Cost classification and behaviour - Production vs non-produc...

Learning Outcomes

After reading this article, you will understand how costs are classified within organisations, distinguish between production and non-production costs, and identify direct and indirect costs. You will recognise why these distinctions matter for preparing accounts, budgeting, and inventory valuation. You will also be able to explain the practical consequences of incorrect cost classification and apply these concepts using exam-standard examples.

ACCA Management Accounting (MA) Syllabus

For ACCA Management Accounting (MA), you are required to understand how costs are analysed for reporting, control, and inventory valuation. Revision should focus on the following points:

• Explain and illustrate the difference between production and non-production costs.
• Describe the key categories of production costs: materials, labour, and overheads.
• Identify and explain non-production cost elements: administration, selling, distribution, and finance.
• Discuss the importance of separating production and non-production costs for inventory valuation.
• Explain the terms direct and indirect costs and provide examples of each.
• Analyse costs for management accounting, including by function (production/non-production) and by traceability (direct/indirect).

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following is a non-production cost?
   1. Factory rent
   2. Sales commission
   3. Raw materials
   4. Machine operator wages
2. For manufacturing a table, which cost is most likely to be classified as indirect?
   1. Timber for the tabletop
   2. Factory supervisor salary
   3. Joiner’s wage
   4. Paint used for finishing

3. Why must production and non-production costs be separated in accounting records?

4. State the difference between direct and indirect costs, giving one example of each.

Introduction

Cost classification underpins all cost accounting. Correctly identifying whether a cost is production or non-production, and whether it is direct or indirect, is fundamental to accurate financial statements, inventory valuation, and managerial decision-making. This article explains how to reliably classify a cost, what each category means, and why precision in these definitions is important for effective management accounting.

Functional Cost Classification

Costs are first classified by function—production (manufacturing) costs or non-production costs.

Production (Manufacturing) Costs

Production costs relate directly to manufacturing a product or providing a service. These include materials consumed in making the product, wages for workers creating the item, and overheads incurred within the production process.

Key Term: Production cost
All costs associated with converting raw materials into finished goods, including direct materials, direct labour, and production overheads.

Non-Production Costs

Non-production costs are those not directly involved in creating goods or services. These include administrative, selling, distribution, and finance costs. Non-production costs are expensed in the period incurred and are never included in the value of inventory on the balance sheet.

Key Term: Non-production cost
Costs incurred outside the manufacturing process, such as administration, selling, distribution, and finance expenses.

Elements of Production Cost

Production costs are further subdivided into three elements:

• Direct materials
• Direct labour
• Production overheads (indirect materials, indirect labour, and indirect expenses incurred in manufacturing)

Each element plays a role in calculating product cost for inventory and decision-making.

Key Term: Direct material
Raw materials and components that become an essential part of the finished product and whose use can be directly traced to each unit.

Key Term: Direct labour
Wages for workers who are directly involved in producing specific goods or services—whose effort can be traced to each unit produced.

Key Term: Production overhead
Indirect materials, indirect labour, and other manufacturing expenses that cannot be traced directly to specific units, but support the production process as a whole.

Non-Production Cost Categories

• Administrative costs: General running of the business (e.g., office salaries, audit fees).
• Selling costs: Expenses of selling goods (e.g., sales staff commission, advertising).
• Distribution costs: Costs to deliver products to customers (e.g., warehouse rent, transport).
• Finance costs: Expenses incurred from financing (e.g., bank loan interest).

Key Term: Administrative cost
Expenses related to the overall management and administration of an organisation, not linked to production.

Why the Distinction Matters

Only production costs are included in the cost of inventory for both financial reporting and decision-making under standard accounting rules. Non-production costs are charged directly as expenses in the period incurred.

Direct and Indirect Cost Classification

Costs can also be classified by how easily they are traced to products or services.

• Direct costs can be directly attributed to a specific cost unit (e.g., a single product or service).
• Indirect costs (overheads) cannot be easily traced to a single unit and are shared among products or services.

Key Term: Direct cost
A cost that can be clearly identified with a specific cost unit, cost centre, or department.

Key Term: Indirect cost
A cost that cannot be traced directly to a single cost unit and is instead shared across the organisation—also called an overhead.

Examples of Direct and Indirect Costs

Worked Example 1.1

A furniture manufacturer pays $4,000 for timber, $1,000 for joiner wages, $500 for the factory supervisor, and $300 for advertising. Classify each cost as production/non-production and direct/indirect.

Answer:
Timber: Production cost, direct
Joiner wages: Production cost, direct
Supervisor: Production cost, indirect
Advertising: Non-production cost (selling), indirect

The Importance of Accurate Classification

Mistakes in cost classification affect financial statements (inventory valuation), decision-making, budgeting, and performance measurement. Production cost overstatement inflates inventory; non-production costs included in inventory can overstate profits.

Worked Example 1.2

A company reports $50,000 wages for production-line staff, $5,000 for the production manager, and $10,000 for sales team salaries. Which costs should be included in inventory valuations under IAS 2?

Answer:
Only the production-line staff wages and production manager’s salary are included. Sales team salaries are non-production and excluded.

Exam Warning

Be careful: only production costs (including both direct and indirect) may be included in product cost for inventory purposes. Administrative, selling, distribution, and finance costs must not be included.

Summary

Correct cost classification underpins management and financial accounting. Distinguishing between production and non-production costs ensures accurate inventory valuation and financial reporting. Knowing whether costs are direct or indirect allows for correct cost assignment to products or services and supports budgeting, performance measurement, and control.

Key Point Checklist

This article has covered the following key knowledge points:

• Distinguish between production and non-production costs and list examples of each.
• Explain the elements of production cost: direct materials, direct labour, production overheads.
• Identify categories of non-production cost: administration, selling, distribution, finance.
• Define and provide examples of direct and indirect costs.
• Recognise the importance of correct cost classification for inventory valuation and decision-making.

Key Terms and Concepts

• Production cost
• Non-production cost
• Direct material
• Direct labour
• Production overhead
• Administrative cost
• Direct cost
• Indirect cost