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If you are starting out in a new business, especially a service/manufacturing business, understanding the cost accounting system and which cost accounting system will work best for your company, is the first step to being successful. Once you find someone to help you navigate those waters, let them help you sail the rough seas of direct and indirect inventory, direct and indirect labor costs, and how to allocate factory overhead as well. While it all may sound confusing, having the right person with the right knowledge and advice, can make all the difference to you and the success of your business.
We learned in Chapter 19 that cost accounting systems calculate, register, and record product costs. Once these costs have been recorded, administrators and supervising personnel can use these costs for setting their product prices, controlling operations and developing financial statements. These reports can play an important role in the financial decision making process for your company so it is imperative that they are accurate and detailed.
There are two different types of cost accounting systems. There are called job order cost systems and process cost systems. While both systems are used by manufacturing companies, the job order cost system is used by companies that manufacture custom products or groups of products that are alike. The process cost system, on the other hand, is chosen by manufacturing companies that make units of a product that are impossible to tell apart and are produced using a continuous production process.
Once you have chosen your type of cost accounting system, you will need to know what types of costs that will need to be reported and the difference in those costs.
First, you have direct materials cost and indirect materials cost. Direct materials costs are materials that will be used as an essential part of the finished product. For example, for an electrician, direct materials would be receptacles and wiring. To be considered and classified as a direct materials cost, it has to be used as an essential part of the finished product and it has to be a significant portion of the total cost of the finished product.
If it does not fit these two requirements, then it is considered an indirect materials cost, or factory overhead cost. “Indirect materials are materials used in the production process, but which cannot be linked to a specific product or job. Alternatively, they may be used in such insubstantial quantities on a per-product basis that it is not worthwhile to track them as direct materials” (Bragg) .An example of an indirect materials cost, or factory overhead cost, for an electrician would be electrical tape and solder.
Next, we have direct and indirect labor costs. As with direct materials costs, labor costs must also meet the same two requirements to be labeled direct labor costs. They must be an essential part of the finished product and must be a significant portion of the total cost of the finished product. If they meet these two requirements, these labor costs are considered direct labor costs.
If they do not meet these requirements, they are indirect labor costs, or factory overhead costs. The janitor who cleans the building incurs labor costs for the company; however, the janitorial costs are not an essential cost of manufacturing their product. As a result, the janitorial labor costs are indirect labor costs, or factory overhead cost.
So what are factory overhead costs and how do you measure and record it? Our textbook describes both in detail.
Factory overhead costs are indirect costs of the product. As previously mentioned, these can be materials and labor costs that do not directly enter
into the finished product. Some examples include:
Heating and lighting the factory
Property taxes on factory buildings and land
Depreciation on factory plant and equipment
Sandpaper, glue, buffing compound
Power to run the machines
Salaries of production supervisors
Because factory overhead costs cannot be directly earmarked to jobs, they are instead, applied to jobs using a common measure related to each job. This common measure is called an activity base. The activity base used to apply overhead should reflect the use of factory overhead costs.
Factory overhead costs are usually applied to jobs using a predetermined factory overhead rate computed as follows:
Predetermined FactoryEstimated Total Factory Overhead Costs
Overhead Rate = Estimated Activity Base
For example, if a company estimated a total factory overhead cost of $50,000 for the year and the activity base as 10,000 direct labor hours, a predetermined factory overhead rate of $5 per direct labor hour is computed using the estimated amounts at the beginning of the period. Predetermined factory overhead rated are computed because managers need information about the product cost of each job in a timely manner. With timely information, managers can fine-tune manufacturing methods or product pricing.
Remember, during each step of your manufacturing process, identify and record every cost as well as determine whether the costs are direct, indirect, or factory overhead. Keeping up with these costs will help you determine the final cost of each unit and whether or not to make any changes necessary for a more profitable future.
Bragg, Steven, “What are Indirect Materials?” Questions & Answers – Accounting Tools 1 June 2013.
Warren, Reeve and Duchac. ACCT 1101 Chapters 18-26 Managerial Accounting. Ohio: Cengage, 2012. Print.