Cost classification, Meaning, Types

Cost classification is a fundamental aspect of business financial management and accounting practices. It involves categorising expenditures based on various criteria to facilitate effective financial analysis, decision-making, and control. By systematically organising cost classification into different groups, businesses can gain insights into their cost structure, understand cost behaviour, and allocate resources efficiently. Costs are classified into several categories based on different criteria, such as nature, function, behaviour, traceability, and relevance to decision-making. Each classification provides unique perspectives and helps in addressing specific management objectives.

What is the Cost?

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Types Of Cost

1. Fixed Costs : Cost classification that remains unchanged regardless of changes in production or sales volume. Examples include rent, salaries of permanent staff, and insurance premiums.
2. Variable Costs : Costs that fluctuate directly to changes in production or sales levels. Examples include raw materials, direct labour tied to production volume, and utilities.
3. Direct Costs : Costs directly attributable to the production of specific goods or services. Examples include raw materials used in manufacturing a product and labour directly involved in its production.
4. Indirect Costs (Overheads) : Cost classification is not directly attributable to producing specific goods or services but is necessary for business operations. Examples include rent, utilities for the entire facility, administrative salaries, and depreciation.
5. Sunk Costs : Costs that have already been incurred cannot be recovered or changed by any future action. These costs are irrelevant to future business decisions. An example is money spent on research and development for a product that never launched.
6. Marginal Costs : The additional cost incurred by producing one additional unit of a product or service. It includes both variable costs and the portion of fixed costs that change with output.
7. Opportunity Costs : The cost of forgoing the next best alternative when deciding. It represents the potential benefit lost by choosing one option over another.
8. Imputed Costs : Costs that do not involve a cash outflow but are relevant for decision-making. For example, the opportunity cost of using a company-owned building instead of renting it out to another firm.
9. Incremental Costs : The additional cost incurred when a business decides to produce more or less of a product or service.
10. Explicit Costs: Costs that involve a direct payment of money by the firm, such as wages and utility bills.
11. Implicit Costs : Cost accounting that represents the opportunity cost of using resources owned by the firm rather than selling them to others or leasing them out.

Classification of Costs

Classification by Nature

• Material Costs : This category has expenses on materials used in production, further divided into raw materials, spare parts, and packaging costs.
• Labour Costs : Comprising salaries and wages paid to permanent and temporary employees engaged in manufacturing goods.
• Expenses : Includes all other expenditures related to production and sales of goods or services.

Classification by Functions

• Production Costs : It have expenses directly linked to manufacturing or construction processes.
• Commercial Costs : Covers total operational expenses excluding manufacturing costs, such as administrative costs, selling, and distribution expenses.

Classification by Traceability

• Direct Costs : Easily identifiable with specific cost units or centres, such as materials used in production and labour directly involved in manufacturing.
• Indirect Costs : Incurred for multiple purposes across various cost centres, such as building rent and managerial salaries, making them challenging to allocate to a specific cost unit.
• Classification by Normality

• Normal Costs : Costs typically incurred at a given output level under standard conditions form part of production costs and impact profit and loss.
• Abnormal Costs : Cost classification is not expected at a usual output level under standard conditions; it is charged to the profit and loss account rather than included in production costs.

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