Cost Classification: How to Categorize or Classify Your Costs Based on Different Attributes or Dimensions

1. What is Cost Classification and Why is it Important?

cost classification is the process of grouping or categorizing costs based on different attributes or dimensions, such as the nature of the cost, the function of the cost, the behavior of the cost, or the relevance of the cost for decision making. Cost classification is important for various purposes, such as planning, budgeting, controlling, reporting, and analyzing costs. In this section, we will explore some of the common ways of classifying costs and their implications for managers and accountants.

Some of the common ways of classifying costs are:

1. By nature: This refers to the basic characteristics or elements of the cost, such as materials, labor, or overhead. For example, the cost of raw materials used in production is a material cost, the cost of wages paid to workers is a labor cost, and the cost of rent, utilities, and depreciation is an overhead cost. Classifying costs by nature helps to identify the sources of costs and to allocate them to different products or services.

2. By function: This refers to the activities or operations that the cost is associated with, such as production, administration, selling, or distribution. For example, the cost of materials, labor, and overhead used in the manufacturing process is a production cost, the cost of salaries, office supplies, and insurance is an administration cost, the cost of advertising, commissions, and travel is a selling cost, and the cost of transportation, warehousing, and packaging is a distribution cost. Classifying costs by function helps to measure the efficiency and profitability of different functions and to prepare financial statements.

3. By behavior: This refers to the response or change of the cost to the changes in the level of activity or output, such as fixed, variable, or mixed. For example, the cost of rent is a fixed cost, as it does not change with the changes in the output level, the cost of raw materials is a variable cost, as it changes proportionally with the changes in the output level, and the cost of electricity is a mixed cost, as it has both a fixed and a variable component. Classifying costs by behavior helps to predict the total cost at different output levels and to analyze the cost-volume-profit relationship.

4. By relevance: This refers to the usefulness or significance of the cost for decision making, such as relevant or irrelevant, differential or incremental, opportunity or sunk. For example, the cost of materials is a relevant cost, as it affects the decision to produce or buy a product, the cost of labor is a differential cost, as it differs between two alternatives, the cost of rent is an opportunity cost, as it represents the forgone benefit of using the space for another purpose, and the cost of machinery is a sunk cost, as it has already been incurred and cannot be recovered. Classifying costs by relevance helps to evaluate the economic consequences of different choices and to select the best alternative.

2. How to Distinguish Between Direct and Indirect Costs?

One of the most common ways to classify costs is by their nature, which refers to the type of resources or inputs that are consumed or used in the production process. costs can be either direct or indirect, depending on whether they can be easily traced or attributed to a specific cost object, such as a product, service, department, or project. In this section, we will explore how to distinguish between direct and indirect costs, why this distinction is important, and what are some of the challenges and limitations of this classification method.

1. Direct costs are those that can be clearly identified and measured in relation to a specific cost object. For example, the cost of raw materials, labor, and machinery used to produce a product are direct costs of that product. direct costs are usually variable, meaning they change in proportion to the level of output or activity.

2. Indirect costs are those that cannot be easily traced or allocated to a specific cost object, or that require a lot of effort and judgment to do so. For example, the cost of rent, utilities, insurance, and depreciation of the factory building are indirect costs of the products made in that factory. indirect costs are usually fixed, meaning they do not change with the level of output or activity.

3. The distinction between direct and indirect costs is important for several reasons, such as:

- It helps to determine the cost of goods sold (COGS), which is the total cost of producing and selling a product or service. COGS is calculated by adding up all the direct costs of the product or service and subtracting them from the sales revenue.

- It helps to determine the gross profit (GP), which is the difference between the sales revenue and the COGS. GP measures the profitability of a product or service before considering other expenses, such as selling, general, and administrative (SG&A) costs.

- It helps to determine the contribution margin (CM), which is the difference between the sales revenue and the variable costs (both direct and indirect) of a product or service. CM measures the amount of revenue that is left to cover the fixed costs and generate a profit.

- It helps to perform cost-volume-profit analysis (CVP), which is a technique that examines the relationship between the costs, sales volume, and profit of a product or service. CVP helps to answer questions such as: How many units must be sold to break even? How much profit will be made if the sales volume increases by 10%? How will the profit change if the price or the costs change?

4. The distinction between direct and indirect costs is not always clear-cut or consistent, and it may depend on the context and the purpose of the analysis. For example, a cost that is direct for one cost object may be indirect for another. For instance, the salary of a supervisor who oversees the production of multiple products is a direct cost of the production department, but an indirect cost of each individual product. Similarly, a cost that is indirect at one level of aggregation may be direct at another. For example, the cost of electricity for the factory is an indirect cost of the products made in that factory, but a direct cost of the factory itself. Therefore, it is important to define the cost object and the level of detail that is relevant for the analysis.

