# Cost Classifications

### Direct Labor and Direct Materials

Manufacturing companies often differentiate between direct labor and direct materials costs.

Direct labor and direct materials are typically the highest costs for companies that manufacture products. Direct labor means the hours spent producing a product or providing a service that can easily be traced to the product or service. Direct labor also includes costs such as benefits and insurance.

An example of direct labor in manufacturing is an assembly-line worker who is part of the production process for a finished product. The assembly-line worker is directly involved with converting direct materials into the final product. Any wages and other benefits that worker receives are a direct labor cost.

A company's cost of direct labor varies based on its volume. For example, if a crew of assembly-line workers works overtime to catch up with new orders, then the company's direct labor costs will be higher for that time period.

Direct materials are raw goods that can be traced directly to or easily identified with a product. For example, for a manufacturing company that produces clothes, the fabric used for the clothes is a direct material. The fabric is a component of the final product that is easily identifiable as part of the finished product. Any thread, buttons, zippers, or rivets that the company used would also be direct materials.

Direct materials are typically listed as a bill of materials for a given product. A bill of materials is a list that details the amount and cost of each item that goes into a finished product.
Bill of Materials Example for Shelving Unit
Level of Production Part No. Material Description Quantity Unit Cost Total Cost
1 256−004 Wheel 4 $1.25$5.00
2 846−841 Plywood bottom 1 $4.00$4.00
2 146−747 Plywood sides 2 $4.00$8.00
3 646−369 Plywood back 1 $3.50$3.50
3 426−877 Top piece 1 $9.00$9.00
3 849−887 Hole coverings 16 $0.25$4.00
4 917−319 Labor 1 $80.00$80.00
4 284−673 Shelves 4 $3.00$12.00
5 917−319 Polish 1 $15.00$15.00
5 521−758 Labor 0.5 $80.00$40.00
Total Cost of Finished Product = \$180.50

The bill of materials often lists the level of production where each material is used, each material's part number, a description of each material, the quantity required of each material, the cost per unit, and the total cost.

A company's costs for its direct materials also includes any waste that occurred as part of the manufacturing process. Waste appears in the form of excess materials and damaged or unsellable products. Among manufacturers, waste is usually a small part of the budget. However, reducing waste can make individual products and product lines more profitable. It can also help the company's image if consumers or members of the public believe that the company is environmentally friendly.

### Overhead and Other Indirect Costs

Manufacturing overhead and administrative overhead are separate costs.

Manufacturing overhead, also known as indirect manufacturing costs, refers to all costs that are a result of producing a product but that are not direct materials or direct labor. Examples of manufacturing overhead include electricity and heat for a factory. An indirect cost is an expense that cannot be attributed to a specific product but requires allocation. For example, an accountant's salary isn't attached to any particular product line. Since manufacturing overhead excludes direct materials and direct labor, the category serves as a catchall for all other costs—namely indirect costs that are incurred as part of the manufacturing process.

Examples of manufacturing overhead include utilities such as electricity, heat, and air conditioning for production plants. It also includes depreciation for equipment used to create the finished product. Depreciation is the gradual loss of an asset's value. Examples include a machine that wears out and a computer that becomes outdated. For a manufacturer, manufacturing overhead expenses may include machine maintenance and repairs, insurance, property taxes for the production plants, and the salaries and benefits of quality control personnel.

All publicly listed companies in the U.S. must follow generally accepted accounting principles (GAAP), which are a combination of accounting principles, standards, and procedures that govern the preparation of financial statements. Under GAAP, manufacturing overhead, along with direct materials and direct labor, is considered part of the cost of a product for determining the cost of goods sold. GAAP requires absorption costing. Therefore, companies must identify a product's direct and indirect manufacturing costs for accurate reporting. Since manufacturing overhead is an indirect cost, the company must decide where the costs should be allocated. This can be difficult because these manufacturing overhead costs are often not directly associated with a specific product.

Generally, manufacturing overhead is applied to a company's inventory, which includes work in process goods and finished goods. Importantly, manufacturing overhead is entirely different from the administrative overhead the companies incur. Administrative overhead refers to costs that a company incurs for business activity other than for the production of goods. An example of administrative overhead is the cost a company incurs for a receptionist, an office manager, or other support staff. Sales commissions are another example of administrative overhead.