Cost Classification For Inventory Valuation And Profit

Cost Elements:
The total cost of a cost unit is made up of the following three elements of cost.

1. Materials
2. Labour
3. Other expenses (such as rent and rates, interest charges and so on)

Cost elements can be classified as direct costs or indirect costs.

Direct Cost and Prime Cost:

A direct cost is a cost that can be traced in full to the product, service, or department that is being costed.

(a) Direct material costs are the costs of materials that are known to have been used in making and selling a
product (or providing a service).

(b) Direct labour costs are the specific costs of the workforce used to make a product or provide a service.
Direct labour costs are established by measuring the time taken for a job, or the time taken in 'direct
production work'.

(c) Other direct expenses are those expenses that have been incurred in full as a direct consequence of
making a product, or providing a service, or running a department.

Prime cost = Direct Material cost + Direct Labour Cost + Direct Expenses

Prime cost is the 'total of direct material, direct labour and direct expenses'.

Direct material is all material becoming part of the product (unless used in negligible amounts and/or having
negligible cost).

Direct wages are all wages paid for labour (either as basic hours or as overtime expended on work on the product
itself).

(a) Workers engaged in altering the condition, conformation or composition of the product.

(b) Inspectors, analysts and testers specifically required for such production.

Direct expenses are any expenses which are incurred on a specific product other than direct material cost and
direct wages. Direct expenses are also referred to as chargeable expenses.

a) The cost of special designs, drawings or layouts

b) The hire of tools or equipment for a particular job

Indirect cost/overhead
An indirect cost (or overhead) is a cost that is incurred in the course of making a product, providing a service or
running a department, but which cannot be traced directly and in full to the product, service or department.

Examples of indirect costs might be the cost of supervisors' wages on a production line, cleaning materials and
buildings insurance for a factory.

A- Production Overhead
Production (or factory) overhead includes all indirect material cost, indirect wages and indirect expenses incurred
in the factory from receipt of the order until its completion, including:

(a) Indirect materials which cannot be traced in the finished product.

Consumable stores, eg material used in negligible amounts

(b) Indirect wages, meaning all wages not charged directly to a product.

Salaries of non-productive personnel in the production department, eg supervisor

(c) Indirect expenses (other than material and labour) not charged directly to production

(i) Rent, rates and insurance of a factory

(ii) Depreciation, fuel, power and maintenance of plant and buildings

B- Administration overhead
Administration overhead is all indirect material costs, wages and expenses incurred in the direction, control and
administration of an undertaking, including:

a. Depreciation of office equipment

b. Office salaries, including the salaries of secretaries and accountants
c. Rent, rates, insurance, telephone, heat and light cost of general offices
C- Selling overhead
Selling overhead is all indirect materials costs, wages and expenses incurred in promoting sales and retaining
customers, including:

 Printing and stationery, such as catalogues and price lists

 Salaries and commission of sales representatives

 Advertising and sales promotion, market research

 Rent, rates and insurance for sales offices and showrooms

D- Distribution overhead
Distribution overhead is all indirect material costs, wages and expenses incurred in making the packed product
ready for despatch and delivering it to the customer, including:

• Cost of packing cases

• Wages of packers, drivers and despatch clerks

• Depreciation and running expenses of delivery vehicles

Summary
A product cost is a 'cost of a finished product built up from its cost elements'.

A period cost is a 'cost relating to a time period rather than to the output of products or services'.

CIMA Official Terminology