The last topic sorted costs by what they are, why they are incurred and how they behave. This topic adds three more ways of looking at cost. First, can the cost be traced to a single cost unit (direct) or must it be shared (indirect)? Second, is it charged to profit now (a period cost) or carried forward in inventory (a product cost)?
Third, how can a business label every cost with a short code so that thousands of transactions can be recorded, sorted and checked quickly?
These points are popular in the exam: prime cost and full cost calculations, a list of direct and indirect items, and a cost coding table. This page covers every point in the syllabus, with worked numbers and a coding scheme you can practise with.
In 30 seconds
A direct cost can be traced in full to a cost unit (direct materials, direct labour, direct expenses). Their total is prime cost. An indirect cost (overhead) cannot be traced in full to one unit. Prime cost plus a share of production overheads is the full production cost. Adding administration and selling and distribution overheads gives the full cost of sale.
Product costs (prime cost plus production overhead) are held in inventory until the goods are sold. Period costs (non-production overheads) are expensed in the period they occur. A cost code is a set of symbols that identifies a cost, and a good coding system is comprehensive, unique, simple, expandable and tightly controlled.
Direct costs
A direct cost is a cost that can be traced in full to a cost unit. Costs are direct or indirect for materials, labour and expenses alike. In a television factory, the direct cost of a set is its direct materials and direct labour and possibly some direct expenses.
Direct materials
Direct materials are the materials that end up in the cost unit and can be charged to it in full. They may be raw materials, such as timber, glass or chemicals, or finished components bought from outside, such as the battery and screen a phone assembler buys in. Service businesses can have direct materials too: a caterer’s main food items are direct materials of each event.
| Cost unit | Direct materials |
|---|---|
| Wooden door | Timber, hinges, varnish |
| Bottle of juice | Fruit concentrate, bottle, cap, label |
| Printed book | Paper, ink, binding glue, cover board |
| Mobile phone | Screen, battery, circuit board, casing |
| Wedding cake | Flour, sugar, eggs, butter, icing |
Direct labour
Direct labour is the pay for time that can be traced in full to a cost unit. It belongs to employees who spend their working time making the product or providing the service. The same rule applies in service businesses.
| Cost unit | Direct labour |
|---|---|
| Wooden door | Carpenters and finishers |
| Bottle of juice | Operators on the filling and capping line |
| Kilometre of road laid | Road gang labourers and machine operators |
| Patient-day (service) | Nurses on the ward |
| Tax return prepared (service) | Tax consultants |
| Student-term (service) | Teaching staff |
Direct expenses
Direct expenses are expenses incurred in full as a direct result of making a unit, providing a service or running a department. They are not common in manufacturing, where direct cost usually means just materials and labour. Examples are the hire of equipment for a particular house (such as a cement mixer) and fees paid to sub-contractors for work on that house.
Prime cost
Prime cost is the sum of all the direct costs of a cost unit: direct materials + direct labour + direct expenses.
Indirect costs (overheads)
An indirect cost, also called an overhead, is any cost that is not a direct cost. It cannot be attributed in full to one cost unit. Overheads include production overheads and non-production overheads, and each may include indirect materials, indirect labour and indirect expenses.
| Type | What it is | Examples |
|---|---|---|
| Indirect materials | Materials used or consumed that cannot be attributed in full to the item being costed. They may be production, administration or selling and distribution overheads | Cleaning materials and materials used by production departments or staff not directly making the product. Also cheap items such as nails, nuts and bolts, buttons and thread |
| Indirect labour | Pay of employees who do not work directly on the items produced or the services provided | Stores and materials handling staff (such as fork-lift drivers), supervisors, repairs and maintenance engineers. All staff in administration and marketing departments, including management |
| Indirect expenses | Costs that cannot be linked directly to cost units | Factory rent, gas and electricity for the factory, all costs of administration, most or all selling and distribution costs |
Why are small items such as nails and thread treated as indirect even though they are in the product? The cost of measuring the exact amount used is greater than the value of the information. This follows the rule that information must be worth more than it costs.
