Difficulty: Intermediate | Prerequisites: Part 1 (Obj. 2.1-2.2) and Part 2 (Obj. 2.3-2.4) study notes.
This section brings together everything from the first four objectives and applies it to the real-world structure of manufacturing, merchandising and service businesses. You will learn how costs flow through inventory accounts, which costs are inventoriable (product costs) versus period costs, and how to build the cost-of-goods-manufactured and cost-of-goods-sold schedules that appear on manufacturing income statements. The labour cost details (overtime premiums, idle time) and the different definitions of "product cost" depending on context round out the chapter.
Manufacturing firms hold three types of inventory (direct materials, work-in-process, finished goods) and report three categories of manufacturing cost (direct materials, direct manufacturing labour, manufacturing overhead). Inventoriable costs sit as assets on the balance sheet until sold; period costs hit the income statement immediately. Prime costs = direct materials + direct labour. Conversion costs = direct labour + manufacturing overhead. Overtime premiums and idle time are treated as manufacturing overhead, not direct labour. The meaning of "product cost" changes depending on whether you are doing financial reporting (GAAP), pricing, or government contracting.
Inventoriable cost (product cost for GAAP)
All costs of a product that are recorded as assets on the balance sheet when incurred and become cost of goods sold only when the product is sold. For manufacturers, these are direct materials, direct manufacturing labour and manufacturing overhead. Think of them as costs that "travel with" the product through the inventory accounts.
Period cost
All costs in the income statement other than cost of goods sold. They are expensed in the period incurred, not when a product is sold. Examples include R&D, marketing, distribution, customer service and administrative salaries.
Direct materials
The acquisition costs of all materials that become part of the cost object and can be traced in an economically feasible way. Acquisition costs include the purchase price plus freight-in, sales taxes and customs duties.
Direct manufacturing labour
The compensation of all manufacturing labour that can be traced to the cost object in an economically feasible way. Assembly-line worker wages are the classic example. Some firms also include fringe benefits here.
Manufacturing overhead (indirect manufacturing costs)
All manufacturing costs related to the cost object that cannot be traced to it in an economically feasible way. Synonyms include factory overhead, indirect manufacturing costs. Examples: plant rent, plant insurance, depreciation on factory equipment, lubricants, indirect materials, indirect labour.
Prime costs
Direct materials + direct manufacturing labour. These are the costs that can be traced directly to the product.
Conversion costs
Direct manufacturing labour + manufacturing overhead. These are the costs of converting raw materials into finished goods.
Work-in-process (WIP) inventory
Goods partially worked on but not yet fully completed.
Finished goods inventory
Goods fully completed but not yet sold.
Direct materials inventory
Materials in stock and awaiting use in the manufacturing process.
Merchandise inventory
The single inventory account used by merchandising companies. These are products purchased for resale without changing their basic form.
Cost of goods manufactured (COGM)
The cost of goods brought to completion during the period, whether they were started this period or last. It is the figure that transfers from WIP to finished goods.
Gross margin (gross profit)
Revenues minus cost of goods sold.
Three business sectors
Service sector: provides intangible products (KPMG, Marriott, law firms). No inventory accounts on the balance sheet. All costs on the income statement are period costs.
Merchandising sector: buys tangible products and resells them without changing their form (Macy's, Whole Foods). One inventory account: merchandise inventory.
Manufacturing sector: purchases materials and components and converts them into finished goods (Nike, Apple). Three inventory accounts: direct materials, work-in-process and finished goods.
Three categories of manufacturing cost
Direct materials: materials that become part of the finished product and can be traced to it (steel in a car, wood in furniture, semiconductor chips in laptops).
Direct manufacturing labour: wages of workers whose effort can be traced to the product (assembly-line operators).
Manufacturing overhead: all other manufacturing costs that cannot be traced to the product in an economically feasible way (plant rent, depreciation on factory equipment, indirect materials like lubricants, indirect labour like supervisors).
Total manufacturing costs = Direct materials + Direct manufacturing labour + Manufacturing overhead.
