* Beginning raw materials inventory: $32,000
* Raw materials purchased: $276,000
* Ending raw materials inventory: $28,000
* Raw materials available for use: $32,000 + $276,000 = $308,000
* Raw materials used: Raw materials available - Ending inventory = $308,000 - $28,000 = $280,000
The cost of direct material used is $280,000.
The answer is C.
material was still present. What is the cost of
direct material used?
A. $276,000
B. $272,000
C. $280,000
D. $ 2
2. Classification of Cost
Cost may be classified into different categories depending upon the purpose of
classification. Some of the important categories in which the costs are classified are as
follows:
1. Classification of cost methods on the basis of nature of production or manufacturing
process
i. Job Costing and
ii. Process Costing
2. Classification of Costs on the basis of their variability in relation to output:-
i. Fixed Cost
ii. Variable Cost
iii. Semi-Variable and Semi-Fixed Cost
3. Costs for Managerial Decision Making :-
i. Marginal Costing
ii. Incremental ( or Differential ) Cost
iii. Uniform Costing
iv. Opportunity Cost
v. Replacement Cost
vi. Sunk Cost
vii. Relevant Cost
Arunraj Arumugam
3. 4. Costs According to Functions (Manufacturing & Non-Manufacturing Cost):-
i. Manufacturing or Production Cost
ii. Administrative Cost
iii. Selling and Distribution Cost
iv. Research & Development Cost
v. Pre-Production Cost
5. Classification of cost methods on the basis of Time:-
1. Historical Cost
2. Pre-Determined Costs
6. Classification of Costs based on establishment of relationship between input and
output:-
i. Engineering Cost
ii. Managed Cost, discretionary or programmed Cost
7. Controllable and Uncontrollable costs
8. Other Types of Costs
Costs which arises in a particular contests and which are used for particular purposes are :-
Conversion Cost
Common Cost
Traceable Cost or Directly Attributable Cost
Joint Cost
Avoidable Cost
Unavoidable Cost
Total Cost Arunraj Arumugam
4. Fixed, Variable and Semi-Variable Costs
The cost which varies directly in proportion with every increase or
decrease in the volume of output or production is known as
variable cost. Some of its examples are as follows:
• Wages of laborers
• Cost of direct material
• Power
Semi-variable costs are costs that have both a variable and fixed
component. Commercial leases often have a fixed rent per month
plus an additional rent based on the amount of production or
sales.
For example, rent is $5,000 plus five cents for each pencil that is
made. The base rent of $5,000 is a fixed cost and the five cents
per pencil is a variable cost.
Step-variable costs are costs that are constant over a range of
production.
If one employee can make 10,000 pencils, then the employee’s wage
is constant over a production range of one to 10,000 pencils. If
you produce 11,000 pencils, you will need another employee. So
your cost doubles. If you make 25,000 pencils your cost triples
because you need three employees.
Arunraj Arumugam
6. Product Costs and Period Costs
Product costs
• The costs which are a part of the cost of a product rather than an expense of the
period in which they are incurred are called as “product costs”.
e.g., cost of raw materials and direct wages, depreciation on plant and
equipment etc.
Period costs.
• The costs which are not associated with production are called period costs.
• They are treated as an expense of the period in which they are incurred. They
may also be fixed as well as variable.
• Such costs include general administration costs, salaries salesmen and
commission, depreciation on office facilities etc.
Arunraj Arumugam
8. Direct and Indirect Costs
• The expenses incurred on material and labor which are economically and
easily traceable for a product, service or job are considered as direct
costs. In the process of manufacturing of production of articles, materials
are purchased, laborers are employed and the wages are paid to them.
• The expenses incurred on those items which are not directly chargeable
to production are known as indirect costs.
For example, salaries of timekeepers, storekeepers and foremen. Also certain
expenses incurred for running the administration are the indirect costs.
Arunraj Arumugam
9. Decision-Making Costs and
Accounting Costs
• Decision-making costs are future costs. They represent
what is expected to happen under an assumed set of
conditions.
• Accounting costs are compiled primarily from financial
statements. They have to be altered before they can be
used for decision-making
Arunraj Arumugam
10. Relevant and Irrelevant Costs
• Relevant costs are those which change by managerial decision.
• Irrelevant costs are those which do not get affected by the decision.
For example,
if a manufacturer is planning to close down an unprofitable retail sales
shop,
This will affect the wages payable to the workers of a shop. This is
relevant in this connection since they will disappear on closing down
of a shop.
