Management Accounting

Cost Classification – Part 1

Classification by elements of a product/service

Classification of costs by its elements involves examining the products and services to identify different components of costs which were incurred to produce those products or providing those services. If we examine any product or service, we can easily identify different elements which require spending money to produce that product or provide the service. Labour and material costs are the most obvious ones which almost always exist in the cost structure. However, there are also other expenses which require a payment.

For example, a car mechanic fixes your car by changing a part (material) which takes time (labour). However, the car mechanic also has to pay rent and other expenses for its workshop. Even if the mechanic is a mobile mechanic with no workshop, they still have to use a van and fuel to run their operations. This method of classification helps us to identify different costs while calculating the total cost. Accountants and management should be aware of all the costs if they want to calculate accurate costs, run their business efficiently and make effective decisions.

Hence, this category will give us three types of costs;




The expenses usually cannot be directly identified with the products or services which a business sell. For example, it can be difficult to establish if any cleaning costs were incurred while manufacturing a product. These expenses may not relate to production and could have been incurred to run the other support functions of the business, for example, cost of running an office canteen. These are also known as “Overheads”

Total cost of any product or service will comprise of the above mentioned three elements. However, in the last 50 years the percentage composition of these costs has changed significantly. Before automation of the production processes I.e., production by robots and automatic production lines in factories, Labour amounted to 50-70% of the total production cost. However, in modern production, the bigger chunk of total production cost is overheads as most of the labour work has been replaced by machines now, cost of running these machines fall under expenses category.

Direct or indirect Costs

This classification looks at each item of costs to ascertain if that specific cost is being incurred directly due to the production of a unit of product or service or there is an indirect relationship of the cost with products and services. Direct costs are usually incremental costs which means the money is only spent on direct costs if another unit is produced or service is provided. In the times of inactivity, e.g., strikes or lockdowns during a pandemic, these costs can be avoided. Indirect costs or overheads (mentioned earlier as common costs) are usually the costs which will be spent anyway. This classification can help in decision making. For example, it can be identified how much extra will be spent by producing more.

It is worth mentioning here that indirect costs are the “problem child” of management accounting. These are the costs which makes it difficult to determine the costs of different products in a company with accuracy. Different organisations use different techniques to allocate these costs. Chapter 4 and 5 of this book will explore this issue in detail.

This classification gives us following categories of costs;

Direct and indirect material

Direct material is the material which can be identified from an individual product. This material is usually core to the product and the cost of it is significant to the total value of the product and this cost can be accurately determined and attributed to the product. For example, a typical table in a classroom has two major materials used in it, wood and aluminium. These materials will be called direct material and cost of each material for each table will be calculated to determine the total cost of each table.

However, the same table may have other materials too which are not obvious or substantial but still cost money i.e., varnish, paint, screws, welding rods etc. These materials are called indirect as

1-The cost of these on each product is insignificant or immaterial to the total cost of the product. What is material or not is very subjective and different organisations have different threshold (e.g., less than 5%) for all or each raw material

2-One box, bag or bottle of these materials is used on multiple products e.g. tables, chairs, desks etc

3-Most importantly, determination of the costs of these materials on each product will take more time (and money) than the cost saving or other benefits which can be obtained by accurately determining the cost of these materials on each product (cost v benefit analysis). In other words, we might be able to directly apportioned these costs to different units which could result in increase in profits or decrease in costs by 2% but in doing so other costs will increase by more than 2%.

Therefore, indirect materials are grouped with other indirect expenses which are later allocated to each product using different methods under different accounting approaches. This will be discussed in detail in chapter 4 and 5 of this book.

Direct and indirect labour

Direct Labour is the cost which is directly incurred in making a Specific product or providing a service. This cost can be directly attributed to each unit/ service and calculated precisely. For example, in a factory which produces tables, chairs and desks, it can be observed how long it takes workers to cut, carve, assemble and finish a unit. The hour(s) can be multiplied with the rate per hour to calculate the cost of labour.

However, the same factory needs other staff who are not directly making those products but offering support services e.g.,

•a supervisor monitoring 50 workers manufacturing different products,

•cleaners cleaning the factory floor after every shift,

•security staff looking after the building etc.

These costs are not directly attributed to each unit due to the same reasons we discussed in direct material section plus it can be practically impossible to determine e.g., how much cleaning had to be done for table number 15 or chair number 45.

Direct and indirect expenses

Most of the expanses are indirect I.e., the money spent on those is generally for more than one type of product and consequently, these costs are generally divided among the different products. Few examples of indirect expenses are

-Rent and rates

-Maintenance and depreciation (reduction in the value and life of) plant & machinery, buildings, motor vehicles etc


-Administrations costs

-Legal and professional fees etc

However, direct expenses are rare, exist only in few organisations and in project-based costing. Direct expenses are items of cost other than material and labour where cost incurred on those can be reliably measured and attributed to a specific unit of product or service.

This article is written by Raja Mizan who is a senior lecturer in accounting & finance in a UK university. He is an ACCA member and also runs his own accountancy practice RMR Accountants & Business Advisors.

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