Elements of Cost in Cost Accounting

Everything you need to know about the elements of cost in Cost Accounting. A cost is composed of three elements – Material, Labour and Expenses. Each of these three elements can be direct and indirect, i.e., direct materials and indirect materials, direct labour and indirect labour, direct expenses and indirect expenses.

In this context the total cost of manufacture is classified under three elements called the elements of cost. This element wise classification of cost is based on the nature of the cost itself.

Learn about the elements of cost. They are:-

1. Direct Material Cost 2. Direct Wages 3. Direct or Chargeable Expenses 4. Indirect Materials 5. Indirect Labour 6. Indirect Expenses 7. Overheads.

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.

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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

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2. Labour,

3. Expenses and

4. Overheads

The above elements of cost are explained below:

Element # 1 Materials:

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“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:

“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.

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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.

Labour cost is also divided into direct and indirect portions:

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(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:

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:

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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:

(i) Direct expenses, and

(ii) Indirect expenses.

(i) Direct Expenses:

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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.

(ii) Indirect Expenses:

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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.

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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.

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(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.

Elements of Cost Accounting – 4 Basic Elements: Direct Materials, Direct Labour Cost, Direct Expenses, Overheads

A cost is composed of three elements – Material, Labour and Expenses. Each of these three elements can be direct and indirect, i.e., direct materials and indirect materials, direct labour and indirect labour, direct expenses and indirect expenses.

The following are the various elements of costs:

1. Direct Materials:

Direct materials are those materials which can be conveniently identified with and allocated to cost units. Direct materials generally become a part of the finished product. Examples of direct material are – leather in shoe making, clay in bricks, cloth in garments, timber in furniture, etc. However, in many cases, though material forms a part of the finished product, yet it is not treated as direct material, e.g., nails in furniture, threads used in stitching shoes, etc. This is because value of such material is so small that it is quite difficult and futile to measure them. Such materials are treated as indirect materials.

2. Direct Labour Cost:

Direct labour cost consists of wages paid to workers directly engaged in converting raw materials into finished products. These wages can be conveniently identified with a particular product, job or process. Wages paid to a machine operator is a case of direct wages.

3. Direct Expenses:

These expenses, also known as chargeable expenses, include all direct costs, other than direct material and direct labour that are special incurred for a particular product or process. For example, cost of special moulds and patterns, cost of patents, royalties, hire charges of plant for a particular job or contract, etc., are direct expenses.

The aggregate of direct material cost, direct labour cost and direct expenses is termed as PRIME COST.

4. Overhead:

Overhead is the total of all indirect costs. It is defined as – “the aggregate of indirect materials, indirect labour and indirect expenses”. Overhead is also known on-cost, supplementary cost, burden etc.

Overhead thus consists of three elements, i.e.:

1. Indirect materials,

2. Indirect labour and

3. Indirect expenses.

1. Indirect materials – These are those materials which cannot be conveniently identified with individual cost units. These are generally minor in importance. Examples are coal, lubricating oil, sand paper, soap, etc.

2. Indirect labour – It is of general character and cannot be conveniently identified with a particular cost unit. Indirect labour is not directly engaged in production but only indirectly assists in production operations. Examples are peon, supervisor, clerk, watchman etc.

3. Indirect expenses – All indirect costs, other than indirect materials and indirect labour costs, are termed indirect expenses. These cannot be directly identified with a particular job, process or work order and are common to cost units and cost centres. Examples are rent and rates, insurance, depreciation, power, lighting, cartage, advertising etc.

Elements of Cost Accounting – Top 7 Elements: Direct Material Cost, Direct Wages, Chargeable Expenses, Indirect Material, Indirect Labour, Indirect Expenses and Overheads

In order to exercise proper control of costs for sound managerial decisions, the management may be provided with necessary data. For this reason, the total cost of the product is analysed by the elements of cost—nature of expenses. Traditionally, the product cost is divided into three—material, labour and other overhead expenses and these can further be analysed into different elements.

The total expenditure consisting of material, labour and expenses can further be analysed as under:

Prime Cost = Direct materials + Direct Labour + Direct expenses

Works Cost (Factory) = Prime Cost + Factory overhead

Cost of Production = Factory Cost + Administration overhead

Total Cost (Cost of sales) = Cost of production + Selling and distribution overhead

Each element of cost is explained in detail, as below:

Element # 1. Direct Material Cost:

Direct material is material that can be directly identified with each unit of the finished product. Direct material is that material which becomes a part of the product. Raw materials, semi-finished materials, components etc. which become part and parcel of the product are known as direct materials. For example, cloth in garments, leather in shoe-making, spares parts in assembling of radio, cycle, scooter etc. In case, certain materials become part of the product, but are of negligible value; they may be grouped under indirect materials.

