Cost is the value of resources sacrificed, consumed or given up to obtain any other resource/ benefit or asset. For example a manufacturer of garments incurs various costs such as purchase unstitched cloth for further processing, stitching and designing, payment of wages to labor, consumption of electricity, use of machinery (depreciation) etc.
Total costs are broadly classified into two categories:
All costs, whether directly or indirectly, associated with the production or manufacturing of a product are classified as production costs. These production costs are further classified into three types:
- Direct materials cost: Costs of raw materials or purchases used directly in the production of finished goods. For example cost of unstitched cloth, in case of manufacturer of garments.
- Direct labor cost: Costs incurred in relation to labor time used directly for manufacturing a product. For example wages paid to tailors for stitching and embroidery, in case of manufacturer of garments.
- Production/ manufacturing overheads: All production costs other than those classified as direct material cost and direct labor cost. For example depreciation of machinery and equipment, electricity and fuel costs etc.
All costs, other than production costs are classified as non-production costs. These costs include marketing and distribution expenses, administrative expenses and financial charges.
All costs that can be attributed to the cost of inventory are classified as product cost. In other words, production costs are also known as product costs. Product costs are capitalized as inventory when they are incurred and are expensed in profit and loss account in the period in which related goods are sold. This treatment is in accordance with the matching principle of accounting which requires that expenses should be recognized in the same period in which related revenues are recognized.
Examples of product costs are direct material costs, direct labor cost, factory electricity expense, depreciation of machinery etc.
All costs other than product costs are classified as period costs. In other words, non-production costs are also known as period costs. As the name suggests, period costs are expensed in profit and loss account in the period in which they are incurred.
Examples of period costs are marketing expenses, rent of head office, depreciation of furniture and fixture, sales commission, finance cost etc.
Direct and indirect costs
Production costs can be classified as direct or indirect costs on the basis of their identifiability into the cost object. This classification is based on the fact that whether the costs can be easily traced or linked to a specific cost object or not.
A cost object may be a product, a service, a department or any other thing for which cost is compiled.
Those costs which can be easily traced or linked to a specific cost object are classified as direct costs.
Examples of direct costs in case of furniture manufacturer include direct material costs such as wood, plastic etc. and direct labor costs such as wages of persons making furniture from wood and plastic.
Those costs which cannot be easily traced or linked to a specific cost object are classified as indirect costs.
Examples of indirect costs include manufacturing overheads such as depreciation of machinery, electricity, rent of factory, salaries of supervisors etc.