But prepaid rent of a shop or unrecovered costs of any
equipment which will have to be scrapped are irrelevant costs
which should be ignored.
Arunraj Arumugam
11. Shutdown and Sunk Costs
• Sunk costs are historical or past costs. These are the costs which have
been created by a decision that was made in the past and cannot be
changed by any decision that will be made in the future.
– Investments in plant and machinery, buildings etc.
• A manufacturer or an organization may have to suspend its operations
for a period on account of some temporary difficulties, e.g., shortage of
raw material, non-availability of requisite labor etc. During this period,
though no work is done yet certain fixed costs, such as rent and
insurance of buildings, depreciation, maintenance etc., for the entire
plant will have to be incurred. Such costs of the idle plant are known as
shutdown costs.
Arunraj Arumugam
12. Learning Objective 1
Identify and give examples of
each of the three basic
manufacturing cost
categories.
Arunraj Arumugam
13. Manufacturing Costs
Direct
Direct Direct
Direct Manufacturing
Manufacturing
Materials
Materials Labor
Labor Overhead
Overhead
The Product
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14. Direct Materials
Raw materials that become an integral part
of the product and that can be conveniently
traced directly to it.
Example: A radio installed in an automobile
Example: A radio installed in an automobile
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15. Direct Labor
Those labor costs that can be easily
traced to individual units of product.
Example: Wages paid to automobile assembly workers
Example: Wages paid to automobile assembly workers
Arunraj Arumugam
16. Manufacturing Overhead
Manufacturing costs cannot be traced directly
to specific units produced.
Examples: Indirect materials and indirect labor
Examples: Indirect materials and indirect labor
Materials used to support Wages paid to employees
the production process. who are not directly
involved in production
Examples: Lubricants and work.
cleaning supplies used in the Examples: Maintenance
automobile assembly plant. workers, janitors and
security guards.
Arunraj Arumugam
18. Learning Objective 2
Distinguish between
product costs and period
costs and give examples
of each.
Arunraj Arumugam
19. Product Costs Versus Period
Costs
Product costs include Period costs are not
direct materials, direct included in product
labor, and costs. They are
manufacturing expensed on the
overhead. income statement.
Cost of
Inventory Goods Sold Expense
Sale
Balance Income Income
Sheet Statement Statement
Arunraj Arumugam
20. Quick Check
Which of the following costs would be
considered a period rather than a product cost
in a manufacturing company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production
facility.
E. Sales commissions.
Arunraj Arumugam
21. Quick Check
Which of the following costs would be
considered a period rather than a product cost
in a manufacturing company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production
facility.
E. Sales commissions.
Arunraj Arumugam
22. Prime Cost and Conversion
Cost
Manufacturing costs are often
classified as follows:
Direct
Direct Direct
Direct Manufacturing
Manufacturing
Material
Material Labor
Labor Overhead
Overhead
Prime Conversion
Cost Cost
Arunraj Arumugam
23. Comparing Merchandising and
Manufacturing Activities
Merchandisers . . . Manufacturers . . .
– Buy finished goods. – Buy raw materials.
– Sell finished goods. – Produce and sell
finished goods.
MegaLoMart
Arunraj Arumugam
24. Balance Sheet
Merchandiser Manufacturer
Current Assets Current Assets
Cash Cash
Receivables Receivables
Prepaid Expenses Prepaid Expenses
Merchandise Inventories:
Inventory 1. Raw Materials
2. Work in Process
3. Finished Goods
Arunraj Arumugam
25. Balance Sheet
Merchandiser Manufacturer
Current Assets Current Assets
Cash Cash
Receivables Receivables
Materials waiting to
Prepaid Expenses Prepaid Expenses
be processed.
Merchandise
Partially complete Inventories:
Inventory – some
products 1. Raw Materials
material, labor, or 2. Work in Process
overhead has been
3. Finished Goods
added.
Completed products
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awaiting sale.
26. Learning Objective 3
Prepare an income
statement including
calculation of the cost of
goods sold.
Arunraj Arumugam
27. The Income Statement
Cost of goods sold for manufacturers
differs only slightly from cost of goods
sold for merchandisers.
