Accounts Notes: CLASSIFICATION OF COSTS on Manufacturing

Tuesday 12 April 2011

CLASSIFICATION OF COSTS on Manufacturing

We first classify costs according to the three elements of cost:
a) Materials b) Labour c) Expenses

Product and Period Costs: We also classify costs as either
1 Product costs: the costs of manufacturing our products; or
2 Period costs: these are the costs other than product costs that are charged to,
debited to, or written off to the income statement each period.

The classification of Product Costs:

Direct costs: Direct costs are generally seen to be variable costs and they are called direct costs because they are directly associated with manufacturing. In turn, the direct costs can include:

• Direct materials: plywood, wooden battens, fabric for the seat and the back, nails, screws, glue.
• Direct labour: sawyers, drillers, assemblers, painters, polishers, upholsterers
• Direct expense: this is a strange cost that many texts don't include; but (International Accounting Standard) IAS 2, for example, includes it. Direct expenses can include the costs of special designs for one batch, or run, of a particular set of tables and/or chairs, the cost of buying or hiring special machinery to make a limited edition of a set of chairs.

Total direct costs are collectively known as Prime Costs and we can see that Product Costs are the sum of Prime costs and Overheads.

Indirect Costs: Indirect costs are those costs that are incurred in the factory but that cannot be directly associate with manufacture. Again these costs are classified according to the three elements of cost, materials labour and overheads.

• Indirect materials: Some costs that we have included as direct materials would be included here.
• Indirect labour: Labour costs of people who are only indirectly associated with manufacture: management of a department or area, supervisors, cleaners, maintenance and repair technicians
• Indirect expenses: The list in this section could be infinitely long if we were to try to include every possible indirect cost. Essentially, if a cost is a factory cost and it has not been included in any of the other sections, it has to be an indirect expense. Here are some examples include:
Depreciation of equipment, machinery, vehicles, buildings
Electricity, water, telephone, rent, Council Tax, insurance
Total indirect costs are collectively known as Overheads.

Finally, within Product Costs, we have Conversion Costs: these are the costs incurred in the factory that are incurred in the conversion of materials into finished goods.

The classification of Period Costs:

The scheme shows five sub classifications for Period Costs. When we look at different organisations, we find that they have period costs that might have sub classifications with entirely different names. Unfortunately, this is the nature of the classification of period costs; it can vary so much according to the organisation, the industry and so on. Nevertheless, such a scheme is useful in that it gives us the basic ideas to work on.

Administration Costs: Literally the costs of running the administrative aspects of an organisation. Administration costs will include salaries, rent, Council Tax, electricity, water, telephone, depreciation, a potentially infinitely long list. Notice that there are costs here such as rent, Council Tax, that appear in several sub classifications; in such cases, it should be clear that we are paying rent on buildings, for example, that we use for manufacturing and storage and administration and each area of the business must pay for its share of the total cost under review.

Without wishing to overly extend this listing now, we can conclude this discussion by saying that the costs of Selling, the costs of Distribution and the costs of Research are all accumulated in a similar way to the way in which Administration Costs are accumulated. Consequently, our task is to look at the selling process and classify the costs of running that process accordingly: advertising, market research, salaries, bonuses, electricity, and so on. The same applies to all other classifications of period costs that we might use.

Finance Costs: Finance costs are those costs associated with providing the permanent, long term and short term finance. That is, within the section headed finance costs we will find dividends, interest on long term loans and interest on short term loans.

Finally, we should say that we can add any number of subclassifications to our scheme if we need to do that to clarify the ways in which our organisation operates. We will also add further subclassifications if we need to refine and further refine out cost analysis.