Quick answer: The three elements of cost are material, labour and expenses. Each is either direct (traceable to a product) or indirect (overheads). Direct material + direct labour + direct expenses = prime cost. Adding factory overheads gives works cost, office overheads give cost of production, and selling and distribution overheads give cost of sales. Cost of sales plus profit equals the selling price.
| Element | Examples |
|---|---|
| Material | Direct: wood, steel. Indirect: glue, oil |
| Labour | Direct: machine operator. Indirect: supervisor |
| Expenses | Direct: royalty per unit. Indirect: rent, power |
| Prime cost | DM + DL + DE |
Take a chair made in a small furniture workshop. The wood is material. The carpenter’s wages are labour. The electricity for the saw, the rent for the workshop and the cost of delivering the chair are expenses. Every cost a business incurs falls into one of these three groups, and that is what cost accountants call the elements of cost.
Each element is then split into direct (traceable to a specific product) and indirect (shared across products, also called overheads). Getting this split right is what lets a business know its real cost per unit and set a sensible price.
The Three Elements of Cost
1. Material
Direct material becomes part of the finished product and can be measured per unit: the wood in the chair, cotton in a shirt, steel in a car body. Indirect material is used in production but is too small or too shared to trace: glue, nails, lubricating oil, cleaning cloths.
2. Labour
Direct labour is wages paid to workers who work on the product itself, such as the carpenter or a machine operator. Indirect labour is wages for people who support production without working on a specific unit: supervisors, storekeepers, maintenance staff, security guards.
3. Expenses
Direct expenses are costs other than material and labour that can be charged to a specific job: hire of a special machine for one order, royalty paid per unit, cost of a special mould or design. Indirect expenses are everything else: factory rent, power, depreciation, insurance, office salaries, advertising.
How Indirect Costs Are Grouped (Overheads)
| Overhead | What it covers | Examples |
|---|---|---|
| Factory (works) overheads | Indirect costs of running the factory | Factory rent, power, supervisor salary, machine depreciation |
| Office and administration overheads | Running the business as a whole | Office rent, accountant salary, stationery, audit fees |
| Selling overheads | Getting orders | Advertising, sales staff salaries and commission, showroom rent |
| Distribution overheads | Getting goods to customers | Packing, freight outward, warehouse rent, delivery vans |
Worked Example: Building Up the Cost
A workshop makes 1,000 chairs in a month. Here is how the elements add up in a cost sheet.
| Item | ₹ |
|---|---|
| Direct material (wood, fabric) | 50,000 |
| Direct labour (carpenters) | 30,000 |
| Direct expenses (hire of special router) | 5,000 |
| Prime cost | 85,000 |
| Factory overheads | 15,000 |
| Works (factory) cost | 1,00,000 |
| Office and administration overheads | 10,000 |
| Cost of production | 1,10,000 |
| Selling and distribution overheads | 8,000 |
| Cost of sales (total cost) | 1,18,000 |
| Profit | 22,000 |
| Sales | 1,40,000 |
Cost per chair works out to ₹118 (₹1,18,000 ÷ 1,000) and the selling price to ₹140. If the owner only counted direct material and labour (₹80 per chair), they might price at ₹100 and lose money on every sale without realising it.
Quick Formulas
| Cost level | Formula |
|---|---|
| Prime cost | Direct material + Direct labour + Direct expenses |
| Works cost | Prime cost + Factory overheads |
| Cost of production | Works cost + Office and administration overheads |
| Cost of sales | Cost of production + Selling and distribution overheads |
| Sales | Cost of sales + Profit |
For more practice, see our unit costing questions with a solved cost sheet and overheads questions and answers.