3. How to Allocate Costs to Different Activities or Processes?

One of the ways to classify costs is by their function, which means how they relate to the activities or processes of a business. This can help managers to understand how costs behave, how they affect profitability, and how they can be controlled or reduced. In this section, we will discuss the main types of cost functions, how to allocate costs to different activities or processes, and the advantages and disadvantages of this method of cost classification. Here are some of the points we will cover:

1. The main types of cost functions are production costs, administrative costs, selling and distribution costs, and finance costs. Each of these functions has different subcategories of costs, such as direct and indirect costs, fixed and variable costs, and controllable and uncontrollable costs. We will explain what these terms mean and how they apply to each function.

2. To allocate costs to different activities or processes, we need to identify the cost drivers or the factors that cause the costs to change. For example, the cost driver for direct labor costs in production is the number of labor hours worked, while the cost driver for advertising costs in selling and distribution is the number of ads placed. We will discuss how to choose the appropriate cost drivers and how to measure them accurately.

3. The advantages of cost classification by function are that it can help managers to plan and budget for the costs of each function, to evaluate the performance of each function and its subunits, and to make decisions based on the profitability and efficiency of each function. We will provide some examples of how managers can use this information for planning and decision making.

4. The disadvantages of cost classification by function are that it can overlook the interrelationships between the functions and the activities or processes, that it can ignore the value-added by each function and its subunits, and that it can create conflicts between the functions and their managers. We will discuss how these problems can arise and how they can be avoided or resolved.

4. How to Identify Fixed, Variable, and Mixed Costs?

One of the most important aspects of cost classification is understanding how costs behave in relation to changes in the level of activity or output. By analyzing the behavior of costs, managers can make better decisions about planning, budgeting, and controlling the operations of a business. In this section, we will discuss how to identify fixed, variable, and mixed costs, and how they affect the total cost of a product or service.

- Fixed costs are costs that do not change in total amount regardless of the level of activity or output. For example, rent, depreciation, insurance, and salaries are typically fixed costs. These costs are incurred even if the activity or output is zero. Fixed costs are also known as capacity costs, as they represent the cost of maintaining the capacity to produce or deliver a product or service. Fixed costs can be further classified into committed fixed costs and discretionary fixed costs. Committed fixed costs are long-term and unavoidable, such as rent or depreciation. Discretionary fixed costs are short-term and can be modified or eliminated, such as advertising or research and development.

- Variable costs are costs that change in total amount in direct proportion to changes in the level of activity or output. For example, raw materials, direct labor, and commissions are typically variable costs. These costs vary with the quantity of output produced or service delivered. variable costs are also known as operating costs, as they represent the cost of operating or producing a product or service. Variable costs can be further classified into direct variable costs and indirect variable costs. Direct variable costs are directly traceable to a specific product or service, such as raw materials or direct labor. Indirect variable costs are not directly traceable to a specific product or service, but are allocated based on some measure of activity, such as overhead or utilities.

- Mixed costs are costs that have both fixed and variable components. For example, electricity, telephone, and maintenance are typically mixed costs. These costs have a fixed base amount that is incurred regardless of the level of activity or output, and a variable amount that changes with the level of activity or output. Mixed costs are also known as semi-variable costs or semi-fixed costs. Mixed costs can be further classified into step-fixed costs and curvilinear costs. Step-fixed costs are fixed within a certain range of activity or output, but change to a different fixed amount when the activity or output exceeds or falls below that range. For example, hiring an additional supervisor when the number of workers exceeds a certain limit is a step-fixed cost. Curvilinear costs are costs that increase or decrease at a non-constant rate as the level of activity or output changes. For example, maintenance costs may increase at an increasing rate as the equipment ages or wears out.

To identify the behavior of costs, managers can use various methods, such as:

1. Account analysis: This method involves examining each account in the income statement or the cost ledger and classifying it as fixed, variable, or mixed based on the knowledge and judgment of the managers or accountants. This method is simple and quick, but it may not be very accurate or consistent, as different managers or accountants may have different opinions or assumptions about the cost behavior.

2. high-low method: This method involves identifying the highest and lowest levels of activity or output in a given period, and calculating the variable cost per unit and the fixed cost based on the difference in the total costs at these two points. This method is easy and inexpensive, but it may not be very reliable, as it only uses two data points and ignores the rest of the data. It may also be affected by outliers or extreme values in the data.

