|Identify the cost components of a product made by a manufacturing company: the cost of materials, labor, and overhead.|
A major focus for managerial accountants is determining product costGeneral, selling, and administrative costs that are expensed in the period in which the economic sacrifice is incurred. (Contrast with product costs.).1 Managers need to know the cost of their products for a variety of reasons. For example, cost-plus pricingStrategy that sets the selling price at cost plus a markup equal to a percentage of the cost. is a common business practice.2 Product costingClassifying and accumulating the costs of individual inputs (materials, labor, and overhead) to determine the cost of making a product or providing a service. is also used to control business operations. It is useful in answering questions such as: Are costs higher or lower than expected? Who is responsible for the variances between expected and actual costs? What action can be taken to control the variances?
The cost of making products includes the cost of materials, labor, and other resources (usually called overheadMethod of reporting cash flows from operating activities on the statement of cash flows that starts with the net income from the income statement, followed by adjustments necessary to convert accrual-based net income to a cash-basis equivalent.). To understand how these costs affect financial statements, consider the example of Tabor Manufacturing Company.
Tabor Manufacturing Company
Tabor Manufacturing Company makes wooden tables. The company spent $1,000 cash to build four tables: $390 for materials, $470 for a carpenters labor, and $140 for tools used in making the tables. How much is Tabors expense? The answer is zero. The $1,000 cash has been converted into products (four tables). The cash payments for materials, labor, and tools were asset exchange transactions. One asset (cash) decreased while another asset (tables) increased. Tabor will not recognize any expense until the tables are sold; in the meantime, the cost of the tables is held in an asset account called Finished GoodsCompleted products resulting from the manufacturing process; measured by the accumulated cost of raw materials, labor, and overhead. Inventory. Exhibit 1.3 illustrates how cash is transformed into inventory.
|EXHIBIT 1.3||Transforming the Asset Cash Into the Asset Finished Goods|
Average Cost per Unit
How much did each table made by Tabor cost? The actual cost of each of the four tables likely differs. The carpenter probably spent a little more time on some of the tables than others. Material and tool usage probably varied from table to table. Determining the exact cost of each table is virtually impossible. Minute details such as a second of labor time cannot be effectively measured. Even if Tabor could determine the exact cost of each table, the information would be of little use. Minor differences in the cost per table would make no difference in pricing or other decisions management needs to make. Accountants therefore normally calculate cost per unit as an average. In the case of Tabor Manufacturing, the average cost(per unit) The total cost of making products divided by the total number of products made. per table is $250 ($1,000 ÷ 4 units). Unless otherwise stated, assume cost per unit means average cost per unit.
Check Yourself 1.1
All boxes of General Mills Total Raisin Bran cereal are priced at exactly the same amount in your local grocery store. Does this mean that the actual cost of making each box of cereal was exactly the same price?
No, making each box would not cost exactly the same amount. For example, some boxes contain slightly more or less cereal than other boxes. Accordingly, some boxes cost slightly more or less to make than others do. General Mills uses average cost rather than actual cost to develop its pricing strategy.
Costs Can Be Assets or Expenses
It might seem odd that wages earned by production workers are recorded as inventory instead of being expensed. Remember, however, that expenses are assets used in the process of earning revenue. The cash paid to production workers is not used to produce revenue. Instead, the cash is used to produce inventory. Revenue will be earned when the inventory is used (sold). So long as the inventory remains on hand, all product costs (materials, labor, and overhead) remain in an inventory account.
When a table is sold, the average cost of the table is transferred from the Inventory account to the Cost of Goods Sold (expense) account. If some tables remain unsold at the end of the accounting period, part of the product costs is reported as an asset (inventory) on the balance sheet while the other part is reported as an expense (cost of goods sold) on the income statement.
Costs that are not classified as product costs are normally expensed in the period in which they are incurred. These costs include general operating costs, selling and administrative costs, interest costs, and the cost of income taxes.
