Before you can absorb overheads into product costs, you need to classify them — put them in the right box. Think of it like sorting your monthly expenses before budgeting: groceries, rent, travel. Same logic applies in a factory. The ICAI curriculum recognises three primary ways to classify overheads, and the exam tests all three.
By Function (Where did the cost happen?) — This is the most exam-heavy classification. Overheads are split into: Production/Manufacturing overheads (factory rent, machine depreciation, power in the shop floor), Administration overheads (MD's salary, office stationery, accounting software), Selling overheads (salesman commission, advertisement spend), and Distribution overheads (warehouse rent, delivery van fuel). A cost like the factory manager's salary is a production overhead; the HR manager's salary at head office is an administration overhead. Don't mix them.
By Nature/Element (What type of cost is it?) — Here you classify as Indirect Material (lubricants, consumables — materials you can't trace to one unit), Indirect Labour (supervisor wages, security guards — labour you can't pin to one unit), or Indirect Expenses (factory rent, insurance — neither material nor labour). This classification matters when you're building a cost sheet and you need to know what you're dealing with before you decide where it belongs.
By Behaviour (How does it react to output?) — This is critical for marginal costing and budgeting. Fixed overheads stay flat regardless of production — factory rent is ₹2 lakh whether you make 500 units or 5,000 units. Variable overheads move in direct proportion — power cost doubles when output doubles. Semi-variable (or mixed) overheads have a fixed core and a variable tail — a phone bill with a ₹500 line rental plus per-call charges is a classic example. The exam often gives you a mixed cost and asks you to separate it using the High-Low method.
This is asked frequently as a 4-mark theory question or as the lead-in to a larger absorption costing problem. Nail the classification first — everything else in overhead accounting flows from it.