Direct material includes the following:

i. Materials including component parts specially purchased for the job.

ii. Material transferred from one cost center to another, one process to another process.

iii. Primary packing materials like cartons, wrappings, card-board boxes etc.

Element # 2. Direct Wages:

All labour expenses in altering, composition, construction, conformation etc. of the product are included in direct wages; they include the payment made to the following group of labour:

i. Labour engaged on the actual production of the product; i.e., carrying out the operation or process.

ii. Labour engaged in aiding the operation; i.e., supervision, foreman, wages of internal transport personnel, shop clerks etc.

iii. Inspectors, analysts etc., specially needed for the production.

Direct wages are also known as direct labour, productive labour, process labour or prime cost labour.

Element # 3. Direct or Chargeable Expenses:

Expenses other than direct material, direct labour, which can be identified with and allocated to cost units or cost centers as they are specially incurred for a particular product or process, form a part of prime cost. Direct expenses are also known as chargeable expenses, prime cost expenses, process expenses or productive expenses.

The following groups of expenses fall under direct expenses:

i. Cost of special drawings, designs or layout

ii. Hire charge, repair and maintenance of special equipment hired

iii. Experimental expenses of a job

iv. Excise duty, Royalty

v. Architect or surveyor’s fee

vi. Travelling expense connected to the job

vii. Cost of rectifying defective work.

Element # 4. Indirect Materials:

Indirect materials are those materials which cannot be traced as part of the product. They are also known as on cost materials or expense materials which cannot be allocated, but which, can be apportioned to or absorbed by the cost centers or cost units also come under this group.

Examples are:

(i) Stores items used in maintenance of machinery like lubricant, cotton waste, grease, oil, stationery etc.

(ii) Small tools for general use.

(iii) Some minor items of materials, treated as indirect materials, due to their small costs, such as cost of thread in dress-making, cost of nails in shoe-making etc.

Element # 5. Indirect Labour:

Labour whose wage cannot be allocated, but which can be apportioned to or absorbed by the cost center or cost units is known as indirect labour. Indirect wages represent the cost of labour, ancillary to the production. In other words, wages which cannot be directly identified with a job; are generally treated as indirect wages. Examples are- Salaries and wages of foremen, supervisors, inspectors, maintenance labour, store-keepers, clerical staff, watch and ward, internal transport etc.

Element # 6. Indirect Expenses:

These are expenses which cannot be allocated, but can be apportioned to or absorbed by the cost centers or cost units. In other words, expenses other than indirect material and labour are indirect expenses.

The following are examples of indirect factory expenses:

(i) Rent, rates and insurance in relation to factory

(ii) Depreciation, repairs, maintenance on factory building, plant etc.

(iii) Welfare and medical expenses

(iv) Expenses of service department such as tool-room, boiler-house, drawing-office, production and planning center.

(v) Cost of training of new employees.

Element # 7. Overheads:

All expenses other than the direct material cost, direct wages and direct expenses are known as indirect expenses or overhead. According to Weldon, overhead means “the cost of indirect materials, indirect labour and such other expenses, including services as cannot conveniently be charged direct to specific cost units”. In other words, overhead means the aggregate of indirect material cost, indirect labour and indirect expenses.

In general, overheads may be sub-divided into the following groups:

(i) Production Overhead or Works Overhead or Factory Overhead or Manufacturing Overhead:

They refer to all indirect expenses incurred on processes and operations, which commence from the receipt of work order till its completion, ready for delivery to customer or to the finished goods store.

They are:

a. Indirect materials in works.

b. Indirect wages to workshop employees.

c. Factory expenses like rent, rates, taxes, insurance, repairs etc.

d. Depreciation on plant, machinery and maintenance of factory building.

e. Welfare and medical expenses of factory employees.

(ii) Administrative Overhead:

It consists of all expenses incurred in formulating the policies, directing the organisation and controlling the operations of an undertaking, which are not directly connected to production, selling, distribution, research and development activities.

(iii) Selling Overhead:

It is the cost of seeking to create and stimulate demand and of securing orders. In other words all expenses in securing and retaining customers for the products are selling expenses, since they have been spent on creating and maintaining demand for the product.

(iv) Distribution Overhead:

These are the expenses concerned with the delivery and dispatch of finished goods to customers. In other words, it is an expenditure incurred from the time; the product is completed until it reaches its destination, for example-

(a) Cost of packing cases.

(b) Oil, grease, spare parts used in the upkeep of delivery vans.

(d) Loading expenses, carriage out, salaries of dispatch clerk, wages of dispatching attenders, cost of repairing of empties for reuse.

Elements of Cost Accounting – 4 Broad Elements: Material, Labour, Expenses and Overheads

There are four broad elements of cost:

1. Material:

The substance from which the product is made is known as material. It may be in a raw or a manufactured state. It can be direct as well as indirect.

i. Direct Material:

All material which becomes an integral part of the finished product and which can be conveniently assigned to specific physical units is termed as “Direct Material”.