Merchandising Company
Cost of goods sold:
Beg. merchandise
inventory $ 14,200
+ Purchases 234,150
Goods available
for sale $ 248,350
- Ending
merchandise
inventory (12,100)
= Cost of goods
sold $ 236,250
Arunraj Arumugam
28. Inventory Flows
Withdrawals
Withdrawals
Beginning
Beginning Additions
Additions Ending
Ending
balance
balance
+ to inventory
to inventory
= balance
balance
+ from
from
inventory
inventory
Arunraj Arumugam
29. Quick Check
If your inventory balance at the beginning of
the month was $1,000, you bought $100
during the month, and sold $300 during the
month, what would be the balance at the end
of the month?
A. $1,000.
B. $ 800.
C. $1,200.
D. $ 200.
Arunraj Arumugam
30. Quick Check
If your inventory balance at the beginning of
the month was $1,000, you bought $100
during the month, and sold $300 during the
month, what would be the balance at the end
of the month?
A. $1,000. $1,000 + $100 = $1,100
B. $ 800. $1,100 - $300 = $800
C. $1,200.
D. $ 200.
Arunraj Arumugam
32. Schedule of Cost of Goods
Manufactured
Calculates the cost of raw
material, direct labor and
manufacturing overhead used
in production.
Calculates the manufacturing
costs associated with goods
that were finished during the
period.
Arunraj Arumugam
33. Schedule of Cost of Goods
Manufactured
Manufacturing Work
As items are removed from
As items are removed from
Raw Materials Costs In Process
raw materials inventory and
raw materials inventory and
Beginning raw
materials inventory placed into the production
placed into the production
+ Raw materials process, they are called direct
process, they are called direct
purchased
= Raw materials materials.
materials.
available for use
in production
– Ending raw materials
inventory
= Raw materials used
in production
Arunraj Arumugam
34. Schedule of Cost of Goods
Manufactured
Manufacturing Work
Conversion
Conversion
Raw Materials Costs In Process
costs are costs
costs are costs
Beginning raw Direct materials incurred to
incurred to
materials inventory + Direct labor convert the
+ Raw materials + Mfg. overhead convert the
purchased = Total manufacturing direct material
direct material
= Raw materials costs into a finished
into a finished
available for use product.
product.
in production
– Ending raw materials
inventory
= Raw materials used As items are removed from raw
As items are removed from raw
in production materials inventory and placed into
materials inventory and placed into
the production process, they are
the production process, they are
called direct materials.
called direct materials.
Arunraj Arumugam
35. Schedule of Cost of Goods
Manufactured
Manufacturing Work
Raw Materials Costs In Process
Beginning raw Direct materials Beginning work in
materials inventory + Direct labor process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending raw materials – Ending work in
inventory All manufacturing costs incurred
All manufacturing costs incurred
process inventory
= Raw materials used during the period are added to the
during the period = Cost of goods the
are added to
in production beginning balance of work in
manufactured.
beginning balance of work in
process.
process.
Arunraj Arumugam
36. Schedule of Cost of Goods
Manufactured
Manufacturing Work
Raw Materials Costs In Process
Beginning raw Direct materials Beginning work in
materials inventory + Direct labor process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending raw materials – Ending work in
inventory process inventory
Costs associated with the goods that
Costs associated with the goods that
= Raw materials used = Cost of goods
areincompletedduring the period are
arecompleted during the period are
production manufactured.
transferred to finished goods
transferred to finished goods
inventory.
inventory.
Arunraj Arumugam
38. Manufacturing Cost Flows
Balance Sheet Income
Costs Inventories Statement
Material Purchases Raw Materials Expenses
Direct Labor Work in
Process
Manufacturing
Overhead Finished Cost of
Goods Goods
Sold
Selling and Period Costs Selling and
Administrative Administrative
Arunraj Arumugam
39. Quick Check
Beginning raw materials inventory was
$32,000. During the month, $276,000 of raw
material was purchased. A count at the end of
the month revealed that $28,000 of raw
material was still present. What is the cost of
direct material used?
A. $276,000
B. $272,000
C. $280,000
D. $ 2,000
Arunraj Arumugam
40. Quick Check
Beginning raw materials inventory was
$32,000. During the month, $276,000 of raw
material was purchased. A count at the end of
the month revealed that $28,000 of raw
material was still present. What is the cost of
direct material used?
A. $276,000
B. $272,000
C. $280,000
D. $ 2,000
Arunraj Arumugam
41. Quick Check
Direct materials used in production totaled
$280,000. Direct labor was $375,000 and
factory overhead was $180,000. What were
total manufacturing costs incurred for the
month?
