Accounting and Finance for Managers

Chapter Two
Managerial Accounting, Cost terminologies and Classifications

2.1. Introduction

Cost accountancy is a wide term. It means and includes the principles,

conventions, techniques and systems which are employed in a business to plan
and control the utilization of its resources. It is defined as "the application of
costing and cost accounting principles, methods and techniques to the science,
art and practice of cost control and the ascertainment of profitability. It
includes the presentation of information derived therefrom for the purposes
of managerial decision making. Cost accountancy is thus the science, art and practice of a
cost accountant. It is a science in the sense that it is a body of systematic knowledge
which a cost accountant should possess for the proper discharge of his duties and
responsibilities. It is an art as it requires the ability and skill on the part of a cost
accountant in applying the principles of cost accountancy to various managerial problems
like price fixation, cost control, etc.

Cost accounting is the process of determining and accumulating the cost of product or
activity. It is a process of accounting for the incurrence and the control of cost. It also
covers classification, analysis, and interpretation of cost. In other words, it is a system of
accounting, which provides the information about the ascertainment, and control of costs
of products, or services. It measures the operating efficiency of the enterprise. It is an
internal aspect of the organization. Cost Accounting is accounting for cost aimed at
providing cost data, statement and reports for the purpose of managerial decision making.
The Institute of Cost and Management Accounting, London defines “Cost accounting is
the process of accounting from the point at which expenditure is incurred or committed to
the establishment of its ultimate relationship with cost centers and cost units. In the
widest usage, it embraces the preparation of statistical data, application of cost control
methods and the ascertainment of profitability of activities carried out or planned”.

Page 1
 Accounting and Finance for Managers

Costing includes “the techniques and processes of ascertaining costs.” The ‘Technique’
refers to principles which are applied for ascertaining costs of products, jobs, processes
and services. The `process’ refers to day to day routine of determining costs within the
method of costing adopted by a business enterprise.
Costing involves “the classifying, recording and appropriate allocation of expenditure for
the determination of costs of products or services; the relation of these costs to sales
value; and the ascertainment of profitability”.

2.2. Objectives of cost accounting

There is a relationship among information needs of management, cost accounting

objectives, and techniques and tools used for analysis in cost accounting. Cost accounting
has the following main objectives to serve:

 Determining selling price: The objective of determining the cost of products is of

main importance in cost accounting. The total product cost and cost per unit of
product are important in deciding selling price of product. Cost accounting provides
information regarding the cost to make and sell product or services. Other factors
such as the quality of product, the condition of the market, the area of distribution, the
quantity which can be supplied etc., are also to be given consideration by the
management before deciding the selling price, but the cost of product plays a major
role.
 Controlling cost: Cost accounting helps in attaining aim of controlling cost by using
various techniques such as Budgetary Control, Standard costing, and inventory
control. Each item of cost [viz. material, labor, and expense] is budgeted at the
beginning of the period and actual expenses incurred are compared with the budget.
This increases the efficiency of the enterprise.
 Providing information for decision-making: Cost accounting helps the
management in providing information for managerial decisions for formulating
operative policies. These policies relate to: Determination of cost-volume-profit
relationship; Make or buy a component; Shut down or continue operation at a loss;

Page 2
 Accounting and Finance for Managers

Continuing with the existing machinery or replacing them by improved and

economical machines.
 Ascertaining costing profit: Cost accounting helps in ascertaining the costing profit
or loss of any activity on an objective basis by matching cost with the revenue of the
activity.
 Helps in estimates: Adequate costing records provide a reliable basis upon which
tenders and estimates may be prepared. The chances of losing a contract on account
of over-rating or the loss in the execution of a contract due to under-rating can be
minimized. Thus, "ascertained costs provide a measure for estimates, a guide to
policy, and a control over current production.

