Ch14 Managerial Accounting Concepts and Principles

COST COMPONENTS

PRODUCTION COSTS

Companies that manufacture a product face an expanded set of accounting issues. In addition to the usual accounting matters associated with selling and administrative activities, a manufacturer must deal with accounting concerns related to acquiring and processing raw materials into a finished product. Cost accounting for this manufacturing process entails consideration of three key cost components that are necessary to produce finished goods:

(1) Direct materials include the costs of all materials that are an integral part of a finished product and that have a physical presence that is readily traced to that finished product. Examples for a computer maker include the plastic housing of a computer, the face of the monitor screen, the circuit boards within the machine, and so forth. Minor materials such as solder, tiny strands of wire, and the like, while important to the production process, are not cost effective to trace to individual finished units. The cost of such items is termed "indirect materials." These indirect materials are included with other components of manufacturing overhead, which is discussed below.

(2) Direct labor costs consist of gross wages paid to those who physically and directly work on the goods being produced. For example, wages paid to a welder in a bicycle factory who is actually fabricating the frames of bicycles would be included in direct labor. On the other hand, the wages paid to a welder who is building an assembly line that will be used to produce a new line of bicycles is not direct labor. In general, indirect labor pertains to wages of other factory employees (e.g., maintenance personnel, supervisors, guards, etc.) who do not work directly on a product. Indirect labor is rolled into manufacturing overhead.

(3) Manufacturing overhead includes all costs of manufacturing other than direct materials and direct labor. Examples include indirect materials, indirect labor, and factory related depreciation, repair, insurance, maintenance, utilities, property taxes, and so forth. Factory overhead is also known as indirect manufacturing cost, burden, or other synonymous terms. Factory overhead is difficult to trace to specific finished units, but its cost is important and must be allocated to those units. Normally, this allocation is applied to ongoing production based on estimated allocation rates, with subsequent adjustment processes for over- or under-applied overhead. This is quite important to product costing, and will be covered in depth later.
Importantly, nonmanufacturing costs for selling and general/administrative purposes (SG&A) are not part of factory overhead. Selling costs relate to order procurement and fulfillment, and include advertising, commissions, warehousing, and shipping. Administrative costs arise from general management of the business, including items like executive salaries, accounting departments, public and human relations, and the like.
Accountants sometimes use a bit of jargon to describe certain "combinations" of direct materials, direct labor, and manufacturing overhead:

prime Costs = Direct Labor + Direct Material
Conversion Costs = Direct Labor + Manufacturing Overhead




Unlike retailers, manufacturers have three unique inventory categories: Raw Materials, Work in Process, and Finished Goods.

SCHEDULE OF RAW MATERIALS

Focusing first on raw material, a company must determine how much of the available supply was transferred into production during the period.

SCHEDULE OF WORK IN PROCESS

The following schedule presents calculations that pertain to work in process. Pay attention to its details, noting that (1) direct materials flow in from the schedule of raw materials, (2) the conversion costs (direct labor and overhead) are added into the mix, and (3) the cost of completed units to be transferred into finished goods is called cost of goods manufactured. The amounts are assumed, but would be derived from accounting records and/or by a physical counting process.


SCHEDULE OF COST OF GOODS MANUFACTURED

The schedules of raw materials and work in process are often combined into a single schedule of cost of goods manufactured. This schedule contains no new information from that presented above; it is just a combination and slight rearrangement of the separate schedules.

SCHEDULE OF COST OF GOODS SOLD

The determination of cost of goods sold is made via an examination of changes in finished goods:



THE INCOME STATEMENT

An income statement for a manufacturer will appear quite similar to that of a merchandising company. The cost of goods sold number within the income statement is taken from the preceding schedules, and is found in the income statement at right.


REVIEWING COST FLOW CONCEPTS FOR A MANUFACTURER

Review the following diagram that summarizes the discussion thus far. Notice that costs are listed on the left -- the "product costs" have a blue drop shadow and the "period costs" have a pink drop shadow. Further, the "prime costs" of production have a back slash in the blue shadow, while the "conversion costs" have a forward slash in the blue shadow. Yes, the direct labor shadow has both forward and back slashes; remember that it is considered to be be both a prime and a conversion cost!