Chapter 4: Accounting for Cost flow

Accounting systems serve people both inside and outside an organization. The different needs of external
and internal users require different approaches to reporting information.

Flow of costs refers to the manner or path in which costs move through a firm. Typically, the flow of costs
is relevant to a manufacturing environment where accountants must quantify what costs are in raw
materials, work in process, finished goods inventory and cost of goods sold. Flow of costs does not only
apply to inventory, but also to factors in other processes to which a cost is attached such as labor and
overhead.

There are several methods for accounting for the flow of costs. These include FIFO (first in, first out),
specific identification and weighted-average cost.

Three types Companies in Managerial Accounting

It is important to identify the type of company you are working within managerial accounting. Depending
on the type of company, you will identify different costs and set up reports differently. There are three
major types of companies we will deal with in this course:

a. Service companies
b. Merchandising companies
c. Manufacturing companies

Service companies
Service firms make up the largest business sector in the United States. Service companies are those that
do not sell a physical product but instead provide services to their customers. Service firms include
accounting firms, law firms, marketing firms, IT services firms, banks, dry cleaners, health care
organizations, educational institutions and many other businesses we interact with on a daily basis.

One major difference between service companies and the other two types is that service companies do
not have the cost of goods sold because there is no product being sold. Service firms also do not have
inventory, also because no physical product is being sold. There may be direct costs associated with
providing the service, but no physical product.

Merchandising companies
Merchandising companies are those which sell products but do not make products. Merchandising
companies are broken up into two different types: retailers and wholesalers.

Retailers sell products directly to the end user. Staples, Wal-Mart, Target, American Eagle, GAP, and Home
Depot are all retailers. They sell products that consumers and businesses use, rather than resell.

Wholesalers buy products from manufacturers and sell them to other merchandising companies, usually
retailers. For example, most small breweries will use a distributor to help get their beers into stores and
restaurants. These distributors have established relationships with local stores and restaurants, making
easier for small breweries to get their beers to the public. A distributor is a wholesaler. Wholesalers are
sometimes referred to as “middlemen” because they act as an intermediary between a manufacturer and
a retailer.

Merchandising companies purchase inventory (an asset) and sell that inventory. When inventory is sold,
the asset is considered used up, and the cost of that inventory is transferred from the balance sheet to
the income statement as an expense. This expense is called cost of goods sold. For merchandising
companies, the inventory account can also be referred to as merchandise inventory.

Manufacturing companies
Manufacturing companies are companies that make a product. Monster Beverages, Dell Computers,
Boeing, and General Motors are all companies that produce a product. These companies use labor and
machinery to turn materials into a product. Some manufacturing companies sell their products directly to
the end user, like Boeing. Some companies like Dell, sell their product directly to consumers and to
retailers. Monster Beverages and General Motors sell their products to retailers who sell the product to
the end user.

All manufacturing companies have three different inventory accounts to account for the steps in the
production process.

a. Raw materials inventory

b. Work-in-progress
c. Finished goods inventory

Raw materials inventory

Raw materials are the components that companies use to produce their products. Don’t let the word
“raw” lead you to think that this account is full of wood, plastic, metal or bolts of fabric. Many companies
purchase components already manufactured and use them in their finished products. For example, Dell
purchases processors from Intel to put in their computers. These processors are considered raw materials
until those processors actually go into a computer. Raw materials are any materials that have not yet been
used in the production process.

Work-in-progress
Companies are continuously making products, which means that at the end of each day or week or month
there are products that are not finished. These products have entered the manufacturing process but are
not completed. Work-in-progress is inventory that has gone into the production process but has not yet
been finished. Think of an aircraft at Boeing that does not have the seats or engines installed, but the rest
of the plane is built. We cannot call these raw materials, but we also cannot say that it is finished. This
plane would be considered part of work-in-process.

Finished goods inventory

When a product is finished it is transferred to finished goods inventory. Typically when we think of
inventory, we think of finished goods inventory, the stuff that is ready to be sold to our customers. Once
a product is classified as finished goods inventory, no additional costs can be added to the product. This
is a very important concept when we start talking about types of costs.

Hybrid companies
Many companies do not fit neatly into one of these categories. For example, restaurants make a product
(meals), sell products it does not make (wine and beer), and provides a service (serving the meal). These
companies are considered hybrid companies. When classifying companies, make sure to consider that a
company could fit into more than one of the categories above.