 Facilitating preparation of financial and other statements: Cost accounting helps

to produce statements at short intervals as the management may require. The financial
statements are prepared generally once a year or half year to meet the needs of the
management. In order to operate the business at high efficiency, it is essential for
management to have a review of production, sales and operating results. Cost
accounting provides daily, weekly or monthly statements of units produced,
accumulated cost with analysis. Cost accounting system provides immediate
information regarding stock of raw material, semi-finished and finished goods. This
helps in preparation of financial statements

2.3. Financial, Cost and Management Accounting

Accounting system takes economic events and transactions, such as sales and purchases,
and processes the data into information helpful to managers, sales representatives,
production supervisors and others. Processing any economic transaction means
collecting, categorizing, summarizing and analyzing. For example, costs are collected by
category, such as materials, lobar and overhead. These costs are then summarized to
determine total cost by month, quarter, or year. The results are analyzed to evaluate, say,
how costs have changed relative to revenue from one period to the next. Managers use
this information to administer the activities or functional areas they oversee and to
coordinate those activities or functions within the frame work of the organization.

Page 3
 Accounting and Finance for Managers

Individual managers often require the information in an accounting system to be

presented and reported differently. Consider, for example, sales order information. A
sales manager may be interested in the total birr amount of sales to determine the
commission to be paid. A distribution manager may be interested in sales order quantities
by geographical regions and by customers requested delivery dates to ensure timely
delivery. This indicates that the financial information required by different bodies is not
the same.
Financial accounting includes all the principles that regulate the accounting and reporting
for financial information that must be disclosed to people outside the company, to
stockholders, bankers, creditors, and brokers. In contrast, management accounting exists
primarily for the benefit of those inside the company, the people who are responsible for
its operations.

Management and financial accounting have differing goals. Management accounting

measures analyzes, and reports financial and non-financial information that helps
managers make decision to fulfill the goals of an organization. Managers use
management accounting information to choose, communicate, and implement strategies.
They also use management accounting information to coordinate product design,
production, and marketing. Management accounting focuses on internal reporting.
Financial accounting focuses on reporting to external parties such as, investors,
government agencies, banks and suppliers. It measures and records business transactions
and provides financial statement that are based on Generally Accepted Accounting
Principles (GAAPs). A manager’s compensation can be affected by the numbers in this
financial statement. Consequently, managers are interested in both management
accounting and financial accounting.
Many of the procedures and principles that stem from financial accounting can also apply
to management accounting. Depreciation techniques, cash collection and disbursement
procedures, inventory valuation methods, and the recognition of what is an asset or a
liability are all essential to the study of management accounting. The reports such as
balance sheet, income statement and statement of of cash flow are common to both
management accounting and financial accounting. But, because their output is

Page 4
 Accounting and Finance for Managers

communicated to different audiences for different reasons, financial accountants and

management accountants follow different rules. The rules of management accounting are
somewhat less defined and place fewer restrictions on the accountant’s day-to-day
activities whereas financial accounting strictly follows GAAP. The following table
summarizes the major difference between Management accounting and financial
accounting.

Areas of Comparison Financial Accounting Management Accounting

1. Primary users of Persons and organizations outside the Various levels of internal management
information business entity
2.Purpose of the Communicate organization’s financial Help managers make decisions to fulfill
Information and operating information to investors, an organizations goal
banks, regulators and other outside parties
3. Types of accounting Double entry system Not restricted to double entry system;
systems any useful system can be used
4. Restrictive guidelines Adherence to GAAP No formal guidelines or restrictions,
only criterion is usefulness
5. Units of Historical (past) Monetary unit Any useful monetary (historical and
measurement future) or physical measure such as
machine hours, labor hours etc
6. Focal point for Business entity as a whole Various segments of the business
analysis entity.
7.Report Summarized report; concerned primarily Detailed report; concerned about details
with the entity as a whole of parts of the entity’s products,
departments, territories
8. Frequency of Periodical on a regular basis When ever needed; may not be on a
reporting regular basis
9. Degree of objectivity Demands objectivity; historical in nature Heavily subjective for planning
purposes, but objective data are used
when relevant and future in nature.

