Cost is a very vague term and barely has any meaning until it is classified into logical groups. For example, if we know total expenses are of $500 Million against $550 Million revenue.What insight can we derive? Nothing. Now if we add one more information say $350 Million is direct material cost and $150 Million is a direct labor and other overheads. Now, the management can focus on direct material cost because that forms the major part of the total cost as far as cost control initiatives are concerned.
Basis of Classification of Cost
There can be various bases on which classification of costs can be done. Following are the important ones, we will discuss in brief.
1. Nature of Expense: By nature of expenses, costs are classified into material, labor and expenses.
2. Relation to Cost Object – Traceability: This classification is based on the relation of cost element with the cost object. The classification is done into direct and indirect costs. The basis is cause and effect relationship between cost element and cost object or traceability of costs to its cost object.
3. Functions / Activities: Costs can also be classified into various functions / activities. Common functional classification of costs are done into following:
- Research and Development
- Quality Check etc.
4. The behavior of Costs: The behavior of costs is seen with respect to the change in volume. On this basis, costs are classified into Fixed Costs, Variable Costs, and Semi-variable Costs. Fixed costs do not change with the small change in volume, variable costs do change. Semi-variable costs have characteristics of both fixed and variable costs.
5. The purpose of Decision Making by Management: For decision-making purpose of management, costs can be classified into various types such as opportunity cost, marginal cost, differential cost, relevant cost, imputed cost, replacement cost, sunk cost, normal/ abnormal cost, avoidable/ unavoidable costs, etc.
6. Production Process: It’s an important classification for cost accounting of different manufacturing industries. Based on the production process of the industry, costs can be classified into following:
- Batch Cost
- Process Cost
- Operation Cost
- Operating Cost
- Contract Cost
- Joint Cost
7. Time Period: Based on a time period of assessment or any other specific purpose, costs can be classified into historical cost, pre-determined cost, standard cost, and estimated cost.