Classification and Elements of Cost

Elements of Cost in Cost Accounting: Direct Material Cost, Direct Wages, Direct Expenses, Indirect Materials and Overheads

Elements of Cost Accounting – 4 Important Elements: Materials, Labour, Expenses and Overheads

“A classification has to be made to arrive at the detailed costs of departments, production orders, jobs or other cost units. The total cost of production can be found without such analysis, and in many instances an average unit cost could be obtained but none of the advantages of an analysed cost would be available”. Harold. J. Wheldon.

Simple ascertainment of total cost cannot satisfy the various requirements of decision making. For effective control and managerial decision making, data is to be provided on the basis of analysed and classified costs. In order to satisfy this objective, cost is analysed by elements of cost i.e., by nature of expenditure.

The elements of cost are:

1. Materials

2. Labour,

3. Expenses and

4. Overheads

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The above elements of cost are explained below:

Element # 1 Materials:

“The material cost is the cost of commodities supplied to an undertaking”- I.C.M.A.

Materials cost is of two types, viz.:

(i) Direct materials cost, and

(ii) Indirect materials cost.

(i) Direct Materials Cost:

Direct material cost is “The cost of materials entering into and becoming constituent elements of a product or saleable service”. Thus, materials which can be identified with units of output or service are known as direct materials.

Cotton used in production of cloth, leather used in the case of production of leather goods and lime in the production of chalk, etc., are the examples of direct materials. Any materials purchased and used for a specific job are also direct materials.

(ii) Indirect Materials:

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“Materials used for the product other than the direct materials are called indirect materials. In other words, materials cost which cannot be identified with a specific product, job, process is known as indirect material cost.

Small tools, stationery used in works, office stationery, advertising posters, and materials used in maintenance of plant and machinery are a few examples of indirect materials.

Element # 2 Labour:

Labour is the remuneration paid for physical or mental effort expended in production and distribution.

“The labour cost is the cost of remuneration (wages, salaries, commissions, bonus, etc.) of the employees of an undertaking” – I.C.M.A.

(i) Direct Labour Cost:

It is also called ‘Direct-wages’. Direct labour cost is the cost of labour directly engaged in production operations. E.g., workmen engaged in assembling parts, carpenters engaged in furniture making, etc.

(ii) Indirect Labour Cost:

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Indirect labour cost is the remuneration paid for labour engaged to help the production operations, e.g., inspectors, watchmen, sweepers, store keepers, etc. The remuneration paid to these persons cannot be traced to a job, process or production order. The labour costs of idle time, overtime, holidays, etc., are also taken as indirect costs. Similarly, clerical and managerial staff, salesmen, distribution employees are also included in the orbit of ‘indirect labour’.

Element # 3 Expenses:

Expenditure other than material and labour is the third element of cost.

It is defined by I.C.M.A. as- “The cost of service provided to an undertaking and the notional cost of the use of owned assets”.

Expenses are of two types:

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(i) Direct expenses, and

(ii) Indirect expenses.

(i) Direct Expenses:

These are the expenses which can be directly identified with a unit of output, job, process or operation. They are specifically incurred for a job, or unit or process and in no way they are connected with other jobs or processes. The direct expenses are also known as chargeable expenses.

Some examples are:

(a) Hire charges of special plant used for a job.

(b) Royalty on products.

(c) Cost of special patterns, designs or plans for a particular job or work order, etc.

(ii) Indirect Expenses:

Indirect expenses are expenses other than indirect material and indirect labour, which cannot be directly identified with units of output, job, process or operation. These expenses are incurred commonly for jobs and processes. E.g., rent, power, lighting, depreciation, bank charges, advertising, etc.

Direct and Indirect Costs:

Direct Cost or Prime Cost:

The aggregate of all the direct costs i.e., Direct Materials, Direct Labour or wages and Direct expenses is termed as- ‘Prime Cost’ or ‘Direct cost’. Thus prime cost or direct cost is the sum of all the elements of costs which can be specifically identified with particular products or jobs and allocated to such output.

Indirect Cost or ‘Overhead’ or ‘On Cost’ or ‘Burden’:

The aggregate of all the indirect costs i.e., Indirect Material, Indirect labour and Indirect expenses is variously termed as ‘On cost’ or ‘overhead’ or ‘Burden’. Over heads or on cost or indirect cost cannot be identified with specific products or jobs. So it is apportioned to the output on some reasonable basis.

I.C.M.A., defines overheads as follows:

“The aggregate of indirect materials cost, indirect wages cost (indirect labour cost) and indirect expenses”. I.C.M.A. has stated in the note appended to this definition – ‘on cost’ and “Burden” as synonymous terms which are not recommended.

Elements # 4. Overhead:

On the basis of functions overhead is classified as:

(i) Factory overhead

(ii) Administration or office overhead, and

(iii) Selling and Distribution overhead.

(i) Factory Overhead:

This is the aggregate of indirect material, indirect wages and indirect expenses incurred in the factory. Examples of indirect factory expenses are rent, power, depreciation lighting and heating incurred in the factory.

(ii) Administration or Office Overhead:

All the indirect administration expenses, come under this category. Salaries of office staff, accountants, directors’ fees, rent of office building, stationery expenses incurred in the office lighting and bank charges, etc., are the examples.

(iii) Selling and Distribution Overhead:

This includes indirect selling and distribution expenses. Examples are salaries of salesmen, selling commission, advertising, warehouse rent, maintenance of delivery vans, warehouse staff expenses, warehouse lighting, etc.

Expenses Excluded from Costing:

The following items are excluded from computation of total cost:

(a) Capital Costs and Capital Losses- Purchase of fixed assets, plant and machinery, building, etc. Loss on sale of fixed assets, abnormal losses, preliminary expenses, patents written off, etc.

(b) Transfer to reserves, income tax, dividend, bonus to shareholders, etc.

(c) Financial items like, cash discount, interest on debentures, interest on loans, interest on own capital, etc.