CHAPTER TWO

2.Introduction to cost terms and cost Classification

Costs can be classified in to various parts as follows:
1. Fixed, Variable and Mixed Costs
 Variable Costs: Variable costs are those costs that vary in total as the volume of activity
changes; the total dollar amount rise, when the volume of activity increases, and falls when
the volume of activities goes down.

Example:
Wages of laborers,
Cost of direct material
Power.
Characteristics of Variable costs:
Variability of the total amount in directly proportion to the volume of output;
Fixed amount per unit in the face of change volume;
Easy and reasonably accurate allocation and apportionment to departments;
such cost can be controlled by functional managers.
 Fixed Costs: These are those costs that remain constant in total amount over a specific
range of activity for a specific period of time/ relevant range That is, these costs do not
increase or decrease when the volume of production changes.
Example:
Building/factory rent
managerial salaries
Insurance charges
Characteristics of fixed costs:
Fixed in their total amount within a relevant range of output.
Increase or decrease in per unit fixed cost when the quantity of production changes;
Apportioned to department on some arbitrary basis;
Such cost can be controlled mostly by top level management.
Fixed costs can be divided in to:
a) Committed Costs: these costs consist largely of those fixed costs that arise from the
possession of plant, equipment and a basic organizational structure. For example, once a
building is constructed and plant is installed, nothing much can be done to reduce the costs
such as depreciation, property taxes, insurance and salaries of the key personnel, etc.,
without impairing the organization's competence to meet the long-term goals. They are
unavoidable in the short run.
b) Discretionary Costs: set at fixed amount, for specific time periods by the management, in
the budgeting process. These are costs which can be avoided by management decision.
They are not permanent. These costs directly reflect top management policies and have no
particular relationship with volume of output. These costs can therefore be reduced or
eliminated entirely, if the circumstances so require.
Example:
Advertising and sales promotion costs,

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 Research and development costs,
Donations,
Management consulting fees, etc.

 A mixed cost- contains both variable and fixed elements. Mixed costs are costs that
have both fixed and variable components; also called semi-variable costs
Example:
a telephone bill: there is a flat charge (fixed cost), even if no calls are made, but the
total telephone expense increases as calls (variable costs) are made.
a salesperson compensated with a fixed monthly salary plus commissions on sales is
a mixed cost.
Light and power
Depreciation
Maintenance and repair
2. Product Cost and Period Costs
 Product costs- represent all manufacturing costs: direct material, direct labor, and
indirect manufacturing costs. These costs appear as assets on balance sheet until sold.
By the time the units are sold, the costs transfer from an asset account into cost of goods
sold.
All manufacturing costs include:
Direct material,
Direct labor, and are product costs.
Manufacturing overhead
 Period costs- represent non-manufacturing costs that are incurred in order to run the
operation of the organization.
 P e r i o d costs are non-manufacturing costs.
 T h e two types of period costs are selling costs, and administrative costs.
3. Direct and Indirect costs
 direct costs: Direct costs are those cost that are incurred for and conveniently identified with
particular cost unit, process or department. Costs of material used in and wage of machine
operator are common examples of direct costs.
Example: cost of lumber and cost of steel in carpenter industry, wage paid for person who
directly involved in production of particular product etc.
 Direct costs are traceable directly to the product or cost object or process in the
manufacturing process.
 Indirect costs: These are general cost and are incurred for the benefit of a number of cost
units, departments or processes. These costs cannot be conveniently identifiable with a
particular cost unit or cost center.
Example: costs incurred for depreciation of machinery, insurance, lighting, power, rent,
managerial salary, material used in repairs etc are included under indirect costs.
 i n d i r e c t costs cannot trace or identified directly with a cost unit for one of the following
three reasons:
It is impossible to do so; example rent of building can not be traced directly to a
particular product, rather it is common to all products produced in the given period
It is not convenient to do so; example nails used in furniture industry by carpenter,
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 sewing thread used by tailor etc, are very difficult to directly trace to a given product.
Management chooses no to do so; example many companies classify certain items of
cost as indirect because it is customary in the industry to do so.
4. Prime and Conversion Costs
 Prime Cost- refers to the sum of direct materials and direct labor used in production. it is also
called direct manufacturing costs, because it includes direct material and direct labor costs.
 Conversion C o s t s : are the combination of direct labor and manufacturing overhead.
Conversion costs are the costs of converting direct materials into finished manufactured part.
In other words, conversion costs refer to the factory costs minus direct material costs.
Conversion costs are also called processing cost.
5. Avoidable and unavoidable Costs
 Avoidable cost: Cost that can be avoided by eliminating a product or department.
 Unavoidable cost: is cost that which cannot be avoided by eliminating a product or
department.
Example: Rent of factory or the salary of a factory manager is unavoidable if a product is
discontinued.
6. Controllable and Uncontrollable coats
 Controllable Costs: are costs which can be influenced by the action of the manager of the
responsibility center or specified member of the undertaking.
 Uncontrollable costs: are costs that cannot be influenced by a given level of management
or a specific member of the undertaking.

