1.2: Cost Terminology and Concepts

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For a manufacturing company, a significant goal of managerial accounting is to keep track of the costs of the units that are produced. A cost is a current or future expenditure of cash for something that will ultimately generate revenue. Inmanufacturing, many costs relate to products that are ultimately sold to customers.

Period costs include selling and administrative expenses that are unrelated to the production process in a manufacturing business. Selling expenses are incurred to market products and deliver them to customers. Administrative expenses are required to provide support services that are not directly related to the manufacturing or selling activities. Administrative costs may include expenditures for a company’s accounting department, human resources department, and president’s office. Selling and administrative expenses may also include utilities, insurance, property taxes, depreciation, supplies, maintenance, salaries, etc., that are incurred in a business, but outside of the factory production area.

Product costs are incurred when a company manufactures goods. Product costs may be classified as either direct or indirect. Direct costs are expenditures in a factory that can be specifically traced to a manufactured item and that become part of its overall cost. Indirect costs are also incurred in a factory where production takes place, but they are more general and cannot be attributed to any specific product.

There are three product costs associated with a manufactured item:

Direct materials
Direct labor cost
Factory overhead

Direct materials are raw materials that will be used to create finished goods. Their cost becomes part of the product that customers ultimately purchase.

Direct labor is the cost of hourly wages of production workers who assemble manufactured goods. These employees work on products that are sold to customers when finished.

Factory overhead is an indirect cost and includes ANY expense in a factory that is not specifically traced to products that customers purchase. These may be general expenses, such as utilities, insurance, property taxes, depreciation, supplies, maintenance, supervisor salaries, and expired prepaid items. Factory overhead also includes any materials or labor that do not become part of a manufactured product.

Product costs may be further categorized, as follows:

Prime cost = direct labor + direct materials
Conversion costs = direct labor + factory overhead

Example

A manufacturing company produces kitchen cabinets. Direct materials include wood, hinges, and hardware. Direct labor is the cost of wages of factory employees who assemble the cabinets. Factory overhead includes expendituresfor electricity and water bills, insurance premiums, roof repair, depreciation of machinery, materials used to build shelves in the factory, and wages of factory workers to assemble those shelves.

Assume that direct materials cost $700, direct labor is $500, and factory overhead is $300 for cabinets that have been manufactured.

1.	How much are prime costs?	$700 + $500 = $1,200
2.	How much are conversion costs?	$500 + $300 = $ 800
3.	What is the total cost of the product?	$700 + $500 +$300= $1,500