From the course: Accounting Foundations

Product costing: Materials and labor

From the course: Accounting Foundations

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Product costing: Materials and labor

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- One important function of managerial accounting is computing the internal cost of providing our products or our services. Let's do an illustration. We're in a hypothetical company, Ryan Furniture Company. Ryan Furniture manufactures custom made wood furniture. Now, what does it take to make wood furniture? What do you need? Well, you need some wood, but what else do you need? We want to compute the cost of all the things required to make wood furniture. We are here at Ryan Furniture Company. It's August 17th. A customer comes in and orders one custom made dining table, a beautiful piece of work made out of oak. The customer says, "I'm going around to various furniture makers, describing to them the table that I want. I need a bid. How much will you charge me to make this table for me?" If I want to make an intelligent bid, I'd better first figure out how much it will cost me to make that table. First, making the table will require some wood. In a managerial accounting setting, we call this cost direct materials. This is the actual stuff that the item is made out of. In this case, it's wood. If we were making automobiles, the direct materials cost would be metal and rubber, and the other things that go into making automobiles. The direct materials cost is pretty easy to estimate. You describe the size of the table and the design and the type of the wood, oak, in this case, and our experienced people can figure out how much wood will be required. Let's say that the wood will cost me about $1,000. By the way, I'm not telling any of this to the customer. I'm doing this privately in the back room. Direct material cost is about $1,000, but the wood doesn't form itself into a table. In this case, let's say that the number of worker hours to make the table is about 30 hours. In managerial accounting, we call these people the direct labor people. They are the skilled craftspeople who actually do the work. This project will take my skilled craftspeople 30 hours, and I pay them a wage rate of $30 per hour, so the estimate of the direct labor cost is $900. The direct material cost is $1,000 and the direct labor cost is $900. These two numbers are easy. Anybody who makes furniture can easily estimate the amount of direct materials, the amount of oak in this case, that is required to make this table. The number of hours required for the direct labor hour people to complete the table, that's also easily estimated. Okay, am I done? Well, if I go out into the desert somewhere with a pile of wood, and have some workers, do I have myself a nice, custom made dining table? No, I need infrastructure. I need a building, and some machines and electricity, and some supervisors and some maintenance people. These costs are called overhead costs, and it's a bit more difficult to figure out how much of say the supervisor cost should be assigned to this table and that bookcase in the corner and that desk on the far side of the room. Overhead cost is difficult to track to individual projects or processes or customers. The three categories of product costs are direct materials, direct labor, and overhead. The cost of direct materials and direct labor is relatively easy to trace to individual products. Overhead is more difficult, and so it merits a separate discussion.

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