Costs by function

What it means

Classifying costs by function sorts them according to what they were incurred for: a particular product, job, cost centre, production, administration or sales. It answers why a cost arose and what it served, not just what the company consumed.

It complements the by-nature classification used in financial accounting, which groups costs by their nature, such as materials, energy, services, wages or depreciation. The same energy cost can thus be classified by nature as energy consumption and by function as a cost of the production hall or the office.

The basic distinction is between direct costs, which can be assigned precisely to a specific output, and indirect costs, that is overheads, which relate to several outputs and are allocated using keys. This classification underpins costing and management accounting.

How it works in practice

In practice, classification by function is achieved through cost centres, jobs or projects assigned to each cost when it is booked. The accounting software can then produce cost reports by centre, job or product alongside the ordinary profit and loss statement.

Classification by function is essential for management accounting. Only when a company knows what a particular service, job or customer costs can it set prices correctly, judge the profitability of individual activities and find where costs are rising unnecessarily.

Even a small firm can start simply, for example by separating costs by its main types of service or by individual locations. What matters is setting consistent allocation rules and agreeing with the accountant what information must appear on documents.

What to watch out for

Allocating overheads with unsuitable keys can distort the picture of product profitability. If, for example, all overheads are allocated by revenue, some activities may appear profitable while in reality consuming a disproportionate share of resources.

Classification by function is an internal tool whose structure the company sets itself. It does not affect tax, but poor allocation quality leads to wrong management decisions. The rules are therefore best written into an internal policy and checked regularly.