Elements of Cost in Cost Accounting
ELEMENTS OF COSTS
Production costs are classified into three principal divisions, known as the elements of costs:
“Direct Charges” is that element of cost that enters into, and can be charged directly to, the product.
The cost of the substance out of which the product is made is the direct material charge; the cost of the labor applied directly to the productive process is the direct labor charge; and any other expense that can be charged directly to an order, job or process may be included as a direct
charge under the caption “Direct Expense.” The expense of workmen in traveling to and from a job, as well as their hotel expenses while engaged out of town on a particular job, are examples of direct expenses.
Direct expense, while an important factor of cost in some lines of business, rarely enters into the cost calculations of ordinary manufacturing, and is disregarded in the present volume.
Indirect material consists of such material as factory supplies, which, while used in processes, either does not enter into the product itself, or else enters in such a way as not to be chargeable conveniently to any particular article.
Indirect or non-productive labor is that used in repairing, handling, supervision, etc.—in short, any labor not expended directly on the article or process itself.
Indirect expense as used here refers only to those expenses incurred in the manufacturing end of the business which are properly a part of the cost of production; e.g., supervision, repairs, light, power, depreciation, etc.
All expenses and charges other than direct charges come under the general head of “Indirect Expense.” This includes indirect material and indirect labor, as well as the more closely delimited “indirect expense” of the preceding section. Indirect expense is often known as “Burden” or “Overhead.”
Indirect expenses, as a class, fall into two divisions, depending upon how they are to be apportioned or distributed in costs. The first division consists of those expenses that can be apportioned to individual products or certain processes, because they are incurred in particular departments of the factory, while the second is made up of expenses which extend over the plant as a whole and must be distributed over the products as a whole, and which are therefore designated as general operating expenses.
Items Composing the Indirect Expenses
The following list shows some of the more constant items which compose the indirect expenses. The classification will vary in almost every factory, but the items listed almost invariably appear.
Indirect material Taxes
Freight and express inward, Depreciation
Rent, Taxes and Insurance
When rent is paid, it is generally distributed over the different departments on the basis of floor space occupied.
Taxes are a part of the general operating expenses, as they are independent of department value.
Insurance, on the other hand, is partly distributed over the plant as a whole, and partly over each department according to its value.
Depreciation, Maintenance and Repairs
Depreciation, maintenance and repairs are distributed
material cost Indirect labor Supervision Inspection Experimental work Rent
when not charges to direct
Power or power plant
Over, short and damage
between the plant as a whole and its departments, depending on where the expenses are incurred.
The loss of value due to depreciation is undoubtedly the most difficult of all expenses to reduce to accurate figures, because there are so many elements to be taken into consideration. For instance, the general nature of the equipment, the length of service to be expected, the amount of use per day or month, the kind of business, the amount spent for maintenance and repairs, and the likelihood of new methods and machinery, are a few of the more important influences that determine the actual amount.
The discussion of depreciation, as a whole, must be left to special books on that subject. The province of the present volume extends only to the manner of its treatment in cost finding; and here depreciation is usually disposed of by distributing the cost of the equipment of a plant over the product it turns out during a period of time estimated as the life of the equipment.
There are two general ways of arriving at the entries for depreciation:
(1) Periodical revaluation of all the property, the difference between any two consecutive valuations representing the depreciation for the period. This would seem to be the most accurate plan; but practice has shown that such revaluation is at best an estimate, which must be based on two factors, condition and earning power. The gain in accuracy, if any, is not enough to justify the difficulty and trouble of the physical revaluation, except at long intervals.
(2) A more common method is to estimate the life of a machine or building, and then write off a certain per cent of its value each year.
Two cautions in particular must be observed in writing off valuations by the per cent method. First, the estimates should be reviewed at intervals, and corrections made for apparent errors. In case of doubt as to the proper rate, it is considered better policy to choose the higher of the rates considered, as any mistake is better corrected by restoring values where they belong than by charging the Profit and Loss account.
