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Classification of Costs based on Functions / Activities

There are various classification of costs. It could be based on nature, traceability, functions, behavior, purpose, production process, and period of costs. In this post, we will discuss the classification of costs based on functions or activities in an organization. All the costs of a business can be classified into activities such as production costs, administration costs, finance costs, selling costs, distribution costs, research, and development costs. These are just the primary functions or activities in business, but there can be more detailed classification.

Functional Classification of Costs

We have classified costs into the following functions. The classification is not rigid, like the rule of law. Majorly, our classification is influenced by the value chain of a business. There could be a different and better way to classify costs. Most importantly, we should study the business model of the organization for such a classification. Then, we should design an appropriate classification for that organization—a classification that helps take management-related decisions, internal control of the organization, etc.

Production or Manufacturing Costs

All the costs relating to the production of goods or services, whether direct or indirect, variable or fixed, are included in the production cost. We can classify production costs into direct and indirect production costs.

Example of Direct Production Costs (also known as direct manufacturing costs)

  • Direct Raw Material
  • Direct Labor
  • Other Direct Expenses such as job work charges relating to a particular product, etc.

Examples of Indirect Production Costs (also known as Production or Manufacturing Overheads)

  • Salaries of Supervisors, Production Heads, Technical and Planning Staff, etc
  • Quality control costs
  • Other labor-related expenses
  • Quality control
  • Store expenses
  • Depreciation of plant and machinery
  • Repair and maintenance of factory building and plant & machinery
  • Security expenses for the Unit
  • Labour welfare expenses like Canteen expenses
  • Insurance etc.

In summary, we can say that all the costs that a firm incurs for the production of goods are part of production or manufacturing costs. This is a critical cost classification. Most companies have a bigger chunk of total costs incurred here. Therefore, companies invest a lot of its time and energy to streamline these costs. They have a direct role to play in the sustainability of the company.

Administration Costs

These costs are incurred in connection with the general management of the business. These usually are indirect costs and are also known as administrative overheads. Example of such costs can be the following:

  • Salaries of staff in general management
  • Office-related expenses such as rent, rates, taxes, telephone, stationery, etc.
  • Charges levied by the bank.
  • Audit and legal fees
  • Office-related depreciation etc.

This includes all those costs which are not related to product manufacturing but are unavoidable for the overall administration of the organization. These costs support the primary activity of production. Most organizations wish to keep these costs as low as possible. It is because the managers are not able to link them directly to the profits of the company. For example, the contribution of an accountant towards the earnings of a particular year is challenging to judge.

Classification of Cost based on Functions or activities

Marketing or Selling Costs

Selling costs include all kinds of expenses incurred for achieving sales of the products and services. These are also considered indirect expenses are known as selling overheads. Examples of such costs are as follows:

  • Salaries of selling staff
  • Commission, conveyance, discount, etc
  • Product market research
  • Royalty etc

This function gets a lot of focus by management. This is a very crucial function because if there were no sales, all other activities or functions are useless. Streamlining the selling function has fast and visible fruits for the management. For example, a small change in the commission structure of the selling task force could lead to lot of additional sales. Additional sales have a lot of advantages like control in stock levels, better capacity utilization, lower fixed costs per unit, etc.

Distribution Costs

Distribution costs include all kinds of expenses are incurred for distributing the products from its point of production to its customers. Examples of distribution costs are as follows:

  • Transportation costs
  • Warehouse rents
  • Commission to Distribution channel etc

This classification of cost is vital for customer satisfaction. A sound distribution system ensures timely and safe delivery of goods, a reduction in wastage in transportation, etc. Many businesses run through distribution channels. From the selection of the distribution channel to deciding the commission structure comes under there purview of distribution management. Streamlining these costs could make the product cheaper for the customer. There are various strategies companies follow to optimize such costs.

Research and Development Costs

Costs under these heads are the costs comprising of development costs of new products, improvement related expenses, etc. These are not unavoidable costs. A company may wish not to spend even a penny on1 such costs. But, this would a mistake. With current products and production lines, a company can sustain itself in the short run. With the change in technology, consumer choices, it is crucial to continually innovate new products and streamline the existing ones. Most companies try and allocate a budget for these costs every year. 

Customer Service

These days after-sales service is a primary key to support the marketing or selling function of the organization. We can notice that the consumer now requires not only a tension-free purchase but also its utilization. For example, servicing AC, Washing Machines, etc. Most importantly, the customers are ready to pay more for products of companies who have proved a better customer service after selling the product also.

Conclusion

To conclude, the classification of costs into functions could be different in different organizations. Therefore, a company can completely customize it based on its requirements. Once the classification is done, the strategy to manage and control that cost should be framed in line with the classification.

1.
Horngren CT, Datar SM. Cost Accounting – A Managerial Emphasis. 13th ed. Pretice Hall; 2020.
Last updated on : April 30th, 2020
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  1. Avatar Viraj Singh

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