Classification of Costs

A useful approach for understanding the various aspects of costs consists in examining alternative cost classification schemes. Generally, costs incurred by manufacturers are classified in different ways. Three of these that we come across frequently are

1. By objects of expenditure/nature of elements.

2. By programme (such as cost of Job No.1, No. 2 etc)

3. By responsibility center (condending & drying, packing)

Each classification serves a specific purpose. In this section we shall discuss the first one in detail

I. Cost classification by Objects of Expenditure/ Nature of Elements In this classification costs are recorded according to the factors upon which expenditure is incurred viz., material cost, wages (labour cost) and expenses

Material cost: The term material refers to all those commodities that are consumed in the process of manufacture. Materials can be further classified into direct materials and indirect materials.Direct materials are those whose consumption may be identified with specific production units. Direct materials usually become integral part of the finished product. Direct materials thus include:
All materials used in production are wholly consumed in the production processes.For example milk used in making products such as butter, ghee, cheese or Ice cream. Sugar used in Ice cream or colour used in flavoured dairy drink. The cost on those items shall form direct material cost. Component parts used in product. Any primary packing materials such as LDPE film for packing milk or ghee.

Indirect Material: All materials which are used for purposes ancillary to the business and which can not conveniently assigned to specific physical units are known as indirect materials. Furnace oil used for boiler, grease and oil for machines, hydrochloric acid and caustic soda for house keeping in dairy industry fall under the category of indirect materials.Material cost includes cost on direct materials and indirect materials.

Labour Cost: The cost of remuneration of the employees of an undertaking fall under this category. It includes wages, salaries, commission, bonuses etc paid to employees. As per the statistics during 2001-2002 there were 865 dairy factories functioning in the organized sector in India having 83623 employees. Their total emoluments stood at Rs. 825.87 crores for the period under consideration. These employees included workers, supervisory and managerial staff and other employees.Employees can be further bifurcated into direct labour and indirect labour and cost associated with them is known as Direct labour cost and the 
Indirect labour cost respectively.

Direct Labour Cost. The wages paid to workers who are directly engaged in converting raw materials into finished products come under this category. These wages can be conveniently identified with a particular product; job or process.Wages paid to a technicians manufacturing butter or ghee or skim milk powder is an example of direct labour cost.

Indirect Labour Cost: Labour employed for the purpose of carrying out tasks incidental to goods produced or services provided is called indirect labour or indirect wages. Indirect labour is not directly engaged in the production operations required for product manufacture but only to assist or help on production operations. Mechanics, boiler attendant watch & ward staff, supervisors,storekeepers are examples of indirect labour and cost on these employees constitute indirect labour cost.


All costs other than material and labour fall under this category and are termed as expenses. Expenses may be direct or indirect.

1. Direct Expenses

These are the expenses, which can be identified with and allocated to cost centers or units. Direct expenses can be conveniently allocated to a particular job or product or unit of service. These are also known as chargeable expenses or productive expenses. Hire of special machinery for a particular contract, cost of special drawings, designs and layout, carriage paid for materials purchased for a specific job fall under this category.

2. Indirect Expenses

Expenses which cannot be charged to production directly and which are neither indirect materials nor indirect wages are known as indirect expenses. Rent rates and taxes, insurance, depreciation, repairs and maintenance, power, lighting and
heating are few examples of indirect expenses.
The following chart shows the elements of cost mentioned above.

Overheads: Overhead costs are the indirect costs simply referred to as overhead. These cannot be directly attributed to any particular cost unit. The determination of overhead that should be properly associated with a given product is more difficult. It is because overhead costs cannot be identified with individual cost units and there are no accounting means of its exact distribution. Moreover they are generally not assumed to be directly associated with a department or product,either because there is no obvious relationship or because the cost of analysis and record keeping is considered too great.

There are three types of overheads.

1. Factory Overhead: Factory overhead includes all indirect expenses, which are incurred in connection with the manufacture of a product. They are also known as works overheads or factory burden or manufacturing overheads.Salary of plant manager and fee paid to Directors for guidance to solve production problems. Salary and other benefits paid to the Foremen, Timekeeper, Store Keepers and clerical staff of the factory,Cost of consumable stores,. Materials of small value such as cotton waste, small tools etc Rent, municipal taxes, depreciation, insurance etc., of the factory land and building,insurance, depreciation etc. of the factory plant, machineries, and equipment Factory lighting, heating and air conditioning, power and fuel (furnace oil, coal,gas, electric, etc.)Canteen and welfare expenses, telephone charges.Cost of training new employees, cost of experiment and research work.Cost of designing for production and drawing office expenses.Factory overheads may be fixed or variable.Fixed factory overhead are those costs, which do not vary with the volume of production. Examples are rent on factory building, insurance charges, property taxes, depreciation and supervisory salaries.
Variable factory overhead vary directly with the level of production. They include cost of fuel and power, repair and maintenance, cost of supplies and most indirect labour.

2. Administrative Overhead: It includes all those indirect expenses, which are incurred in general administrative and management function of an enterprise.
These overheads are of general character and are incurred for the business as a whole. Like factory overheads, administrative overheads tend to be fixed and variable.

The usual items generally included in these overheads are Salaries to Managing Directors, Directors, Executives and their staff, fees of Directors.

Office rent and rates and repairs and depreciation of office premises, power required for office equipment Audit fees, legal charges etc.

Stationary, postage, telephone charges, lighting and heating expenses and other utilities.

3. Selling and Distribution Overhead: Selling expenses are expenses of seeking to create and stimulate demand and of securing orders. Distribution expenses are expenses incurred in moving the goods from the company’s go downs to the customers’ premises. Selling and distribution expenses form no part of the cost of production but they take a considerable proportion of the price of the product.

The usual items included in selling and distribution expenses are :

Fee of Sales Directors, salaries of the Sales Manager and his staff including his office staff and his salesmen.

Traveling expenses and commission payable to salesmen.

Advertising and showroom expenses including rent and lighting.

Printing of catalogues and price lists and general stationary.

Rent of finished goods go downs and their repairs, etc.

Packing and carriage outwards, insurance in transit..

Depreciation, repairs and running expenses of delivery vans.

Telephone and postage etc. of sales department. Subscriptions to different agencies and trade journals.

Bad debts, legal charges for recovery of debts.

Having known classification of cost by elements of expenditure we can now derive various other costs.

The total of the Direct Expenditure comprising of Direct Materials, Direct Labour and Direct Expenses ——is known as Prime Cost or Flat Cost.

Prime cost plus Works or Factory Expenses is known as Works Cost or Manufacturing Cost or Factory Cost.
Product Costing

Works Cost plus Office and Administrative Cost is called Gross or Office Cost or Cost of Production.

Cost of Production plus Selling and Distributive Expenses is known as Cost of Sales. This differs from Selling price. Selling Price is equal to Cost of Sales plus Net Profit (or minus loss).

No comments:

Post a Comment

Note: Only a member of this blog may post a comment.


Most Reading