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Product costs are related to the products or services that generate an entity’s revenues.
These costs can be separated into three components: direct material, direct
labor, and production overhead.6 A direct cost is one that is distinctly traceable

to a specified cost object. A cost object is anything of interest or useful informational
value, such as a product, service, department, division, or territory. Costs
that must be allocated or assigned to a cost object using one or more predictors
or cost drivers are called indirect (or common) costs. Different cost objects may
be designated for different decisions. As the cost object changes, the costs that are
direct and indirect to it may also change. For instance, if a production division is
specified as the cost object, the production division manager’s salary is direct. If,
instead, the cost object is a sales territory and the production division operates in
more than one territory, the production division manager’s salary is indirect.


Direct Material
Any readily identifiable part of a product is called a direct material. Direct material
costs theoretically should include the cost of all materials used in the manufacture
of a product or performance of a service. However, some material costs are not
conveniently or practically traceable from an accounting standpoint. Such costs are
treated and classified as indirect costs. For example, in producing gallon-sized
kitchen storage bags (see Exhibit 3–3), the polyethylene raw material, dye to highlight
the bag zippers, and packaging for the bags are all costs for the materials
needed in production. Because the dye cost is not easily traceable or monetarily
significant to WF&B’s production cost, this cost may be classified and accounted
for as an indirect material and included as part of overhead.

Direct Labor
Direct labor refers to the individuals who work specifically on manufacturing a
product or performing a service. Another perspective of direct labor is that it
directly adds value to the final product or service. The chef preparing the meals
at the local restaurant and the dental hygienist at the dental clinic represent direct
labor workers.
Direct labor cost consists of wages or salaries paid to direct labor employees.
Such wages and salaries must also be conveniently traceable to the product or service.
Direct labor cost should include basic compensation, production efficiency
bonuses, and the employer’s share of Social Security and Medicare taxes. In addition,
if a company’s operations are relatively stable, direct labor cost should include
all employer-paid insurance costs, holiday and vacation pay, and pension
and other retirement benefits.

Overhead
Overhead is any factory or production cost that is indirect to manufacturing a product
or providing a service and, accordingly, does not include direct material and
direct labor. Overhead does include indirect material and indirect labor as well as
any and all other costs incurred in the production area.8 As direct labor has become
a progressively smaller proportion of product cost in recent years, overhead
has become progressively larger and merits much greater attention than in the past.
The following comments reflect these fundamental changes in the way manufacturing
is conducted:
Automation, technology and computerization have shifted costs, making
the typical manufacturing process less labor intensive and more capital intensive.
This shift has changed the cost profile of many industries. No longer do direct
materials and labor costs make up the major portion of total product cost.
Instead, overhead, which is shared by many products and services, is the dominant
cost.