1. Introduction and Objectives
To prepare compliant income statements and accurately value inventory for balance sheets, costs must be categorized by their organizational function and their traceability to the final product.
2. Functional Classifications
  • Manufacturing (Product) Costs: All costs incurred during the physical production process. Under both US GAAP and IFRS, these costs are capitalized into inventory (Work-in-Progress and Finished Goods) and hit the income statement only when the product is sold as Cost of Goods Sold (COGS).
    • Direct Materials: Raw materials that can be easily and economically traced to a specific unit of output.
    • Direct Labor: Wages paid to workers who physically touch and transform the raw material into the finished product.
    • Manufacturing Overheads (MOH): All indirect factory costs that support production but cannot be directly traced to specific units (e.g., factory utilities, factory janitor wages, machine lubricants).

  • Non-Manufacturing (Period) Costs: Costs incurred outside the production facility. These are expensed directly on the income statement in the accounting period they occur and are never capitalized into inventory.
    • Selling and Distribution Costs: Marketing, sales commissions, warehouse shipping, delivery fleet expenses.
    • Administrative Costs: Corporate executive salaries, legal fees, headquarters rent, HR department expenses.

3. Assignment and Traceability
  • Direct Costs: Easily, unambiguously, and cost-effectively traced to a specific cost object.
  • Indirect Costs: Cannot be directly or economically traced to a single cost object; they must be allocated using an overhead absorption rate or cost driver.

4. Core Cost Formulas
Prime Cost = Direct Materials + Direct Labor
Conversion Cost = Direct Labor + Manufacturing Overheads
 
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