COST CLASSIFICATION: TYPES AND THEIR CHARACTERISTICS - DUDAS - 2025

The cost classification is the separation of a group of spending in different categories. A classification system is used to draw the attention of management to certain costs that are considered more important than others, or to involve them in financial modeling.

Cost can be defined as a sacrifice of resources to obtain a benefit or any other resource. For example, in the production of a car, materials, electricity, the value of the machine's useful life (depreciation), labor wages, etc. are sacrificed.

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So these would be the costs. Costs can be subdivided or classified in many ways. Only some of the classifications are made within the formal accounting system, mainly to classify costs by department.

Other types of classifications must be done manually, usually with an electronic spreadsheet.

Ways to classify costs

There are many ways to classify costs, the most used by organizations are the following.

-According to the management function

Production costs

They are the costs incurred in the factory to convert raw materials into finished products. It includes the cost of materials used in production, or direct materials, direct labor, and general factory costs.

Material costs

It is the cost of the material of any nature used for the production of a product or service. The cost of the material includes the acquisition cost, freight to the plant, taxes and duties, insurance, etc., directly attributable to the acquisition.

When determining material costs, trade discounts, refunds, duty refunds, sales taxes, etc. are deducted.

Direct labor costs

Includes wages and production bonuses paid to permanent, temporary, and contractor personnel who work directly in manufacturing.

They also include monetary benefits to be paid later, such as social security contributions, pensions and bonuses linked to earnings.

There are also non-monetary benefits within these costs, paid by the company, such as food, medical facilities, education for the employees' children, housing, etc.

General manufacturing costs

These are the costs, in addition to the two above, involved in production. They are the expenses involved in public services, quality, maintenance, production supervisors, etc.

Non-manufacturing costs

They are the costs that are not incurred in the transformation of materials to finished products, but in other activities of the company.

These include selling expenses, such as advertising expenses, delivery expenses, sellers' salaries and commission, and administrative expenses, such as executive salaries and legal expenses.

-According to traceability

Direct costs

They are those that can be directly identified in an easy and indisputable way to a particular cost object, such as a product, department or cost center.

Examples include materials and direct labor. Some operating expenses can also be classified as direct costs, such as the expense of advertising a particular product.

Direct material, direct labor, and direct expense costs can be assigned or identified directly with a particular cost center or cost unit and can be charged directly to that cost center or cost unit.

Indirect costs

They are those that cannot be attributed to a particular object of cost calculation. They are also called common costs or overhead costs.

Indirect costs include manufacturing overhead and operating expenses that benefit more than one product, department, or branch.

They are not assignable to any plant, department, operation, or any final product. All overheads are indirect costs.

Indirect costs cannot be assigned directly, but can be distributed to different cost centers or cost units. These costs are also called common expenses.

-According to the weather

Historical cost

It is the actual cost, determined after an event. The historical cost valuation establishes the costs of the plant and materials. For example, the price that was originally paid for them.

The costs reported by conventional financial accounts are based on historical valuations.

However, during periods of changes in price levels, historical costs may not be the correct basis for projecting future costs. Naturally, historical costs must be adjusted to reflect current or future price levels.

Default cost

These product-related costs are calculated before production, based on a specification of all factors that affect costs and cost data. Default costs can be standard or estimated.

Standard cost

It is a predetermined cost based on a reasonable basis, such as past experiences, budgeted amounts, industry standards, etc.

It indicates how much the costs should be worth under certain working conditions. Actual costs incurred are compared to standard costs.

It is built from evaluating the value of cost elements, correlating the technical specifications and the quantification of materials, labor and other costs, with the prices and / or rates of use that are expected to apply during the period when they are intends to use standard cost.

Its main objective is to provide a basis for controlling, through accounting variation, the valuation of stock and work in progress and, in some cases, for determining sales prices.

Estimated cost

It is a predetermined cost based on past performance, adjusted for anticipated changes, without a careful assessment of each individual component. It can be used in any business or decision-making situation that does not require a precise cost.

It is also used in the budget control system and in the historical costing system. It is used for making decisions and selecting alternatives with maximum profitability. It is also used in pricing and bidding.

-According to the time of loading against income

Product costs

It is an aggregate of the costs that are associated with a unit of product. These costs may or may not include an element of overheads, which depend on the type of cost system in force: absorption or direct.

Product costs are related to goods produced or purchased for resale, and are initially identifiable as part of inventory.

These costs are converted to expenses, in the form of cost of merchandise sold, only when inventory is sold.

