Cost classification may be defined as ‘the arrangement of cost items in a logical sequence having regard to their nature and purpose to be fulfilled’. The term cost must be qualified when in use in order that its precise meaning is established in a particular situation; however, cost refers to the amount of resources that have been diverted from other uses or sacrificed so as to achieve the desired objective. But the term is used to refer to various aspects of cost, depending on the base of argument that one is approaching the issue from.

Different bases are used in classifying costs, thus giving us several types of costs. We look at these bases in the following sections.

Cost Classification bases

Costs can be classified on either one or more of the following bases:

  1. Are the costs dependent on the level of output (variable) or are the costs the same irrespective of the level of output (fixed)?
  2. Have the costs already been incurred (sunk) or are they going to be incurred in the future depending on what we decide (incremental) ?
  3. Are they already incurred (sunk/historical) or are the costs due to a benefit foregone for not taking a certain option (opportunity cost)?
  4. Are we in a position to decide not to incur the costs (avoidable) or are we bound to incur them by authorities we are subject to such as higher managers and the government (unavoidable)?
  5. Are the costs actually incurred (actual) or are they the expected as per the expenditure guidelines set by the management (standard)?
  6. Can we be able to control the costs , for example , by varying the level of output or by making appropriate decisions (controllable costs) , or are the costs beyond us because they are fixed or the decisions are made by higher authorities (uncontrollable)?
  7. Can we trace the exact costs incurred to the final product (direct costs) or can we not, may be only estimate such costs (indirect costs)?
  8. What is the function that makes the costs to be incurred in the organization, is it production, administration or selling and distribution?
  9. Is the cost incurred for manufacturing reasons (production cost) or for manufacturing support reasons (non-manufacturing cost)?
  10. How does the cost behave with respect to changes in the output level,
    • Does it remain fixed through-out irrespective of the output level (fixed cost),
    • Does it change proportionately with the change in output level (variable cost),
    • Does it remain fixed when output is zero but increases as output increases from that point onwards (semi-variable); or
    • Does the cost remain fixed within certain production bands but change immediately to another fixed level once the output band changes (a stepped cost)?