To illustrate, return to the Tabor Manufacturing example. Recall that Tabor made four tables at an average cost per unit of $250. Assume Tabor pays an employee who sells three of the tables a $200 sales commission. The sales commission is expensed immediately. The total product cost for the three tables (3 tables × $250 each = $750) is expensed on the income statement as cost of goods sold. The portion of the total product cost remaining in inventory is $250 (1 table × $250). Exhibit 1.4 shows the relationship between the costs incurred and the expenses recognized for Tabor Manufacturing Company.
|EXHIBIT 1.4||Cost Classification for Tabor Manufacturing Company|
Effect of Product Costs on Financial Statements
|Explain the effects on financial statements of product costs versus general, selling, and administrative costs.|
We illustrate accounting for product costs in manufacturing companies with Patillo Manufacturing Company, a producer of ceramic pottery. Patillo, started on January 1, 2008, experienced the following accounting events during its first year of operations.3 Assume that all transactions except 6, 8, and 10 are cash transactions.
- Acquired $15,000 cash by issuing common stock.
- Paid $2,000 for materials that were used to make products. All products started were completed during the period.
- Paid $1,200 for salaries of selling and administrative employees.
- Paid $3,000 for wages of production workers.
- Paid $2,800 for furniture used in selling and administrative offices.
- Recognized depreciation on the office furniture purchased in Event 5. The furniture was acquired on January 1, had a $400 estimated salvage value, and a four-year useful life. The annual depreciation charge is $600 [($2,800 $400) ÷ 4].
- Paid $4,500 for manufacturing equipment.
- Recognized depreciation on the equipment purchased in Event 7. The equipment was acquired on January 1, had a $1,500 estimated salvage value, and a three-year useful life. The annual depreciation charge is $1,000 [($4,500 $1,500) ÷ 3].
- Sold inventory to customers for $7,500 cash.
- The inventory sold in Event 9 cost $4,000 to make.
The effects of these transactions on the balance sheet, income statement, and statement of cash flows are shown in Exhibit 1.5. Study each row in this exhibit, paying particular attention to how similar costs such as salaries for selling and administrative personnel and wages for production workers have radically different effects on the financial statements. The example illustrates the three elements of product costs, materials (Event 2), labor (Event 4), and overhead (Event 8). These events are discussed in more detail below.
|EXHIBIT 1.5||Effect of Product versus Selling and Administrative Costs on Financial Statements|
Materials Costs (Event 2)
Materials used to make products are usually called raw materialsPhysical commodities (e.g., wood, metal, paint) transformed into products through the manufacturing process.. The cost of raw materials is first recorded in an asset account (Inventory). The cost is then transferred from the Inventory account to the Cost of Goods Sold account at the time the goods are sold. Remember that materials cost is only one component of total manufacturing costs. When inventory is sold, the combined cost of materials, labor, and overhead is expensed as cost of goods sold. The costs of materials that can be easily and conveniently traced to products are called direct raw materialsCosts of raw materials used to make products that can be easily and conveniently traced to those products. costs.
Labor Costs (Event 4)
The salaries paid to selling and administrative employees (Event 3) and the wages paid to production workers (Event 4) are accounted for differently. Salaries paid to selling and administrative employees are expensed immediately, but the cost of production wages is added to inventory. Production wages are expensed as part of cost of goods sold at the time the inventory is sold. Labor costs that can be easily and conveniently traced to products are called direct laborWages paid to production workers whose efforts can be easily and conveniently traced to products. costs. The cost flow of wages for production employees versus salaries for selling and administrative personnel is shown in Exhibit 1.6.
|EXHIBIT 1.6||Flow of Labor Costs|
Overhead Costs (Event 8)
Although depreciation cost totaled $1,600 ($600 on office furniture and $1,000 on manufacturing equipment), only the $600 of depreciation on the office furniture is expensed directly on the income statement. The depreciation on the manufacturing equipment is split between the income statement (cost of goods sold) and the balance sheet (inventory). The depreciation cost flow for the manufacturing equipment versus the office furniture is shown in Exhibit 1.7.
|EXHIBIT 1.7||Flow of Depreciation Costs|
Total Product Cost. A summary of Patillo Manufacturings total product cost is shown in Exhibit 1.8.
|EXHIBIT 1.8||Schedule of Inventory Costs|
The income statement, balance sheet, and statement of cash flows for Patillo Manufacturing are displayed in Exhibit 1.9.
