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Cost Classification in Managerial Accounting

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Cost Classification

Cost Classification

Meaning of Cost

As a noun the term cost refers to a measure of resources consumed or forgone in monetary terms. As a verb the term cost means to ascertain what the cost has been. Cost can be classified in several ways. For example, factory rent can be classified as a fixed cost (classification by behaviour) or as a production cost (classification by function) or as an indirect cost (classification by nature), etc.


Cost Classification By Behavior

1. Variable costs

These are costs that change in total as the level of activity changes. However, you must note that variable costs per unit remain constant. Examples of variable costs include the cost of raw materials which increases as more and more raw materials are being produced.

2. Fixed costs

These are costs that do not change (remain constant) as the level of activity changes. Examples include rent, salaries and insurance.

3. Stepped fixed costs

These are costs that remain fixed within a relevant range and outside that relevant range they increase and remain fixed for the next relevant range. In fact most fixed costs are stepped fixed cost as no cost will remain fixed up to infinity.

4. Semi-variable (semi-fixed or mixed) costs

These are costs that are partly fixed and partly variable. For example, a saleslady can be paid a basic salary plus commission as her gross pay. Her gross pay is an example of a mixed cost as the basic salary is fixed and the commission is a variable cost which depends on the number of units sold by the saleslady.

Cost Classification By Function

Costs can also be classified according to the function of the business they relate

1. Administration costs

These are costs incurred in the running of the organisation. Examples include offices rent, CEO’s salary (compare with factory rent and production manager’s salary below under production costs), depreciation of computers used by accounts personnel, etc.

2. Finance costs

These are costs incidental to the raising of finance by the organisation. Examples include dividends and interest cost.

3. Selling costs

These are costs incidental to the selling of products or services. Examples include salesperson’s commission, showroom rent, advertising, etc.

4. Distribution costs

These are costs incidental to the making of products or services available to customers after production (that is, for products). Examples include cost of transportation of goods to customers, repair of delivery vans and warehouse rent.

5. Production costs

These are costs incidental to the production of products. Examples include raw materials cost,
factory rent costs, packaging cost, production manager’s salary, etc.


Direct and Indirect Costs

1. Direct costs

Direct costs are those costs that can be specifically and exclusively identified with a particular cost object.

2. Indirect costs

Indirect costs cannot be identified specifically and exclusively with a given cost object. The total of all direct costs is called prime cost whereas indirect costs are also called overheads (or sometimes overhead costs).

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Period and Product Costs

This classification is all about which costs should be included in inventory valuation and which must not.

1. Period costs

Period costs are those that are not included in the inventory valuation and as a result are treated as expenses in the period in which they are incurred. Hence no attempt is made to attach period costs to products for inventory valuation purposes.

2. Product costs

Product costs are those costs that are identified with goods purchased or produced for resale. In a manufacturing organization they are costs that the accountant attaches to the product and that are included in the inventory valuation for finished goods, or for partly completed goods (work in progress), until they are sold; they are then recorded as expenses and matched against sales for calculating profit.


Relevant and Irrelevant Costs

For the purposes of decision-making costs can be classified as relevant or irrelevant to the particular decision being made.

1. Relevant costs

Relevant costs are those future costs that will be changed by a decision.

2. Irrelevant costs

Irrelevant costs are those costs that will not be affected by the decision.

The following cost terms are in turn used in relation to relevant and irrelevant costs:


Avoidable and Unavoidable Costs

Avoidable costs are those costs that may be saved by not adopting a given alternative, whereas unavoidable costs cannot be saved. Therefore, only avoidable costs are relevant for decision making purposes.

Sunk costs

These costs are the cost of resources already acquired where the total will be unaffected by the choice between various alternatives. They are costs that have been created by a decision made in the past and that cannot be changed by any decision that will be made in the future.

Opportunity costs

An opportunity cost is a cost that measures the opportunity that is lost or sacrificed when the choice of one course of action requires that an alternative course of action be given up. Opportunity costs only arise where scarce resources are used.

Incremental and Marginal Costs

1. Incremental costs

Incremental costs are also called differential costs and are the difference between costs for the corresponding items under each alternative being considered.

2. Marginal costs

Marginal costs are similar to incremental costs only that marginal costs are the additional costs for an extra unit of output whereas incremental costs are the additional costs for a number of units.


Cost Object, Cost Unit and Cost Centre

1. Cost object

A cost object is any activity for which a separate measurement of costs is desired. In other words, if the users of accounting information want to know the cost of something, this something is called a cost object. Examples of cost objects include the cost of a product, the cost of rendering a service to a bank customer or hospital patient, the cost of operating a particular department or sales territory, or indeed anything for which one wants to measure the cost of resources used.

2. Cost unit

A cost unit is a unit of product or service in relation to which costs are ascertained. For example, for a hospital a cost unit can be a patient or an operation on a patient and for a carpentry shop the cost unit can be a chair produced.

3. Cost centre

A cost centre is a production or service location, function, activity or item of equipment for which costs are accumulated. Examples of a cost centre include a purchasing department and a printing machine in a printing firm

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