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Direct Labor, Direct Materials, and Overhead
One of the things that makes accounting tricky is that many common everyday words have very precise definitions in accounting. "Depreciation" is one good example. "Overhead" is another. They are common words that everyone understands. But in accounting, the words have special meaning. In order to get your homework correct, you need to have a clear understanding of the precise definitions.
The definition of direct labor is pretty easy. Direct labor represents the people who do the core work of the business. For example, if the business is a construction company, direct labor would be the people actually constructing the building. They would be the people with hammers and saws in their hands. In a retail store, direct labor would be the people helping on the sales floor doing the basic work that takes place serving the customers. In a grocery bag factory, direct labor are the people running the machines actually making the bags. I think of direct labor as the people who make or build the product.
The Tricky Thing About Direct Labor
Determining if a person should be classified as direct labor can be tricky at times. This is especially so if the company operates on a "job order" basis. Job order businesses are common. Almost any time a product is customized for a customer, the company will operate on a "job order" basis. Some examples would include an auto mechanic shop, a construction company building custom homes, and the grocery bag factory. The grocery bag factory was always doing special orders for Safeway and other stores. Here is the trick with direct labor and job order companies.
The labor must clearly be associated with a particular job, in order for the labor to be called "direct labor."
Here is an example. A secretary in a large, custom home construction company will usually do a variety of things, but it is almost impossible to keep track of how or when the secretary benefits a certain custom home project when their are several projects going at the same time. Since the secretary's time cannot be assigned conveniently to any certain custom home, the secretary would not be considered direct labor.
Another example would be the inspector at the grocery bag factory. The inspector would go from machine to machine inspecting grocery bags to make sure their were not any defects in the bags. Although the inspector did an important job, it was impossible to assign the inspector's time to any particular customer's order. As a result, the inspector's labor was not considered direct labor.
One last thought... If a person's labor cannot be easily linked to a specific customer's order or the person does not directly build the product, the person's labor is called "indirect labor."
All of the materials that go into making a product are called "Raw Materials." Raw materials come in two flavors: Direct Materials and Indirect Materials.
Direct materials are the raw materials that become part of the product. For example, bricks, shingles, and bath tubs would be the direct materials when building a house. Paper would be a direct material when making grocery bags. Seems easy, but there is a catch.
The Catch with Direct Materials
In order for a raw material to be classified as a direct material, the amount of raw material must be easily counted or kept track of. Here is an example. When making grocery bags, it is pretty easy to keep track of the amount of paper being used for each bag, but it is very difficult to know exactly how much glue is being used to hold the paper bag together. Of course, if a person got a magnifying glass and really examined the bags, maybe the amount of glue could be determined. But would it be worth all of the time and effort? Compared to the paper, the glue is pretty inexpensive. Other than holding the bag together, the glue is rather insignificant. Sooooo..... The glue is not tracked on a product or job basis. It is just not worth the effort. Since the glue is not tracked on a product or job basis, the glue is not considered a direct material even though the glue is part of the product.
In a nutshell, direct materials are those materials that become part of the finished product... providing it is possible and worth the effort to keep track of those materials on a per product basis.
So what are raw materials called that are either not worth keeping close track of or are difficult to know exactly how much raw material is going into each product? Indirect materials. Indirect materials also include other materials used in the production process such as oil for machines, welding rods for repairs, sand paper for making tables, and any other small miscellaneous materials.
The definition for overhead is easy. Here it is......
If a cost is not direct labor or direct materials, the cost is overhead.
In other words, overhead is a multitude of different costs including indirect labor and indirect materials. Here are a few of many examples: electricity, property taxes, advertising, accounting, janitors, cleaning supplies, distribution costs, legal fees, interest, inspectors, human resources department, etc, etc, etc.
Life would be too easy if it were just that simple. There is one wrinkle. There is a distinction between between overhead and manufacturing overhead.
The generic term "overhead" can refer to all the costs in a company that are not direct labor or direct materials.
Manufacturing overhead means the same thing.... all costs except direct labor and direct materials. The difference is that manufacturing overhead refers to those costs closely related to the factory or production process. So here is a definition for manufacturing overhead:
Manufacturing overhead is everything (all costs) except direct labor, direct materials, administrative costs, and marketing costs.
So, manufacturing overhead does not include the president's salary, accountants, lawyers, interest expense, advertising, marketing, secretarial staff, distribution costs, income taxes, etc, and any other costs related to a company's administration. By the way, manufacturing overhead is what goes on the "Cost of Goods Manufactured Statement."
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