Cost classification

Costs can be classified in 4 ways - by function, by element, by nature and by behaviour.

Classification of costs by function:

Production costs- this is also known as “cost of sales”. This category would include production labour costs, materials, factory supervisor salaries, factory rent. These are any costs which are directly linked with organisations production process. 

Selling & distribution costs- this will include any selling and distribution costs incurred by the organisation in getting the products to its end users. This category would include sales team commission, delivery costs. 

Administration costs- this will include any other costs that are incurred in the organisations operations. This category would include all other head office costs, IT support, HR support

Classification of costs by element:

Materials- these will include raw materials for a manufacturer, costs of goods to be resold in a retail organisation or service items or consumables to be used within a business operation. 

Labour- these will include all salary and wages costs to employees, including overtime, commissions and bonuses. 

Other expenses- this will include any other costs that are incurred in the organisations operations, such as, electricity, depreciation, rent, telephone. Most of these types of expenses are usually known as “overheads

Classification of costs by nature:

Direct costs- This is an item of cost that is traceable directly to a unit of production produced by a manufacturing organisation or a unit of service delivered by a service delivery organisation. The total of all direct costs is known as the “prime cost” per unit. These will include cost of raw materials used for production. 

Indirect costs- This is an item of cost that cannot or cannot be easily identified directly with any one finished unit. Expenses that do not relate directly to production (nonproduction costs) will all be classified as indirect costs and these are usually known as “overheads”. These will include HR costs, IT support, selling & distribution.

Classification of costs by behaviour:

Variable costs- these are costs that vary with the level of production or activity. It is usually assumed to vary in direct proportion to production. For example, if you make twice the number of chairs then the assumption is that the amount of wood used would be doubled. 

Fixed costs- these are costs that are not affected by changes in the level of production or activity, hence costs that don’t vary. For example, rent costs for a factory. It is assumed that if production increases, the factory rent cost would not be increasing based on the production volume. 

Semi-variable costs- these are costs that have a fixed element and a variable element. This means that if production were to double, the cost of production will not double because of the fixed cost element in the production cost, which will remain the same. For example, the cost of electricity for the factory has a fixed element relating to lighting and a variable element relating to power used in the production line. 

Stepped costs- these are costs that remain fixed up to a particular level of activity, but which rise to a higher (fixed) level, if activity goes beyond that range. For example, a firm may pay £40,000 per year to rent a factory in which they can produce up to 1 million units of product per year. However, if demand increases to more than 1 million units, a second factory may be required, in which case the cost if factory rent may step up to, say, £80,000 per year and then be constant until we want to make 3 million units.