Cost accounting: 4 essential elements

Cost is the value of an activity or asset. Generally, this value is determined by the cost of the resources that are expended to complete the activity or produce the asset. Although money and time are sometimes thought of as resources, they only implement or constrain the use of physical resources. The final activity or asset produced depends on what can be “afforded” given the money and time allocated to the project. Resources can be separated into four elements: equipment, materials, labor, and overhead:

1: Materials

Materials are a very important part of business. Normally you think of material as the physical composition of the asset. However, the value of the asset may also include the cost elements of scrap material or manufacturing spares, construction form work and expendable safety items, and the cost of transporting the material to the work site. Generally, a distinction can be made between direct and indirect material cost:

• Direct material cost: all type of raw material issued, raw material purchased, transferred from one cost center to another cost center, primary packing material.

• Indirect material cost: stores used in maintenance of machinery, building, etc., stores used by service departments, material which have very low cost.

2: Equipment

This represents the mechanical equipment. It is often the main cost driver for the total project, which is why it is often identified as a separate cost element. Equipment costs are part of the direct cost.

3: Labor

Often, we think of labor as the value of the work needed to complete the activity or asset; i.e. the worker’s labor in painting the building or soldering an electrical contact. Labor also includes the work of the engineer who prepares the design, the foreman supervising the field work, or the technician that maintains the wave soldering equipment. Also, here a distinction can be made between direct and indirect contributions to the project:

• Direct labor:  engaged on the actual production of the product, like fabrication, installation, equipment setting, etc.

• Indirect labor: supporting activities, engineering, supervision, etc.

4: Overhead (Fixed/ Variable)

This element consists of resources needed to support the activity and/or asset. They can be broken down in the following cost categories:

• Manufacturing (factory) overhead: includes such things as the electricity used to operate the factory equipment, depreciation on the factory equipment and building, factory supplies and factory personnel (other than direct labor). How these costs are assigned to products has an impact on the measurement of an individual product’s profitability.

• Nonmanufacturing (administrative) overhead: these costs are not assigned to products for purposes of reporting inventory and the cost of goods sold on a company’s financial statements. However, they should always be considered as part of the total cost of providing a specific product to a specific customer. Some of the costs that would typically be included in nonmanufacturing costs include:

i. Salaries and fringe benefits of selling, general and administrative personnel. This would include the company president, vice presidents, managers, and other employees in the nonmanufacturing functions of the company.

ii. Rent, property taxes, utilities for the space used by the nonmanufacturing functions of the company.

iii. Insurance for areas outside of the factory.

iv. Interest on business loans.

v. Marketing and advertising.

vi. Depreciation and maintenance of equipment and buildings outside of manufacturing.

vii. Supplies for the offices.

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