Cost accounting is an accounting information system that records, measures and reports
information about cost. Every business operates with the objective of making profit for its
owners, which is revenue generated less cost of producing that revenue. Cost accounting
deals with accumulating cost of manufacturing a product and other functional processes
and identifying these costs with units produced or some other cost object to enable the

Page 5
 Accounting and Finance for Managers

determination of profit. Cost Accounting measures and reports financial and other
information related to the organization’s acquisition or consumption of resource. Cost
accounting can be applied in any type of organization but primarily applied in
manufacturing organization that combine and process raw material in to finished product.
Cost accounting provides information for both management accounting and financial
accounting. Cost accounting is required everywhere cost information needs to be
collected or analyzed. Cost information is required for financial accounting to determine
the cost of goods manufactured or sold and operational costs while preparing the income
statement and to determine the value of inventories on the balance sheet. Management
accounting requires cost information to set product price, to identify potential areas that
could be taken care of, or area of possible cost reduction and the like. Hence, cost
accounting is important for both financial accounting and management accounting. It is a
subfield of managerial accounting that interfaces with both managerial and financial
accounting.
Distinction between Cost Accounting and Management Accounting
Point of Cost accounting Management accounting
distinction
Coverage It deals with ascertainment, It is concerned with the impact and
allocation, distribution and effect aspects of costs.
accounting aspects of costs
Position in the Cost accountant is generally placed Management accountant assumes a
Hierarchy at a lower level of hierarchy than a superior level in the management
management accountant. hierarchy.
Approach Narrow, as the focus is primarily on Wider, as one may have to use
cost data certain economic and statistical
data along with costing data to
assist managerial decision making.
Emphasis It lays emphasis on cost It is used as a decision making
ascertainment and cost control. technique.

Scope The scope of cost accounting is It Makes use of other techniques

limited to important techniques like like funds flow, ratio analysis, cash
variable costing, break-even analysis flow etc. in addition to variable
and standard costing. costing, break-even analysis and
standard costing. This includes
financial accounting, tax planning

Page 6
 Accounting and Finance for Managers

and tax accounting.

Orientation It deals with data supplied by Futuristic in orientation, is more
financial accounting, orientation is predictive in nature than cost
not futuristic. accounting.

2.4. Cost Concepts and Terminologies

Many accounting reports contain several cost terminologies. A good understanding of the
different cost terminology is essential at least for two reasons. First, it enables accounting
information users to best use the information provided. Second, the use of common
terminology avoids confusion and misunderstanding among the users. Accordingly, the
following are some of the terms and concepts used in cost accounting

 Cost, Expense and loss: One of the common confusion in accounting is the
distinction between cost and expense. Many people use cost and expense
interchangeably. Thus, we start with the definition of these terms. Accountants
usually define cost as resource sacrificed or forgone to achieve a specific objective. It
refers to an outlay or expenditure of money to acquire goods and services in the
course of generating revenue. For instance purchase of raw martial represent a cost as
the raw material is used to produce finished goods that generate revenue when sold.
However some disbursements are not costs. For example, payment of dividend is
disbursement but it does not help to generate revenue, hence it is not a cost.
All costs initially represent an asset. As the asset is used in generating revenue,
the amount consumed becomes an expense. The cost of the asset used should then be
recognized as an expense to properly match revenues and expenses in the process of
determining the income of the organization over a given period. For instance,
insurance premium paid in advance to serve the coming period are initially
recognized as an asset (prepaid insurance), but as time passes on, the asset is
continually converted in to an expense (Insurance expanse). Another example may be
a motor vehicle bought for use for the coming five years is an asset when initially

Page 7
 Accounting and Finance for Managers

purchased. However, as the asset is used up in the process of generating revenue, the
cost gradually becomes an expense. Thus, expenses are expired costs or costs used up
in the course of generating revenue.
The distinction between cost and expenses is important for the preparation of
financial statement for service, merchandising and manufacturing firms. In fact, it has
more importance relatively for manufacturing enterprise. This is because, costs
incurred in the manufacturing process don’t become expense until the product is sold
and thus, items that are fully or partially manufactured represent costs and should be
recognized as assets on the balance sheet. Therefore, financial reporting in
manufacturing firms has some complication as compared to financial reporting in the
service and merchandising business. Sometimes, a firm may incur a cost that
produces neither immediate nor future benefit. This is called a loss. For example
damage caused by fire or flood on property held is a loss.

 Cost object: is anything for which a separate measurement of cost is desired. In

manufacturing company, the cost object is the unit of finished goods manufactured.