The second caution relates to the ground covered by single calculations of depreciation. The same per cent must not be extended to cover complex groups. If a single per cent were used on the whole plant, the result would be quite untrustworthy, since the true rate of depreciation varies in different parts, depending on the nature and cost of machines, amount of idle time, and other conditions. To be accurate, each element of equipment should have its own depreciation rate.
The power costs are somewhat complex, especially where a factory produces its own power. The power plant is regarded as a department by itself, and bears its own assignment of direct, as well as certain indirect, expenses. If the power plant furnishes heat and light to the factory, the cost of these items must be subtracted from the total power cost, to get the net power cost applying to production centers. To obtain accuracy, it is generally necessary to segregate and distribute the power costs as a direct . charge to each department or machine. The net power cost is usually distributed in the ratio of use, thus making each machine or department bear its share of unutilized power, or power lost in transmission.
The calculation of the power actually consumed by any machine or department is a mechanical problem. There are special machines for the purpose, such as dynamometers for steam-driven machinery, and wattmeters or power factor indicators for machines using electricity.
The value to be set on tools made in the plant should include all the elements of cost that enter into their manufacture. It may be stated as a general principle that the cost of any equipment manufactured by the plant itself must include its share of the indirect expenses as well as the labor and material cost. For the same reason, installation charges would be treated as a part of the cost of a machine.
If special dies or tools are bought or made for a particular order, the total cost is charged against that order, unless they are retained after its completion, and an allowance made, either on their scrap value, or on the possibility of their being of some future use.
When the expenses of the experimental department arise from work directed on the current product, the cost becomes properly an item of indirect expense; but when the expense results from work on products or processes that are to be used at a future time, the correct method is to make a deferred charge of it, which will not be absorbed until the results of the experimental work are in actual operation. In practice, however, such expenses are usually absorbed in current indirect expense, and are not treated as deferred charges unless they are large enough to affect the cost calculations perceptibly.
Machines and appliances that are perfected through experiment do not come under the same head, but should be considered as assets, their theoretical value being the sum of all the elements of cost that have been incurred on their behalf during the course of the experiments.
Over, Short and Damage
Wastes of material, shrinkage in weight, defective work, etc., are charged to Over, Short and Damage account. After this account has been credited with the value received for any disposition of the items charged, the balance becomes a part of the indirect expenses.
Interest, as an expense, is generally treated according to its origin, as follows:
(1) Interest on mortgages, as a part of the rent charge.
(2) Interest on buildings and land values, as one of the general operating expenses.
(3) Interest on the value of different machines or equipment of different manufacturing departments, as a charge to the product of these machines or departments.
Production Costs and Selling Costs
A clear distinction must be made between production costs and selling costs. The latter include the selling expenses, such as advertising, commissions, salaries, etc., which are necessary elements in determining the price for which an article may sell, but have no direct bearing on the cost of producing the article itself. The cost of production ends when the finished stock is ready for sale.
The expenses that arise from advertising, commissions, salaries of officers, etc., are known as commercial, or selling and administrative expenses.
•See Chapter III, “Interest in Its Relation to Cost.”
The segregation of administrative expenses, as a distinct class, is sometimes a matter of convenience. In the majority of cases the time of the administrative force is spent in supervising the selling organization, in solving problems of production, and in looking after the finances of the business. Therefore, administrative expense is partly a production cost, and partly a selling cost. The purposes of cost finding are best served by separating expenses of such a nature from those expenses which arise from production proper and its direct supervision.
Relation of Cost Elements to Selling Price
The sum of the direct material and labor cost is known as the “Prime Cost.” This, combined with the indirect expenses, gives the final “Factory Cost.” The total of the selling and administrative expenses, plus the factory cost, shows the cost of making and marketing the article; and this total—plus the profit—gives the actual selling price.
This relation of the different elements may be illustrated by the diagram on the preceding page, which, in the light of what has been said, is self-explanatory.
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