Classification of Costs: 5 Types | Accounting

The following points highlight the five main types of classification of costs. The types are: 1. Cost Classification by Nature 2. Cost Classification in Relation to Cost Centre 3. Cost Classification by Time 4. Cost Classification for Decision Making 5. Cost Classification by Nature of Production Process.

Type # 1. Cost Classification by Nature:

The total cost of a product or service is basically classified into material cost, labour cost and expenses as follows:

i. Material Cost:

It is the cost of material of any nature used for the purpose of production of a product or a service. Material cost includes cost of procurement, freight inwards, taxes and duties, insurance etc. directly attributable to the acquisition. Trade discounts, rebates, duty drawbacks, refunds on account of modvat, cenvat, sales tax and other similar items are deducted in determining the costs of material.

ii. Labour Cost:

Labour cost includes salaries and wages paid to permanent employees, temporary employees and also to employees of the contractor.

The labour cost can be analyzed into the following:

a. Monetary benefits payable immediately:

Salaries and wages, dearness and other allowances, production incentive or bonus.

b. Monetary benefits after sometime in future:

Employer’s contribution to P.F., E.S.I., Pension etc. Gratuity, Profit linked bonus.

c. Non-monetary benefits (fringe benefits):

Free or subsidized food, free medical or hospital facilities, free or subsidized education to the employees children, free or subsidized housing etc.

iii. Expenses:

These are the costs other than material cost or labour cost which are involved in an activity. Expenditure on account of utilities, payment for bought-out services, job processing charges etc. can be termed as expenses.

Type # 2. Cost Classification in Relation to Cost Centre:

The elements of cost can be studied under the classification direct and indirect costs. If the object of interest for identifying and measuring cost is to determine how much sacrifice is involved in manufacturing a particular product, then initially one can define the three elements of total cost i.e., materials, labour, and expenses.

i. Direct Costs:

The direct costs are those which can be identified easily and indisputably with a unit of operation or costing unit or cost centre. Costs of direct material, direct labour and direct expenses can be directly allocated or identified with a particular cost centres or a cost unit and can be directly charged to such cost centre or cost unit. These costs are also called ‘traceable costs’.

ii. Direct Material:

The direct material costs are those which can be identified easily and indisputably with a unit of operation or costing unit or cost centre. The direct material cost can be directly allocated or identified with particular cost centres or cost units and can be directly charged to such cost centres or cost units.

Raw materials are directly identifiable as part of the final product and are classified as direct materials. For example, wood used in production of tables and chairs, steel bars used in steel factory etc. are the direct materials that becomes part of the finished product.

iii. Direct Labour:

The labour cost incurred on the employees who are engaged directly in making the product, their work can be identified clearly in the process of converting the raw materials into finished product is called ‘direct labour cost’.

For example, wages paid to the workers engaged in machining department, fabrication department, assembling department etc.

iv. Direct Expenses:

The direct expenses refers to expenses that are specifically incurred and charged for specific or particular job, process, service, cost unit or cost centre. These expenses are also called ‘chargeable expenses’.

Some of the examples of direct expenses include the following:

(1) Cost of drawings, designs and layout.

(2) Royalties payable on use of patents copyrights etc.

(3) Hire charges of special tools and equipment for a particular job or work.

(4) Architects, surveyors and other consultation fees of particular job or work.

Sometimes, if the direct expenses are negligible or small amount, it will be treated as overhead.

v. Indirect Costs:

Indirect costs cannot be allocated but which can be apportioned to cost centres or cost units. These costs are also called as ‘common costs’. The indirect costs are not traceable to any plant, department, operation or to any individual final product. All overhead costs are indirect costs.

Costs of indirect material, indirect labour and indirect expenses in aggregate constitute the overhead costs and are the indirect component of the total cost. Indirect costs cannot be directly allocated to cost units or cost centres and have to be absorbed or recovered into cost units.

vi. Indirect Material:

The costs incurred on materials used to further the manufacturing process, which cannot be traced into the end product and the material required in the production process but not necessarily built into the product are called ‘indirect material’.