7. Historical Cost And Pre-determined costs

 Historical costs; - These are costs which are ascertained after they have been incurred.
Historical costs are thus, nothing but actual costs. These costs are not available until the
completion of the manufacturing operations.
 Pre-determined costs: - These are future costs which are ascertained in advance of the
production on the basis of specification of all the factors affecting the cost. These costs are
extensively used for the purpose of planning and controlling.
8. Normal and Abnormal Costs
 Normal cost: defined as a cost which is normally incurred on expected lines at a given
level of output. This cost is a part of cost of production.
 Abnormal cost: is that which is not normally incurred at a given level of output. Such
cost is over and above the normal cost and is not treated as a part of the cost of production.
It is charged to costing profit and loss account.
9. Relevant costs and irrelevant costs
 Relevant costs: is a cost whose magnitude will be affected by decision being made. In
decision making, management should consider only future costs and revenues that will
differ under each alternative.
 Irrelevant costs: are those costs that will not be affected by a decision. Irrelevant costs
do not show any difference between different alternatives. For example, in a
manufacturing firm the cost we incur for factory rent is irrelevant for decision to buy or
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 to make a part to be used in the process.
10. Unit Costs and Total Costs
 Unit costs: are the average cost of each units produced.
 Total cost: represents the total cost of goods manufactured. Unit costs are computed by
dividing total costs by the total units produced.

11. Prevention and Appraisal Costs

 Prevention Costs: are costs those Support activities whose purpose is to reduce the
number of defects. Examples: Quality training, Quality circles, Statistical process control
activities.
 Appraisal Costs: are costs incurred to identify defective products before the products
are shipped. Example:
Testing & inspecting incoming materials
Final product testing
Depreciation of testing equipment
12. Internal and External Failure Costs
 Internal Failure Costs: Incurred as a result of identifying defects before they are
shipped
Example: Scrap, Spoilage, Rework
 External Failure Costs: Incurred as a result of defective products being delivered to
customers. Example:
Cost of field servicing & handling complaints

Warranty repairs
Lost sales
2.2. Other Cost Related Terminologies
2. Cost Unit and Cost Center
The techniques of costing involve the following concepts:
Collection and classification of expenditure according to cost elements
Allocation and apportionment of expenditure to the cost centers or cost unit or both.
A) Cost Unit
The quantity up on which cost can be conventionally allocated is known as a cost unit. The
Chartered Institute of Management Accountant, London, defines a unit of cost as a unit of quantity
of product, service in relation to which cost may be ascertained or expressed. For example, in a
sugar mill, the cost per tone of sugar may be ascertained; in a textile mill the cost per meter of
cloth may be ascertained. Thus, a tonne of sugar and a meter of cloth are cost units. In short
cost unit is unit of measurement of cost.
Cost unit may be of two types:
i) Units of production: e.g. A tone of steel, a meter of cable, etc
ii) Units of service: e.g. Passenger miles, cinema seats, consulting hours, etc.
Other examples of cost units are:
Industry/Business Cost unit