Where each cost sits on the balance sheet
Direct material costs can appear in all three manufacturing inventory accounts (materials, WIP, finished goods), depending on where in the process the materials are. Direct labour and manufacturing overhead appear in WIP and finished goods (they are added during production, so they are never in the raw materials account).
Inventoriable vs period costs
Inventoriable costs are recorded as assets (inventory) when incurred. They become an expense (cost of goods sold) only when the product is sold. Period costs are expensed in the accounting period they are incurred, regardless of when products are sold.
For a manufacturer, inventoriable costs = all manufacturing costs. Period costs = everything else (R&D, design, marketing, distribution, customer service, administration).
For a merchandiser, inventoriable costs = the cost of purchasing the merchandise plus incoming shipping costs. Period costs = selling and administrative expenses.
For a service firm, there are no inventoriable costs. All costs are period costs.
Cost of goods sold for a merchandiser
Beginning inventory + Purchases - Ending inventory = Cost of goods sold.
Cost of goods manufactured (COGM) for a manufacturer
Beginning WIP + Manufacturing costs incurred during the period - Ending WIP = Cost of goods manufactured.
Manufacturing costs incurred = Direct materials used + Direct manufacturing labour + Manufacturing overhead.
Direct materials used = Beginning direct materials inventory + Purchases - Ending direct materials inventory.
Cost of goods sold for a manufacturer
Beginning finished goods + Cost of goods manufactured - Ending finished goods = Cost of goods sold.
The income statement structure
Revenues - Cost of goods sold = Gross margin (gross profit). Gross margin - Operating costs (R&D, design, marketing, distribution, customer service, administration) = Operating income.
Operating income is not simply revenues minus operating expenses. Cost of goods sold must be deducted first.
Prime costs and conversion costs
Prime costs = Direct materials + Direct manufacturing labour.
Conversion costs = Direct manufacturing labour + Manufacturing overhead.
Total manufacturing costs = Direct materials + Conversion costs = Prime costs + Manufacturing overhead. Another way: Total manufacturing costs = Direct materials + Direct labour + Manufacturing overhead, which is the most straightforward formulation.
Overtime premium
The extra amount paid above the straight-time rate for overtime hours. If a worker earns $25/hour straight-time and $37.50/hour overtime, the overtime premium is $12.50/hour (the difference). The straight-time portion of overtime hours ($25 x overtime hours) is direct manufacturing labour. The premium ($12.50 x overtime hours) is manufacturing overhead, because overtime is usually caused by the overall volume of work, not a specific job.
Exception: if overtime is caused by a specific rush job, the premium can be charged directly to that job.
Idle time
Wages paid for unproductive time caused by machine breakdowns, material shortages or lack of orders. Idle time is classified as manufacturing overhead (indirect labour), not direct labour, because it is not productive work on any specific product.
Rework
Labour time spent redoing defective units. Rework is treated as manufacturing overhead, not direct labour.
Fringe benefits
Some companies include fringe benefits (health insurance, pension contributions) as part of direct manufacturing labour. Others classify them as manufacturing overhead. Know that fringe benefits paid to machine operators can be considered a direct manufacturing cost.
Different meanings of "product cost"
The costs included in "product cost" depend on the purpose:
Financial statements (GAAP): product cost = inventoriable costs only (direct materials + direct labour + manufacturing overhead). This is the narrowest definition.
Pricing and product-mix decisions: product cost may include all value-chain costs (R&D, design, production, marketing, distribution, customer service) because managers need the full picture to set prices.
Government contracts: product cost typically includes design costs and production costs, but excludes marketing, distribution and customer service. R&D may be partially allowed.
Cost accounting supports decisions
Cost accounting helps managers formulate strategies, set prices, decide on product mix, and identify relevant versus irrelevant information for decisions like make-or-buy. In a make-or-buy scenario, the relevant cost is the cost that will change as a result of the decision. Sunk costs (already paid, cannot be recovered) are irrelevant. Opportunity costs (the benefit forgone by choosing one option over another) are relevant.