For example cutting oil used in cutting surface, threads and buttons used in stitching clothes, lubricants used in maintenance of plant and machinery, cotton waste used in cleaning the machinery etc. are considered as indirect materials.

Sometimes indirect materials like coal, fuel used in kilns etc. are considered as part of the prime cost and some materials which are contained in small quantities in the end product like gums and threads used in binding the books even though forming part of direct material cost, but is considered not worth analyzing to cost units and may be categorized as indirect material cost.

vii. Indirect Labour:

The cost of indirect labour consist of all salaries and wages paid to the staff for the purpose of carrying and tasks incidental to goods or services provided which will not form part of salaries and wages paid in working directly upon the product.

For example, salaries and wages paid to store keepers, watch and ward, supervisors, timekeepers, quality control, managers, clerical staff, salesmen etc. These indirect labour costs cannot be identified with any particular job, process, cost unit or cost centre.

viii. Indirect Expenses:

Indirect expenses are those which are incurred by the organization in carrying out their total business activities and cannot be conveniently allocated to job, process, cost unit or cost centre. Rent, rates, taxes, insurance, lighting, telephone, postage and telegrams, depreciation etc. are the examples of indirect expenses.

The concepts of direct and indirect costs are meaningless without identification of the relevant cost unit or cost centre. Segregation of costs into direct and indirect costs is essential for proper accounting and control of costs and also for managerial decision making purpose.

Advanced manufacturing technologies such as Robotics, Computer Aided Design and Manufacture, Flexible Manufacturing Systems, Optimized Production Technology, Just-in-Time etc., are revolutionizing the manufacturing process at shop-floor, quality and creating areas for improved opportunities. They have dramatically changed the manufacturing cost behaviour patterns.

The direct cost component of product cost is decreasing while depreciation, engineering and information processing costs are increasing. These changes have resulted in higher overhead rates and a shrinking base of direct costs over which to allocate those costs.

Type # 3. Cost Classification by Time:

i. Historical Cost:

The historical cost is the actual cost, determined after the event. Historical cost valuation states costs of plant and materials, for example, at the price originally paid for them.

Costs reported by conventional financial accounts are based on historical valuations. But during periods of changing price levels, historical costs may not be correct basis for projecting future costs. Naturally historical costs must be adjusted to reflect current or future price levels.

ii. Predetermined Cost:

These costs relating to the product are computed in advance of production, on the basis of a specification of all the factors affecting cost and cost data. Predetermined costs may be either standard or estimated.

iii. Standard Cost:

It is a predetermined calculation of how much costs should be under specified working conditions. It is built up from an assessment of the value of cost elements and correlates technical specifications and the quantification of materials, labour and other costs to the prices and/or usage rates expected to apply during the period in which the standard cost is intended to be used.

Its main purpose is to provide basis for control through variance accounting for the valuation of stock and work-in-progress and in some cases, for fixing selling prices. A standard cost is a planned cost for a unit of product or service rendered.

iv. Estimated Cost:

It is a predetermined cost based on past performance adjusted to the anticipated changes. No minute appraisal of each individual component cost. It can be used in any business situation or decision making which does not require accurate cost.

It is used in budgetary control system and historical costing system. Its emphasis is on the level of costs not to be exceeded. It is used in decision making and selection of alternative with maximum profitability. It is also used in price fixation and tendering. It is determined generally for the period.

Type # 4. Cost Classification for Decision Making:

For the managerial decision making the cost data can be analyzed keeping in view the following cost concepts:

i. Marginal Cost:

The term ‘marginal cost’ is defined as the amount at any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit. It is a variable cost of one unit of a product or a service i.e., a cost which would be avoided if that unit was not produced or provided.

ii. Differential Cost:

It is also known as ‘incremental cost’. It is the difference in total cost that will arise from the selection of one alternative to the other. It is an added cost of a change in the level of activity.

