COST ELEMENTS

In activity based costing (which states that products consume activities and activities consume resources), cost element is the cost of a resource or input consumed by an activity. Cost element is a specific function (or a group of functions) which is considered a specific entity for the purpose of estimating, controlling, and reporting costs.

Direct Materials
Direct materials are raw materials that become an integral part of the finished goods. Direct materials should be distinguished from indirect materials (part of overhead costs). Direct materials always have a variable nature. Variable costs change in proportion to production. For instance, a company purchases metal parts (raw material) to produce valves. he more valves are produced, the more parts the company has to ac!uire. herefore, parts have a variable nature" the amount of raw materials bought and used changes in direct proportion to amount of valves created. #ther direct materials would include, for e$ample, plastic parts and paint etc. Different manufacturing companies will have different direct material costs depending on the types of finished goods they produce. he table below provides a few e$amples. Illustration 2: Examples of direct material costs Examples %ublishing company 'utomobile manufacturer Computer manufacturer Direct Materials %aper, in&, boo& covers, etc ires, automobile metal parts, etc. (ard drives, monitors, etc.

From the table we can observe that direct materials are the integral part and a significant portion of finished goods.

Direct Labor

'lmost any production plant or factory re!uires employees to operate e!uipment, move raw materials from the warehouse to e!uipment, and so on. hese employees are directly involved in the production process and cost of their remuneration and benefits represents direct labor. Direct labor is the cost of wages to be paid to individuals who wor& on specific products or in other words, the cost of wages of employees who are directly involved in converting raw materials into finished goods. )sually direct labor is a variable cost. In most situations the amount of direct labor re!uired is directly correlated with the amount of finished goods produced. For e$ample, wages and related benefits of employees who operate machinery to produce valves represent direct labor costs for a company. he more valves are to be produced, the more employees will be re!uired to operate machinery, paint, assemble, etc. Direct materials and direct labor, when added together, represent the prime cost. Direct materials and direct labor are called prime costs because they are directly (physically, *primarily*) associated with the production of the finished good.

Factor O!er"ead
Factory overhead is any manufacturing cost that is not direct materials or direct labor. Factory overhead can have variable or fi$ed nature, depending on whether overhead changes in direct proportion with production levels. he following are some e$amples of factory overhead costs+

Illustration #: Examples of fixed and !ariable factor o!er"ead costs $ariable Factor O!er"ead Examples ,lectricity

Fixed Factor O!er"ead Examples Depreciation

(eating -ater Indirect .aterials

%roperty ta$es %roperty insurance 0alaries for non1production employees

Indirect /abor

Indirect materials are materials that are" a) not an integral (physical) part of the finished goods, or b) a minor part of the finished goods to be economically traced to the finished good or have a very small physical association with the finished product. For e$ample, a manufacturing company may treat the following costs as indirect materials+ oil lubricants and light bulbs used in manufacturing e!uipment, pac&age bo$es, wrenches, etc. #ther companies will have different types of indirect materials depending on their manufacturing processes. he table below provides a few e$amples. Illustration %: Examples of indirect materials cost &o!er"ead cost' Examples %ublishing company 'utomobile manufacturer Computer manufacturer Indirect Materials 2lue, printing press lubricants, etc Factory light bulbs, drill bits etc. 'ssembly line lubricants, screwdrivers, polishers, etc.

's can be seen from the table, indirect materials are an insignificant portion or not an integral part of the finished goods. Indirect labor is the cost of production employees who are involved in the manufacturing process, but do not wor& on a specific product. For e$ample, wages of custodians, maintenance people, supplies room supervisors, etc. are considered indirect labor.

Direct labor and factory overhead, when added together, represent the con!ersion cost. Direct labor and factory overhead are called conversion costs because they are involved in converting raw materials into finished goods. Illustration below shows relationship between direct materials, direct labor, overhead, prime cost and conversion cost. Illustration (: )elations"ip bet*een direct materials+ direct labor+ o!er"ead+ prime cost and con!ersion cost

Elements of cost

3. .aterial(.aterial is a very important part of business)

o

'. Direct material

4. Indirect material '. Direct labor 4. Indirect labor '. Indirect material 4. Indirect labor

5. /abor
o o

6. #verhead
o o

(In some companies, machine cost is segregated form overhead and reported as a separate element)

hey are grouped further based on their functions as,

3. %roduction or wor&s overheads 5. 'dministration overheads 6. 0elling overheads 7. Distribution overheads

ELEMENTS OF COST Direct materials cost+ Direct materials cost is the cost of materials which can be identified with, and allocated to, cost centres or cost units. Direct material is that material which becomes a part of the product. Direct wages+ Direct wages (labour costs) are the wages which can be identified with and allocated to cost centres and cost units. Direct labour is the labour e$pended in altering the condition, conformation or composition of the product.

