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Manufacturing Cost Breakdown Pt. 1

Updated on January 27, 2014

Cost of Goods Manufactured Vs. Cost of Goods Sold

Cost of Goods Manufactured is Direct Materials, Direct Labor, and Manufacturing Overhead added together to create Work in Progress. Work in Progress (WIP) is the partly built product before it becomes a Finished Good. Finished Goods (FG) are the completed product that was built using Direct Materials, Direct Labor, and Manufacturing Over Head. WIP and FGs are added to the balance sheet until sold, where it will then be moved to the income statement at the time of sale and labeled Cost of Goods Sold.

COGM Vs. COGS

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Sample Bill of Materials

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DNA of Manufacturing Cost

Manufacturing cost is a very import part of managerial accounting in an organization as it allows for planning, controlling, and decision making by management. Managers need to understand three important elements of manufacturing cost to make good decisions for the organization. Manufacturing cost is broken up into three different buckets to really isolate cost related to building a profit. The three buckets of manufacturing cost are Direct Materials, Direct Labor, and Manufacturing Over Head, which we will identify as the DNA of manufacturing cost.

Direct Materials - The materials involved in directly creating or building a product that are considered variable cost. These are what some call raw materials. The direct materials involved in building the product are usually found on a bill of materials. A bill of materials is a list of items needed to build a product correctly. Direct materials are not the items used in a manufacturing environment to clean the product like rags, cleaning supplies, or lubricants that are not on the actual bill of materials, rather they are indirect items used in the manufacturing environment to support building the products. Direct Materials are the physical materials that you can see and easily locate on a product.

Example:

  • The wood, legs, and metal trim to build a table would be considered direct materials, but nails and glue would be considered indirect materials

Bill of Materials:

  1. Wood table top 1pc.
  2. Metal Trim 4pcs.
  3. Table legs 4pcs.


Direct Labor - The labor directly involved in creating or building a product that can be directly linked to a time card showing the time it took to create or build the product that is consider a variable cost in the cost accounting world. This is the labor that you would see actually putting the product together using tools on the manufacturing floor of any organization. The labor directly building the product will punch in and out when building the product to help track the time it took to build the product. This will allow management to see how much time and money it is taking to directly build the product. Direct labor is not linked the administration staff in the office, it is not the maintenance team on the floor fixing the equipment, and it is not the leadership team coordinating with the direct labor on the floor to build the product. Direct labor is the actual work force building the product with their own hands and tools.

Example:

  • The assembler taking the 16 nails and the 4 legs with a hammer or screw gun to attach them to the table top that is listed on the bill of materials.
  • The assembler taking the 4 pieces of trim with a hammer to attach them to the table top.

Time Card:

  1. 7:00am Punch In
  2. 8:00am Punch Out
    1 Hour of direct labor to build one complete table using the Bill of Materials.


Manufacturing Over Head:
Manufacturing overhead is a bucket of items not directly related to building the product. It is made up of mixed cost containing both variable and fixed cost items within its bucket. Often this will be called indirect labor or indirect parts. These items are still needed to manufacture parts, but they are not directly used to build the product. The items are bucketed into this category to fully understand the separation of direct items compared to indirect items. These indirect items are still an important part of building the product because these items are inclusive of rent, electricity, insurance, indirect labor, indirect parts, and several others that make up the over head. On a financial report it will be separated into many different categories, but it will all be summed together as manufacturing overhead.

Example:

January to February

  • Indirect Labor $12,000
  • Supplies and Perishable Tools $ 2,000
  • Rent $ 4,000
  • Electricity $ 1,000
  • Insurance $ 500

Total Manufacturing Overhead $19,500





Cost of Goods Manufactured

Cost of Goods Manufactured (COGM) is the three categories of manufacturing cost we discussed earlier added together. COGM will be on the balance sheet as WIP or FGs until it is sold.

Example:

  • COGM = Direct Materials + Direct Labor + Manufacturing Over Head
  • $5,000 = $1,000 + $2,000 + $2,000
    So the Cost of Goods Manufactured is $5,000

Cost Flow

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Product Cost Vs. Period Cost

Product Cost

Product cost is the manufacturing cost related to the direct creation of what ever product is be manufactured. Product Cost are made up of inventory cost, asset account cost, depreciation cost, direct manufacturing cost, work in progress (WIP), cost of goods manufactured (COGM), and finished goods (FG), which can all be found on the balance sheet as an asset.

Period Cost

Period cost is the non-manufacturing cost associated with manufacturing a product. Period cost are selling cost and administrative cost in the organization not directly related to the manufacturing of the product. Selling cost include all cost that are incurred while trying to secure customer orders and/or getting the product to the customer. Administrative cost are the cost associated with the organization's executives salaries, secretary wages, human resource department salaries, and the sales staff wages/commissions. These cost can be found on the income statement during the period it was incurred.

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Prime Cost and Conversion Cost

Prime Cost

Prime cost is the sum of direct materials cost and direct labor cost.

Example:

  • PC = DM + DL
  • $3,000 = $1,000 + $2,000


Conversion Cost

Conversion Cost is the sum of direct labor and manufacturing overhead.

Example:

  • CC = DL + MOH
  • $4,000 = $2,000 + $2,000

Variable and Fixed Graph

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Mixed Cost Graph

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Three Types of Costs

There are three types of cost that you must be familiar with in order to make good decisions in cost accounting, and you must understand how to compute them to make educated decisions about the organization's position.