This concept is similar to the economists’ concept of marginal cost which is defined as the additional cost incurred by producing one more unit of product. It refers to any kind of change like add or drop a new product/existing product, changing distribution channels, add or drop business segments, adding new machinery, sell or process further, accept or reject special orders etc.

iii. Opportunity Cost:

It is the value of a benefit sacrificed in favour of an alternative course of action. It is the maximum amount that could be obtained at any given point of time if a resource was sold or put to the most valuable alternative use that would be practicable. Opportunity cost of good or service is measured in terms of revenue which could have been earned by employing that good or service in some other alternative uses.

Opportunity cost can be defined as the revenue forgone by not making the best alternative use. Opportunity costs represent income foregone by rejecting alternatives. They are, therefore not incorporated into formal accounting systems because they do not incorporate cash receipts or outflows.

iv. Relevant Cost:

The relevant cost is a cost appropriate in aiding to make specific management decisions. Business decisions involve planning for future and consideration of several alternative courses of action. In this process the costs which are affected by the decisions are future costs. Such costs are called relevant costs because they are pertinent to the decisions in hand.

The cost is said to be relevant if it helps the manager in taking a right decision in furtherance of the company’s objectives. A relevant cost is a future cost which differs between alternatives. It can also be defined as any cost which is affected by the decision at hand. The relevant cost must be a future cost, i.e., one which is expected to be incurred and not a historic or sunk cost which has already been incurred.

v. Sunk Cost:

The sunk cost is one for which the expenditure has taken place in the past. This cost is not affected by a particular decision under consideration. Sunk costs are always results of decisions taken in the past. This cannot be changed by any decision in future. The sunk costs are those costs that have been invested in a project and which will not be recovered if the project is terminated.

The sunk cost is one for which the expenditure has taken place in the past. This cost is not affected by a particular decision under consideration. Sunk-costs are always results of decisions taken in the past;-This cost cannot be changed by any decision in future. Investment in plant and machinery as soon as it is installed, its cost is sunk cost and is not relevant for decisions.

Amortisation of past expenses, e.g., depreciation is a sunk cost. Sunk costs will remain the same irrespective of the alternative selected. Thus, it need not be considered by the management in evaluating the alternatives as it is common to all of them.

vi. Replacement Cost:

The replacement cost is a cost at which material identical to that is to be replaced could be purchased at the date of valuation (as distinct from actual cost price at the date of purchase). The replacement cost is a cost of replacing an asset at any given point of time either at present or in the future (excluding any element attributable to improvement).

vii. Normal Cost:

The normal cost is normally incurred at a given level of output in the conditions in which that level of output is achieved. Normal cost includes those items of cost which occur in the normal situation of production process or in the normal environment of the business. The normal idle time is to be included in the ascertainment of normal cost.

viii. Abnormal Cost:

It is an unusual or a typical cost whose occurrence is usually irregular and unexpected and due to some abnormal situation of the production. Abnormal cost arises due to idle time for some heavy break down or abnormal process loss. They are not considered in the cost of production for decision making and charged to Profit and Loss Account.

ix. Avoidable Cost:

The avoidable costs are those costs which under given conditions of performance efficiency should not have been incurred. Avoidable costs are logically associated with some activity or situation and are ascertained by the difference of actual cost with the happening of the situation and the normal cost.

When spoilage occurs in manufacture in excess of normal limit, the resulting cost of spoilage is avoidable cost. Cost variances which are controllable may be termed as avoidable cost. These costs are also called as ‘escapable costs’. The avoidable cost will not be incurred if an activity is not undertaken or discontinued.

Avoidable cost will often correspond with variable costs. Avoidable cost can be identified with an activity or sector of a business and which would be avoided if that activity or sector did not exist. It refer to costs which can be reduced due to a contraction in the activities of a business enterprise. It is the net effect on costs that is important, not just the costs directly avoidable by the contraction.

x. Unavoidable Cost:

The unavoidable costs are ‘inescapable costs’ which are essentially to be incurred, within the limits or norms provided for. It is the cost that must be incurred under a program of business restriction. It is fixed in nature and inescapable.

xi. Pre-Production Cost:

The costs incurred prior to the starting of commercial production are called as ‘pre-production costs’. These costs include preliminary expenses, trail run costs etc. These costs are incurred from the initiation of project till its formal commercial production.