Same item, different treatment
Whether a cost is direct or indirect depends on the cost unit. Fuel is a good illustration.
| Type of company | Fuel treated as | Reason |
|---|---|---|
| Manufacturing company | Indirect expense | Fuel for its vehicles is not a material cost of the product. It is an overhead |
| Road haulage company | Direct material | Fuel is a major cost of providing the transport service |
| Construction company | Indirect expense | The same reasons as a manufacturer |
| Motorway fuel station | Direct material (cost of sale) | It sells fuel, so the cost of the fuel sold is a direct cost of sale |
Full cost
The full cost of a unit includes both its direct costs and a share of overheads. It builds up in layers.
- Prime cost = direct materials + direct labour + direct expenses.
- Full production cost (also called fully absorbed production cost) = prime cost + a share of production overhead.
- Full cost of sale = full production cost + administration overhead + selling and distribution overhead.
In practice, cost accounting systems usually include production overhead in the unit cost, giving the full production cost per unit. Administration and selling and distribution overheads are normally not included in each unit’s cost. They are treated in total as expenses of the period, that is, as period costs.
Product costs and period costs
When financial statements are prepared, costs are classified as product costs or period costs.
| Product costs | Period costs | |
|---|---|---|
| Meaning | Costs of goods produced or bought for resale | Costs deducted as expenses in the period they occur |
| What they include | Prime cost plus production overhead | Non-production overheads |
| Where they sit | In inventory on the statement of financial position, subject to valuation rules | Not in inventory. They do not add to its value |
| When charged to profit | When the inventory is sold | As soon as they are incurred |
Consider a retailer. The cost of goods bought for resale is a product cost: it stays in inventory and is expensed only when the goods are sold, which may be in a later period. Advertising, sales costs and the salary of the shop assistant are period costs, expensed straight away in the period in which they were incurred. The shop assistant’s salary is an administration expense.
Cost codes
Once costs have been classified, a coding system makes the cost data easier to manage. A code is a collection of symbols used to refer to a particular item.
Purposes of cost codes
- Precise communication and less clerical work. The code 31205 could replace the long title “administration expense, Port Harcourt branch internet charges”, which improves accuracy and speed.
- Electronic data processing. Computers can analyse, summarise and present coded data more easily.
- Logical, systematic arrangement of cost records. Accounts can be arranged in blocks of codes so that new codes can be inserted in logical order.
- Easier comparison. Totals of similar expenses can be compared instead of individual items, which helps control.
- Check codes. A check code built into the main code helps verify the accuracy of posting.
Characteristics of a good coding system
- Comprehensive: every recorded item can be coded easily.
- Unique and consistent: each expense type has its own code, ideally of uniform length and built by consistent rules.
- Easy to use: easy to use, communicate and interpret.
- Expandable: room for growth.
- Tightly controlled: strict rules for adding, deleting or changing codes.
A coding scheme worked through
Suppose a company designs a four-digit code. The first two digits say what the cost is for, and the last two say how it behaves.
| Function (first two digits) | Code | Behaviour (last two digits) | Code |
|---|---|---|---|
| Direct production cost | 11 | Fixed | 01 |
| Indirect production cost | 12 | Variable | 02 |
| Selling and distribution | 21 | Semi-variable | 03 |
| Administration | 31 |
| Cost | Function | Behaviour | Code |
|---|---|---|---|
| Warehouse rent for raw materials | Indirect production (12) | Fixed (01) | 1201 |
| Leather for shoes | Direct production (11) | Variable (02) | 1102 |
| Marketing director’s salary | Selling and distribution (21) | Fixed (01) | 2101 |
| Electricity used in the factory | Indirect production (12) | Variable (02) | 1202 |
In practice, codes are much longer and carry more detail about the expense.
