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Cost Classification: Predicting Behavior & Decision

Costs can be classified according to cost behavior or decision-making. Learn about cost classifications on cost behavior (variable, fixed, and...

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Cost Classification: Predicting Behavior & Decision-Making

Instructor: Deborah Schell

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Costs can be classified according to cost behavior or decision-making. Learn about cost classifications on cost behavior (variable, fixed, and mixed costs) and on decision-making (direct and indirect costs), and explore the differential cost concept. Updated: 12/14/2021

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Cost Classification & Behaviors

Mr. Shute owns the Best Doors Company, which manufactures wooden doors. Currently, all of his doors are manufactured in house at his production facility. Mr. Shute plans to start selling a new type of door, but he is unsure whether it would be more profitable for him to manufacture the door or to buy it from one of his suppliers. To make this important decision, Mr. Shute needs to better understand his cost structure.

Costs can be classified as variable, fixed or mixed. Variable costs are those costs that vary with the amount of activity. For example, the amount of wood that Mr. Shute uses to manufacture his doors would vary depending on how many doors he manufactured in a particular month. Similarly, the Best Doors Company would incur more direct labor costs as more doors are produced. Knowing the variable cost per door allows Mr. Shute to estimate the costs he would incur at different volumes of production.

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Cost Classification & Decision-Making

It is useful to classify costs as direct or indirect when making decisions like whether to make or buy a particular product. Direct costs are those costs that can be directly attributed to the manufacture of a product, department or particular project. Knowing how costs behave is helpful when calculating an overall cost for a particular item or project at an estimated volume. Examples of direct costs for the Best Doors Company would be raw materials, or the cost of the wood used to manufacture the doors and direct labor. Most variable costs are examples of direct costs, and the concept of direct costs does not apply to non-manufacturing activities, like administrative activities.

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Calculating Differential Cost

Differential cost is what ultimately must be calculated to help Mr. Shute decide whether to make or buy the new door. Differential cost represents the difference between two alternatives. In this case, it would be the difference between the cost to manufacture the new door at Best Doors or outsource it. When Mr. Shute is making this decision, he would only consider the relevant costs and ignore the fixed costs, as those costs were incurred in the past. Relevant costs are future costs that are relevant to the decision being made.

Let's assume that Mr. Shute determines that the cost of manufacturing the new door in house at Best Doors would be $275 per door, and the cost to buy the door from another company would be $325. The differential cost in this situation would be $50 per door ($325 - $275), and Mr. Shute's company would be more profitable if he decided to manufacture the new door in house at Best Doors' manufacturing facility.

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Lesson Summary

Classifying costs as variable costs, fixed costs or mixed costs is necessary when determining how costs will behave. This is because variable costs and some components of mixed costs will change when production volumes increase or decrease, while fixed costs are unchanged.

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Accounting 102: Intro to Managerial Accounting

10 chapters | 81 lessons | 9 flashcard sets

Ch 1. Overview of Managerial...

Ch 2. Cost Types

Comparing Cost Classifications

5:46

Cost Behavior: Definition & Pattern Analysis

5:00

Cost Classification: Predicting Behavior & Decision-Making

6:02 4:15 Next Lesson

Fixed Costs: Definition, Formula & Examples

Variable Cost: Definition, Formula & Examples

4:54

Opportunity Cost: Definition & Examples

6:43

How to Calculate Opportunity Cost

6:11

Sunk Costs: Definition & Examples

4:14

Implicit Costs: Definition & Examples

5:55

Contribution Margin vs. Traditional Income Statements

3:18 Go to Cost Types

Ch 3. Cost Behavior Analysis & Cost-Volume...

Ch 4. Job-Order Costing & Process...

Ch 5. Basics of Activity-Based Costing

Ch 6. Budgeting & Standard Costs

Ch 7. Reporting Systems & Structures in...

स्रोत : study.com

Cost Classification

Cost claassification can be referred to the grouping of cost into various groups based on certain criteria/features or behaviour of cost. The cost of a product can be classified into various groups according to nature, behaviour, functions, among others.

Cost Classification

Management Accounting / By NHYIRA PREMIUM

Module objectives:

Define and explain the various basis of cost classification

Understand the various cost and responsibility centres used in various organisation

Explain the concept of cost behaviour

Perform calculations to distinguish between variable costs and fixed costs using the High and Low method.

1.     Cost classification

Cost claassification can be referred to the grouping of cost into various groups based on certain criteria/features or behaviour of cost. The cost of a product can be classified into various groups according to nature, behaviour, functions, among others.

1.1.                        Classification by nature

The total cost of making a product or providing a service consists of the following:

(a) Cost of materials

(b) Cost of the wages and salaries (labour costs)

(c) Cost of other expenses

(i) Rent and rates

(ii) Electricity and gas bills

(iii) Depreciation

A direct cost is a cost that can be traced in full to the product, service, or department that is being costed.

An indirect cost (or overhead) is a cost that is incurred in the course of making a product, providing a service or running a department, but which cannot be traced directly and in full to the product, service or department.

Materials, labour costs and other expenses can be classified as either direct costs or indirect costs

Direct material costs are the costs of materials that are known to have been used in making and selling a product (or even providing a service). Example

Materials              = Direct materials + Indirect materials

+      +        +

Labour                   = Direct labour + Indirect labour

+ +   +

Expenses                 = Direct expenses + Indirect expenses

Total cost                = Direct cost + Overhead

Direct labour costs are the specific costs of the workforce used to make a product or provide a service. Direct labour costs are established by measuring the time taken for a job, or the time taken in ‘direct production work’

Other direct expenses are those expenses that have been incurred in full as a direct consequence of making a product, or providing a service, or running a department.