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 Cement pet tone
Chemicals Per tone, kilogram, liter, gallon, etc
Bricks Per 1,000 bricks, 500 bricks
Soft drink per crate of 24 bottles or 12 bottles
Petroleum Per barrel, tone, liter, etc
Pencil Per dozen or gross
Paper Per ream
B) Cost center
Chartered Institute of Management Accountant (CIMA), London, defines cost center as “a
location, person, or item of equipment (group of these) for which costs may be ascertained and
used for the purpose of cost control.” Thus, a cost center refers to a section of the business to which
costs can be charged. It may be a location (a department, a sales area); an item of equipment (a
machine, a delivery van); a person (a salesman, a machine operator) or a group of these (two
automatic machines operated by workman).
The main purpose of ascertaining the cost of a cost center is control of cost. The person in charge
of a cost center is held responsibility for the control of cost of that center.
Cost centers are primary of two types:
i) Personal cost center: consists of a person or a group of persons.
ii) Impersonal cost center: consists of a location or an item of equipment or group of these
From a functional point of view, cost centers may be of the following two types:
a) Production cost center: are cost centers where actual production work takes place.
Example: weaving department in a textile mill, melting shop in a steel mill, cane
crushing shop in a sugar mill, etc.
b) Service cost center: are cost centers that render services to production cost centers.
Example: Administrative department, Power house, tool room, store department, repair
shop, canteen/cafeteria, etc.
Other types of cost centers are:
Operation cost center: cost centers consisting of those machines or persons which carry
out the same operation
Process cost center: cost center consisting of a continuous sequence of operation.
3. Differential (Incremental) Cost
Differential costs are those costs that increase or decrease in total costs that result from
an alternative course of action as compared to an alternative course of action. Often
managers are in a position to choose between two or more alternatives.
 The difference in total cost between two alternatives is termed as differential cost.
 In case the choice of an alternative results in an increase in total cost, such increased
costs are known as incremental costs. While assessing the profitability of a proposed
change, the incremental costs are matched with incremental revenue.
4. Marginal Cost
Marginal cost represents the extra cost incurred when one additional unit is produced.
Marginal costs differ across different ranges of production as the cost of production varies
along with production levels.

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 5. Sunk Cost
A sunk cost is an expenditure made in the past that cannot be changed and over which the
management no longer has control. These costs are:
 Costs that have already been incurred and cannot be changed now or in the future.
 Costs should be ignored when making decisions.
 Irrelevant for decision making.
 Historical or past costs
Example: -Depreciation on the building,
- Cost of the building
6. Opportunity Cost
Opportunity cost is the sacrifice involve in accepting an alternative under consideration. It is
the benefit forgone while pursuing one course of action ignoring the next best alternative.
Opportunity cost can also be defined as the cost that measures the benefit that is lost or
sacrificed when the choice of one course of action is being given up.
For example, if a building is proposed to be utilized for housing a new project plant, the
likely revenue which the building could fetch, if rented out, is the opportunity cost which
should be taken into account while evaluating the profitability of the project.
Costing Vs Cost Accounting
Costing is defined as the techniques and processes of ascertaining of cost.
It can also be defined as the proper allocation of expenditure that involves the collection
of costs for every order, job, process, service or unit.

Costing simply means cost finding by any process or technique.

It consists of principles and rules which are used for determining the cost of
manufacturing a product and, the cost of providing the service.

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 COST ELEMENTS
A cost is composed of three elements, i.e., material, labor and expense. Each of these three
elements may be direct or indirect. The classification of these costs elements as direct and
indirect will be shown as follows;

Element
Elementofofcost
cost

Materials Labors Expenses

Direct Indirect Direct Indirect Direct

Indirect

MATERIAL COST
Material cost is the cost of commodities supplied to underling. A material cost includes costs of
procurement, freight inwards, taxes, insurance, etc., directly attributable to the acquisition.
Materials may be classified as direct or indirect.
 Direct Materials: - direct material cost is that which can be conveniently identified with and
allocated to cost units. A direct material is the cost of material that is directly entered into the
manufactured product. It includes cost of procurement, freight inwards, taxes, insurance etc.,
directly attributable to the acquisition.
 Indirect Materials: - These are those materials which cannot be conveniently identified with
individual cost units. That cost must also represent a significant portion of the total cost of
the product manufactured.
These are minor in importance, such as;
Small and relatively expensive items which may become a part of the finished product.
Example; Pins , screws, nuts and bolts, thread etc.,
Those items which do not physically become a part of finished products,
Example: Coal, lubricating oil and grease, sand paper used in polishing, soap etc.
LABOUR COSTS:
This is the cost of remuneration (wages, salaries, commission, bonus etc.) of the employees of
undertaking .It includes all cost incurred directly or indirectly for the production of goods and
services.
 Direct Lab our Costs:
A direct labor cost consists of wages and salaries paid to workers directly engaged in
production process.

