Monday, May 23, 2022

Managerial Accounting 1.6: Manufacturing vs Nonmanufacturing Costs

This is Kurt Heisinger, accounting professorat Sierra College and author of Managerial Accounting. In this video we are going to talkabout the differences between manufacturing costs and nonmanufacturing costs. So we will startwith manufacturing costs and by the way they are also called product costs. With manufacturingcosts these are all the costs that are associated with production. So I will use the exampleof producing, let's say high-end racing road bikes. We are going to talk about some of thecosts that will be considered production costs. So what are those production costs, what are theyinclude. Well, we will start with direct materials. So with direct materials, these are the itemsthat are easily traced to the product that we are building. So for example, if we are producing aracing bike these would be things like the wheels, .

The tires, the chain, the derailers, these wouldall be considered direct materials. Now they are also our materials called indirect materialsthat I will get to in just a second that would fall under the manufacturing overhead category.So the next category of manufacturing costs is called direct labor. And direct labor this wouldbe the production workers whose time is easily traced to the products that they are workingon. So for example, if we have a person that is assembling a custom racing bike, the time and thecost associated with that production worker would be called direct labor, and would be considereda manufacturing cost as we talked about up above. And then the third category of manufacturingcosts is manufacturing overhead. And this really is everything else, all other costs that arerelated to production other than direct materials .

And direct labor. So what might that be. Well ifwe are producing racing bikes in a factory, in a building, then the costs, and we'll call it thefactory, then the costs of the factory would go into manufacturing overhead. So costs like therent on the factory, or any insurance that we pay related to the factory, or any maintenanceon the factory, or utilities within the factory, any costs associated with the factory would gointo this manufacturing overhead category. Also as I mentioned earlier, any materials that are notdirect materials, they would be considered to be indirect materials, and that would be interms of building a bike, things like oil that we put on the chain, maybe it is some stickers thatwe put on the bike that aren't very expensive, they are items, indirect materials, or items that areused in the production of these bikes, but they are .

Not easily traced to the bike, or maybe they are soinexpensive that we really don't want to take the time to trace those materials to the bike. There isalso a labor, a category of labor called indirect labor. So it does not go into this category directlabor, it is called indirect labor, and it is similar to indirect materials, this would be labor coststhat are not easily traced to the bike. For example if we are producing several different racing bikeswithin our factory and we have a supervisor who is overseeing the production of let's say twenty orthirty bikes, then that supervisor's salary would probably go into manufacturing overhead, into thatmanufacturing overhead category, and would be called indirect labor. So those are the three categoriesof production costs, direct materials, direct labor, and manufacturing overhead. So why is it importantto track manufacturing costs. Well there are a lot .

Of different reasons, but some of the key reasonswe are going to talk about right here. First of all we have got to make sure that the costs appearin the right place in the financial statements. So manufacturing costs have to be placed in theright location, either in the income statement as cost of goods sold or an inventory accounts in thebalance sheet. We will talk about that a little bit later. But it is very important to get those costsin the right place within the financial statements. Also tracking manufacturing costs enables us todetermine the cost of our products. And this is very important when it comes time to figure out,for example, how much we are going to charge to our customer for a particular product, it becomesimportant when we are trying to figure out how much we should pay our workforce, how much itcosts for us to get the materials that go into .

The products that we are building. So it enablesus to determine the costs of our products. And this then in turn leads to, hopefully, better decisionmaking. If we have accurate product cost information we could make better decisions, for example in pricingour products. So it is important that we track our manufacturing costs to the individual productsthat we are building. I gave you some examples of product costs related to the building of racingbikes, now let's talk about another type of product just to give you a variety of examples. What aresome examples of production costs or manufacturing costs at a company that builds custom woodfurniture, and this is the example that I use in my book. So we have got three different categories aswe mentioned before, direct materials, direct labor, and manufacturing overhead. If we build customwood furniture, for example let's say that we build .

Beautiful wood tables that are used in conferencerooms in large companies. Look at the direct materials, what would be some examples of directmaterials. Well, certainly the wood if it is high-end wood, would bein this category of direct materials. So if we had cherry wood, or maple, oak, whatever the type of woodthat we use, we would track that, those materials to the tables that we are building. If we haveany hardware that we are using. So let's say that we have drawers in a particular table that we arebuilding, we have drawer handles that are high-end drawer handles that might be relatively costly, those handles would be considered direct materials. Now what about direct labor. Well theworkers who cut, plane, and glue the wood together in these tables, these high-end tables, the costof those workers would be considered direct labor .

