Chapter 2 Notes
A. Manufacturing costs are the costs involved in making a product. Manufacturing costs
can be divided into three basic elements: direct materials, direct labour, and
1. Direct materials are those materials that become an integral part of a finished
product and can be conveniently traced to it.
a. An example of direct materials would be the screen on a laptop
b. Small material items, such as glue, are classified as indirect
materials rather than as direct materials. It is too costly to trace such
small costs to individual units.
2. Direct labour consists of those labour costs that can be easily traced to
individual units of product. Direct labour is sometimes called touch labour.
a. An example of direct labour would be a worker on a manufacturing
b. Other labour costs, such as supervisors and janitors, are treated
as indirect labour rather than as direct labour. These costs cannot be
easily traced to individual units of product since these individuals do
not directly work on the product.
3. Manufacturing overhead consists of all manufacturing costs except direct
materials and direct labour.
a. Manufacturing overhead includes indirect materials, indirect labour, and
other manufacturing costs such as factory rent, factory insurance, and
depreciation on factory equipment and facilities.
b. Synonyms for manufacturing overhead include factory overhead and
indirect manufacturing costs.
4. The terms prime cost and conversion cost are also used to categorize
a. Prime cost consists of direct materials plus direct labour.
b. Conversion cost consists of direct labour plus manufacturing overhead.
B. Labour costs can be broken down into five main categories: direct labour, indirect
labour, idle time, overtime premium, and labour fringe benefits.
1. As mentioned earlier, direct labour consists of factory labour costs that can be
easily traced to products.
2. Indirect labour consists of factory labour costs that are supportive or
supervisory. These include the costs of supervisors, superintendents,
custodians, maintenance persons, and others who do not work directly on the
product. 3. Idle time represents the costs of direct labour workers who are unable to
perform their assignments due to material shortages, power failures, and the
like. Idle time is treated as part of manufacturing overhead.
4. Overtime premium consists of any amount paid above an employees base
hourly rate for working beyond normal working hours.
a. For example, if the base rate is $6 per hour and an employee is paid
time-and-a-half for overtime, then the overtime premium would be $3
per hour. In other words, the total pay would be $9 per hour of
b. An overtime premium ordinarily is not charged to specific jobs, but
rather is included as part of manufacturing overhead. An exception is
when a customer specifically requests a rush job that results in having
to work overtime. In such a case, the overtime premium might be
charged directly to that job.
5. Labour fringe benefits include employment-related costs paid by the employer,
such as insurance, retirement plans, etc.
a. Many companies include such costs as part of manufacturing overhead.
b. The preferred method is to include only the labour fringe benefits
relating to indirect labour as part of manufacturing overhead and treat
the fringe benefits relating to direct labour as added direct labour costs.
C. Non manufacturing costs are those costs involved with selling and administrative
1. Selling, or marketing, costs include all costs associated with marketing finished
products such as sales commissions, costs of delivery equipment, costs of
finished goods warehouses, and advertising.
2. Administrative costs include all costs associated with the general
administration of an organization, including accounting services, depreciation
of general administrative facilities and equipment, and executive
D. For purposes of external financial reports, costs can be classified as product costs or
1. Period costs are expensed on the income statement in the period in which
they are incurred. (By incurred, we mean the period in which the cost is
accrued, not necessarily when it is paid. For example, remember from
financial accounting that salaries are counted as costs not when they are
paid, but when they are earned by employees. The cost is incurred in the
period in which it is earned. Continue to use the rules you learned in financial
accounting.) 2. Product costs are matched with units of product and are recognized as an
expense on the income statement only when the units are sold. Until that
time, product costs are considered to be assets and are recognized on the
balance sheet as inventory.
3. In a manufacturing company, product costs include direct materials, direct
labour, and manufacturing overhead. Thus, in a manufacturing company,
product costs and manufacturing costs are synonymous.
4. In a manufacturing company, period costs and non-manufacturing costs are
synonymous terms. Thus, the period costs are selling and administrative
5. In a merchandising company such as Canadian Tire or Chapters, product
costs consist solely of the costs of products purchased from suppliers for
resale to customers. All other costs are period costs.
E. Income statements and balance sheets prepared by manufacturing firms differ from
those prepared by merchandising firms.
1. The balance sheet of a manufacturing firm contains three inventory accounts:
Raw Materials, Work in Process, and Finished Goods. By contrast, the
balance sheet of a merchandising firm contains only one inventory account
a. Raw Materials inventory consists of materials on hand in stockrooms
that will be used to make products.
b. Work in Process consists of products that have been started but not-
yet-completed as of period end.
c. Finished Goods consists of units of product that are completed and
ready for sale.
2. The income statement of a manufacturing firm contains an element termed
cost of goods manufactured. You should study the schedule of cost of goods
manufactured in Exhibit 24 in the text very carefully. F. Manufacturing costs (direct materials, direct labour, and overhead) are also known
as inventoriable costs.