ACCOUNTING DECISIONS 157
be readily traced to particular products/services. Indirect costs are often referred
to asoverheads. Any cost may be either direct or indirect, depending on its
traceability to particular products/services. Because of their traceability, direct
costs are generally considered variable costs because costs increase or decrease
with the volume of production. However, aswe saw in Chapter 10, direct labour
is sometimes treated as a fixed cost. Indirect costs may be variable (e.g. electricity)
or fixed (e.g. rent).
Direct materialsare traceable to particular products throughmaterial issuedocu-
ments. For a manufacturer, direct material costs will include the materials bought
and used in the manufacture of each unit of product. They will clearly be identifi-
able from abill of materials: a detailed list of all the components used in production.
There may be other materials of little value that are used in production, such
as screws, adhesives, cleaning materials etc., which do not appear on the bill of
materials because they have little value and the cost of recording their use would
be higher than the value achieved. These are still costs of production, but because
they are not traced to particular products they areindirect materialcosts.
While the cost of materials will usually only apply to a retail or manufacturing
business, the cost of labour will apply across all business sectors.Direct labouris
traceable to particular products or services via atime-recordingsystem. It is the
labour directly involved in the conversion process of raw materials to finished
goods (see Chapter 9). Direct labour will be clearly identifiable from an instruction
list orrouting, a detailed list of all the steps required to produce a good or service.
In a service business, direct labour will comprise those employees providing the
service that is sold. In a call centre, for example, the cost of those employees
making and receiving calls is a direct cost. Other labour costs will be incurred
that do not appear on the routing, such as supervision, quality control, health and
safety, cleaning, maintenance etc. These are still costs of production, but because
they are not traced to particular products, they areindirect labourcosts.
Other costs are incurred that may be direct or indirect. For example, in a
manufacturing business, the depreciation of machines (a fixed cost) used to make
products may be a direct cost if each machine is used for a single product or an
indirect cost if the machine is used to make many products. The electricity used
in production (a variable cost) may be a direct cost if it is metered to particular
products or indirect if it applies to a range of products. A royalty paid per unit
of a product/service produced or sold will be a direct cost. The cost of rental of
premises, typically relating to the whole business, will be an indirect cost.
Prime costis an umbrella term to refer to the total of all direct costs.Production
overheadis the total of all indirect material and labour costs and other indirect
costs, i.e. all production costs other than direct costs. This distinction applies
equally to the production of goods and services.
However, not all costs in an organization are production costs. Some, as we
have seen, relate to the period rather than the product. These other costs (such
as marketing, sales, distribution, finance, administration etc.) are not included in
production overhead. These other costs are classed generally as overheads, but in
the case of period costs they arenon-production overheads.