Following are some of the examples of direct material:

(a) All material or components specifically purchased, produced or requisitioned from stores.

(b) Primary packing material (e.g., cartoon, wrapping, cardboard, boxes etc.).

Direct material is also described as raw-material, process material, prime material, production material, stores material, constructional material etc.

ii. Indirect Material:

All material which is used for purposes ancillary to the business and which cannot be conveniently assigned to specific physical units is termed as “Indirect Material”. Consumable stores, oil and waste, printing and stationery etc. are a few examples of indirect material.

Indirect material may be used in the factory, the office or the selling and distribution division.

2. Labour:

For conversion of materials into finished goods, human effort is needed, such human effort is called labour. Labour can be direct as well as indirect.

i. Direct Labour:

Labour which takes an active and direct part in the production of a particular commodity is called direct labour. Direct labour costs are, therefore, specially and conveniently traceable to specific products.

Direct labour is also described as process labour, productive labour, operating labour, manufacturing labour, direct wages etc.

ii. Indirect Labour:

Labour employed for the purpose of carrying out tasks incidental to goods or services provided, is indirect labour. Such labour does not alter the construction, composition or condition of the product. It cannot be practically traced to specific units of output. Wages of store-keepers, foremen, timekeepers, directors’ fees, salaries of salesmen, etc. are all examples of indirect labour costs.

Indirect labour may relate to the factory, the office or the selling and distribution divisions.

3. Expenses:

Expenses may be direct or indirect.

Direct Expenses – These are expenses which can be directly, conveniently and wholly allocated to specific cost centres or cost units. Examples of such expenses are – hire of some special machinery required for a particular contract, cost of defective work incurred in connection with a particular job or contract etc. Direct expenses are sometimes also described as “chargeable expenses.”

Indirect Expenses – These are expenses which cannot be directly, conveniently and wholly allocated to cost centres or cost units.

4. Overheads:

It is to be noted that the term overheads has a wider meaning than the term indirect expenses. Overheads include the cost of indirect material and indirect labour besides indirect expenses.

Indirect expenses may be classified under the following three categories:

(a) Manufacturing (works, factory or production) Expenses – Such indirect expenses which are incurred in the factory and concerned with the running of the factory or plant are known as manufacturing expenses. Expenses relating to production, management and administration are included therein.

Following are a few items of such expenses:

Rent, rates and insurance of factory premises, power used in factory building, plant and machinery, etc.

(b) Office and Administrative Expenses – These expenses are not related to factory but they pertain to the management and administration of business. Such expenses are incurred on the direction and control of an undertaking.

Examples are:

Office rent, lighting and heating, postage and telegrams, telephones and other charges; depreciation of office building, furniture and equipment, bank charges, legal charges, audit fee etc.

(c) Selling and Distribution Expenses – Expenses incurred for marketing of a commodity, for securing orders for the articles, despatching goods sold, and for making efforts to find and retain customers, are called selling and distribution expenses.

Examples are:

Advertisement expenses, cost of preparing tenders, travelling expenses, bad debts, collection charges etc.

Warehouse charges, packing and loading charges, carriage outwards, etc.

Elements of Cost Accounting – Direct Material Cost, Direct Labour Cost, Direct Expenses and Overheads

Total cost can be broken up into the following elements:

1. Direct material cost;

2. Direct labour cost;

3. Direct expenses; and

4. Overheads

According to functions, overheads may be classified into the following three categories:

(i) Manufacturing overheads

(ii) Administration overheads

(iii) Selling and distribution overheads.

A brief description of each element of cost is given below:

1. Direct Raw Material:

Cost of cloth in garments, cost of wood in furniture, cost of pig iron in foundry, cost of seeds in oil, etc., are examples of direct material cost of respective products. It may, however, be noted that directs materials generally do not include minor items such as buttons, thread, nails, glue etc., because the cost of tracing these items to the finished product may exceed the benefit derived from computing very accurate direct material costs. The cost of such minor items is included in indirect material costs.

2. Direct Labour:

All labour cost incurred in the transformation of raw material into a finished product and traceable to the finished product, process or job is identified as direct labour cost.

In any manufacturing concern workmen employed can be divided into two categories:

(i) Those engaged in the actual production of the product or carrying out the process or the operations; and

(ii) Those who help in the production process by way of supervision, material handling, plant guarding, plant maintenance, tool setting, etc.

The labour cost of the first category of workers is treated as direct labour cost and is directly charged to the product. Direct labour costs also generally vary in direct proportion to output/activity. But the labour cost of the second category of workers/employees is treated as indirect labour cost and is recovered by way of overhead rates.

