Classification of cost implies grouping of cost with common characteristics or base.

Classification of cost implies grouping of cost with common characteristics or base. A number of bases or characteristics are there on which costs can be classified.

Important of them are: (1) According to Elements, (2) According to Functions, (3) According to their identity with the product, job or service, (4) According to Variability, (5) According to time, (6) According to their controllability and (7) According to relevance to decision-making.

Element-wise Classification

According to this classification, the costs are classified into three categories: material, labour and expenses.

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Material cost is the cost of components used as input of finished products or cost that helps in conversion to finished products.

Labour cost includes wages and salaries paid to the employees as remuneration for service rendered in the process of production and sale.

Cost other than material cost and labour cost, required for production and sale is known as expense.

Functional Classification

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The most common classification of cost is by functions. It is important because cost is ascertained on the basis of functions. On functional basis cost is classified into four categories: (1) Production, manufacturing or factory cost, (2) Administrative cost, (3) Selling cost and (4) Distribution cost.

Manufacturing Cost: Manufacturing cost refers to all expenditure incurred in the course of production from acquisition of material to primary packing of finished product. It includes cost of material, labor, direct expenses and factory overheads. This is also termed as ‘Production Cost’ or ‘Factory Cost’. Power and lighting, factory rent, factory depreciation, etc. come under this category. Administrative Cost: All costs incurred for general administration and operation control are known as ‘administrative cost. Examples of such cost are: salary to office staff, rent of office building, repairs to furniture, legal expenses, electricity charges for the office, etc.

Selling Cost: Selling cost comprises of expenses exclusively incurred for sale of goods. They are cost of warehousing, advertising, salary of sales personnel, showroom expenses, etc.

Distribution Cost: Expenses on dispatch of goods to the customers including transportation are known as distribution cost. Some of such costs are packing for transportation, carriage outward and insurance, salary for transport staff, maintenance of delivery vans, etc.

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According to identity with the product

On this basis cost is divided into (1) direct cost and (2) indirect cost.

Direct Cost: Cost that can be directly, completely and conveniently identified with or traced to a product, job, process or service is known as direct cost. For example: material used, labour employed and expenses incurred for production can be easily identified with the product. Hence these are direct costs.

Indirect Cost: It refers to expenses that cannot be completely and easily identified with a product, job, process or service. These are common in nature for many products and need allocation to all products on some rational basis. Examples of such cost are: salary to managers, watchman, etc, which is a common cost for various products manufactured. This cost is also known as ‘Overheads’ or ‘On costs’ and subdivided as factory overheads, administrative overheads, and selling and distribution overheads.

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According to variability

On this basis cost can be broadly classified into fixed, variable, semi-variable and step up costs. This classification is helpful in estimating total cost at various levels of activity and taking managerial decisions.

Fixed Cost:

Cost that remains constant or unaffected irrespective of changes in the volume of output are termed as ‘fixed cost’. Examples of such cost are: rent, insurance, manager’s salary, insurance and depreciation of building, etc, which remain constant irrespective of number of units produced, 7,000, 5,850 or 8,900.

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It remains constant per unit of time. As a result, it changes with change with output per unit of time. For rent paid per month Rs. 5,000 for an output of 500 units, the rent per unit comes to Rs. 10. In case the output increases to 1,000 units, the rent per unit will decrease to Rs. 5.

Variable Cost: This cost varies in direct proportion to output. It increases or decreases in the same proportion with increase and decrease in production unit. Expenditure on direct material and direct labour are of this type of cost. This cost remains constant per unit of output. For example, if for 1,000 units of output, expense on material is Rs. 2,000, then for output of 1,500 units the expense on material shall be Rs. 3,000 (Rs. 2,000 / 1,000 x 1,500). It is also called as ‘product cost’.

