Cost Classification

Cost Classification and its types

Cost classification is the process of categorizing various expenses incurred by a business or organization into specific groups or categories based on their nature, function, behavior, or other relevant criteria. This classification helps in analyzing and managing costs more effectively, making informed decisions, and preparing financial statements.

Cost classification according to behavior

Cost classification according to behavior refers to costs that are observed through their behavior on production of units produced. This type of cost can consist of various components, including:

a. Fixed Cost

b. Variable cost

c. Mixed Cost

Fixed Cost

Fixed cost is an expense that does not change when sales or production volumes increase or decrease. Examples include factory rental, depreciation expenses of factory building, transportation, and so on.

Characteristics of Fixed Costs:

a. Stability: Fixed costs remain the same regardless of whether a business produces one unit or a thousand units of a product. They provide a stable foundation for a company's cost structure.

b. Time-Based: Fixed costs are typically considered on a monthly or yearly basis. For example, if a business pays a monthly rent of $1,000 for its office space, that $1,000 remains constant each month as long as the lease terms do not change.

c. Non-Production Dependent: These costs are not tied to production or sales activities. Even if production comes to a halt or sales decrease, fixed costs persist.

Variable Cost

Variable cost is an expense that changes in proportion to production units or activity units. Examples include direct raw materials, direct labor, sales commission and so on.

Characteristics of Variable Costs:

a. Direct Relationship: Variable costs have a direct and linear relationship with production or sales. If a business doubles its production, its variable costs will roughly double as well.

b. Per-Unit Basis: Variable costs are typically expressed on a per-unit basis. For instance, the cost of raw materials per unit or the direct labor cost per unit produced.

c. Production-Dependent: These costs are directly tied to production activities. As more units are produced, more resources (and costs) are required.

Mixed Cost

Mixed cost is a cost that contains both fixed costs and variable costs. Examples include utilities, rent, salaries, landline telephone bill and so on.

Characteristics of Mixed Costs:

a. Combination of Fixed and Variable Elements: Mixed costs have both a fixed portion and a variable portion. The fixed portion remains constant over a certain range, while the variable portion changes with production or activity levels.

b. Step-Like Behavior: Mixed costs often exhibit a step-like behavior, where they remain constant within a certain range and then abruptly increase when production or activity exceeds that range.

c. Non-Linear Relationship: The relationship between mixed costs and production or activity is not linear. This means that the variable portion of mixed costs does not change at a constant rate.

In conclusion, cost classification is a vital accounting process that involves categorizing expenses within a business or organization based on various criteria, including their behavior. The behavior-based cost classification, in particular, is crucial for understanding how costs relate to production or activity levels.

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