Classification of Costs: A Complete Guide

Cost can be divided into various basis- Time (Historical, Predetermined), Basis of Elements (Material, Labor and Overheads), Basis of function (Production, Marketing, Selling), Basis of Traceability (Direct and Indirect Cost), Basis of Activity (Fixed, Variable), Basis of Normality (Normal and Abnormal), and Basis of Analytics (Opportunity, Joint). Here, you will gain a clear understanding of the cost division. Let's understand in detail!

Understanding the different types of costs is crucial in cost accounting to make informed decisions about pricing, production, and resource allocation. Classification of costs can be done based on their behaviour, function, or relationship to production volume. Each classification has unique characteristics and implications for business operations, from direct and indirect costs to avoidable and sunk costs. This article will explore the various classifications of costs and how they impact decision-making for businesses of all sizes and industries.

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Table of Content

• On the basis of Time
• On the basis of Nature or Elements
• On the Basis of Function
• On the Basis of Traceability
• On the basis of Activity or Volume
• On the basis of Normality
• On the basis of Analytical and Decision Making Purpose
• Other Costs

On the Basis of Time

• Historical Cost

Historical cost refers to the original cost of an asset or liability when acquired or incurred. Companies often use historical costs in accounting to value assets and liabilities on a company’s balance sheet. This means we record assets or liabilities at their original cost rather than their current market value or replacement cost.

• Predetermined Cost

A predetermined cost is a budgeted or estimated cost established before producing or purchasing goods or services. Companies typically use it in cost accounting and managerial accounting to help them plan and control costs.

• Estimated Cost

Estimated cost refers to calculating or projecting the expected cost of a project, product, or service. We can typically use it in project management, construction, manufacturing, and other industries where cost estimation is an important part of planning and budgeting.

• Standard Cost

Standard cost refers to a predetermined cost established as a benchmark for measuring actual costs in a manufacturing or production process. It is used in cost accounting to help companies plan and control costs and to identify areas where cost savings can be achieved.

On the Basis of Nature or Elements

• Cost of Material

Cost of materials refers to the raw materials and components used to produce a product or service. This includes the cost of any materials that companies purchase from suppliers, as well as the cost of any materials that they produce or process in-house.

• Cost of Labour

Labour costs refer to wages, salaries, benefits, and other expenses associated with the labour required to produce a product or service. This includes the cost of all employees involved in the production process, such as direct labourers, supervisors, and support staff.

• Expenses

Expenses refer to the costs incurred by a business or individual to generate revenue or achieve a particular objective. They are typically classified into two main categories: operating and non-operating expenses.

On the Basis of Function

• Cost of Production

The cost of production refers to the total expense incurred by a business in creating and selling its products or services. These expenses may include costs associated with raw materials, labour, equipment, rent, utilities, marketing, and other overhead expenses.

• Cost of Marketing

The marketing cost refers to the expenses incurred by a business or organization to promote its products, services, or brand to potential customers or clients. These costs can include advertising fees, promotional materials, public relations expenses, and salaries or fees for marketing personnel.

• Cost of Selling

The cost of selling refers to the expenses incurred by a business or organization to sell its products or services to customers. These costs can include salaries or commissions for sales personnel, advertising and marketing expenses, travel and entertainment costs associated with sales efforts, and any fees associated with payment processing or shipping.

On the Basis of Traceability

• Direct Cost

Direct costs are expenses companies can directly attribute to producing a specific product or service. These costs are typically associated with the materials, labour, and equipment needed to create the product or service. Direct costs include:

• Raw materials.
• Wages for manufacturing personnel.
• The cost of equipment and machinery used in the production process.

• Indirect Cost

Indirect costs are expenses not directly related to the production of a specific product or service but are necessary for the business to operate. We typically associate these costs with overhead and administrative expenses such as rent, utilities, and office supplies. Indirect costs can also include salaries for non-production personnel such as management, marketing, and accounting staff.