Variable Cost

Variable cost is a cost that varies with the level of output in building the product. The cost varies according to the activity level of the inputs that lead to outputs. Activity Base is the measure of whatever causes the occurrence of a variable cost. Variable cost are the cost that vary depending on a company's production volume, when the volume rises in production the variable cost increase, and when the volumes fall in production the variable costs decrease. The unit cost will stay the same with variable cost no matter if production rises or falls.

Fixed Cost

Fixed cost is that cost that remains constant in total, regardless, of any changes in the activity level. The cost does not account for activity level as it does in the variable cost. The company's rise and fall in production have no toll on fixed cost. Fixed cost are items that manufacturing needs to produce a product like rent cost, insurance cost, straight line depreciation cost, property taxes cost, and supervisor salaries cost. The unit cost will increase and decrease with the rise and fall of production levels.

Mixed Cost

Mixed cost is a mixture of variable cost and fixed cost also known as semi-variable cost. A good example of mixed cost is a salesman's salary that is fixed and a salesman's commission pay that is variable based on his/her sales in a certain period. These costs together equal a mixed cost.





Acronyms

VC = Variable Cost

FC = Fixed Cost

MOH = Manufacturing Over Head

OP = Operating Profit

UC = Unit Cost

COGM = Cost of Goods Manufactured

COGS = Cost of Goods Sold

TC = Total Cost

GP = Gross Profit

CM = Contribution Margin

HC = Highest Cost

LC = Lowest Cost

HU = Highest Units

LU = Lowest Units

Sample of Contribution Format

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Contribution Accounting Format

The contribution accounting format is used by managers as a tool for decision making for the future state of the business. It addresses the decision makers and shareholders as it gives them specific details of how the business is doing. This format makes it easier for decision makers to see what the current state of the business is, to see if the business should stay in business, and to see what actions are needed to keep the business profitable. It is future driven, which in turn helps managers make better decisions for the future.

Example:

Sales ___________$10,000

VC _____________$ (2,000)

CM______________$ 8,000

FC _____________$ (3,000)

Net OP __________$ 5,000

In this example, the company is profitable and should stay in business as they are making money after there variable and fixed cost.


Example of Rise Over Run Formula

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Example Chart to Use For High Low Method Formula *not related to article problem*

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High & Low Method

We use the high & low method in manufacturing to determine cost. It is based on the rise over run formula for the slope of a straight line, which is an algebraic formula. The point is to pull the highest and lowest numbers from a list of costs and units to determine the true cost of any item. Use the historical income statements for finding the needed figures.

Example:

  • Highest Cost - $60,000
  • Lowest Cost - $15,000
  • Highest Units - 30,000
  • Lowest Units - 10,000

Rise = HC - LC

$45,000 = $60,000 - $15,000

Run = HU - LU

20,000 = 30,000 - 10,000

Take the highest cost and subtract the lowest cost to get the Rise. Take the highest units and subtract the lowest units to get the run. remember the Rise and Run for the next step of the High Low Method.

Unit Cost

UC = Rise / Run

$2.25 = $45,000 / 20,000

So the cost per unit is $2.25 by taking the rise divided by the run. Remember the unit cost number as you will need it to figure out the variable cost and the fixed cost of manufacturing the products.

Variable Cost

VC = HU x UC

$67,500 = 30,000 x $2.25

or

VC = LU x UC

$22,500 = 10,000 x $2.25

The variable cost is figured by taking the total highest and/or lowest units and multiplying it by the unit cost. Remember the variable cost as you will need it to figure the fixed cost.

Fixed Cost

FC = HC - HVC


$7,500 = $60,000 - $67,500

or

FC = LC - LVC

$7,500 = $15,000 - $22,500

The fixed cost is figured by taking the highest and/or lowest cost and subtracting the highest variable cost or the lowest variable cost. Make sure that the highest and the lowest figures stay together. Never use the highest figures with the lowest figures, or you will get a wrong answer.

As you can see the Variable and Fixed Cost stay the same. If these two numbers are different, then something was figured wrong.

Remember, the fixed cost will increase or decrease with production activity levels rising and falling. Variable cost will not ever increase or decrease with production levels rising and falling as it will stay constant with any production level, unless factors in direct materials, direct labor, or over head activity increases and decreases due to rising materials prices and/or labor salaries.














How does it All Come Together? Watch this very informative video I found on You Tube as this Professor really explains it well.

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    • Lean Dream profile image
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      Daniel J. Carr 3 years ago from Sacramento, CA

      I hope you find this article helpful. Please comment on the article so I can improve on my future articles. I really want to help the new manager entering a new managerial role, and refresh those managers who have been out of work for a while. I will be creating more parts to this lesson as time permits. Please enjoy and offer feedback as I welcome it.

      Thanks

    • profile image

      Management411 3 years ago

      This was informative as it all helps a manager better understand what the break down is. It's hard to teach this topic, and you have created a great break down on this topic.

    • Lean Dream profile image
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      Daniel J. Carr 3 years ago from Sacramento, CA

      Thanks for reading my Hub Page. I will have another hub to follow this Hub that will be based around Job Costing Sheets. I hope it will help you as well in your adventures in Management!

    • DestinySuccess profile image

      DestinySuccess 3 years ago from Folsom, California

      This was a very informative and helpful article. This is also very useful!

    • Lean Dream profile image
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      Daniel J. Carr 3 years ago from Sacramento, CA

      Thank you for reading my Hub Page. Please follow me, and stay tuned for more articles.

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