Companies that manufacture a product face an expanded set of accounting issues. In addition to the usual accounting matters associated with selling and administrative activities, a manufacturer must deal with accounting concerns related to acquiring and processing raw materials into a finished product. Accounting for this manufacturing process entails consideration of three key cost components that are necessary to produce finished goods.

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Cost Components
Direct Materials

The cost of all materials that are an integral part of a finished product and that have a physical presence that is readily traced to that finished product.

Examples for a computer maker include the plastic housing of a computer, the face of the monitor screen, the circuit boards within the machine, and so forth. Minor materials such as solder, tiny strands of wire, and the like, while important to the production process, are not cost effective to trace to individual finished units. These costs are termed “indirect materials.” Indirect materials are included with other components of manufacturing overhead, as discussed below.

Direct Labor

Consists of gross wages paid to those who physically and directly work on the goods being produced.

For example, wages paid to a welder in a bicycle factory who is actually fabricating the frames of bicycles would be included in direct labor. On the other hand, the wages paid to a welder who is building an assembly line that will be used to produce a new line of bicycles is not direct labor. In general, indirect labor pertains to wages of other factory employees (e.g., maintenance personnel, supervisors, guards, etc.) who do not work directly on a product. Indirect labor is considered to be manufacturing overhead.

Manufacturing Overhead

All costs of manufacturing other than direct materials and direct labor.

Examples include indirect materials, indirect labor, and factory related depreciation, repair, insurance, maintenance, utilities, property taxes, and so forth. Factory overhead is also known as indirect manufacturing cost, burden, or other synonymous terms. Factory overhead is difficult to trace to specific finished units, but its cost is important and must be allocated to those units. Normally, this allocation is applied to ongoing production based on estimated allocation rates, with subsequent adjustment processes for over- or under-applied overhead. This is quite important to product costing, and will be covered in depth later.

 

Accountants sometimes use a bit of jargon to describe certain “combinations” of direct materials, direct labor, and manufacturing overhead:

Prime Costs = Direct Labor + Direct Material

Conversion Costs = Direct Labor + Manufacturing Overhead

Prime costs are the components that are direct in nature. Conversion costs are the components to change raw materials to finished goods.

Importantly, nonmanufacturing costs for selling and general/administrative purposes (SG&A) are not part of factory overhead. Selling costs relate to order procurement and fulfillment, and include items like advertising and commissions. Administrative costs arise from general management functions and include executive salaries, accounting departments, and human relations.

 

Did you learn?
What three costs are incurred by a manufacturing concern?
Distinguish between direct and indirect materials.
Distinguish between direct and indirect labor.
Identify costs that are typically regarded as part of manufacturing overhead.
What comprises prime and conversion costs?