When a new factory is in the process of establishment or a new product line or product is taken-up, a new project is undertaken, but the commercial operations have not started, during such period all costs incurred are considered as pre-production costs and are treated as deferred revenue expenditure except the costs which have been capitalized. Such deferred expenses are charged to future production.

xii. Product Cost:

The product cost is aggregate of costs that are associated with a unit of product. Such costs may or may not include an element of overheads depending upon the type of costing system in force – absorption or direct. Product costs are related to goods produced or purchased for resale and are initially identifiable as part of inventory.

These product or inventory costs become expenses in the form of cost of goods sold only when the inventory is sold. Product cost is associated with unit of output. The costs of inputs in forming the product viz., the direct material, direct labour, factory overhead constitute the product costs.

xiii. Period Cost:

The period cost is a cost that tends to be unaffected by changes in level of activity during a given period of time. Period cost is associated with a time period rather than manufacturing activity and these costs are deducted as expenses during the current period without previously classified as product costs. Selling and distribution costs are period costs and are deducted from the revenue without their being regarded as part of the inventory cost.

xiv. Traceable Cost:

The traceable costs are those which can be identified easily and indisputably with a unit of operation or costing unit or cost centre. Costs of direct material, direct labour and direct expenses can be directly allocated or identified with particular cost centres or cost units and can be directly charged to such cost centres or cost units.

xv. Common Cost:

The common costs cannot be allocated but which can be apportioned to cost centres or cost units. The indirect costs are not traceable to any plant, department, operation or to any individual final product. All overhead costs are indirect costs. Cost of indirect material, indirect labour and indirect expenses in aggregate constitute the overhead costs and are the indirect component of the total cost.

The concepts of direct and indirect costs are meaningless without identification of the relevant cost unit or cost centre. Segregation of costs into direct and indirect costs is essential for proper accounting and control of costs and also for managerial decision making purpose.

xvi. Controllable Cost:

The controllable cost is a cost chargeable to a budget or cost centre, which can be influenced by the actions of the person in whom control of the centre is vested. It is always not possible to predetermine responsibility, because the reason for deviation from expected performance may only become evident later.

For example excessive scrap may arise from inadequate supervision or from latent defect in purchased material. The controllable cost is a cost that can be influenced and regulated during a given time span by the actions of a particular individual within an organization.

xvii. Uncontrollable Cost:

These costs cannot be influenced by the action of a specified member of the organization. The controllability of cost depends upon the level of responsibility under consideration. Direct costs are generally controllable by the shop level management. The uncontrollable cost is a cost that is beyond the control (i.e., uninfluenced by actions) of a given individual during a given period of time.

xviii. Short-Run Cost:

The short-run costs are costs that vary with output when fixed plant and capital equipment remain the same and become relevant when a firm has to decide whether or not to produce more in the immediate future.

xix. Long-Run Cost:

The long-run costs are those which vary with output when all input factors including plant and equipment vary and become relevant when the firm has to decide whether to setup a new plant or to expand the existing one.

xx. Past Cost:

The past costs are actual costs incurred in the past and are generally contained in the financial accounts. These costs report past events and the time lag between event and its reporting makes the information out of date and irrelevant for decision-making. These costs will just act as a guide for future course of action.

xxi. Future Cost:

The future costs are costs expected to be incurred at a later date and are the only costs that matter for managerial decisions because they are subject to management control. Future costs are relevant for managerial decision making in cost control, profit projections, appraisal of capital expenditure, introduction of new products, expansion programs and pricing etc.

xxii. Explicit Cost:

These costs are also called as ‘out of pocket costs’. The explicit cost is a cost that will necessitate a corresponding outflow of cash. These costs involve cash outlay or payment to other parties. Explicit costs are relevant in some decision making problems such as fluctuation of prices during recession, make or buy decisions etc. These costs are recorded in the books of account and can be easily measured.

xxiii. Implicit Cost:

These costs are also called as ‘imputed costs’ or ‘notional costs’. The implicit cost is a cost which doesn’t involve actual cash outlay, which are used only for the purpose of decision making and performance evaluation. Interest on capital is common type of implicit cost. No actual payment of interest is made but the basic concept is that, had the funds been invested elsewhere they would have earned interest.

