What is Cost?
In the business sector and accounting department, cost is the monetary value that a company needs to spend in order to produce something. Cost means the amount of money which a company spends on the creation or production of the goods or services.
Also, to understand cost, we need to check from a seller’s point of view, cost is that amount of money that is spent to produce a good or a product. While, from a buyer’s point of view the cost of a product is also known as the price of the product. This is the amount that the seller charges for buying the particular product, and it includes both the production cost (borne by the seller) and the mark-up price (for the profit of the seller), which is added by the seller in order to make a profit.
In accounting terminology, the term cost refers to the monetary value of expenditures engaged with the production of goods. In the further section we will know more about the elements of cost.
Example of Costing
When it comes to recording the costs, it’s done according to the purpose and the reason for the cost. For instance, when there is a record of the cost of purchase inventory it is booked under the account of cost of goods sold when a sale of the goods are made. When you record costs that are necessary for the organization, which includes rent, salary, and more, it is recorded as a selling expense and it is added in the multi-step income statement.
Types of Cost
Private Costs
These are the costs incurred that the buyer pays to the seller when the purchase of goods is completed.
External Costs
This is a cost that is incurred when the buyer is asked to pay as per the result of the transaction.
Social Costs
The social costs are a sum of private and the external costs.
Defensive Cost
This is an environmental expenditure that is incurred to prevent any environmental damage.
Labor Costs
This is the cost that occurs for travel time, training costs, and more.
Elements of Cost Accounting
In Accounting, a cost is composed of three elements –
Material
Labor
Expenses
The above three elements can either be direct and indirect cost.
Thus, to understand the elements of cost we need to learn them vividly.
Direct Materials:
As there will be only one product and the process of manufacture is simple, the raw material if any is directly charged to the production of the period in total cost.
Labor:
The labor costs are collected periodically on a regular basis through pay rolls which are prepared separately for each work department.
Chargeable Expenses:
Expenses other than material and labor are chargeable expenses like excise duty, royalty, expenses on designs, patterns and models.
Overhead – Another Element of Cost
Overhead consists of all the indirect costs. Overhead is also known as the on-cost, supplementary cost, burden cost etc.
Overhead consists of three elements:
Indirect materials
Indirect labor
Indirect expenses
Indirect materials – These materials cannot be conveniently identified with the individual cost units. They are generally of minor importance. Examples of indirect materials are - coal, lubricating oil, sand paper, soap, etc.
Indirect labor –This cannot be identified with a particular cost unit. Indirect labor is not engaged in the production process directly but only this is indirectly and this assists in the production operations. Examples of indirect labor are peon, supervisor, clerk, watchman etc.
Indirect expenses – All kinds of indirect costs, other than the indirect materials and indirect labor costs, are termed as indirect expenses. This cost cannot be directly identified with a particular job, process or identified with work order and is common to cost units and cost centers. Examples of Indirect expenses - rent and rates, insurance, depreciation, power and lighting, cartage, advertising.
Cost Center in Cost Accounting
A cost center is a department or function within an organization which does not directly add to the profit but still incurs costs the organization money to operate effectively. Cost centers merely contribute to a company's profitability indirectly. Managers of cost centers, like human resources and accounting departments. They are responsible for keeping their cost line low budget.
Thus, to sum up:
A cost center is a function within an organization which does not directly add to the profit but still costs money to operate, like working in the accounting, HR, or IT departments.
The main use of a cost center is to track the actual expenses for comparison to the budget.
A cost center indirectly contributes to a company’s profit professing in operational excellence, customer service, with enhanced product value.
The manager is only responsible for keeping the costs in line with the budget and who does not bear any responsibility regarding the revenue or in investment decisions.
Whatever operations that take place in cost’s center, they don’t get displayed in the company’s profit. However, services, such as customer service enhance the overall value of the company
FAQs on Elements of Cost: A Quick Overview
1. What are the three main elements of cost in accounting?
The total cost of a product or service is broken down into three fundamental elements:
- Materials: The cost of all physical substances used to create the product.
- Labour: The cost of human effort, including wages and salaries, involved in production.
- Expenses: All other costs incurred besides material and labour, such as rent, utilities, and depreciation.
2. What is the difference between a direct cost and an indirect cost?
A direct cost is any expense that can be directly and wholly traced to a specific product, service, or cost unit. For example, the wood used to make a specific chair. An indirect cost, on the other hand, cannot be easily traced to a single product and is incurred for the benefit of multiple cost objects. For example, the factory manager's salary benefits all products being made.
3. How are materials classified within the elements of cost? Provide examples.
Materials are classified based on their traceability to the final product:
- Direct Materials: These are materials that become an integral part of the finished product and can be easily identified. Examples include fabric for a shirt, steel for a car, or paper for a book.
- Indirect Materials: These are materials necessary for the production process but do not form a significant part of the final product. Examples include lubricating oil for machinery, cleaning supplies, and nails or glue used in small quantities.
4. What are 'overheads' in cost accounting?
Overheads, also known as on-cost or burden costs, are the total of all indirect costs combined. They represent the expenses required to run the business but cannot be directly attributed to a single product. Overheads are composed of:
- Indirect Materials
- Indirect Labour (e.g., salaries of supervisors, security guards)
- Indirect Expenses (e.g., factory rent, insurance, depreciation of machinery)
5. Why is it crucial for a business to accurately classify costs into direct and indirect categories?
Correctly classifying costs is crucial for several reasons. It helps in:
- Accurate Product Costing: It ensures the cost of each product is calculated correctly, which is vital for setting competitive and profitable selling prices.
- Effective Cost Control: By identifying and tracking all costs, management can monitor spending, identify inefficiencies, and implement measures to control expenses.
- Informed Decision-Making: Understanding the cost structure helps management make strategic decisions, such as whether to make or buy a component or accept a special order.
6. How do the elements of cost directly influence a company's pricing strategy?
The elements of cost form the foundation of a company's pricing strategy. The total cost (direct materials + direct labour + direct expenses + allocated overheads) represents the cost price of a product. To make a profit, a company must set a selling price that is higher than this cost price. A thorough understanding of each cost element allows a business to determine its break-even point and set a price that covers all expenses while achieving the desired profit margin.
7. What is a cost centre, and what is its main purpose in a business?
A cost centre is a specific department, function, or location within a business to which costs can be allocated. It does not directly generate revenue but incurs expenses to support the profit-making activities of the company. Examples include the Human Resources (HR) department, the accounting department, or a maintenance division. The primary purpose of a cost centre is to track and control expenses by comparing actual costs against a set budget.
8. In a furniture manufacturing business, how would you classify the salary of a factory supervisor and the rent for the factory building?
In this scenario:
- The factory supervisor's salary is an example of Indirect Labour. The supervisor oversees the entire production process, not just the creation of a single piece of furniture, so their salary cannot be directly traced to one chair or table.
- The rent for the factory building is an example of an Indirect Expense. The rent is for the entire facility where multiple products are made, so it is an overhead cost that must be shared or allocated across all units produced.
