ELEMENTS OF COST

The elements of cost are those elements which constitute the cost of manufacture of a product.
We can broadly divide these elements of cost into three categories. In a manufacturing
organization, we convert raw materials into a finished product with the help of labour and other
services. These services are Material, Labour and Expenses.

Elements of Cost- bifurcation

Again, we can bifurcate these elements of cost into two categories such as Direct Material and
Indirect Material, Direct Labour and Indirect Labour, Direct Expenses and Indirect Expenses.
We need to add all direct material, direct labor, and direct expenses to calculate the prime cost.

Likewise, we add all indirect material, indirect labor, and indirect expenses to calculate the
overhead cost. Again, we can bifurcate the overheads into four categories. They are factory
overhead, administrative overhead, selling overhead and distribution overhead.

1. Direct Material

It represents the raw material or goods necessary to produce or manufacture a product. The cost
of direct material varies according to the level of output. For example, Milk is the direct material
of ghee.

2. Indirect Material

It refers to the material which we require to produce a product but is not directly identifiable. It
does not form a part of a finished product. For example, the use of nails to make a table. The cost
of indirect material does not vary in the direct proportion of product.

3. Direct Labour

It refers to the amount which paid to the workers who are directly engaged in the production of
goods. It varies directly with the level of output.

4. Indirect Labour

It represents the amount paid to workers who are indirectly engaged in the production of goods.
It does not vary directly with the level of output.

5. Direct Expenses

It refers to the expenses that are specifically incurred by the enterprises to produce a product.
The production cannot take place without incurring these expenses. It varies directly with the
level of production.
6. Indirect Expenses/ Overhead

It represents the expenses that are incurred by the organization to produce a product. These
expenses cannot be easily identified accurately. For example, Power expenses for the production
of pens.

It refers to all indirect materials, indirect labour, or/and indirect expenses.

a. Factory Overhead

Factory overhead or Production Overhead or Works Overhead refers to the expenses which a
firm incurs in the production area or within factory premises.

Indirect material, rent, rates and taxes of factory, canteen expenses etc.are example of factory
overhead.

b. Administration Overhead

Administrative or Office Overhead refers to the expenses which are incurred in connection with
the general administration of the organizations.

Salary of administrative staff, postage, telegram and telephone, stationery etc.are examples of
administration overhead.

c. Selling Overhead

All expenses that a firm incurs in connection with sales are selling overheads. Salary of sales
department staff, travelers’ commission, advertisement etc.are example of selling overhead.

d. Distribution Overhead

It represents all expenses incurred in connection with the delivery or distribution of finished
goods and services from the manufacturer to the consumer. F Delivery van expenses. loading and
unloading, customs duty, the salary of deliverymen are examples of distribution overhead.
CLASSIFICATION OF COSTS
Classification of Costs essentially means the grouping of costs according to their similar
characteristics. Now, in costing there are a dozen ways to classify costs as per their nature,
functions, traceability etc. Here we will be focusing on four such classifications.

Let us learn this in detail.

1] Classification by Nature

This is the analytical classification of costs. Let us divide as per their natures. So basically there
are three broad categories as per this classification, namely Labor Cost, Materials Cost and
Expenses. These heads make it easier to classify the costs in a cost sheet. They help ascertain the
total cost and determine the cost of the work-in-progress.

1. Material Costs: Material costs are the costs of any materials we use in the production of
goods. We divide these costs further. For example, let’s divide material costs into raw
material costs, spare parts, costs of packaging material etc.
2. Labor Costs: Labor costs consists of the salary and wages paid to permanent and
temporary employees in the pursuit of the manufacturing of the goods
3. Expenses: All other expenses associated with making and selling the goods or services.

2] Classification by Operations

This is the operational classification of costs. So the classification follows the pattern of basic
managerial activities of the organization.
The grouping of costs is according to the broad divisions of functions such as production,
administration, selling etc.

 Production Costs: All costs concerned with actual manufacturing or construction of the
goods
 Commercial Costs: Total costs of the operation of an enterprise other than the
manufacturing costs. It includes the admin costs, selling and distribution costs etc.

3] Classification by Traceability

This aspect one of the most important classification of costs, into direct costs and indirect costs.
This classification is based on the degree of traceability to the final product of the firm.

 Direct Costs: So these are the costs which are easily identified with a specific cost unit or
cost centers. Some of the most basic examples are the materials used in the
manufacturing of a product or the labor involved with the production process.
 Indirect Costs: These costs are incurred for many purposes, i.e. between many cost
centers or units. So we cannot easily identify them to one particular cost center. Take for
example the rent of the building or the salary of the manager. We will not be able to
accurately determine how to ascertain such costs to a particular cost unit.

4] Classification by Normality

This classification determines the costs as normal costs and abnormal costs. The norms of
normal costs are the costs that usually occur at a given level of output, under the same set of
conditions in which this level of output happens.

 Normal Costs: This is a part of the cost of production and a part of the costing profit and
loss. These are the costs that the firm incurs at the normal level of output in standard
conditions.
 Abnormal Costs: These costs are not normally incurred at a given level of output in
conditions in which normal levels of output occur. These costs are charged to the profit
and loss account; they are not a part of the cost of production.

5] Classification by Functionality

Cost is classified by the following categories. The main four categories of functional costs are
given below-

 Prime cost: Prime cost is the adjustment of the direct material, direct labor, and direct
costs. It is actually the result of these three elements.
 Product cost: It means the factory cost with administrative and office overheads
 Factory cost: Factory cost is also known as work cost. It is combined with work cost and
work expenses
6] Classification by Behaviour

By behavior or variability cost is classified as Variable cost, Fixed cost and Mixed cost which is
explained below.

 Variable cost: Variable cost is such a cost which proportion is changing with the amount
of production. Such as direct material and changeable costs
 Fixed cost: This cost won’t change with the proportion of production. It is maximum
time fixed. But it is notable that this cost may be changed after a long time. For example,
office rent, insurance, and hospital cost.
 Mixed cost: Mixed cost can change overall but not with the proportion of production.
More changeable cost is count under a Mixed cost. The example of a mixed cost is
electricity expenses.

7] Classification by Relevance

Relevance base cost is mainly divided into five categories which are given below;

 Relevant cost: Which cost can be by making a new decision is called relevant cost.
Occasionally there may have many relevant costs. This cost is not fixed from before.
 Opportunity cost: Opportunity cost is the system of getting some extra advantages from
the existing things of a factory like land, money and time etc. Someone can rent his office
for another purpose of advantages. Moreover, they can rent their other things also. It is
actually an extra benefit for a company.
 Standard cost: Standard cost is fixed from the previous experience. It was fixed
according to the specific budget, the volume of an industry. The actual cost is also
included with this cost.
 Controllable cost: Which cost can be controlled by management is called controllable
cost. The manager can control some cost.
 Sunk cost: It is known as a historical cost. Sunk cost effect is most important for a
company. It is such a cost which is already lost and can’t be undone anymore. If a
company is paid their monthly rent than we can say this rent cost is sunk cost.

8] Classification by Management

These costs are mainly divided into two categories; Manufacturing cost and Non-manufacturing
cost given are given below;

 Manufacturing cost: Manufacturing cost refers to the total cost of a product from the
raw materials to finish the product. It is mainly the combination of direct material cost,
labor cost, and manufacturing overheads.
 Non-manufacturing cost: In order, the rules of GAAP Non-manufacturing cost are not
actual product cost. It is a part of the company’s income statement.