COST CLASSIFICATION ACCORDING TO NATURE, FUNCTIONS, RELEVANCY, CONTROLLABILITY, TRACEABILITY, BEHAVIOUR

J.O. EMMANUEL
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Cost classification can be defined as the process of grouping costs according to common characteristics.

It is the grouping of costs according to similar characteristics.

Cost can be classified based on behavior, nature, functions, relevancy, controllability, and traceability.

Cost Classification By Nature

Cost classification by nature can be defined as the grouping of costs according to the natural elements of the cost.

Based on the nature of the cost, we can classify cost into material cost, labor cost and expenses.

1. Material costs: These are the costs of materials used in the production of goods and services.

They are costs associated with the acquisition and use of materials in the production of goods.

Materials costs include the cost of spare parts, raw materials, direct materials, and packaging material costs.

2. Labor costs: These are the costs incurred by a company for salary and wages paid to employees involved in the production of goods and services.

Labor costs include direct and indirect labor costs.

3. Expenses: These include all other costs associated with making and selling goods or services that are not labor costs or material costs.

Advertising, utilities, rent, and phone costs are a few examples of expenses.

Cost classification By Function

Cost classification according to function is the grouping of costs according to the function or activity they are connected to in a business

By function, costs can be classified into production costs, administration, marketing costs, and research and development costs.

1. Production costs: As the name suggests, production costs are real costs incurred during the production of goods and services.

They include costs of raw materials, labor, factory overheads and the use of equipment.

Production costs are sometimes called manufacturing costs.

2. Administration costs: These are costs incurred in connection with the general management and administration of the organization.

Although they are crucial for the smooth running of the business, administrative costs are not directly related to the creation of goods and services.

Administrative costs include salaries of general managers and office-related expenses.

3. Marketing costs: Also called selling and distribution costs, marketing costs are costs associated with making sales as well as the cost of distributing goods to the consumer.

Marketing costs can also be defined as the cost incurred in the process of selling and distributing goods.

Marketing costs include commissions paid to marketers, discounts, and product market research expenses. 

4. Research and development costs: As the name might seem to suggest, research and development costs are costs associated with researching and developing new products.

An example of R&D costs is the salaries of research and development personnel. 

Cost Classification According to Relevancy

Cost classification according to relevancy refers to the classification of costs based on whether or not they will be relevant for future decision-making.

Based on relevancy, costs can be classified into relevant and irrelevant costs.

1. Relevant costs: These are costs that are directly influenced by decisions.

That is, they are costs that will change as a result of the decision or action made.

Relevant costs can also be defined as all future costs that will be avoided or incurred as a result of a decision.

Among the best-known examples of relevant costs are costs of additional labor and costs of new equipment.

Relevant costs include all variable costs and additional fixed costs which are incurred because of the decision being taken. Relevant costs do not include fixed costs but include the 'additional fixed cost" incurred as a result of a decision being taken.

2. Irrelevant Costs: These are costs that cannot be changed by the decision to be taken.

Irrelevant costs are costs which have already been incurred and as a result, are considered irrelevant to decision-making. 

Examples of irrelevant costs include the cost of purchasing a building and the cost of training employees. 

Generally speaking, all fixed costs within a relevant range are irrelevant costs. Additionally, all sunk costs are considered sunk costs. Irrelevant costs only include fixed costs within a relevant range, it does not include additional fixed costs that can be incurred, once the relevant range is exhausted.

Cost classification according to controllability

This means classifying costs according to the degree to which they can be controlled by managers.

Based on the degree of controllability, costs can be classified into controllable and uncontrollable

1. Controllable costs: Costs are called controllable if the firm has the power to control or authorize the costs.

Controllable costs include costs of direct labor and costs of raw materials.

2. Uncontrollable costs: Costs are called uncontrollable if the firm does not have the power to control or authorize the costs.

The best example of uncontrollable costs is tax costs.

Cost classification according to traceability

Cost can be classified based on traceability.

By traceability, we mean costs are classified based on whether or not it is economically feasible to trace costs according to trace them to a specific good.

According to traceability, costs can be classified into direct and indirect costs.

1. Direct costs: These are costs that are directly traceable to a specific good or service.

Direct costs include direct material costs and direct labor costs

2. Indirect costs: These are costs that cannot be directly traced to a specific good or service, but are necessary for the production process.

Indirect costs cannot be directly traced to particular cost units.

Cost classification according to behavior

This is a method of classifying costs where costs are grouped based on how they change in relation to the level of activity or production.

According to behavior, cost can be classified into fixed cost, variable costs, and semi-variable costs

1. Fixed costs: These are costs that do not change within a relevant range.

They are costs that a business incurred regardless of how much output it produces.

Fixed costs are usually fixed within a given range and may increase after the range is attained.

An example of fixed costs is the rent paid on the factory building, which remain constant with a given range, regardless of whether or not the company is producing.

2. Variable costs: These are costs that increase or decreases proportionally to the level of output produce.

In other words, variable costs increases proportionally as production increases, and they decrease correspondingly as production decreases.

A good example of variable costs is the cost of direct labor used in the production of goods and services.

3. Semi-variable costs: These are costs that have both fixed costs and variable costs components.

Semi-variable costs, also known as mixed costs, changes as output changes but also include fixed components.

Semi-variable costs arises when a business incurred a cost that includes both a fixed-rate charge and an additional activity-based charge.

To illustrate, the costs of sales personnel, which includes a fixed salary and a variable commission, is an example of semi-variable costs.

Conclusion

To summarize, we can classify costs in different ways.

If we divide costs into materials, labor, and expenses, we are classifying costs according to their nature

We classify costs into manufacturing, marketing, administrative, and research and development costs when we classify costs by function.

Based on relevancy, we can classified costs into relevant and irrelevant costs.

If we are to classify costs based on degree of controllability, cost will be categorized into controllable and uncontrollable costs.

According traceability, costs can be classified as either direct or indirect costs.

Costs can be classified into three categories based on behavior: fixed costs, variable costs, and semi-variable costs.

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