Product Costs
Costs are classified according to their purpose. The two main classifications of costs based on purpose are
product (or production) costs and period costs.
Product Costs (also called Inventoriable Costs)
Product costs, or inventoriable costs, are costs for the production process without which the product could not be made. Product costs are “attached” to each unit and are carried on the balance sheet as inventory during production (as work-in-process inventory) and when production is completed (as finished goods inventory) until the unit is sold. When a unit is sold, the item’s cost is transferred from the balance sheet to the income statement where it is classified as cost of goods sold, which is an expense.
The main types of product costs are:
- direct materials
- direct labor
- manufacturing overhead (both fixed and variable)
These different product costs can be combined and given different names . we need to know what types of costs are included in the different classifications.
Types of Product Costs
The costs that follow are the main costs incurred in the production process.
| Direct material | Direct materials are the raw materials that are directly used in producing the finished product. The costs included in the direct material cost are all the costs associated with acquiring the raw material: the raw material itself, shipping-in cost, and insurance while in transit, among others. Common examples of direct materials are plastic and components. |
| Direct labor | Direct labor costs are the costs of labor that can be directly traced to the production of a product. The cost of wages for production workers is a direct labor cost for a manufacturing company. |
| Manufacturing overhead |
Manufacturing overhead costs are the company’s costs related to the production process that are not direct material or direct labor but are necessary costs of production. Examples are indirect labor, indirect materials, rework costs, electricity and other utilities, depreciation of plant equipment, and factory rent. |
| Indirect labor | Indirect labor is labor that is part of the overall production process but does not come into direct contact with the product. A common example is labor cost for employees of the manufacturing equipment maintenance department. Indirect labor is a manufacturing overhead cost. |
| Indirect material | Indirect materials are materials that are not the main components of the finished goods. Examples are glue, screws, nails, and other materials such as machine oils, lubricants, and miscellaneous supplies that may not even be physically in corporated into the finished good. Indirect materials are a manufacturing overhead cost. |
Groupings of Product Costs
The five main types of product costs in the previous table can be further combined to create different cost classifications. The three classifications are prime costs, manufacturing costs, and conversion costs.
| Prime costs | Prime costs are the costs of direct material and direct labor. Direct material and direct labor are the direct inputs, or the direct costs of manufacturing. |
| Conversion costs | Conversion costs include manufacturing overhead (both fixed and variable) and direct labor. Conversion costs are the costs required to convert the direct materials into the final product. |
| Manufacturing costs | Manufacturing costs include the prime costs and manufacturing overhead applied. Manufacturing costs are all the costs that need to be incurred to produce the product. Manufacturing costs do not include selling or administrative costs, which are period costs. |