Question

Cost can be classified in 5 categories-behavior, traceability, controllability, relevance and function. Briefly explain each category.

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Answer 1

The explanation for each category is provided below:

(i): Behavior – Costs can be classified according to behavior in accordance with activity. The costs are variable costs, fixed costs and mixed costs. Variable costs vary in proportion to changes in activity. Fixed costs remain constant irrespective of the level of activity. Mixed costs vary with activity level but not in proportion as it includes a fixed cost portion and additional variable costs.

(ii); Traceability – In this category costs are often traced to a cost object and the cost object can be a product, or a process or a department. As per this category costs can be direct costs and indirect costs. Direct costs are those that can be traced directly to a particular object. Examples are direct labor and direct materials. Indirect costs are those costs that cannot be traced to any particular object of costing. A good example will be factory overheads.

(iii): Controllability – In this category costs are classified as either controllable costs or non-controllable costs. Controllable costs are those in whose regards manager has the power to control them or influence them in a strong manner. However in case of non-controllable costs the manager does not have any power to either control or influence the costs. Controllability of costs depends on responsibilities of an employee. For example investments in machines are controllable by senior managers but not lower level employees.

(iv): Relevance – In this category costs are classified according to their relevance to decision making. Relevant costs are those costs that will differ under alternative courses of action. Standard costs are predetermined costs and are determined on the basis of past budgets, industry standards etc. Opportunity costs are those benefits that have been forgone when an alternative is selected. Sunk costs are historical costs that will not make any difference in making a decision.

(v): Function: In this category there are generally two types of costs – product costs and period costs. Product costs are inventoriable costs and hence are charged against revenue when sales occur. Examples are all manufacturing costs like direct material, direct labor, factory overheads. Period costs are not inventoriable costs and hence are immediately charged against revenue. Examples are selling expenses, administrative expenses etc.