Classification of Costs: Explained

The term cost means the economic value of expenditures for raw materials, equipment, supplies, services, labour, products, etc. It is an amount that is displayed as an expense classification in bookkeeping records.

Different Types of Cost

Any business requires an investment of capital or money. The investor or owner of the business has to keep a record of the total money he has spent for the various operations in the business. It can be for anything required to start and establish any enterprise up to gaining of the final profit. Under this topic, we will learn and identify various expenditures that are incurred while running any business endeavor. There are also different formats and categories for the classification of all costs.

First classification is in relation to the resources that the money has been spent on. It can be for raw materials, land, labour, transportation, marketing, infrastructure, communication, management, and everything else. However, all these expenses are broadly put under three types such as Labour cost, Material cost, and Expenses. It can be easily recognized by understanding the nature of the commodities obtained through the expenses. Materials are the raw materials used for the production of any final product. It includes all the expenses of packaging and value addition too. The salary and wages paid to the persons working for the manufacturing of the product is termed as Labour cost. It includes both permanent and temporary workers. However, only producing a product does complete the job of running a business. It has to be marketed and transported to the market for getting selled and returning a profit. All these expenses are categorized under expenses.

All in all the expense for producing a final product is known as Production cost. And all other expenses are termed as commercial costs.  Some have also categorized the costs into direct costs and indirect costs. The other classification is Normal cost versus Abnormal cost. Other than that there are several other costs which do not pertain to commercial operations so will be included in the subsequent chapters.

Classification of Costs

Classification of cost in economics is the classification of cost based on various factors which are discussed below. The following will be the types of cost classification.

Classification by Nature

This classification of cost is based on the nature of the expenditure, which are the three broad categories as per this, namely Labor Cost, Materials Cost, and Expenses. This cost makes it easier to classify them on a cost sheet. They help in estimating the total cost and also to estimate the work-in-progress cost.

• Material Costs: These are the costs of any materials that are used in the production of goods. This is further divided into further costs. For instance, we can classify material costs into spare parts, raw material cost, packaging material cost, etc.

• Labour Costs: This cost includes the salary and wages paid to temporary and permanent employees for the manufacturing of the goods.

• Expenses: It includes all other expenses associated with manufacturing and selling the services or goods.

Classification by Functions

This is the classification based on functional costs. The cost classification by function flows the pattern of basic managerial activities. So, this cost is classified as production, administration, selling, etc. 

• Production Costs: These costs are related to the real construction or manufacturing of the goods. 

• Commercial Costs: This cost includes the operation of an enterprise except for the manufacturing costs. It consists of the admin costs, distribution and selling cost, etc.

Classification by Traceability

This cost is classified into direct costs and indirect costs. This classification is classified on the degree of traceability to the final product of the firm.

• Direct Costs: These are the costs that are easily related to a specific cost unit. The most significant examples are the materials used to manufacture a product or the labour involved in the production process.

• Indirect Costs: These costs are used for many purposes, which are between many cost centers or units. So we cannot put them to one specific cost center—for instance, the rent of the place or the manager's remuneration. We will not be able to identify how to estimate costs to a specific cost unit.

Classification by Normality

This classification is based on the costs as the normal costs and abnormal costs. The normal costs are the costs that happen at a given point of output, under the same set of conditions in which this point of output occurs.

• Normal Costs: The cost of production and also the part of the costing profit and loss. These are the type of costs that the organization incurs at the standard level of output under normal conditions.

• Abnormal Costs: These costs are not normally occurring at a particular level of output in conditions in which normal levels of output happen. These costs are calculated according to the profit and loss account; they are not a part of the production cost.