The Inventory-Cost Connection: Extra Steps for Manufacturers
Not only do manufacturers need extra steps to figure out their product costs; they also have to deal with three distinct types of inventory: raw materials, work in progress, and finished goods. Raw materials inventory includes any untouched building blocks that you will eventually use to create your products. Work in process includes partially made products, whether they’re in the very earliest stages of production or almost to the end. Finished goods include products that are ready to be sold right now. Each of these distinct inventory groups will be valued, using one of the four valuation methods discussed in the previous section.
In addition to more steps, manufacturers’ product costs also have more components. Not only do you count the physical pieces that go into the final product; you also count the work it takes to create that product, as well as some more indirect creation expenses.
These three pieces of the cost puzzle are split out as follows:
- Direct materials
- Direct labor
- Manufacturing overhead
Direct materials include the basic raw materials you need to make your product: wood to build tables, flour to bake cakes, rubber to make tires. Direct labor includes the wages of the people who actually make your products. Manufacturing overhead involves things that you need to create your finished goods but that can’t be directly linked to the process. Common costs included here would be such things as lubricants, the electricity it takes to run the machinery, and factory supervisors’ salaries. You include these indirect costs because your products couldn’t be made without them.