In this article, we're going to talk about costing definitions. A lot of these definitions are quite straightforward but it's important to be clear on exactly what we mean when using these terms, because they come up again and again.
Direct v Indirect Costs
The first two definitions we're going to look at are direct costs and indirect costs.
Very simply, a direct cost is a cost that can be directly related to a unit produced or a service provided. Let's think of the very basic example of a chocolate bar factory. If we're buying in the ingredients for the chocolate bar, so maybe sugar, chocolate, and the other different ingredients, those would be direct costs, because we can directly relate them back to the actual unit being produced i.e. the chocolate bar.
An indirect cost is a little bit different. This is a cost that we cannot directly attribute to a unit produced or to a service provided. If we take the same example of the chocolate bar; what if that factory has security outside, guarding the factory every night? We can't really relate that cost of providing security back to each bar produced. So, this is an example of an indirect cost. It's not related to the actual unit being produced. But it is a cost that we have to incur.
The next definition that we're going to look at is cost centres. Very simply, a cost centre is an area of the business that collects costs. What does that mean? Let’s take the same example of the chocolate bar factory. Perhaps the factory has a cleaning department. This means there are people who come in and clean the factory at night or during the day. They wipe down all the machinery etc. We might want to look at what cost cleaning is actually driving for each period. That would be a cost centre i.e. the cleaning department, taking into consideration the cost of employing the cleaners, all the cleaning goods, soap brushes, disinfectant, soap etc.
Cost centres can be broken up between production cost centres and service cost centres. A production cost centre relates to the production flow. Again, let’s take the chocolate bar production example. There might be a process whereby we have to add sugar into the chocolate to get the chocolate bar mix. That actual process of adding sugar could be an example of a cost centre in a chocolate bar factory, a specific process on the production line.
However, the service cost centre is like the cleaning example that we already ran through. It's not actually related to the production of the outputs in the factory. It's more so related to supporting the production, the production of the chocolate bar in this instance.
Classification of Costs
We can actually break these definitions down a bit further into classifications. Classifications of costs are really important because, depending on how a cost is classified, it can be treated a little bit differently in the management accounting remit. It's really important that when you see a cost, you're able to identify what sort of classification that cost fits under.
The first classification we're going to run through is direct materials. These are the raw materials that are incorporated into the product. Let’s take a smartphone factory as an example. So, this factory is producing phones, perhaps a touchscreen phone. The raw materials in that phone are items like batteries, the screen, all the screws used to keep the phone together. Those would be examples of direct materials that are directly used in the production process.
The next classification is direct labour. Direct labour is the labour that is used to produce output. In the smartphone factory example this would mean all the workers on the factory floor who are involved in putting the product together, assembling the phone or the smartphone, putting all the bits together, gluing the back of the screen on etc. Essentially, these are the people who are directly involved in producing the product.
The next classification is direct expenses. These can be quite confusing, but very simply, direct expenses are expenses that are incurred and are related to each unit produced. A good example of this is a royalty or a license fee that has to be paid for each unit produced. In some industries a company might use someone else's intellectual property, something like a patent or a piece of technology that's been invented by another person. In such a situation the company might have to pay a fee each time that piece of technology is replicated. So, the patent or the license fee fits under direct expenses because it's incurred each time a unit is produced. It's directly related to the units of production.
The next classification we're going to run through is indirect materials. These are materials that are used in the actual production process though they're not incorporated into the product. Once again, let’s take the smartphone production facility as an example. Each time machinery is used it quite frequently needs to be sanitised, especially if it’s switching from one task to another. The cleaner might have to use a cleaning solvent or a special chemical to clean all the heavy machinery down. While the cleaning solvent is a raw material we have to use, it's not actually used in the production of the phone. We don't put cleaning solvent in a phone, but we would still use it as part of the production process. It's required to make sure that the phones can be produced to a high standard.
The next classification that we're going to look at is indirect labour. This is labour that is not actually directly involved in producing a product. An example of this would be a supervisor or a manager in the production line; they're not actually producing the product. Their job is to make sure that targets are being met and that people are turning up and that they're motivated. Their job is not to produce the product, so they're clearly not direct labour. Indirect labour is not directly involved in producing the product.
Finally, an indirect expense is an expense that is not related to individual units of production. So a good example of that would be something like rent. The facility that we're talking about in our smartphone example might have to pay rent each month. Naturally this is not related to the number of units of production; it's completely independent. That would be an example of an indirect expense, something that we have to spend, but it's not directly related to each unit of production.
An Example of Cost Classification
Let's work through an example, just to make sure that we can apply the above points in a practical setting. So, the question here is:
Odium Ltd is a manufacturer of different food snacks. Some snacks produced by the company contain nuts. Government regulations require Odium to spray each machine with disinfectant before producing a different product with the same machine. This is done to prevent the risk of cross-contamination between different products. What cost classification would the disinfectants sit under?
A. Direct Materials
B. Indirect Materials
C. Direct Expenses
D. Indirect Expenses
The best way to approach this question is by process of elimination. Go through all the answers and see which of the definitions is most appropriate. So, the disinfectant is a product that we're using on the production line. It's not used in the actual product itself. We wouldn't put disinfectant in a snack bar, but we do need to use it on the machines that are used to produce the product because we don't want to cross-contaminate various products. Government regulations have pointed this out, as per the question. We'll just run through each answer and eliminate each one, based on the criteria in the question.
So, firstly, direct materials. We know that direct materials are directly used in the production process. Now, we use disinfectant in the production process, but it's not actually incorporated into the product. So, by a process of elimination, we can't use direct materials as an answer, because we're not actually putting disinfectant directly into the product.
Indirect materials are materials that are used on the production line, but they're not actually incorporated into the product. So, that probably fits our definition here and it's the most likely answer. But, we'll just run through the other potential answers to make sure that we've covered all our bases.
What about direct expenses? Well, direct expenses are related to each product produced. In this case, the disinfectant is not related to each unit produced. We use the disinfectant when the machine is producing a new product, but it's not tied to the number of units produced. So, C is not correct here.
And indirect expenses? Well, indirect expenses are not related to units of production. So, we can't say that D is correct.
So, the answer is B, indirect materials, as it's not incorporated into the product but it is a part of the production process. So, it fits the definition quite well.