Block codes
Because accounts can be arranged in blocks of codes, a company often reserves a range for each class of cost. For example, a range of numbers might be set aside for direct materials, the next for direct labour, and so on, with another set of ranges for the cost centre to which the cost is charged.
The first part of the code tells you the type of cost, and the second part tells you where it is charged. This arrangement lets new codes be inserted in order inside a block.
The ideas in more depth
A decision path for any cost
- Choose the cost unit (the thing you are costing).
- Ask: can this cost be traced in full to that cost unit? If yes, it is direct. If not, it is indirect.
- Ask: does it relate to making the product (production) or to administration, selling, distribution or finance (non-production)?
- Production costs are product costs and go into inventory. Non-production costs are period costs and are expensed at once.
Why the direct and indirect split matters
Direct costs can be charged straight to the cost unit, so the figures are reliable. Indirect costs have to be shared between units on some basis, and the choice of basis changes the unit cost. Later chapters on overheads and absorption costing deal with how this sharing is done.
Is labour always direct?
No. A machinist is direct labour for a car. The factory supervisor, the stores clerk and the maintenance engineer are indirect labour because their time cannot be traced to a particular car. Every administration and marketing employee, however senior, is indirect.
Do codes just create work?
A good code saves effort. A clerk posting a payment writes one number instead of a long description. A computer can total all costs with a particular code and report them by function, by behaviour or by cost centre. The risk is that codes are misused. That is why the system must be tightly controlled with strict protocols for changes, and why check codes help catch posting errors.
Worked example: wardrobes
Scenario. Osogbo Woodworks Ltd makes wardrobes. For one wardrobe: direct materials ₦30,000; direct labour ₦18,000; hire of a special spray booth for that job ₦2,000; share of production overhead ₦12,000; share of administration overhead ₦4,000; share of selling and distribution overhead ₦3,000. The selling price is ₦80,000. (a) Find the prime cost, the full production cost and the full cost of sale of one wardrobe, and the profit per wardrobe.
(b) In a month the firm made 100 wardrobes and sold 80. Administration costs for the month were ₦300,000 and selling and distribution costs were ₦240,000. Treat these as period costs and find the closing inventory value and the profit for the month. (c) Design a code for “supervisor’s wages” using the scheme below.
- Prime cost:
₦30,000 + ₦18,000 + ₦2,000 = ₦50,000.
(The spray booth hire is a direct expense.) - Full production cost:
₦50,000 + ₦12,000 = ₦62,000. - Full cost of sale:
₦62,000 + ₦4,000 + ₦3,000 = ₦69,000. - Profit per wardrobe:
₦80,000 − ₦69,000 = ₦11,000. - Closing inventory (product cost):
20 unsold wardrobes × ₦62,000 = ₦1,240,000.
Only the full production cost is held in inventory. - Cost of sales:
80 × ₦62,000 = ₦4,960,000. - Revenue:
80 × ₦80,000 = ₦6,400,000.
Gross profit = ₦6,400,000 − ₦4,960,000 = ₦1,440,000. - Period costs:
₦300,000 + ₦240,000 = ₦540,000, deducted in full this month.
Profit = ₦1,440,000 − ₦540,000 = ₦900,000. - Code scheme: five digits. Digit 1 shows the element (1 material, 2 labour, 3 expense). Digit 2 shows traceability (1 direct, 2 indirect). Digit 3 shows function (1 production, 2 selling and distribution, 3 administration). Digits 4 and 5 are the item number. Supervisor’s wages are labour (2), indirect (2), production (1), and say item 05, so the code is 22105.
Common mistakes in the exam
- Treating all labour as direct. Supervisors, stores staff and maintenance staff are indirect.
- Leaving direct expenses out of prime cost.
- Including administration or selling costs in the cost of inventory. They are period costs.
- Saying that a cost is always direct or always indirect. It depends on the cost unit, as with fuel.
- Mixing up prime cost (direct costs only) and full production cost (prime cost plus production overhead).