The cost of the product is associated with a unit of production. It is made up of the costs of inputs in product formation, that is, direct material, direct labor, and factory overhead.

Period costs

They are costs that tend not to be affected by changes in the level of activity during a given period of time.

They are associated with a period of time, rather than a production activity, and are deducted as expenses during the current period, without being previously classified as product costs.

Selling expenses and administrative expenses are expenses for the period and are deducted from income, without being considered part of the cost of inventory. They are charged to income immediately.

-According to the behavior according to the activity

The information of this type of costs is used to carry out the break-even analysis.

Variable costs

They are costs that vary in proportion to changes in activity. Examples include direct materials, direct labor, and sales commissions based on sales.

These costs are subtracted from revenue to obtain a company's contribution margin.

Fixed costs

They are costs that remain constant regardless of the level of activity. Examples include rent, insurance, and depreciation using the straight-line method.

Mixed costs

They are costs that vary in total, but not in proportion to changes in activity. It basically includes a fixed cost potion plus additional variable costs.

An example would be the cost of electricity, which consists of a fixed amount plus variable charges based on use.

-According to the relevance for decision making

Relevant cost

It is an appropriate cost to help make managerial decisions. Business decisions involve planning for the future and considering various alternative courses of action.

In this process, the costs that are affected by the decisions are future costs. These costs are called relevant costs because they are tailored to the decisions in question.

Cost is said to be relevant if it helps the manager make the right decision to further the company's goals.

It can also be defined as any cost that is affected by a decision. The relevant cost must be a future cost, that is, one that is expected to be incurred and not a historical or sunk cost that has already been incurred.

Marginal cost

It is defined as the quantity over any given volume of product by which the aggregate costs change if the volume of the product increases or decreases by one unit.

It is the variable cost of a unit of a product or service. In other words, it is a cost that would be ignored if that unit were not produced or delivered.

Differential cost

Also known as incremental cost. It is the difference in the total cost that will arise with the selection of one alternative over another. It is the additional cost of a change in activity level.

This concept is similar to the economists' concept of marginal cost, which is defined as the additional cost incurred in producing one more unit of output.

It refers to any type of change, such as adding a new product or removing an existing product, changing distribution channels, adding or removing business segments, adding new machinery, selling or processing more, accepting or rejecting special orders, etc.

Opportunity cost

It is the benefit that is renounced or sacrificed when one alternative is chosen over the others. Example: If a company decides to use its production plant instead of renting it to certain tenants, the opportunity cost of this decision would be the income that would be obtained from the rent if the company decided to rent it.

The opportunity cost of the good or service is measured in terms of the income that could have been obtained by using that good or service in other alternative uses.

They represent the income lost by rejecting alternatives. Therefore, they are not incorporated into formal accounting systems, because they do not incorporate cash inflows or outflows.

Sunk cost

It is the one for which the expenses have been made in the past. This cost is not going to be affected by a particular decision under consideration. Sunk costs are always the result of decisions made in the past.

This cannot be changed by any decision in the future. Sunk costs are those costs that have been invested in a project and that will not be recovered if the project is completed.

The cost of investment in a plant and machinery as soon as they are installed is a sunk cost and will not be relevant to decisions. Amortization of past expenses and depreciation are sunk costs.

These costs will remain the same regardless of the alternative selected. Therefore, it is not necessary to take them into account when evaluating alternatives, since it is common to all of them. Unlike relevant costs, they do not have an impact on the matter at hand.

Replacement cost

It is the cost at the date of quotation at which an item identical to the one to be replaced can be purchased, as opposed to the actual cost price on the date of purchase.

It is the cost of replacing an asset at any given time in the present or in the future, excluding any item attributable to an improvement.

Controllable cost

It is a cost attributable to a budget or cost center, which can be influenced by the actions of the person in whom control of the center is conferred.

It is not always possible to predetermine responsibility, as the reason for deviation from expected performance can only become apparent later.

For example, excess scrap can arise from inadequate supervision or a latent defect in purchased material.

Controllable cost is a cost that can be influenced and regulated over a given period of time by the actions of a particular individual within an organization.

The managers of each department must be evaluated based on the costs they can control.

Discretionary costs

Expenses that can be temporarily reduced or eliminated are classified as discretionary.

This approach is used to cut costs temporarily, especially when a company anticipates having a brief decline in revenue.

References

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5. Accounting Explained (2018). Cost and Cost Classifications Taken from: accountingexplained.com.
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