Chapter 29

Manufacturing Costs
All companies benefit from determining the cost of providing products or services to their customers. Managers use these costs in order to make pricing decisions, determine if a product should be discontinued or initiated, and other product related decisions. You may recall that the focus in your financial accounting class related primarily to merchandising companies. Product costs were relatively easy to identify because the cost was equal to the invoice price plus shipping costs less any cash discounts. Determining product costs in manufacturing companies is more challenging because of the number of costs that are incurred in manufacturing a product. We begin with a brief review of how manufacturers differ from merchandisers.

Manufacturing vs. Merchandising Differences Merchandising companies buy products that are ready for sale and then sell them to customers. One inventory account is used which is referred to as Merchandise Inventory, often shortened to simply, Inventory. It is reported on a merchandisers balance sheet in the current asset section as shown in Figure 3-1. Manufacturing companies buy materials and use labor to produce the products prior to selling them to customers. A number of other costs beyond materials and labor that are related to the production process must be considered as well. Manufacturing companies utilize three inventory accounts: Raw Materials Inventory, Work in Process Inventory, and Finished Goods Inventory. These account titles are often shortened by omitted the inventory label. All three are reported on the manufacturers balance sheet in the current assets section as shown in Figure 3-1. Note that as an option, some manufacturing companies add these three inventory amounts together and report the total as Inventories on the balance sheet, then provide note disclosure which shows the detail of the three amounts. Merchandising Company Balance Sheet Current Assets Inventories Manufacturing Company Balance Sheet Current Assets Inventories: Raw materials Work in process Finished goods

$4,600

$4,000 1,000 1,200

Figure 3-1

Balance Sheet Presentation of Product Costs

Perhaps surprising to you, the income statements of both merchandising and manufacturing companies are identical. For both types of companies, Cost of Goods Sold is the only amount on each income statement that contains product costs, as shown in Figure 3-2. As required under the matching concept, product costs (cost of goods sold) are reported on the income statement at the same time the revenue from selling the goods is reported (i.e., when the goods are sold.) Note that reporting1 for product costs is identical in presentation on the income statement for both a merchandising and a manufacturing company.

Reporting means to show the amount on one of the financial statements.

Manufacturing Costs

Merchandising and Manufacturing Companies Income Statement Sales Cost of goods sold Gross profit Operating expenses . Operating income $ xx 85,600 $ xx

Figure 3-2 Income Statement Presentation of Product Costs

Manufacturing or Non-manufacturing? The key to understanding if a cost is manufacturing or non-manufacturing is to think about where in the process the cost occurs. If the cost occurs in the factory while being produced, it is considered a manufacturing cost. If the cost occurs after the product is produced or outside the factory, it is considered a non-manufacturing cost.

Product and Period Costs All manufacturing costs are product costs. The matching concept requires that product costs be matched with the related revenue. Accrual accounting tells you that revenue is earned when the product is sold. As a result, you must expense2 product costs when the related products are sold. All non-manufacturing costs are period costs. The matching concept (part of accrual accounting) requires that period costs be matched with the related revenue. Since period costs relate to accounting periods, they are expensed when incurred3, or used up. The timing of when period costs are expensed falls in an accounting period which is unrelated to product sales.

Product Costs for Manufacturers Three product costs go into manufacturing inventories: direct materials, direct labor, and manufacturing overhead. You should recall from financial accounting that merchandise inventory includes all costs necessary to get the inventory ready to sell. This concept applies to both manufacturing and merchandising companies.
Direct and Indirect Product Costs

Only product costs are categorized as direct or indirect. The labels of direct and indirect pertain to the relationship a product cost has with a product. If a cost is easily identified as belonging to a particular product, you can consider it to be easily traceable. A product cost that is easily traceable is a direct cost. Direct materials and direct labor are considered direct product costs. They can be easily and directly traced to products. Manufacturing overhead consists of only indirect product costs. Some companies even refer to it as indirect overhead. Others call manufacturing overhead by the label, factory overhead. Indirect costs cannot be easily traced to specific

To expense means to record a journal entry that debits an expense account so that the amount will appear on the income statement. 3 Incurred means to use in the production of income.