These wages can be identified with particular product, job or process.

 Indirect Labor Costs

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 Indirect costs are costs that are related to a cost object but cannot be traced to the
cost object directly and in an economically feasible way.
It is of general character and cannot be conveniently identified with particular coast
unit.
Indirect costs are costs that are related to a cost object but cannot be traced to the cost
object directly and in an economically feasible way.
Manufacturing Overheads: are common cost incurred in production process.
Include indirect materials, indirect labor and other manufacturing costs. Some of these
costs are common costs that relate to more than one cost object, and hence cannot be
directly traced to a specific cost object.
Indirect manufacturing costs are also called manufacturing overhead, manufacturing
burden or factory overhead.
A. Costs of Inventory
In manufacturing firms, costs of inventories are classified in to:
 Finished goods inventory costs,
 Work in process inventory costs,
 Raw materials inventory costs.
a) Cost of Finished Good Inventory: consists of costs of completed products
that are ready for sale.
b) Cost of Work –In- Process (Goods in process) Inventory: consists of costs of
products in the process of being manufactured but not yet completed.
c) Cost of Direct Materials Inventory: refers to the costs of direct materials of
the company that are not put in the production process and usually in the
store rooms.
Unused
Direct Direct material
Material
Unfinished
Manufacturin [Work in process]
Direct
Used g process
Labor

Factory Finished goods

Overhead

OVERHEAD COSTS: Manufacturing overhead costs are common costs – costs shared by more
than one cost object- that should be apportioned among the cost objects sharing the cost item.
However, the total overhead costs cannot be known exactly until the end of the year. Thus,
organizations should wait up to the end of the year if they want to charge the actual amount. Yet,
many jobs are completed but the job cost sheet remains open waiting for the actual overhead
cost.

Overhead costs = Indirect material  indirect labor  indirect expenses = Overhead

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A predetermined overhead rate is required to allocate such costs to individual jobs, which is found by
dividing estimated overhead cost to the estimated amount of allocation base. The allocation base is
assumed to be a cost driver of manufacturing overhead costs.
Overheads are divided into three groups as follows;
1. Production overhead
2. Office and Administrative overhead
3. Selling and distribution overhead
1. Production overhead:
Production overheads are also known as works overhead or manufacturing overhead. These are
those overheads which are concerned with production functions. They include indirect material,
indirect labor, indirect expenses in production of goods and services.
2. Office and administrative overheads
This is indirect expenditure incurred in general administrative functions, in formulating
policies, in planning and controlling the functions, in directing and motivating the personnel
of the organization in the attainment of its objectives.
These overheads are of general character and have no direct connection with production or
sales activities. This category overhead is also classified into indirect material, indirect labor,
and indirect expenses that use specifically for office uses.
3. Selling and Distribution overhead;
Selling overhead is the cost of promoting sales and retaining customers.
It is defined as the cost of seeking to create and stimulate demand and of securing orders.
Example:-Advertisements, samples and free gifts, salaries of salesmen, etc.
Components of total cost-element of cost may be grouped as follows.
a. Prime cost = Direct material  Direct labor costs
b. Factory cost = Prime cost  Factory overhead.
c. Cost of production = works cost Administration overhead.
d. Total Cost or Cost of Sales = Cost of production  Selling and distribution
overhead.
Cost sheet:
It is a statement which is prepared periodically to provide detailed cost of a cost center or
cost unit.
A cost sheet not only shows the total cost but also the various components of the total
cost.
Period covered by a cost sheet may be a year, a month, or a week etc.

DIRECT MATERIAL COST COMPUTATION

Direct material costs represent cost of all materials that are integral parts of the cost
object like a product and that can be traced back to the cost object (product for example)
in an economically feasible way.
The direct material used in producing product needs a separate computation that shows
the direct material placed into the production process in that period.

