Manufacturing cost

Manufacturing cost - is the total cost a company incurs to convert raw materials into finished products during a given period, made up of three elements: direct materials, direct labour and manufacturing overhead^[1]. Accountants also call it factory cost or production cost. It covers only what happens inside the factory walls. Selling, distribution and head-office expenses are excluded, however large they get.

The figure matters for two quite different audiences. Financial accountants need it to value inventory and report cost of goods sold. Plant managers and controllers want it for pricing, budgeting and finding out which products actually earn money. A broader, more economic treatment of the same subject, including the split between fixed and variable cost behaviour, can be found in the article on cost of production; the present entry focuses on the cost accounting mechanics.

Components of manufacturing cost

Every textbook splits manufacturing cost into the same three buckets (Garrison, Noreen, Brewer 2021)^[2]. The boundaries between them aren't always obvious, though.

Direct materials

Direct materials are raw materials and purchased components that become an integral part of the finished product and can be traced to it easily and economically. Examples:

timber in a wooden chair,
steel sheet and tyres in a car,
flour and sugar in a bakery,
purchased circuit boards in a television.

Small items such as glue, screws or lubricants physically end up in the product too. Tracing them unit by unit would cost more than it's worth, so they are usually treated as indirect materials and moved into overhead.

Direct labour

Direct labour is the pay of workers who work hands-on with the product: machine operators, assemblers, welders, painters on the line. Wages, and in many firms the related payroll taxes and fringe benefits, are included. Supervisors, maintenance staff, forklift drivers and quality inspectors are a different story. Their work supports production as a whole and can't be linked to individual units, so their pay falls under indirect labour.

In heavily automated plants direct labour has shrunk to a small slice of total cost. Some companies have stopped tracking it separately altogether and fold it into overhead.

Manufacturing overhead

Manufacturing overhead (also factory overhead or factory burden) is every manufacturing cost that is neither direct material nor direct labour. Typical items:

indirect materials (cleaning supplies, small tools, lubricants),
indirect labour (supervisors, maintenance crews, material handlers, quality control),
depreciation of factory buildings and machinery,
factory rent, property taxes and insurance,
utilities used for production (power, heating, water, compressed air),
repairs and maintenance of equipment,
costs of the production planning and engineering departments located at the plant.

Overhead is the troublesome component. It can't be traced to units, part of it is fixed and part variable, and it has to be spread over products by some allocation rule. Most of the disputes in cost accounting are, at bottom, disputes about overhead.

Two combined measures appear constantly in practice. Prime cost is direct materials plus direct labour. Conversion cost is direct labour plus manufacturing overhead, i.e. the cost of turning materials into product.

Formula of manufacturing cost

Total manufacturing cost for a period is simply the sum of its three elements:

\[\text{Total manufacturing cost} = \text{Direct materials used} + \text{Direct labour} + \text{Manufacturing overhead applied}\]

Direct materials used is not the same as materials purchased. Inventory changes have to be taken into account:

\[\text{Direct materials used} = \text{Beginning raw materials} + \text{Purchases} - \text{Ending raw materials}\]

Formula of cost of goods manufactured

Total manufacturing cost tells you what was spent in the factory this period. It doesn't tell you the cost of units actually finished, because some work started last period and some of this period's work is still on the floor. The cost of goods manufactured (COGM) adjusts for work-in-process inventory^[1]:

\[\text{COGM} = \text{Total manufacturing cost} + \text{Beginning WIP} - \text{Ending WIP}\]

COGM then flows into finished goods. Once those goods are sold, their cost becomes cost of goods sold:

\[\text{COGS} = \text{Beginning finished goods} + \text{COGM} - \text{Ending finished goods}\]

Dividing COGM by the number of units completed gives the average manufacturing cost per unit.

Example of manufacturing cost

The following example is hypothetical. All figures are invented for illustration.

A small furniture workshop makes one model of wooden chair. Data for March:

raw materials: beginning inventory $20,000, purchases $150,000, ending inventory $25,000,
direct labour: 4,000 hours at $25 per hour,
overhead: indirect materials $12,000, indirect labour $30,000, factory rent $18,000, depreciation of machines $15,000, utilities $9,000, maintenance and insurance $6,000,
work in process: beginning $40,000, ending $35,000,
units completed in March: 10,000 chairs.

Item	Amount ($)
Beginning raw materials	20,000
+ Purchases of raw materials	150,000
− Ending raw materials	25,000
Direct materials used	145,000
Direct labour (4,000 h × $25)	100,000
Indirect materials	12,000
Indirect labour	30,000
Factory rent	18,000
Depreciation of machines	15,000
Utilities	9,000
Maintenance and insurance	6,000
Manufacturing overhead	90,000
Total manufacturing cost	335,000
+ Beginning work in process	40,000
− Ending work in process	35,000
Cost of goods manufactured	340,000

The chairs finished in March cost $340,000 ÷ 10,000 = $34.00 per unit. Prime cost was $145,000 + $100,000 = $245,000; conversion cost was $100,000 + $90,000 = $190,000.

