What is 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. A proper analysis of cost classifications can result in increased profits. Several types of cost classifications are noted below:

Fixed and variable costs. Expenses are separated into variable cost 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. A proper understanding of fixed costs is useful for determining the minimum amount of sales that must be generated each month in order to avoid reporting a loss.
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. This analysis will depend on the responsibilities of each department, which may change over time.
Distribution channel costs. Expenses are separated into each of the distribution channels used, such as retail, wholesale, and Internet stores. The aggregate amount of each of these classifications is then subtracted from the related channel revenues to determine channel profit. This analysis can be used to decide which channels call for further investment, and which ones should be shut down.
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. This can result in decisions to stop selling to some customers on which the company consistently loses money.
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. Examples of discretionary costs are training, maintenance, and advertising.
Uncontrollable costs. This classification includes those costs that management cannot easily change, such as the rent expense associated with a long-term rent agreement. It is useful to understand the amount and type of uncontrollable costs when examining how to cut business expenses, since these items will be out of bounds.

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.