Direct Materials used = Beginning Direct Materials inventory + Direct Materials Purchased – Ending
Direct Materials inventory
 For illustration purposes, assume that the direct materials inventory of ABC Furniture Factory
amounts to Birr 248,000.00 as of January 1, 2009, purchases of Birr 880,000.00 and freight costs
Birr 3,200.00 is made during the year, and the amount of direct materials inventory at the end of
the year is Birr 234,900.00.
The direct material used, therefore, will be shown in the schedule below.
Beginning direct material inventory Br. 248,000.00
Add: Total cost of direct materials purchased :
Direct materials purchased Br. 880,000.00
Freight in 3,200.00
Br. 883,200.00
Direct materials available for use 1,131,200.00
Deduct: Ending direct materials inventory 234,900.00
Direct Materials Used in Production Br. 896,300.00 *

The direct material used in production shows the portion of direct material that have already put
in the production process and the ending direct material cost shows that portion of direct material
left in the store at the end of the period or direct material inventory
COST OF GOODS MANUFACTURED COMPUTATION
Cost of goods manufactured refers to those costs that are added in production process and finally
converted into finished goods during a given production period .The cost of goods manufactured,
consists of three cost elements:-
Cost of direct materials used,
Cost of direct labor, and
Manufacturing overhead.
Extending the same example of ABC Furniture Factory, let's assume the cost of direct labor
employed for the year is Birr 875, 00.00, and the following overhead costs are incurred:
Indirect labor Br. 197,200.00
Depreciation on factory equipment 89,200.00
Light and power 87,200.00
Depreciation of Factory building 24,000.00
Insurance expense on factory properties 19,000.00
Property tax 39,000.00
Factory supplies expense 11,600.00
Miscellaneous factory costs 8,200.00
Total overhead Br. 475,400.00
After the information for the three elements of costs of good manufactured gathered, additional
information about the beginning and ending Work- In -Process are needed. Let’s assume farther
that the beginning and ending Work-In-Process inventory costs for ABC Furniture Factory are
Br. 220,000.00 and Br.263200.00 respectively.
Cost of goods manufactured will be calculated using the following formula.
Cost of Goods Manufactured = beginning work in process inventory + (direct material used + direct labor
incurred + manufacturing overhead) – ending work in process inventory

The computation of Cost of Goods Manufactured for ABC Furniture Factory will take
the following form:

Work in process inventory January 1, 2009 Br. 220,000.00

Add: Direct Materials used* (previous computation.) Br.896,300.0
Direct labor 875,000
Factory overhead 475,400.0
Manufacturing cost incurred during the year 2,246,700.00
Total work in process inventory during the year (to date) 2,466,700.00
Deduct: Work in process inventory Dec, 2009 263,200.00
Cost of Goods Manufactured Br. 2,203,500.00

COST OF GOODS SOLD COMPUTATION

The cost of goods sold represents the cost of goods that are sold during a given year. The cost
of goods sold is computed using the following formula:

Cost of Goods Sold = Beginning finished good inventory + Cost of goods manufactured –

Ending finished good inventory

Assume that the finished good inventory for ABC Furniture Factory as of the beginning of
the year was Birr 314,000.00, and the ending inventory of finished good inventory is
Birr
364,000.00. The cost of goods sold is then prepared as follows:

Finished goods inventory, January 1, 2009 Br. 314,000.00

Add: Cost of goods manufactured* 2,203,500.00
Cost of goods available for sale 2,517,500.00
Deduct: finished good inventory Dec.31, 2009 364,000.00
Cost of goods sold Br.2,153,500.00

General Cost
Accounting:
General cost Accounting system is an extension of the periodic inventory system
of
merchandising businesses. The only difference between the general cost accounting system and
periodic inventory system of merchandising businesses is that the adjustment for general cost
accounting system has additional item called manufacturing summary to which
manufacturing costs are closed.
The year-end adjustments are almost similar except that there are additional efforts to adjust
direct materials and work in process.
The direct material, and other manufacturing costs and work in process are adjusted through
an account called manufacturing summary, and
The finished good is adjusted through the income summary account just in the same way
merchandising businesses do.
The balance of manufacturing summary shows the cost of goods manufactured, and
The manufacturing summary will eventually be closed to income summary as purchase is
closed to same.
The following table shows the balance of sales, beginning inventories of direct materials,
work in process, finished good, and manufacturing costs made during the year for ABC
Furniture Factory.