 Cost Accumulation and cost Assignment: A costing system typically account for
costs in two basic stages, accumulation followed by assignment. Cost accumulation is
the collection of cost data in some organized means of accounting system and cost
assignment is a general term that encompass both (1) tracing accumulated cost that
have direct relationship to the cost object and (2) allocating accumulated costs that
have an indirect relationship to the cost object. For example, a publisher that purchase
paper rolls for printing magazines collect the cost of paper bought and used in any
one month to obtain the total monthly cost of paper used. Beyond accumulating costs,
the cost accountant assign cost to the different magazines the publisher publish to
help decision making

 Cost driver: is any factor that affects total cost. That is a change in the cost driver
will cause a change in the level of the cost of a related cost object. For example, the
following are some of the cost drivers used for each types of costs mentioned.
 Mile driven for transport cost
 Length of time of call for telephone cost

Page 8
 Accounting and Finance for Managers

 Metric cube of water consumed for water cost

 Unit sold for cost of goods sold
 Cost management: cost management is the essence of cost accounting. Cost
management refers to the planning and execution of activities both in the short run
and long run to control costs. Profoundly, cost management is about cost reduction
but it is not confined to it alone. Sometimes managers may incur additional costs in
order to increase their future sales. This activity is also a cost management. It is the
set of actions that a manager takes to satisfy customers while continuously reducing
and controlling cost. Cost reduction efforts frequently focus on two key areas:
 Doing only value adding activities, that is, those activities that customers perceive
as adding value to the product or service they purchase
 Efficiently managing the use of the cost drivers in the value adding activities.

2.5. Classifications of Cost

There are several standard cost classifications and each classification has its own unique
terminology. In this chapter, we present a comprehensive list of ways costs may be
grouped, the concepts underlying each, and the terminology commonly used. Remember
that the same cost may be included in several or in all of the following classifications.

1. Time Period for Which the Cost is computed: Time can be broadly classified in to
past and future. Costs can also be classified according to these time periods.
Historical costs are those costs that were incurred in past period. Future costs,
generally called budgeted costs, are those costs that are expected to be incurred in the
future period. For example, the Br.8, 000 cost of a computer acquired in 2018 is a
historical cost in the financial statement of 2019. However, the Br.10, 000 cost to
acquire a new computer in 2021 to replace the existing computer is a future cost.

2. Management Function : An organization may be separated into functional areas. A

manufacturing company’s functional areas generally include manufacturing,
marketing, and general administration. One individual, such as a vice president of
manufacturing or a vice president of marketing, has primary responsibility for a

Page 9
 Accounting and Finance for Managers

specific functional area. To evaluate the effectiveness of the functional area and the
individual in charge of it, costs also must be grouped by functional area as follows.
 Manufacturing Costs - include costs from the acquisition of raw materials
through production, until the product is turned over to the marketing division to
be sold. Manufacturing costs include the cost of the raw materials, payroll costs
for people working on the product, and incidental costs such as taxes, power,
depreciation, and repairs associated with manufacturing the product.
 Selling Costs - are all costs associated with marketing and selling a product. They
include all costs incurred by the marketing division from the time the
manufacturing process is complete until the product is delivered to the customer.
These costs include advertising, promotional offers, freight to deliver the product,
and warehouse costs while the product is waiting to be sold.
 Administrative Costs are all costs associated with the management of the
company and include expenditures for accounting, legal, and administrative
activities. Interest costs are also included among administrative costs.

3. Generally Accepted Accounting Treatment: The alternatives in accounting for a

cost are to expense it or to capitalize it.
 Periodic Costs are costs that are expensed in the period in which they are
incurred. Periodic costs possess no future benefit and are generally associated
with a non manufacturing area of the business. Examples of periodic costs include
advertising, Interest, president’s salary and sales commissions.
 Product Costs consist of all costs associated with the manufacturing function of
the business. They include materials, labor, and 0ther factory overhead costs
associated with assembling and processing the units. Because the company still
holds the product and its usefulness has not yet expired, it is not appropriate to
expense these costs. They are capitalized as inventory and held as unexpired until
they are sold.
 Capital Costs are similar to product costs in that they are also capitalized as
assets. However, capital cost is the term used to describe the equipment, building
and land held permanently for making business. These items are capitalized as

