All types of organizations incur costs—governmental, not-for-profit, manufacturing, retail, and service. Generally, the kinds of costs that are incurred and the way in which these costs are classified depend on the type of organization. For this reason, we will consider in our discussion the cost characteristics of a variety of organizations—manufacturing, merchandising, and service.

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Our initial focus in this chapter is on manufacturing companies, since their basic activities include most of the activities found in other types of organizations. Manufacturing companies such as Texas Instruments, Ford, and DuPont are involved in acquiring raw materials, producing finished goods, marketing, distributing, billing, and almost every other business activity. Therefore, an understanding of costs in a manufacturing company can be very helpful in understanding costs in other types of organizations.

Manufacturing Costs

Most manufacturing companies separate their manufacturing costs into three broad categories: direct materials, direct labor, and manufacturing overhead. A discussion of each of these categories follows.

Direct Materials   The materials that go into the final product are called raw materialsMaterials that are used to make a product.. This term is somewhat misleading, since it seems to imply unprocessed natural resources like wood pulp or iron ore. Actually, raw materials refers to any materials that are used in the final product; and the finished product of one company can become the raw materials of another company. One study of 37 manufacturing industries found that materials costs averaged about 55% of sales revenues.¹

Raw materials may include both direct and indirect materials. Direct materialsMaterials that become an integral part of a finished product and whose costs can be conveniently traced to it. are those materials that become an integral part of the finished product and whose costs can be conveniently traced to the finished product. This would include, for example, the seats that Airbus purchases from subcontractors to install in its commercial aircraft and the tiny electric motor Panasonic uses in its DVD players.

Sometimes it isn’t worth the effort to trace the costs of relatively insignificant materials to the end products. Such minor items would include the solder used to make electrical connections in a Sony TV or the glue used to assemble an Ethan Allen chair. Materials such as solder and glue are called indirect materialsSmall items of material such as glue and nails that may be an integral part of a finished product but whose costs cannot be easily or conveniently traced to it. and are included as part of manufacturing overhead, which is discussed later in this section.

Direct Labor   Direct laborLabor costs that can be easily traced to individual units of product. Also called touch labor. consists of labor costs that can be easily (i.e., physically and conveniently) traced to individual units of product. Direct labor is sometimes called touch labor, since direct-labor workers typically touch the product while it is being made. Examples of direct labor include assembly-line workers at Toyota, carpenters at the home builder Kaufman and Broad, and electricians who install equipment on aircraft at Bombardier Learjet.

Labor costs that cannot be physically traced to the creation of products, or that can be traced only at great cost and inconvenience, are termed indirect laborThe labor costs of janitors, supervisors, materials handlers, and other factory workers that cannot be conveniently traced to particular products.. Just like indirect materials, indirect labor is treated as part of manufacturing overhead. Indirect labor includes the labor costs of janitors, supervisors, materials handlers, and night security guards. Although the efforts of these workers are essential to production, it would be either impractical or impossible to accurately trace their costs to specific units of product. Hence, such labor costs are treated as indirect labor.

Major shifts have taken place and are taking place in the structure of labor costs in some industries. Sophisticated automated equipment, run and maintained by skilled indirect workers, is increasingly replacing direct labor. Indeed, direct labor averages only about 10% of sales revenues in manufacturing. In some companies, direct labor has become such a minor element of cost that it has disappeared altogether as a separate cost category. Nevertheless, the vast majority of manufacturing and service companies throughout the world continue to recognize direct labor as a separate cost category.

Manufacturing Overhead   Manufacturing overheadAll manufacturing costs except direct materials and direct labor., the third element of manufacturing cost, includes all costs of manufacturing except direct materials and direct labor. Manufacturing overhead includes items such as indirect materials; indirect labor; maintenance and repairs on production equipment; and heat and light, property taxes, depreciation, and insurance on manufacturing facilities. A company also incurs costs for heat and light, property taxes, insurance, depreciation, and so forth, associated with its selling and administrative functions, but these costs are not included as part of manufacturing overhead. Only those costs associated with operating the factory are included in manufacturing overhead. Across large numbers of manufacturing companies, manufacturing overhead averages about 16% of sales revenues.²

Various names are used for manufacturing overhead, such as indirect manufacturing cost, factory overhead, and factory burden. All of these terms mean the same thing as manufacturing overhead.

Nonmanufacturing Costs

Nonmanufacturing costs are often divided into two categories: (1) selling costs and (2) administrative costs.

Selling costsAll costs that are incurred to secure customer orders and get the finished product or service into the hands of the customer.include all costs necessary to secure customer orders and get the finished product into the customer’s hands. These costs are often called order-getting and order-filling costs. Examples of selling costs include advertising, shipping, sales travel, sales commissions, sales salaries, and costs of finished goods warehouses.

Administrative costsAll executive, organizational, and clerical costs associated with the general management of an organization rather than with manufacturing or selling. include all executive, organizational, and clerical costs associated with the general management of an organization rather than with manufacturing or selling. Examples of administrative costs include executive compensation, general accounting, secretarial, public relations, and similar costs involved in the overall, general administration of the organization as a whole.

Nonmanufacturing costs are also often called selling and administrative costs.

² J. Miller, A. DeMeyer, and J. Nakane, Benchmarking Global Manufacturing (Homewood, IL: Richard D. Irwin), Chapter 2. The Boer and Jeter article previously cited contains a similar fi nding concerning the magnitude of manufacturing overhead.