A. $555,000
B. $835,000
C. $655,000
D. Cannot be determined.
Arunraj Arumugam
42. Quick Check
Direct materials used in production totaled
$280,000. Direct labor was $375,000 and
factory overhead was $180,000. What were
total manufacturing costs incurred for the
month?
A. $555,000
B. $835,000
C. $655,000
D. Cannot be determined.
Arunraj Arumugam
43. Quick Check
Beginning work in process was $125,000.
Manufacturing costs incurred for the month
were $835,000. There were $200,000 of
partially finished goods remaining in work in
process inventory at the end of the month.
What was the cost of goods manufactured
during the month?
A. $1,160,000
B. $ 910,000
C. $ 760,000
D. Cannot be determined.
Arunraj Arumugam
44. Quick Check
Beginning work in process was $125,000.
Manufacturing costs incurred for the month
were $835,000. There were $200,000 of
partially finished goods remaining in work in
process inventory at the end of the month.
What was the cost of goods manufactured
during the month?
A. $1,160,000
B. $ 910,000
C. $ 760,000
D. Cannot be determined.
Arunraj Arumugam
45. Quick Check
Beginning finished goods inventory was
$130,000. The cost of goods manufactured for
the month was $760,000. The ending finished
goods inventory was $150,000. What was the
cost of goods sold for the month?
A. $ 20,000.
B. $740,000.
C. $780,000.
D. $760,000.
Arunraj Arumugam
46. Quick Check
Beginning finished goods inventory was
$130,000. The cost of goods manufactured for
the month was $760,000. The ending finished
goods inventory was $150,000. What was the
cost of goods sold for the month?
A. $ 20,000.
B. $740,000. $130,000 + $760,000 = $890,000
$890,000 - $150,000 = $740,000
C. $780,000.
D. $760,000.
Arunraj Arumugam
47. Learning Objective 5
Define and give
examples of variable
costs and fixed costs.
Arunraj Arumugam
48. Cost Classifications for Predicting
Cost Behavior
How a cost will react to
How a cost will react to
changes in the level of
changes in the level of
business activity.
business activity.
Total variable costs
Total variable costs
change when activity
change when activity
changes.
changes.
Total fixed costs remain
Total fixed costs remain
unchanged when activity
unchanged when activity
changes.
changes.
Arunraj Arumugam
49. Total Variable Cost
Your total long distance telephone bill is
based on how many minutes you talk.
Minutes Talked
Telephone Bill
Total Long Distance
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50. Variable Cost Per Unit
The cost per long distance minute talked is
constant. For example, 10 cents per minute.
Minutes Talked
Telephone Charge
Per Minute
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51. Total Fixed Cost
Your monthly basic telephone bill
probably does not change when you
make more local calls.
Number of Local Calls
Telephone Bill
Monthly Basic
Arunraj Arumugam
52. Fixed Cost Per Unit
The average fixed cost per local call
decreases as more local calls are made.
Monthly Basic Telephone
Bill per Local Call
Number of Local Calls
Arunraj Arumugam
53. Cost Classifications for Predicting
Cost Behavior
Behavior of Cost (within the relevant range)
Cost In Total Per Unit
Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Average fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.
Arunraj Arumugam
54. Quick Check
Which of the following costs would be variable
with respect to the number of cones sold at a
Baskins & Robbins shop? (There may be
more than one correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.
Arunraj Arumugam
55. Quick Check
Which of the following costs would be variable
with respect to the number of cones sold at a
Baskins & Robbins shop? (There may be
more than one correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.
Arunraj Arumugam
56. Learning Objective 6
Define and give
examples of direct and
indirect costs.
Arunraj Arumugam
57. Assigning Costs to Cost Objects
Direct costs Indirect costs
• Costs that can be • Costs that cannot be
easily and conveniently easily and conveniently
traced to a unit of traced to a unit of
product or other cost product or other cost
object. object.
• Examples: Direct • Example: Manufacturing
material and direct labor overhead
Arunraj Arumugam
58. Learning Objective 7
Define and give examples of
cost classifications used in
making decisions: differential
costs, opportunity costs, and
sunk costs.
Arunraj Arumugam
59. Cost Classifications for Decision
Making
Every decision involves a choice
between at least two alternatives.
Only those costs and
benefits that differ
between alternatives
are relevant to the
decision. All other
costs and benefits can
and should be ignored.
Arunraj Arumugam
60. Differential Costs and Revenues
Costs and revenues that differ
among alternatives.