Page 10
 Accounting and Finance for Managers

tangible fixed assets and are depreciated over their useful lives. Product costs are
reserved for inventorable costs associated with the manufacturing process

4. Traceability to Products : From traceability point of view, cost is divided in to

direct and Indirect cost:
 Direct Cost: is a cost that can be economically traced to a single unit of finished
product. For example; direct material & direct labor are direct costs
 Indirect Cost: is one that is not directly traceable to the manufactured product.It
is associated with the manufacture of two or more units of finished product, or is
an immaterial cost that cannot be economically traced to single units of finished
product. For example: Cost of electricity, Depreciation of equipment, indirect
labor, indirect material, Cost of different utilities, Cost of repair and maintenance,
Insurance for the factory are indirect costs.
A comparison of the labor cost of an assembly worker and a repair person
in a cabinet shop will illustrate the difference between a direct and an indirect
cost. The assembly worker’s salary is typically classified as a direct cost because,
it is a significant portion of the cabinet’s total cost and because it is easy to trace
the assembly worker’s efforts to a particular set of cabinets. The machine repair
person’s salary would probably be classified as an indirect cost because; it is
difficult or impossible to trace that individual’s efforts to a unit of output. The
repairperson is responsible for keeping all machines running properly. Since he or
she work on several machines and the machines work on several different
cabinets each day, we cannot trace this person’s salary to a particular set of
cabinets. The lack of traceability requires that it should be classified as an indirect
cost. The economics of tracing a cost to a particular unit of finished product is an
important distinction between direct costs and indirect costs. Take a table that
requires a few screws and a little glue to complete the assembly. Both of these
items can be traced to a particular unit of finished product and would, therefore,
qualify as direct costs. However, these items are usually classified as indirect
costs if their amounts are immaterial when compared to the other materials going
into the product. Also, the cost involved in tracing and recording the items as

direct costs would be greater than the benefit of having that information.

Page 11
 Accounting and Finance for Managers

5. Cost Behavior: Cost behavior describes how a cost changes with time or with
changes in volume. Variable costs are costs that vary proportionately in total as the
volume of production or sales changes. For example, if it takes Br.100 of lumber to
make one unit of table and if five units are produced, the total cost of the lumber is
Br. 50. The total variable cost increases in proportion with the number of unit’s
produced, but the cost of each unit remains the same. Fixed cost remains constant in
amount as volume of production or sales changes. Straight-line depreciation on a
plant asset is an example of a fixed cost. The amount of depreciation is the same
regardless of the number of units produced.

6. Decision Significance: A decision involves making choices among alternative

courses of action. The decision maker generally collects cost information to assist in
making the decision. Relevant cost is future costs that differ with the various decision
alternatives. They are costs that make a difference in a decision-making process.
Irrelevant Costs do not relate to any of the decision alternatives, are historical in
nature or are the same under all decision alternatives. Irrelevant costs are generally
excluded from the analysis.

7. Managerial Influence: Managerial influence refers to the ability of a manager to

control a particular cost. Remember that all costs are controlled by someone at some
level in the organization if the time period is long enough. However, when we see for
a particular manager at a particular level in the organization and for a short period of
time, there are some costs that can be influenced and some that cannot. Controllable
costs are subject to significant influence by a particular manager within the time
period under consideration. Uncontrollable costs are those costs over which a given
manager does not have a significant influence.

8. Commitment to Cost Expenditure: Commitment to a cost expenditure focuses on

fixed costs as opposed to variable costs and on budgeted costs as opposed to historical
costs. Budgeted fixed costs can be broadly classified as committed costs and
discretionary costs.

Page 12
 Accounting and Finance for Managers

 Committed cost is one that is an inevitable consequence of a previous

commitment. Property tax budgeted for the coming year is an example of a
committed cost. Suppose top management made the decision two years ago to
construct a new warehouse. After it was completed, the tax commission placed
an assessed value on it, and a property tax notice is now recapped annually
according to the tax law. The property tax must be paid or the warehouse will be
seized by the tax authority and sold to cover the unpaid taxes. Property tax is a
committed cost that resulted from the decision to construct the warehouse.
 Discretionary Cost, also called a programmed cost or a managed cost, is one
for which the amount or the time of incurrence is a matter of choice. There are
some nonrecurring costs for which a final commitment has not yet been made
and that can be postponed until a future period or cancelled entirely. Replacing
the carpet in the demolished offices and repainting the walls of the factory are
examples of discretionary costs where the right timing is a matter of judgment.
Even though the carpet is beginning to show some wear, it could continue to be
used for several months without any interruption to normal operations.

