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Cost Classification for Manufacturing Cost

  • Manufacturing / Inventoriable / Product Costs (Balance Sheet)

    • Direct Materials (DM): Raw materials that become an integral part of the product and can be conveniently traced directly to it.

    • Example: For a car manufacturer, examples of direct materials include tires, engine components, steering wheels, leather seats, windows, doors, and windshields.

    • Direct Labour (DL): Labor costs that can be easily traced to individual units of a product or service. Often referred to as "Touch labor".

    • Example: Wages paid to automobile assembly workers (for manufacturing) or hairdressers, lawyers, and auditors (for service industries).

    • Manufacturing Overhead (MOH): Costs that cannot be traced directly to specific units of product, representing all manufacturing costs except DM and DL.

    • Components of MOH:

      • Indirect materials (e.g., lubricants and cleaning supplies used in the assembly plant)

      • Indirect labor (e.g., wages paid to maintenance workers, janitors, and security guards)

      • Other MOH (e.g., factory rent, depreciation of manufacturing plant and equipment).

Classifications of Manufacturing Costs

  • Prime vs. Conversion Costs

    • Prime Cost: Sum of Direct Materials and Direct Labour Costs.

    • Conversion Cost: Sum of Direct Labour and Manufacturing Overhead Costs.

Product Costs vs. Period Costs

  • Product Costs: Manufacturing costs that include Direct Materials, Direct Labour, and Manufacturing Overhead.

  • Period Costs: Non-manufacturing costs, which include all costs not included in product costs. Examples include selling expenses and general administrative expenses.

    • Selling Expenses: Costs necessary to secure customer orders and get the finished products or services to the customer (e.g., advertising and sales commissions).

    • Administrative Expenses: Costs related to executive, organizational, and clerical functions (e.g., executive compensation, general accounting).

Cost Classification for Financial Reporting

  • Manufacturing / Inventoriable / Product Costs

    • Similar to manufacturing costs, comprising Direct Materials, Direct Labour, and Manufacturing Overhead.

  • Non-Manufacturing / Non-Inventoriable / Period Costs

    • Include selling, general and administrative, R&D, and non-operating costs (e.g., income taxes and interest expenses).

Matching Principle (from Accounting 221)

  • Definition: Revenues and expenses are recorded in the period they are earned or incurred, regardless of cash transactions.

  • All costs related to a particular revenue must be recorded in the same period as that revenue is recognized.

Inventoriable Costs

  • Accumulated in asset-inventory (Balance Sheet) and recognized as Expenses (Cost of Goods Sold - COGS) in the income statement once the finished goods are sold.

  • Misclassification of period costs as product costs can lead to overstated profit if those costs remain in inventory.

Cost of Goods Manufactured (COGM)

  • COGM Formula:
    extCOGM=extBeginningWIPInventory+extDMUsed+extDL+extMOH−extEndingWIPInventoryext{COGM} = ext{Beginning WIP Inventory} + ext{DM Used} + ext{DL} + ext{MOH} - ext{Ending WIP Inventory}

  • Work-In-Process (WIP) Inventory: Represents all units that are partially completed during a certain period.

Cost Structure of Merchandising vs. Manufacturing

  • Merchandisers: Buy and sell finished goods.

    • Balance Sheet Components:

    • Current Assets: Cash, Receivables, Prepaid Expenses, Merchandise Inventory.

  • Manufacturers: Buy raw materials and produce finished goods.

    • Balance Sheet Components:

    • Current Assets:

      • Cash

      • Receivables

      • Prepaid Expenses

      • Inventories (Raw Materials, WIP, Finished Goods).

Inventory Equation

  • For calculating available inventory for use over a period:
    extAvailableInventory=extBeginningBalance+extAdditions−extWithdrawalsext{Available Inventory} = ext{Beginning Balance} + ext{Additions} - ext{Withdrawals}

Income Statement for COGS in Manufacturing vs. Merchandising

  • Manufacturing COGS

    • Begins with Beginning Finished Goods Inventory + Cost of Goods Manufactured = Goods Available for Sale - Ending Finished Goods Inventory = Cost of Goods Sold.

  • Merchandising COGS: Similar structure, focusing on Beginning Merchandise Inventory + Purchases to determine the Cost of Goods Sold.

Quick Check Examples

  1. Inventory example for calculating used raw materials:

    • Beginning RM Inventory: $32,000

    • Purchased RM: $276,000

    • Ending RM Inventory: $28,000

    • Formula:
      extRawMaterialsUsed=extBeginningRM+extPurchasedRM−extEndingRMext{Raw Materials Used} = ext{Beginning RM} + ext{Purchased RM} - ext{Ending RM}

    • Cost of Raw Materials Used = $276,000 - ($28,000 - $32,000) = $280,000.

Cost Behavior Prediction

  • Costs react differently to changes in activity levels:

    • Variable Costs (VC): Vary in direct proportion to activity levels (e.g., raw materials, sales commissions).

    • Fixed Costs (FC): Remain constant regardless of activity levels (e.g., rent).

Mixed Cost Behavior

  • Costs that contain both fixed and variable components (e.g., utility bills).

Decision Making Costs

  • Relevant Costs: Costs that differ between alternatives and impact decisions.

    • Example: Choosing between two job offers involves considering the salary differences and commute costs.

  • Opportunity Cost: The benefit lost when choosing one alternative over another (e.g., income from not working while attending college).

  • Sunk Cost: A cost that has already been incurred and cannot be changed, thus not relevant to future decisions (e.g., a previous car purchase).

Summary of Cost Classifications

  • Manufacturing vs. Non-Manufacturing Costs

  • Product vs. Period Costs

  • Variable, Fixed, and Mixed Costs

  • Relevant, Sunk, and Opportunity Costs in Decision Making.