Different classifications of costs

There are multiple types of costs and it may sometimes be hard to differentiate them. In this article, we will review cost classifications.

1. Cost classifications (types of costs)

Costs can be classified based on different criteria.  Let us take a look at some of them:

Cost Nature

  • Material costs are costs of raw materials and other physical inventory items acquired by a company.  Material costs can be direct and indirect. 
  • Labor costs are costs of labor (e.g., payroll).  Labor costs can be direct and indirect.
  • Overhead costs are costs other than material costs and labor costs.

For more information about material, labor and overhead costs, refer to this tutorial: Manufacturing and nonmanufacturing costs.

Traceability to Final Products

  • Direct costs can be traced to a single unit or batch of units of final products.  These costs are usually direct materials and direct labor. For example, when a company buys raw materials, it usually can trace them to the product(s) manufactured using such raw materials.
  • Indirect costs can’t be traced to a single unit or batch of unit of final products.  For example, a piece of manufacturing equipment creates depreciation expense. Typically, equipment is used to manufacture different products.  Thus, depreciation expense can’t be traced to a single product (unless this equipment is only used to manufacture one product).

Association with Final Products

  • Product costs are all costs related to manufacturing products.  Examples of such costs include materials, labor and overhead.  Product costs result in assets (i.e., inventory).
  • Period costs are not related to the manufacturing process and represent selling and administration costs.  Such costs are expensed when they are incurred; these costs don’t typically result in assets.

For more information about product and period costs, refer to this tutorial: Accounting in merchandising companies.

Association with Changes in Activity

  • Fixed costs do not change with the change in activity or volume of production.  Such costs may include salaries of administration personnel, fixed annual insurance costs, costs of permits, etc.
  • Variable costs change when the related activity or volume changes.  Classical examples of variable costs are raw materials and payroll of manufacturing personnel.
  • Step-variable costs is a hybrid of fixed and variable costs.  Step-variable costs remain fixed for a given level of activity or volume.  When the critical level of the activity or volume is exceeded, the cost increases incrementally.  A good example of a step-variable cost is a large piece of manufacturing equipment which does not change unless its capacity is exceed; at this point, another piece of manufacturing equipment is acquired.

For more information about fixed, variable and step-variable costs, refer to this tutorial: Accounting cost behavior.

Functional Classification

  • Manufacturing costs represent costs related to the manufacturing process.  For example, these costs include materials, labor and overhead costs of a manufacturing plant.
  • Selling and distribution costs are costs associated with the selling and distribution activities of a company.  For example, advertising and market research represent selling costs.
  • Administration costs are other costs of running a business.  Examples of such costs include payroll of administration personnel and the cost of annual events.
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