CHAPTER FIVE

Cost Concepts & Cost Classifications

Learning Objectives:

After studying this chapter, you should be able to-

 Describe cost accumulation and cost objective.
 Understand manufacturing cost elements.
 Explain product cost versus period cost.
 Understand manufacturing inventories &
 Analyze activities in inventory accounts.
 Explain how the statement of cost of goods manufactured is
prepared. .

Introduction

The purpose of this chapter is to introduce cost concepts and

measurements that are widely used in Management Accounting. In the
course of our study, we will determine how costs are best measured for
different purposes.

5.1. Cost Objective Defined

Costs are measured and used in many different ways by managers to fit
the requirements of various situations. Cost data are especially
important in the following areas:

(a) Planning – The estimation of future costs in budget preparation

and in decision making.
(b) Control – The measurement of costs incurred and the comparison
of those costs with budgets and standards in the process of
directing and controlling the enterprise.

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 (c) Income Statement – the determination of the costs associated with
the Goods Sold during the fiscal period and the costs of inventories
remaining at the end of the fiscal period.

A cost may be broadly defined as being a measurement, in monetary

terms of the amount of resources used for some purpose.

Accountants usually define cost as a resource sacrifice or foregone to

achieve specific objective.

To guide decisions, managers want to know the cost of something. We

call this something a “Cost Objective;” and define it as “anything for
which a separate measurement of costs is desired.

Examples include: a product, a service, a project, a customer, a brand

category, an activity, a department, and a program.

Cost objectives are chosen not for their own sake but for helping
decision-making.

5.2 Cost Accumulation & Cost Assignment

A costing system typically accounts for costs in two broad stages:

(1) It accumulates costs by some “natural” classification such as

materials, labor, fuel, advertising, shipping, and then
(2) It assigns these costs to cost objectives.

Cost accumulation is the collection of cost data in some organized way

through an accounting system.

Cost assignment is a general term that encompasses both:

(a) Tracing accumulated costs to cost objectives ; and

(b) Allocating accumulated costs to a cost objective.

Direct Costs & Indirect Costs

A major question concerning costs is whether they have a direct or an

indirect relationship to a particular cost objective.

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Direct costs of a cost objective: costs that are related to the cost
objective and can be traced to it in an economically feasible way.

Indirect costs of a cost objective: costs that are related to the cost
objective but cannot be traced to it in an economically feasible way.

Direct Costs Cost Tracing

Cost assignment Cost

Objective

Indirect Costs Cost Allocation

5.3 Product Costing

The process of assigning costs to inventories as they are converted

from raw materials to finished goods is called Product Costing.

Product costs must be determined for the purpose of inventory valuation

and expense measurement in general purpose financial statements.
Product cost information is also used by management to plan and
control firm activities and pricing decisions.

5.4 Manufacturing Company

In a Manufacturing Company materials and other resources are

purchased and converted into finished products through the
manufacturing process. Product costs in a manufacturing company
include all costs necessary for a manufacture of a product. These costs
are recorded as assets until the product is sold and the revenue from
the sales of the product is reported in the income statement.

Manufacturing Cost Elements

We shall first distinguish Manufacturing from Non-manufacturing Costs.

Manufacturing (Product Costs) are those costs related to factory
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operations, which are essential to the completion of a product. We shall
further classify Manufacturing Costs as Raw (Direct) Materials Costs,
Direct Labor Costs, and Manufacturing (Factory) Overhead Costs.

Raw (Direct) materials are the materials which are the major
components of the finished product and can be clearly identified with the
product.

Direct Labor is the labor which is used in actual producing of the

product – for instance that of the assembly line workers.

Manufacturing (Factory) overhead consists of all other costs related to

the manufacturing process but not classified as either Direct Materials
or Direct Labor – for example, Salaries of cleaners & forklift operators,
cost of fuel & oil, Depreciation of the Equipment used in the
manufacturing process.

Non-manufacturing Costs consists of all other costs of running the

business and selling the product (i.e., Operating Expenses) and may be
classified very broadly as both Selling Expenses and Administrative
Expenses.
We refer to the combination of Manufacturing and Non-manufacturing
the Full (Total) Cost of the product produced.
Let as summarize the classifications of the total costs for a
manufacturing company we have made so far.

Manufacturing Costs Raw (Direct) Material

A Manufacturing (Product costs) Direct Labor
Company Factory Overhead
Total Cost
Selling

Non-manufacturing Costs
(Period Costs) Administrative

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Prime Costs and Conversion Costs

Two terms found in manufacturing costing systems are prime costs and
conversion costs.

Prime Costs: are all direct manufacturing costs. In the three-part

classification, noted above, Prime Costs would comprise Direct material
Costs and Direct labor Costs.

Conversion Costs are all manufacturing costs other than direct

material Costs. These costs are for converting direct materials into
finished goods. Conversion costs would comprise direct labor and factory
overhead.

