To assist managers in planning, decision making, and cost management, managerial accountants classify costs by the functional area of the organization to which costs relate.
Some examples of functional areas are manufacturing, marketing, administration, and research and development. Manufacturing costs are further classified into the following three categories: direct material, direct labor, and manufacturing overhead. Manufactur- ing overhead is sometimes referred to more generally as production overhead, thereby including the overhead used in producing services.
Exhibit 2–5 Types of Production Processes
Type of Production Process
Description of Process
Example of Manufacturer
Multiple products; low volume; high product diversity; some customization.
Caterpillar ( batch production of heavy equipment ).
A few major products; higher volume;
lower diversity; minimal customization.
Ford ( automobile assembly line ).
High production volume; highly standardized commodity products.
ExxonMobil ( production of gasoline, a continuous-flow product ).
Continuous Flow Assembly Batch Job Shop
Low production volume; little standardization; one-of-a-kind products.
Habitat for Humanity (custom home builder).
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Learning Objective 2-5 Give examples of three types of manufacturing costs.
3As mentioned at the beginning of Chapter 1, the focus organizations around which the remaining chapters in the text are built are not real organizations. They are, however, realistic settings in which to discuss business and mana- gerial accounting issues. In most cases they are based on real organizations. These realistic illustrations are intended to help students connect the business and managerial accounting issues discussed in this book to the management process and to everyday life.
Direct Material Material that is consumed in the manufacturing process, is physically incorporated in the finished product, and can be traced to products relatively easily is called direct material. Examples include the sheet metal in a Subaru automobile and the microprocessor chips in a Comet computer.
Some students are confused by the seemingly interchangeable use of the terms raw material and direct material. However, there is a difference: before material is entered into the production process, its cost is classified as raw material; after it enters produc- tion, its cost is reclassified as direct material (which, as we shall see in the next section of this chapter, is a part of work-in-process inventory).
Direct Labor The cost of salaries, wages, and fringe benefits for personnel who work directly on the manufactured products is classified as direct-labor cost. Examples include the wages of personnel who assemble Comet computers in Hanoi, Vietnam, and those who operate the equipment in one of Royal Dutch Shell’s refineries.
The cost of fringe benefits associated with any labor spending classified as direct labor should also be classified as direct-labor costs. Fringe benefits include the costs of providing health insurance, making pension and social security contributions, and other non-salary benefits provided by the employer to the employee.
Manufacturing Overhead All other costs of manufacturing are classified as manufacturing overhead (also known as production overhead), which includes three types of costs: indirect material, indirect labor, and other manufacturing costs.
Indirect Material
The cost of materials that are required for the production process but do not become an integral part of the finished product are classified as indirect material costs. An example is the cost of drill bits used in a metal-fabrication department at Ford Motor Company. The drill bits wear out and are discarded, but they do not become part of the product.
Materials that do become an integral part of the finished product but are insignificant in cost are also often classified as indirect material. For example, the various machine screws used in assembling Comet computers are so inexpensive that it is not worth trac- ing their costs to specific products as direct materials. Instead, they are added to the cost of indirect materials and become part of manufacturing overhead cost.
Indirect Labor
The costs of personnel who do not work directly on the product, but whose services are necessary for the manufacturing process, are classified as indirect labor. At Comet Computer Company, such personnel include production department supervisors, quality control inspectors, and assembly plant security guards.
Other Manufacturing Costs
All other manufacturing costs that are neither material nor labor costs are classified as manufacturing overhead. These costs include various costs of the plant such as deprecia- tion of building and equipment, property taxes, insurance, and utilities such as electricity, as well as the costs of operating service departments. Service departments, also known as support departments, are those that do not work directly on manufacturing products but are necessary for the manufacturing process to occur, such as equipment-maintenance departments. In some firms, departments are referred to as work centers.
