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Cost Classifications for Preparing External Financial Statements.

section of the chapter focuses on the problem of valuing inventories and
determining cost of goods sold for external financial reports. Before beginning
this discussion, you may want to explain the difference between a
manufacturing and a merchandising company. Manufacturing companies
convert raw materials into a product. The company then sells that product
either to other companies or, less commonly, directly to individuals.
Manufacturing includes restaurants, movie studios, and other service-type
companies as well as the more obvious examples of manufacturing such as
automobile and clothing production. Merchandising companies, by contrast,
buy finished products and resell the products to customers. Valuing inventories
and determining cost of goods sold is simple in a merchandising company, but
is difficult in a manufacturing company. For that reason, we concentrate on
manufacturing in this section of the chapter.
1. Manufacturing costs. These costs are incurred to make a product. Manufacturing
costs are usually grouped into three main categories: direct materials, direct labor, and
manufacturing overhead.
a. Direct materials. Direct materials consist of those raw material inputs that become
an integral part of a finished product and can be easily traced into it. Examples
include the aircraft engines on a Boeing 777, the Intel processing chip in a personal
computer, and the blank video cassette in a pre-recorded video.
b. Direct Labor. 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.
c. Manufacturing Overhead. Manufacturing overhead consists of all manufacturing
costs other than direct materials and direct labor. These costs cannot be easily and
conveniently traced to products. Examples include miscellaneous supplies such as
rivets in a Boeing 777, supervisors, janitors, factory facility charges, etc.
d. Prime versus Conversion Costs. Prime cost consists of direct materials plus direct
labor. Conversion cost consists of direct labor plus manufacturing overhead.
2. Non-manufacturing costs. 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 (marketing) costs and administrative costs.
Marketing and administrative costs are incurred in both manufacturing and
merchandising firms.
a. Marketing Costs. These costs include the costs of making sales, taking customer
orders, and delivering the product to customers. These costs are also referred to as
order-getting and order-filling costs.
b. Administrative Costs. These costs include all executive, organizational, and
clerical costs that are not classified as production or marketing costs.
3. Period vs. product costs. Costs can also be classified as period or product costs.

a. Period Costs. Period costs are expensed in the time period in which they are
incurred. All selling and administrative costs are typically considered to be period
costs. You should be careful to point out that the usual rules of accrual accounting
apply. For example, administrative salary costs are incurred when they are earned
and not necessarily when they are paid to employees.
b. Product Costs. Product costs are added to units of product (i.e., inventoried) as
they are incurred and are not treated as expenses until the units 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 in which all manufacturing costs are treated as product costs.
4. Inventory valuations and Cost of Goods Sold. In a manufacturing company, raw
materials purchases are recorded in a raw materials inventory account. These costs are
transferred to a work in process inventory account when the materials are released to
the production departments. Other manufacturing costsdirect labor and
manufacturing overheadare charged to the work in process inventory account as
incurred. As work in process is completed, its costs are transferred to the finished
goods inventory account. These costs become expenses only when the finished goods
are sold. Period expenses are taken directly to the income statement as expenses of the
5. Schedule of Cost of Goods Manufactured. Because of inventories, the cost of
goods sold for a period is not simply the manufacturing costs incurred during the
period. 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 assets. 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. You should take some time to
explain the cost of goods manufactured schedule since it is often difficult for students
to understand.
Why important?
According to About Business Finance, cost classification as a part of cost accounting provides managers
with a close look at the fixed and indirect costs of manufacturing products or providing services. Cost
classification helps management set up cost control programs to keep expenses down and stay under
budget by clearly showing which expenses are inflexible and in what areas savings are possible.

What Are the

in Manufacturing

Three Types of Costs Used


by Mary Jane,

Demand Media

A business requires
basic business operations
consumers. Like
costs are divided into
department can track all
accurate annual reports.
the production expands
existing products as part

funding to operate, whether it is for

or to manufacture products for
operational costs, manufacturing
several types so the accounting
manufacturing expenses to get
These manufacturing costs change if
or if the business decides to replace
of a product line.

Labor Costs
Labor costs, also known
funding given to workers
question. Examples of
machine operators and
to individuals who are
indirect roles in the
workers include janitors,

as direct labor costs, refer to any

who produce and buildthe products in
labor include assembly line workers,
installation clerks. Indirect labor refers
working for the company but have
manufacturing process. Indirect
supervisors and security guards.

Material Costs
Material costs refer to the
raw materials that actually create the
product in question. Raw materials cover anything from the finished product itself to
any bolts, nuts and wood that went into building the original product. The final
product is considered raw since it may be used as raw materials for another
product for another business. Material costs also include direct materials that play a
role in the manufacturing process, such as tiny motors, buttons and light bulbs.

Overhead Costs
Overhead costs are those associated with the manufacturing process, excluding the
raw materials and labor funding. The machinery and equipment used to build the
products must undergo frequent maintenance and funding must be available to
complete repairs. Overhead costs also cover any maintenance or rebuilding of the
manufacturing facilities, such as expanding the production line or adding new lighting
in the factory. Any expense or cost that does not fit into direct material costs and
labor costs may fall into the manufacturing overhead category.

Nonmanufacturing Costs
Nonmanufacturing costs refer to any funding that is not directly associated with
creating a product but connect to the actual product in terms of sales. In other words,
nonmanufacturing costs refer to the funding spent on marketing, sales associates,
equipment maintenance and automobile expenses. Salaries for marketers,
accountants and managers in various departments in the company also falls into this

category. Facility expenses, such as rent, light, heat and property taxes, are also
nonmanufacturing costs as they fall into general operations costs.

Beginning Finished Goods Inventory + Cost of Goods Manufactured = Finished Goods

Available for Sale Ending Finished Goods Inventory = Cost of Goods Sold.