5.5 Product versus Period Costs

Accountants make a distinction between the cost of manufactured

products and the costs incurred in non-manufacturing activities.

Product costs are recorded and carried as assets (inventories) at the

time products are made; they become expenses only when the product is
sold. They are costs associated with the purchase of Goods for Sale (in
the case of merchandise inventory) or costs associated with the
acquisition and conversion of materials and all other manufacturing
inputs into goods for sale (in the case of manufacturing
inventories).Under GAAP, inventoriable costs are restricted to
manufacturing costs for manufacturing Sector Company.

Period costs are costs of “goods and services’ that are recorded as
expenses in the period in which they are consumed. They include costs
initially recorded as non-inventoriable capitalized costs (Building,
equipment, and computers) and costs recorded immediately as expenses
as they are incurred (advertising expense, administrative salaries, office
supplies and the like.)

5.6 Manufacturing Inventories

In manufacturing firms, inventories typically play a more important role

than in other types of business. Service firms have no inventory that
they hold for resale to customers. Operating Supplies are carried only to
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facilitate the main function of providing service. Merchandising firms
acquire inventory for resale to customers. A Merchandising firm may
have many classifications of inventory and many items within each
inventory classification, but all inventory items are ready made for sale.

A Manufacturing firm has three major levels of inventory:

1. Raw Materials Inventory
2. Work-In-Process Inventory, and
3. Finished Goods Inventory
Raw Materials (RM) Inventory is the basic inputs or ingredients that
are converted into final product through the production process.
Work-In-Process (WIP) Inventory is the second level of inventory in a
manufacturing firm. It consists of unfinished products that are in the
process of being converted into final products. Many different products
can be in work in process simultaneously. For example, a Bakery may
have a variety of breads, cakes, and doughnuts in process at any given
time.
Finished Goods Inventory is the final level of inventory consists of
finished goods, which are products ready for sale. In a multiple products
manufacturing firm, there are many different finished goods inventory
items.

Analyzing Activity in Inventory Accounts

An understanding of account activity and accounts interrelationships

is extremely important for product costing and control. During any time
period, the activity in any account can be broken down into four parts.

Beginning balance + Increases – Decreases = Ending

Balance

Knowing any three of these items, we can always find the fourth.

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 For example:
Cash Account Merchandise Inventory Accounts Payable
Beginning Balance Beginning Balance Beginning Balance
+ Cash receipts + Purchases + purchase on
account
= Total cash available = Total Inventory = Total
Payable
- Cash disbursements - Cost of Goods Sold - Payment on
Account
= Ending Balance = Ending Balance = Ending Balance
Activity in one account always affects at least one other account. For
example, inventory purchased on account in a Merchandising firm
“Increases” (Debited) Merchandise Inventory and Accounts Payable
(Credited). Inventory issued to the factory in a manufacturing firm
“Decreases” (Debited) Raw Materials Inventory and “Increases” Work-
In-Process Inventory (Credited).

Complete analyses of a manufacturing organization’s Inventory Account

relationships are presented below (Table 5.1).
Table 5.1: Analysis of Activity in Manufacturing Company’s Inventory Accounts
___________________________________________________________________________________
Raw Materials Inventory Work-In-Process Inventory Finished Goods Inventory
Beginning Balance Beginning Balance Beginning Balance
Add: Add: Add:
Current Manufacturing Costs:
Purchase Cost of Goods
Direct Materials + Direct Labor
Manufactured
+ Factory Overhead

= Total available = Total Cost in Process = Total Available for Sale

Minus: Minus: Minus:

Cost of Materials Cost of Goods

Cost of
Placed in production Manufactured
Goods Sold

= Ending Balance = Ending Balance = Ending Balance

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In Table 5.1 the cost of Raw Materials placed in Production
decreases Raw Materials Inventory and Increases Work-In-Process
Inventory. The total additions to Work-In-Process Inventory are
collectively identified as Current Manufacturing Costs and the total costs
assigned to products completed are collectively identified as the Cost of
Goods Manufactured. The Cost of Goods Manufactured id deducted from
Work-In-Process Inventory and added to Finished Goods Inventory. Once
the relationship between inventories accounts are known, items of
interest, such as, the Cost of Materials Placed in Production, the Cost
of Goods Manufactured, and the Cost of Goods Sold are readily
determined. Consider the following illustration.

ILLUSTARION

On September 30, 2015, the Beginning Inventory accounts Balances

of Harmon Manufacturing Company were:

Raw Materials Inventory ---------------------

$5,000

Work-In-Process Inventory -----------------

$8,000

Finished Goods Inventory ------------------

$11,000

During the month of September, Raw Materials costing $12,000 were

purchased. Direct Labor and Factory Overhead costs were $20,000 and
$15,000 respectively.

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The September 30, Ending Inventory Accounts Balances were as
follows:

Raw Materials Inventory ---------------------

$7,000

Work-In-Process Inventory -----------------

$14,000

Finished Goods Inventory ------------------

$6,000

An analysis of activity in inventory accounts is presented in Table 5.2.

