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. Cost accounting for this manufacturing process entails consideration of three key cost components that are necessary to produce finished goods:
1) Direct materials include the costs 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. The cost of such items is termed "indirect materials." These indirect materials are included with other components of manufacturing overhead, which is discussed below.
2) Direct labor costs consist 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 rolled into manufacturing overhead.
3) Manufacturing overhead includes 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.
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 advertising, commissions, warehousing, and shipping. Administrative costs arise from general management of the business, including items like executive salaries, accounting departments, public and human relations, and the like.
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.
Product Versus Period Costs
Now, another way to look at manufacturing costs is to think of them as attaching to a product. In other words, products result from the manufacturing process and "product costs" are the summation of direct materials, direct labor, and factory overhead. This is perhaps easy enough to understand. But, how are such costs handled in the accounting records?
To build your understanding of the answer to this question, think back to your prior studies about how a retailer accounts for its inventory costs. When inventory is purchased, it constitutes an asset on the balance sheet (i.e., "inventory"). This inventory remains as an asset until the goods are sold, at which point the inventory is gone, and the cost of the inventory is transferred to cost of goods sold on the income statement (to be matched with the revenue from the sale).
By analogy, a manufacturer pours money into direct materials, direct labor, and manufacturing overhead. Should this spent money be expensed on the income statement immediately? No! This collection of costs constitutes an asset on the balance sheet ("inventory"). This inventory remains as an asset until the goods are sold, at which point the inventory is gone, and the cost of the inventory is transferred to cost of goods sold on the income statement (to be matched with the revenue from the sale). There is little difference between a retailer and a manufacturer in this regard, except that the manufacturer is acquiring its inventory via a series of expenditures (for material, labor, etc.), rather than in one fell swoop. What is important to note about product costs is that they attach to inventory and are thus said to be "inventoriable" costs.
Some terms are hard to define. In one school of thought, period costs are any costs that are not product costs. But, such a definition is a stretch, because it fails to consider expenditures that will be of benefit for many years, like the cost of acquiring land, buildings, etc. It is best to relate period costs to presently incurred expenditures that relate to SG&A activities. These costs do not logically attach to inventory, and should be expensed in the period incurred.
It is fair to say that product costs are the inventoriable manufacturing costs, and period costs are the nonmanufacturing costs that should be expensed within the period incurred. This distinction is important, as it paves the way for relating to the financial statements of a product producing company. And, the relationship between these costs can vary considerably based upon the product produced. A soft drink manufacturer might spend very little on producing the product, but a lot on selling. Conversely, a steel mill may have high inventory costs, but low selling expenses. Managing a business will require you to be keenly aware of its cost structure.