Cost Classification for Control and
Decision-making
Prof Magnus Amajirionwu
•
4 Mar (Edited 4 Mar)
In this topic, we will cover many cost classifications useful for planning and control.
We will introduce the basic concepts behind these classifications but you will use
them (and get in greater depth). Understanding the different types of costs is
crucial in cost accounting to make informed decisions about pricing, production,
and resource allocation. Classification of costs can be done based on their
behaviour, function, or relationship to production volume. Each classification has
unique characteristics and implications for business operations, from direct and
indirect costs to avoidable and sunk costs. This article will explore the various
classifications of costs and how they impact decision-making for businesses of all
sizes and industries.
Historical cost refers to the original cost of an asset or liability when acquired or
incurred. Companies often use historical costs in accounting to value assets and
liabilities on a company’s balance sheet. This means we record assets or liabilities
at their original cost rather than their current market value or replacement cost.
A predetermined cost is a budgeted or estimated cost established before
producing or purchasing goods or services. Companies typically use it in cost
accounting and managerial accounting to help them plan and control costs.
Estimated cost refers to calculating or projecting the expected cost of a project,
product, or service. We can typically use it in project management, construction,
manufacturing, and other industries where cost estimation is an important part of
planning and budgeting.
Standard cost refers to a predetermined cost established as a benchmark for
measuring actual costs in a manufacturing or production process. It is used in cost
accounting to help companies plan and control costs and to identify areas where
cost savings can be achieved.
Cost of materials refers to the raw materials and components used to produce a
product or service. This includes the cost of any materials that companies
purchase from suppliers, as well as the cost of any materials that they produce or
process in-house.
Labour costs refer to wages, salaries, benefits, and other expenses associated
with the labour required to produce a product or service. This includes the cost of
all employees involved in the production process, such as direct labourers,
supervisors, and support staff.
Expenses refer to the costs incurred by a business or individual to generate
revenue or achieve a particular objective. They are typically classified into two
main categories: operating and non-operating expenses.
The cost of production refers to the total expense incurred by a business in
creating and selling its products or services. These expenses may include costs
associated with raw materials, labour, equipment, rent, utilities, marketing, and
other overhead expenses.
The marketing cost refers to the expenses incurred by a business or organization
to promote its products, services, or brand to potential customers or clients. These
costs can include advertising fees, promotional materials, public relations
expenses, and salaries or fees for marketing personnel.
The cost of selling refers to the expenses incurred by a business or organization to
sell its products or services to customers. These costs can include salaries or
commissions for sales personnel, advertising and marketing expenses, travel and
entertainment costs associated with sales efforts, and any fees associated with
payment processing or shipping.
Direct costs are expenses companies can directly attribute to producing a specific
product or service. These costs are typically associated with the materials, labour,
and equipment needed to create the product or service. Direct costs include:
Raw materials.
Wages for manufacturing personnel.
The cost of equipment and machinery used in the production process.
Indirect costs are expenses not directly related to the production of a specific
product or service but are necessary for the business to operate. We typically
associate these costs with overhead and administrative expenses such as rent,
utilities, and office supplies. Indirect costs can also include salaries for non-
production personnel such as management, marketing, and accounting staff.
1. Fixed vs Variable Costs.
A fixed cost remains the same in total but changes per unit. Fixed costs examples
include your monthly rent, salaried employees, straight-line depreciation as these
amounts do not change based on volume. A variable cost remains the same per
unit but changes in total. Variable cost examples include sales commissions,
hourly workers, and units-of-production method depreciation as these amounts will
change based on total volume but the amount charged per unit does not change.
2. Direct vs Indirect Costs.
A direct cost is an amount that can be traced to a specific department, process or
job. Direct costs can be product costs like direct materials or direct labor or they
can be period costs like an accountant’s salary would be traced to the accounting
department. Indirect costs is an amount that cannot be traced to a specific
department, process or job. These costs are typically allocated (or estimated) to
the departments, processes or jobs using those items. Indirect costs can be
product costs like overhead or period costs like an IT employee’s salary to the
sales department. The sales department needs the services provided by IT and
the IT employee’s time would be an indirect expense to the sales department.
3. Controllable vs Non-controllable Costs.
When evaluating the performance of an executive or manager under managerial
accounting, it is helpful to recognize that some costs and expenses may be out of
the control of that manager or executive. One example is the manager’s salary.
The manager has no control over his own salary and has no power to change or
stay within the budget for the salary. Controllable costs are things the executive,
manager, or department even can control or change. If the executive, manager or
department cannot change or control the cost, it is an uncontrollable cost. An
example of an uncontrollable cost would be an allocation of administrative
expenses to each job or department.
4. Differential Costs including Sunk and Opportunity Costs.
Differential Costs represent the difference between two alternatives. We will
analyze what is relevant to our decision making including any opportunity costs.
Opportunity costs are what you give up by choosing one alternative over another
(think about what you are giving up by taking this course — what else could you
be doing?). Sunk costs are not relevant for decision making as the cost cannot be
recovered at a later date.
