Difficulty: Intermediate | Prerequisites: Unit 8 (plant assets, depreciation), basic understanding of debits/credits, income statement structure.
These two units shift the focus from recording individual transactions to understanding how costs flow through a business and how managers plan for the future. Unit 9 covers how different types of firms (service, merchandising, manufacturing) classify and track costs, including the distinction between product costs and period costs, inventory cost-flow assumptions (FIFO, LIFO), and how manufacturing firms allocate overhead. Unit 10 introduces budgeting: how companies build a master budget from the sales forecast down through production, materials, labour, overhead, and ultimately the cash budget and budgeted balance sheet. If you are comfortable with the income statement and balance sheet from earlier units, you have the foundation you need.
Product costs attach to inventory and hit the income statement only when the product is sold; period costs are expensed in the period incurred. Merchandisers track inventory using FIFO or LIFO; manufacturers split costs into direct materials, direct labour, and overhead across three inventory accounts (raw materials, work in process, finished goods). Budgeting ties all of this together: a master budget starts with the sales forecast and cascades through production, materials, labour, overhead, selling and administrative expenses, and finally into the cash budget and budgeted balance sheet.
Product costs (inventoriable costs)
Costs directly tied to producing or purchasing goods. They sit on the balance sheet as inventory until the product is sold, at which point they move to the income statement as cost of goods sold. They appear "above the line" for gross margin.
Period costs (indirect costs)
Costs expensed in the period incurred regardless of whether products were sold. They appear "below the line" for gross margin. Examples: rent, salaries of admin staff, advertising.
Gross margin
Revenues minus product costs. The profit figure before period costs are deducted.
FIFO (First-In-First-Out)
Inventory cost-flow assumption where the oldest inventory acquired is assumed to be sold first. Most widely used method.
Think of it as: the first items onto the shelf are the first ones off.
LIFO (Last-In-First-Out)
Inventory cost-flow assumption where the most recently acquired inventory is assumed to be sold first.
Overhead (manufacturing overhead)
The total of all indirect manufacturing costs, those that cannot be directly traced to a specific product. Examples: factory rent, utilities, supervisor salaries.
Cost pool
The total costs to be allocated across cost objects.
Cost objects
The items or entities to which costs from the cost pool are allocated. Examples: products, departments, projects.
Cost driver (allocation basis)
A measurable attribute used to distribute costs from the cost pool to cost objects. Examples: machine hours, direct labour hours.
Allocation rate (overhead rate)
The cost pool divided by the total allocation volume (denominator volume). Used to assign overhead to each unit or job.
Budget
A formal written statement of management's financial plan for a specific future period.
In simple terms: the company's financial game plan, expressed in numbers.
Master budget
A set of interrelated budgets that together form the company's complete plan for a given period. Contains operating budgets and financial budgets.
Budgetary slack
Occurs when managers intentionally underestimate revenues or overestimate expenses to make targets easier to hit.
Participative budget
A bottom-up approach in which each level of management contributes to the budget. More time-consuming but increases buy-in.
Product costs appear above the line on the income statement (they form cost of goods sold). Period costs appear below the line (selling, general, and administrative expenses).
Gross Margin = Revenues - Product Costs
Profit Before Taxes = Gross Margin - Period Costs
Product costs are treated as an asset (inventory) until the product is sold. Period costs are expensed immediately in the period incurred.
Total Costs = Product Costs + Period Costs
Service firms: provide intangible, non-storable products. No inventory of goods.
Merchandising firms: buy finished goods from suppliers and resell them. They maintain one inventory account.
Manufacturing firms: use labour and equipment to transform raw materials into finished products. They maintain three inventory accounts: Raw Materials, Work in Process (WIP), and Finished Goods.
Cost of beginning inventory + Cost of goods purchased during the period - Cost of ending inventory = Cost of goods sold (COGS)
FIFO (most commonly used): the first units purchased are assumed to be the first units sold. Ending inventory reflects the most recent purchase prices.
LIFO: the last units purchased are assumed to be the first units sold. COGS reflects the most recent purchase prices.
Manufacturing costs are grouped by function:
Prime costs: direct materials + direct labour
Conversion costs: direct labour + manufacturing overhead (variable + fixed)
Capacity costs: variable overhead + fixed overhead
Beginning WIP balance + Costs charged for operations during the period - Ending WIP balance = Cost of goods manufactured
When overhead cannot be traced directly to a product, it must be allocated.
Cost pool: the total indirect costs to be distributed
Cost driver: the measurable activity used to distribute costs (e.g. machine hours)
Allocation volume (denominator volume): the sum of the cost driver across all cost objects
Allocation rate: cost pool / allocation volume
Allocated cost per object: number of cost driver units in that object x allocation rate
A budget is a formal written financial plan for a specific future period. Budgeting is not the same as long-range planning.
Budgeting: up to 1 year, more detailed, short-term goals
Long-range planning: 5+ years, less detailed, strategic direction
Benefits of budgeting: forces management to plan ahead and formalise goals, provides measurable objectives for performance evaluation, creates early warning for problems, coordinates activities across the business, increases awareness of operations and external factors, and motivates personnel.
The effectiveness of a budget depends on buy-in from all levels of management.
A participative budget is built bottom-up: each management level contributes. Disadvantages: more time-consuming and can encourage "gaming" (budgetary slack), where managers intentionally sandbag revenue forecasts or inflate expense estimates.