Note what's missing. The workshop's sales commissions, delivery van and office rent never appear in this schedule. They are real costs, of course. They just aren't manufacturing costs.

Product costs vs period costs

The manufacturing / non-manufacturing line drives the most basic split in cost accounting^[2]:

Product costs (inventoriable costs) are all manufacturing costs. They attach to units and sit on the balance sheet as inventory (raw materials, WIP, finished goods) until the goods are sold. Only then do they hit the income statement as cost of goods sold.
Period costs are selling, general and administrative expenses. They are expensed in the period in which they are incurred, regardless of how many units are produced or sold.

Why does it matter? Timing. A factory that produces more than it sells parks part of this year's manufacturing cost in inventory, and that cost won't reduce profit until next year. A marketing campaign gets no such deferral.

Financial reporting rules lean on the same distinction. Under IAS 2, "the cost of inventories includes all costs of purchase, costs of conversion (direct labour and production overhead) and other costs incurred in bringing the inventories to their present location and condition" (IFRS Foundation, IAS 2)^[3]. The standard keeps selling costs and administrative overheads that don't contribute to bringing inventories to their present location and condition out of inventory, and abnormal amounts of wasted materials, labour or other production costs are expensed as well. Fixed production overhead is allocated to units on the basis of normal capacity; overhead that goes unallocated in a low-output period is expensed rather than piled onto fewer units.

Absorption costing vs variable costing

There are two ways of deciding which manufacturing costs belong to a unit of product (Drury 2017)^[4].

Absorption costing (full costing) assigns all manufacturing costs to products: direct materials, direct labour, variable overhead and fixed overhead. It's the method required for external financial statements under IFRS and US GAAP.

Variable costing (also direct or marginal costing) assigns only variable manufacturing costs to products. Fixed manufacturing overhead is treated as a period cost and written off in full each period. The income statement is arranged around contribution margin, which suits internal decisions on pricing, product mix and make-or-buy.

The difference shows up whenever production and sales volumes differ. A hypothetical illustration: a firm makes 10,000 units and sells 8,000 at $40 each. Variable manufacturing cost is $20 per unit, fixed manufacturing overhead $50,000, variable selling cost $2 per unit and fixed selling and administrative cost $30,000. There's no opening inventory.

	Absorption costing ($)	Variable costing ($)
Unit product cost	25 (20 + 50,000/10,000)	20
Sales (8,000 × $40)	320,000	320,000
Cost of goods sold	200,000 (8,000 × 25)	160,000 (8,000 × 20)
Variable selling cost (8,000 × $2)	16,000	16,000
Fixed manufacturing overhead expensed	included in COGS	50,000
Fixed selling and administrative cost	30,000	30,000
Operating income	74,000	64,000
Ending inventory (2,000 units)	50,000	40,000

The $10,000 gap equals the fixed overhead carried in ending inventory under absorption costing: 2,000 units × $5. Same factory, same month, two profit figures.

Here's the catch. Under absorption costing a manager can raise reported profit simply by producing more than the market takes, because fixed overhead gets parked in the warehouse. Variable costing removes that temptation, which is one reason many companies use it for internal reports while keeping absorption costing for the published accounts.

Cost allocation and activity-based costing

Direct materials and direct labour are traced. Overhead has to be allocated. The traditional method uses a single plant-wide predetermined overhead rate:

\[\text{Predetermined overhead rate} = \frac{\text{Estimated manufacturing overhead}}{\text{Estimated amount of allocation base}}\]

The allocation base is usually direct labour hours, machine hours or direct labour cost. Each product is then charged overhead in proportion to the base it consumes. Departmental rates, one for each production department, refine the picture somewhat. For the wider question of how shared costs are spread over departments and products, see cost allocation.

Simple, but often wrong. In Relevance Lost (1987), H. Thomas Johnson and Robert S. Kaplan argued that management accounting had become subordinate to the needs of financial reporting and no longer gave managers timely, accurate cost information^[5]. A year later Robin Cooper and Kaplan showed how volume-based allocation distorts product costs: high-volume, standard products end up subsidising low-volume, complex ones, because many overhead costs (setups, engineering changes, purchasing, material handling) are driven by batches and product variety rather than by labour hours (Cooper, Kaplan 1988)^[6].

Their remedy, activity-based costing (ABC), works in two stages:

overhead costs are assigned to activities (machine setup, inspection, order processing, material movement),
activity costs are assigned to products according to the cost drivers each product consumes (number of setups, inspections, orders, moves).

ABC often reveals that a "profitable" niche product actually loses money. The information also feeds activity-based management, where the goal shifts from measuring costs to cutting the activities that cause them.

