Manufacturing costs: direct and indirect costs
A manufacturer's costs are direct (materials, labour, expenses) or indirect (factory overheads). Together they make the cost of production; office and selling costs are period costs.
Product costs and period costs
A trading business buys goods ready to sell. A manufacturing business converts raw materials into finished goods, so it must work out what its goods cost to make. Direct costs can be traced to each unit: direct materials (fabric in a shirt), direct labour (wages of machine operators) and direct expenses (a royalty per unit). Indirect costs, or factory overheads, cannot be traced to one unit: supervisors' salaries, factory rent, factory power, depreciation of machines. Direct costs and factory overheads are product costs; office, selling and finance costs are period costs, charged straight to the income statement.
Classifying the costs of a garment factory
| Cost | Classification | Where it goes |
|---|---|---|
| Fabric used in shirts | Direct material | Manufacturing account (prime cost) |
| Wages of sewing machine operators | Direct labour | Manufacturing account (prime cost) |
| Royalty paid per shirt made | Direct expense | Manufacturing account (prime cost) |
| Thread, buttons, machine oil | Indirect materials | Factory overheads |
| Salary of the factory supervisor | Indirect labour | Factory overheads |
| Factory rent and electricity | Indirect expenses | Factory overheads |
| Depreciation of sewing machines | Indirect expense | Factory overheads |
| Salaries of office staff | Administration | Income statement (period cost) |
| Delivery van costs, advertising | Selling and distribution | Income statement (period cost) |
How manufacturing costs flow
Each stage has an opening and a closing inventory, so a manufacturer reports three inventories.
The accounting cycle for a manufacturing company
Why the split matters
- Prime cost shows the costs that rise and fall directly with output.
- Overheads must be shared among products to price them correctly.
- Product costs stay in inventory until the goods are sold; period costs reduce profit at once.
- Managers use the figures to control waste and set selling prices.
In a Sri Lankan apparel factory, such as those run by MAS or Hirdaramani, fabric and operators' wages are direct costs, while factory power, supervisors and machine depreciation are overheads. Getting this split right is how exporters price each order.
Short answer: “What is prime cost?” Direct materials + direct labour + direct expenses: the total of all direct costs of production.
Structured question: “Distinguish direct costs from indirect costs with examples from a manufacturing business.” Define each, give three examples of each from one factory, and show where each appears (prime cost or factory overheads).
Prime cost = DM + DL + DE. Add factory overheads for the cost of production. Office and selling costs never enter the manufacturing account.