9. Other Cost Classifications: Several other cost classifications are frequently used in
discussing cost accounting and management decisions. Their primary usefulness is in
helping to place correct perspective of the potential benefit of a possible course of
action. These classifications include marginal costs, out –of –pocket costs, sunk costs,
and opportunity costs.
 Marginal Costs, also called incremental costs, are the costs that are associated
with the next unit or the next project. The term marginal cost is widely used in
economics to refer to the added cost associated with the production of an
additional unit of output.
 Out- of – Pocket Cost: is a cost that must be met with a current expenditure.
Generally an out – of – pocket cost is a cash expenditure associated with a
particular decision alternative.
 Sunk Costs: are defined as past costs that have already been incurred. Because
sunk costs are historical costs, they are generally irrelevant to decisions affecting
the current or future use of the asset.

Page 13
 Accounting and Finance for Managers

 Opportunity Cost: is defined as the cost or value of an opportunity forgone

when one course of action is chosen over another. Opportunity cost is not an out-
of –pocket cost, or even a future cost associated with the selected alternative, but
represents the lost opportunity associated with each of the alternatives that are
rejected.

2.6. Financial Statement for a Manufacturing Organization

Accounting for manufacturing process has the finished products as the primary cost
object. The cost accounting system applied to the cost object is designed to accumulate
the manufacturing cost and assign them to the units produced. We will first identify the
terminology used for different types of manufacturing costs and then illustrate how they
are combined in to a statement of cost of goods manufactured. Product costs are
classified for accounting purpose in to direct material, direct labor and indirect
manufacturing cost. The criteria used for the classification are the type of cost
traceability to particular units of finished product and materiality.

 Direct Material: Product costs that relates to the use of raw material and supplies
must be identified as either direct material or indirect material. Direct material
includes the raw material component that can be physically identified with or traced
to the finished product. It is distinguished from indirect material by the ability to
identify it economically with finished products. Indirect material lacks traceability to
the finished product and is included as an element of indirect manufacturing costs.
The type of manufacturing process and the products being produced must be
identified to evaluate whether a raw material input is direct or indirect. For example,
paper used in a printing shop would be classified as direct material because the paper
is a significant part of each printing job and can easily be identified with the finished
product. However, paper used in a glass factory to pack around the finished product
would probably be classified as indirect material. Here, the paper is an insignificant
part of the finished product, and it is not economically feasible to identify the quantity
and cost of the paper used with each product. Other example of direct materials
includes wheat in a flour mill, malt in a beer factory, and lumber in manufacturing
wooden tables.

Page 14
 Accounting and Finance for Managers

 Direct Labor: salaries and wages properly classified as product cost must be
separated into direct labor or indirect labor for accounting purposes. Direct labor
includes the wage of employees who work directly on the product and whose efforts
can economically be traced to a particular unit. The wage paid to a laborer who will
cut and polish lumber and assemble it to a table is a direct labor cost for the table. But
the salary of a supervisor who will oversee the production process of the different
products in the factory is an in direct cost as he will not be directly involved in the
production process.
 Indirect Manufacturing Costs: All manufacturing costs other than direct materials
and direct labor are classified as indirect manufacturing costs. There are several other
titles commonly used to describe this group of manufacturing costs, including factory
overhead, manufacturing overhead or factory burden. The followings are some of the
manufacturing overhead costs for a furniture manufacturing company:
o Indirect materials, such as glue, nails, screws
o Indirect labor, such as supervisor’s salary and Janitorial services.
o Taxes on manufacturing facilities.
o Utilities for the manufacturing process.
o Depreciation on manufacturing faculties.

Prime Costs and Conversion Cost: Prime costs and conversion cost are two other terms
used to describe production costs.

