Types of Costs and Work in Progress

Explanation

Cost accounting is the branch of accounting that gathers, records and analyses the costs involved in producing a good or a service. For a manufacturing firm, understanding types of cost is the foundation for working out the true cost of each unit produced, setting a reasonable selling price and measuring profit margin. This standard focuses on the concept of cost, the classification of cost types, the components of production cost, how to calculate Direct Material, Direct Labour, Direct Expenses, Prime Cost and Overhead, together with the treatment of opening and closing Work in Progress (WIP) when determining the cost of finished goods produced.

Costs can be classified in two main ways. First, by traceability to the product: Direct Cost is a cost that can be traced directly to one unit of output (for example the wood used to make a chair and the wages of the worker who builds it), whereas Indirect Cost or Overhead cannot be traced directly (for example the factory supervisor's salary and depreciation of machinery). Second, by how the cost behaves as output changes: Fixed Cost stays the same in total even when output changes (for example factory rent), while Variable Cost changes with the quantity produced (for example raw materials). This classification matters because it decides where in the Manufacturing Statement each cost is recorded.

Production cost is made up of four main components. Direct Material is the raw material that becomes part of the finished product; the amount used equals Opening Raw Material Inventory plus Purchases of Raw Material minus Closing Raw Material Inventory. Direct Labour is the wages and salaries of workers directly involved in making the product. Direct Expenses are other costs that can be traced directly to production, such as the hire of a special machine for one order or a royalty paid per unit produced. Factory Overhead covers all indirect factory costs, such as supervisors' salaries, depreciation of plant and machinery, factory insurance and rates, and indirect materials.

Two key cost figures are calculated in the Manufacturing Statement. Prime Cost is the total of all direct costs, that is, Direct Material plus Direct Labour plus Direct Expenses. Cost of Finished Goods Produced is Prime Cost plus Factory Overhead, then adjusted for Work in Progress. This layout shows the flow of cost from raw material, plus labour applied, plus indirect costs, until the goods become finished and ready for sale.

Work in Progress (WIP) refers to goods that are still partly finished at the end of the accounting period, meaning they have absorbed some material, labour and overhead but are not yet finished goods. As production is continuous, the cost of Opening WIP (carried from the previous period) must be added because it is completed in the current period, while Closing WIP must be subtracted because it is not yet finished. The formula is: Production Cost = Prime Cost + Factory Overhead + Opening WIP - Closing WIP. This adjustment ensures that only the cost of goods completed during the period is carried to the Trading Account as the cost of goods produced.

Worked examples

Practice

Exam tips

Key terms

Direct Cost

A cost that can be traced directly to one unit of output, such as direct material and direct labour.

Factory Overhead

All indirect factory costs such as supervisors' salaries, machine depreciation and factory insurance.

Prime Cost

The total of direct costs, that is Direct Material + Direct Labour + Direct Expenses.

Work in Progress (WIP)

Goods still partly finished at period end; Opening WIP is added and Closing WIP is subtracted when computing production cost.

Source: DSKP KSSM Prinsip Perakaunan Tingkatan 5

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