Direct e$penses+ Direct e$penses are e$penses (other than direct material cost or direct wages) which can be identified with and allocated to cost centres or cost units. %roduction or factory overhead+ %roduction or factory overhead includes all indirect material cost, indirect wages, and indirect e$penses incurred in the factory from the receipt of the order until its completion ready for dispatch. Indirect materials Indirect wages Indirect e$penses

'dministration overhead+ 'dministration overhead includes all indirect materials cost, indirect wages and indirect e$penses incurred in the direction, control and administration of an underta&ing. 0elling overhead+ 0elling overhead includes all indirect materials cost, indirect wages and indirect e$penses incurred in promoting sales and retaining customers. Distribution overhead+ Distribution overhead includes all indirect material cost, indirect wages and indirect e$penses incurred with ma&ing the pac&ed product available for dispatch and ends with ma&ing the reconditioned returned empty pac&ages available for reuse.

Introduction #ne of the basic purposes of a system of cost accounting is to determine the cost of products (or services). his information is re!uired, inter alia, for estimating the cost of goods sold and valuing inventories. In a manufacturing enterprise the total cost may be divided into two broad categories+ manufacturing costs and non1manufacturing costs. a' Manufacturin, Cost Cost accounting has traditionally been concerned with manufacturing costs. #nly in recent years has the analysis of non1manufacturing costs received more attention. (owever, the principal focus of cost accounting continues to be on manufacturing costs. he reasons for this are+ (i) he general accounting practice is to include only manufacturing costs in the valuation of inventories" and (ii) .anufacturing activity is more standardi8ed and routinised compared to non1 manufacturing activities (li&e general administration, mar&eting and research and development). he three elements of manufacturing costs are material, labour, and manufacturing overhead. -. Material ' distinction is made between direct materials and indirect materials when the product is the relevant cost ob9ective. Direct materials are those which can be logically and readily identified with the product. /umber re!uired for manufacturing furniture, steel for manufacturing automobiles, and crude1oil for petroleum products are e$amples of direct materials. .aterial cost of a product, mostly refer to the cost of direct materials only.

Indirect materials are those which are not readily identified with the product. ,$amples of indirect materials are+ glues, nails, and tac&s. hese are included under manufacturing overhead 2. Labour 's in the case of materials, a distinction is made between direct labour and indirect labour. Direct labour represents labour which wor&s directly on the product (the cost ob9ective for our present purposes). ,$amples of direct labour are+ lathe operators, welders, assembly wor&ers. he cost element labour includes the cost of direct labour only. Indirect labour represents labour which does not wor& directly on the product. ,$amples+ foremen, 9anitors, watchmen. Indirect labour is included under manufacturing overhead. #. Manufacturin, O!er"ead his refers to manufacturing costs other than direct material and direct labour costs. he ma9or items included under manufacturing overhead are indirect materials, indirect labour, factory supplies, utilities depreciation, repairs and maintenance, and rent and insurance. b' Non/manufacturin, Costs Cost accountants are now bestowing attention to non1manufacturing costs as well. control. :on1manufacturing costs categori8ed into four components+ (i) (ii) (iii) (iv) Distribution costs, ;esearch and development costs, Financial costs, and 'dministrative costs. here is a

reali8ation that these costs need to be analy8ed more penetratingly for purposes of planning and

3. Distribution Costs hese include costs incurred in mar&eting1related activities such as selling, distribution, transportation advertising, sales promotion, etc.

2. )esearc" and De!elopmental Costs hese are incurred for developing new products or processes, improving e$isting products or processes, and searching for new &nowledge. ;epresenting outlays on scientific research and development efforts 1 not for production and mar&eting activities 1 these costs are assuming greater significance with rapid changes in technology. 6. Financial Costs he principal financial cost is the interest on wor&ing capital advance, term loans, and debentures. #ther financial costs that may be incurred by a business are commitment fee and ban& commission. 7. 0dministrati!e Costs his category includes the cost of general administration and other costs which logically do not fit into other classifications. Important items included under this head are+ salaries of top managerial personnel, directors< fees, public relations e$pense, general accounting costs, audit and legal fees, and head office e$penses