- Writing codes that are not unique or are inconsistent in length.
- Listing the characteristics of a coding system without explaining them.
Quick revision
- Direct costs: direct materials, direct labour, direct expenses. Prime cost = sum of direct costs.
- Indirect costs = overheads: indirect materials, indirect labour, indirect expenses.
- Prime cost + production overhead = full production cost. + administration and selling and distribution overhead = full cost of sale.
- Product costs (prime cost + production overhead) sit in inventory until sold. Period costs (non-production overheads) are expensed immediately.
- Code purposes: precise communication, electronic processing, logical arrangement, comparison and control, check codes.
- Code characteristics: comprehensive, unique and consistent, easy to use, expandable, tightly controlled.
Practice questions
These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer.
Section A style: multiple choice
Question 1. Prime cost is the total of:
- Direct materials, direct labour and direct expenses
- Direct materials and production overhead
- All production costs
- Direct labour and overhead
Show the answer
A. Prime cost is all direct costs.
Question 2. Direct materials ₦40,000, direct labour ₦25,000, direct expenses ₦5,000 and production overhead ₦15,000. The full production cost is:
- ₦70,000
- ₦80,000
- ₦85,000
- ₦65,000
Show the answer
C. Prime cost is ₦70,000. Adding the overhead of ₦15,000 gives ₦85,000.
Question 3. Which of these is an indirect labour cost in a factory?
- Wages of a machinist
- Wages of a stores clerk
- Wages of an assembly worker
- Wages of a bricklayer on a building site
Show the answer
B. Stores staff do not work directly on the product.
Question 4. Fuel is a direct material cost for a:
- Manufacturing company
- Construction company
- Road haulage company
- Software company
Show the answer
C. Fuel is a major cost of providing the transport service.
Question 5. Which is a period cost?
- Direct materials
- Production overhead
- Salary of the sales manager
- Direct labour
Show the answer
C. Selling costs are non-production and are expensed in the period.
Question 6. Product costs are charged against profit:
- When incurred
- When the related inventory is sold
- Only at the end of five years
- Never
Show the answer
B. They are held in inventory until sale.
Question 7. Nails, nuts and bolts used in furniture are often treated as indirect materials because:
- They are not used in the product
- The cost of measuring them is not worth the information
- They are free
- They are labour
Show the answer
B. They are inexpensive and immaterial.
Question 8. A good coding system should NOT:
- Allow every item to be coded
- Give some items the same code
- Allow for expansion
- Control changes to codes tightly
Show the answer
B. Each item should have a unique code.
Question 9. In a four-digit scheme, 11 means direct production cost, 12 means indirect production cost, and for the behaviour 01 means fixed and 02 means variable. The code for indirect production cost that is variable is:
- 1102
- 1201
- 1202
- 1101
Show the answer
C. Indirect production is 12 and variable is 02, giving 1202.
Question 10. Hire of a special machine for one customer’s job only is a:
- Direct expense
- Indirect labour cost
- Period cost
- Finance cost
Show the answer
A. It is incurred in full as a direct result of that job.
Section B style: written questions
Question 11 (10 marks). Distinguish between direct and indirect costs and between product costs and period costs. Give two examples of each.
Question 12 (20 marks). Ado Metalworks Ltd uses a coding system.
