(See related pages)
|
|
|
Earlier in the chapter, we defined product costs as costs incurred to either purchase or manufacture goods. For manufactured goods, these costs consist of direct materials, direct labor, and manufacturing overhead. It will be helpful at this point to look briefly at the flow of costs in a manufacturing company. This will help us understand how product costs move through the various accounts and how they affect the balance sheet and the income statement. Exhibit 1-7 illustrates the flow of costs in a manufacturing company. Raw materials purchases are recorded in the Raw Materials inventory account. When raw materials are used in production, their costs are transferred to the Work in Process inventory account as direct materials. Notice that direct labor cost and manufacturing overhead cost are added directly to Work in Process. Work in Process can be viewed most simply as products on an assembly line. The direct materials, direct labor, and manufacturing overhead costs added to Work in Process in Exhibit 1-7 are the costs needed to complete these products as they move along this assembly line.
Notice from the exhibit that as goods are completed, their costs are transferred from Work in Process to Finished Goods. Here the goods await sale to customers. As goods are sold, their costs are transferred from Finished Goods to Cost of Goods Sold. At this point the various costs required to make the product are finally recorded as an expense. Until that point, these costs are in inventory accounts on the balance sheet. Inventoriable CostsAs stated earlier, product costs are often called inventoriable costs. The reason is that these costs go directly into inventory accounts as they are incurred (first into Work in Process and then into Finished Goods), rather than going into expense accounts. Thus, they are termed inventoriable costs. This is a key concept because such costs can end up on the balance sheet as assets if goods are only partially completed or are unsold at the end of a period. To illustrate this point, refer again to Exhibit 1-7. At the end of the period, the materials, labor, and overhead costs that are associated with the units in the Work in Process and Finished Goods inventory accounts will appear on the balance sheet as assets. As explained earlier, these costs will not become expenses until the goods are completed and sold. Selling and administrative expenses are not involved in making a product. For this reason, they are not treated as product costs but rather as period costs that are expensed as they are incurred as shown in Exhibit 1-7.
An Example of Cost FlowsTo provide an example of cost flows in a manufacturing company, assume that a company’s annual insurance cost is $2,000. Three-fourths of this amount ($1,500) applies to factory operations, and one-fourth ($500) applies to selling and administrative activities. Therefore, $1,500 of the $2,000 insurance cost would be a product (inventoriable) cost and would be added to the cost of the goods produced during the year. This concept is illustrated in Exhibit 1-8, where $1,500 of insurance cost is added to Work in Process. As shown in the exhibit, this portion of the year’s insurance cost will not become an expense until the goods that are produced during the year are sold—which may not happen until the following year or even later. Until the goods are sold, the $1,500 will be part of inventories—Work in Process or Finished Goods—along with the other costs of producing the goods.
By contrast, the $500 of insurance cost that applies to the company’s selling and administrative activities will be expensed immediately. Thus far, we have been mainly concerned with classifications of manufacturing costs for the purpose of determining inventory valuations on the balance sheet and cost of goods sold on the income statement in external financial reports. However, costs are used for many other purposes, and each purpose requires a different classification of costs. We will consider several different purposes for cost classifications in the remaining sections of this chapter. These purposes and the corresponding cost classifications are summarized in Exhibit 1-9. To help keep the big picture in mind, we suggest that you refer back to this exhibit frequently as you progress through the rest of this chapter.
| ||||||||||||||||||||||