Manufacturing Costs

products, however, they are part of the cost of getting a product ready to sell. Since period costs have no relationship with products, they are never labeled as direct or indirect. Direct Materials Direct materials include materials that become part of, and can be easily traced to a finished product. Direct materials are considered to be variable costs because the total cost of direct materials increases as more units are produced. Materials are referred to as direct materials once they are put into production, i.e., transferred into the factory for use in producing products. Materials that have been acquired remain in the Raw Materials Inventory account and as such, as designated as Raw Materials. Acquisition Cost of Materials In determining the acquisition cost of materials that will be used in production, you must include all costs necessary to get the materials ready to use in production. The following costs are included: Invoice cost to buy materials Less purchase (cash) discounts taken, (e.g., 1/10, n/30) Plus sales taxes if assessed Plus freight-in (delivery costs to acquire materials) A couple of items should be noted. Cash discounts are allowed on the cost of the materials purchased only. No cash discounts are allowed on sales taxes or freight-in. Sales taxes are never assessed on freight-in. Shipping costs are added to materials costs only for materials acquired, not for the costs of shipping to customers. Recall that both transportation-in and freight-in are common names of shipping costs related to acquiring materials. Because companies typically keep materials on hand so they are available for production, beginning and ending inventories must be considered in tracking materials costs. The cost of acquiring materials (purchase cost) will likely differ from the cost of materials used in manufacturing. Some examples of direct materials costs that may be incurred by Coca Cola include lids for 2-liter bottles, labels for the 2-liter bottles, syrup and other ingredients to manufacture, and any packaging of the product. These are all costs which can be easily traced and identified as being a material in the final product. Direct Labor Direct labor consists of labor costs that can be easily traced to a finished product. This course assumes direct labor to be hourly wages. Most companies include the gross hourly wages as part of their labor cost and the related fringe benefits. Gross hourly wages represent the cost per hour that employees earn before payroll taxes are subtracted. Fringe benefits, such as employer payroll taxes and health benefits for manufacturing employees are usually considered part of direct labor. For example, assumer employees are paid $12 per hour and the employers payroll taxes cost is 15 percent of wages. The employer provides fringe benefits costing $3 per hour. Total direct labor per hour would be $12 plus 15% times $12 plus $3, for a total of $16.80 per hour. Direct labor is considered to be a variable cost because the total cost of direct labor (hourly wages) increases as more units are produced. Materials Storeroom

Manufacturing Costs

Some examples of direct labor costs that may be incurred by Coca Cola include wages for workers that assemble, cut, mix, package, or other tasks which directly contribute to producing products. Manufacturing Overhead Manufacturing overhead, sometimes referred to as factory overhead, includes all indirect manufacturing costs. The same concept applies to manufacturing overhead as for direct labor and direct materials; that is, if the cost is indirect and is part of the cost of getting the products ready to sell, the cost is included. Manufacturing overhead consists of three primary costs: indirect materials, indirect labor, and factory-related costs. Indirect Labor Indirect labor includes factory supervisor salaries, factory janitors salaries or wages, factory maintenance workers salaries or wages, and other costs for factory-related workers who do not directly contribute to producing a particular product. Indirect labor costs differ from direct labor in that indirect costs are not traceable to a particular product. Indirect Materials Indirect materials include factory supplies such as sandpaper to smooth rough edges, blades to cut materials, oil for the production machines, paper towels for the factory workers restrooms, and other factory-related materials and supplies that do not directly become part of a product. Indirect material costs differ from direct materials in that indirect costs are not traceable to a particular product. Factory-related Costs Costs associated with occupancy4 of the factory are considered manufacturing overhead costs. Like indirect materials and indirect labor, factory-related costs are not easily traced or identified with particular products. Some examples are factory rent, factory insurance, factory building and equipment depreciation, factory utilities, and factory and equipment maintenance. These costs would not be incurred if the company decided to buy the products instead of manufacturing them. Keep in mind that all manufacturing overhead costs are indirect costs. Watch for key words that flag the nature of costs. Manufacturing overhead costs will often include factory, manufacturing, or production, as part of the label.

Prime and Conversion Costs

Direct labor and direct materials are often referred to as prime costs as they are the primary costs of production. Direct labor and manufacturing costs are referred to as conversion costs because these are the costs necessary to convert materials into products. Period Costs Period costs are not associated with the production of goods. Some examples of period costs are: Selling, advertising, marketing costs Delivery of products to customers (e.g., freight-out, transportation-out, delivery expense) General and administrative costs Corporate occupancy such as corporate rent, corporate insurance, corporate utilities, corporate depreciation Research and development costs and other product development costs Salaries of corporate administrators, such as the companys president and VPs Accounting and payroll department costs
Occupancy refers to the costs incurred in occupying space. If owned, the company will incur depreciation on the building. If leased or rented, the company will incur rent expense. Utilities, property taxes, insurance and related costs are included as part of occupancy costs though some are period and some are product costs.
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Manufacturing Costs

Suppose a company incurs selling costs (cashiers), marketing (outside sales personnel) and advertising costs (television ads). Would the company still have costs such as these if it decided to buy instead of manufacture its products? Yes! It would still have to market and advertise in order to sell it products. Since these costs are not incurred solely for the purpose of manufacturing products, they are not considered product costs. All of these costs are period costs. Period costs are often known as operating costs because when they become incurred (used), they are categorized as operating expenses on the income statement. Period costs can be fixed or variable. Product and Period Costs on the Financial Statements Any cost that is not a product cost is considered a period cost. As it pertains to the income statement, cost of goods sold is a product cost. All other income statement costs are period costs. As it pertains to the balance sheet, product costs are found in the three inventory accounts. While some capitalized assets such as buildings, equipment, intangibles, and some prepaid costs are amortized as product costs, the designation of product cost accounts is primarily limited to inventories.