Managerial Cost Concepts
There are many types of costs in a business, as you can imagine.
For example, a company producing and selling bicycles will have manufacturing costs (the cost of actually producing the different parts and putting them together); administrative expenses; selling expenses; depreciation on buildings and equipment, etc. These costs, depending on their nature, belong in different cost categories and this is what we will see next. [It is important to understand from the beginning in what category each cost belongs and why in order to understand Cost Behaviour Analysis, the topic that will be posted next.]
1. MANUFACTURING COSTSÂ
There are three categories of manufacturing costs, namely:
Direct materials
are the raw materials that can be directly associated with the finished product. For example, cocoa is a direct material in the production of chocolate.
Direct labour is the work of factory employees that can be directly associated with transforming the direct materials into finished products. The cook working in a restaurant is an example of direct labour.
Overhead (aka manufacturing overhead) consists of costs that are indirectly related to the manufacture of the finished good. Overhead includes: indirect labour, indirect materials, taxes, insurance, maintenance on factory facilities and depreciation on factory machinery and buildings.Â
2. PRODUCT COSTS vs. PERIOD COSTS
Product costs are manufacturing costs that are necessary to the production of the finished good. Therefore, we can logically deduct that direct materials, direct labour and overhead are all product costs since they are essential to the "birth" of the finished product. Product costs are also called inventoriable costs because they are recorded as inventory when incurred and become expenses (cost of goods sold) only when the finished product is sold.
Period costs, on the other hand, are non-manufacturing costs (such as selling and administrative expenses, i.e. operating expenses). They are matched to revenue from a specific period, hence the name "period costs".
3. PRIME COSTS and CONVERSION COSTS
Prime costs are very simple to understand. They are equal to all direct material costs + all direct labour costs.Â
Conversion costs are, as their name suggests, the costs of converting raw materials into the final good. So, conversion costs equal all direct labour costs + overhead costs.Â
[In case you are interested, this post was based on the info. found in my textbook, "MANAGERIAL ACCOUNTING -Â TOOLS FOR BUSINESS DECISION-MAKINGÂ Second Canadian Edition" by Kieso et al.]