|EXHIBIT 1.9||PATILLO MANUFACTURING COMPANY|
Product Costs. The $4,000 cost of goods sold reported on the income statement includes a portion of the materials, labor, and overhead costs incurred by Patillo during the year. Similarly, the $2,000 of finished goods inventory on the balance sheet includes materials, labor, and overhead costs. These product costs will be recognized as expense in the next accounting period when the goods are sold. Initially classifying a cost as a product cost delays, but does not eliminate, its recognition as an expense. All product costs are ultimately recognized as expense (cost of goods sold). Cost classification does not affect cash flow. Cash inflows and outflows are recognized in the period that cash is collected or paid regardless of whether the cost is recorded as an asset or expensed on the income statement.
General, Selling, and Administrative Costs. General, selling, and administrative costsAll costs not associated with obtaining or manufacturing a product; sometimes called period costs because they are normally expensed in the period in which the economic sacrifice is incurred. (GS&A) are normally expensed in the period in which they are incurred. Because of this recognition pattern, nonproduct expenses are sometimes called period costsRules and practices that accountants agree to follow in financial reports prepared for public distribution.. In Patillos case, the salary expense for selling and administrative employees and the depreciation on office furniture are period costs reported directly on the income statement.
Overhead Costs: A Closer Look
Costs such as depreciation on manufacturing equipment cannot be easily traced to products. Suppose that Patillo Manufacturing makes both tables and chairs. What part of the depreciation is caused by manufacturing tables versus manufacturing chairs? Similarly, suppose a production supervisor oversees employees who work on both tables and chairs. How much of the supervisors salary relates to tables and how much to chairs? Likewise, the cost of glue used in the production department would be difficult to trace to tables versus chairs. You could count the drops of glue used on each product, but the information would not be useful enough to merit the time and money spent collecting the data.
Costs that cannot be traced to products and services in a cost-effective manner are called indirect costsTechnique in which upper-level managers involve subordinates in setting budget objectives, thereby encouraging employee cooperation and support in attaining the companys goals.. The indirect costs incurred to make products are called manufacturing overheadProduction costs that cannot be easily or economically traced directly to products.. Some of the items commonly included in manufacturing overhead are indirect materials, indirect labor, factory utilities, rent of manufacturing facilities, and depreciation on manufacturing assets.
Check Yourself 1.2
Lawson Manufacturing Company paid production workers wages of $100,000. It incurred materials costs of $120,000 and manufacturing overhead costs of $160,000. Selling and administrative salaries were $80,000. Lawson started and completed 1,000 units of product and sold 800 of these units. The company sets sales prices at $220 above the average per unit production cost. Based on this information alone, determine the amount of gross margin and net income. What is Lawsons pricing strategy called?
Total product cost is $380,000 ($100,000 labor + $120,000 materials + $160,000 overhead). Cost per unit is $380 ($380,000 ÷ 1,000 units). The sales price per unit is $600 ($380 + $220). Cost of goods sold is $304,000 ($380 × 800 units). Sales revenue is $480,000 ($600 × 800 units). Gross margin is $176,000 ($480,000 revenue $304,000 cost of goods sold). Net income is $96,000 ($176,000 gross margin $80,000 selling and administrative salaries). Lawsons pricing strategy is called cost-plus pricing.
Since indirect costs cannot be effectively traced to products, they are normally assigned to products using cost allocationProcess of dividing a total cost into parts and assigning the parts to relevant objects., a process of dividing a total cost into parts and assigning the parts to relevant cost objects. To illustrate, suppose that production workers spend an eight-hour day making a chair and a table. The chair requires two hours to complete and the table requires six hours. Now suppose that $120 of utilities cost is consumed during the day. How much of the $120 should be assigned to each piece of furniture? The utility cost cannot be directly traced to each specific piece of furniture, but the piece of furniture that required more labor also likely consumed more of the utility cost. Using this line of reasoning, it is rational to allocate the utility cost to the two pieces of furniture based on direct labor hours at a rate of $15 per hour ($120 ÷ 8 hours). The chair would be assigned $30 ($15 per hour × 2 hours) of the utility cost and the table would be assigned the remaining $90 ($15 × 6 hours) of utility cost. The allocation of the utility cost is shown in Exhibit 1.10.
|EXHIBIT 1.10||Cost Allocation|
We discuss the details of cost allocation in a later chapter. For now, recognize that overhead costs are normally allocated to products rather than traced directly to them.