On the Basis of Activity or Volume

• Fixed Cost

Fixed costs remain constant regardless of the activity level or volume. These costs only change slowly, even if production increases or decreases. Examples of fixed costs include rent, property taxes, and salaries for non-production personnel.

• Variable Cost

Variable Costs: Variable costs are expenses that fluctuate based on the activity level or volume. These costs increase or decrease as production levels change. Examples of variable costs include raw materials, direct labour, and sales commissions.

• Sem-Variable Cost

Semi-variable costs, also known as semi-fixed costs, are expenses that have both fixed and variable components. These costs may have a fixed portion that remains constant regardless of activity or volume and a variable portion that fluctuates based on production levels. Examples of semi-variable costs include utilities, maintenance, and some types of labour.

On the Basis of Normality

• Normal Cost 

Normal costs are expenses typically incurred during the normal course of business operations. These costs are considered predictable and expected and are included in the cost of goods sold or operating expenses. Examples of normal costs include raw materials, direct labour, and utilities.

• Abnormal Cost

Abnormal costs, also known as extraordinary costs, are not considered part of normal business operations. These costs are unexpected and typically result from unforeseen events or circumstances. Examples of abnormal costs include repairs due to natural disasters, legal settlements, and expenses related to a sudden drop in demand for a product or service.

On the basis of Analytical and Decision Making Purpose

• Opportunity Cost

Opportunity cost refers to the value of the next best alternative forgone when deciding. In other words, it’s the cost of the missed opportunity. Whenever a decision is made, there are always choices that are not pursued. The opportunity cost is the value of the benefits that would have been gained from the next best alternative that was not chosen.

For example, a person has $100 to spend and is trying to decide whether to buy a new jacket or go out to dinner. If they choose to buy the jacket, the opportunity cost is the dinner value they didn’t go to. If they choose to go out to dinner, the opportunity cost is the value of the jacket that they didn’t buy.

• Joint Cost

Joint cost is a type of cost that arises when a single production process generates multiple products or outputs simultaneously. These products cannot be easily separated or identified as individual products until a certain point in production. Joint costs are incurred up to that point and allocated to the different products based on some agreed-upon cost allocation method.

An example of joint cost can be seen in oil and gas production. When oil is extracted from a well, it often comes out along with natural gas. Extracting oil and gas incurs joint costs, such as drilling the well and operating the extraction equipment. These joint costs must be allocated to the different products to determine their costs and profitability.

• Sunk Cost

Sunk cost refers to a cost that has already been incurred and cannot be recovered or changed, regardless of any future actions taken. In other words, it’s a cost that has been spent and cannot be reversed.

An example of a sunk cost would be a non-refundable airline ticket. Once the ticket has been purchased, the cost is sunk and cannot be recovered, even if the traveller decides not to use the ticket.

• Differential Cost

Differential cost, also known as incremental cost, refers to the difference in cost between two alternatives. In other words, it’s the additional cost incurred or saved by choosing one option over another.

Differential cost can be calculated by subtracting one option’s cost from another’s. For example, if a business decides whether to produce a product in-house or outsource production to a third-party manufacturer, the differential cost would be the difference in cost between producing the product in-house and outsourcing production.

• Common Cost

Common cost is incurred for the joint benefit of two or more products, departments, or activities within an organization. These costs are not directly traceable to a specific product or activity and cannot be easily allocated to a single cost object.

An example of a common cost would be the rent for a building shared by multiple organizational departments. The cost of rent is incurred for the joint benefit of all departments and cannot be easily allocated to a single department based on usage.

• Imputed Cost

Imputed cost refers to a cost that is not incurred but is assigned to a particular activity or product to reflect its true economic cost. These costs are often used in cost accounting to provide a more accurate picture of the true costs of an activity or product.

An example of the imputed cost would be using a company-owned building or equipment for a particular activity or project. While the company may not incur any actual expenses for using the building or equipment, an imputed cost would be assigned to the activity or project to reflect the true economic cost of using those resources.

