In the Oxford Dictionary ‘cost‘ means ‘the price paid for something’. But in the management terminology, ‘cost’ refers to expenditure and not to price. ‘Cost’ represents a sacrifice, a foregoing or a release of something of value. The Institute of Cost and Management Accountants, London, has defined cost as “the amount of expenditure (actual or notional) incurred on or attributable to a given thing.”
For manufacturing of cotton fabrics, the expenditure incurred on the purchase of cotton yarn, wages paid to weavers, salary paid to factory foreman, depreciation on machinery used in the manufacture of fabrics, notional rent of owned factory building etc., are the items of cost.
Elements of Costs
One of the main objects of cost accounting is to present the analysis of the total cost of production in such a manner as to provide the maximum information useful to the business. The analysis and classification of costs are basically made with reference to factors on which expenditure is incurred.
These factors are known as ‘elements of cost’. ‘Element’ may also be defined as a group name of smaller costs of identical nature. The various elements of cost are:
1. Material cost
2. Labour cost or wages
‘Material cost’ refers to the cost of commodities supplied to an undertaking e.g. , cost of yarn and dyes supplied to an undertaking engaged in the manufacture of cloth, cost of leather, thread, nails and shoe polish supplied to an undertaking engaged in the manufacture of shoes, etc.
Material cost may be further subdivided into:
(a) Direct Material Cost: Direct material cost means the cost of materials which can be identified with and allocated to cost centers or cost units e.g., the cost of wood in case of furniture, cost of cotton in case of cotton yarn, cost of yarn in case of cloth, cost of iron in case of machinery etc. The main feature of direct materials is that these enter into and form part of the finished product.
(b) Indirect Material Cost: It refers to the material cost which cannot be allocated but can be apportioned to or absorbed by cost centers or cost units. These are the materials which cannot be traced as part of the product and their cost is distributed among the various cost centers or cost units on some equitable basis. Examples of indirect materials are coal and fuel for generating power, cotton waste, lubricating oil and grease used in maintaining the machinery, materials consumed for repair and maintenance work, dusters and brooms used for cleaning the factory, etc.
Labour Cost (or Wages)
Labour cost refers to the cost of remuneration of the employees of an undertaking e.g., wages, salaries, commission etc. Labour cost may be sub-divided into:
(a) Direct Labour Cost (or Direct Wages): It refers to labour cost which can be identified with and allocated to cost centers or cost units. It includes the remuneration paid for converting the raw material into finished products or for altering the construction, composition or condition of the product manufactured by an undertaking e.g., wages paid for spinning yarn in case of spinning mill, wages paid for weaving cloth in case of cloth mill, wages paid to a mason for construction of building by a building contractor etc. In case of a service concern, direct labour cost refers to the wages paid to those who directly carry out or operate the service e.g., wages paid to the driver and conductor of a bus in case of the transport business.
(b) Indirect Labour Cost (or Indirect Wages): It refers to the labour cost or wages which cannot be allocated but can be apportioned to or absorbed by cost centers or cost units e.g., salary paid to factory manager, salary paid to factory supervisor or foreman, salary paid to general manager or sales manager etc.
Expenses refer to the cost of services provided to an undertaking and the notional cost of the use of owned assets (i.e., depreciation of owned factory building, depreciation of office building, depreciation of show-room building, depreciation of plant and machinery etc.). Expenses are sub-divided into:
(a) Direct Expenses (or Chargeable Expenses): These are the expenses (other than direct material cost and direct labour cost) which can be identified with and allocated to cost centres or cost units e.g., royalties paid on the basis of output, hire charges of special plant or machinery, carriage and freight on direct materials purchased if such carriage and freight have not been added to the cost of materials, import duty and octroi paid on the purchases of imported direct materials (if not added to their purchase price).
(b) Indirect Expenses: Expenses which cannot be allocated but can be apportioned to or absorbed by cost centres or cost units e.g., rent, rates, taxes and insurance of factory building, factory lighting, repairs to factory building, depreciation of plant and machinery, repairs to machinery, depreciation and insurance of office building, depreciation and insurance of show-room building etc., are known as indirect expenses.
The aggregate of direct material cost, direct labour cost and direct expenses is known as ‘Direct Cost’ whereas the aggregate of indirect material cost, indirect labour cost and indirect expenses is known as
‘Indirect Cost’ or ‘Overhead’. Indirect cost or overhead may again be classified on the basis of functions as follows:
(i) Factory Overhead or Works Overhead: Factory overhead includes all the indirect costs incurred in the factory in connection with manufacturing operations. Factory overhead comprises the cost of indirect materials, cost of indirect labour and all other indirect expenses which are incurred in the running of the factory or works e.g., lubricating oil, cotton waste for cleaning the machinery, coal, gas and fuel, wages of store-keeper, wages of time-keeper, salaries of foremen and factory, supervisors, factory rent, factory rates and insurance, repairs to factory building, depreciation of factory plant and machinery, depreciation of owned factory building etc.
(ii) Office and Administration Overhead: These include all indirect costs relating to the direction, control and administration of an undertaking. In other words, office and administration overhead refers to general office expenses and expenses of administration and control of business e.g., office rent, office rates and insurance, depreciation of owned office building, office lighting, depreciation of office furniture, office stationery, audit fee, directors’ remuneration, salary of general manager, salaries of general clerical staff, bank charges etc.
(iii) Selling and Distribution Overhead: These include all indirect costs which are incurred for promoting sales and retaining the customers and for delivering the goods after their manufacture to the consumers e.g., cost of advertisement, rent, rates, taxes and insurance of show-room building, depreciation of owned show-room building, show-room lighting, salary of sales manager, salaries of salesmen, commission on sales, carriage on sales, packing charges, rent or depreciation of warehouse, salary of warehouse-keeper, running and maintenance of delivery vans etc.
Components of Costs
A ‘component of cost‘ may be defined as the cumulative or aggregate of different elements of cost. By aggregating or grouping the various elements of cost, the following components or types of cost are obtained:
(a) Prime Cost: Prime cost is the aggregate of direct material cost, direct labour cost and direct expenses. Prime Cost is also known as ‘Flat Cost’, ‘First Cost’ or ‘Direct Cost’.
(b) Factory Cost: Prime cost plus factory overhead (or works overhead) is known as factory cost. Thus, factory cost is the aggregate of direct material cost, direct labour cost, direct expenses and factory overhead. Factory cost is also known as ‘Works Cost’ , ‘Production Cost’ or ‘Manufacturing Cost’.
(c) Office Cost: Factory cost plus office and administrative overhead is known as ‘Office Cost’. Office cost is also known as ‘Gross Cost’ or ‘Cost of Production’.
(d) Total Cost: Total cost is made up of cost of production plus selling and distribution overhead. Thus, total cost includes all the elements of cost or all the items of expenditure till the commodity has been finally sold Total cost is also known as ‘Selling Cost’ or ‘Cost of Sales’.
Selling price is not the same thing as selling cost. Selling price is the Selling Cost (or Total Cost or Cost of Sales) plus profit. The various components of cost can be shown by means of the following diagram:
Direct Material Cost + Direct Wages + Direct Expenses = Prime Cost.
Prime Cost + Factory Overhead = Factory Cost.
Factory Cost + Office and Administration Overhead = Office Cost.
Office Cost + Selling and Distribution Overhead = Total Cost.
Total Cost + Profit = Selling Price.