This chapter discusses cost concepts and classifications that are used in management accounting. It defines key terms like cost objective, direct and indirect costs, product costs, and period costs. It also explains how costs are accumulated and assigned in a manufacturing company, including distinguishing between raw materials, direct labor, manufacturing overhead, prime costs, and conversion costs. Inventory accounts for raw materials, work-in-process, and finished goods are also introduced.
This chapter discusses cost concepts and classifications that are used in management accounting. It defines key terms like cost objective, direct and indirect costs, product costs, and period costs. It also explains how costs are accumulated and assigned in a manufacturing company, including distinguishing between raw materials, direct labor, manufacturing overhead, prime costs, and conversion costs. Inventory accounts for raw materials, work-in-process, and finished goods are also introduced.
This chapter discusses cost concepts and classifications that are used in management accounting. It defines key terms like cost objective, direct and indirect costs, product costs, and period costs. It also explains how costs are accumulated and assigned in a manufacturing company, including distinguishing between raw materials, direct labor, manufacturing overhead, prime costs, and conversion costs. Inventory accounts for raw materials, work-in-process, and finished goods are also introduced.
This chapter discusses cost concepts and classifications that are used in management accounting. It defines key terms like cost objective, direct and indirect costs, product costs, and period costs. It also explains how costs are accumulated and assigned in a manufacturing company, including distinguishing between raw materials, direct labor, manufacturing overhead, prime costs, and conversion costs. Inventory accounts for raw materials, work-in-process, and finished goods are also introduced.
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CHAPTER FIVE
Cost Concepts & Cost Classifications
Learning Objectives:
After studying this chapter, you should be able to-
Describe cost accumulation and cost objective. Understand manufacturing cost elements. Explain product cost versus period cost. Understand manufacturing inventories & Analyze activities in inventory accounts. Explain how the statement of cost of goods manufactured is prepared. .
Introduction
The purpose of this chapter is to introduce cost concepts and
measurements that are widely used in Management Accounting. In the course of our study, we will determine how costs are best measured for different purposes.
5.1. Cost Objective Defined
Costs are measured and used in many different ways by managers to fit the requirements of various situations. Cost data are especially important in the following areas:
(a) Planning – The estimation of future costs in budget preparation
and in decision making. (b) Control – The measurement of costs incurred and the comparison of those costs with budgets and standards in the process of directing and controlling the enterprise.
1|Page (c) Income Statement – the determination of the costs associated with the Goods Sold during the fiscal period and the costs of inventories remaining at the end of the fiscal period.
A cost may be broadly defined as being a measurement, in monetary
terms of the amount of resources used for some purpose.
Accountants usually define cost as a resource sacrifice or foregone to
achieve specific objective.
To guide decisions, managers want to know the cost of something. We
call this something a “Cost Objective;” and define it as “anything for which a separate measurement of costs is desired.
Examples include: a product, a service, a project, a customer, a brand
category, an activity, a department, and a program.
Cost objectives are chosen not for their own sake but for helping decision-making.
5.2 Cost Accumulation & Cost Assignment
A costing system typically accounts for costs in two broad stages:
(1) It accumulates costs by some “natural” classification such as
materials, labor, fuel, advertising, shipping, and then (2) It assigns these costs to cost objectives.
Cost accumulation is the collection of cost data in some organized way
through an accounting system.
Cost assignment is a general term that encompasses both:
(a) Tracing accumulated costs to cost objectives ; and
(b) Allocating accumulated costs to a cost objective.
Direct Costs & Indirect Costs
A major question concerning costs is whether they have a direct or an
indirect relationship to a particular cost objective.
2|Page Direct costs of a cost objective: costs that are related to the cost objective and can be traced to it in an economically feasible way.
Indirect costs of a cost objective: costs that are related to the cost objective but cannot be traced to it in an economically feasible way.
Direct Costs Cost Tracing
Cost assignment Cost
Objective
Indirect Costs Cost Allocation
5.3 Product Costing
The process of assigning costs to inventories as they are converted
from raw materials to finished goods is called Product Costing.
Product costs must be determined for the purpose of inventory valuation
and expense measurement in general purpose financial statements. Product cost information is also used by management to plan and control firm activities and pricing decisions.
5.4 Manufacturing Company
In a Manufacturing Company materials and other resources are
purchased and converted into finished products through the manufacturing process. Product costs in a manufacturing company include all costs necessary for a manufacture of a product. These costs are recorded as assets until the product is sold and the revenue from the sales of the product is reported in the income statement.
Manufacturing Cost Elements
We shall first distinguish Manufacturing from Non-manufacturing Costs.
