Manufacturing Costs

Manufacturing costs are the costs a company incurs in its factories to convert raw materials into finished goods. They are grouped into three categories: direct materials, which become part of the product; direct labor, the wages of workers who make the product; and manufacturing overhead, which covers all other factory costs such as power, machine depreciation, supervision and maintenance. Together they make up the cost of a manufactured product. They are also called production costs.

Manufacturing costs are product costs, also called inventoriable costs. Under GAAP and IFRS they are recorded as inventory when incurred and expensed as cost of goods sold only when the products are sold. This sets them apart from selling, administrative and research costs, which are period costs and are expensed when incurred. Indirect factory costs on their own are covered in the entry on indirect manufacturing costs.

• Direct materials: raw materials and components that can be traced to a specific product, such as steel in a car body or flour in bread.
• Direct labor: wages and related payroll costs of workers who physically make the product, such as assemblers and machine operators.
• Manufacturing overhead: all other production costs, including indirect materials like glue and lubricants, indirect labor like supervisors and maintenance staff, factory rent, utilities, insurance and depreciation of equipment.

Two subtotals are widely used. Prime cost is direct materials plus direct labor. Conversion costs are direct labor plus manufacturing overhead, the cost of turning materials into products.

Costs move through three inventory accounts. Materials purchased go into raw materials inventory. When materials are issued to production, and labor and overhead are applied, the costs enter work in process inventory. When products are completed, their cost moves to finished goods inventory, and when they are sold it moves to cost of goods sold on the income statement. The total cost of products completed in the period is called the cost of goods manufactured:

Here $\text{COGM}$ is cost of goods manufactured, $\text{Beginning WIP}$ and $\text{Ending WIP}$ are opening and closing work in process, and $\text{Manufacturing costs incurred}$ is the total of direct materials used, direct labor and overhead for the period.

A furniture maker records the following for a month: direct materials used $120,000, direct labor $80,000 and manufacturing overhead $60,000, so total manufacturing costs are $260,000. Beginning work in process is $30,000 and ending work in process is $40,000. Cost of goods manufactured is $30,000 plus $260,000 minus $40,000, which is $250,000. If beginning finished goods were $50,000 and ending finished goods are $70,000, cost of goods sold is $50,000 plus $250,000 minus $70,000, or $230,000. Of the month's $260,000 of manufacturing costs, $30,000 has stayed on the balance sheet in the increase in inventories.

Prime cost here is $200,000 and conversion cost is $140,000. If 5,000 chairs were completed, the average manufacturing cost per chair is $250,000 divided by 5,000, or $50.

Because manufacturing costs are held in inventory until sale, a company that produces more than it sells pushes part of its fixed overhead onto the balance sheet, which raises current profit under absorption costing. Managers who are rewarded on profit may be tempted to overproduce for this reason, which is one reason internal reports often use variable costing instead. Accurate classification also matters for pricing, for tax (US tax rules under section 263A require many indirect costs to be capitalized into inventory) and for comparing costs across plants. Product costing systems such as job order costing and process costing exist to assign these costs to individual products.