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Tabor Manufacturing CompanyTabor Manufacturing Company makes wooden tables. The company spent $1,000 cash to build four tables: $390 for materials, $470 for a carpenter’s labor, and $140 for tools used in making the tables. How much is Tabor’s 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.
Average Cost per UnitHow 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.
Costs Can Be Assets or ExpensesIt 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.
Effect of Product Costs on Financial StatementsWe 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.
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.
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.
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.
Total Product Cost. A summary of Patillo Manufacturing’s total product cost is shown in Exhibit 1.8.
Financial StatementsThe income statement, balance sheet, and statement of cash flows for Patillo Manufacturing are displayed in Exhibit 1.9.
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 Patillo’s 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 LookCosts 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 supervisor’s 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 company’s 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.
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.
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 SummaryAs 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.
Upstream and Downstream CostsMost 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. | ||||||||||||||||||||||||||||||||||||||||||||
