Cost Flows and Cost Terminology

CHAPTER 3 Cost Flows and Cost Terminology

Learning Objectives After studying this chapter, you will be able to: 1. Distinguish product costs from period costs. 2. Understand the flow of costs in service firms. 3. Discuss how inventories affect the flow of costs in merchandising firms. 4. Explain the cost terminology and the flow of costs in manufacturing firms. 5. Allocate overhead costs to products.

Overview In this chapter, we discuss the kinds of accounting systems you will encounter in the workplace. Most firms design their financial records to track costs by business function, such as whether they relate to manufacturing, selling, or administration. Why? Because formal accounting systems typically are set up to help with financial reporting, and Generally Accepted Accounting Principles (GAAP) requires financial reports to group costs by business function. We begin this chapter with a short look at how firms accumulate costs for financial reporting purposes. We then examine cost accumulation in three types of organizations: service, merchandising, and manufacturing. We discuss the similarities and differences in the flow of costs in these organizations, focusing particularly on how they accumulate costs for valuing inventory and reporting income. Because cost allocations play an integral role in this process, we end with a brief overview of the mechanics of cost allocations.

Learning Objective 1 Distinguish product costs from period costs.

Product and Period Costs 1. In financial accounting terms, the costs associated with getting products and services ready for sale are product costs. 2. Product costs always appear “above the line” for gross margin, which is revenues less product costs. 3. Period costs do not directly relate to readying products or services for sale. 4. Period costs, which are all costs that are not product costs, always appear “below the line” for gross margin. 5. The matching principle in GAAP is the answer for why we need to separate product and period costs. a. GAAP requires that we match the revenues and costs associated with making and selling a product or service during the same accounting period. b. We flow product costs through inventory accounts to enable such matching. c. There is no need to match period costs, as they are not associated with making and selling a product or service. d. Thus, we immediately expense, or charge to the income statement, all of our period costs. 1 Learning Objective 2 Understand the flow of costs in service firms.

Cost Flows in Service Organizations 1. What distinguishes service firms from other firms? 2. Like all organizations, these firms use a mix of human and capital resources to perform their functions. 3. However, unlike merchandising and manufacturing firms, the products service firms offer are not tangible or storable. 4. In essence, service firms make their facilities available to others for a fee. 5. GAAP statements provide limited information about opportunity costs. a. For such reasons, it frequently is vital to modify accounting reports and use nonfinancial data to estimate the controllable costs and benefits of a decision option. b. Although the GAAP income statement separates product costs from period costs, it combines controllable costs with noncontrollable costs and fixed costs with variable costs. c. In Chapter 4, we learn some techniques for modifying GAAP statements to estimate the controllable costs of a decision.

Learning Objective 3 Discuss how inventories affect the flow of costs in merchandising firms.

Cost Flows in Merchandising Organizations 1. Merchandising firms buy goods from suppliers and resell substantially the same products to customers. 2. Unlike service firms, merchandising firms maintain an inventory of goods that they buy and sell. 3. They use this inventory to make goods available in the quantities, varieties, and delivery schedules demanded by customers.

Inventory Equation 1. Because inventories are a necessary part of a merchandiser’s business, such firms need to distinguish the cost of goods purchased from the cost of goods sold. 2. For financial reporting purposes, firms expense the cost of items when they sell the items, not when they purchase them. 3. The inventory equation is shown below:

Cost of beginning inventory + Cost of goods purchased during the period - Cost of ending inventory Cost of goods sold (COGS) during the = period

2 4. Firms use cost flow assumptions when different inventory “layers” are present (inventory items bought at different times and prices).

Income Statement 1. Except for the presence of the inventory account, the cost flows in merchandising firms resemble the flows for service firms. 2. As with service firms, period costs appear below the line for gross margin.

Learning Objective 4 Explain the cost terminology and the flow of costs in manufacturing firms.

Cost Flows in Manufacturing Organizations 1. Unlike merchandising firms, manufacturing firms use labor and equipment to transform inputs such as raw materials and components into outputs. 2. The many kinds of costs and variations in manufacturing production processes result in a dizzying array of cost terms. 3. Exhibit 3.5 summarizes the most important of these terms commonly found in practice.

Cost Terminology 1. The costs of manufacturing the products are known as product costs. 2. Typical inputs in a manufacturing firm include materials, such as steel, leather, canvas, and plastic, and labor, the physical work required to convert materials to a finished product. a. These items represent variable manufacturing costs as expenditures on these items vary proportionally with production volume. b. Since firms frequently can trace materials and labor costs directly to products, they are direct costs. c. As such, many refer to materials and labor costs as direct materials and direct labor, respectively. 3. Costs we cannot trace directly to a specific product are indirect costs. a. We refer to the total of all these indirect manufacturing inputs as overhead, or sometimes as manufacturing overhead. b. Some overhead costs, such as the costs of supplies and packaging materials, might vary with production volume. c. We refer to the variable portion of these costs as variable overhead and the fixed portion as fixed overhead. 4. Direct materials, direct labor, and overhead (both variable and fixed) are all product costs because they are connected with getting the product ready for sale. 5. Manufacturing firms also incur nonproduction related costs. a. Firms also incur administration costs associated with managing the organization itself. b. Collectively, we refer to these costs as selling and administration costs. 6. The sum of materials and labor costs are prime costs. 7. The sum of variable and fixed overhead are considered capacity costs.

