Almost any production plant or factory requires employees to operate equipment, move raw materials from the warehouse to equipment, and so on.  These employees are directly involved in the production process and cost of their remuneration and benefits represents direct labor.

Direct labor is the cost of wages to be paid to individuals who work on specific products or in other words, the cost of wages of employees who are directly involved in converting raw materials into finished goods.

Usually direct labor is a variable cost. In most situations the amount of direct labor required is directly correlated with the amount of finished goods produced.  For example, wages and related benefits of employees who operate machinery to produce valves represent direct labor costs for Friends Corporation.  The more valves are to be produced, the more employees will be required to operate machinery, paint, assemble, etc.

Direct materials and direct labor, when added together, represent the prime cost. Direct materials and direct labor are called prime costs because they are directly (physically, "primarily") associated with the production of the finished good.

Factory overhead is any manufacturing cost that is not direct materials or direct labor.

Factory overhead can have variable or fixed nature, depending on whether overhead changes in direct proportion with production levels. The following are some examples of factory overhead costs:

Illustration 3: Examples of fixed and variable factory overhead costs

Most items in the above table are self-explanatory, so they don’t require further explanation, while indirect materials and labor may benefit from further explication.

Indirect materials are materials that are (a) not an integral (physical) part of the finished goods, or (b) a minor part of the finished goods to be economically traced to the finished good or have a very small physical association with the finished product.

For example, Friends Corporation would treat the following costs as indirect materials: oil lubricants and light bulbs used in manufacturing equipment, package boxes, wrenches, etc.

Other companies will have different types of indirect materials depending on their manufacturing processes. The table below provides a few examples.

Illustration 4: Examples of indirect materials cost (overhead cost)

As you can see form the table, indirect materials are an insignificant portion or not an integral part of the finished goods.

Indirect labor is the cost of production employees who are involved in the manufacturing process, but do not work on a specific product.

For example, wages of custodians, maintenance people, supplies room supervisors, etc. are considered indirect labor.

Direct labor and factory overhead, when added together, represent the conversion cost. Direct labor and factory overhead are called conversion costs because they are involved in converting raw materials into finished goods.

 Illustration below shows relationship between direct materials, direct labor, overhead, prime cost and conversion cost.

Illustration 5: Relationship between direct materials, direct labor, overhead, prime cost and conversion cost