Example: You have a job paying $1,500 per month in
your hometown. You have a job offer in a
neighboring city that pays $2,000 per month. The
commuting cost to the city is $300 per month.
Differential revenue is: Differential cost is:
$2,000 – $1,500 = $500 $300
Net Differential Benefit is:
$200
Arunraj Arumugam
61. Opportunity Costs
The potential benefit that is given up
when one alternative is selected
over another.
Example: If you were
not attending college,
you could be earning
$15,000 per year.
Your opportunity cost
of attending college for
one year is $15,000. Arumugam
Arunraj
62. Sunk Costs
Sunk costs cannot be changed by
any decision. They are not
differential costs and should be
ignored when making decisions.
Example: You bought an automobile that cost
$10,000 two years ago. The $10,000 cost is
sunk because whether you drive it, park it, trade
it, or sell it, you cannot change the $10,000 cost.
Arunraj Arumugam
63. Quick Check
Suppose you are trying to decide whether to
drive or take the train to Agra to attend a
concert. You have ample cash to do either, but
you don’t want to waste money needlessly. Is
the cost of the train ticket relevant in this
decision? In other words, should the cost of the
train ticket affect the decision of whether you
drive or take the train to Agra?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not
relevant.
Arunraj Arumugam
64. Quick Check
Suppose you are trying to decide whether to
drive or take the train to Agra to attend a
concert. You have ample cash to do either, but
you don’t want to waste money needlessly. Is
the cost of the train ticket relevant in this
decision? In other words, should the cost of the
train ticket affect the decision of whether you
drive or take the train to Agra?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not
relevant.
Arunraj Arumugam
65. Quick Check
Suppose you are trying to decide whether to
drive or take the train to Agra to attend a
concert. You have ample cash to do either,
but you don’t want to waste money
needlessly. Is the annual cost of licensing your
car relevant in this decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.
Arunraj Arumugam
66. Quick Check
Suppose you are trying to decide whether to
drive or take the train to Agra to attend a
concert. You have ample cash to do either,
but you don’t want to waste money
needlessly. Is the annual cost of licensing your
car relevant in this decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.
Arunraj Arumugam
67. Quick Check
Suppose that your car could be sold now for
$5,000. Is this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.
Arunraj Arumugam
68. Quick Check
Suppose that your car could be sold now for
$5,000. Is this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.
Arunraj Arumugam
69. Summary of the Types of Cost
Classifications
Predicting
Financial
Cost
Reporting
Behavior
Assigning
Decision
Costs to
Making
Cost Objects Arumugam
Arunraj
Editor's Notes
Arunraj Arumugam
Learning objective number 1 is to identify and give examples of each of the three basic manufacturing cost categories. Arunraj Arumugam
Manufacturing costs are usually grouped into three main categories: direct materials, direct labor, and manufacturing overhead. These costs are incurred to make a product. Arunraj Arumugam
Direct materials are raw materials that become an integral part of the finished product and that can be physically and conveniently traced to it. Examples include the aircraft engines on a Boeing 777, the Intel processing chip in a personal computer, the blank video cassette in a pre-recorded video, and a radio in an automobile. Arunraj Arumugam
Direct labor consists of that portion of labor cost that can be easily traced to a product. Direct labor is sometimes referred to as “touch labor” since it consists of the costs of workers who “touch” the product as it is being made. Arunraj Arumugam
Manufacturing overhead includes all manufacturing costs except direct materials and direct labor. These costs cannot be easily traced to specific units produced (also called indirect manufacturing cost, factory overhead, and factory burden). Manufacturing overhead includes indirect materials that are part of the finished product, but that cannot be easily traced to it and indirect labor costs that cannot be physically or conveniently traced to the creation of products. Other examples of manufacturing overhead include: maintenance and repairs on production equipment, heat and light, property taxes, depreciation and insurance on manufacturing facilities, and salaries for supervisors, janitors, and security guards. Arunraj Arumugam
A manufacturing company incurs many other costs in addition to manufacturing costs. For financial reporting purposes, most of these other costs are typically classified as selling costs and administrative costs. These costs are also called selling, general and administrative costs, or SG&A. Selling and administrative costs are incurred in both manufacturing and merchandising firms. Selling costs include all costs necessary to secure customer orders and get the finished product into the hands of the customer. These costs are also referred to as order-getting and order-filling costs. Administrative costs include all executive, organizational, and clerical costs associated with the general management of an organization that are not classified as production or marketing costs. Arunraj Arumugam
Learning objective number 2 is to distinguish between product costs and period costs and give examples of each. Arunraj Arumugam
