Businesses have different degrees of complexity in their operations. While a reseller simply looks at cost of products to include the price they paid some businesses may have very complex cost structures due to manufacturing or other processes involved in getting the product ready to its saleable state. In addition to this service businesses differ in how they may arrive at product cost as do businesses which combine a product with a service. The elements of cost include materials, labour and overhead which we will look at in detail.
Table Of Contents
The first element of cost we can easily identify is material cost. Naturally in the provision of goods or services there are materials that are used up. A baker who produces bread would look at the flour, yeast, sugar and salt that go into the production of bread as material costs. Material costs are not exclusive to manufacturing businesses as many are quick to assume. Take the example of a cleaning business. They clearly provide a service however the chemicals and other consumables used in the cleaning process clearly form part of a material cost of providing the service. Material as a cost element can easily be further divided into direct costs and indirect costs.
Direct Material Costs
While the plain meaning of the term direct material costs may lead you to believe that this element of cost refers to materials that are directly used in the making of the product that is not always the case. Direct material costs are more often a group of costs that can be directly attributed accurately to an individual unit of of a good or measurable unit of a service. Consider packaging, it makes up no part of the product but it can however be accurately calculated how much packaging material goes into a unit of a good. Therefore this element of cost is not just a matter of being part of the product.
Indirect Material Costs
Looking at the previous cost element you should by now have surmised that Indirect material costs follow the same criteria of identification as direct material costs; they are determined based on the difficulty to attribute them to individual product units. An interesting example that can make this easy to understand is a shoe manufacturer, let’s assume the job is done by hand. Each shoe needs glue in order to complete the job. However, it is difficult to ascertain exactly how much glue is used in each shoe or where it is ascertainable the amount is insignificant amounting to a fraction of a cent per pair of shoes. To attribute this cost element the business would need to use an allocation method that spreads the cost of glue over the entire batch of shoes. Indirect material cost element should also include the cost of carriage or freight on a product. You may be familiar with Cost, Insurance and Freight (CIF) prices that include these factors.
Depending on the type of business labour may form the bulk of cost elements. Some goods manufacturing businesses have a high degree of specialised labour which does not come cheaply. Service businesses are more likely to have labour make up a huge element of cost. Labour of course is not limited tow work done on the producted but may also include work done in order to make the product ready for use or the materials available for production of goods. Warehousing costs for example are not directly related to production of tghe product but are an element of cost. Labour, like material, can also be classified into direct and indirect costs elements.
Direct Labour Costs
A recurring theme in identifying these cost elements is that cost accounting is concerned with the attribution of costs and direct labour follows the same methodology as direct material cost; direct costs are costs that can be reliably measured for a single measure of output and be allocated to the product or service. Direct labour costs are usually measured in hours and allocated a rate per hour. The cost of an employee who is paid to clean hotel rooms at a standard rate of 4 rooms per hour is considered a direct labour cost element. It is easy to directly ascertain that labour costs will increase with the more rooms they have to clean.
Indirect Labour Costs
Again following the logic we have already established for direct labour costs, indirect labour costs also form part of the elements of cost. Indirect costs cannot be directly linked to any activity or behaviour in the process of providing goods or services. Let us take a look at the example we have used of the hotel employee to understand but let us look a little deeper into the measurement of the work. Assume the employee is required to log the time they enter a room and leave a room so as to get an accurate measure of how much time they spend cleaning each room. If this employee were paid only for the time they spend in rooms it would be very unfair to them because they spend time moving between rooms, getting materials required to clean the rooms and other functions. Of course in reality such employees are paid per hour on the floor however looking at businesses that sell goods such as retail shops a lot of labour hours are spent stocking shelves and storing products. These are indirect labour costs and an element of cost.
Overheads are so named because this element of cost metaphorically comes from above. These are cost elements which cannot be linked at all to production or provision of services. They will be incurred by the business regardless of business activity or a lack thereof. Example of such expenses are rent, accounting fees, advertising, insurance, interest, legal fees, repairs, supplies, taxes, telephone bills, travel expenditures, and utilities. These cost elements are important to the running of the business but do not always amount to earning the business revenue. While we would always hope our advertising expenditure brings customers it is not guaranteed. These are sometimes referred to as period costs.
The elements of product cost include materials, labour and overhead. For both material and labour cost elements they can further be divided in direct and indirect elements. This is based on whether or not the cost be directed attributed to the activity level of the cost driver. Overheads or period costs occur regardless of activity level hence their name.