3 Typical Production Process 1. When firms purchase raw materials, they add the cost to the materials inventory account. 2. Firms accumulate labor and overhead costs incurred during a given accounting period in temporary “control” accounts, which are zeroed out at the end of each accounting period. 3. As production commences, firms assign the cost of materials, labor, and overhead from the respective inventory and control accounts to a work-in-process (WIP) account. 4. The sum of materials, labor, and overhead costs added to the work-in-process account during the period are the total manufacturing costs charged to production. 5. Each step in the production process consumes some overhead resources. 6. Once the production process is completed, firms transfer finished work physically from work-in-process inventory to finished goods (FG) inventory. 7. Correspondingly, they transfer the cost of goods manufactured (COGM) from the work- in-process inventory account to the finished goods inventory account. 8. When firms sell finished goods, they physically transfer the goods to buyers. a. At the same time, firms remove the associated cost from the FG inventory account and transfer it to the cost of goods sold (COGS) account. b. Cost of goods sold appears as a deduction from revenues in the income statement, with gross margin equaling the difference between revenues and COGS.

Income Statement 1. Exhibit 3.7 shows a series of illustrations the flow of costs for a sample company. 2. The cost of goods sold represents the product costs associated with the items sold during the year. 3. It is not necessarily the same as the cost of goods manufactured during the year. 4. A manufacturing firm, however, has three inventory accounts: raw materials, work in process, and finished goods. 5. The final income statement looks the same for service, merchandising, and manufacturing firms.

Learning Objective 5 Allocate overhead costs to products.

Cost Allocations 1. We next turn to an issue of how firms assign overhead costs, for example, when multiple products exist. Firms will have multiple work-in-process and finished goods accounts, one for each product, when assigning overhead costs. 2. We can directly assign the costs of materials and labor to each WIP and FG account because we can trace these costs to each product. 3. However, assigning manufacturing overhead to individual work-in-process accounts poses a problem. 4. Overhead costs are indirect and, as such, are not traceable to each product. 5. A cost allocation is a procedure that allocates, or distributes, a common cost.

4 6. There are four important elements in every cost allocation: a. cost pools, b. cost objects, c. cost drivers, d. and allocation volume. 7. After considering these elements, the allocation procedure itself consists of two steps. a. Determine the Allocation Rate (Overhead Rate) b. Allocate the Cost. 8. GAAP gives firms considerable leeway regarding their choices of how to allocate manufacturing overhead to products. 9. Commonly used allocation bases include direct labor hours, direct labor cost, machine hours, and the number of units. 10. Usually, firms pick a cost driver that exhibits a cause-effect relation with the cost being allocated.

Beware of Allocated Costs When Making Decisions 1. GAAP income statements combine controllable costs with noncontrollable costs and fixed costs with variable costs. 2. As a result, it is difficult to use the summary data provided by GAAP income statements for internal decision making. 3. To facilitate decisions, many firms prepare reports that regroup costs by their variability, as shown in Exhibit 3.15.

CHAPTER 3 REVIEW QUESTIONS

TRUE/FALSE

1. We subtract product costs from gross margin to arrive at profit before taxes.

2. Gross margin equals revenues less product costs or cost of providing services.

3. Cost of merchandise sold would be classified as a product cost.

4. Labor to machine blades would be classified as fixed manufacturing overhead.

5. Prime costs equal the sum of direct materials and manufacturing overhead.

6. In both merchandising and manufacturing firms, there are three primary inventory accounts in the balance sheet.

7. Direct manufacturing labor is a variable product cost.

MULTIPLE CHOICE

5 1. Which of the following is not an example of a product cost at a gym? A. Salary paid to instructors. B. Corporate office rent. C. Supplies D. Utility cost in the gymnasium.

2. Gross margin equals: A. Revenues less product costs. B. Revenues less period costs. C. Revenues less selling and administrative expenses. D. Revenues less depreciation expense.

3. Metal used to make components is an example of: A. Direct Labor B. Variable Manufacturing Overhead C. Direct Materials D. Fixed Manufacturing Overhead

4. Which of the following is not an example of a direct material? A. Steel. B. Packaging Materials. C. Leather. D. Canvas.

