Learning objective 5: Business Sectors, Types of Inventory, Inventoriable Costs, and Period

Costs.

In this section, we first describe the different sectors of the economy, the different types of
inventory that companies hold, and then discuss how these factors affect commonly used
classifications of inventoriable and period costs.

1. Manufacturing, Merchandising, and Service-Sector Companies:

There are three sectors of economy:
- Manufacturing-sector companies purchase materials and components and convert
them into various finished goods. Examples are automotive companies such as Toyota
- Merchandising-sector companies purchase and then sell tangible products without
changing their basic form. This sector includes companies engaged in retailing,
distribution, or wholesaling.
- Service-sector companies provide services (intangible products) to their customers.
Examples are law firms, accounting firms, banks, insurance companies, advertising
agencies,...

2. Types of Inventory
- Manufacturing-sector companies typically have one or more of the following three
types of inventory:
+ Direct materials inventory. Direct materials in stock that will be used in the
manufacturing process.
+ Work-in-process inventory. Goods partially worked on but not yet completed.
+ Finished-goods inventory. Goods completed, but not yet sold.

- Merchandising-sector companies hold only one type of inventory, which is products in

their original purchased form, called merchandise inventory.

- Service-sector companies provide only services or intangible products and do not

hold inventories.

3. Commonly Used Classifications of Manufacturing Costs

- Direct materials costs are the acquisition costs of all materials that eventually
become part of the cost object. The steel and tires used to make the Tesla Model 3 are
examples of direct material costs.
- Direct manufacturing labor costs include the compensation of all manufacturing
labor. Examples include wages and fringe benefits paid to machine operators and
workers who convert direct materials into finished goods.
- Indirect manufacturing costs are all manufacturing costs that are related to the cost
object, but that cannot easily be traced to the cost object. Examples include indirect
materials such as oil, indirect manufacturing labor such as plant maintenance and
cleaning labor, plant rent, etc. This cost category is also referred to as manufacturing
overhead costs or factory overhead costs.

4. The different between Inventoriable Costs and Period Costs:

(note: RM-raw materials; WIP-work in process; FG-finished goods)
Learning objective 6: Illustrating the Flow of Inventoriable Costs and Period Costs

1. Manufacturing-Sector Example: Cellular Products

- Step 1: Cost of direct materials used in 2020. Company has $11,000 of direct
materials inventory at the beginning inventory of the period, purchases during the
period amounted to $73,000, $76,000 of direct materials were used, leaving an
ending inventory of direct materials of $8,000 that becomes the beginning inventory
for the next year.

- Step 2: Total manufacturing costs incurred in 2020. Total manufacturing costs for
2020 refers to all direct manufacturing costs and manufacturing overhead costs
incurred during 2020 for all goods worked on during the year.

- Step 3: Cost of goods manufactured in 2020. Cost of goods manufactured refers

to the cost of goods brought to completion during the period, regardless of whether
they were started before or during the current accounting period.

- Step 4: Cost of goods sold in 2020. The cost of goods sold is the cost of finished
goods inventory sold to customers during the current accounting period.

2. Recap of Inventoriable Costs and Period Costs

- Manufacturing company:
 - Merchandising company:

3. Prime Costs and Conversion Costs

- Prime costs:
Prime costs = Direct material costs + Direct manufacturing labor costs
- Conversion cost:
Conversion costs = Direct manufacturing labor costs + Manufacturing overhead costs

Learning objective 7: Measuring Costs Requires Judgment

- Judgment is frequently required when measuring costs.
- Differences can exist in the way accounting terms are defined.

1. Manufacturing Labor costs classifications vary among companies.

The following distinctions are generally found:
- Direct programming labor costs
- Overhead costs
+ Indirect labor costs (compensation for office staff, office security,
rework labor, overtime premium and idle time)
+ Managers’ salaries
+ Payroll fringe costs

2. Benefits of Defining Accounting Terms

- In every situation, it is important for managers and management accountants to
clearly define what direct labor includes and what direct labor excludes.
- This clarity will help prevent disputes regarding cost-reimbursement contracts,
income tax payments, and labor union matters, which often can take a substantial
amount of time for managers to resolve.

3. Different Meanings of Product Costs

- A product cost is the sum of the costs assigned to a product for a specific purpose:
+ Pricing and product-mix decisions: The costs included are all areas of
the value chain.
+ Contracting with government agencies: Companies must follow the
guidelines provided on the allowable and nonallowable items in a product-
cost amount.
+ Preparing financial statements for external reporting under Generally
Accepted Accounting Principles (GAAP): The focus is on inventoriable
costs. Usually under GAAP, only manufacturing costs are assigned to
inventories in the financial statements.