Cost classification is the framework for managerial accounting. For a refresher on what managerial accounting is and why we utilize it check out this blog post.
To determine how you want to classify your costs you need to first look at why you want to classify them. Below we outline the 5 main purposes of classifying costs and how those costs are classified, we'll go into more detail for each purposes in other posts so don't worry if this looks a little vague.
Evaluating Cost Objects - Cost object is a fancy term for something that you want data for, it could be different product lines, different locations, different clients, etc. When looking at cost objects you want to determine if a cost is a direct cost, or can be easily tied to an object or an indirect cost. Indirect costs cannot be easily tied to a cost object. An example of a direct cost for locations would be the rent or utilities for a specific store location. An example of an indirect cost for product lines would be the cost of the CEO's salary.
Manufacturing Companies - These are divided into manufacturing costs and nonmanufacturing costs. Manufacturing costs include three categories, direct materials, direct labor, and manufacturing overhead. Nonmanufacturing costs can be divided into selling costs and administrative costs. An example for each of these include the wood that goes into building a shed (this would be a direct material cost). The labor to assemble the shed would be a direct labor cost whereas the salary for the manufacturing plant supervisor would be a manufacturing overhead cost, it cannot be directly tied to a single product being produced in the plant. For nonmanufacturing costs a sales rep's salary would be considered a selling expense as would advertising. Rent on the corporate headquarters or the accounting system cost would be considered administrative costs.
Financial Statement Preparation - Financial statements include product costs and period costs. Product costs are costs that can be tied to a product such as the cloth that goes into making the clothes for a doll or the plastic that goes into making camping utensils. These costs are put into inventory and expensed when the item is sold. On the other hand period costs are costs that cannot be tied to a product such as the cost of a promotional event. These costs are expensed as they are incurred because they cannot be attributed to a specific product or unit. (When we talk about the timing of expense we are assuming the company is working on an accrual basis. Even if the company utilizes the cash basis for taxes often the accrual basis provides more useful management information).
Cost Behavior Analysis with Changes in the Company - These costs are either tied to or independent from a specific activity. We call these variable costs (they fluctuate with the activity level), fixed costs (they do not fluctuate with a change in activity), and mixed costs (they have a fixed component and variable component). For example, if we are measuring costs as they relate to sales volume Cost of Goods Sold is going to be a variable cost, as sales fluctuate so should the cost of the items that are sold. However rent for a store front would remain the same despite changes in sales volume, this would be a fixed cost. A mixed cost would be a software cost that charges a flat rate per month and then a fee per sale that it imports into your accounting program. The fixed part is the flat rate per month, this won't change with the volume of sales. The variable part would be the rate per sale, the total will fluctuate with the volume of sales.
Decision Making - There is a decision making process that looks at the costs and benefits of a decision. The costs here are split into three types, differential costs are going to be different between the two decisions. Sunk costs are costs that have already occurred and cannot be recovered. Opportunity costs are benefits that will not be realized with a specific decision. For example, when looking at changing an accounting software from program A to program B a differential cost would be the different monthly rates for the subscriptions. A sunk cost would be the new computer system that was purchased a year ago so program A could be installed. These costs are unable to be recovered and will have occurred regardless of which program is chosen. An opportunity cost for staying with program A would be the additional features that come with program B for free with a value of $2,000.
As you can see there are many ways to classify costs, this just provides a broad overview of the different scenarios and options that are available. In other posts we will go into more detail on each of these methods.
Interested in this type of analysis for your business, but not wanting to learn the ins and outs? We provide financial analysis in all of our bookkeeping packages!