Sales Br. 3,663,200.00

Finished goods inventory, January 1,2009 314,000.00
Work in process inventory, January 1,2009 220,000.00
Direct materials, January 1,2009 248,000.00
Purchases (Direct materials) 883,200.00
Direct labor 875,000.00
Indirect labor 197,200.00
Depreciation on factory equipment 89,200.00
Light and power 87,200.00
Depreciation of Factory building 24,000.00
Let’s assume that the company uses the periodic inventory system, and the00.00
Insurance expense on factory properties 19,0 physical count made
Property tax
at the end of the year revealed the following results: 39,000.00
Factory supplies expense 11,600.00
Direct materials, Dec.31, 2009
Miscellaneous factory costs 234,900.00 8,200.00
Work in process Dec.31, 2009 263,200.00
Finished good Dec.31, 2009 364,000.00
Since the company uses the periodic inventory system, adjustments are necessary. The beginning
inventories must be excluded and replaced by the ending inventory in the following manner.
Debit Credit
Manufacturing summary 248,000.00
Direct materials 248,000.00
Manufacturing summary 220,000.00
Work in process 220,000.00

It is only the direct material, and work in process that are adjusted though manufacturing
summary. The finished good inventory is adjusted by income summary as usual.
 Debit Credit
Income summary 314,000.00
Finished good 314,000.00
The direct materials purchased, the direct labor costs, and factory overhead are all closed to the
manufacturing summary account.
The following table shows how the different manufacturing costs are closed.
Debit Credit
Manufacturing summary 2,233,600.00
Purchases 883,200.00
Direct labor 875,000.00
Indirect labor 197,200.00
Depreciation – Factory Equipment 89,200.00
Light and power 87,200.00
Depreciation – Factory Building 24,000.00
Insurance expense on factory properties 19,000.00
Property tax 39,000.00
Factory supplies expenses 11,600.00
Miscellaneous factory costs 8,200.00

The ending inventories of direct materials, work in process, and finished good are adjusted in the
following manner:
Debit Credit
Direct material 234,900.00
Work in process 263,200.00
Manufacturing summary 498,100.00

The Finished good inventory is adjusted by the income summary as usual.

Debit Credit
Finished good inventory 364,000.00
Income summary 364,000.00

The Balance of manufacturing summary now shows a balance of Birr 2,203,500.00, which is the
value of cost of goods manufactured.
Manufacturing summary

Br. 468,000.00 Br. 498,100.00

2,233,600.00
Br. 2,203,500.00
Thus, the cost of goods manufactured is Birr 2,203,500.00. The cost of goods manufactured it
self is closed to the income summary account.

Debit Credit
Income summary 2,203,500.00
Manufacturing summary 2,203,500.00

The income summary account after adjusting for beginning and ending inventories of finished
good and closing the manufacturing summary account has a balance of Birr 1,076,750.00, which
represent the cost of goods sold.
Income summary
Br. 314,000.00 Br. 364,000.00
2,203,500.00
Br. 2,153,500.00
To make the illustration complete, let’s add the following from the accounts of ABC Furniture
Factory that is listed in the previous unit:
 Sales ------------------------------------ Br. 3,663,200.00
 Operational expenses:
Selling --------------------------------------660,000.00
Administrative -----------------------------337,700.00
The sales and operational expense accounts are closed to the income summary account as usual.
Debit Credit
Sales
Income summary 3,663,200.00
(To close the sales account ) 3,663,200.00

Income summary Selling

expenses Administrative 997,700.00
expenses 660,000.00
(To close selling and administrative expenses) 337,700.00
The income summary balance after all adjustment and closing shows net income or loss of the
period before any income tax.
Income summary
Br. 2,153,500.00 Br. 3,663,200.00
997,700.00
Br. 512,000.00
The income summary account finally will be closed to the appropriate capital account. Assume
that ABC Furniture Factory is a sole proprietorship belonging to Keneni. The closing will be as
follows:
 Income summary 512,000.00
Keneni, Capital 512,000.00