Production, Marketing and Administrative Costs

All costs fall into one of three general classification: production, marketing and administrative. Production
costs refer to the costs incurred by a business from manufacturing a product or providing a service.
Production costs can include a variety of expenses, such as labor, raw materials, consumable
manufacturing supplies, and general overhead. Taxes levied by the government or royalties owed by
natural resource-extraction companies also are treated as production costs. Product engineering and
design costs occurring before manufacturing are also production costs. Marketing costs is the total cost
associated with delivering goods or services to customers. The marketing cost may include expenses
associated with transferring title of goods to a customer, storing goods in warehouses pending delivery,
promoting the goods or services being sold, or the distribution of the product to points of sale.
Administrative costs result from directing and controlling the company and for general activities such as
personnel and legal functions. They include management and financial accounting salaries, clerical costs,
communication costs, and rental fees. Both production and marketing costs incur administrative cost.
Figure 4.1 Flow of costs in a merchandising company

Costs Balance Sheet Income Statement

•Merchandise •Merchandise •Cost of goods sold

purchases Inventory

•Selling and
administrative •DO NOT APPEAR ON •Selling and
expense THE BALANCE SHEET administrative
expense

MERCHANDISING
Illustration:
Magkaibigan Merchandise had the following transactions for the month of June 2019.

Date Transactions
June 03 Bought merchandise amounting to P32,500 for 500 units on
account.
June 05 Additional merchandise was bought 600 units.
Freight in charge amounting to P540
June 09 10% discount was given upon settlement of June 03
balance.
June 15 Sales on account of 200 units for P85 each
June 16 Cash sales of 250 units
10% discount was given to customer
June 20 Merchandise returned to supplier 10 units
June 25 Selling and administrative expense amounts to P12,500

The following entries were made to record these transactions:

Perpetual Method

Date Particulars DR CR
June 3 Merchandise inventory 32,500.00
Accounts payable 32,500.00

5 Merchandise inventory 39,000.00

Cash 39,000.00

Merchandise inventory 540.00

Cash 540.00

9 Accounts payable 32,500.00

Merchandise inventory 3,250.00
 Cash 29,250.00

15 Account receivables 17,000.00

Sales 17,000.00

Cost of goods sold 13,000.00

Merchandise inventory 13,000.00

16 Cash 21,250.00
Sales 21,250.00

Cost of goods sold 16,250.00

Merchandise inventory 16,250.00

Sales discount 2,125.00

Cash 2,125.00

20 Cash 650.00
Merchandise inventory 650.00

25 Selling and administrative expense 12,500.00

Cash 12,500.00

Merchandise inventory:
June 3 Purchases 32,500.00
5 Additional purchases 39,000.00
Fright in 540.00
Discount - 3,250.00
15 Cost of goods sold - 13,000.00
16 Cost of goods sold - 16,250.00
20 Returned - 650.00
Ending Merchandise Inventory 38,890.00

Income Statement:
Gross sales 38,250.00
Sales discount - 2,125.00
Net sales 36,125.00
Cost of goods sold - 29,250.00
Gross profit 6,875.00
Selling and administrative expense - 12,500.00
Net loss - 5,625.00

Periodic Method

Date Particulars DR CR
June 3 Purchases 32,500.00
Accounts payable 32,500.00
 5 Purchases 39,000.00
Cash 39,000.00

Fright in 540.00
Cash 540.00

9 Accounts payable 32,500.00

Purchase discount 3,250.00
Cash 29,250.00

15 Account receivables 17,000.00

Sales 17,000.00

16 Cash 19,125.00
Sales discount 2,125.00
Sales 21,250.00

20 Cash 650.00
Purchase returns and allowances 650.00

25 Selling and administrative expense 12,500.00

Cash 12,500.00

Purchases 1,100.00
Sold - 450.00
Unsold inventory 650.00
Multiply by unit cost 65.00
Total unsold inventory 42,250.00
Fright in 540.00
Discount - 3,250.00
Returned - 650.00
Ending inventory 38,890.00

Income Statement:
Gross sales 38,250.00
Sales discount - 2,125.00
Net sales 36,125.00
Cost of goods sold:
Purchases 71,500.00
Freight in 540.00
Purchase returns and allowances - 650.00
Purchase discount - 3,250.00
Net purchases 68,140.00
Ending Inventory - 38,890.00 29,250.00
Gross profit 6,875.00
Selling and administrative expense - 12,500.00
Net loss - 5,625.00
Ex. (Do it yourself)
ShopNice had the following transactions for the month of April 2019.

