Elements and Components of Cost

True Tamplin

Written by True Tamplin, BSc, CEPF®
Updated on September 13, 2021

According to the Oxford Dictionary, cost means “the price paid for something.” 

However, in management terminology, cost refers to expenditure and not to price. A cost represents a sacrifice or a release of something of value. 

The Institute of Cost and Management Accountants, London, has defined cost as “the amount of expenditure (actual or notional) incurred on or attributable to a given thing.”

For instance, cost items in the manufacture of cotton fabrics comprise the expenditure involved in the purchase of cotton yarn, wages paid to weavers, factory foreman salaries, depreciation on machinery, notional rent of owned factory building, and so forth.

Elements of Cost

One of the primary objects of cost accounting involves analyzing the total cost of production and providing the most helpful information. 

The analysis and classification of costs refer to the factors resulting in expenditure. Otherwise known as the elements of cost, these costs may also refer to smaller costs of identical nature. 

The elements of cost comprise:

Material Cost

Material cost refers to the commodities supplied to an undertaking, such as the cost of yarn and dyes engaged in manufacturing cloth.

Further subdivisions of material costs include:

(a) Direct material cost: The cost of materials identifiable with and allocated to cost centers or cost units, such as the cost of wood in the case of furniture. Direct materials enter into and form part of the finished product.

(b) Indirect material cost: The material cost that cannot be allocated but can be apportioned to or absorbed by cost centers or cost units. These materials cannot be traced as part of the product, and their cost is distributed among the cost centers or cost units on an equitable basis. 

Labor Cost (or Wages)

The cost of remunerating the employees of an undertaking, e.g., wages, salaries, and commission. 

Further subdivisions include:

(a) Direct labor cost (or direct wages): The labor cost identifiable with and allocated to cost centers or cost units.

Direct labor cost includes the remuneration paid to convert raw materials into finished products or alter the construction, composition, or condition of the product manufactured by an undertaking.

Direct labor cost also includes the wages paid to those who directly carry out or operate a service, such as a driver and conductor of a bus in the transport business.

(b) Indirect labor cost (or indirect wages): The labor cost or wages that cannot be allocated but can be apportioned to or absorbed by cost centers or cost units, such as the salary paid to a factory manager.

Expenses

The cost of services provided to an undertaking and the notional cost of using owned assets (i.e., depreciation of an owned factory building). 

Subdivisions of expenses include:

(a) Direct expenses (or chargeable expenses): The expenses (other than direct material cost and direct labor cost) identifiable with and allocated to cost centers or cost units.

One example is octroi paid on the purchases of imported direct materials (if not added to their purchase price).

(b) Indirect expenses: Expenses that cannot be allocated but can be apportioned to or absorbed by cost centers or cost units, such as rent, rates, taxes, insurance of the factory building, factory lighting, repairs, and so forth. 

The aggregated direct material cost, direct labor cost, and direct expenses result in the direct cost. The aggregated indirect material cost, indirect labor cost, and indirect expenses are known as the indirect cost or overhead, which can be classified into:

(i) Factory overhead or works overhead: All the indirect costs incurred in manufacturing operations: indirect materials, indirect labor, and all other indirect expenses, such as wages, factory rent, factory rates, repairs, and so forth.

(ii) Office and administration overhead: All the indirect costs relating to the direction, control, and administration of an undertaking, such as office rent and staff salaries.

(iii) Selling and distribution overhead: All indirect costs incurred for promoting sales, retaining customers, and delivering goods after their manufacture, such as advertising, salesmen salaries, commission on sales, carriage on sales, and packing charges.

Components of Cost

The cumulation or aggregate of different elements of cost. Aggregating or grouping the various elements obtains the following components or types of cost:

(a) Prime cost: The aggregate of the direct material cost, direct labor cost, and direct expenses. Otherwise known as flat cost, first cost, and direct cost.

(b) Factory cost: Results from the prime cost plus the factory overhead (or works overhead) and comprises the aggregated direct material cost, direct labor cost, direct expenses, and factory overhead.

Factory cost is also known as works cost, production cost, or manufacturing cost.

(c) Office cost: Results from the factory cost plus the office and administrative overhead. Otherwise known as gross cost or cost of production.

(d) Total cost: Made up of the cost of production plus the selling and distribution overhead. Comprises all elements of cost or items of expenditure up until the sale of the commodity. Otherwise known as the selling cost or cost of sales.

Selling Price

The selling cost (or the total cost or the cost of sales) plus profit.

Simplified Formulas

  • Direct material cost + Direct wages + Direct expenses = Prime cost
  • Prime cost + Factory overhead = Factory cost
  • Factory cost + Office and administration overhead = Office cost
  • Office cost + Selling and distribution overhead = Total cost
  • Total cost + Profit = Selling price
True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, his interview on CBS, or check out his speaker profile on the CFA Institute website.

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