Chapter 6: Cost Accounting

Contents:

Chapter 6: Cost Accounting

6.1 Accounting for Manufacturing Operations

6.2 Product Costs vs. Period Costs

6.3 Product Costs and the Matching Principle

6.4 Cash Effects

6.5 Inventories of a Manufacturing Business

6.6 You as the Chief Financial Officer

6.7 The Need for "Per – Unit Cost Data"

6.8 Determining the Cost of Finished Goods Manufactured

6.9 Financial Statements of a Manufacturing Company

6.1

Accounting for Manufacturing Operations

6.1 Accounting for Manufacturing Operations

A Merchandising company buys its inventory in a ready-to-sell condition. Therefore, its cost of goods is mostly composed of the purchase price of the products it sells. A manufacturing company, however, produces the goods that it sells. As a consequence, its cost of goods sold consists of various manufacturing costs, including the cost of materials, wages earned by production workers and a variety of other costs relating to the operation of a production facility.  

Manufacturing operations are an excellent example of how managerial and financial accounting overlaps because manufacturing costs are of vital importance to both financial and managerial accountants also rely on prompt and reliable information about manufacturing costs to help answer such questions as:

 What sales price must we charge for our products to earn a reasonable profit?

 Is it possible to lower the cost of producing a particular product line in order to be more prices competitive?

 Is it less expensive to buy certain parts used in our products than to manufacture these parts ourselves?

 Should we automate our production process with a robotic assembly line?

Direct materials

Direct labor

Manufacturing overhead

6.1.1 Classifications of Manufacturing Costs

 A typical manufacturing company purchases raw materials and converts these materials into finished goods through the process of production. The conversion from raw materials to finished goods results from utilizing a combination of labor and machinery. Thus manufacturing costs are often divided into three broad categories:

(a)       Direct materials – the raw materials and component parts used in production whose costs are directly traceable to the products manufactured.

(b)       Direct labor - Wages and other payroll costs of employees whose efforts are directly traceable to the products they manufacture, either by hand or with machinery.

(c)        Manufacturing overhead – a catch – all classification, which includes all manufacturing costs other than the costs of direct materials and direct labor.

Examples include factory utilities, supervisor salaries, equipment repairs and depreciation on machinery.

Note that manufacturing costs are not immediately recorded as current period expenses. Rather. They are costs of creating inventory and they remain on the balance sheet until the inventory is sold. For this reason manufacturing costs are often calls product costs (or inventorial costs).

6.2

Product Costs vs. Period Costs

Operating expenses

Distinction between product and period costs

6.2 Product Costs vs. Period Costs

The terms product costs and a period costs are helpful in explaining the difference between manufacturing costs and operating expenses. In a manufacturing environment, product costs are those costs incurred to manufacture inventory. Thus, until the related goods are sold, Product costs represent inventory. As such, they are reported on the balance sheet as an asset. When the goods are ultimately sold, product costs are transferred from the balance sheet to the income statement. Where they are deducted from revenue as the cost of goods sold 

Operating expenses that are associated with time period, rater than with the production of inventory, are referred to as period costs. Period costs are charged directly to expense accounts on the assumption that their benefit is recognized entirely in the period when the cost is incurred. Period costs include all selling expense, general and administrative expenses, interest expense, and income tax expense. In short period costs are classified on the income statement separately from cost of goods sold. As deductions from a company's gross profit.

 The flow of product costs and period costs through the financial statements is shown in the diagram below.

 To further illustrate of the distinction between product and period costs, consider two costs that, on the surface, appear quite similar: the depreciation of a warehouse used to store raw materials versus depreciation of a warehouse used to store finished goods. Depreciation of the raw materials warehouse is considered a product cost (a component of manufacturing overhead) because the building is part of the manufacturing process. Once the manufacturing process is complete and the finished goods are available fro sale all costs associated with their storage are considered selling expenses. Thus the depreciation of the finished goods warehouse is a period cost.

6.3

Product Costs and the Matching Principle

Example

6.3 Product Costs and the Matching Principle

Underlying the distinction between product costs and period costs is familiar accounting concept – the matching principled. In short, Product costs should be reported on the income statement only when they can be matched against product revenue, to illustrate see Table 6.1:

 Table 6.1: Product costs

Consider a real estate developer who stats a tract of 10 homes in May of the current year, during the year, the developer incurs material, labor, and overhead cost amounting to $ 1 million ( assume $ 100,000 per house ) . By the end of December, none of the houses has been sold. How much of the $1 million in construction costs should appear on the developer's income statement for the current year?

 The answer is none. These costs are not related to any revenue earned by the developer during the current year. Instead, they are related to future revenues the developer will earn when the houses are eventually sold. Therefore, at the end of the current year, the $ 1 million of product costs should appear in the developer's balance sheet as inventory. As each house is sold $ 100,000 will be deducted from sales revenue as cost of goods sold. This way, the developer's income statements in future period will properly match sales revenue with the cost of each sale.