The master budget is a set of interrelated budgets forming the company's complete plan. It has two classes:
Operating budgets feed into the budgeted income statement:
Sales Budget – the starting point, derived from the sales forecast. Sales Budget = Expected Unit Sales x Anticipated Unit Selling Price.
Production Budget – how many units to produce. Required Production = Budgeted Sales + Desired Ending Finished Goods - Beginning Finished Goods.
Direct Materials Budget – quantity and cost of materials to purchase. Required Purchases = Materials Needed for Production + Desired Ending Materials - Beginning Materials. Budgeted Cost = Required Units x Cost per Unit.
Direct Labour Budget – hours and cost of labour. Total Direct Labour Cost = Units to Produce x Labour Time per Unit x Labour Cost per Hour.
Manufacturing Overhead Budget – expected overhead costs.
Selling and Administrative Expense Budget – projected period costs.
Budgeted Income Statement – expected profitability.
Financial budgets focus on cash and the balance sheet:
Cash Budget – often called the most important financial budget. Contains cash receipts, cash disbursements, financing, and beginning/ending cash balances.
Budgeted Balance Sheet – built from the prior year's balance sheet and the current year's budgets.
Merchandisers replace the production budget with a merchandise purchases budget and do not need separate direct materials, direct labour, or manufacturing overhead budgets.
Required Merchandise Purchases = Budgeted COGS + Desired Ending Inventory - Beginning Inventory.
Service companies base budgets on expected output or expected input. Non-profit organisations budget on a cash-flow basis (expenditures and receipts), starting from expenditures rather than revenues.
\text{Gross Margin} = \text{Revenues} - \text{Product Costs}\text{Profit Before Taxes} = \text{Gross Margin} - \text{Period Costs}\text{COGS} = \text{Beginning Inventory} + \text{Purchases} - \text{Ending Inventory}\text{Cost of Goods Manufactured} = \text{Beginning WIP} + \text{Costs Charged} - \text{Ending WIP}\text{Allocation Rate} = \frac{\text{Cost Pool}}{\text{Allocation Volume}}\text{Sales Budget} = \text{Expected Unit Sales} \times \text{Unit Selling Price}\text{Required Production} = \text{Budgeted Sales} + \text{Desired Ending FG} - \text{Beginning FG}\text{Required DM Purchases} = \text{DM for Production} + \text{Desired Ending DM} - \text{Beginning DM}\text{Total Direct Labour Cost} = \text{Units} \times \text{Labour Time/Unit} \times \text{Labour Cost/Hour}\text{Required Merch. Purchases} = \text{Budgeted COGS} + \text{Desired Ending Inv.} - \text{Beginning Inv.}Students often think product costs hit the income statement when incurred. They do not. Product costs sit as inventory (an asset) until the product is sold.
FIFO and LIFO are cost-flow assumptions, not rules about which physical goods leave the warehouse first. The actual movement of goods is irrelevant.
Students sometimes assume budgeting and long-range planning are the same thing. Budgeting is short-term (up to one year) and detailed; long-range planning covers five or more years at a higher level.
Overhead is often confused with period costs. Manufacturing overhead (factory rent, factory utilities) is a product cost. Selling and administrative expenses are period costs.
⚠️ Be able to classify any cost as product or period, and know which line of the income statement it affects.
⚠️ Know the inventory equation cold: Beginning + Purchases - Ending = COGS.
⚠️ The production budget formula (Sales + Desired Ending FG - Beginning FG) appears frequently. Practice it with numbers.
⚠️ Expect a question asking you to compute the direct materials purchases budget, including desired ending materials.
⚠️ Know the sequence of the master budget components and whether each is an operating or financial budget.
⚠️ The cash budget is often flagged as the most important financial budget.
True or False: Period costs are included in inventory on the balance sheet. (False. Only product costs are inventoried.)
Fill in the blank: Under FIFO, ending inventory reflects the ________ purchase prices. (Most recent)
True or False: Manufacturing overhead is a period cost. (False. Manufacturing overhead is a product cost.)
Fill in the blank: Required Production = Budgeted Sales + Desired Ending Finished Goods - ________. (Beginning Finished Goods)
True or False: The sales budget is the last budget prepared in the master budget sequence. (False. It is the first.)
Q: A company has beginning inventory of $12,000, purchases of $45,000, and ending inventory of $10,000. What is COGS?
A: 12,000 + 45,000 - 10,000 = $47,000.
Q: A factory's total overhead is $300,000 and total machine hours across all products are 50,000. What is the overhead allocation rate per machine hour?
A: 300,000 / 50,000 = $6 per machine hour.
Q: A company expects to sell 10,000 units. It wants ending finished goods of 1,500 units and has beginning finished goods of 2,000 units. How many units must it produce?
A: 10,000 + 1,500 - 2,000 = 9,500 units.
Q: A merchandiser budgets COGS of $80,000, wants ending inventory of $15,000, and has beginning inventory of $12,000. What are required merchandise purchases?
A: 80,000 + 15,000 - 12,000 = $83,000.
Q: Name the two classes of budgets within a master budget.
A: Operating budgets and financial budgets.
The product-vs-period distinction underpins the statement of cash flows (Unit 12): product costs flow through inventory accounts and affect cash differently from period costs that are paid and expensed in the same period.
Budgets set the baseline for variance analysis (Unit 13). Every variance is the difference between an actual result and a budgeted amount, so understanding how the budget is built is essential for interpreting variances.
Cost allocation concepts from Unit 9 carry directly into capital budgeting (Unit 11), where overhead rates help estimate the operating cash flows of a proposed investment.
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