3. Scatter diagram: This method involves plotting the historical data of the total costs and the level of activity or output on a graph, and visually inspecting the pattern or trend of the data points. This method can help identify the general shape and direction of the cost behavior, and detect any outliers or anomalies in the data. However, this method does not provide a precise or mathematical estimate of the fixed and variable components of the cost.

4. Regression analysis: This method involves using a statistical technique to fit a line or a curve that best describes the relationship between the total costs and the level of activity or output, based on the historical data. This method can provide a more accurate and objective estimate of the fixed and variable components of the cost, and measure the degree of correlation or fit between the data and the line or curve. However, this method requires more data and more sophisticated tools and skills to perform the analysis.

To illustrate the concept of cost behavior, let us consider the following example:

Suppose a company produces and sells widgets. The company incurs the following costs per month:

- Rent: $10,000

- Raw materials: $5 per widget

- Direct labor: $10 per widget

- Supervision: $2,000

- Electricity: $500 + $0.50 per widget

- Maintenance: $1,000 + $0.20 per widget

The company sells each widget for $25. The company's monthly activity or output ranges from 0 to 10,000 widgets.

Using the account analysis method, we can classify the costs as follows:

- Rent: Fixed

- Raw materials: Variable

- Direct labor: Variable

- Supervision: Fixed

- Electricity: Mixed

- Maintenance: Mixed

Using the high-low method, we can estimate the variable cost per unit and the fixed cost for the mixed costs as follows:

- Electricity: The highest level of activity or output is 10,000 widgets, and the total electricity cost at this point is $5,500. The lowest level of activity or output is 0 widgets, and the total electricity cost at this point is $500. The difference in the total costs is $5,000, and the difference in the level of activity or output is 10,000 widgets. Therefore, the variable cost per unit is $5,000 / 10,000 = $0.50 per widget. The fixed cost is the total cost at the lowest level of activity or output, which is $500.

- Maintenance: The highest level of activity or output is 10,000 widgets, and the total maintenance cost at this point is $3,000. The lowest level of activity or output is 0 widgets, and the total maintenance cost at this point is $1,000. The difference in the total costs is $2,000, and the difference in the level of activity or output is 10,000 widgets. Therefore, the variable cost per unit is $2,000 / 10,000 = $0.20 per widget. The fixed cost is the total cost at the lowest level of activity or output, which is $1,000.

Using the scatter diagram method, we can plot the data of the total costs and the level of activity or output on a graph, and observe the pattern or trend of the data points. The graph may look something like this:

![Scatter diagram of total costs and level of activity or output](https://i.imgur.com/0xYQwZC.

5. How to Separate Relevant and Irrelevant Costs for Decision Making?

One of the most important aspects of cost classification is to determine which costs are relevant and which are irrelevant for decision making. Relevant costs are those that differ between the alternatives under consideration, while irrelevant costs are those that do not differ or do not affect the decision. By separating relevant and irrelevant costs, managers can focus on the information that matters and avoid being distracted by the information that does not. In this section, we will discuss how to identify relevant and irrelevant costs, and how to use them in various decision making scenarios.

Some of the points that we will cover are:

1. The concept of differential cost and differential revenue. These are the changes in cost and revenue that result from choosing one alternative over another. They are also known as incremental or marginal cost and revenue. For example, if a company can sell 100 units of product A for $10 each or 120 units of product B for $9 each, the differential cost of choosing product B over product A is the additional cost of producing 20 more units, and the differential revenue is the additional revenue of selling 20 more units at a lower price.

2. The concept of opportunity cost. This is the benefit that is forgone or sacrificed when one alternative is chosen over another. It is the value of the next best alternative that is rejected. For example, if a company has a limited amount of capital and can invest in project X or project Y, the opportunity cost of choosing project X is the expected return from project Y that is given up.

3. The concept of sunk cost. This is a cost that has already been incurred in the past and cannot be changed or avoided by any current or future decision. It is irrelevant for decision making because it does not differ between the alternatives. For example, if a company has already purchased a machine for $100,000 and is considering whether to replace it with a new one, the original cost of the machine is a sunk cost and should not affect the decision.

4. The concept of avoidable and unavoidable cost. These are costs that can be eliminated or reduced by choosing one alternative over another, or costs that cannot be avoided regardless of the choice. Avoidable costs are relevant for decision making, while unavoidable costs are irrelevant. For example, if a company is deciding whether to continue or discontinue a product line, the variable costs of the product line are avoidable costs, while the fixed costs that are allocated to the product line are unavoidable costs (unless they can be eliminated or reassigned to other products).

