Such materials, called indirect materials or supplies, are included in manufacturing overhead. Indirect materials are materials used in the manufacture of a product that cannot, or will not for practical reasons, be traced directly to the product being manufactured. As their names indicate, direct material and direct labor costs are directly traceable to the products being manufactured. Manufacturing overhead, however, consists of indirect factory-related costs and as such must be divided up and allocated to each unit produced. For example, the property tax on a factory building is part of manufacturing overhead.
Executive salaries, clerical salaries, office expenses, office rent, donations, research and development costs, and legal costs are administrative costs. In a manufacturing company, overhead is generally called manufacturing overhead. (You may also see other names for manufacturing overhead, such as factory nonmanufacturing costs include overhead, factory indirect costs, or factory burden.) Service companies use service overhead, and construction companies use construction overhead. Any of these companies may just use the term overhead rather than specifying it as manufacturing overhead, service overhead, or construction overhead.
To help clarify which costs are included in these three categories, let’s look at a furniture company that specializes in building custom wood tables called Custom Furniture Company. Each table is unique and built to customer specifications for use in homes (coffee tables and dining room tables) and offices (boardroom and meeting room tables). The sales price of each table varies significantly, from $1,000 to more than $30,000. Figure 2.3.1 shows examples of production activities at Custom Furniture Company for each of the three categories.
Costs that are not related to the production of goods are called nonmanufacturing costs23; they are also referred to as period costs24. The wood used to build tables and the hardware used to attach table legs would be considered direct materials. Small, inexpensive items like glue, nails, and masking tape are typically not included in direct materials because the cost of tracing these items to the product outweighs the benefit of having accurate cost data. These minor types of materials, often called supplies or indirect materials, are included in manufacturing overhead, which we define later.
Note “Business in Action 2.3.2” provides examples of nonmanufacturing costs at PepsiCo, Inc. This is the relationship between direct materials, direct labor, overhead, prime cost and conversion cost. Indirect labor is the cost of production employees who are involved in the manufacturing process, but do not work on a specific product. The finished product of a company may become raw material of another company.
Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years.
7: Cost Terminology
All manufacturing costs that are easily traceable to a product are classified as either direct materials or direct labor. All nonmanufacturing costs are not related to production and are classified as either selling costs or general and administrative costs. Even though nonmanufacturing overhead costs are not product costs according to GAAP, these expenses (along with product costs and profit) must be covered by the selling prices of a company’s products.
Examples of marketing and selling costs include advertising costs, order taking costs and salaries of sales persons etc. Examples of administrative costs include salaries of executives, accounting costs, and general administration costs etc. While depreciation on manufacturing equipment is considered a manufacturing cost, depreciation on the warehouse in which products are held after they are made is considered a period cost. While carrying raw materials and partially completed products is a manufacturing cost, delivering finished products from the warehouse to clients is a period expense. For accounting purposes, nonmanufacturing costs are expensed periodically (typically in the period they are incurred).