Manufacturing or production costs are classified into three basic elements:
(1) direct materials (2) direct labor (3) factory overhead.
Direct Materials
The materials that become part of a certain manufactured product and can be readily identified with that product are classified as direct materials. Examples include lumber used in making furniture, fabric used in the production of clothing, iron ore used in the manufacture of steel products, and rubber used in the production of athletic shoes. Many types of materials and supplies necessary for the manufacturing process either cannot be readily identified with any particular manufactured item or have a relatively insignificant cost. Items such as sandpaper used in sanding furniture, lubricants used on machinery, and other items for general factory use are classified as indirect materials. Similarly classified are materials that actually become part of the finished product, such as thread, screws, rivets, nails, and glue, but whose costs are relatively insignificant, making it not cost effective to trace them to specific products.
Direct Labor
The labor of employees who work directly on the product manufactured, such as machine operators or assembly-line workers, is classified as direct labor The employees who are required for the manufacturing process but who do not work directly on the units being manufactured are considered indirect labor. This classification includes department heads, inspectors, materials handlers, and maintenance personnel. Payroll-related costs, such as payroll taxes, group insurance, sick pay, vacation and holiday pay, retirement program contributions, and other fringe benefits are usually treated as indirect costs. Some companies, however, more appropriately,treat the fringe benefits paid for direct laborers as additional direct labor cost for the purpose of more precisely determining how much each hour of direct labor really costs. As manufacturing processes have become increasingly automated, direct labor cost as a percentage of total product cost has decreased for many companies. Harley-Davidson, the motorcycle manufacturer, stopped tracking direct labor as a separate cost category because it was only 10% of total product cost but required an inordinate amount of time to trace directly to the individual products manufactured.
Factory Overhead
Factory overhead, also known as manufacturing overhead and factory burden, includes all costs related to the manufacture of a product except direct materials and direct labor. Thus, factory overhead includes the previously mentioned indirect materials and indirect labor, plus other Manufacturing expenses, such as depreciation on the factory building and the machinery and equipment, heat, light, power, maintenance, insurance, and taxes. As factories have become more automated, factory overhead as a percentage of total manufacturing cost has increased dramatically. The costs of direct materials and direct labor are sometimes combined and Described as the prime cost of manufacturing a product. Prime cost plus factory overhead equals the total manufacturing cost. Direct labor cost and factory overhead, which are necessary to convert the direct materials into finished goods, can be combined and described as conversion cost. These relationships are .Marketing expenses, general administrative costs, and other non-factory expenditures are not included in the costs of manufacturing. Some costs incurred by a manufacturer, however, may benefit both factory and non-factory operations. Examples include depreciation, insurance, and property taxes on a building that houses both the factory and the administrative offices. In this situation, an allocation of cost must be made to each business function.
