Merchandiser and manufacturer accounting: Differences in cost concepts

Cost is a financial measure of the resources used or given up to achieve a stated purpose. Product costs are the costs a company assigns to units produced. Product costs are the costs of making a product, such as an automobile; the cost of making and serving a meal in a restaurant; or the cost of teaching a class in a university.

Manufacturing companies use the most complex product costing methods. To ensure that you understand how and why product costing is done in manufacturing companies, we use many manufacturing company examples. However, since many of you could have careers in service or merchandising companies, we also use nonmanufacturing examples.

In manufacturing companies, a product’s cost is made up of three cost elements: direct material costs, direct labor costs, and manufacturing overhead costs.

Direct materials

Materials are unprocessed items used in the manufacturing process. Direct materials are those materials used only in making the product and are clearly and easily traceable to a particular product. For example, iron ore is a direct material to a steel company because the iron ore is clearly traceable to the finished product, steel. In turn, steel becomes a direct material to an automobile manufacturer.

Some materials (such as glue and thread used in manufacturing furniture) may become part of the finished product, but tracing those materials to a particular product would require more effort than is sensible. Such materials, called indirect materials or supplies, are included in manufacturing overhead. Indirect materials are materials used in the manufacture of a product that cannot, or will not for practical reasons, be traced directly to the product being manufactured. Indirect materials are part of overhead, which we will discuss later.

Direct labor

Direct labor costs include the labor costs of all employees actually working on materials to convert them into finished goods. As with direct material costs, direct labor costs of a product include only those labor costs clearly traceable to, or readily identifiable with, the finished product. The wages paid to a construction worker, a pizza delivery driver, and an assembler in an electronics company are examples of direct labor.

Many employees receive fringe benefits—employers pay for payroll taxes, pension costs, and paid vacations. These fringe benefit costs can significantly increase the direct labor hourly wage rate. Some companies treat fringe benefit costs as direct labor. Other companies include fringe benefit costs in overhead if they can be traced to the product only with great difficulty and effort.

Firms account for some labor costs (for example, wages of materials handlers, custodial workers, and supervisors) as indirect labor because the expense of tracing these costs to products would be too great. These indirect labor costs are part of overhead. Indirect labor consists of the cost of labor that cannot, or will not for practical reasons, be traced to the products being manufactured.

Overhead

In a manufacturing company, overhead is generally called manufacturing overhead. (You may also see other names for manufacturing overhead, such as factory overhead, factory indirect costs, or factory burden.) Service companies use service overhead, and construction companies use construction overhead. Any of these companies may just use the term overhead rather than specifying it as manufacturing overhead, service overhead, or construction overhead. Some people confuse overhead with selling and administrative costs. Overhead is part of making the good or providing the service, whereas selling costs result from sales activity and administrative costs result from running the business.

In general, overhead refers to all costs of making the product or providing the service except those classified as direct materials or direct labor. (Some service organizations have direct labor but not direct materials.) In manufacturing companies, manufacturing overhead includes all manufacturing costs except those accounted for as direct materials and direct labor. Manufacturing overhead costs are manufacturing costs that must be incurred but that cannot or will not be traced directly to specific units produced. In addition to indirect materials and indirect labor, manufacturing overhead includes depreciation and maintenance on machines and factory utility costs. Look at the following for more examples of manufacturing overhead costs.

Selling expenses

Selling expenses are costs incurred to obtain customer orders and get the finished product in the customers’ possession. Advertising, market research, sales salaries and commissions, and delivery and storage of finished goods are selling costs. The costs of delivery and storage of finished goods are selling costs because they are incurred after production has been completed. Therefore, the costs of storing materials are part of manufacturing overhead, whereas the costs of storing finished goods are a part of selling costs. Remember that retailers, wholesalers, manufacturers, and service organizations all have selling costs.

Administrative expenses

Administrative expenses are nonmanufacturing costs that include the costs of top administrative functions and various staff departments such as accounting, data processing, and personnel. Executive salaries, clerical salaries, office expenses, office rent, donations, research and development costs, and legal costs are administrative costs. As with selling costs, all organizations have administrative costs.

Product Costs vs Period Expenses

Companies also classify costs as product costs and period costs. Product costs are the costs incurred in making products. These costs include the costs of direct materials, direct labor, and manufacturing overhead.

Period expenses are closely related to periods of time rather than units of products. For this reason, firms expense (deduct from revenues) period costs in the period in which they are incurred. Accountants treat all selling and administrative expenses as period costs for external financial reporting.

To illustrate, assume a company pays its sales manager a fixed salary. Even though the manager may be working on projects to benefit the company in future accounting periods, it expenses the sales manager’s salary in the period incurred because the expense cannot be traced to the production of a specific product.

In summary, product costs (direct materials, direct labor and overhead) are not expensed until the item is sold when the product costs are recorded as cost of goods sold.  Period costs are selling and administrative expenses, not related to creating a product, that are shown in the income statement along with cost of goods sold.