Costs can also be classified as product or period costs. Product costs include all the costs that are involved in acquiring or making a product. In the case of manufactured goods, it includes direct materials, direct labor, and manufacturing overhead. Consistent with the matching principle, product costs are recognized as expenses when the products are sold. This can result in a delay of one or more periods between the time in which the cost is incurred and when it appears as an expense on the income statement. Product costs are also known as inventoriable costs. The discussion in the chapter follows the usual interpretation of GAAP, whereby all manufacturing costs are treated as product costs. Period costs include all selling and administrative costs. These costs are expensed on the income statement in the period incurred. All selling and administrative costs are typically considered to be period costs. The usual rules of accrual accounting apply to period costs. For example, administrative salary costs are “incurred” when they are earned by the employees and not necessarily when they are paid to employees. Arunraj Arumugam
Which of the following costs would be considered a period rather than a product cost in a manufacturing company? A. Manufacturing equipment depreciation. B. Property taxes on corporate headquarters. C. Direct materials costs. D. Electrical costs to light the production facility. E. Sales commissions. Arunraj Arumugam
Property taxes on corporate headquarters and sales commissions are period costs. All of the other costs listed are product costs. Arunraj Arumugam
Prime cost consists of direct materials plus direct labor. Conversion cost consists of direct labor plus manufacturing overhead. Arunraj Arumugam
Merchandising companies purchase finished goods from suppliers for resale to customers. Manufacturing companies p urchase raw materials from suppliers and produce and sell finished goods to customers. Arunraj Arumugam
Now, let’s consider the similarities and differences on the balance sheet for merchandising and manufacturing companies. Both merchandising and manufacturing companies will likely have Cash, Receivables and Prepaid Expenses. However, merchandising companies do not have to distinguish between raw materials, work in process, and finished goods. They report one inventory number on their balance sheet labeled merchandise inventory. Manufacturing companies report three types of inventory on their balance sheets: raw materials, work in process and finished goods. Arunraj Arumugam
Part I Raw materials are the materials used to make the product. Part II Work in process consists of units of product that are partially complete, but will require further work to be saleable to customers. Part III Finished goods consists of units of product that have been completed, but not yet sold to customers. Arunraj Arumugam
Learning objective number 3 is to prepare an income statement including calculation of the cost of goods sold. Arunraj Arumugam
Merchandising companies calculate cost of goods sold as Beginning Merchandise Inventory plus Purchases minus Ending Merchandise Inventory. For manufacturing companies, the cost of goods sold for a period is not simply the manufacturing costs incurred during the period. They calculate cost of goods sold as Beginning Finished Goods Inventory plus Cost of Goods Manufactured minus Ending Finished Goods Inventory. For a manufacturing company, some of the cost of goods sold may be for units completed in a previous period. And some of the units completed in the current period may not have been sold and will still be on the balance sheet as an asset. The cost of goods sold is computed with the aid of a schedule of costs of goods manufactured, which takes into account changes in inventories. The schedule of cost of goods manufactured is not ordinarily included in external financial reports, but must be compiled by accountants within the company in order to arrive at the cost of goods sold. We will learn more about a schedule of costs of goods manufactured later in this chapter. Arunraj Arumugam
The computation of Cost of Goods Sold relies on this basic equation for inventory accounts: beginning inventory balance plus additions to inventory equals ending inventory balance plus withdrawals from inventory. The logic underlying this equation applies to any inventory account. Any units that are in inventory at the beginning of the period appear as the beginning balance. During the period, additions are made to the inventory through purchases or other means. At the end of the period, everything that was in the beginning inventory or that was added must be in the ending inventory account or have been transferred out to another inventory account or to cost of goods sold. Arunraj Arumugam
If your inventory balance at the beginning of the month was $1,000, you bought $100 during the month, and sold $300 during the month, what would be the balance at the end of the month? Arunraj Arumugam
Right. $800. This is calculated as beginning inventory of $1,000 plus purchases of $100 minus ending inventory of $300. Arunraj Arumugam
Learning objective number 4 is to prepare a schedule of cost of goods manufactured. Arunraj Arumugam
The schedule of cost of goods manufactured contains the three elements of costs mentioned previously, namely, direct materials, direct labor, and manufacturing overhead. The purpose of the schedule is to calculate the cost of raw materials, direct labor, and manufacturing overhead used in production. In addition, it is used to calculate the manufacturing costs associated with goods that were finished during the period. Arunraj Arumugam