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Step Cost: Fixed cost generally remains fixed up to a particular activity level or units of output. At times, if the output exceeds that level then the fixed cost is jumped to a higher level but in equal proportion. For example, a room can accommodate a given number of machines or employees. Beyond that, it is necessary to go for a second, third and so on with the increase in the number of machines or employees. This increase in fixed cost is known as step cost.

On the basis of time

Cost can be classified as (1) historical cost and (2) pre- determined cost.

Historical Cost: The costs that are already incurred, recorded and ascertained are called historical cost. This cost cannot be reversed or revised by subsequent decisions. It is not relevant for control of cost. This is also known as ‘sunk cost’ or ‘past cost’.

Pre-determined Cost: The cost that is computed in advance on the basis of estimates made, taking historical cost and possibility of change in future into consideration, is known as pre-determined cost.

On the basis of controllability

Cost can be classified as controllable and uncontrollable cost. This classification is made on the basis of relationship between the cost and the management action.

Controllable Cost: Cost, which can be identified and controlled by the action of the management or a specified member of the organisation, is known as controllable cost. For example, control on electricity cost, raw material cost, fuel cost, etc. are possible by the foreman or supervisor of the production department. These are therefore, considered as controllable cost.

Uncontrollable Cost: There are costs, which cannot be influenced by action of the management or a specified member of the organisation, for example, depreciation and cost of material consumed. If the purchase manager purchases the fixed assets and materials at a higher price, production manager cannot control these costs.

On the basis of relevance to decision-making According to this basis of classification cost is divided as follows:

Marginal Cost:

‘Marginal cost’ refers to increase and decrease in the aggregate cost on account of increase and decrease in production by a single unit. The unit may be an article or a batch of similar articles. It is ordinarily equal to the increase or decrease in total variable cost because of increase or decrease of one unit in production,

Opportunity Cost:

Opportunity cost is the advantages in terms of money foregone due to not using the facilities as it was originally planned. For example, if own building is proposed to be used for installing a plant, the amount of rent the building could have fetched, if let out, is the opportunity cost.

Differential, Incremental or Detrimental Cost:

Difference in total cost between two alternative processes of production is known as differential cost. If the alternative chosen results in increase in total cost, then such increased cost is known as incremental cost. Otherwise if the choice results in decrease in total cost, then such decrease is known as decremented cost. For assessing profitability, the incremental cost is matched with incremental revenue.

Out of Pocket Cost:

Out of pocket cost means the cost which requires immediate or future cash payment to outside parties on the basis of an alternate decision. For example, the business has its own machines. It seeks to replace these machines on hire. In making this decision, the amount of cash to be paid is taken as out of pocket cost. But depreciation charged on own machines does not amount to out of pocket cost, as it does not involve payment of cash.

Imputed or Hypothetical Cost:

Cost that does not involve payment of cash or cash outflow, is known as imputed or hypothetical cost. It does not form a part of total cost. But it is important for taking decisions. For example, interest on capital. This does not form a part of total cost but treated as expenditure in financial accounting. –

Shutdown Cost:

It is that part of fixed cost that has to be incurred even if the factory is shutdown or closed temporarily due to shortage of material, non-availability of work force, etc. For example, rent, insurance, depreciation, maintenance, etc. for the idle plant and equipments for the period of closer are known as shutdown cost.

Sunk Cost:

Cost that is being incurred due to a past decision and cannot be reversed or revised by subsequent decisions, is known as sunk cost. It is not relevant for decision-making. Examples of such cost are investment in plant and machinery, building, etc.

Joint Cost:

Cost incurred when two or more products are produced out of one or same input or process, the cost of material and the cost of processing is called joint cost. Oil refinery is the example where a range of products such as bitumen, petrol, diesel, kerosene, etc. are derived in the process of refining crude oil and hence the cost of crude oil and the cost of refining is the joint cost.

Conversion Cost:

Cost incurred for transforming direct material into finished product is known as conversion cost. It is the aggregate of costs of direct labour, direct expenses and factory overheads.