Let’s illustrate this by looking at the cost of property insurance. The cost of insuring the factory building is a fixed cost when the independent variable is the number of units produced within the factory. In other words, the factory’s property insurance might be $6,000 per year whether its output is 2 million units, 3 million units, or 5 million units. On the other hand, if the independent variable is the replacement cost of the factory buildings, the insurance cost will be a variable cost. The reason is the insurance cost on $12 million of factory buildings will be more than the insurance cost on $9 million of factory buildings, and less than the insurance premiums on $18 million of factory buildings.

In the case of worker compensation insurance, the cost will vary with the amount of payroll dollars (exluding overtime premium) in each class of workers. For example, if the worker comp premiums are $5 per $100 of factory labor cost, then the worker comp premiums will be variable with respect to the dollars of factory labor cost. If the units of output in the factory correlate with the direct labor costs, then the worker compensation cost will also be variable with respect to the number of units produced. On the other hand, the worker compensation cost for the office staff is usually a much smaller rate and that worker compensation cost will not be variable with respect to the number of units of output in the factory. However, the worker compensation cost of the office staff will be variable with respect to the amount of office staff salaries and wages.

As you have seen, determining which costs are fixed and which are variable can be a bit tricky.

Let’s assume that the net cost of worker comp insurance after discounts and dividends is 5% of the wages and salaries of  direct and indirect manufacturing employees. If for the month of January the direct labor is $40,000, then $2,000 of the worker comp cost should be included as direct labor. If indirect labor for January is $60,000 then $3,000 of worker comp cost should be included as the cost of the indirect labor.

If the general office worker comp rates are 0.2% of the general office wages and salaries, then 0.2% of January’s general office wages and salaries will be expensed as worker comp insurance expense.

If the employer remits each month’s worker comp cost to its insurance company each accounting period, there will be no prepaid insurance nor will there be a liability for accrued worker comp expense.

If the employer remits worker comp premiums to the insurance company in advance of the cost associated with wages and salaries, the amount that is prepaid as of the balance sheet date should be reported as Prepaid Insurance, a current asset. If the employer has remitted less than the worker comp cost associated with the wages and salaries, the amount owed to the insurance company as of the balance sheet date is reported as a current liability such as Accrued Worker Comp Payable.

Learn more about accruals and deferrals under the topic Adjusting Entries.

Product costs cling to the units of products purchased or manufactured. If a unit is unsold, the product costs will be reported as inventory, a current asset on the balance sheet. The product costs for a retailer will be the amount paid to the supplier plus any freight-in. Product costs for a manufacturer will be the direct materials, direct labor, and manufacturing overhead. Product costs will be reported on the income statement as the cost of goods sold expense in the period that the units of product are sold.

Period costs do not cling or attach to the units of product and will not be included in the cost of inventory. For example, the interest incurred by a retailer to finance its operations will be expensed in the period in which the interest occurs. Interest is not deferred by adding it to the cost of the units in inventory. Similarly, selling expenses and general administrative salaries are expensed in the period that the employees earn those salaries, the same period in which the company incurs the salaries expense. The insurance premiums that a company pays for nonmanufacturing protection will be expensed in the period in which the insurance premiums expire.  (Insurance premiums for the factory building will be included in the manufacturing overhead which will be part of the products’ cost.)

While a simple cost system using just one cost driver (machine hours) may result in accurate financial statements, it often fails to provide the true cost of individual products that vary in complexity. For example, one product might require very few machine hours but will require many hours of special handling. The costs assigned on the basis of machine hours alone will be too low in relationship to the true cost of manufacturing this product. Another product might require many machine hours but no other activities. This product’s cost will be overstated because the rate assigned via the machine hours will include an amount for other activities that generally occur for the other products manufactured.

A cost system developed for inventory valuation is limited to the cost of direct materials, direct labor, and manufacturing overhead. The total cost of providing products to a customer will also include nonmanufacturing expenses. One customer might require a company to incur additional selling, delivering, storing, and administrative expenses. Another customer might not require any of those activities and their related expenses.

Activity based costing attempts to calculate the true cost of a product and customer by assigning costs and expenses based on their root causes. Because there are many root causes, the company will assign costs based on many cost drivers. This results in more accuracy for the cost and expense of a specific product for a specific customer than simply spreading the manufacturing costs on the basis of one cost driver such as machine hours.

Learn more about activity based costing.

The rental cost of a building that is not used for manufacturing (e.g. rent for a sales office, rent for the general administrative office) is not part of the manufacturing overhead. This rent does not cling to the products and will not be part of the cost of an item in inventory. The rent for nonmanufacturing facilities is immediately expensed in the accounting period when the building is rented.

If a rented building is used for both manufacturing and nonmanufacturing activities, the rent should be allocated to each (perhaps on the basis of square footage).

Learn more about manufacturing overhead and nonmanufacturing overhead.

Period costs are not a necessary part of the manufacturing process. As a result, period costs cannot be assigned to the products or to the cost of inventory. The period costs are usually associated with the selling function of the business or its general administration. The period costs are reported as expenses in the accounting period in which they 1) best match with revenues, 2) when they expire, or 3) in the current accounting period. In addition to the selling and general administrative expenses, most interest expense is a period expense.

Learn more about Manufacturing Overhead and Nonmanufacturing Overhead.

For example, if a company produces artisan furniture, the cost of the wood and the cost of the craftsperson are direct costs—they are clearly traceable to the production department and to each item produced—no allocation was needed. On the other hand, the rent of the building that houses the production area, warehouse, and office is not a direct cost of either the production department or the items produced. The rent is an indirect cost—an indirect cost of operating the production department and an indirect cost of crafting the product.

To calculate the total cost of the production department or to calculate each product’s total cost, it is necessary to allocate some of the rent (and other indirect costs) to the department and to the product.

I associate indirect with allocation and arbitrary.

If the rent is for items involved in the selling function (rent for office space, equipment, autos, etc.) or if the rent is for items in the administrative function of the company, the rent is a period cost and will be expensed in the period when the expense is incurred. These rents will not be allocated to the products for external financial statements.