Financial accounting is focused on external users and focuses on following GAAP. Managerial accounting focuses on internal users and decision-making.

A manufacturing company buys raw materials, makes the product and sells it to retailers.

A merchandising company (retailer) buys a completed product and sells it to customers.

A service business provides a service to the customer.

All types of companies need managerial accounting information.

Manufacturing companies have three costs: materials, labor and manufacturing overhead.

Materials can be direct or indirect. Direct materials are a bigger component of the product than indirect materials.

Labor costs can be direct or indirect. If a worker is actually manufacturing the product by hand, this is direct labor. Otherwise, it is indirect labor.

Manufacturing Overhead costs include non-materials and non-labor costs such as rent, utilities, insurance and equipment depreciation.

All overhead costs are indirect costs which means they can not be directly traced to the product. Therefore, we add indirect materials and indirect labor costs to overhead costs.

The cost of manufacturing any product is now:

Direct materials + direct labor + manufacturing overhead

All of the above costs are called manufacturing costs (product costs). Nonmanufacturing costs are called period costs.

Nonmanufacturing costs include selling and administrative costs. Examples include salespeople’s salaries and commissions and all administrative costs.

The product’s selling price should consider manufacturing and nonmanufacturing costs nut the costs of production have to be calculated separately.

Standard costing applies only to overhead costs. Direct materials and direct labor costs are easily determined.

1. Estimate total overhead costs for the next year. Actual overhead costs are not known until the end of the month. That is why we use estimates.

2. Select a cost driver that has a strong relationship with overhead costs. For example, which activity makes electricity costs go up? The more of this activity we

have, the higher our overhead costs will be. It could be direct labor hours.

3. Estimate that cost driver for the next year.

4. Calculate a predetermined overhead rate (also an estimate) as follows:

Estimated manufacturing overhead costs

Estimated cost driver

5. Multiply the predetermined rate by the cost driver that applies only to that product.

Finally, we have to add the overhead costs that we just calculated to the costs of materials and labor.