Explain Cost Classification?

Cost classification involves the separation of a group of expenses into different categories. A classification system is used to bring to management’s attention certain costs that are considered more crucial than others, or to engage in financial modeling.

Here are several types of cost classifications:

  • Fixed and variable costs. Expenses are separated into variable and fixed cost classifications, and then variable costs are subtracted from revenues to arrive at a company’s contribution margin. This information is used for break even analysis.
  • Departmental costs. Expenses are assigned to the departments responsible for them. This information is used on a trend line to examine the ability of each department manager to control his or her assigned costs.
  • Distribution channel costs. Expenses are separated into each of the distribution channels used, such as retail, wholesale, and Internet store. The aggregate amount of each of these classifications is then subtracted from the related channel revenues to determine channel profit.
  • Customer costs. Expenses are classified by individual customer, such as the costs of warranties, returns, and customer service. This information is used to determine individual customer profitability.
  • Discretionary costs. Those expenses that can be temporarily reduced or eliminated are classified as discretionary. This approach is used to reduce costs on a temporary basis, particularly when a business anticipates having a brief decline in revenues.

The preceding examples of cost classifications should make it clear that costs can be subdivided in many ways. Only a few of these classifications are provided for within the formal accounting system (mostly to classify costs by department). Other types of classifications must be performed manually, usually with an electronic spreadsheet.