Classification of Costs in Products Manufacturing

We can classify costs according to these three elements:

• materials
• labour
• expenses or overheads

We can also classify costs into two types - Product and Period Costs.

• Product costs - the costs of manufacturing our products; or
• Period costs - 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 as variable costs because they are directly associated with manufacturing. Direct costs include direct materials (raw materials), direct labour ( machine operators) and direct expenses (royalties paid, etc). Prime Cost is the aggregate of all direct costs. Overhead is the aggregate of all indirect costs. Total Product Cost is the sum of prime cost 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.

1) indirect materials
Some materials are on the edge of being direct or indirect material costs. You have to know you products and processes well before you classify them. Example of indirect material costs includes lubricants, cleaning materials, etc.

2) indirect labour
It includes labour costs of people who are only indirectly associated with manufacture (managers, supervisors, operators, technicians, etc).

3) indirect expenses
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. For example, the depreciation of equipment, machinery, vehicles, buildings electricity, water, telephone, rent, tax, insurance, etc. Total indirect costs are collectively known as Overheads.

The Classification of Period Costs

The classification of Period costs varies according to the types of organisation and the industry. They includes:

1) Administration costs
These are the costs of running the administrative aspects of an organisation. (example: salaries, rent, tax, electricity, water, telephone, depreciation, etc)

2) Sales and Distribution costs
The costs of distribution and selling (example: advertising, market research, salaries, bonuses, electricity, and so on) are all accumulated in a similar way in which Administration costs are accumulated.

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

In deed you can add any number of sub-classifications depends on the ways in which your organisation operates and how you want to refine cost analysis.

Fixed v Variable costs

Fixed costs are expenses whose total does not change in proportion to the activity of a business, within the relevant time period or scale of production. Examples of fixed costs are overheads (rent, insurance etc), monthly salary of the managers, monthly deprecation of a single machine. Fixed costs are irrelevant for short-term decisions, as fixed costs do not change if more or less products or services are sold.

Variable costs vary in direct proportion to changes in the level of activity. This means that if the activity level doubles, then the variable cost will double. Examples of variable costs are direct material, direct labour and direct expenses. In comparison with fixed costs, variable costs do vary with the level of production or services provided. They are relevant for short-term decisions.

Marginal and Absorption Costing

Marginal costing is a costing technique where each unit of output is charged with variable production costs. Marginal costing also shows the effect on profit of changes in volume/type of output by differentiating between fixed and variable costs. Fixed production costs are not considered to be real costs of production, but just enabling the production to take place. They are treated as costs of the period and charged to the period in which they are incurred.

Marginal costing is contrasted with absorption costing, which is a costing technique where each unit of output is charged with both fixed and variable production costs. Unlike marginal costing, with absorption costing stock is valued on a full production cost basis. When stock is sold in the next accounting period these costs are released and matched with the revenue of that period.

Looking at marginal and absorption costing this can be tied into the various cost classifications that has been discussed in the assignment. Marginal costing can be linked in with using relevant costing classification, as the methods of marginal costing aid managerial decisions which is also used with relevant and irrelevant costing. Absorption costing can be compared with the method of fixed v variable costing. This is due to the fact that absorption costing recognized the importance of fixed costs in production. However, marginal costing can also be compared with the costing classification of fixed v variable cost are this again is used to separate fixed and variable costs.

Activity-Based Costing (ABC)

Activity Based Costing (ABC) emphasizes the need to obtain a better understanding of the behavior of overhead costs, and thus ascertains what causes overhead to occur and how they relate products. ABC recognizes that in the long run most costs are not fixed, and it seeks to understand the forces that cause overhead costs to change overtime.

ABC systems assume that activities cause costs and also that products or services create demands for activities. ABC is simply a more rigours abspotion costing. This means instead of all the overhead being recovered on a single basis (i.e. labour hours) ABC recognizes that different overheads are driven by different factors (cost drivers).

ABC not only links in with marginal and absorption costing, but also with fixed v variable cost classifications. For example, ABC takes into account overheads that change over time, which is what is incurred during fixed vs variable costs. This is due to the fact that even though ABC does recognize fixed cost, it understands that there is variable cost such as direct labour. This links in with both marginal costing, by separating fixed and variable costs, as well as absorption costing, recognizing the importance of fixed costs.

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