(a) State five purposes of a cost coding system. (5 marks)
(b) State five characteristics of a good coding system. (5 marks)
(c) The company uses a four-digit code. The first two digits are 11 direct production cost, 12 indirect production cost, 21 distribution, 31 administration. The last two digits are 01 fixed, 02 variable, 03 semi-variable. Code the following: (i) steel sheets used in making gates; (ii) factory rent; (iii) delivery van insurance; (iv) office telephone rental plus call charges. (4 marks)
(d) For one gate: direct materials ₦15,000, direct labour ₦9,000, direct expenses ₦500, production overhead ₦5,000, administration overhead ₦2,000, selling and distribution overhead ₦1,500. Calculate prime cost, full production cost and full cost of sale. (6 marks)
A further written question
Question 13 (10 marks). A retailer buys goods for ₦900,000 and sells half of them during the year for ₦700,000. It pays shop assistants ₦120,000 and advertising of ₦80,000. (a) Identify the product costs and the period costs. (3 marks) (b) Calculate the closing inventory and the profit for the year. (5 marks) (c) Explain when the unsold goods will be charged to profit. (2 marks)
Model answers
Show the model answer to Question 11
Direct and indirect costs. A direct cost can be traced in full to a cost unit. Examples are leather in a pair of shoes and the wages of a machinist who makes a product. An indirect cost, or overhead, cannot be attributed in full to a cost unit. Examples are factory rent and the wages of a supervisor. Direct costs are charged straight to the cost unit. Indirect costs must be shared among units on a chosen basis.
Product and period costs. Product costs are the costs of goods produced or bought for resale: prime cost plus production overhead. They are held in inventory and charged to profit only when the goods are sold. Examples are direct materials and factory power. Period costs are non-production overheads that are expensed in the period in which they are incurred and are not part of inventory. Examples are advertising and the salary of the finance director.
Show the model answer to Question 12
(a) Purposes. (1) To communicate precise information and reduce clerical work, since a short code replaces a long description. (2) To make electronic data processing easier, because computers analyse, summarise and present coded data. (3) To arrange cost records logically, in blocks of codes that allow new codes to be inserted in order. (4) To simplify comparison of totals of similar expenses, which helps control. (5) To include check codes that verify the accuracy of posting.
(b) Characteristics. (1) Comprehensive: every item can be coded. (2) Unique: each expense type has its own code, ideally of uniform length and built by consistent rules. (3) Easy to use, communicate and interpret. (4) Able to be expanded. (5) Tightly controlled, with strict protocols for adding, deleting or changing codes.
(c) Codes. (i) Steel sheets: direct production (11), variable (02), so 1102. (ii) Factory rent: indirect production (12), fixed (01), so 1201. (iii) Delivery van insurance: distribution (21), fixed (01), so 2101. (iv) Office telephone rental plus calls: administration (31), semi-variable (03), so 3103.
(d) Cost build-up.
- Prime cost.
₦15,000 + ₦9,000 + ₦500 = ₦24,500. - Full production cost.
₦24,500 + ₦5,000 = ₦29,500. - Full cost of sale.
₦29,500 + ₦2,000 + ₦1,500 = ₦33,000.
Show the model answer to Question 13
(a) The cost of goods bought for resale (₦900,000) is a product cost. The shop assistants’ pay (₦120,000) and advertising (₦80,000) are period costs.
(b)
- Half of the goods were sold, so cost of goods sold = ₦450,000 and closing inventory = ₦450,000 (₦900,000 − ₦450,000).
- Gross profit.
₦700,000 − ₦450,000 = ₦250,000. - Period costs.
₦120,000 + ₦80,000 = ₦200,000. - Profit for the year.
₦250,000 − ₦200,000 = ₦50,000.
(c) The unsold goods are product costs and remain in inventory on the statement of financial position. They are charged to profit in the period in which they are sold, which may be a later year.
Pathfinder on Direct and indirect costs, product and period costs, codification
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
Part (a), worth 10 marks, asks you to assign each of ten expenditure items a block code and a cost centre code from given ranges. Part (b) is on big data, a different topic.
Revise first: Cost codes
From the previous syllabus. Asks which item may NOT be classified as a period cost.
Revise first: Product costs and period costs
Multiple-choice items often test prime cost, direct and indirect cost and period cost. Check Section A of every diet you practise.
Revise first: Direct costs
Source: ICAN Pathfinder, Management Accounting. Diets covered: May Diet, 2026 and May Diet, 2018 (previous syllabus). May Diet, 2025 and November Diet, 2024 are not covered here.
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