Other manufacturing overhead costs include overtime premiums and the cost of idle time. An overtime premium is the extra compensation paid to an employee who works beyond the time normally scheduled. For most nonmanagement employees in the United States and Canada, government regulations require that overtime work be paid at one and
“If you just simply have [an employee] performing an [assembly] operation, that’s direct labor. But when you put in a robot to do the job, which we’re all doing, then you’ve got to have an engineer to make sure the [robot] is programmed right.
So now it becomes indirect labor.” (2e)
Chrysler
one-half times the regular rate of pay (“time and a half”). So the overtime premium por- tion is the extra one-half that is added to the regular pay rate.
Suppose a technician who assembles Comet computers earns $16 per hour. The tech- nician works 48 hours during a week and overtime is paid after the the scheduled time of 40 hours. The overtime pay scale is time and a half, or 150 percent of the regular wage.
The technician’s compensation for the week is classified as follows:
Direct-labor cost ($16 × 48) ... $768 Overhead (overtime premium: ½ × $16 × 8) ... 64 Total compensation paid ... $832
Direct-labor cost ($14 × 38) ... $532 Overhead (idle time: $14 × 2) ... 28 Total compensation paid ... $560
Only the extra compensation of $8 per hour is classified as overtime premium. The regular wage of $16 per hour is treated as direct labor, even for the eight overtime hours.
Idle time is time that is not spent productively by an employee due to such events as equipment breakdowns or new setups of production runs. Such idle time is an unavoid- able feature of most manufacturing processes. The cost of an employee’s idle time is classified as overhead so that it may be spread across all production jobs, rather than being associated with a particular production job. Suppose that during one 40-hour shift, a machine breakdown resulted in idle time of 1½ hours and a power failure idled workers for an additional ½ hour. If an employee earns $14 per hour, the employee’s wages for the week will be classified as follows:
Overtime premiums and the cost of idle time should be classified as manufactur- ing overhead, rather than associated with a particular production job, because the par- ticular job on which idle time or overtime may occur tends to be selected at random.
Suppose that to meet holiday demand, Comet must schedule computer production in November for 10 hours per day instead of eight hours. The overtime premium paid only during the extra two hours is actually a result of all of the computers needing to be produced each day and not just the ones that happen to be produced during hours 9 and 10. Similarly, if a power failure occurs during one of several production jobs, the idle time that results is not due to the job that happens to be in process at the time. The power failure is a random event, and the resulting cost should be treated as a cost of all of the department’s production.
As summarized in Exhibit 2–6 total manufacturing cost includes direct material, direct labor, and manufacturing overhead. Direct labor and manufacturing overhead are often called conversion costs, since they are the costs of “converting” raw material into finished products. Direct material and direct labor are often referred to as prime costs.
Exhibit 2–6
Total Manufacturing Cost Total Manufacturing Cost
Direct Labor Direct
Material
Manufacturing Overhead
Prime Costs
Conversion Costs
+ +
Manufacturing Cost Flows
Direct material, direct labor, and manufacturing overhead are called product costs because they are assigned to products and stored in inventory cost until the time period when the manufacturer’s products are sold. Manufacturers have product-costing systems to keep track of the flow of these costs from the time production begins until finished products are sold. This flow of manufacturing costs is depicted in Exhibit 2–7. As material is con- sumed in production, the cost of these direct materials is removed from the raw-material inventory account and added to work-in-process inventory. Similarly, the costs of payroll classified as direct labor and manufacturing overhead expenditures, as discussed in the previous section, are accumulated in work in process.
When products are finished, their costs are transferred from work-in-process inven- tory to finished-goods inventory. The total cost of direct material, direct labor, and manu- facturing overhead transferred from work-in-process inventory to finished-goods inventory is called the cost of goods manufactured.4 The costs then are stored in fin- ished goods until the time period when the products are sold. At that time, the costs of those products are transferred from finished goods to cost of goods sold, which is an expense of the period when the sale is made. Exhibit 2–7 concentrates on the conceptual basis of a product-costing system. The detailed procedures and accounts used to keep track of product costs are covered in Chapters 3 and 4.
