6. Cost
classifications
There are a variety of reasons why we need to classify costs.
Among the most important are the prediction of their behaviour, the tracing of
these costs to the various cost units or cost centres or the valuation of
inventories. Depending on the kind of company under study, we have different
types of costs in the picture; the costs identified in a manufacturing company
may not be the same as those of a service company, a retailer may not have the
same costs as his supplier dealing in the wholesale business.
In order to provide management with accurate information about
costs we therefore need to analyse them into logical sections that will be more
meaningful than the current bulk of data.
The three major ways of classifying costs use three
parameters, namely: the nature, function and behaviour.
COSTS CLASSIFIED ACCORDING TO THEIR
NATURE
The nature of a cost is related to its traceability,
relevance, and its sensitivity to management actions in the decision making
process. Here is a brief description of the different types of costs listed
according to their nature.
Direct cost:
This is an expression used to describe costs that can be
easily and conveniently traced to the particular cost object under
consideration. (Garrison & Noreen 2003). It is generally used along side
with the concept of indirect cost.
Indirect cost:
This is simply the contrary of the direct cost and Garrison
and Noreen (2003) refer to it as the cost that cannot be easily and
conveniently traced to the particular cost object under consideration.
Costs are generally classified as direct or indirect when we
need to devise a means for the assignment of costs to the cost objects. This is
very helpful as it gives the manager the opportunity to evaluate either the
profitability or implement cost control programmes for the cost object
concerned, as he will have valid information on the amount of resources
consumed by that cost object.
Product and period costs:
The nature of the cost here relate to the timing of their
liquidation as expenses on the income statement. This distinction between
product and period costs is mainly due to the Matching principle of
financial accounting, Drury (1992). This principle is based on the accrual
concepts and it states that: «Costs incurred to generate a particular
revenue should be recognised as expenses in the same period that the revenue is
recognised.» So the difference between product and period cost will be due
to the purpose for which the costs are incurred; if it is a cost used to
produce or acquire an item that may be sold then it will be considered as
product cost otherwise it is a period cost. We can therefore agree with the
definition of Garrison and Noreen (2003), that a product cost
includes all costs that are involved in the acquisition or making of a product.
Taking the example of a manufacturing company, product costs are the direct
materials, direct labour and manufacturing overhead costs that are used to
manufacture a particular item.
These costs have a double treatment according to the time and
financial account. Since these costs are incurred while acquiring or making a
product, they will be used in the valuation of the stocks of that product until
it is sold. This means that, before the sale, these costs are treated as assets
in the balance sheet of the company. Once the sale has been performed, the
revenue earned from their sales must be matched against the costs incurred for
during their production; these costs are then treated as expenses on the income
statement to match them to the sales revenues and obtain the margin or
contribution to the overall profits of the company. So these can be
called inventoriable costs as they are used for stock valuation
purposes.
Garrison and Noreen (2003) define a period cost as all the
costs that are not included in product costs. Since these costs are not used
for acquiring or making products, the company considers them as expenses in the
period in which they are incurred. Some examples of this type of costs include
selling and administrative costs, office rent or financial charges.
To better illustrate the concept of product and period cost,
let us draw a diagram that will show how costs may be classified and how they
flow into the various accounts of a company.
Figure 2-2: COST FLOW AND CLASSIFICATIONS IN A
MANUFACTURING COMPANY
Finished goods inventory
Raw materials inventory
Product costs
Work in progress inventory
Selling and administrative expenses
Goods completed (cost of goods manufactured)
Direct materials used in production
BALANCE SHEET
COSTS
Raw materials purchases
Direct labour
Manufacturing overhead
Period costs
Cost of goods sold
INCOME STATEMENT
Selling and administrative
Source: Garrison R. H., Noreen E. W., Managerial Accounting,
Mc-Graw Hill, New York, 2003, p 50
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