5. The concept of future and historical cost. These are costs that will be incurred or have been incurred in the future or in the past, respectively. Future costs are relevant for decision making, while historical costs are irrelevant. For example, if a company is deciding whether to buy or lease a car, the future costs of maintenance, insurance, and fuel are relevant costs, while the historical costs of research and development of the car are irrelevant costs.

Using these concepts, we can apply cost classification by relevance to various decision making situations, such as:

- Make or buy decisions. These are decisions about whether to produce a product or service internally or to outsource it to an external supplier. The relevant costs are the differential costs of making or buying the product or service, including the opportunity cost of using the internal resources for other purposes. The irrelevant costs are the sunk costs and the unavoidable costs that do not differ between the alternatives.

- Sell or process further decisions. These are decisions about whether to sell a product at an intermediate stage of production or to process it further and sell it at a higher price. The relevant costs are the differential costs and revenues of processing the product further, including the opportunity cost of using the resources for other products. The irrelevant costs are the sunk costs and the unavoidable costs that do not differ between the alternatives.

- Accept or reject special orders decisions. These are decisions about whether to accept a one-time order from a customer at a lower price than the normal selling price. The relevant costs are the differential costs and revenues of accepting the order, including the opportunity cost of using the capacity for other orders. The irrelevant costs are the sunk costs and the unavoidable costs that do not differ between the alternatives.

- Keep or replace equipment decisions. These are decisions about whether to keep using an existing asset or to replace it with a new one. The relevant costs are the differential costs and benefits of keeping or replacing the asset, including the opportunity cost of selling the old asset and the salvage value of the new asset. The irrelevant costs are the sunk costs and the unavoidable costs that do not differ between the alternatives.

By using cost classification by relevance, managers can improve their decision making process and enhance their performance. However, it is important to note that not all costs can be easily classified as relevant or irrelevant, and that some costs may have both relevant and irrelevant components. Therefore, managers should exercise caution and judgment when applying this technique, and consider other qualitative factors that may affect the decision as well.

6. How to Differentiate Between Normal and Abnormal Costs?

One of the ways to classify costs is by their normality, which refers to how frequently and predictably they occur in the production process. Normal costs are those that are expected and budgeted for, while abnormal costs are those that are unusual and unplanned for. Normal and abnormal costs have different implications for accounting and decision making, as they affect the calculation of product costs, inventory valuation, and income measurement. In this section, we will explore how to differentiate between normal and abnormal costs, and how to account for them properly. We will also discuss some of the advantages and disadvantages of using normal costing versus actual costing methods.

Some of the points that we will cover in this section are:

1. The definition and examples of normal and abnormal costs. Normal costs are the costs that are incurred regularly and consistently in the normal course of business. They include direct materials, direct labor, and manufacturing overhead that are applied to the products using predetermined rates. Abnormal costs are the costs that are unexpected and arise from abnormal events or inefficiencies. They include spoilage, rework, idle time, machine breakdowns, and other variances from the standard costs.

2. The accounting treatment of normal and abnormal costs. Normal costs are assigned to the products as part of the product costs, and are included in the inventory valuation and cost of goods sold. Abnormal costs are not assigned to the products, but are written off as period costs in the income statement. This is because abnormal costs do not reflect the normal operations of the business, and should not affect the product profitability or inventory valuation.

3. The advantages and disadvantages of using normal costing versus actual costing methods. Normal costing is a method of assigning costs to products using predetermined rates based on estimates of the expected costs and activity levels. Actual costing is a method of assigning costs to products using the actual costs and activity levels that occurred during the period. Normal costing has the advantage of being simpler, faster, and more stable than actual costing, as it avoids the fluctuations and delays of actual costs. Normal costing also provides a basis for performance evaluation and variance analysis, as it allows comparing the actual costs with the standard costs. However, normal costing also has some disadvantages, such as being less accurate, requiring adjustments for under- or over-applied overhead, and relying on subjective estimates and assumptions. Actual costing has the advantage of being more accurate, objective, and reflective of the actual operations of the business. However, actual costing also has some disadvantages, such as being more complex, time-consuming, and volatile than normal costing, as it depends on the actual costs and activity levels that may vary significantly from period to period. Actual costing also does not provide a basis for performance evaluation and variance analysis, as it does not have a standard to compare with.

7. How to Compare Historical, Predetermined, and Estimated Costs?

One of the ways to classify costs is by the time period in which they are incurred or measured. This is important for decision making, planning, and control purposes. Depending on the time frame, costs can be classified as historical, predetermined, or estimated. In this section, we will compare these three types of costs and explain how they are used in different situations. We will also discuss the advantages and disadvantages of each type of cost and the factors that affect their accuracy.