Early ABC systems proved expensive to build and maintain, since they relied on interviews and employee time surveys. Kaplan and Steven Anderson responded with time-driven ABC, which needs only two estimates: the cost per time unit of supplying capacity and the time each activity takes (Kaplan, Anderson 2004)^[7].

Ways to reduce manufacturing cost

Knowing the cost is one thing. Lowering it is another. Common approaches:

Materials - renegotiating supplier contracts, consolidating purchases, standardising components across product lines, reducing scrap and rework.
Product design - value engineering strips out features and parts that add cost without adding value for the customer. Much of a product's cost is locked in at the design stage, long before production starts.
Process - lean manufacturing attacks waste such as overproduction, waiting, unnecessary transport and defects. Shorter setups allow smaller batches.
Inventory - just-in-time delivery cuts storage, handling and obsolescence costs, along with the capital tied up in WIP.
Capacity - spreading fixed overhead over higher output lowers unit cost, as long as the extra units can be sold (otherwise see the absorption costing trap above).
Labour productivity - training, better tooling, ergonomic workstations, selective automation.
Energy - for energy-intensive processes, efficiency measures and better scheduling of peak loads can lower overhead noticeably.

Advantages of tracking manufacturing cost

Inventory and cost of goods sold can be valued in line with accounting standards.
Unit costs give a floor for pricing and a basis for cost-plus contracts.
Profitability can be compared across products, customers and plants.
Make-or-buy and outsourcing decisions rest on actual numbers rather than guesswork.
Comparing actual with budgeted or standard costs highlights variances early.
Separating the three components shows where cost reduction effort should go first.
Understanding cost behaviour (which costs move with volume and which don't) improves budgeting and capacity planning.

Limitations of manufacturing cost

Allocation is arbitrary. Any unit cost that includes fixed overhead depends on the chosen allocation base. Change the base and the "cost" of a product changes too.
Volume distortion. Under absorption costing, unit cost falls as output rises, which can encourage overproduction and inventory build-up.
Historical focus. Actual cost records describe the past. Decisions need future and incremental costs, which may differ sharply.
Narrow scope. Manufacturing cost ignores design, distribution, marketing and after-sales costs. A product may look cheap to make yet be expensive to sell or support.
Classification grey zones. Whether a supervisor's salary, a setup worker or factory IT support is direct, indirect or non-manufacturing is partly a judgement call, and different firms decide differently. Cross-company comparisons suffer.
Cost of the system itself. Detailed job costing or ABC requires data collection that small firms may find too expensive.

Related concepts

Cost of production - a broader term, often used in economics, for all costs of producing output; see cost of production.
Job order costing vs process costing - job costing accumulates manufacturing cost by individual order (furniture, machinery, printing), while process costing averages it over large volumes of identical units (cement, chemicals, beverages).
Standard costing - predetermined costs per unit used as benchmarks; differences between standard and actual manufacturing cost are analysed as variances.
Target costing - starts from the market price, subtracts the desired margin, and treats the result as the maximum allowable cost that design and production must meet.
Life-cycle costing - tracks costs from research and development through disposal, not just in the factory.

References

Cooper R., Kaplan R.S. (1988), Measure Costs Right: Make the Right Decisions, Harvard Business Review, September-October 1988
Datar S.M., Rajan M.V. (2018), Horngren's Cost Accounting: A Managerial Emphasis, 16th edition, Pearson, Boston
Drury C. (2017), Management and Cost Accounting, 10th edition, Cengage Learning, Andover
Garrison R.H., Noreen E.W., Brewer P.C. (2021), Managerial Accounting, 17th edition, McGraw-Hill Education, New York
IFRS Foundation (2003), IAS 2 Inventories, International Accounting Standards Board, London
Johnson H.T., Kaplan R.S. (1987), Relevance Lost: The Rise and Fall of Management Accounting, Harvard Business School Press, Boston
Kaplan R.S., Anderson S.R. (2004), Time-Driven Activity-Based Costing, Harvard Business Review, November 2004

Footnotes

↑ Datar S.M., Rajan M.V., Horngren's Cost Accounting: A Managerial Emphasis, Pearson, 2018
↑ Garrison R.H., Noreen E.W., Brewer P.C., Managerial Accounting, McGraw-Hill Education, 2021
↑ IFRS Foundation, IAS 2 Inventories, International Accounting Standards Board, 2003
↑ Drury C., Management and Cost Accounting, Cengage Learning, 2017
↑ Johnson H.T., Kaplan R.S., Relevance Lost: The Rise and Fall of Management Accounting, Harvard Business School Press, 1987
↑ Cooper R., Kaplan R.S., Measure Costs Right: Make the Right Decisions, Harvard Business Review, 1988
↑ Kaplan R.S., Anderson S.R., Time-Driven Activity-Based Costing, Harvard Business Review, 2004

Manufacturing cost — recommended articles

Cost of production — Manufacturing overhead — Direct material — Direct labor — Product cost — Conversion cost — Overhead rate — Cost allocation — Activity-based management — Lean manufacturing