Cost Classification: How to Identify Your Cash Outflows

People that work within the worlds of accounting and business speak the universal language of money, whether it’s coming in as revenue or going out as cost. While these businessmen and women prefer to see money coming in, this wouldn’t be possible if there wasn’t an outflow of money and resources, also referred to as cost. Not only are these people concerned with where their money is coming from and where it’s going, they are also an organized bunch, and they need to know what type of money is leaving the firm, and this process is called cost classification.

Cost classification is our subject today, and it is the categorization of various costs incurred by a company into similar categories. We will be discussing the various ways to categorize the resources (it’s not always money) that a business uses to obtain benefits and other resources. We’ll mention the various types of cost classification, who’s interested in them, and why it’s done. If you’re curious about accounting and other finance-related careers, this article on finance 101 will tell you about accounting, management, and markets, and this course on how to operate a business will show you how to track sales, monitor costs, and make a profit.

What is Cost and Why Should it Be Classified?

Most people that don’t run or manage a business usually think of cost strictly in terms of cash. For example, the cost of a candy bar is $1.00, or the cost of a semester of college is $10,000. While cash is an agent of cost, there are many others to consider when an entire business is concerned. A cost is anything that is given up by a business in order to obtain any kind of benefit or resource. Cost may include many different resources depending on what is being produced, and almost always includes cash (usually the biggest cost), which is used in many different ways, but may also include materials used to make a product, the electricity used to power a factory, the depreciation of a machine, and many others.

So why should cost be so meticulously classified? If you have any experience with the inner workings of a business, you know that any successful enterprise is incredibly organized, and it’s up to the managers, owners, and accountants of the business to do the organizing. As a result of this rigorous internal categorizing, managers are able to track expenditures relative to their budgets, and alter it as needed.

Different Types of Cost Classification

Now that you know the importance of classifying costs, let’s discuss the different categories that it can fall into. Because the cost classifications themselves fall into larger categories, we will discuss these larger categories, and then the more specific classifications that fall within them. If you have a knack for organization, and would like to make a career out of it, but aren’t interested in accounting, this course on project management will introduce you to this highly organized career that focuses on costs and budgets.

1. Behavior: Because budgets are fluid, and it’s necessary to know how costs will change so that an accurate budget can be made, it must be determined if costs will fluctuate or not along with the business’ own peaks and valleys.
2. Time:Sometimes costs are calculated before they are incurred, and they must be accounted for. 
3. Location: Categorizing costs by where in the company they are incurred tells management if the cost is related to the production, storing, or delivery process.
4. Function: Many costs fall into this category, relating to development, marketing, administration, or any other step in the production of a product or service.
5. Traceability: This concerns whether a cost is directly or indirectly related to production.
6. Who’s Responsible: Because of the strict accountability practiced in well-run companies, all costs must be answered to by a clearly identified manager.

So let’s get to the actual cost classifications which you would actually run into if you were a cost accountant.

• Product Costs and Period Costs

This is one of the widest cost classifications. Product costs are associated with the manufacturing of a product, and are incurred when it is sold, and may include direct materials, labor, and overhead. Period costs are all costs other than product costs, and include administrative costs, marketing, deliver costs, etc.

• Fixed, Variable, and Semi-Variable Costs

Fixed costs, such as rent, remain constant no matter the activity. However much of a product is made, these costs stay the same. Variable costs will change directly proportional to the activity, like cost of material. Semi-Variable costs contain elements of the two, and usually involve a fixed cost for having a service, as well as a variable for its use. Example: phone bill.

• Prime Costs and Conversion Costs

Prime costs consist of the all of the direct costs added up, including any material, labor, and any other costs used directly in manufacturing. Conversion costs are how much it was to convert raw materials to the finished product, and include the prime costs, excluding materials, but including manufacturing overheads.

• Sunk Costs and Opportunity Costs

Sunk costs are costs that cannot be recovered. They have happened, and nothing can undo that. Opportunity costs, on the other hand, are the costs of a potential benefit. It’s the money you would have earned had you not done something else.

That’s the end of our discussion on cost classification. You can see that it’s based on common sense, but as with anything else, especially in the accounting and business worlds, these simple cost classifications are a rabbit hole to far more complex and specific categorizations that change depending not only the size of the company, but also the industry. If you’re serious about giving accounting a shot, we have a set of courses that will test your abilities: this first course in accounting deals with the more basic concepts, and this second accounting course of the set will then introduce you to some of the more in-depth concepts.