1. Historical costs are the actual costs that have been incurred in the past. They are based on factual data and can be verified by accounting records. Historical costs are useful for reporting, auditing, and evaluating past performance. However, they may not be relevant for future decisions, as they do not reflect the current market conditions or the expected changes in costs. Historical costs may also be affected by inflation, depreciation, and accounting methods.

2. Predetermined costs are the costs that are calculated before the actual production or service delivery takes place. They are based on standard or expected inputs, outputs, and efficiency levels. Predetermined costs are useful for budgeting, setting prices, and measuring variances. However, they may not be accurate, as they rely on assumptions and estimates that may not match the actual results. Predetermined costs may also be influenced by the choice of standards and the degree of detail.

3. Estimated costs are the costs that are projected for a future period or activity. They are based on forecasts, trends, and scenarios. Estimated costs are useful for planning, decision making, and evaluating alternatives. However, they may not be reliable, as they depend on the quality of information and the methods of estimation. Estimated costs may also be affected by uncertainty, risk, and changes in the environment.

To illustrate the differences between these three types of costs, let us consider an example of a company that produces and sells widgets. The company has the following information for the year 2023:

- The historical cost of producing one widget in 2022 was $10, which included $6 of direct materials, $2 of direct labor, and $2 of overhead.

- The predetermined cost of producing one widget in 2023 is $12, which includes $7 of direct materials, $3 of direct labor, and $2 of overhead. The predetermined cost is based on the standard quantities and prices of inputs and the expected output and efficiency.

- The estimated cost of producing one widget in 2023 is $11, which includes $6.5 of direct materials, $2.5 of direct labor, and $2 of overhead. The estimated cost is based on the forecasted demand, supply, and productivity of the company.

Using these data, we can compare the historical, predetermined, and estimated costs of producing and selling 100,000 widgets in 2023. The table below shows the calculation and the results:

| cost Type | Cost per unit | Total Cost |

| Historical | $10 | $1,000,000 |

| Predetermined | $12 | $1,200,000 |

| Estimated | $11 | $1,100,000 |

As we can see, the historical cost is the lowest, but it may not reflect the current or future situation of the company. The predetermined cost is the highest, but it may not match the actual performance of the company. The estimated cost is in between, but it may not be certain or realistic. Therefore, each type of cost has its own strengths and weaknesses, and the company should use them appropriately for different purposes.

8. How to Use Cost Classification for Effective Cost Management and Reporting?

Cost classification is a useful technique for organizing and analyzing your costs based on different criteria, such as behavior, function, nature, or relevance. By applying cost classification, you can gain more insights into your cost structure, performance, and profitability. You can also use cost classification to improve your cost management and reporting practices. In this section, we will discuss how to use cost classification for effective cost management and reporting. We will cover the following points:

1. How to choose the appropriate cost classification method for your purpose. There are various methods of cost classification, such as fixed and variable costs, direct and indirect costs, product and period costs, and so on. Each method has its own advantages and disadvantages, and you should select the one that best suits your objective. For example, if you want to analyze the cost behavior and the impact of changes in activity level, you should use the fixed and variable cost method. If you want to allocate costs to different cost objects, such as products, services, or departments, you should use the direct and indirect cost method. If you want to prepare financial statements, you should use the product and period cost method.

2. How to apply cost classification to your cost data. Once you have chosen the cost classification method, you need to apply it to your cost data. This involves identifying, measuring, and grouping your costs according to the chosen criteria. For example, if you use the fixed and variable cost method, you need to separate your costs into fixed and variable components, using techniques such as the high-low method, the scatter diagram method, or the regression method. If you use the direct and indirect cost method, you need to assign your costs to different cost objects, using techniques such as the direct tracing method, the allocation method, or the activity-based costing method.

3. How to use cost classification for cost management and reporting. After you have classified your costs, you can use them for various purposes, such as budgeting, forecasting, decision making, performance evaluation, and reporting. For example, if you use the fixed and variable cost method, you can use the contribution margin approach to prepare budgets and forecasts, and to analyze the break-even point, the margin of safety, and the operating leverage. If you use the direct and indirect cost method, you can use the cost-volume-profit analysis to evaluate the profitability of different products, services, or segments, and to make decisions such as pricing, outsourcing, or product mix. If you use the product and period cost method, you can use the absorption costing or the variable costing method to prepare income statements and balance sheets, and to report your financial results.

Cost classification is a powerful tool that can help you understand and manage your costs more effectively. By using cost classification, you can enhance your cost management and reporting practices, and ultimately improve your business performance and profitability. We hope that this section has provided you with some useful insights and tips on how to use cost classification for your benefit. Thank you for reading this blog.

Read Other Blogs