Manufacturing cost concepts and a simple budget

A maker is not a reseller

Everything so far has assumed a trading business: it buys finished goods and sells them. Cost of sales is easy there, because someone else's invoice tells you what the goods cost.

A manufacturer has no such invoice. Lerato Mokoena makes candles in a small factory in Bloemfontein. Nobody sold her a candle. She bought wax, wicks and glass jars, paid people to pour and trim, and paid rent on the factory. Before she can price a candle or work out whether she is making money, she has to build the cost of one candle herself.

That is what cost accounting does: it collects the costs of making something and attaches them to the thing that was made.

Two ways of sorting a cost

The same cost gets sorted twice, for two different purposes.

Sort one: can you trace it to the product?

• Direct costs can be traced to each unit made. Direct materials are the wax, wicks and jars that end up in the candle. Direct labour is the wage of the person who pours and trims candles.
• Indirect costs, also called factory overheads, are needed to make the product but cannot be traced to any single candle: factory rent, factory electricity, the supervisor's salary, depreciation of the pouring machine.

Only costs incurred in the factory are manufacturing costs. The delivery driver's wage is a selling and distribution cost, and the office stationery is an administration cost. Neither belongs in the cost of making a candle.

Sort two: does it change when output changes?

• Variable costs move with the number of units made. Make no candles and you buy no wax.
• Fixed costs stay the same over a range of output. The factory rent is R6 000 whether Lerato makes 500 candles or 3 000.

The two sorts overlap but are not the same. Direct materials are usually variable, factory rent is indirect and fixed, and the supervisor's salary is indirect and fixed.

Worked example

Worked example. In March Lerato's Candle Works made 2 000 candles and recorded these costs.

Cost per candle = R58 000 ÷ 2 000 = R29,00.

Now suppose April output rises to 3 000 candles with the same factory. Variable costs are R14 + R6 = R20 a candle, so they rise to R60 000. Fixed costs stay at R18 000. Total cost = R78 000, and the cost per candle = R78 000 ÷ 3 000 = R26,00.

Nothing became cheaper. The wax still costs R14 and the rent is still R6 000. The R18 000 of fixed cost is simply spread over more candles, so each candle carries R6,00 of it instead of R9,00. That is the whole reason a factory wants to be busy.

Budgeting: the same costs, pointed forwards

A budget is a financial plan for a future period. It is built out of exactly the cost behaviour above, which is why the two topics sit together. Once you know which costs are variable per unit and which are fixed per month, you can predict what any level of output will cost.

A Cash Budget plans money in and money out, month by month. It is not the same as expected profit. It includes things that are not expenses at all, such as drawings and the purchase of a machine, and it excludes depreciation entirely, because depreciation never leaves the bank.

The point of the budget is not the closing figure. It is that a shortfall shows up on paper in April, while there is still time to delay the machine or arrange finance, rather than showing up in the bank in May when it is too late.

Core checkpoint: classify a cost by asking two separate questions in order. Can I trace it to one unit? Does its total change when output changes? The first answer decides whether it is direct or indirect; the second decides whether it is fixed or variable. A cost has one answer to each question, and the two answers are independent.