At first glance, the schedule of cost of goods manufactured appears complex. However, it is all quite logical. The schedule of cost of goods manufactured contains the three types of product costs that we discussed earlier—direct materials, direct labor, and manufacturing overhead. The raw materials cost is not simply the cost of raw materials purchased during the period—rather it is the cost of materials used during the period. Raw material purchases made during the period are added to the beginning raw materials inventory balance to determine the cost of materials available for use during the period. The ending materials inventory is deducted from this amount to arrive at the cost of raw materials used in production. As items are removed from raw materials inventory and placed into the production process, they are called direct materials. Arunraj Arumugam
After we calculated the raw materials used in production, we take that amount and add the conversion costs (direct labor and manufacturing overhead) to get total manufacturing costs for the period. Arunraj Arumugam
After we calculate our total manufacturing costs, we take beginning work in process inventory, add to that, total manufacturing costs, and we get the total work in process for the period. Arunraj Arumugam
Finally, we subtract ending work-in-process inventory from work in process for the period to get cost of goods manufactured. Completed goods are transferred to finished goods inventory. Arunraj Arumugam
You can see that the cost of goods manufactured is added to the beginning finished goods inventory to get the cost of goods available for sale. The ending finished goods inventory is subtracted to arrive at the cost of goods sold. Arunraj Arumugam
Part I Let’s briefly look at the flow of costs in a manufacturing company. This will help us understand how product costs move through the various accounts and how they affect the balance sheet and the income statement. Raw materials are purchased and placed into raw materials inventory. Part II Raw materials are requisitioned out of raw materials inventory into work in process. Direct labor and manufacturing overhead are charged directly to work in process inventory. Part III When we complete the product, the product and its costs are transferred out of work in process inventory into finished goods. All raw materials, work in process and unsold finished goods at the end of the period are shown as inventoriable costs in the asset section of the balance sheet. Part IV As finished goods are sold, their costs are transferred to cost of goods sold on the income statement. Part V Selling and administrative expenses are not involved in making the product; therefore, they are treated as period costs and reported in the income statement for the period the cost is incurred. Arunraj Arumugam
Beginning raw materials inventory was $32,000. During the month, $276,000 of raw material was purchased. A count at the end of the month revealed that $28,000 of raw material was still present. What is the cost of direct material used? Arunraj Arumugam
Right. $280,000. Take a minute and review the solution before proceeding. Arunraj Arumugam
Direct materials used in production totaled $280,000. Direct labor was $375,000 and factory overhead was $180,000. What were total manufacturing costs incurred for the month? Arunraj Arumugam
Right. $835,000. Take a minute and review the solution before proceeding. Arunraj Arumugam
Beginning work in process was $125,000. Manufacturing costs incurred for the month were $835,000. There were $200,000 of partially finished goods remaining in work in process inventory at the end of the month. What was the cost of goods manufactured during the month? Arunraj Arumugam
Right. $760,000. Take a minute and review the solution before proceeding. Arunraj Arumugam
Beginning finished goods inventory was $130,000. The cost of goods manufactured for the month was $760,000. The ending finished goods inventory was $150,000. What was the cost of goods sold for the month? Arunraj Arumugam
Right. $740,000. Take a minute and review the solution before proceeding. Arunraj Arumugam
Learning objective number 5 is to define and give examples of variable costs and fixed costs. Arunraj Arumugam
Managers often need to be able to predict how costs will change in response to changes in activity. The activity might be the output of goods or services or it might be some measure of activity, internal to the company, such as the number of purchase orders processed during a period. In this chapter, nearly all of the illustrations assume that the activity is the output of goods or services. In later chapters, other measures of activity will be introduced. Cost behavior refers to how a cost will react to changes in the level of activity within the relevant range. The most commonly used classifications of cost behavior are variable and fixed costs, which we will discuss in this chapter. The total of just about any cost will change if there is a big enough change in activity. There is some controversy concerning the proper definition of the “relevant range.” Some refer to the relevant range as the range of activity within which the company usually operates. We refer to the relevant range as the range of activity within which the assumptions about variable and fixed costs are valid. Either definition could be used—our choice was dictated by our desire to highlight the notion that fixed costs can change if the level of activity changes enough. Arunraj Arumugam
A variable costs varies, in total, in direct proportion to changes in the level of activity. For example, your long distance telephone bill may be based on how many minutes you talk—the total bill varies with the number of minutes used. Arunraj Arumugam