3. Direct or Chargeable Expenses:

All expenses, other than direct materials and direct labour cost, which are specifically and solely incurred on production, process or job are treated as direct or chargeable expenses. These are charged direct to the product, process or job, etc., as part of prime cost.

The following are the examples of direct expense:

(i) Rental of a machine or plant hired for a specific job.

(ii) The cost of making a specific pattern, design, drawing or making tools for a job.

(iii) The costs of making experiments, models and conducting pilot schemes.

(iv) Fees of architects, surveyors and consultants.

(v) Expenses on travelling and other incidental expenses incurred in connection with a specific job.

(vi) Carriage inwards, freight and insurance on procuring direct materials,

(vii) The costs of primary packing materials.

(viii) The costs of patents, amount of royalty and licence fees incurred or paid in connection with a specific job.

4. Overheads:

These are classified under the following three headings:

(i) Manufacturing Overheads:

All costs, other than direct costs (direct material, direct labour and direct expenses) associated with the production are included in manufacturing overheads. They consist of indirect materials, indirect labour and indirect expenses. Manufacturing overheads are also known by various other names, such as factory overheads, factory burden, manufacturing expenses, work overheads, works on cost, etc.

These may be variable or fixed. Variable overheads are related with the volume of production. Fixed overheads are related with time. Power, fuel etc. are examples of variable overheads whereas rent, insurance, rates and taxes, salaries of supervisions, etc. are examples of fixed overheads. Overheads are allocated, apportioned and absorbed by products on some equitable basis.

(ii) Administration Overheads:

All expenses incurred on the administration, direction and control of an organisation are collected and accumulated under ‘administrative overheads’. Staff salaries, rent, electricity, legal expenses, audit fee, director’s fees, rent and maintenance of office equipment, depreciation on office furniture and equipment and insurance thereof, etc. are all example of administrative overheads.

(iii) Selling and Distribution Overheads:

All costs related to selling and distribution of products are included under selling and distribution overheads. Selling costs are incurred in obtaining and retaining a customer. Sales office expenses, commission and salaries of sales force, expenses on advertising, publicity and show room, etc., constitute selling overheads. Expenses incurred on the distribution of products are called distribution overheads.

All expenses starting from receiving finished products into the stores/warehouse up to their delivery to customers are included in distribution overheads. Warehouse rent, salaries of warehouse staff, expenses on delivery vans and trucks, etc. are examples of distribution overheads. Selling and distribution overheads can also be variable or fixed depending on their nature and behaviour.

Elements of Cost Accounting – 4 Main Elements: Material Cost, Labour Cost, Expenses and Overheads

It means the essential components or parts of the total cost of a product or service.

Following are the elements of cost:

(1) Material Cost

(2) Labour cost &

(3) Expenses.

(4) Overheads

(1) Material Cost:

It means the cost of various items of materials. Materials may be direct or indirect.

(i) Direct materials – Direct material cost is that which can be conveniently identified with and allocated to cost units. Direct materials generally become a part of the finished product.

Example- Clay in Bricks, Leather in Shoes, Steel in Machines, Cloth in Garments, Timber in Furniture, Jute in the manufacture of Gunny bags, Pig iron in Foundry, Fruits in Canning industry, Glue for Book binding, Starch powder for Dressing yarn, Batteries for Transistor/radios, packing materials like cartons, wrappings, card-board boxes, etc.

Direct material cost can be defined as ‘The Cost of material which can be attributed to a cost object in an economically feasible way’.

(ii) Indirect materials – Indirect materials are those materials which cannot be conveniently identified with individual cost units. These are minor in importance.

Example- Pins, Screws, nuts and bolts, thread, lubricating oil, Sand paper, Coal, Small tools, Office stationery, Stores used in maintenance of machinery, lubricants, cotton waste. Stores used by the service departments, like Power House, Boiler House and Canteen etc.

(2) Labour Cost:

It means the remuneration like wages, salaries, commission, bonus & all other incentives paid to different types of employees in a business concern. It may be direct or indirect.

(i) Direct labour – Direct labour cost consists of wages paid to workers directly engaged in converting raw materials into finished goods. These wages can be conveniently identified with a particular product, job, or process.

Example – Wages paid to machine operator, shoe-maker, Carpenter, Weaver, Tailor, Labour engaged on the actual production of the product or in carrying out of an operation or process, Labour engaged in adding the manufacture by way of supervision, maintenance, tool setting, Transportation of material, Inspectors, analysts etc., specially required for such production.

(ii) Indirect labour – It is of general in character and cannot be conveniently identified with a particular cost unit. In other words, indirect labour is not directly engaged in the production operations but only to assist or helping production operations.

Example – Salary paid to supervisor, inspector, Cleaner, Clerk, Peon, Watchman, maintenance workers; men employed in service departments, material handling and internal transport; apprentices, trainees and instructors; clerical staff and labour employed in time office and security office.

