Direct costing is not possible
It is not possible to directly post the various direct labor and manufacturing overhead costs to specific jobs. Factory rent, for example, is a cost that is shared by all jobs. The same principle applies to all manufacturing overhead costs, as well as direct labor costs such as downtime, benefits, taxes, and insurance.
Absorption costing is used instead
Even though direct costing is not possible, it is still vitally important to incorporate direct labor and manufacturing overhead into the estimated cost and inventory cost of your manufactured items. This is done using absorption costing.
What is absorption costing?
Absorption costing is the process by which direct labor and manufacturing overhead costs are absorbed into the inventory cost of manufactured items. This is done by applying hourly rates for direct labor and manufacturing overhead to job labor transactions.
Labor and overhead costs are investments in inventory
Absorption costing converts direct labor and manufacturing overhead costs into investments in inventory. Those costs are not reflected in your income statement until items are sold, in the form of cost of goods sold, which correctly aligns revenue with manufacturing costs.
Costs are absorbed through hourly rates
The means by which direct labor and manufacturing overhead costs are absorbed into inventory is through work center hourly rates that are applied to job labor transactions.
Absorbed costs can only approximate actual costs
Bear in mind that the work center hourly rates that determine absorbed costs can only approximate the actual costs and job hours that are likely to occur during the current accounting period. As such, absorbed costs can never be exactly equal to actual costs and therefore there will always be a variance between absorbed and actual costs. This is normal and expected and is properly handled by the chart of accounts structure. See the next chapter for details on cost variances.
