Classification of Costs
Category: Financial Control Management
Costs should be divided into two basic categories:
— Fixed or Variable — depending on whether the costs change with variations in production volume;
— Direct or Indirect — depending on whether costs are directly related to a certain product.
The purpose of these classifications is:
— Fixed/Variable Costs are used for the Cost-Volume-Profit Analysis and for the optimization of the structure of production;
— Direct/Indirect Costs are used in assessing the allocation of a cost to a particular product or company division.
Fixed Costs do not vary with the quantity produced, no matter what the output is, the amount of fixed costs will be the same. (rent, interest, G&A expenses); Variable Costs vary with the quantity produced. A variation in output will cause a variation in the cost by the same proportion. (raw materials, wages, power energy); Semi-Fixed Costs depend on the quantity produced, but will not vary in direct proportion to the quantity produced. They increase in steps, i.e., they are fixed until a certain level of output is reached at which point they become variable. (shipment for bulk).
Direct Costs are incurred exclusively for one product. They can easily be traced to a specific product. They are generally incurred in the production/marketing process. Dropping the product would eliminate this cost. (raw materials, power energy, wages);
Indirect Costs are incurred for more than one product. They can not be traced for a specific product. Dropping the product would not eliminate this cost. (energy to heat, production supervision Labour).
Classification of costs as Fixed or Variable is necessary for making decisions that affect the volume of output. Managers want to know how such decisions will effect Cost and Revenues, and most importantly — Income.