(3) Expenses:

Expenses refers to all costs other than materials cost & labour cost incurred by a business concern.

(i) Direct or Chargeable Expenses – Direct expenses are expenses relating to manufacture of a product or rendering a service which can be identified or linked with the cost object other than direct material cost and direct employee cost. Such expenses are charged directly to the particular cost account concerned as part of the prime cost.

Direct expenses are those expenses which can be identified with and allocated to cost centers or units. They are also known as chargeable expenses.

Example – Excise duty, Royalty, Architect or Supervisor’s fees, Cost of rectifying defective work, Experimental expenses of pilot projects, Expenses of designing or drawings of patterns or models, Repairs and maintenance of plant obtained on hire and Hire of special equipment obtained for a contract, Cost of patent rights, carriage on purchases etc.

(ii) Indirect Expenses – All indirect costs other than indirect materials and indirect labour costs are called as indirect expenses. These cannot be conveniently identified with a particular job, process or work order and are common to cost units or cost center

Example – Rent and rates, Depreciation, lighting and power, Advertising, insurance, repairs, Transportation, Printing & Stationery, etc.

(4) Overheads:

This is the aggregate of indirect material cost, indirect labour cost and indirect expenses. Overheads are also known as on cost.

Overhead = Indirect materials + Indirect labour + Indirect expenses.

Elements of Cost Accounting – With Components of Total Costs

There are broadly four elements of cost:

1. Material:

The matter or substance from which the product is made is the material. It may be in raw or processed form. It can be direct or indirect.

i. Direct Material- All material which becomes an integral part of the finished product and which can be conveniently assigned to specific physical units is termed Direct Material.

Examples are:

a. All material or components specifically purchased, produced or requisitioned from stores

b. Primary packing materials (e.g. cartons, boxes)

c. Partly produced or purchased components.

ii. Indirect Material – All material which is used for purposes ancillary to production and which cannot be conveniently assigned to specific physical units, is termed Indirect Material. Consumable stores, oil and waste are a few examples of indirect material.

2. Labour:

For the conversion of raw material into finished goods, human effort is required and such human effort is called labour. Again, labour can be direct or indirect.

i. Direct Labour – Labour which takes an active and direct part in the production of a particular commodity is direct labour. Direct labour costs are, therefore, specifically and conveniently traceable to specific products.

ii. Indirect Labour – Labour employed for the purpose of carrying out tasks incidental to goods produced or services provided is indirect labour. It cannot be practically traced to specific units of output. Wages of foremen/supervisors, time keepers and salaries of salesmen are some examples of indirect labour costs.

3. Expenses:

Expenses too may be direct or indirect.

i. Direct Expenses – These are expenses which can be directly and wholly allocated to a specific cost centre or unit (e.g. hiring of some special machinery for a particular contract, commission for a specific product).

ii. Indirect Expenses – These are the expenses which cannot be conveniently and wholly allocated to cost centres or cost units (e.g. rent, electricity, insurance).

4. Overheads:

The term overheads includes indirect materials, indirect labour and indirect expenses. Thus all indirect costs are overheads.

In a manufacturing organization, these can be broadly divided into three categories:

i. Factory/works production overheads, where production is carried out

ii. Office and administration overheads, where routine as well as policy matters are decided

iii. Selling and distribution overheads, where products are sold and finally despatched to customers.

Components of Total Costs:

1. Prime Cost – Prime cost is the sum of direct material costs, direct labour costs and direct expenses. It is also known as Basic, First or Flat Cost.

2. Factory Cost – This comprises Prime Cost and factory or works overheads which include costs of indirect material, indirect labour and indirect factory expenses. This cost is also known as Works Cost, Production Cost or Manufacturing Cost.

3. Office Cost – Office cost includes Factory Cost and office and administration overheads; this is also termed Cost of Production.

4. Total Cost – This is the sum of the Cost of Production and selling and distribution overheads. It is also termed Cost of Sales.

Elements of Cost Accounting – 4 Major Elements: Material Cost, Labour Cost, Expenses and Overheads

Manufacturing organizations have to analyse the total cost of manufacturing a product, in order to control the cost, offer the products to the market at a low price and ultimately remain competitive. This however requires the total cost of manufacture to be divided under several categories.

It is in this context that the total cost of manufacture is classified under three elements called the elements of cost. This element wise classification of cost is based on the nature of the cost itself.

The following are the elements according to the above basis:

1. Material cost

2. Labour cost

3. Expenses

4. Overheads

Element # 1. Material Cost:

This refers to the cost of all the materials which are consumed in the process of production of a product.

“Material cost is the cost of commodities supplied to an undertaking”. – ICMA, London

The material cost is further divided into two classifications as follows:

a. Direct material cost

b. Indirect material cost

a. Direct Material Cost:

Direct material cost is the amount incurred on the direct materials. Direct materials are those which are conveniently identified and can be allocated to a particular job, product, process etc. These materials enter the production process and become a part of the finished goods products.