Manufacturing Product Cost Summary
As explained, the cost of a product made by a manufacturing company is normally composed of three categories: direct materials, direct labor, and manufacturing overhead. Relevant information about these three cost components is summarized in Exhibit 1.11.
|EXHIBIT 1.11||Components of Manufacturing Product Cost|
Component 1Direct Materials
Sometimes called raw materials. In addition to basic resources such as wood or metals, it can include manufactured parts. For example, engines, glass, and car tires can be considered as raw materials for an automotive manufacturer. If the amount of a material in a product is known, it can usually be classified as a direct material. The cost of direct materials can be easily traced to specific products.
Component 2Direct Labor
The cost of wages paid to factory workers involved in hands-on contact with the products being manufactured. If the amount of time employees worked on a product can be determined, this cost can usually be classified as direct labor. Like direct materials, labor costs must be easily traced to a specific product in order to be classified as a direct cost.
Component 3Manufacturing Overhead
Costs that cannot be easily traced to specific products. Accordingly, these costs are called indirect costs. They can include but are not limited to the following:
- Indirect materials such as glue, nails, paper, and oil. Indeed, note that indirect materials used in the production process may not appear in the finished product. An example is a chemical solvent used to clean products during the production process but not a component material found in the final product.
- Indirect labor such as the cost of salaries paid to production supervisors, inspectors, and maintenance personnel.
- Rental cost for manufacturing facilities and equipment.
- Utility costs.
- The cost of preparing equipment for the manufacturing process (i.e., setup costs).
- Maintenance cost for the manufacturing facility and equipment.
Answers to The Curious Accountant
As you have seen, accounting for depreciation related to manufacturing assets is different from accounting for depreciation for nonmanufacturing assets. Depreciation on the checkout equipment at Best Buy is recorded as depreciation expense. Depreciation on manufacturing equipment at Apple Computer is considered a product cost. It is included first as a part of the cost of inventory and eventually as a part of the expense, cost of goods sold. Recording depreciation on manufacturing equipment as an inventory cost is simply another example of the matching principle, because the cost does not become an expense until revenue from the product sale is recognized.
Upstream and Downstream Costs
|Distinguish product costs from upstream and downstream costs.|
Most companies incur product-related costs before and after, as well as during, the manufacturing process. For example, Ford Motor Company incurs significant research and development costs prior to mass producing a new car model. These upstream costsCosts incurred before beginning the manufacturing process, such as research and development costs. occur before the manufacturing process begins. Similarly, companies normally incur significant costs after the manufacturing process is complete. Examples of downstream costsCosts incurred after the manufacturing process is complete, such as delivery costs and sales commissions. include transportation, advertising, sales commissions, and bad debts. While upstream and downstream costs are not considered to be product costs for financial reporting purposes, profitability analysis requires that they be considered in cost-plus pricing decisions. To be profitable, a company must recover the total cost of developing, producing, and delivering its products to customers.
Exercise 1-2A, 1-2B, 1-3A, 1-3B, 1-4A, 1-4B, 1-5A, 1-5B, 1-6A, 1-6B, 1-7A, 1-7B, 1-8A, 1-8B, 1-9A, 1-9B, 1-10A, 1-10B, 1-11A, 1-11B, 1-12A, 1-12B
Problem 1-19A, 1-19B, 1-20A, 1-20B, 1-21A, 1-21B, 1-22A, 1-22B, 1-23A, 1-23B
1This text uses the term product in a generic sense to mean both goods and services.
2Other pricing strategies will be introduced in subsequent chapters.
3This illustration assumes that all inventory started during the period was completed during the period. Patillo therefore uses only one inventory account, Finished Goods Inventory. Many manufacturing companies normally have three categories of inventory on hand at the end of an accounting period: Raw Materials Inventory, Work in Process Inventory (inventory of partially completed units), and Finished Goods Inventory. Chapter 11 discusses these inventories in greater detail.