Manufacturing (Product Costs) are those costs related to factory 3|Page operations, which are essential to the completion of a product. We shall further classify Manufacturing Costs as Raw (Direct) Materials Costs, Direct Labor Costs, and Manufacturing (Factory) Overhead Costs.
Raw (Direct) materials are the materials which are the major components of the finished product and can be clearly identified with the product.
Direct Labor is the labor which is used in actual producing of the
product – for instance that of the assembly line workers.
Manufacturing (Factory) overhead consists of all other costs related to
the manufacturing process but not classified as either Direct Materials or Direct Labor – for example, Salaries of cleaners & forklift operators, cost of fuel & oil, Depreciation of the Equipment used in the manufacturing process.
Non-manufacturing Costs consists of all other costs of running the
business and selling the product (i.e., Operating Expenses) and may be classified very broadly as both Selling Expenses and Administrative Expenses. We refer to the combination of Manufacturing and Non-manufacturing the Full (Total) Cost of the product produced. Let as summarize the classifications of the total costs for a manufacturing company we have made so far.
Manufacturing Costs Raw (Direct) Material
A Manufacturing (Product costs) Direct Labor Company Factory Overhead Total Cost Selling
Two terms found in manufacturing costing systems are prime costs and conversion costs.
Prime Costs: are all direct manufacturing costs. In the three-part
classification, noted above, Prime Costs would comprise Direct material Costs and Direct labor Costs.
Conversion Costs are all manufacturing costs other than direct
material Costs. These costs are for converting direct materials into finished goods. Conversion costs would comprise direct labor and factory overhead.
5.5 Product versus Period Costs
Accountants make a distinction between the cost of manufactured
products and the costs incurred in non-manufacturing activities.
Product costs are recorded and carried as assets (inventories) at the
time products are made; they become expenses only when the product is sold. They are costs associated with the purchase of Goods for Sale (in the case of merchandise inventory) or costs associated with the acquisition and conversion of materials and all other manufacturing inputs into goods for sale (in the case of manufacturing inventories).Under GAAP, inventoriable costs are restricted to manufacturing costs for manufacturing Sector Company.
Period costs are costs of “goods and services’ that are recorded as expenses in the period in which they are consumed. They include costs initially recorded as non-inventoriable capitalized costs (Building, equipment, and computers) and costs recorded immediately as expenses as they are incurred (advertising expense, administrative salaries, office supplies and the like.)
5.6 Manufacturing Inventories
In manufacturing firms, inventories typically play a more important role
than in other types of business. Service firms have no inventory that they hold for resale to customers. Operating Supplies are carried only to 5|Page facilitate the main function of providing service. Merchandising firms acquire inventory for resale to customers. A Merchandising firm may have many classifications of inventory and many items within each inventory classification, but all inventory items are ready made for sale.
A Manufacturing firm has three major levels of inventory:
1. Raw Materials Inventory 2. Work-In-Process Inventory, and 3. Finished Goods Inventory Raw Materials (RM) Inventory is the basic inputs or ingredients that are converted into final product through the production process. Work-In-Process (WIP) Inventory is the second level of inventory in a manufacturing firm. It consists of unfinished products that are in the process of being converted into final products. Many different products can be in work in process simultaneously. For example, a Bakery may have a variety of breads, cakes, and doughnuts in process at any given time. Finished Goods Inventory is the final level of inventory consists of finished goods, which are products ready for sale. In a multiple products manufacturing firm, there are many different finished goods inventory items.
Analyzing Activity in Inventory Accounts
An understanding of account activity and accounts interrelationships
is extremely important for product costing and control. During any time period, the activity in any account can be broken down into four parts.
Knowing any three of these items, we can always find the fourth.
6|Page For example: Cash Account Merchandise Inventory Accounts Payable Beginning Balance Beginning Balance Beginning Balance + Cash receipts + Purchases + purchase on account = Total cash available = Total Inventory = Total Payable - Cash disbursements - Cost of Goods Sold - Payment on Account = Ending Balance = Ending Balance = Ending Balance Activity in one account always affects at least one other account. For example, inventory purchased on account in a Merchandising firm “Increases” (Debited) Merchandise Inventory and Accounts Payable (Credited). Inventory issued to the factory in a manufacturing firm “Decreases” (Debited) Raw Materials Inventory and “Increases” Work- In-Process Inventory (Credited).
