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Types of Costs
Cost classifications

Introduction

Costs can be classified into different categories for different purposes. Costs may be categorized according to their: (1) function, (2) ease of traceability, (3) timing of charge against revenue, (4) behavior in accordance with activity, and (5) relevance to decision making.

In a Nutshell

Costs according to function include: manufacturing and non-manufacturing costs.

Ease of traceability: direct and indirect costs.

Timing: product and period costs.

Behavior: variable, fixed, and mixed costs.

Relevance: relevant, standard, opportunity, sunk, and controllable costs.

According to Function

1. Manufacturing costs - incurred in the factory to convert raw materials into finished goods. It includes cost of raw materials used (direct materials), direct labor, and factory overhead.

2. Non-manufacturing costs - not incurred in transforming materials to finished goods. These include selling expenses (such as advertising costs, delivery expense, salaries and commission of salesmen) and administrative expenses (such as salaries of executives and legal expenses).

According to Ease of Traceability

1. Direct costs - those that can be traced directly to a particular object of costing such as a particular product, department, or branch. Examples include materials and direct labor. Some operating expenses can also be classified as direct costs, such as advertising cost for a particular product.

2. Indirect costs - those that cannot be traced to a particular object of costing. They are also called common costs or joint costs. Indirect costs include factory overhead and operating costs that benefit more than one product, department, or branch.

According to Timing of Charge against Revenue

1. Product costs - are inventoriable costs. They form part of inventory and are charged against revenue, i.e. cost of sales, only when sold. All manufacturing costs (direct materials, direct labor, and factory overhead) are product costs.

2. Period costs - are not inventoriable and are charged against revenue immediately. Period costs include non-manufacturing costs, i.e. selling expenses and administrative expenses.

According to Behavior in Accordance with Activity

1. Variable costs - vary in total in proportion to changes in activity. Examples include direct materials, direct labor, and sales commission based on sales.

2. Fixed costs - costs that remain constant regardless of the level of activity. Examples include rent, insurance, and depreciation using the straight line method.

3. Mixed costs - costs that vary in total but not in proportion to changes in activity. It basically includes a fixed cost potion plus additional variable costs. An example would be electricity expense that consists of a fixed amount plus variable charges based on usage.

According to Relevance to Decision Making

1. Relevant cost - cost that will differ under alternative courses of action. In other words, these costs refer to those that will affect a decision.

2. Standard cost - predetermined cost based on some reasonable basis such as past experiences, budgeted amounts, industry standards, etc. The actual costs incurred are compared to standard costs.

3. Opportunity cost - benefit forgone or given up when an alternative is chosen over the other/s. Example: If a business chooses to use its building for production rather than rent it out to tenants, the opportunity cost would be the rent income that would be earned had the business chose to rent out.

4. Sunk costs - historical costs that will not make any difference in making a decision. Unlike relevant costs, they do not have an impact on the matter at hand.

5. Controllable costs - refer to costs that can be influenced or controlled by the manager. Segment managers should be evaluated based on costs that they can control.

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