Prime Costs are the most important or significant costs traceable to unit of finished
product. They include direct material and direct labor. Conversion costs are those
required to convert raw materials into finished product and consists of direct labor and
factory overhead. As noted earlier, the same cost may be given different titles and used
for different purpose. Paper in a copy center, for example, would be classified as direct
material for accounting purposes, but it would also be called a prime cost.
Prime cost = Direct Material Cost + Direct Labor Cost
Conversion cost = Direct Labor Cost + Manufacturing Overhead Cost

Page 15
 Accounting and Finance for Managers

Financial statement of a manufacturing company is more complex as compared to

financial statement of merchandising and service giving companies. Particularly, the
balance sheet and income statement of a manufacturing enterprise are somewhat different
from their merchandising and service counterpart. All costs mentioned above should be
properly accounted for and reported in the financial statement of a manufacturing firm.

Manufacturing organizations perform selling and administrative functions similar to

merchandising firms. However, instead of purchasing goods that are ready for resale, a
manufacturing firm buys raw materials, labor, and other components needed to perform
the manufacturing function of converting the raw materials into finished products. This
difference is shown in the cost-of –goods –sold statements. In addition, the balance sheet
at the end of the period will show ending inventories for raw materials, work in process,
and finished goods. Our objective here is to explain the computation of cost of goods
manufactured and to illustrate the development of external financial statements for a
manufacturing organization.

Balance Sheet of a Manufacturing Firm

The balance sheet of a manufacturing firm differs from the balance sheet of a
merchandising firm principally by the type of inventories reported. A manufacturing firm
carries three types of inventory. Namely, Raw material inventory, Work in Process
inventory and Finished Goods inventory.
 Raw Material Inventories: are raw materials in stock and waiting to be used in
manufacturing process.
 Work in Process Inventories: are goods partially processed but not yet
completed. They are also called Work In Progress (WIP).
 Finished Goods Inventories: are goods fully completed but not yet sold.
The balance sheet presented below for a hypothetical manufacturing company shows how
the three types of inventories are presented.

ABC Furniture Factory

Balance Sheet
June 30, 2019

Page 16
 Accounting and Finance for Managers

Current assets:
Cash --------------------------------------------------- Br.250, 000
Accounts receivable ------------- Br. 315,000
Allowance for uncollectible-------- (15,000) 300,000
Inventories:
Raw material ------------------------Br.150,000
Work in process ----------------------- 75,000
Finished goods --------------------- . 225,000 450,00

2. Income Statement of a Manufacturing Firm

Income statement of a manufacturing firm differs from income statement of a

merchandising firm by the cost of goods manufactured section. A merchandising firm
sells goods that are bought from another merchandising firm or from a manufacturing
firm. But a manufacturing company sells goods that are internally produced. Hence, the
cost of goods sold section contains cost of goods manufactured instead of purchase. Cost
of goods manufactured must first be computed before the income statement is prepared.
The cost of goods manufactured by itself needs a computation that presents the cost of
direct material used, cost of labor incurred, and factory overhead costs. The direct
material used is a separate schedule that shows the direct material placed in to the
production process in that period. In general, the following four steps are required to
prepare income statement of a manufacturing firm.

Step 1: The Schedule of Direct Materials Used in Production

The cost of direct material used is equivalent to the beginning inventory of direct material
plus purchase made during that period less the direct material left at the end of the period.
Schedule1: Cost of Direct Material Used
Beginning direct material inventory XX
Add: Purchase in the period XX
Direct material available for use XX
Less: Ending direct material inventory (XX)
Cost of direct material used XX
Step 2: The Schedule of Cost Goods Manufactured
Cost of goods manufactured refers to the cost of goods brought to completion
whether they were started before or during the accounting period. To determine the

Page 17
 Accounting and Finance for Managers

cost of goods manufactured, three factors are necessary; cost of direct materials used,
cost of direct labor and manufacturing overhead. In addition, work in process at the
beginning and at the end should be incorporated in the calculation. The following is
the schedule used to calculate the cost of goods manufactured.
Schedule 2: Cost of Goods Manufactured
Work in process at the beginning----------------------- XX
Add: Cost of direct material used -------------XX
Direct labor cost --------------------------XX
Manufacturing over head cost -----------XX
Cost incurred in current period ----------------------- (XX)
Total cost incurred to date ------------------------------ XX
Less: Work in process ending ---------------------------XX
Cost of goods manufactured ----------------------------XX