Complete analyses of a manufacturing organization’s Inventory Account
relationships are presented below (Table 5.1). Table 5.1: Analysis of Activity in Manufacturing Company’s Inventory Accounts ___________________________________________________________________________________ Raw Materials Inventory Work-In-Process Inventory Finished Goods Inventory Beginning Balance Beginning Balance Beginning Balance Add: Add: Add: Current Manufacturing Costs: Purchase Cost of Goods Direct Materials + Direct Labor Manufactured + Factory Overhead
= Total available = Total Cost in Process = Total Available for Sale
Minus: Minus: Minus:
Cost of Materials Cost of Goods
Cost of Placed in production Manufactured Goods Sold
7|Page In Table 5.1 the cost of Raw Materials placed in Production decreases Raw Materials Inventory and Increases Work-In-Process Inventory. The total additions to Work-In-Process Inventory are collectively identified as Current Manufacturing Costs and the total costs assigned to products completed are collectively identified as the Cost of Goods Manufactured. The Cost of Goods Manufactured id deducted from Work-In-Process Inventory and added to Finished Goods Inventory. Once the relationship between inventories accounts are known, items of interest, such as, the Cost of Materials Placed in Production, the Cost of Goods Manufactured, and the Cost of Goods Sold are readily determined. Consider the following illustration.
ILLUSTARION
On September 30, 2015, the Beginning Inventory accounts Balances
of Harmon Manufacturing Company were:
Raw Materials Inventory ---------------------
$5,000
Work-In-Process Inventory -----------------
$8,000
Finished Goods Inventory ------------------
$11,000
During the month of September, Raw Materials costing $12,000 were
purchased. Direct Labor and Factory Overhead costs were $20,000 and $15,000 respectively.
8|Page The September 30, Ending Inventory Accounts Balances were as follows:
Raw Materials Inventory ---------------------
$7,000
Work-In-Process Inventory -----------------
$14,000
Finished Goods Inventory ------------------
$6,000
An analysis of activity in inventory accounts is presented in Table 5.2.
This illustration focused on inventory account activity. Cost of Goods
Sold is, of course, just one item on the Income Statement. Harmon’s September Income Statement would also include Revenue from sales and Expenses. Harmon’s September 30 Balance Sheet would include inventories and many other Assts as well as Liabilities and Owner’s Equity (Capital) accounts.
Because activity in one account always affects at least one other account, the analysis here is complete. The acquisition of Raw Materials and Direct Labor and the incurrence of Factory Overhead costs affect many other accounts. We have ignored these accounts for the movement in order to emphasize the essential inventory relationships found on Product Costing under Cost Accounting.
9|Page Table 5.2: Analysis of Harmon Company’s Inventory Accounts
Cost of Goods Sold ------------------------------------------------ $44,000
5.7 Statement of Cost of Goods Manufactured
The activity in Raw Materials and Work-In-Process Inventory accounts is
formally summarized in a Statement of Cost of Goods Manufactured. Harmon’s Manufacturing Company’s September 30, 2015 Statement of Cost of Goods Manufactured is presented in Table 5.3 below. To show 10 | P a g e the relationship between this Statement and Income Statement, Harmon’s September 30, 2015 Income Statement is also presented in Table 5.4. For this illustration assume that the month’s Sales of $90,000 and Selling & Administrative Expenses of $30,000.
Table 5.3: Statement of Cost of Goods Manufactured
HARMON MANUFACTURING COMPANY
STATEMENT OF COST OF GOODS MANUFACTURED FOR MONTH ENDED SEPTEMBER 30, 2015
Current Manufacturing Costs:
Raw Materials Inventory 01/09/2015 $5,000
+ Purchases ----------------------------- 12,000
Total available for use ---------------- 17,000
- Raw Materials Inventory 30/09/2015 $7,000
Cost of Materials Placed in Production $10,000
Direct Labor --------------------------------- 20,000
Cost of Goods Manufactured -----------------------------------------
$39,000
Note that the Cost of Goods Manufactured is similar to purchase for a
merchandising company. The “Purchase” in merchandising company 11 | P a g e represents “The cost of goods bought” for sale to customers. The “Cost of Goods Manufactured” in a manufacturing company represents “The cost of goods produced”” for sale to customers.
Table 5.4: Income Statement
HARMON MANUFACTURING COMPANY
INCOME STATEMENT FOR MONTH ENDED SEPTEMBER 30, 2015
Sales ------------------------------------------------------------------- $90,000 Cost of Goods Sold: Finished Goods Inventory 01/09/2015------------ $11,000 + Cost of Goods Manufactured --------------------- $39,000 Total available for sale ------------------------------- $50,000 Finished Goods Inventory 30/09/2015------------ $ 6,000 44,000 Gross Profit ----------------------------------------------------------- 46,000 - Selling & Administrative Expenses ------------------------------ 30,000 Net Income ---------------------------------------------------------- $ 16,000
The three Inventory accounts together with other assets would appears in Harmon’s September 30, 2015 Balance Sheet. A partial Balance sheet appears below (Table 5.5).