Date Transactions
April 03 Bought 350 units of sleepers at P50 per unit on account
2/15, n/30.
April 04 Paid freight cost of P300, term FOB Destination.
April 09 Bought additional 400 sleepers with 10% trade discount
April 13 Retuned 10 defective sleepers with cash refund.
April 17 Payment of April 03 transaction.
April 20 Sold 550 pairs of sleepers at P70 per pair.
April 25 Customers returned defective 12 sleepers with cash refund.
April 27 Selling and administrative expense incurred and paid
amount to P8,500

Journalize these transactions using both perpetual and periodic method, calculate the ending inventory
and present the income statement.

Figure 4.2 Cost flow for Manufacturing

Illustration
Masigla Manufacturing Company had beginning balances in its inventory for the month of June, 2019,
P25,600 for direct materials, P620,910 for its work in process and P16,500 for finished goods. In
addition, Masigla incurred the following transactions for the month of June, 2019.

Date Transactions
June 02 Total purchases amounted to P768,500 on account.
June 07 Purchase returned amounted to P500 in connection with June 02 purchases.
June 15 Accrued direct salary amount to P56,200
June 17 Budgeted manufacturing overhead amounted to P36,900, while actual overhead
amount to P45,120
June 21 Materials put into process amounting to P62,100
June 22 Goods manufactured amount to P710,500
June 25 Selling and administrative expense paid amount to 79,200
June 27 Company sales amount to P1.2 million with cost of P700,600
Journal entries

Date DR CR
June 02 Direct materials inventory 768,500
Accounts payable 768,500

07 Accounts payable 500

Direct materials inventory 500

15 Work in process 56,200

Salary payable 56,200

17 Work in process 36,900

Applied factory overhead 36,900

Factory overhead control 45,120

Cash 45,120

21 Work in process 62,100

Direct materials inventory 62,100

22 Finished goods inventory 710,500

Work in process 710,500

25 Selling and administrative expense 79,200

Cash 79,200

27 Cash 1,200,000
Sales 1,200,000

Cost of goods sold 700,600

Finished goods inventory 700,600

30 (Adjusting) Applied factory overhead 36,900

Cost of goods sold 8,220
Factory overhead control 45,120

Direct Materials Work in Process Finished goods COGS

25,600 500 620,910 710,500 16,500 700,600 700,600
768,500 62,100 56,200 710,500 8,200
731,500 36,900 26,400 708,820
62,100
65,610

Masidhi Manufacturing Company had beginning balances in its inventory for the month of June, 2019,
P14,210 for direct materials, P120,620 for its work in process and P7,580 for finished goods. In addition,
Masidhi incurred the following transactions for the month of June, 2019.

Date Transactions
June 02 Total purchases amounted to P68,408 on account.
June 07 Purchase discount amounted to 10% in connection with June 02 purchases.
June 15 Accrued direct salary amount to P12,700
June 17 Budgeted manufacturing overhead amounted to P15,800, while actual overhead
amount to P13,120
June 21 Materials put into process amounting to P62,100
June 22 Goods manufactured amount to P151,680
 June 25 Selling and administrative expense paid amount to 29,680
June 27 Company sales amount to P270,000 with cost of P87,590

Journal entries:

Date DR CR
June 02 Direct materials inventory 68,408.00
Accounts payable 68,408.00

07 Accounts payable 6,840.80

Direct materials inventory 6,804.80

15 Work in process 12,700

Salary payable 12,700

17 Work in process 15,800

Applied factory overhead 15,800

Factory overhead control 13,120

Cash 13,120

21 Work in process 62,100

Direct materials inventory 62,100

22 Finished goods inventory 151,680

Work in process 151,680

25 Selling and administrative expense 29,680

Cash 29,680

27 Cash 270,000
Sales 270,000

Cost of goods sold 87,590

Finished goods inventory 87,590

30 (Adjusting) Applied factory overhead 15,800

Cost of goods sold 2,680
Factory overhead control 13,120

Direct Materials Work in Process Finished goods COGS

14,210.00 6,840.80 120,620 151,680 7,580 87,590 87,590 2,680
68,408.00 62,100.00 12,700 151,680 84,910
13,677.20 15,800 71,670
62,100
59,540
 Masidhi Manufacturing Company
Income Statement
For the month ended June 2019

