What is Cost Classification - Types and Methods Explained

The process of categorising a company’s expenses for the decision-maker to have a clearer understanding defines the cost classification. Seamless execution allows various teams to use data for financial modelling and other accounting purposes.

To get a better understanding of this process, keep reading!

The list below highlights the four different types of cost classification.

• Fixed and Variable Cost: The primary way of classifying costs is by considering one as fixed and the other as a variable. Fixed costs are accounted for before the start of any project. In contrast, the anticipation of the variable costs is difficult to attain. Thus, these are those units generated at an unaccounted cost.
• Distribution Channel Cost: Another way of classifying costs is to distribute the expenses into various channels. These include retail, wholesale, etc. Then, the collection of revenues from these channels is done after deducting the sales cost.
• Customer Cost: A company uses expenses to maintain its reputation and build good customer relationships. Therefore, this cost includes warranties, returns, customer service, etc. The company then evaluates this information about their customers to improve its targeting approach and increase profitability.
• Departmental Cost: These are the costs allocated to the respective managers of different departments. They use this cost as a medium to analyse each manager's performance and identify their potential.

To understand what cost classification is, one must go through the basics of those classifications. There are six classifications in total, some of which also have sub-parts.

1. Cost Classification Depending on Nature

The analytic classification depends on its nature. Hence there are three categories, material cost, labour cost and other expenses. In addition, categorising in this manner helps monitor specific expenses of any work still in progress.

• Cost of Material: Simply put, this is the cost of the materials required in the production of goods. The cost of material gets further bifurcated into the cost of raw materials, spare components, costs for packaging, etc.
• Cost of Labour: This includes the wages and salaries labour gets, whether working on a temporary or permanent project.
• Expenses: This category is inclusive of any kind of miscellaneous expense related to manufacturing goods and trading services.

2. Cost Classification by Functions

As the name suggests, this categorisation checks the basic administrative actions of any organisation.

• Cost Production: The production cost is the amount a firm needs while manufacturing a product.
• Cost Commercials: This includes a cumulative cost of the overall production except for the manufacturing costs. Therefore, it includes administration costs, distribution, selling costs, and many more.

3. Cost Classification According to Behaviour

Cost classification is also done by segregating them as the following:

• Fixed Costs: Rent, lease, and salaries fall under fixed expenses.
• Variable Costs: Packaging charges and commissions fall under variable costs.
• Semi-Variable Costs: Electricity, building maintenance, and management fall under semi-variable costs.

4. Cost Classification by Management Decision-Making

In every company, those in managerial positions use money as a tool for their business growth. Hence this category of cost classification is solely dependent on management's decision. It is up to them how they want to distinguish or divide the expenses.

This may include differential cost, sunk cost, abnormal cost, marginal cost, replacement cost, etc.

5. Cost Classification by Production Process

Companies that manufacture businesses use this technique. However, such companies need to follow specific processes to launch their final product ultimately.

For example:

• Process cost
• Batch cost
• Contract cost
• Joint cost, etc.

6. Cost Classification by Time

There is a dependency on cost over time. For example, it is quite common that an expense of today may have no value tomorrow. Therefore, the managers categorise costs depending on time so that they can effectively distribute costs according to their occurrence.

Hence, the sub-division can be like this:

• Historical
• Pre-determined
• Standard
• Estimated costs

Every company needs unique costing strategies to demonstrate its expenses. Here is a list of some popular methods of cost classification.

1. Job Costing

Typically, all firms have a business rationale that allows them to manage the flow of their work process. For example, they allocate a certain cost to a particular job or assignment. The increase in profit depends on the accurate application of this strategy.

A prominent characteristic of job costing is that it applies to every particular order costing irrespective of the duration it needs to complete the job. Generally, job costing is employable for works that take a shorter period to complete.

2. Contract Costing

This method only applies if there is any involvement of a contract between a client and a contractor. However, employing this strategy benefits the contractee as it helps track all the expenses.

Primarily construction companies use the method of contract costing. For example, the construction of dams, railways, building complexes, highways, etc., are somewhere contract costing is implemented. Some may confuse this with job costing, but they differ in one aspect. Projects that take longer periods use contract costing, whereas works that take a shorter period for completion use job costing.

3. Batch Costing

Batch costing is applicable when the production of goods does not meet the demand. In such cases, they replicate the products. Nevertheless, the strategy remains persistent, and it is done in batches. These batches contain uniform products that may fulfil one order or meet the predetermined quantity requirements.

In this system, the expenditure during these batches of products is further divided by the total number of produced units. This results in the cost per unit. For example, companies that produce electronic goods like television or dryers use batch costing strategies.

4. Process Costing

This is another popular strategy of costing. Here numerous products are manufactured at the same time, and all of them are similar. Companies use this strategy to know the production cost of single units.

To determine this, first, they find the production cost of every process and then divide it by the manufactured units. Those who manufacture salt, sugar, other chemicals, or edible oil use this strategy.

5. Operating Costing

Another method of cost classification is operating costing. This is an ideal strategy for service sectors. These companies use this method to evaluate the cost of services.

However, to employ this method, companies should ensure certain formalities. Firstly, all of the services must be uniform. Secondly, they cannot be any of those specialised services.

Till now, we explained the cost classification, its types and different strategic methods. Now for a quick recap, maintaining the costs in a running business is essential as it acts as a tool for future evaluations. Therefore, we can say that by classifying costs into separate categories, one can clarify their entire business model.