COST CLASSIFICATION

What is cost?

Cost is the expenditure incurred on resources that are used to achieve a particular objective.
Resources may be tangible (materials or machinery) or intangible (labour skills, patent, copyright
etc.) so cost is the amount of money required to produce a product or perform a service.

Costs can be classified in a number of different ways:

1. Classification of cost by behaviour

2. Classification of cost by function or department
3. Classification of cost by ease of traceability
4. Classification of cost by timing of charge against revenue
5. Classification of cost by relevance to decision making.

1. Classification of cost by behavior

Costs are classified into fixed and variable costs based on their behaviour. Variable costs and
fixed costs behave differently with change in the activity levels and hence this classification is
called the behavioural classification.

(a) Fixed and semi-fixed or stepped fixed costs:

Fixed cost: A cost that remains constant in total, within the current budget period, irrespective of
changes in volume of activity, is called a fixed cost. Or fixed costs are the expenses which do not
change in proportion to the activity of a business, within the relevant period of time e.g.
insurance costs, depreciation on assets, or rent of office building or factory premises.

Stepped fixed cost or semi fixed cost: Cost that are fixed for a given level of activity but in due
course changes by a constant amount at some point is a stepped fixed cost. A stepped fixed cost
remains the same up to a certain level of activity or a certain period of time, then changes and
again remains constant up to a new activity level or a period of time. E.g. rent costs for extra
storage.

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 (b) Variable Cost:

The cost that varies with a change in the volume of activity is known as variable cost.

Variable cost It varies in total but its variable cost per unit remains constant. For example, 1 item
costs Tshs1, 000 and 10 items cost Tshs10, 000. The cost of each individual unit is Tshs1, 000,
but in total the costs are Tshs10, 000. Variable costs are expenses that change in direct
proportion to the activity of a business.

Example of variable cost are direct material and labour cost, indirect material and labour cost,
Power and fuel, Lubricants.

(c) Total cost:

Are the sum of total fixed cost and total variable cost for a given level of activity at a given
period of time.

(d) Semi-variable costs:

A cost that is composed of a mixture of fixed and variable components is known as a semi-
variable cost. It is also known as a mixed cost. E.g. Monthly telephone costs, electricity costs.

HOW TO SEPARATE BETWEEN VARIABLE COST AND FIXED COST

(USING HIGH – LOW METHOD)
 High / low Method:

High/low method is a method that are used to compares the costs at two different activity levels
so as to identify the fixed and variable cost components of the total cost.

STEP TO FOLLOW:

i. Calculate the variable cost per units (VC/Q)

ii. Determine the total fixed cost
iii. Forming the total cost function or equation

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Example: The following data relates to the monthly output and related costs for Only ABC Ltd, a
soap manufacturing company.

Month Output (Units) Costs

(TZS)
January 10,000 50,000
February 11,000 54,000
March 12,000 58,000
April 13,000 62,000

Required: Separate total cost into the fixed and variable elements, apply the high or low
method.

2. Classification of cost by function or department:

Classification of cost by function categorized cost into manufacturing and non-manufacturing

costs.

Manufacturing costs (or Production costs): are those cost incurred in the factory to convert raw
materials into finished goods. It includes cost of raw materials used (direct materials), direct
labor, and factory overhead.

Non-manufacturing costs (or non-Production costs): are those cost which do not incurred in
transforming materials to finished goods. These include selling expenses (such as advertising
costs, delivery expense, salaries and commission of salesmen) and administrative expenses (such
as salaries of executives and legal expenses).

3. Classification of cost by ease of traceability.

Are they direct or indirect? Direct costs are closely related and traceable to each item produced.
Indirect costs are not so easy to relate and trace to each unit of production.

Direct costs: those that can be traced directly to a particular object of costing such as a particular
product, department, or branch. Examples include materials and direct labor. Some operating
expenses can also be classified as direct costs, such as advertising cost for a particular product.

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Indirect costs: those that cannot be traced to a particular object of costing. They are also called
common costs or joint costs. Indirect costs include factory overhead and operating costs that
benefit more than one product, department, or branch.

4. Classification of cost by timing of charge against revenue:

Product costs: are inventoriable costs. They form part of inventory and are charged against
revenue, i.e., cost of sales, only when sold. All manufacturing costs (direct materials, direct
labor, and factory overhead) are product costs.

Period costs: are not inventoriable and are charged against revenue immediately. Period costs
include non-manufacturing costs, i.e., selling expenses and administrative expenses.

5. Classification of cost by relevance to decision making:

Relevant cost: cost that will differ under alternative courses of action. In other words, these costs
refer to those that will affect a decision.

Standard cost: predetermined cost based on some reasonable basis such as past experiences,
budgeted amounts, industry standards, etc. The actual costs incurred are compared to standard
costs.

Opportunity cost: benefit forgone or given up when an alternative is chosen over the other/s.
Example: If a business chooses to use its building for production rather than rent it out to tenants,
the opportunity cost would be the rent income that would be earned had the business chose to
rent out.

Sunk costs: historical costs that will not make any difference in making a decision. Unlike
relevant costs, they do not have an impact on the matter at hand.

Controllable costs: refer to costs that can be influenced or controlled by the manager. Segment
managers should be evaluated based on costs that they can control.

Uncontrollable costs: refer to cost over which a person has no direct control. The concept most
commonly applies to the manager of a department, whose several line items which he has no
ability to alter.

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