Although variable costs change in total as the activity level rises and falls, variable cost per unit is constant. For example, the cost per long distance minute may be ten cents a minute. Arunraj Arumugam
A fixed cost remains constant, in total, within the relevant range, regardless of changes in the level of the activity. In other words, fixed costs do not change as long as the activity level falls within the “relevant range.” For example, your monthly basic telephone bill probably is a set amount and does not change based on the number of local calls you make. Arunraj Arumugam
When expressed on a per unit basis, the average fixed cost per unit varies inversely with changes in activity. In other words, for a fixed cost, the per unit cost decreases when activity rises and increases when activity falls. For example, the average fixed cost per local call decreases as more local calls are made. Arunraj Arumugam
It is helpful to think about variable and fixed cost behavior in a two by two matrix, as illustrated here. Take a few minutes and review this summary of cost behavior for variable and fixed costs. Arunraj Arumugam
Which of the following costs would be variable with respect to the number of cones sold at a Baskins and Robbins shop? (There may be more than one correct answer.) A. The cost of lighting the store. B. The wages of the store manager. C. The cost of ice cream. D. The cost of napkins for customers. Arunraj Arumugam
Right. The cost of ice cream and the cost of napkins for customers would be variable costs. As Baskins and Robbins sells more ice cream cones, we would expect the total cost of ice cream and napkins to increase. Arunraj Arumugam
Learning objective number 6 is to define and give examples of direct and indirect costs. Arunraj Arumugam
A cost object is anything for which cost data are desired including products, customers, jobs, organizational subunits, etc. For purposes of assigning costs to cost objects, costs are classified two ways: Direct costs are costs that can be easily and conveniently traced to a unit of product or other cost object. Examples of direct costs are direct material and direct labor. Indirect costs are costs that cannot be easily and conveniently traced to a unit of product or other cost object. An example of an indirect cost is manufacturing overhead. Common costs are indirect costs incurred to support a number of cost objects. These costs cannot be traced to any individual cost object. Arunraj Arumugam
Learning objective number 7 is to define and give examples of cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs. Arunraj Arumugam
It is important to realize that every decision involves a choice between at least two alternatives. The goal of making decisions is to identify those costs that are either relevant or irrelevant to the decision. Costs and benefits that differ between alternatives are relevant to the decision. All other costs and benefits are irrelevant and can and should be ignored. To make decisions, it is essential to have a grasp on three concepts: Differential costs, opportunity cost, and sunk cost. Let’s take a look at each of these on the next few slides. Arunraj Arumugam
Differential costs (or incremental costs) is a difference in cost between any two alternatives. A difference in revenue between two alternatives is called differential revenue. Differential costs can be either fixed or variable. For example, assume you have a job paying $1,500 per month in your hometown. You have a job offer in a neighboring city that pays $2,000 per month. The commuting cost to the city is $300 per month. In this example, the differential revenue is $500 and the differential cost is $300. The net differential benefit associated with accepting the new job is $200. Arunraj Arumugam
An opportunity cost is the potential benefit that is given up when one alternative is selected over another. These costs are not usually entered into the accounting records of an organization, but must be explicitly considered in all decisions. Arunraj Arumugam
A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future. Since sunk costs cannot be changed, they cannot be differential costs; therefore, sunk costs should be ignored in decision making. While students usually accept the idea that sunk costs should be ignored on an abstract level, like most people, they often have difficulty putting this idea into practice. Arunraj Arumugam
Suppose you are trying to decide whether to drive or take the train to Portland to attend a concert. You have ample cash to do either, but you don’t want to waste money needlessly. Is the cost of the train ticket relevant in this decision? In other words, should the cost of the train ticket affect the decision of whether you drive or take the train to Portland? Arunraj Arumugam
Yes, it should be considered because the cost of the train ticket is relevant. Arunraj Arumugam
Suppose you are trying to decide whether to drive or take the train to Portland to attend a concert. You have ample cash to do either, but you don’t want to waste money needlessly. Is the annual cost of licensing your car relevant in this decision? Arunraj Arumugam
No, the licensing cost is not relevant. Arunraj Arumugam
Suppose that your car could be sold now for $5,000. Is this a sunk cost? Arunraj Arumugam
No, it is not a sunk cost. Arunraj Arumugam
We have looked at the cost classifications used for financial reporting, predicting cost behavior, assigning costs to cost objects, and making business decisions. Arunraj Arumugam