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The main items of costs shown on the income
statement are factory costs which include direct materials, direct labor and factory overhead; and selling and administrative expenses. A breakdown of costs is shown in Figure 17.2.2.
Materials The cost of materials purchased is recorded from purchase invoices. When the materials are used in the factory, an assumption must be made as to cost flow, that is, whether to charge them to operations at average prices, at costs based on the first-in, first-out method of costing, or at costs based on the last-in, first-out method of costing. Each method will lead to a different cost figure, depending on how prices change. Each situation must be studied individually to determine which practice will give a maximum of accuracy in cost figures with a minimum of accounting and clerical effort. Once the choice has been made, records must be set up to charge materials to operations based on requisitions. Indirect material is necessary to the completion of the product, but its consumption with regard to the final product is either so small or so complex that it would be futile to treat it as a direct-material item.
Labor
Labor also consists of two categories: direct and indirect. Direct labor, also called productive labor, is expended immediately on the materials comprising the finished product. Indirect labor, in contrast to direct labor, cannot be traced specifically to the construction or composition of the finished product. The term includes the labor of supervisors, shop clerks, general helpers, cleaners, and those employees engaged in maintenance work.
Factory Overhead Indirect materials or factory supplies and indirect labor constitute an important segment of factory overhead. In addition, costs of fuel, power, small tools, depreciation, taxes on real estate, patent amortization, rent, inspection, supervision, social security taxes, health and accident insurance, workers’ compensation insurance, and many others fall into this large category. These expenses must be collected and allocated to all jobs or units produced. Many expenses are definitely applicable to a specific department and are easily assigned thereto. Other expenses relate to the entire plant and must be prorated to departments on some suitable basis. For instance, heat might be prorated to departments on the basis of volume of space occupied. The expenses of the service departments are prorated to the producing departments on some basis such as service rendered in the case of a maintenance department or so much dollar payroll processed in the case of a cost department.
The charging of factory overhead to jobs or products is accomplished by means of an overhead or burden rate. This rate is essentially a ratio computed to show the relationship of the total burden of a department to some other easily measurable total figure for the department. For example, the total burden cost of a department may be divided by its directlabor cost to give a percentage-of-direct-labor rate. This percentage applied to the direct-labor cost of a job or a product gives the amount of overhead chargeable thereto. Other common types of burden rates are the labor-hour rate (departmental expenses 4 total direct-labor hours) and the machine-hour rate (departmental expenses 4 total machine hours available). Labor rates are most commonly used. When, however, machines perform the greater amount of the work, machine-hour rates give better results. It must be clearly understood that these rates are computed in advance of production, generally at the beginning of the year. They are used throughout the fiscal period unless seasonal fluctuations or unusual changes in expense amounts necessitate the creation of a new rate. The determination of the overhead rate is closely tied up with overhead budgets.
