Cost Classification

What is Cost Classification?

Cost Classification is the process of segregating costs of the company into different categories that gives a fair idea to the decision-maker about the spending pattern. This bifurcation allows teams to efficiently use the data for accounting purposes and for financial modeling which leads the management to decide which cost is important than others.

Types of Cost Classification

Let us discuss some types of cost classification.

Types of Cost

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#1 – Fixed and Variable Cost

These are the two primary categories to segregate the costs; fixed costsFixed CostsFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity.read more include which can be accounted for during the start of any project, and a part of variable expenses can be anticipated too. However, variable cost accounts for the cost associated with the units produced and also for any unaccounted cost coming along.

#2 – Distribution Channel Cost

These are the expenses that are channelized into different segments like retail, wholesale, internet. Revenues from each of the channels come after deducting the cost from sales.

#3 – Customer Cost

These are the costs a company gets involved in to maintain its reputation and after-sale service for the customers. This cost includes returns, warranties, or customer service. This information pertaining to the individual consumers is then evaluated by the company to increase profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.read more and customer targeting.

#4 – Departmental Cost

Expenses related to individual departments are assigned to respective departmental managers, which is then used to analyze the performance of the manager and develop trend analysis to identify the potential of the manager.

Basis of Cost Classification

Now since we have seen the categories of the cost classification briefly, let us examine the basis on which the costs are segregated:

Cost Classification

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#1 – By Nature

As the category itself suggests that this is the expense to be recorded in the way the company bears it, and for the purpose, it is used for, some major categories can be material and labor. For instance, raw material costs and all other costs related to the procurement of the raw material will fall under Material charges. Similarly, salary and wages will belong to labor costsLabor CostsCost of labor is the remuneration paid in the form of wages and salaries to the employees. The allowances are sub-divided broadly into two categories- direct labor involved in the manufacturing process and indirect labor pertaining to all other processes.read more.

#2 – By Functions

Here the costs are divided as they are allocated to different functions in the company, like Production costs, Commercial costs, Administration Costs, Distribution CostsDistribution CostsDistribution cost is the total of all expenses incurred by the producer to make possible the delivery of the product from its location to the location of the end customer.read more, and Research and Development cost. All the categories include the costs pertaining to their nature of occurrence throughout the whole production cycle.

#3 – By Behaviour

It depends on the nature of the cost, like if its fixed, variable, semi-variable costSemi-variable CostFixed and variable costs combine to form semi-variable costs. Because semi variable costs are influenced by both fixed and variable costs, they are also referred to as mixed costs.read more. Rent, Lease, salary comes under Fixed expenses; Packaging, commission falls under the variable head; lastly, management cost, power consumption cost, maintenance cost comes under semi-variable cost.

#4 – By Management Decision Making

As we know, costs to the company are not only a number but also as a tool to make managerial decisions. So, management decides how to distinguish the costs and what categories should they be bifurcated into like Marginal Cost, Differential cost, Sunk Cost, Abnormal Cost, Replacement cost, and so on.

#5 – By Production Process

This type of category is generally used by the companies involved in manufacturing business where there is a lot of processes to be followed by the product to become a finished good. Some examples of this cost may be Batch cost, Process costProcess CostProcess costing is a method of costing wherein the products go through two or more processes and the costs are assigned/charged to individual operations averaged over the number of units produced during that time. It is used commonly in manufacturing units like paper, steel, soaps, medicines, vegetable oils, paints, rubber, and chemicals.read more, Contract cost, Joint cost, and so on.

#6 – By Time

The cost comes to the company as it depends on the time frame the cost has occurred. The expense which is of importance today may not hold any value tomorrow, so the basic categories in this can be Historical, pre-Determined, Standard, and Estimated costsEstimated CostsCost estimate is the preliminary stage for any project, operation, or program in which a reasonable calculation of all project costs is performed and thus requires precise judgement, experience, and accuracy.read more. Based on these sub-categories helps the management to effectively distribute the costs as per their occurrence time, which eventually leads to a broader picture of cost evaluation.

Conclusion

As much as cost is an expense to the company, it is also considered a tool for future evaluations. Categorizing the costs into appropriate categories allows us to have a clear picture of the whole business model and gives the management an eagle-eye view of the entire process.

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