Let's start by introducing our Cost Elements.

The cost elements in our manufacturing process are 1) Direct Materials, 2) Direct Labor and 3) Overhead Costs.

Direct Materials Costs – these are the cost of materials that are directly used in the production of goods and can be identified properly in the finished product. For example, in the manufacture of wooden chairs, the direct materials are the pieces of wood used and nails. The costs of these would form part of direct materials cost.

Direct Labor Costs – these are the salaries and wages paid to people who actually worked in the production process. This is usually payment to factory workers. In essence, it is the cost of labor that is directly involved in producing the goods.

Overhead Costs – these are the indirect materials and indirect labor incurred in connection with the production process, as well as other costs incurred in the production department. Examples are wages of factory maintenance personnel, depreciation expenses for the factory machineries, equipment and building, and utilities used in the production process. It also includes other supplies used in production such as glue, paint, adhesive, wires, straws, the small tools used in production that are expensed within the year like hammer, screw drivers, and the like.

All of these costs should be related to the production process. Adding these three costs will give you the TOTAL MANUFACTURING COSTS.

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If you have purchased office supplies, it won’t form part of the manufacturing costs.

If you have store managers, office supervisors, bookkeeper, sales representatives, and maintenance personnel in the office, their salaries and wages won’t form part of the manufacturing costs.

If you have a building being used as office, or store, and equipment used in the office, these won’t form part of the manufacturing costs.

These would be included in your Administrative and selling expenses.

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So, let us look at our income statement for a manufacturing process:

We have to compute first for the Cost of Sales. If you remember your Manufacturing Company’s Income Statement, you would be familiar with this.

Our Manufacturing cost elements are essential. They make up the Total Manufacturing Costs. And this is used in the computation of Cost of Sales. The significance of cost of sales computation lies in setting the price of the product, usually. And in projecting the profit the product will contribute to the company, which will be used in budgeting the resources of the company efficiently.

This practically snowballs to the other departments. The point being, it all starts with the cost of sales before a company starts deciding on other matters.