We initially categorize costs by the three cost components:
Costs for Products and Periods: We categorize costs as either
- Product costs: the expenses incurred during product manufacture; alternatively
- Period costs: these are the expenses other than product costs that are billed, deducted from, or written off from the income statement on a period-by-period basis.
The Classification of Product Costs:
Direct costs: Also known as variable costs, direct costs are often thought of as being directly related to manufacturing. In turn, the direct expenses might comprise:
- Direct materials: comprise plywood, wooden battens, seat and back covering material, nails, screws, and adhesive.
- Direct labor: includes painters, polishers, assemblers, drillers, sawyers, and upholsterers.
- Direct expense: this is a strange cost that many texts don’t include; but (International Accounting Standard) IAS 2, for example, has it. The cost of purchasing or leasing specialized gear to produce a limited edition of a set of chairs is one example of a direct expense. Another is the fee for specific designs for one batch or run, of a particular set of tables and chairs.
We can see that product costs are the total of prime expenses and overheads, which are collectively referred to as prime costs.
Indirect Costs: Indirect costs are those costs that are incurred in the factory but that cannot be directly associated with manufacturing. Once more, these expenses are broken down into the three categories of cost, materials, labor, and overheads.
- Indirect materials: This would include some of the prices that were accounted for indirect materials.
- Indirect labor: Labour costs of people who are only indirectly associated with manufacture: management of a department or area, supervisors, cleaners, maintenance, and repair technicians.
- Indirect expenses: If we were to include every conceivable indirect cost, the list in this section would be infinitely extensive. In essence, a cost must be an indirect expense if it is a factory cost and has not been accounted for in any of the other parts. Here are a few instances, such as:
- Equipment, machinery, vehicles, and building depreciation Rent, Council Tax, phone, water, electricity, and insurance.
Overheads are the collective name for all indirect expenses.
Conversion Costs are the expenses incurred in manufacturing when inputs are transformed into finished goods. These costs are the last category under Product Costs.
The classification of Period Costs:
There are five sub-categories for Period Costs under the system. Different organizations have period charges that may have sub-classifications with wholly different names, as we can see when we examine them. Unfortunately, this is how period charges are classified; it can change depending on the organization, the sector, and other factors. However, a plan like this is helpful since it offers us the fundamental concepts to build upon.
Administration Costs: The costs of running the administrative aspects of an organization. Salaries, rent, Council Tax, power, water, telephone, depreciation, and a potentially endless list of other expenses will be included in administration costs. It should be evident that we are paying rent on buildings, for example, that we use for manufacturing, storage, and administration when expenses like rent and council tax appear in multiple sub-classifications; each area of the business is required to pay its fair share of the total cost under consideration.
Without wanting to unnecessarily prolong this list, we can remark that the costs of selling, distribution, and research are all compounded like how administration costs are accumulated. Therefore, it is our responsibility to examine the selling process and categorize the associated costs, such as advertising, market research, salaries, bonuses, electricity, etc. The same holds for any other categories of period charges we might employ.
Finance Costs: Finance costs are those costs associated with providing permanent, long term and short-term finance. In other words, dividends, interest on long-term loans, and interest on short-term loans can all be included in the part titled financing charges.
Finally, we should say that we can add any number of subclassifications to our scheme if we need to do that to clarify how our organization operates. We will also add further subclassifications if we need to refine and further refine our cost analysis.
|Opening Raw Material Stock Addition: Raw material purchases|
Add: Purchase Expenses
Less: Closing stock of Raw Materials Consumed
Direct Wages (Labour)
|Prime cost (1)||***|
|Add:- Factory Over Heads:|
Drawing Office Salary
Factory Asset Depreciation
|Works cost Incurred||***|
|Add: Opening Stock of WIP|
Less: Closing Stock of WIP
|Works cost (2)||***|
|Add:- Administration Over Heads:-|
Counting house Salary
Other Office Expenses
|Cost of Production (3)||***|
|Add: Opening stock of Finished Goods|
Less: Closing stock of Finished Goods
|Cost of Goods Sold||***|
|Add:- Selling and Distribution OH:-|
Delivery man expenses
|Cost of Sales (5)||***|
|Profit (balancing figure)||***|
- A percentage of direct wages is used to recuperate factory overhead costs.
- Overhead in Administration, Selling, and Distribution A percentage of the cost of the work is recovered for overhead.