• Capacity Cost

Capacity cost refers to the fixed costs associated with an organization’s production capacity, regardless of the production level. These costs include rent, property taxes, building, machinery, and equipment insurance.

Capacity costs are incurred regardless of whether the organization is operating at full capacity or producing at a lower level. They are typically considered sunk costs in the short run. However, businesses can adjust their production capacity to reduce or optimize capacity costs in the long run.

• Marginal Cost

Marginal cost is an important concept in economics and business, as it helps firms determine the most efficient production level. Businesses can determine whether producing additional output units is profitable by comparing the marginal cost to marginal revenue. Suppose the marginal revenue generated by producing an additional unit exceeds the marginal cost. In that case, the firm should continue to produce more units until marginal revenue equals marginal cost.

• Replacement Cost

Replacement cost replaces an asset or item with a new or similar item of equal value. It is the cost that would be incurred to replace an asset at its current market value rather than the historical or original cost of the asset.

For example, if a business’s computer equipment is destroyed in a fire, the replacement cost would be the amount of money needed to purchase new equipment of the same or similar specifications rather than the cost of the original equipment when it was purchased.

• Out-of-Pocket Cost

Out-of-pocket cost refers to the expenses that an individual or business incurs for goods or services not covered by insurance or other reimbursement forms. These costs are paid directly by the individual or business and are not reimbursed by a third party.

Examples of out-of-pocket costs may include deductibles, copayments, coinsurance, and expenses for services not covered by insurance, such as elective medical procedures. Out-of-pocket costs may include travel, lodging, and other incidental expenses associated with medical care or other services.

Other Costs

• Uniform Cost

Uniform cost is a type of cost that remains constant per unit of production, regardless of the production volume. In other words, it is a cost that does not vary with changes in the activity level or output.

Examples of uniform costs include rent, property taxes, and insurance premiums. These costs are considered fixed costs because they do not change with changes in production volume. For instance, if a business rents a building for $10,000 per month, the rent remains the same whether the business produces 1,000 units or 10,000 units.

• Avoidable Costs

Avoidable costs can be eliminated or avoided by making a particular decision or taking a particular action. These costs are considered relevant in decision-making because they are directly affected by the decision.

Examples of avoidable costs include direct materials and labour costs incurred only if a particular product is produced and costs associated with a particular business activity or project. For instance, if a business is considering whether to continue producing a particular product line, the direct materials and labour costs associated with that line would be considered avoidable if the product line were discontinued. 

• Unavoidable Costs

Unavoidable costs are expenses that cannot be avoided or eliminated, regardless of the decision being made. These costs are generally fixed and do not vary based on the level of production or output.

Examples of unavoidable costs include rent, insurance premiums, property taxes, and salaries of permanent employees. These costs must be paid regularly and are necessary for the business to operate, regardless of the level of production or revenue.

• Total Cost

Total cost is the sum of all costs incurred by a business in producing and selling a product or providing a service. It includes both fixed costs and variable costs, as well as direct costs and indirect costs.

Fixed costs, such as rent or salaries, remain unchanged regardless of production level or sales volume. Variable costs, on the other hand, change with changes in production or sales volume, such as raw materials or labour.

• Value-Added Cost

Value-added cost refers to the cost of inputs or resources that increase the value of a product or service to the customer. These costs are considered relevant because they directly contribute to creating value for the customer.

Value-added costs can be divided into two categories: direct value-added costs and indirect value-added costs. Direct value-added costs are directly related to the production or delivery of a product or service, such as the cost of raw materials or labour. Indirect value-added costs are costs that support the production or delivery of a product or service, such as the cost of maintenance or quality control.

Conclusion!

Classification of cost can be categorised in various forms, including bases such as time, elements, function, traceability, activity, normality, and analysis. Understanding these distinctions helps businesses make informed decisions about budgeting, pricing, and profitability. Organizations can optimize their financial performance and achieve sustainable growth by effectively managing all these various costs.