Financial Statement of a Manufacturing Firm

Financial statements of a Manufacturing Company are more complex as compared to financial
statements of Merchandizing and Service businesses.
Financial statements of a Manufacturing Company are more complex as compared to
financial statements of Merchandising and Service companies.
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
statements of a manufacturing firm, which is more complex than that of the
Merchandising and Service complements.
Income Statement of a Manufacturing Firm
The difference between the income statement of a manufacturing firm and a
merchandising business lies on the cost of goods sold caption.
Merchandising firms sale goods that are bought where as manufacturing firm sale goods
that they have produced. Thus, purchase in merchandising business is replaced by cost of
goods manufactured.
A merchandising business can monitor operational performance more easily than a
manufacturing business because they easily know their selling price since they know the buying
price. For this reason, many manufacturing businesses prepare their income statements more
frequently than merchandising businesses to see improvements made through a period. Frequent
preparation allows them to know the results of operation and thereby alter operational strategies.
From the above information of ABC Furniture Factory assume that the net sale for the year is
Br 3,663,200 and total selling expenses is Br 660,000 and total administrative expenses is
Br 337,700and assume there is no income tax. Then, its income statement will be prepared as
follows:

ABC Furniture Factory

Income statement
For the year ended December 31,2009

Sales Br 3,663,200
Cost of goods sold:
Finished goods inventory, January 1,2009 314,000
Cost of goods manufactured 2,203,500
Cost of goods available for sale 2,517,500
Less: Finished goods inventory, ending 364,000
Cost of goods sold 2,153,500
Gross profit 1,509,700

Operating expenses:
 Selling expenses 660,000
Administrative expenses 337,700
Total operating expenses 997,700
Net Income Br 512,000
This income statement is called a single step or condensed income statement, because it does not
show how each element is constructed.
The following is a multiple step income statement of ABC Furniture Factory

ABC Furniture Factory

Income statement
For the year ended December 31, 2009
Sales Br 3,663,200
Less: Cost of Goods Sold
Finished goods inventory,Jan1,2009 314,000
Work in process inventory, Jan 1,2009
220,000
Work in process during the year:
Direct material used:
Direct material, Jan1,2009 248,000
Direct material purchased 883,200
Direct material available for use 1,131,200
Less: Direct material, Dec 31,2009 234,900
Direct material used
896,300
Direct Labor 875,000
Factory Overhead:
Indirect Labor 197,200
Depreciation on factory equipment 89,200
Light and power 87,200
Depreciation on factory building 24,000
Insurance expense on factory properties 19,000
Property tax 39,000
Factory supplies expense 11,600
Miscellaneous factory costs 8,200
Total Factory Overhead 475,400
Total manufacturing costs during the year 2,246,700
Total Work in process during the year 2,466,700
Deduct: Work in process , Dec 31,2009 263,200
Cost of Goods manufactured 2,203,500
Cost of Goods available for sale 2,517,500
Deduct: Finished goods inventory, ending 364,000
Cost of Goods Sold 2,153,500
Gross Profit 1,509,700
Deduct: Operational expenses:
Selling expenses 660,000
Administrative expense 337,700
Total Operational expenses 997,700
Net Income Br 512,000

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 types of inventories reported. A manufacturing firm carries three types of
inventories namely:
 Direct Materials,
 Work-In-Process,
 Finished good.
Merchandising firms carry only one type of inventory and that is merchandise inventory for
sale. Service firms do not even carry any kind of inventory but supplies to run operations.
Inventory of Direct Material represents the costs of materials that are not yet entered into
the production process.
Inventories of work in process represent all goods that are undergoing some
manufacturing process but yet not done fully to be dispatched for end use. The costs of
work in process inventory include all the manufacturing costs incurred so far in the
manufacturing process;
 the cost of direct materials,
 the costs of labor, and
 Applied manufacturing overhead.
The finished good inventory embodies the final product that is not yet sold. The cost of
finished goods inventory includes all manufacturing costs;
direct material,
direct labor, and
Manufacturing overhead incurred to produce that product.
Example: Look at the presentation of inventories in the following partial balance sheet of a
manufacturing firm:
ABC Furniture Factory
Partial Balance Sheet
December 31,2010

Current Assets:
Cash on hand Br. 25,338
Cash at bank 491,960
Account Receivables 250,936
Allowance for doubtful account 9,156
241,780
Inventories:
Direct material 234,900
Work in process 263,200
Finished goods 364,000
Total inventories Br 862,100
[Type here]

Compiled By : Tesfaye N.