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What are Manufacturing Costs?

Manufacturing costs are used to allocate costs to specific products or units during the manufacturing process. We covered some basic information on manufacturing costs in our blog post about classifying costs. Now let's dive a little deeper into manufacturing costs.

There's two broad categories in manufacturing costs, manufacturing and non-manufacturing. Non-manufacturing costs are all indirect costs whereas manufacturing costs include both direct costs and some indirect costs. Not very exciting until you further divide the manufacturing costs into a few different groups. Manufacturing costs include the direct costs of direct materials and direct labor and the indirect cost of manufacturing overhead. Let's take a look at each manufacturing cost:

Direct Materials

These items can be traced to a specific product/unit. These are things such as a keyboard for a computer or an armrest on a chair. These are all considered raw materials by the company. When you think of raw materials most people tend to envision things such as timber or ore. But raw materials are anything that a company brings into their manufacturing process from an outside source. They can be completed parts to a product that are purchased from a vendor. Because the company did not manufacture them they are considered raw materials. Direct materials are easily traced to a specific product/unit. Items such as screws, bolts, etc that are used on multiple products in the company are not considered direct materials. Can you imagine having to keep track of each screw, bolt, washer, etc? It's not practical and these are considered indirect materials which we will discuss in a minute.

Direct Labor

This is labor that is easily attributed to individual products or units. You can also refer to direct labor as touch labor because the worker is "touching" the product/unit. Direct labor would include the labor on an assembly line, a member of the construction crew that works on one job at a time, etc. It does not include labor involved in processes such as operating a fork lift in the shipping bay that handles all the products. A single worker can contribute both direct and indirect labor, they can also contribute direct labor on more than one product/unit. To allocate the labor to the appropriate category, product, and/or unit the worker/manager should be tracking what they are working on during their logged hours if they work in multiple areas.

Prime Costs

This is a term that just includes the direct materials and direct labor for a specific product/unit. Prime costs are the sum of the direct costs.

Manufacturing Overhead

Manufacturing overhead is a catch all of sorts for the indirect costs associated with the manufacturing process. This is where the indirect materials we talked about above fall as well as the indirect labor. In addition to indirect materials and indirect labor costs associated with running the manufacturing facility are also included in manufacturing overhead. These costs include the mortgage/rent on the manufacturing facility, the utilities for the manufacturing facility, janitors, cost of upkeep, etc. This does not include the costs associated with non-manufacturing facilities. Other names you may hear for manufacturing overhead include indirect manufacturing cost, factory overhead, and factory burden.

Conversion Cost

This is the manufacturing overhead combined with the cost of direct labor. This is what it costs the company to take the direct materials and turn them into the finished product/unit.

So we've covered manufacturing costs, let's take some time to go over the non-manufacturing costs. Non-manufacturing costs are often called selling, general, and admin costs (SG&A) or selling and admin costs. These include two different categories, selling costs and administrative costs.

Selling Costs

These are the costs that can be attributed to selling the product and getting the item to the purchaser. These costs can be both direct and indirect and include things such as advertising, salaries and commissions for sales representatives, and shipping.

Administrative Costs

These are the costs associated with the management of the company. This includes things like the cost for the accounting department, the PR department, non-manufacturing buildings, etc. These can also be both direct or indirect costs.

So what's the point of splitting up costs into these categories? These costs can help with the decision making process. They can also help a company determine if a specific product line is cost effective and generating income or if certain changes to the manufacturing process will generate more funds. Categorizing costs is just the beginning of being able to utilize financial information in a way that facilitates better cash management for the company.