Our purpose here is to provide an introduction to the different ways in which costs can be classified, as well as explain the kind of situations where a particular classification is most suitable. Table 1 lists the various classifications on the basis of Behavior, Nature, and Function.
Table 1: Cost Classifications
|Purpose of the Cost Classification
|Direct and indirect costs
|Assigning costs to a cost object
|Product and period costs
|Preparing financial statements
|Manufacturing, merchandising or service sector costing
|Different costs for different sector types
|Absorption and variable costing
|Valuation of inventory for reporting purposes
|Job costing and process costing
|Costing systems for different organizational types
|Variable and fixed costs
|Predicting cost behavior when output/activity levels change
|Standard costs & Controllable and uncontrollable costs
|Costs to assist planning and evaluation
|Relevant costs & Opportunity costs
|Costs used in different decision-making scenarios
Assigning Costs to Cost Objects
Direct and Indirect Costs
In attempting to measure a cost object, an important distinction to make is that between direct and indirect costs:
- Direct costs can be easily associated with a particular cost object.
- Indirect costs evidently support more than one cost object.
Direct costs tend not to be difficult to identify because, by definition, they are incurred as a direct consequence of the cost object’s existence or occurrence.
An example would be the music system inside a high-performance motor car, the cost data for which can be obtained from the bill of materials issued by the supplier.
Indirect costs (sometimes referred to as overheads) can be more problematic. Indirect costs are so called because they are costs that support more than one cost object. They are costs which cannot be identified with a single cost object.
An example would be the electricity costs in a factory which produces several different styles of fashionable ladies’ shoes; where the cost object is one particular style of the shoe there will be a need to calculate the proportion of total electricity costs in the factory which are specifically attributable to the production of that shoe.
Preparing Financial Statements
Product Costs and Period Costs
Another important aspect of management accounting is how and when to recognize the costs of making, acquiring or providing products and services.
A product cost is a cost that is assigned to goods either purchased or manufactured for (re)sale. They are treated as current assets when incurred and posted to the statement of financial position as inventory until the final product is sold.
A cost that is not a product cost is called a period cost. They relate to organizational activities such as selling and administration. Period costs are recognized in the income statement as an expense at the time they are incurred.
Different Costs for Different Sector Types
Next, we consider three different sectors and highlight how the identification and treatment of product costs differ across each; but it should be noted that the following are rather broad descriptions.
Manufacturing costs comprise the following:
- Direct materials – materials that are easily identified with a finished product. For example, this might include the aluminum used to make cookery pans, the yeast used to make beer or the plastic casing for an iPod.
- Direct labor – labor that can be easily identified with (traced) a finished product. For example, this might include a machinist who makes a cutting tool, the salary of a painter who hand-paints a rare set of dinner plates, or the remuneration of a carpenter who plies her trade on a building site.
All the direct costs incurred when making a particular product also have a name – prime costs. In most cases, this is the sum of all direct material and direct labor costs but can sometimes include additional direct expenses.
Another term which seems worthy of a mention here is conversion cost. Conversion costs comprise all manufacturing costs other than direct materials costs. Some organizations adopt this term to simplify their accounts.
Indirect manufacturing costs (or manufacturing overhead) – all manufacturing costs other than direct materials, direct labor, and any other direct expenses. In other words, it comprises:
- Indirect materials, such as the maintenance costs for a factory machine that is used to make several products
- Indirect labor, such as the wages of a factory supervisor who oversees the manufacturing of multiple products, or factory-wide health and safety officers
- Indirect manufacturing expenses, such as the rent or electricity costs incurred in a factory.
Merchandising organizations purchase and then sell tangible products without altering their basic form. They generate profits or surplus by selling their merchandise for a price that is higher than the cost of purchase.
Examples of merchandising organizations include wholesalers and retailers (for example, sportswear stores and bookshops).
Merchandisers hold only one type of inventory, that is, they hold merchandising inventory, which constitutes the purchased products in their original form.
Service-sector organizations provide services and/or intangible products to their customers – for example, in this category we might think of professional accounting firms, lawyers, health-care organizations, airlines and Internet service providers.
Service organizations do not normally hold inventories of any tangible products that are for sale or resale.
Valuation of Inventory for Reporting Purposes
Absorption Costing and Variable Costing
Another distinction to make for costs is between absorption costing and variable costing. Both costing methods establish a way to value inventory in the management accounts, but there are differences between them.
Absorption costing describes when all manufacturing costs are regarded as being inventoriable. That is, all manufacturing costs are absorbed into the valuation of inventory, whereas;
Variable costing describes when only variable manufacturing costs are inventoried, and fixed manufacturing cost is treated as an expense at the time period in which it is incurred (that is, period costs).
Costing systems for Different Organizational Types
Job Costing and Process Costing
For manufacturing organizations, we need to briefly highlight two different methods for determining the cost of products, namely: (1) job costing, and (2) process costing.
Job costing accumulates the costs incurred in the production of a single unit or a single batch of units. Importantly, the unit produced for one job is dissimilar from the unit produced for another job. Thus, cost information is gathered for each individual job in production, and the cost for each unit is calculated separately.
Process costing is most appropriate when an organization’s units of production are identical, or almost identical, such that each individual unit of production consumes the same amount of manufacturing input resource. In such cases, rather than calculate separate costs for each unit, an average per unit cost can be applied across the board.
Predicting Cost Behavior When Output/Activity Levels Change
Variable Costs and Fixed Costs
The distinction between variable costs and fixed costs underpins how we might view costs changing in response to changes in organizational activity.
A variable cost changes (in total) in proportion to the level of activity. For example, direct materials, direct labors.
A fixed cost does not change (in total) as activity levels fluctuate. An example of a fixed cost is the factory rent for a motor car manufacturing plant. If we assume there is an agreed annual fee for rent (say 300k dollars), then future changes in the number of cars produced will have no impact on the total cost of rent, it will remain at 300k dollars.
There is a particular period over which the definition of variable and fixed costs holds, called the relevant range. This relevant range is specific to a particular organization, and can also change over time for the same organization.
Costs to Assist Planning and Evaluation
On the basis of careful analysis and estimation, standard costing establishes an array of acceptable costs that an organization expects to incur, and monitors actual costs against these standards. Traditionally standard costing systems would assist planning, would help to establish performance targets, and would be used routinely to evaluate actual performance against these targets.
Controllable Costs and Uncontrollable Costs
Another important distinction to make when looking at costs, particularly when making business plans and evaluating subsequent performance against those plans, is that between controllable and uncontrollable costs.
Controllable costs are those costs which can be influenced by the actions of a particular person (or group) in relation to a particular undertaking.
Uncontrollable costs are those costs which cannot be influenced by the actions of an individual (or group) for a particular undertaking. Many fixed costs are deemed as uncontrollable, at least in the short term, for example, factory rent or council charges.
Costs Used in Different Decision-Making Scenarios
A relevant cost is a cost (or cash outflow) that would influence the choice among decision alternatives. Relevant costs exhibit two main properties:
- 1) It is a cost which will be incurred in the future, and;
- 2) There must be cost differentials between decision alternatives.
In relation to (1), an organization’s current decisions have no bearing on prior expenditure, and expenditures associated with the past (called sunk costs) cannot be altered through current or future decisions. Therefore, because sunk costs are unaltered by current and future decisions, they are irrelevant to current and/or future decisions.
Another important definition to make is an opportunity cost. Opportunity cost is the value of something that a decision maker gives up as one decision option is selected over another. It is equal to the benefits forgone by electing one decision alternative over another and can be a cost that implies no cash outlay.