One of the basic purposes of a system of cost accounting is to determine the cost of products (or services). This information is required, inter alia, for estimating the cost of goods sold and valuing inventories. This post discusses the framework for cost determination. It is organized into five sections as follows:
- Elements of cost
- Flow of costs
- Product costing
- Problems in cost determination
- Standard costing
ELEMENTS OF COST: In a manufacturing enterprise the total cost may be divided into two broad categories: manufacturing costs and non-manufacturing costs.
Manufacturing Costs in accounting:
Cost accounting has traditionally been concerned with manufacturing costs. Only in recent years has the analysis of non-manufacturing costs received more attention. However, the principal focus of cost accounting continues to be on manufacturing costs. The reasons for this are: (i) the general accounting practice is to include only manufacturing costs in the valuation of inventories; and (ii) manufacturing activity is more standardized and routinized compared to non-manufacturing activities (like general administration, marketing and research and development). The three elements of manufacturing costs are material, labour, and manufacturing overhead.
Material A distinction is made between direct materials and indirect materials when the product is the relevant cost objective. Direct materials are those which can be logically and readily identified with the product. Lumber required for manufacturing furniture, steel for manufacturing automobiles, and crude-oil for petroleum products are examples of direct materials. When we talk of material cost of a product, we refer to the cost of direct materials only.
Indirect materials are those which are not readily identified with the product. Examples of indirect materials are: glues, nails, and tacks. These are included under manufacturing overhead
Labour As in the case of materials, a distinction is made between direct labour and indirect labour. Direct labour represents labour which works directly on the product (the cost objective for our present purposes). Examples of direct labour are: lathe operators, welders, assembly workers. The cost element labour includes the cost of direct labour only. Indirect labour represents labour which does not work directly on the product. Examples: foremen, janitors, watchmen. Indirect labour is included under manufacturing overhead.
Manufacturing Overhead This refers to manufacturing costs other than direct material and direct labour costs. The major items included under manufacturing overhead are indirect materials, indirect labour, factory supplies, utilities depreciation, repairs and maintenance, and rent and insurance.
Non-manufacturing Costs in accounting:
Cost accountants are now bestowing attention to non-manufacturing costs as well. There is a realization that these costs need to be analyzed more penetratingly for purposes of planning and control. While the sub classification of non-manufacturing costs is not as well defined as for the manufacturing costs, we will, for our purposes, divide them into four components:
- distribution costs,
- research and development costs,
- financial costs,
- administrative costs.
Distribution Costs in accounting:
These include costs incurred in marketing-related activities such as selling, distribution, transportation advertising, sales promotion, etc.
Research and Developmental Costs in accounting:
These are incurred for developing new products or processes, improving existing products or processes, and searching for new knowledge. Representing outlays on scientific research and development efforts – not for production and marketing activities – these costs are assuming greater significance with rapid changes in technology.
Financial Costs in accounting:
The principal financial cost is the interest on working capital advance, term loans, and debentures. Other financial costs that may be incurred by a business are commitment fee and bank commission.
Administrative Costs in accounting:
This 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 expense, general accounting costs, audit and legal fees, and head office expenses.