This illustration focused on inventory account activity. Cost of Goods

Sold is, of course, just one item on the Income Statement. Harmon’s
September Income Statement would also include Revenue from sales
and Expenses. Harmon’s September 30 Balance Sheet would include
inventories and many other Assts as well as Liabilities and Owner’s
Equity (Capital) accounts.

Because activity in one account always affects at least one other account,
the analysis here is complete. The acquisition of Raw Materials and
Direct Labor and the incurrence of Factory Overhead costs affect many
other accounts. We have ignored these accounts for the movement in
order to emphasize the essential inventory relationships found on
Product Costing under Cost Accounting.

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Table 5.2: Analysis of Harmon Company’s Inventory Accounts

Raw Materials Inventory Account:

Beginning Balance ------------------------------------------------- $ 5,000

+ Purchases ----------------------------------------------------------- $12,000

Total available for use -------- --------------- ---------------------- $17,000

- Ending Balances -------------------------------------------------- $ 7,000

Cost of Materials Placed in Production (Direct Materials) - $10,000

Work-In-Process Inventory Account:

Beginning Balance ------------------------------------------------- $ 8,000

+ Current Manufacturing Costs:

Direct Material -------------- $10,000

Direct Labor ------------------ 20,000

Factory Overhead ------------ 15,000 45,000

Total Cost in Process ------------------------------------------------ $12,000

- Ending Balances --------------------------------------------------- $14,000

Cost of Goods Manufactured ------------------------------------ $39,000

Finished Goods Inventory Account:

Beginning Balance -------------------------------------------------- $11,000

+ Cost of Goods Manufactured ------------------------------------ $39,000

Total available for sale ---------------------------------------------- $50,000

- Ending Balances --------------------------------------------------- $ 6,000

Cost of Goods Sold ------------------------------------------------ $44,000

5.7 Statement of Cost of Goods Manufactured

The activity in Raw Materials and Work-In-Process Inventory accounts is

formally summarized in a Statement of Cost of Goods Manufactured.
Harmon’s Manufacturing Company’s September 30, 2015 Statement of
Cost of Goods Manufactured is presented in Table 5.3 below. To show
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the relationship between this Statement and Income Statement,
Harmon’s September 30, 2015 Income Statement is also presented in
Table 5.4. For this illustration assume that the month’s Sales of $90,000
and Selling & Administrative Expenses of $30,000.

Table 5.3: Statement of Cost of Goods Manufactured

HARMON MANUFACTURING COMPANY

STATEMENT OF COST OF GOODS MANUFACTURED
FOR MONTH ENDED SEPTEMBER 30, 2015

Current Manufacturing Costs:

Raw Materials Inventory 01/09/2015 $5,000

+ Purchases ----------------------------- 12,000

Total available for use ---------------- 17,000

- Raw Materials Inventory 30/09/2015 $7,000

Cost of Materials Placed in Production $10,000

Direct Labor --------------------------------- 20,000

Factory Overhead --------------------------- 15,000

45,000 Work-In-Process 01/09/2015 -----------------
------------------------- 8,000

Total Cost in Process ------------------------------------------------

53,000

Work-In-Process 30/09/2015 ------------------------------------------

14,000

Cost of Goods Manufactured -----------------------------------------

$39,000

Note that the Cost of Goods Manufactured is similar to purchase for a

merchandising company. The “Purchase” in merchandising company
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represents “The cost of goods bought” for sale to customers. The “Cost
of Goods Manufactured” in a manufacturing company represents “The
cost of goods produced”” for sale to customers.

Table 5.4: Income Statement

HARMON MANUFACTURING COMPANY

INCOME STATEMENT
FOR MONTH ENDED SEPTEMBER 30, 2015

Sales -------------------------------------------------------------------
$90,000
Cost of Goods Sold:
Finished Goods Inventory 01/09/2015------------ $11,000
+ Cost of Goods Manufactured --------------------- $39,000
Total available for sale ------------------------------- $50,000
Finished Goods Inventory 30/09/2015------------ $ 6,000 44,000
Gross Profit -----------------------------------------------------------
46,000
- Selling & Administrative Expenses ------------------------------
30,000
Net Income ----------------------------------------------------------
$ 16,000

The three Inventory accounts together with other assets would appears
in Harmon’s September 30, 2015 Balance Sheet. A partial Balance
sheet appears below (Table 5.5).

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Table 5.5: Partial Balance Sheet

HARMON MANUFACTURING COMPANY

BALANCE SHEET
SEPTEMBER 30, 2015

Assets:
Current Assets:

Cash ---------------------------------------------------------- $12,000

Accounts Receivables -------------------------------------- 4,000
Raw Materials Inventory 30/09/2015 ------------------ 7,000
Work-In-Process 30/09/2015 --------------------------- 14,000
Finished Goods Inventory 30/09/2015------------------ 6,000
Total Current Assets -------------------------------------
$43,000

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