Manufacturers generally prepare a schedule of cost of goods manufactured and a schedule of cost of goods sold to summarize the flow of manufacturing costs during an accounting period. These schedules are intended for internal use by management and not made available to the public. The Excel spreadsheets in Exhibit 2–8 show these two schedules along with an income statement for Comet Computer Company.5 Notice the extremely low inventories of raw material, finished goods, and work in process in these schedules. With annual sales of $700 million, Comet’s year-end inventory of raw material is only $5,020,000, which is less than 1 percent of sales. Work-in-process inventory ($100,000) and finished-goods inventory ($190,000) are even lower. These low invento- ries, relative to sales volume, are characteristic of manufacturers using an online sales business model.
Manufacturing Cost Flows
4Do not confuse cost of goods manufactured with total manufacturing cost for the period. Cost of goods manufac- tured, as indicated, is the cost of goods completed and transferred from work-in-process inventory to finished-goods inventory. However the total manufacturing cost is the sum of direct material, direct labor, and manufacturing over- head incurred during the period, i.e. the spending on manufacturing. Some of that spending may still be in work-in- process inventory and so not part of what is traditionally called cost of goods manufactured.
5Some numerical displays in the text will be presented as Excel spreadsheets, since this tool is widely used in business.
Exhibit 2–7
Flow of Manufacturing Costs Direct Material
Direct Labor Work-in-Process Inventory
Finished-Goods Inventory
Cost of Goods Sold
Manufacturing Overhead
Product costs . . . . . . are stored in inventory . . . . . . until the products are sold.
“In my mind, cost accountants are going to be business analysts.” (2f)
Boeing Learning Objective 2-6 Prepare a schedule of cost of goods manufactured, a schedule of cost of goods sold, and an income statement for a manufacturer.
Exhibit 2–8 Manufacturing Cost Schedules
(continued)
NonManufacturing Production Costs
Service industry firms and many nonprofit organizations are also engaged in production.
What distinguishes these organizations from manufacturers is that a service is consumed as it is produced, whereas a manufactured product can be stored in inventory. Such businesses as Westin Hotels & Resorts, Bank of America, Delta Air Lines, the Chicago Bulls, and UnitedHealthcare are in the business of producing services. Similarly, nonprofit organiza- tions such as the American Red Cross and the Houston Grand Opera Association also are engaged in service production. While less commonly observed in service firms, the same cost classifications used in manufacturing companies can be applied. For example, Air France produces air transportation services. Direct material includes such costs as jet fuel, aircraft parts, and food and beverages. Direct labor includes the salaries of the flight crew and the wages of aircraft-maintenance personnel. Overhead costs include depreciation of baggage- handling equipment, insurance, overtime premium for flight crew, and airport landing fees.
Notice that service firms can have direct material and direct labor costs just as manu- facturing firms do. These costs can be traced to the company’s service outputs, so they com- prise part of the Operating Expenses that match with the Operating Revenues from the sale of services (see Exhibit 2–3). But as noted earlier, they are not product costs but rather they are period costs that are recorded in the accounting period of the expenditure. The reason?
Services cannot be inventoried for future sale like a tangible product, so their costs don’t flow through the work-in-process and finished-goods inventory accounts like products do.
The process of recording and classifying costs is important in service industry firms and nonprofit organizations for the same reasons as in manufacturing firms. Cost analysis is used in pricing banking and health care services, selecting car-rental agency locations, setting enrollment targets in universities, and determining cost reimbursements in hospi- tals. As such organizations occupy an ever-growing role in our economy, applying mana- gerial accounting to their activities will take on ever-greater importance.
Basic Cost Management Concepts: Different Costs for Different Purposes
An understanding of cost concepts is absolutely critical to cost management. More- over, different perspectives on costs are important in different managerial situations.
The phrase different costs for different purposes is often used to convey the notion that
NonManufacturing Production Costs
Basic Cost Management Concepts: Different Costs for Different Purposes
Microsoft Office Excel
Exhibit 2–8 (concluded)
Learning Objective 2-7 Understand the importance of identifying an organization’s