Classification of costs are needed for the development of cost data that are useful to management. There are five major purposes or aims for which the classification of cost is done. Every class of costs is used to make effective decisions by the management of a company or may be used for particular purpose.
- Planning profit by means of budgets
- Controlling costs via responsibility accounting
- Measuring annual or periodic profit, including inventory costing
- Assisting in establishing selling prices and a pricing policy
- Furnishing relevant cost data for analytical processes for decision making.
Therefore, Classification of costs are done :
- By the nature of the item (a natural classification).
- With respect to the accounting period to which they apply.
- By their tendency to vary with volume or activity.
- By their relation to the product.
- By their relation to manufacturing departments.
- For planning and control.
- For analytical processes.
Natural Classification of Costs : The process of the Classifications of costs and expenses can begin with a simple grouping of all manufacturing costs according to the three main elements of cost: materials, labor, and factory overhead. Total cost may be considered as cost or deductions from sales revenue before federal income tax.
In a manufacturing concern, total operating cost is divided into two groups: (1) manufacturing cost and (2) commercial expenses.
(1) Manufacturing cost: Manufacturing cost, often named “production cost ” or “factory cost” -is the sum of direct materials, direct labor, and factory overhead.
During the accounting period, that part of manufacturing cost which represents work completed is transferred to Finished Goods Inventory while incomplete work remains in Work in Process.
(2) Commercial expenses : Commercial expenses also fall into two large classifications: (a) marketing (or distribution or selling) expenses and (b) administrative (general and administrative) expenses. Marketing expenses begin at the point where the factory costs end; that is, when manufacturing has been completed and the product is in salable condition.
Marketing expenses cover the expenses of making sales and delivering products. Administrative expenses include expenses incurred in the direction, control, and administration of the organization. Some of these items such as executive salaries which are often allocated to manufacturing and marketing and included in factory and marketing cost. The sum of the expired factory cost and commercial expenses is the “cost to make and sell.”
This basic classification of costs must be expanded into numerous sub-classes, groups, or divisions. Overhead is segmented into fixed and variable costs. Again, Direct Cost and Absorption costs etc.