Students often think all manufacturing costs are period costs. They are not. Manufacturing costs are inventoriable: they sit on the balance sheet as inventory until the product is sold.
Students often assume a service company has inventoriable costs. It does not. All costs on a service firm's income statement are period costs.
Students often classify overtime premiums as direct labour. The premium portion is manufacturing overhead. Only the straight-time rate for all hours worked (including overtime hours) is direct labour.
Students often think idle time is direct labour because the worker is on the payroll. Idle time is manufacturing overhead because the worker is not productively working on a specific product.
Students often confuse cost of goods manufactured with cost of goods sold. COGM is the cost of products completed. COGS is the cost of products sold. They differ by the change in finished goods inventory.
Students often believe period costs are included in cost of goods sold. They are not. Period costs appear below the gross margin line on the income statement.
Inventoriable vs period cost classification is tested heavily. Know that for a manufacturer, inventoriable = all manufacturing costs. For a merchandiser, inventoriable = purchase cost plus incoming freight. For a service firm, there are no inventoriable costs.
Expect questions asking you to calculate inventoriable cost per unit from a cost breakdown. Add direct materials + direct labour + variable manufacturing overhead + fixed manufacturing overhead. Exclude sales commissions and administrative salaries (those are period costs).
The COGM schedule and COGS calculation are tested in both multiple-choice and extended problems. Know the formulas cold.
Prime costs vs conversion costs is a definitional favourite. Prime = DM + DL. Conversion = DL + MOH. Direct labour appears in both.
Under GAAP, only manufacturing costs can be assigned to inventories. This is a frequently tested true statement.
Overtime premium classification (overhead, not direct labour) is a common exam trap.
True or false: Manufacturing companies hold only one type of inventory. (False. They hold three: direct materials, WIP and finished goods.)
Fill in the blank: Costs that are initially recorded as assets and expensed when goods are sold are called ________ costs. (Inventoriable.)
True or false: Period costs are included in cost of goods sold. (False. Period costs are expensed as incurred and appear below gross margin.)
True or false: Conversion costs include direct materials and manufacturing overhead. (False. Conversion costs = direct labour + manufacturing overhead.)
Fill in the blank: For a merchandiser, COGS = Beginning inventory + Purchases - ________. (Ending inventory.)
Q: Puritan Apparels reports the following unit costs for Product FGS1156: direct materials $80, direct manufacturing labour $40, variable manufacturing overhead $45, fixed manufacturing overhead $31, sales commissions $7, administrative salaries $20. What are the inventoriable costs per unit?
A: $80 + $40 + $45 + $31 = $196. Sales commissions and administrative salaries are period costs.
Q: All Rite Manufacturing reports beginning finished goods of $46,000, COGM of $239,000 and ending finished goods of $45,000. What is cost of goods sold?
A: $46,000 + $239,000 - $45,000 = $240,000.
Q: Jennifer works on the assembly floor at $25/hour straight-time and 1.5x for overtime. She worked 48 hours this week. What is direct manufacturing labour, and what is manufacturing overhead?
A: Direct labour = 48 hours x $25 = $1,200 (the straight-time rate for all hours, including overtime). Manufacturing overhead = 8 overtime hours x $12.50 premium = $100. Total compensation = $1,300.
Q: What are the three types of manufacturing cost?
A: Direct materials, direct manufacturing labour and manufacturing overhead (indirect manufacturing costs).
Q: A company reports revenues of $382,000, COGS of $125,000 and total operating costs of $74,000. What is gross margin and what is operating income?
A: Gross margin = $382,000 - $125,000 = $257,000. Operating income = $257,000 - $74,000 = $183,000.
The COGM schedule built here is the foundation for job-order costing (Chapter 4) and process costing (Chapter 5), where you will apply these categories to specific costing systems. The inventoriable vs period cost distinction matters for understanding absorption costing vs variable costing (Chapter 9). The labour cost classifications (overtime premium, idle time) appear again in variance analysis (Chapters 7 and 8). The different definitions of product cost (GAAP vs pricing vs government) connect to strategic cost management and transfer pricing in later chapters.
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