Direct materials include the following:

i. Materials specifically required for a process, job, order or a production order.

ii. Materials transferred from one process to another.

iii. Requisition charges such as freight, taxes, insurance etc.

iv. Primary packing materials.

Direct materials are also called prime cost materials, process materials, production materials and requisitioned materials. The consumption of direct materials and its cost vary directly with the increase or decrease in production. Examples of direct materials – components in the manufacture of automobiles, cotton in the process of spinning yarn, rubber in the manufacture of tyres, diamonds in the making of jewellery, batteries used in a mobile phone etc.

Certain materials enter production process and become a part of the finished products but they are still not considered direct materials as they are compared with the cost of other materials is very insignificant.

Examples – Thread used in stitching a garment, lace used in shoes, nails used in the furniture etc.

Direct materials are generally of high value and need strict control and accounting.

b. Indirect Material Cost:

Indirect material cost is the cost incurred on indirect materials. Indirect materials are those which enter the process of production but they do not form a part of the finished product nor are they identifiable in the finished products. The cost of these materials cannot be allocated to a certain product but it has to be allocated to several products.

Indirect materials include the following:

i. Materials which get consumed in the process of production but do not become a part of the finished goods.

ii. Materials which get consumed in the process of production but are not identifiable in the finished goods.

iii. Materials which get consumed in the process of production, become a part of the finished goods and are identifiable as a part of the finished goods but their value is very insignificant.

The consumption of indirect material and its cost may not vary exactly in direct proportion to the increase or decrease in production.

Indirect materials are of a lesser value generally as compared with direct materials. Examples- Grease or lubricants used in machines, chemicals used as catalysts, cotton waste used in the maintenance of machines, small tools and components used, stationery used in the office, finishing materials used in jewellery etc.

Element # 2. Labour Cost:

No organization can work without employees, in this context called labourers or labour. Labour cost refers to the total amount paid by an organization towards its employees as their remuneration. This may take any form such as salary, wage, bonus, incentives, allowances, perquisites etc.

“Labour cost is, the cost of remuneration (wages, salaries, commissions, bonuses etc.) of the employees of an undertaking”. – CIMA, London

Examples- Salaries, wages, bonus, overtime wages, incentives etc.

The labour cost is further divided into two classifications as follows:

a. Direct labour cost

b. Indirect labour cost

a. Direct Labour Cost:

This is the amount of labour cost which is paid to such of the labourers who are directly involved in the production/the process of converting raw materials into finished goods. These labourers actually alter the construction, composition, confirmation or condition of the product.

Direct labour can be conveniently identified or attributed completely to a particular job, product or process. Direct labour cost is also called direct wages, process labour, operating labour, prime cost labour or productive labour. The amount of direct labour varies directly with the increase or decrease in production.

Examples of direct labour cost- wages paid to construction labourers in a construction, a weaver weaving cloth, a mechanic operating machines, carpenter making furniture and goldsmith making jewellery.

b. Indirect Labour Cost:

This is the amount of labour cost which is paid to such of the employees who are not directly engaged or involved in the process of production. These employees do not alter the construction, composition, confirmation or condition of the product. These labourers assist or help the direct labour in the manufacturing process. Indirect labour cannot be directly identified with a job, process or production order and therefore it cannot be directly charged to a job, process etc.

Indirect labour cost is also called indirect wage, unproductive wage etc. The amount of indirect labour may not vary directly with the increase or decrease in production. Examples of indirect labour cost – remuneration paid to employees in the personal department, employees in the accounts department, employees in the security department, employees in the stores, general supervisor.

Element # 3. Expenses:

All the costs incurred in an organization other than material cost and labour cost are called expenses.

“Expenses are the cost of services provided to an undertaking and the notional cost of the use of owned assets”. – CIMA, London

Examples of expenses- Travelling expenses, consultation charges, general advertising expenses, excise duty paid, local taxes paid etc.

The expenses are further divided into two classifications as follows:

a. Direct expenses

b. Indirect expenses

a. Direct Expenses:

These are the expenses which are incurred specifically in connection with a particular product, job or operation. These expenses can be directly identified with a particular product, job or process. These expenses are in no way connected with any other product, job or operation.

Direct expenses are also called direct expenses, chargeable expenses, process expenses, prime cost expenses or productive expenses. The amount of direct expenses varies directly with the increase or decrease in production.

Examples of direct expenses- Freight charges incurred on the purchase of materials meant specifically for a specific job, royalty paid for a specific product, cost of operating a machine for a specific job, cost of specific designs or templates for a particular product.

b. Indirect Expenses:

Indirect expenses other than indirect material cost and indirect labour cost are indirect expenses. These cannot be directly identified with a particular job, process or work order, but are common to several jobs, products or processes. The amount of indirect expenses may not vary with the increase or decrease in production. Examples of indirect expenses- Rent of factory building, depreciation of office furniture, telephone expenses, insurance of office building, lighting expenses, cleaning expenses.

