The Secret of all victory lies in the organization of the non-obvious.: Classification of Costs

John Cousins
February 7, 2023
3 min read

The Secret of all victory lies in the organization of the non-obvious.

Marcus Aurelius

In cost accounting we classify and group costs according to their common characteristics. The basic characteristics are what we have just discussed.

There are four basic categories for organizing costs: element, traceability, function and structural. There are three elements of costing: material, labor and overhead. Traceability refers to Direct and Indirect Costs. Functions have to do with departments and how the operation is organized like production, administration, selling and distribution, and R&D. Structural classification means whether a cost is fixed or variable.

Allocating Indirect Costs

In order to allocate an indirect cost to a specific product, we need to determine a function or cost driver that will attribute the proper portion of the indirect cost to the product (cost object). This driver can be related to one of the direct inputs like labor or material, or calculated as a function of time. In this manner standard cost accounting typically determines indirect and overhead costs as a percentage of a direct cost. This is called activity-based costing.

There are two main approaches to aggregating up these costs depending on the manufacturing or production environment based on product or period. The product approach focuses on the product and the resources used to make and individual product. These costs then get accumulated based on how many products were manufactured. The period approach focuses on a period of time such as each month and is used for manufacturing processes that are continual such as producing breakfast cereal. It would not be efficient to analyze the inputs into each Cheerio. In these cases it is more efficient to look at the process flow and the volume produced during a specific time period and to use that as the cost driver for allocating indirect costs.

Inventory, WIP and COGS

The Product Cost approach takes raw materials and labor, both direct and indirect, and overhead, and adds them up in an account called Work in Progress or WIP. When materials are first purchased they are recorded in inventory accounts. As a product is created, more costs are added to the WIP account. When a product is completed, the WIP account transfers to a finished goods inventory. When an item is sold the finished goods inventory account transfers the costs to the Cost of Goods Sold account (COGS). COGS reflects all the direct, indirect, and overhead costs that have gone into making that product or delivering that service.

This procedure of developing a product with a WIP account outlines the flow through the journal accounts of the process of manufacturing.

Translating Cost Accounting to the Income Statement

COGS shows up on the Income Statement as the first line under Sales Revenue. It is subtracted from Sales Revenue in order to calculate Net Sales Revenue.

What COGS does not include are the administrative, sales, and marketing expenses that support the distribution and sales of products and also support the operation of the firm. These expenses are listed on the Income Statement after Net Sales Revenue and are totaled and subtracted from Net Sales in order to calculate Net Income.

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John Cousins
Author, Entrepreneur, & Teacher

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