Costs. The workers that fill and sand the tables,also the cost of those workers would be in the category of direct labor, as well as the workersthat are finishing the tables. When we look at manufacturing overhead, let's take a look at someexamples of manufacturing overhead in our custom wood furniture company. Any indirect materials,so things like glue, screws, nails, sandpaper, stain, any lacquer that we use, we're probably not goingto trace those materials directly to each table that we are building, so we would call those indirect materials. The factory supervisor, similar to the bike example that I gave to you earlier, thefactory supervisor that is overseeing the building of all of the custom wood furniture that we aremaking, the salary of that factory supervisor would fall into this category of manufacturing overhead.And there are lots of other manufacturing costs .

That would also fall into this manufacturingoverhead category. So any maintenance on the production equipment, the depreciation onthe production equipment, the utilities in the factory, the factory property taxes, all of thosethings would be in this category of manufacturing overhead. I talked earlier about the importanceof why we track manufacturing costs, specifically for different products, but let's talk now aboutwhere they appear in the financial statements. That was one important aspect of tracking our costsaccurately, that is where do those costs appear in the financial statements, and making sure that weget that right. So for products that are not yet sold, so these this could be just the raw materialssitting in the raw materials warehouse, this could be products that we've started but we haven't yetfinished, or it could .

Be products that are completely finished but wehaven't yet sold. So varying levels of production here. And we'll talk in a different video about howthose different levels of production, where those costs appear in the accounts on our books. Butfor now, for any products that are not yet sold, those costs are recorded in inventory accounts,and of course inventory accounts go on the balance sheet. Now if the products are sold, thenthe product costs associated with those products are transferred from the inventory accounts overinto cost of goods sold. And of course cost of goods sold will appear on the income statement.So again product costs are comprised of direct materials, direct labor, and manufacturingoverhead, and those costs, if the products are not yet sold go into inventory accounts ofthe balance sheet. Once those products are sold .

Then the costs associated with those products,direct materials, direct labor, and manufacturing overhead, are transferred into cost of goodssold and appear then on the income statement. We have looked at manufacturing costs and lotsof examples of manufacturing costs, for a bike company for example, a manufacturing company,and for a company that manufactures custom wood furniture. So now let's take a look at nonmanufacturing costs, which are also called period costs, which I'll get to why that is thecase in just a minute. With nonmanufacturing cost, these are costs not related to production,and are classified as selling or general and administrative. The selling costs would be anycost associated with making our customers aware of our product and then getting our productto the customer. So that would include things .

Like advertising, any marketing efforts thatwe have that we put into place, the costs of those marketing efforts would go into theselling category. For example, if we run an ad in the newspaper or online, let's say withFacebook, the costs of those ads would go into the selling category. Then we have the generaland administrative category and this category includes costs associated with areas such asaccounting or human resources. It would be the cost of the employees within those departments,the cost of the buildings that they're in, the cost of the computers that they use, of maintainingthose buildings, all of those costs would go into this general and administrative category. So thoseare just some examples for you of the costs that would go into these two different categories thatfall into the category of nonmanufacturing costs. .

Now that we know the nature of nonmanufacturingcosts, let's talk about how nonmanufacturing costs are presented in the financial statements. Nonmanufacturing costs are recorded as an expense on the income statement in the period in whichthe cost is incurred. And that's exactly why we call these costs, period costs. So it is prettystraightforward. If we pay the accounting department, the salary of folks that are in the accountingdepartment, those costs are expensed immediately, and of course expenses fall within the incomestatement in the financial statements. Unlike manufacturing costs, where the costs go throughinventory accounts first, and then on the balance sheet, and then go to the income statement. So nonmanufacturing costs are expensed as incurred. Here is a summary of both manufacturing costs and nonmanufacturing costs, what goes into each of those .

Categories. Here is our manufacturing, here are themanufacturing costs, and here are the nonmanufacturing costs. And remember manufacturing costs are alsocalled product costs, and nonmanufacturing costs are also called period costs. So some examplesof manufacturing costs. The three categories are direct materials, direct labor, and manufacturingoverhead. The timing of the expense, that is when do these costs become an expense on the incomestatement is critical. So for manufacturing costs, the costs are expensed when the goods are sold,and not until the goods are sold. So if the goods are sitting in inventory or they're in the middleof production the cost of those goods, the product costs are sitting in inventory asan asset on the balance sheet. Once those goods are sold, then those product costs are expensedand become part of cost of goods sold. With .

Nonmanufacturing costs, as I mentioned earlier,it is fairly straightforward, these are period costs. So as soon as we incur these expenses,these costs, then they are expensed. The timing of the expense, they are expensed on the incomestatement in the time in which they are incurred.

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