Examples of indirect costs include supervisors’ wages, cleaning materials and buildings insurance

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In costing a small product made by a manufacturing organisation, direct costs are usually restricted to some of the production costs. A commonly found build-up of costs is therefore as follows.

$ Production costs

Direct materials                                          A

Direct wages                                                B

Direct expenses                                           C

Prime cost                                               A+B+C

Production overheads                                 D

Full factory cost                                  A+B+C+D

Administration costs                                   E

Selling and distribution costs                    F

Full cost of sales                               A+B+C+D+E+F

Production (or factory) overhead includes all indirect material costs, indirect wages and indirect expenses incurred in the factory from receipt of the order until its completion.

Production overhead includes the following.

Indirect materials which cannot be traced in the finished product. Consumable stores, e.g. material used in negligible amounts

Indirect wages, meaning all wages not charged directly to a product. Wages of non-productive personnel in the production department, e.g. foremen

Indirect expenses (other than material and labour) not charged directly to production.

(i) Rent, rates and insurance of a factory

(ii) Depreciation, fuel, power, maintenance of plant, machinery and buildings

Administration overhead is all indirect material costs, wages and expenses incurred in the direction, control and administration of an undertaking.

Examples of administration overhead are as follows.

Depreciation of office buildings and equipment.

Office salaries, including salaries of directors, secretaries and accountants.

Rent, rates, insurance, lighting, cleaning, telephone charges and so on.

Selling overhead is all indirect materials costs, wages and expenses incurred in promoting sales and retaining customers.

Examples of selling overhead are as follows.

Printing and stationery, such as catalogues and price lists.

Salaries and commission of salesmen, representatives and sales department staff.

Advertising and sales promotion, market research.

Rent, rates and insurance of sales offices and showrooms, bad debts and so on

स्रोत : nhyirapremiumuniversity.com

Cost Classification

Guide to What is Cost Classification & its Definition. Here we discuss what cost along with its classification is.

Cost Classification

Article by Vivek Shah Reviewed by

Dheeraj Vaidya, CFA, FRM

What is Cost Classification?

Cost Classification is the process of segregating the company’s costs into different categories that gives a fair idea to the decision-maker about the spending pattern. This bifurcation allows teams to efficiently use the data for accounting purposes and financial modeling, leading the management to decide which cost is more important than others.

Table of contents

What is Cost Classification?

Types of Cost Classification

#1 – Fixed and Variable Cost

#2 – Distribution Channel Cost

#3 – Customer Cost

#4 – Departmental Cost

Basis of Cost Classification

#1 – By Nature #2 – By Functions #3 – By Behaviour

#4 – By Management Decision Making

#5 – By Production Process

#6 – By Time Conclusion

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Types of Cost Classification

Let us discuss some types of cost classification.

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#1 – Fixed and Variable Cost

These are the two primary categories to segregate the costs; fixed costs can be accounted for during the start of any project, and a part of variable expenses can be anticipated too. However, variable cost accounts for the cost associated with the units produced and any unaccounted cost.

#2 – Distribution Channel Cost

These expenses are channeled into retail, wholesale, and the internet. Revenues from each of the channels come after deducting the cost from sales.

#3 – Customer Cost

These are the costs a company gets involved in to maintain its reputation and after-sale service for the customers. This cost includes returns, warranties, or customer service. The company then evaluates this information about the individual consumers to increase profitability and customer targeting.

#4 – Departmental Cost

Expenses related to individual departments are assigned to respective departmental managers, which are then used to analyze the manager’s performance and develop trend analysis to identify the potential of the manager.

Basis of Cost Classification

Now since we have seen the categories of the cost classification briefly, let us examine the basis on which the costs are segregated:

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#1 – By Nature

As the category suggests that this is the expense to be recorded in how the company bears it and for its use. Some major categories can be material and labor. For instance, raw material costs and other costs related to the procurement of the raw material will fall under Material charges. Similarly, salary and wages will belong to labor costs.

#2 – By Functions

Here the costs are divided as they are allocated to different functions in the company, like production, commercial, administration Distribution Costs, and Research and Development costs. All the categories include the costs of their nature of occurrence throughout the whole production cycle.

#3 – By Behaviour

It depends on the nature of the cost, like whether it is a fixed, variable, or, semi-variable cost. Rent, Lease, and salary come under Fixed expenses; Packaging and commission fall under the variable head; lastly, management, power consumption, and maintenance costs come under semi-variable costs.

#4 – By Management Decision Making

As we know, costs to the company are not only a number but also a tool to make managerial decisions. So, management decides how to distinguish the costs and what categories they should be bifurcated into Marginal Cost,, Differential cost, Sunk Cost, Abnormal Cost, Replacement cost, and so on.

#5 – By Production Process

This type of category is generally used by the companies involved in the manufacturing business where there are a lot of processes to be followed by the product to become a finished product. Some examples of this cost may be Batch cost Process cost, Contract cost, Joint cost, and so on.

#6 – By Time

The cost comes to the company as it depends on the time frame the cost has occurred. The expense of today’s importance may not hold any value tomorrow, so the basic categories in this can be Historical, pre-Determined, Standard, and Estimated costs. Based on these subcategories helps the management to effectively distribute the costs per their occurrence time, which eventually leads to a broader picture of cost evaluation.

Conclusion

As much as cost is an expense to the company, it is also considered a tool for future evaluations. Categorizing the costs into appropriate categories gives us a clear picture of the whole business model and gives the management an eagle-eye view of the entire process.

Recommended Articles

This article has been a guide to What is Cost Classification & its Definition. Here we discuss what cost along with its classification is. You may learn about it from the following articles –

Cost Allocation Cost Overrun

Objectives of Cost Accounting

Cost Drivers

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