Cost Classification in Financial Projections

Accurate cost classification is important when preparing financial projections as it directly impacts the split between cost of goods sold and inventory, and operating expenses. The purpose of this article is to set out how costs should be classified and included in our financial projections template.

There are two major cost classification items to take into account when preparing financial projections.

1. Manufacturing costs – included in the financial projections as cost of goods sold and inventory
2. Non manufacturing costs – included in the financial projections as operating expenses

Manufacturing Cost Classification

Manufacturing costs are the costs relating to the manufacture of the product to be sold to customers. The important feature of manufacturing costs is that unlike operating expenses, they are first added to the inventory of the business in the balance sheet, and then transferred to the income statement as an expense called cost of goods sold, when the product is sold.

Manufacturing costs are only treated as an expense when the product is sold

For example, if a business manufactures 10 items costing 1,200, the items will be carried as inventory in the balance sheet at a value of 1,200. If in an accounting period three items are sold, then 360 (1,200 x 3/10) will be transferred to the income statement as cost of goods sold, and seven items will remain on the balance sheet as inventory of 840.

This continues each accounting period giving the general formula for cost of goods sold (COGS) as follows:

It should be noted that, the cost of goods sold (often referred to as the cost of sales) should not be confused with a cost of selling. Cost of goods sold relates to the costs incurred in the manufacture of products to be sold and includes only manufacturing costs. A cost of selling such as a sales commission paid to sales staff, is a selling and marketing expense and not part of the cost of manufacturing the product.

What Manufacturing Costs are Included?

Manufacturing costs are all the costs necessary to bring a product to the point where it can be sold. Manufacturing costs in this context is widened to include the costs of purchasing products for resale, a system widely used by retailers.

Manufacturing costs are generally classified into two categories.

Direct costs

1. Direct material
2. Direct labor

Indirect costs

1. Indirect material
2. Indirect labor
3. Other indirect costs

Direct Costs

The term direct simply refers to a cost which can be traced back to an individual product. The direct costs will either be a material cost or a labor cost. For example, if a product requires one sheet of metal and one hour of labor to manufacture, then the direct material cost is the cost of one sheet of metal, and the direct labor cost is the cost of one hour of labor.

Indirect Costs

Indirect costs are manufacturing costs which cannot be attributed directly to a product. For example, if the product uses a sealant in its manufacture, it is uneconomical to attribute the quantity of sealant used directly to each product, instead the sealant is treated as an indirect material cost and allocated to the product on a predetermined basis. Likewise the labor cost of a production supervisor is also a manufacturing cost which cannot be directly attributed to an individual product and is classified as an indirect labor cost.

Other manufacturing costs are costs related to the manufacture of the product such as factory insurance, equipment maintenance, and machinery depreciation. Again these costs cannot be specifically identified with a unit of production, and are allocated to the product on an agreed basis.

Non Manufacturing Cost Classification

Non manufacturing costs are all the other costs of operating a business which are not part of manufacturing the product for sale.

Non manufacturing costs are treated as an expense when the benefit from them is used..

In the financial projections template they are split into three separate categories and included under the general heading of operating expenses of as follows:

Operating expenses

1. Research and development costs (R&D)
2. Sales and marketing costs (S&M)
3. General and administrative costs (G&A)

All of these costs are treated as expenses in the income statement when the benefit from them is used. For example, if the rent on an office building is 12,000 a year, then each year of the financial projections will show 12,000 as a rent expense under the general and administrative expenses category.

Further details on each of these cost classification categories can be found in our articles on Research and development costs, Sales and marketing costs, General and administrative costs.

When preparing financial projections, it is important to accurately distinguish between manufacturing and non manufacturing costs as this will determine the split between cost of goods sold and inventory, and operating expenses. In addition, accurate cost classification, will allow the business to make comparisons with similar operations, and allow decisions about the efficiency of its production facilities and cost structure to be made.