The definition of cost classification is the process of dividing a company's costs into various categories for the decision-maker to have a clear understanding of the spending patterns. Because of this, teams can effectively use the data for financial modelling and accounting purposes. It helps management to determine which cost is more crucial than the others.
Did you know? A book entitled “Cost Accounting Theory and Practice” was published by Nicholson in 1913. According to his work, he used the same methods for estimating inventories, cost estimates, and analysing the cost of sales, but his verification method was different.
Classification of Cost
1. Classification Depending on the Nature
It is the analytic classification of cost. Practically, there are 3 types of cost classification, i.e., labour costs, expenses, and materials costs, making it simpler to categorise the expenses in an expense sheet. They also help demonstrate the aggregate cost and specify the expense of any work in progress.
1. Cost of Material
Material Cost is the cost of any material we employ in the generation of goods. The costs are divided further. For instance, let us divide the material cost into the cost of raw material, spare components, costs of material for packaging, etc.
2. Cost of Labour
Labour cost concepts and classifications comprises of the wages and salaries paid to temporary and permanent workers for goods manufacturing.
Every other expense correlated with manufacturing and trading the services or goods.
2. Functional Classification of Cost
The categorisation follows the structure of the basic administrative actions of an organisation.
The accumulation of costs is done depending on the vast divisions of procedures such as selling, production, administration, etc.
Cost of Production
Every cost is concerned with tangible manufacturing or production of the good.
Cost of Commercials
The cumulative cost of the system of production other than manufacturing expenses. It comprises the administration cost, distribution, selling cost, etc.
3. Classification According to Traceability
This method is one of the most significant classifications of costs. It divides accounting costs into indirect and direct costs. This category is established on the level of traceability of the final commodity of the business.
These are expenses that are effortlessly recognised with a particular cost unit. A few basic instances are the equipment employed in producing a good or the job implicated with the manufacturing process.
This cost is incurred for various motives, i.e., between multiple cost units or centres. We cannot effortlessly recognise them in one specific cost centre or unit. Take, for instance, the building's rent or the earnings of an administrator. We would not be accurately determining how to demonstrate such expenses to a specific cost unit.
4. Classification Depending on Normality
This categorisation can explain the classification of cost. It specifies the cost as abnormal and normal costs. The criteria of normal cost are the cost that generally occurs at an allotted level of outcome, under the exact set of circumstances in which the degree of output occurs.
It is an ingredient of the expense and an ingredient of the profit or loss of cost. These are expenses that the business encounters at the normal outcome level in standard circumstances.
This cost is not generally encountered at an allotted level of outcome in circumstances in which usual levels of outcome occur. This cost is credited to the revenue and loss accounts. It is not an element of the production cost.
Methods of Cost Classification
Every company has a distinct nature and trait. It also requires them to engage in different costing strategies to demonstrate the expense of their commodities. Let's look at a few popular and common costing techniques.
Several firms function on a business work rationale. In cases like these, they employ the business costing technique. The cost gets allocated to a certain job or assignment.
When this strategy is executed precisely, job profitability becomes satisfactory. A few significant characteristics of this kind of costing are that it pertains to a particular order costing and the cost of every job or order, irrespective of the duration that is consumed to attain the job. However, the time taken for every job is comparatively short. The cost is collected when the job gets completed. Prime cost is traced, and any upkeep is allocated to the jobs specifically on a certain proportionate and suitable basis.
It is employed if the goods have not been produced as per the demand. However, they are replicated. The production strategy here is persistent, and it happens in batches. That's why it is referred to as batch costing. The batches can be to fulfil a particular order, or they can be for a predetermined quantity. The goods that are produced are uniform. In this kind of costing, the cost that is encountered during the production of batches of goods is further divided by the unit number that is produced. This gives the cost incurred per unit. This strategy comes in handy and is beneficial when it comes to producing electronic goods like washing machines and televisions.
Process costing is a very popular strategy costing. In this method, several goods are produced at the same time. The goods that are produced are homogeneous, and they are also in vast quantities. This is the reason why this strategy is employed to know the production cost of every unit. The cost of every process is found, and then it is divided by the units that were generated using this procedure. A few instances of commodities that employ this costing process are salt, chemicals, edible oil, and sugar.
Operating costing is a method that is highly employed by the service sector because it is best suited for them. They use an operating cost method when it comes to the classification of costs in cost accounting to evaluate the cost of the services. However, the services should be uniform, and these should not be specialised services in order to evaluate the cost. The average cost of all the services rendered is established.
When a contract is undertaken, the cost of it can be worked out by employing the contract costing method. It helps them to track the expenses of a particular contract with a consumer. The contract costing method is primarily used for things like the construction of dams, bridges, highways, and complexes, and also these are mainly construction contracts. There are not many disparities when it comes to contract costing. Job costing is applied for a shorter period. On the other hand, contract costing is employed for a longer duration. It is generally for a few years.
Benefits of Cost accounting
All firms have to deal with losses, but they also earn profits. However, they must investigate why they have incurred losses and evaluate the profits. It not only helps them in tackling their issues and overcoming the reasons. This will help them to rule out these reasons and minimise the loss.
It plays a major role in determining the reason for losses. For instance, when the production cost is meagre, and the prices are elevated, you can still have losses. It could be because the output was low due to some inefficiency. The process of cost accounting benefits by helping us to discern this.
The biggest advantage when it comes to cost accounting is that it helps the administration with future agendas they might have. For output or selling strategies, it is crucial to have documented information about the devices, the labour ability, output grades, efficiency levels of each procedure, etc.
For cost classification examples, if the administration needs to broaden the production, cost accounting helps specify if the existing machines can deal with these phases of production.
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