Companies which manufacture a product face an elaborated set of accounting issues. Additionally the usual accounting matters related with selling and administrative activities, a manufacturer should deal with the accounting concerns related to the acquiring and processing raw materials into the finished product/commodities. Cost accounting for the manufacturing process entails consideration of the three key cost components which are necessary to produce the finished goods:
1) Direct materials involve the costs of all the materials that are an integral part of the finished product and which have a physical presence which is readily traced to that finished product. Examples for a computer maker include the plastic housing of the computer, the face of monitor screen, circuit boards within machine, and so forth. Minor materials/objects such as solder, tiny strands of wire, and the like, while important to the production process, are not very much cost effective to trace to individual refined units. The price of such products is known as "indirect materials." These indirect materials comprised with other components of the manufacturing overhead, which are discussed as below.
2) Direct labour costs comprises of gross wages paid to those who directly work on goods being produced. For example, wages paid to the welder in the bicycle factory who is in fact fabricating frames of bicycles would be included in direct labour. On the other hand, wages paid to a welder who is building assembly line which will be used to produce a new line of the bicycles is not direct labour. Generally, indirect labour pertains to the wages of other factory employees such as maintenance personnel, guards, supervisors, etc. who do not work straight on a product. Indirect labour is roll into manufacturing overhead.
3) Manufacturing overhead includes all costs of manufacturing other than straight materials and the direct labour. Examples comprise indirect labour, indirect materials, and factory related depreciation, repair, maintenance, insurance, utilities, property taxes, and so forth. Factory overhead is also called as the indirect manufacturing cost, burden, and the other synonymous terms. Factory overhead is difficult to trace and to specific finished units, but its cost is significant and must be allocated to those units. Usually, this allocation is applied to ongoing production based on estimated allocation rates, with the subsequent adjustment processes for over- or under-applied overhead. This is quite significant to product costing, and will be covered in depth later.
Considerably, nonmanufacturing costs for selling and common/administrative purposes (SG&A) are not part of factory overhead. Selling costs relate to the order procurement and fulfilment, and commissions, warehousing includes advertising, , and shipping. Administrative costs arise from general management of the business, including items such as executive salaries, accounting departments, public and human relations, and the like.
Accountants sometimes use a bit of jargon to describe definite "combinations" of direct labour, direct materials, and manufacturing overhead:
Prime Costs = Direct Labour + Direct Material
Conversion Costs = Direct Labour + Manufacturing Overhead
Prime costs are the major components which are direct in nature.