6.4

Cash Effects

6.4 Cash Effects

Classifying costs as period or product costs can have significant cash effects when the classification determines in what period the cost appears on the income statement as an expense. Using the real estate developer example above, assume the $1 million in construction cost was classified as a period expense rather than a product expense. The current period's net income would be substantially reduced by the additional $1 million in expenses and the cash flow associated with the current year's income taxes would be significantly reduced.  

6.5

Inventories of a Manufacturing Business

In many countries

6.5 Inventories of a Manufacturing Business

In the preceding example, assume all 10 houses were completed by the end of the year; in this case the developer's inventory consists only of finished goods. Most manufacturing companies, however typically account for three of inventory.

 Materials inventory – raw materials on hand and available for use in the manufacturing process.

 Work in process inventory – partiality completed good on which production activities have been started but not yet completed.

 Finished good inventory – unsold finished products available for sale to customers. All three of these inventories are classified on the balance sheet as current assets. The cost of the materials inventory is based on its purchase price. The work in process and finished goods inventories are based on the costs of direct martial. Direct labor and manufacturing overhead assigned to them.

 In many countries such as Argentina and Greece, inventory valuation does not conform to the lower of cost or market value rules used in the united stated. In addition, many countries, including Brazil, Korea, Mexico Nigeria, Poland, and Taiwan allow upward revaluation of property and equipment; these differences in accounting methods make comparing inventory values of companies from different parts of the world very difficult.

 Manufacturing companies may use either a perpetual or a periodic inventory system. Perpetual systems have many advantages, however, such as providing managers with up to date information about the amounts of inventory on hand and the per – unit costs of manufacturing products. For these reasons, virtually all large manufacturing companies use perpetually inventory systems. Also the flow of manufacturing costs through the inventory accounts and into the cost of goods sold is most easily illustrated in a perpetual inventory system. Therefore, we will assume the use of a perpetual inventory system, in our discussion of manufacturing activities. 

6.6

You as the Chief Financial Officer

6.6 You as the Chief Financial Officer

Assume that you are the chief financial officer of Conquest, Inc., and that you have just received an income statement and balance sheet from plant accountant Jim Sway in Bend, Oregon. In your conversations with Jim you learn that in the recent reporting period, plant manager Darien Cocky asked that inventory transportation cost, the cost of repairing the plant parking lot, and the newly installed plant landscaping costs all be allocated to the cost of production. In addition, when these allocations took place, the plant produced many more bicycles than were sold creating significant increased in the amount of inventory on hand. As a result, most of the costs described by Jim have been assigned to the inventory,) (included as part of inventory costs on the balance sheet), but have not been assigned to cost of goods sold expenses (Included on the income statement).

6.7

The Need for "Per – Unit Cost Data"

Transferring the cost of specific units from one account to another requires knowledge of each unit's per – unit cost – that is the total manufacturing costs assigned to specific units. The determination of unit cost is one for the primary goals of every cost accounting system.

 Unit costs are of importance to both financial and management accountings. Financial accountants use unit costs in recording the transfer of completed goods from work in process to finished goods and from finished goods to cost of goods sold management accountants use the same information to make pricing decisions. Evaluate the efficiency current operations, and plan for future operations.

6.8

Determining the Cost of Finished Goods Manufactured

Most manufacturing companies prepare a schedule of the cost of finished gods manufactured to provide mangers with an overview of manufacturing activities during the period. Schedule of Summit cost of finished goods manufactured is shown in Table 6.2.

A schedule of the cost of finished goods manufactured is not a formal financial statement and generally does not appear in the company's annual report. Rather, it is intended primarily to assist mangers in understanding and evaluating the overall cost of manufacturing products by comparing these schedules for successive periods, for example, managers can determine whether direct labor or manufacturing overheads is rising or falling as a percentage of total manufacturing costs. In addition, the schedule is helpful in developing information about unit costs.

If a company manufactures only single product line, its cost per unit simply equals its cost, if finished goods manufactured divided by the number of units produced. For example if Summit produces only one line of mountain bike, its average cost per unit would be $80 had it produced 10,000 finished units during 202 ($800,000 divided by 10.000 units) If conquest produced multiple lines of mountain bikes, it would prepare a separate schedule of the cost of finished goods manufactured for each product line.

6.9

Financial Statements of a Manufacturing Company

Let us now illustrate how the information used in our example will be reported in the 2004 income statement and balance sheet of Summit Inc.  The company's 2004 income statement is presented in Table 6.3: 

Table 6.3: Income statement of Summit Inc.

Notice that no manufacturing costs appear among the company’s operating expenses. In fact, manufacturing costs appear in only two places in a manufacturer's financial statements. Costs associated with units sold during the period appear in the income statement as the cost of goods sold. The $782,000 cost of goods sold figure reported in Summit's income statement was taken directly forms the company's perpetual inventory records. However, this amount may be verified as shown in Table 6.4:

Table 6.4: Income statement