Element # 4. Overheads:

The total or aggregate amount of indirect material cost, indirect labour cost and indirect expenses is called ‘overhead’. Overheads cannot be conveniently charged directly to cost units. Overheads are costs incurred in a general way for the organization.

“Overhead is the aggregate of indirect materials cost, indirect wages and indirect expenses”. – CIMA, London

Overheads are also called ‘on cost’.

The equations of overheads:

1. Overhead = indirect material cost + indirect labour cost + indirect expenses.

2. Indirect material cost = Overhead – indirect labour cost – indirect expenses.

3. Indirect labour cost = Overhead – indirect material cost – indirect expenses.

4. Indirect expenses = Overhead – indirect material – indirect labour cost.

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

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.

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 is 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

3. Expenses.

4. Overheads

1. Material Cost:

‘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:

(i) Direct Material Cost:

Direct material cost means the cost of materials which can be identified with and allocated to cost centres or cost units e.g., 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.

(ii) Indirect Material Cost:

It refers to the material cost which cannot be allocated but can be apportioned to or absorbed by cost centres 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 centres 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.

2. 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:

(i) Direct Labour Cost (or Direct Wages):

It refers to labour cost which can be identified with and allocated to cost centres 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.

(ii) 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 centres 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.

3.Expenses:

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:

i. 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).

ii. 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’.

4. Overhead:

Indirect cost or overhead may again be classified on the basis of functions as follows:

a. 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.

b. 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.

c. 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 showroom building, depreciation of owned show-room building, showroom 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.

Elements of Cost Accounting – Material Cost, Labour Cost, Other Expenses and Overheads

The main elements of costs are as under:

(1) Material Cost:

The cost of commodities supplied to an undertakings is known as material costs.

It can be of two types as under:

(a) Direct Materials – Direct material can easily be identified and allocated to cost. If the value is very small, it is treated as indirect material.

(b) Indirect Materials – It cannot be identified with individual cost units. It is not a part of finished product.

(2) Labour Cost:

It is that cost of remuneration which is paid to the employees.

It may be divided into two parts as under:

(a) Direct Labour – It consists of wages paid to employees directly. It can be identified with any product.

(b) Indirect Labour – It is of general nature and cannot be identified. It is not directly engaged in the production operations.

(3) Other Expenses:

All costs other than materials and labour are treated as expenses.

It may be classified into two categories as under:

(a) Direct Expenses – There expenses can easily be identified to cost units and are incurred in relation to particular job.

(b) Indirect Expenses – Other expenses not related directly are included in indirect expenses. These expenses are common to unit cost.

(4) Overheads:

This is the total of indirect materials, indirect labour and other indirect expenses. Thus overheads = Indirect materials + Indirect labour + Other Indirect expenses.

Elements of Cost Accounting – 4 Key Elements: Material Cost, Labour Cost, Expenses and Overheads

“Cost is the amount of expenditure incurred on a given thing.” – ICMA

Cost is the amount of:

(a) Actual expenditure incurred on a thing, and

(b) Notional Expenditure attributable to a thing.

The elements of cost consist of the following:

Element # 1. Material Cost:

The materials cost is the cost of commodities supplied to an undertaking. – I.C.M.A.

Material cost is of two types as:

(a) Direct Materials, and

(b) Indirect Materials.

(a) Direct Materials – Direct material can be identified easily and traced directly with the final product. The Direct material cost consist the cost of purchase of material transport expenses and indirect taxes and duties payable on it. Primary packing expenses are also included in it. They are known as productive materials also.

(b) Indirect Material Cost – Indirect materials cost is the cost of those materials which do not form part of the product such as small tools, stores used for repairs and maintenance etc.

Element # 2. Labour Cost:

The labour cost is the cost of remuneration of the employees of any undertaking. – I.C.M.A.

Labour cost is divided into two groups as under:

(a) Direct Labour Cost – Wages paid to workers is called direct labour cost.

(b) Indirect Labour Cost – Wages which cannot be allocated but which can be ascertained to cost centre is known as indirect labour cost.

Element # 3. Expenses:

The cost of services provided to an undertaking and the national cost of the use of owned assets is included in it.

Expenses are of two types as under:

(a) Direct Expenses – Expenses which can be identified and allocated to cost centre is known as direct expenses.

(b) Indirect Expenses – Expenses which cannot be allocated but which can be apportioned to cost centre is known as indirect expenses. It includes factory expenses, office expenses, selling and distribution expenses.

