank deposits. In such a case the loss of
interest on the bank deposit is the opportunity cost for carrying out the
expansion plan.
5. Out-of-pocket Cost - It is that portion of total cost, which
involves cash outflow. This cost concept is a short-run concept and is
used in decisions relating to fixation of selling price in recession,
make or buy, etc. Out–of–pocket costs can be avoided or saved if a
particular proposal under consideration is not accepted.
6. Shut down Costs - Those costs, which continue to be,
incurred even when a plant is temporarily shut-down e.g. rent, rates,
depreciation, etc. These costs cannot be eliminated with the closure of
the plant. In other words, all fixed costs, which cannot be avoided during
the temporary closure of a plant, will be known as shut down costs.
7. Sunk Costs - Historical costs incurred in the past are
known as sunk costs. They play no role in decision making in the
current period. For example, in the case of a decision relating to the
replacement of a machine, the written down value of the existing
machine is a sunk cost and therefore, not considered.