Sales 270,000.00
Cost of goods sold:
Beginning inventory 14,210.00
Purchases 68,408.00
Purchase discount - 6,840.80
Total materials available for use 75,777.20
Ending inventory - 13,677.20
Total materials used 62,100.00
Direct labor 12,700.00
Factory overhead - applied 15,800.00
Total manufacturing cost 90,600.00
Work in process beginning 120,620.00
Goods put into process 211,220.00
Work in process, end - 59,540.00
Goods manufactured 151,680.00
Finished goods beginning 7,580.00
Total goods available for sale 159,260.00
Finished goods, end - 71,670.00
Cost of goods sold (Normal Cost) 87,590.00
Less: Overapplied Overhead - 2,680.00
Total cost of goods sold 84,910.00
Gross profit 185,090.00
Selling and administrative expense - 29,680.00
Operating income 155,410.00

Based on your further examination, P270,000 sales has a total units of 1,800 units, Cost of goods sold is
85% variable, while Selling and administrative expense is 45% fixed. Compute the followings:

1. What is the company’s breakeven points in units?____________________

2. What is the margin of safety and margin of safety ratio?__________________
3. What is the company’s operating leverage?________________________
4. How much units need to be sold to earn a profit of P425,000?______________
5. Formulate your cost functions and estimate the cost it the following units were produced and
sold. Validate your cost function using High and Low method, and least-square method

Ex. (Do it Yourself)

Masigla Manufacturing Company had beginning balances in its inventory for the month of June, 2019,
P25,600 for direct materials, P620,910 for its work in process and P16,500 for finished goods. In
addition, Masigla incurred the following transactions for the month of June, 2019.

Date Transactions
June 02 Total purchases amounted to P768,500 on account.
June 07 Purchase returned amounted to P500 in connection with June 02 purchases.
June 15 Accrued direct salary amount to P56,200
June 17 Budgeted manufacturing overhead amounted to P36,900, while actual overhead
amount to P45,120
June 21 Materials put into process amounting to P62,100
June 22 Goods manufactured amount to P710,500
 June 25 Selling and administrative expense paid amount to 79,200
June 27 Company sales amount to P1.2 million with cost of P700,600

Masigla Manufacturing Company

Income Statement
For the month ended June 2019

Sales 1,200,000.00
Cost of goods sold:
Beginning inventory 25,600.00
Purchases 768,500.00
Purchase returned and allowances - 500.00
Total materials available for use 793,600.00
Ending inventory - 731,500.00
Total materials used 62,100.00
Direct labor 56,200.00
Factory overhead - applied 36,900.00
Total manufacturing cost 155,200.00
Work in process beginning 620,910.00
Goods put into process 776,110.00
Work in process, end - 65,610.00
Goods manufactured 710,500.00
Finished goods beginning 16,500.00
Total goods available for sale 727,000.00
Finished goods, end - 26,400.00
Cost of goods sold (Normal Cost) 700,600.00
Add: Underapplied Overhead 8,220.00
Total cost of goods sold 708,820.00
Gross profit 491,180.00
Selling and administrative expense - 79,200.00
Operating income 411,980.00

Based on your further examination, the sales has a total units of 1,500 units, Cost of goods sold is 25%
fixed, while Selling and administrative expense is 35% fixed. Compute the followings:

1. What is the company’s breakeven points in units?____________________

2. What is the margin of safety and margin of safety ratio?__________________
3. What is the company’s operating leverage?________________________
4. How much units need to be sold to earn a profit of P615,850?______________
5. Formulate your cost functions and estimate the cost it the following units were produced and
sold. Validate your cost function using High and Low method, and least-square method

Months Units produced and sold

July 2,145 units
August 1,580 units
September 1,485 units
October 2,784 units
November 600 units
December 3,145 units

6. Make a schedule (table) showing the total costs, revenues, and net income or loss of activities
presented in number 5 if the company will have incurred such sales activity levels.