Element # 4. Overheads:

Overheads is the cost of indirect materials, indirect labour and other indirect expenses. Thus overhead is the aggregate of indirect material, indirect labour and other indirect expenses.

Overheads is classified as under:

(1) Factory Overheads

(2) Office and Administrative Overheads

(3) Selling and Distribution Overheads.

(1) Factory Overheads – It includes Indirect Materials, indirect labour and indirect factory expenses. It is also known as production overheads, works overheads, factory on cost or works on cost.

(2) Office and Administrative Overheads – All indirect office and administration expenses are included in it. It can be expressed as the total of general management, administrative services, office expenses such as rent, depreciation, postages, stationery, telephone expenses etc.

(3) Selling and Distribution Overheads – All indirect selling and distribution expenses are included in it. Selling overheads is the cost of selling the goods. Distribution expenses are incurred in the process of packing and despatching of goods.

Elements of Cost Accounting

Total cost can be broken up into the following elements:

(a) Direct material cost;

(b) Direct labour cost;

(d) Overheads.

According to functions, overheads may be classified into the following three categories:

(i) Manufacturing overheads

(ii) Administrative overheads, and

(iii) Selling and distribution overheads.

A brief description of each element of cost is given below:

1. Direct Raw Material:

Every product requires some material. Any material, which can be traced to the finished product, is known as direct material consumed in the production of that finished product and constitutes the first element of cost. Direct costs generally vary in direct proportion to output/activity. Cost of cloth in garments, cost of wood in furniture, cost of pig iron in foundry, cost of seeds in oil, etc., are examples of direct material cost of respective products.

It may, however, be noted that directs materials generally do not include minor items such as buttons, thread, nails, glue etc., because the cost of tracing these items to the finished product may exceed the benefit derived from computing very accurate direct material costs. The cost of such minor items is included in indirect material costs.

2. Direct Labour:

All labour costs incurred in the transformation of raw material into a finished product or traceable to the finished product, process or job is identified as direct labour cost.

In any manufacturing concern workmen employed can be divided into two categories:

(i) Those engaged in the actual production of the product or carrying out the process or the operations; and

(ii) Those who help in the production process by way of supervision, material handling, plant guarding, plant maintenance, tool setting, etc. The labour cost of the first category of workers is treated as direct labour cost and is directly charged to the product. Direct labour costs also generally vary in direct proportion to output/activity. But the labour cost of the second category of workers/employees is treated as indirect labour cost and is recovered by way of overhead rates.

3. Direct or Chargeable Expenses:

The following are the examples of direct expenses:

(i) Rental of a machine or plant hired for a specific job.

(ii) The cost of making a specific pattern, design, drawing or making tools for a job.

(iii) The costs of making experiments, models and conducting pilot schemes.

(iv) Fees of architects, surveyors and consultants.

(v) Expenses on travelling and other incidental expenses incurred in connection with a specific job.

(vi) Carriage inwards, freight and insurance on procuring direct materials.

(vii) The costs of primary packing materials.

(viii) The costs of patents, amount of royalty and license fees incurred or paid in connection with a specific job.

4. Overheads:

(i) Manufacturing Overheads:

These may be variable or fixed. Variable overheads are related with the volume of production. Fixed overheads are related with time. Power, fuel etc. are examples of variable overheads whereas rent, insurance, rates and taxes, salaries of supervisions, etc., are examples of fixed overheads. Overheads are allocated, apportioned and absorbed by products on some equitable basis.

(ii) Administration Overheads:

All expenses incurred on the administration, direction and control of an organisation are collected and accumulated under ‘administrative overheads’. Staff salaries, rent, electricity, legal expenses, audit fee, directors fees, rent and maintenance of office equipment, depreciation on office furniture and equipment and insurance thereof, etc. are all example of administrative overheads.

(iii) Selling and Distribution Overheads:

All costs related to selling and distributions of products are included under selling and distribution overheads. Selling costs are incurred in obtaining and retaining a customer. Sales office expenses, commission and salaries of sales force, expenses on advertising, publicity and show room, etc., constitute selling overheads. Expenses incurred on the distribution of products are called distribution overheads.

All expenses starting from receiving finished products into the stores/warehouse up to their delivery to customers are included in distribution overheads. Warehouse rent, salaries of warehouse staff, expenses on delivery vans and trucks, etc., are examples of distribution overheads. Selling and distribution overheads can also be variable or fixed depending on their nature and behaviour.

The Institute of Cost and Works Accountants of India has established a ‘Cost Accounting Standard Board’ (CASB) to formulate, develop and establish Cost Accounting Standards on important costing issues to help the industries, government and the society at large.

The first in the series brought out is the Cost Accounting Standard 1 (CAS1) on ‘Classification of Cost’. This Standard states that the production cost is the cost of all items involved in the production of a product or service. It includes all direct costs and all indirect costs related to the production.