Step 3: The Schedule of Cost of Goods Sold

The cost of goods sold represents the cost of goods that are sold during a given
period. In computing cost of goods sold amount, cost of finished goods at the
beginning, cost of goods manufactured in the period and cost of finished goods at the
end will be taken in to account. The following is the schedule used to compute cost of
goods sold.
Schedule 3: Cost of Goods Sold
Finished goods beginning --------------------- XX
Add: Cost of goods manufactured ------------XX
Cost of goods available for sale -------------- XX
Less: Finished goods ending ---------------- (XX)
Cost of Goods Sold -----------------------------XX

Step 4: Income Statement

All of the above schedules are inputs one to the other. The ultimate goal of making all the
schedules is to prepare the income statement. The income statement contains three main

Page 18
 Accounting and Finance for Managers

elements. These are sales, cost of goods sold and operational expense. The cost of goods
sold is deducted from sales to arrive at gross profit. From gross profit, operational
expense is deducted to arrive at operating income. The following is the schedule used to
calculate operating income.
Schedule 4: Income Statement
Revenues XX
Cost of goods sold XX
Gross profit XX
Operating expenses (XX)
Operating income XX

Illustration:

Page 19
 Accounting and Finance for Managers

Assume that the direct material inventory of ABC furniture factory amounts to Br. 248,
000 at the beginning of the year i.e., as of June 1, 2019. Purchase of direct material
amounting Br. 440,000 was made and freight cost of Br.3, 200 is incurred during the
year, and the amount of direct materials inventory at the end of the year is Br. 234, 900.
Further, assume that the factory has beginning work in process of Br. 220,000 and ending
work in process of Br. 263,200. The direct labor cost incurred in the year is Br.875, 000
and the different manufacturing overhead costs incurred during the year are given below:
Indirect labor Br.98, 600
Depreciation on factory equipment 44,600
Light and power 43,600
Depreciation of factory building 12,000
Insurance expense on factory properties 9,500
Property tax 19,500
Factory supplies 9,900
Total manufacturing overhead cost Br.237, 700

Assume also that the finished goods inventory at the beginning of the year was Br.
314,000 and the ending inventory of finished goods is Br.364, 000 for the factory. If the
sales amount for the factory is Br.3, 600,800 and the operating expense is Br.1, 500,000,
prepare income statement of the factory as of June, 2019.

1. Schedule of direct material used

Beginning direct materials Inventory Br.248,000
Add: Total cost of direct material purchased
Direct Materials purchased Br.440,000
Freight in 3,200 443,200
Direct material available for use Br.691,200
Deduct: Ending direct material inventory 234,900
Cost of Direct materials used Br.456,300

2. Schedule of cost of goods manufactured

Page 20
 Accounting and Finance for Managers

Beginning Work in process Br.220,000

Add: Cost of direct material used Br.456,300
Direct labor cost 875, 000
Manufacturing overhead cost 237, 700
Cost incurred in current period Br.1,569,000
Total cost incurred to date Br.1,789,000
Ending work in process (263,200)
Cost of goods manufactured Br. 1,525,800

3. Schedule of Cost of Goods Sold

Finished Goods Beginning Br.314,000

Add: Cost of goods manufactured 1,525,800
Cost of goods available for sale 1,839,800
Finished Goods Ending 364, 000
Cost of Goods sold Br. 1,475,800

4. Incomes statement
ABC Furniture Factory
Income Statement
For the year ended June 30, 2019

Sales revenue Br.3,600,800

Cost of Goods sold ( 1,475,800)
Gross profit 2,125,000
Operating expenses (1, 500,000)
Operating Income Br.625,000

The above income statement is called a single step or condensed income statement, as it
does not show how each element is constructed. The separate schedules are inputs to the
income statement. It is also possible to include all the schedules at a time to prepare the
income statement. Such statement contains detailed information about each item and is
called multiple step income statement.

Page 21