Thus, implicit costs are a type of opportunity costs which cannot be recorded in the books of account but are important for certain types of managerial decisions such as replacement of equipment, evaluation of profitability of two alternative courses of action.

xxiv. Book Cost:

The book costs are those which do not require current cash payments. Depreciation, is a notional cost in which no cash transaction is involved. Book costs can be converted into out of pocket costs by selling the assets and having them on hire. Rent would then replace depreciation and interest.

xxv. Shutdown Cost:

The shutdown costs are the costs incurred in relation to the temporary closing of a department / division / enterprise. Such costs include those of closing, as well as, those of reopening. The shutdown costs are defined as those costs which would be incurred in the event of suspension of the plant operation and which would be saved if the operations are continued.

Examples of such costs are costs of sheltering the plant and equipment and construction of sheds for storing exposed property. Further, additional expenses may have to be incurred when operations are restored e.g., reemployment of workers may involve cost of recruitment and training.

xxvi. Abandonment Cost:

The abandonment cost is the cost incurred in closing down a department or a division or in withdrawing a product or ceasing to operate in a particular sales territory etc. The abandonment costs are the cost of retiring altogether a plant from service. Abandonment arises when there is a complete cessation of activities and creates a problem as to the disposal of assets.

xxvii. Urgent Cost:

The urgent costs are those which must be incurred in order to continue operations of the firm. For example, cost of material and labour must be incurred if production is to take place.

xxviii. Postponable Cost:

The postponable cost is that cost which can be shifted to the future with little or no effect on the efficiency of current operations. These costs can be postponed at least for some time, e.g., maintenance relating to building and machinery.

xxix. Conversion Cost:

It is the cost incurred to convert raw materials into finished goods. It is the sum of direct wages, direct expenses and manufacturing overheads.

Type # 5. Cost Classification by Nature of Production Process:

Depending on the nature of production process, the cost can be classified into the following:

1. Batch Cost:

It is the aggregate cost related to a cost unit which consists of a group of similar articles which maintain its identity throughout one or more stages of production.

2. Process Cost:

When the production process is such that goods are produced from a sequence of continuous or repetitive operations or processes, the cost incurred during a period is considered as process cost. The process cost per unit is derived by dividing the process cost by number of units produced in the process during the period. Accounts are maintained for cost of a process for a period. The average cost per unit produced during the period is process cost per unit.

3. Operation Cost:

It is the cost of a specific operation involved in a production process or business activity. When there are distinctly separate operations involved in a process, cost for each operation is found out for effective control mechanism.

4. Operating Cost:

It is the cost incurred in conducting a business activity. Operating costs refer to the cost of undertakings which do not manufacture any product but which provide services.

5. Contract Cost:

It is the cost of a contract with some terms and conditions of adjustment agreed upon between the contractee and the contractor. Contract cost usually implied to major long- term contracts as distinct from short-term job costs. Escalation clause is sometimes provided in the contract in order to take care of anticipated change in material price, labour cost etc.

6. Joint Cost:

These are the common costs of facilities or services employed in the output of two or more simultaneously produced or otherwise closely related operations, commodities or services.

When a production process is such that from a set of same input, two or more distinguishably different products are produced together, products of greater importance are termed as joint products and products of minor importance are termed as by-products and the costs incurred prior to the point of separation of the products are termed as joint costs.

For example, in a petroleum refinery industry, petrol, diesel oil, kerosene oil, naptha, tar etc. are produced jointly in the refinery process. By-product cost is the cost assigned to the by -products.