Manufacturing Costs

Most manufacturing companies divide manufacturing costs into three broad categories: direct materials, direct labour and manufacturing overhead. A discussion of each of these categories follows.

DIRECT MATERIALS. The materials that go into the final product are called raw materials. This term is somewhat misleading, since it seems to imply unprocessed natural resources like wood pulp or iron ore. Actually, raw materials refer to any materials that are used in the final product; and the finished product of one company can become the raw materials of another company. For example, the plastics produced by Du Pont are a raw material used by Compaq Computer in its personal computers.

Direct materials are those materials that become an integral part of the finished product and that can be physically and conveniently traced to it. This would include, for example, the seats Airbus purchases from subcontractors to install in its commercial aircraft. Also included is the tiny electric motor Panasonic uses in its CD players to make the CD spin.

Sometimes it isn’t worth the effort to trace the costs of relatively insignificant materials to the end products. Such minor items would include the solder used to make electrical connections in a Sony TV. Materials such as solder and glue are called indirect materials and are included as part of manufacturing overhead, which is discussed later in this section.

DIRECT LABOUR. The term direct labour is reserved for those labour costs that can easily (i.e., physically and conveniently) be traced to individual units of product. Direct labour is sometimes called touch labour, since direct labour workers typically touch the product while it is being made. The labour costs of assembly-line workers, for example, would be direct labour costs, as would the labour costs of carpenters, bricklayers and machine operators.

Labour costs that cannot be physically traced to the creation of products, or that can be traced only at great cost and inconvenience, are termed and treated as part of manufacturing overhead, along with indirect materials. Indirect labour includes the labour costs of caretakers, supervisors, materials handlers and night security guards. Although the efforts of these workers are essential to production, it would either be impractical or impossible accurately to trace their costs to specific units of product. Hence, such labour costs are treated as indirect labour.

In some industries, major shifts are taking place in the structure of labour costs. Sophisticated automated equipment, run and maintained by skilled indirect workers, is increasingly replacing direct labour. In a few companies, direct labour has become such a minor element of cost that it has disappeared altogether as a separate cost category. More is said in later chapters about this trend and about the impact it is having on cost systems. However, the vast majority of manufacturing and service companies throughout the world continue to recognize direct labour as a separate cost category.

MANUFACTURING OVERHEAD. Manufacturing overhead, the third element of manufacturing cost, includes all costs of manufacturing except direct materials and direct labour. Manufacturing overhead includes items such as indirect materials; indirect labour; maintenance and repairs on production equipment; and heat and light, property taxes, depreciation and insurance on manufacturing facilities. A company also incurs costs for heat and light, property taxes, insurance, depreciation and so forth, associated with its selling and administrative functions, but these costs are not included as part of manufacturing overhead. Only those costs associated with operating the factory are included in the manufacturing overhead category.

Various names are used for manufacturing overhead, such as indirect manufacturing cost, factory overhead, and factory burden. All of these terms are synonymous with manufacturing overhead.

Manufacturing overhead combined with direct labour is called cost. This term stems from the fact that direct labour costs and overhead costs are incurred in the conversion of materials into finished products. Direct labour combined with direct materials is called prime cost.