5. Which account would not be shown under inventory in a manufacturing firm's balance sheet? A. Work-in-Process. B. Merchandising Inventory. C. Finished Goods. D. Held on Consignment.

6. Aspen Company has sales of $2,000,000, cost of goods sold of $200,000, and selling and administrative costs of $500,000. Aspen Company's gross margin is: A. $1,800,000. B. $1,500,000. C. $1,300,000. D. $1,700,000.

7. Aspen Company has sales of $2,000,000, cost of goods sold of $200,000, and selling and administrative costs of $500,000. Aspen Company's profit before tax is: A. $1,800,000. B. $1,500,000. C. $1,300,000. D. $1,700,000.

6 8. Blackledge, Inc., a merchandising firm, provides the following information relating to its most recent year of operations. Blackledge, Inc. charges off the entire cost of transportation in to the income statement for the period. Revenues $15,500,800 Beginning inventory, 1/1 300,600 Ending inventory, 12/31 260,500 Purchases 10,725,250 Transportation in 104,500 Sales commissions 500,064 Store rent 1,235,000 Store utilities 143,765 Other administration 789,354

What is Blackledge, Inc.'s gross margin? A. $4,630,590. B. $4,735,450. C. $4,630,950. D. $4,735,540.

9. Blackledge, Inc., a merchandising firm, provides the following information relating to its most recent year of operations. Blackledge, Inc. charges off the entire cost of transportation in to the income statement for the period. Revenues $15,500,800 Beginning inventory, 1/1 300,600 Ending inventory, 12/31 260,500 Purchases 10,725,250 Transportation in 104,500 Sales commissions 500,064 Store rent 1,235,000 Store utilities 143,765 Other administration 789,354

What is Blackledge, Inc.'s profit before taxes?

A. $2,067,627. B. $2,067,267. C. $1,962,676. D. $1,962,767

MATCHING

1. Match the items below by entering the appropriate code letter in the space provided.

A. Conversion Costs F. Period Costs B. Matching Principle G. Variable Overhead

7 C. Product Costs H. Gross Margin D. Prime Costs I. Cost of goods manufactured (COGM) E. Allocation Rate J. Merchandising Firm

____ 1. The sum of direct materials and direct labor costs, as these are the primary inputs into the production process.

____ 2. Revenues less product costs = revenues less cost of goods sold or cost of providing services.

____ 3. The sum of direct labor and manufacturing overhead costs.

____ 4. The cost pool divided by the allocation volume.

____ 5. GAAP requires that we match the revenues and costs associated with making and selling a product or service during the same accounting period.

____ 6. A financial accounting concept under GAAP. Any cost that is not a product cost. A cost related to the selling of goods and the administration of the organization.

____ 7. The cost of items finished and transferred from work in process inventory to finished goods inventory.

____ 8. A financial accounting concept under GAAP. Any cost associated with getting products and services ready for sale.

____ 9. Indirect manufacturing costs that vary with production volume.

____ 10. A firm that resells essentially the same product it buys from suppliers.

SHORT PROBLEM

1. The following information pertains to the production of 140,000 units of a product: Direct materials cost of $3,000,000 Direct labor cost of 800,000 Factory overhead Allocated to each unit at 130% of labor cost

Required: Calculate the inventoriable cost per unit of this product.

8 CHAPTER 3 REVIEW QUESTIONS ANSWER KEY

TRUE/FALSE

1. LO1 – False 2. LO1 – True 3. LO1 – True 4. LO1 – False 5. LO4 – False 6. LO3 – False 7. LO4 – True

MULTIPLE CHOICE 1. LO1 – B 2. LO4 – A 3. LO1 – C 4. LO1 – B 5. LO4 – B 6. LO4 – A 7. LO4 – C 8. LO4 – C Blackledge, Inc. GAAP Income Statement Item Amount Revenues $15,500,800 Beginning inventory, 1/1 $300,600 Purchases 10,725,250 Ending inventory, 12/31 260,500 $10,765,350 Transportation in 104,500 Gross margin $4,630,950

9. LO4 – D Blackledge, Inc. GAAP Income Statement Item Amount Revenues $15,500,800 Beginning inventory, 1/1 $300,600 Purchases 10,725,250 Ending inventory, 12/31 260,500 $10,765,350 Transportation in 104,500 Gross margin $4,630,950 Sales commissions 500,064 Store rent 1,235,000 Store utilities 143,765

9 Other administration 789,354 Profit before taxes $1,962,767

MATCHING

1. D 6. F 2. H 7. I 3. A 8. C 4. E 9. G 5. B 10. J

SHORT PROBLEM Ans: $34.57

Direct materials cost $3,000,000 Direct labor cost 800,000 Factory overhead 1,040,000 (130% x $800,000 labor cost) Total costs 4,840,000 Number of units 140,000 Cost per unit $34 .57 ($4,840,000 / 140,000)