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In this section of the chapter, we compare the cost classifications used on the financial statements of manufacturing and merchandising companies. The financial statements prepared by a manufacturing company are more complex than the statements prepared by a merchandising company because a manufacturing company must produce its goods as well as market them. The production process involves many costs that do not exist in a merchandising company, and these costs must be properly accounted for on the manufacturing company’s financial statements. In this section, we explain how these costs are recorded on the balance sheet. In the following section, we explain how they are recorded on the income statement. The Balance SheetThe balance sheet, or statement of financial position, of a manufacturing company is similar to that of a merchandising company. However, thier inventory accounts differ. A merchandising company has only one class of inventory—goods purchased from suppliers for resale to customers. In contrast, manufacturing companies have three classes of inventories—raw materials, work in process, and finished goods. Raw materials, as we’ve noted, are the materials that are used to make a product. Work in processUnits of product that are only partially complete and will require further work before they are ready for sale to a customer. consists of units of product that are only partially complete and will require further work before they are ready for sale to a customer. Finished goodsUnits of product that have been completed but have not yet been sold to customers. consist of completed units of product that have not yet been sold to customers. Ordinarily, the sum total of these three categories of inventories is the only amount shown on the balance sheet in external reports. However, the footnotes to the financial statements often provide more detail. We will use two companies—Graham Manufacturing and Reston Bookstore—to illustrate the concepts discussed in this section. Graham Manufacturing is located in Portsmouth, New Hampshire, and makes precision brass fittings for yachts. Reston Bookstore is a small bookstore in Reston, Virginia, specializing in books about the Civil War. The footnotes to Graham Manufacturing’s Annual Report reveal the following information concerning its inventories:
Graham Manufacturing’s raw materials inventory consists largely of brass rods and brass blocks. The work in process inventory consists of partially completed brass fittings. The finished goods inventory consists of brass fittings that are ready to be sold to customers. In contrast, the inventory account at Reston Bookstore consists entirely of the costs of books the company has purchased from publishers for resale to the public. In merchandising companies like Reston, these inventories may be called merchandise inventory. The beginning and ending balances in this account appear as follows:
The Income Statement
Exhibit 1-4 compares the income statements of Reston Bookstore and Graham Manufacturing. For purposes of illustration, these statements contain more detail about cost of goods sold than you will generally find in published financial statements.
At first glance, the income statements of merchandising and manufacturing companies like Reston Bookstore and Graham Manufacturing are very similar. The only apparent difference is in the labels of some of the entries in the computation of the cost of goods sold. In the exhibit, the computation of cost of goods sold relies on the following basic equation for inventory accounts:
The logic underlying this equation, which applies to any inventory account, is illustrated in Exhibit 1-5. The beginning inventory consists of any units that are in the inventory at the beginning of the period. Additions are made to the inventory during the period. The sum of the beginning balance and the additions to the account is the total amount of inventory available. During the period, withdrawals are made from inventory. The ending balance is whatever is left at the end of the period after the withdrawals.
These concepts are used to determine the cost of goods sold for a merchandising company like Reston Bookstore as follows:
To determine the cost of goods sold in a merchandising company, we only need to know the beginning and ending balances in the Merchandise Inventory account and the purchases. Total purchases can be easily determined in a merchandising company by simply adding together all purchases from suppliers. The cost of goods sold for a manufacturing company like Graham Manufacturing is determined as follows:
To determine the cost of goods sold in a manufacturing company, we need to know the cost of goods manufactured and the beginning and ending balances in the Finished Goods inventory account. The cost of goods manufacturedThe manufacturing costs associated with the goods that were finished during the period. consists of the manufacturing costs associated with goods that were finished during the period. The cost of goods manufactured for Graham Manufacturing is derived in the schedule of cost of goods manufactured shown in Exhibit 1-6.
Schedule of Cost of Goods Manufactured
At first glance, the schedule of cost of goods manufacturedA schedule showing the direct materials, direct labor, and manufacturing overhead costs incurred during a period and the portion of those costs that are assigned to Work in Process and Finished Goods. in Exhibit 1-6 appears complex and perhaps even intimidating. However, it is all quite logical. The schedule of cost of goods manufactured contains the three elements of product costs that we discussed earlier—direct materials, direct labor, and manufacturing overhead. The direct materials cost of $410,000 is not the cost of raw materials purchased during the period—it is the cost of raw materials used during the period. The purchases of raw materials are added to the beginning balance to determine the cost of the materials available for use. The ending raw materials inventory is deducted from this amount to arrive at the cost of raw materials used in production. The sum of the three manufacturing cost elements—materials, direct labor, and manufacturing overhead—is the total manufacturing cost of $820,000. However, you’ll notice that this is not the same thing as the cost of goods manufactured for the period of $850,000. The subtle distinction between the total manufacturing cost and the cost of goods manufactured is very easy to miss. Some of the direct materials, direct labor, and manufacturing overhead costs incurred during the period relate to goods that are not yet completed. As stated above, the cost of goods manufactured consists of the manufacturing costs associated with the goods that were finished during the period. Consequently, adjustments need to be made to the total manufacturing cost of the period for the partially completed goods that were in process at the beginning and at the end of the period. The costs that relate to goods that are not yet completed are shown in the work in process inventory figures at the bottom of the schedule. Note that the beginning work in process inventory must be added to the manufacturing costs of the period, and the ending work in process inventory must be deducted, to arrive at the cost of goods manufactured. Since the work in process account declined by $30,000 during the year ($90,000 – $60,000), this explains the $30,000 difference between the total manufacturing cost and the cost of goods manufactured. | |||||||||||||||||||||
