The cost of supplies, which are variable, will increase as the yoga class attracts new members. Apart from the presence of the inventory account, the cost flows in merchandising companies resemble the flows in service companies. The most important item in the first group is the cost of purchasing goods from suppliers.
As we will see next, the cost flow is even more complex in manufacturing firms. Some of these costs, such as the cost of transporting goods to customers and sales commissions, are variable.
H ow muCH does tHat w ii Cost ?
Connecting to Practice
When production begins, companies allocate material, labor, and overhead costs from the appropriate inventory and control accounts to a work in progress (WIP) account. They accordingly transfer the cost of goods manufactured (COGM) from the work-in-progress inventory account to the finished goods inventory account. At the same time, companies remove related costs from the FG inventory account and transfer them to the cost of goods sold (COGS) account.
InCOME StatEMEnt
The sum of materials, labor, and overhead added to the work-in-process account during the period is the total manufacturing cost charged to production. Often the production process consists of many steps, with new materials and/or labor added at each step. At each step, we add the cost of materials, labor, and overhead consumed in that step to the WIP account to "build" the cost of the work performed on a particular product.
Once the production process is complete, firms physically transfer finished work from work-in-process inventory to finished goods (FG) inventory. Cost of goods sold appears as a deduction from revenue on the income statement, with gross margin equal to the difference between revenue and COGS.
As previously discussed, cost of goods sold represents the product costs associated with the items sold during the year. It is not necessarily the same as the cost of goods manufactured during the year. As shown in Figure 3.10, Vulcan Forge uses the inventory equation to match the cost of goods produced and the cost of goods sold.
As we see from this exhibit, we obtain the cost of goods sold ($32 million) by adding the beginning finished goods inventory ($2 million) and the cost of goods manufactured ($35 million from Exhibit 3.8) and the ending cost to subtract merchandise inventory ($5 million). Of course, Vulcan's finished goods inventory increases by the same amount: $2 million at the beginning to $5 million at the end of the period. Finally, Exhibit 3.11, which complies with GAAP, presents Vulcan's income statement for the most recent year of operations.
Recall from Exhibit 3.3 that a trading company has one significant inventory Exhibit 3.9 Vulcan Forge: Cost of Goods.
CHAPTer CONNeCTIONs
Assume that Mason Manufacturing provides the following data for the most recent quarter: raw materials purchases of labor costs of $845,000; and manufacturing overhead of $760,500.
Check It! Exercise #2
Multi-product companies solve this problem by allocating overhead costs to products on a justified basis. Cost objects – the items or units to which we allocate costs in the cost pool. In our example, we have two cost objects: the Smith family and the Jones family.
For example, we could use the number of people in each family as an attribute, or the number of adults, the number of men, the number of left-handed people, and so on. For our example, if we choose the number of people as the allocation basis, then the Smith family has three units of the cost driver and the Jones family has two units. Then we can choose the number of adults as the allocation basis, in which case the Smith and Jones families each have two units of the cost driver.
Allocation volume (denominator volume)—sum of cost driver amounts across all cost objects. In our case, if the number of persons is the cost driver, then the scope of the allocation or denominator is five persons. If the cost driver is the number of adults, then the allocation range is four people.
Calculate the distribution rate by dividing the amount in the cost pool by the denominator volume.
Cost allocations
When the number of adults is the cost driver, our allocation rate is $60/4 adults $15 per adult. Multiply the number of cost driver units contained in each cost object by the allocation rate. But when the number of adults is the cost driver, then both cost objects (both families) pay the same amount: 2 adults $15 per adult $30 per family.
Note that regardless of the cost driver we choose, the sum of the allocations is equal to the cost pool. As you can see in the example, assignments distribute costs in the cost pool in proportion to the number of cost driver units in each cost object. When the number of people is the cost driver, we allocate 60% of the costs to the Smith family because this family accounts for 60% of the cost driver units (people).
When the cost driver is the number of adults, each family pays $30 instead of a split $36/$24. As our example shows, the cost driver we choose can greatly affect the cost allocation results. Since these costs are common to both products, they must be allocated to determine the cost of each product.
In general, regardless of the number of products or allocation basis, this step consists of calculating the overhead rate by dividing the total overhead (the cost pool) by the total sum of the drive units (the allocation amount).
Regardless of the cost driver selected, the proportion of cost allocated to a cost object is equal to the ratio of driving units in that cost object. Assume that Vulcan decides to allocate these costs based on the number of hooks produced and that, for the most recent year, Vulcan produced 15,000 5-ton hooks and 10,000 10-ton hooks. In general, the overhead allocated to an individual unit or product line is the number of driving units included in that unit or product line times the overhead.
In addition to the direct materials and direct labor costs traceable to each hook, they and in allocated overhead will therefore flow through each product's WIP account. Commonly used allocation bases include direct labor hours, direct labor costs, machine hours, and the number of units. Usually, companies choose a cost driver that exhibits a cause-and-effect relationship with the costs being allocated.
As we will learn in Chapter 9, their choice stems from their desire to use allocation both to value inventories and to estimate the long-run change in capacity costs. Thus, companies often allocate control costs and materials handling costs using direct labor costs or material costs as the allocation basis. As Figure 3.14 illustrates, overhead allocation can make uncontrollable fixed costs appear to be controllable and variable.
Assume that Vulcan Forge decides to allocate overhead costs on the basis of direct labor hours.
Check It! Exercise #3
GAAP gives companies significant leeway regarding their choices about how to allocate manufacturing overhead to products. They expect that changes in labor costs will cause or “drive” a proportional change in supervisory costs in the long run. Similar reasoning applies to using material costs as a basis for allocating the costs of handling materials.
As we previously discussed with Hercules, GAAP income statements combine controllable costs with non-controllable costs and fixed costs with variable costs. As a result, it is difficult to use the summary data from the GAAP income statements for internal decision making. This report suggests that the company increases its profits by $2.00 for each additional unit sold.
The report also suggests that the product costs $23.00 to manufacture and sell, meaning that a price lower than $23.00 would be unacceptable. Thus, the firm would reject a one-time offer to buy 1,000 units at $22.50, even though the firm had the capacity to meet this request. The answer is that the report combines variable costs (direct materials, direct labor, variable costs, variable selling and administrative costs) and fixed costs (fixed costs, fixed selling and administrative costs).
In chapter 4, we will carefully examine these statements, which we call contribution margin statements.
- LO1. What is the difference between a product cost and a period cost?
- LO1. What is the gross margin?
- LO1. Why does GAAP require firms to distinguish between product and period costs?
- LO2. What is the key characteristic of a service firm?
- LO3. What is the inventory equation?
- LO4. Why do we frequently refer to materials and labor costs as being both direct and variable?
- LO4. What is the difference between variable manufacturing overhead and fixed manufacturing
- LO4. Define the terms prime costs and conversion costs
- LO5. What are the four elements of every cost allocation?
- LO5. Describe the two-step procedure for allocating costs
- LO5. What is the relation between the proportion of cost allocated to a cost object and the proportion
- LO2. Consider a consulting firm that completes large software projects that often take two or more years to
- LO3. List three reasons why a merchandising firm holds inventory
- LO3. Should a retail firm include the cost of receiv- ing and stocking goods when computing inventory
- LO3 (Advanced). Many merchandising firms charge the entire amount of transportation costs to cost of
- Product versus period cost (LO1). The following are some of the costs incurred by a consulting firm
- Cost flows in a service firm (LO2). The following data pertain to Boyd Associates, a consulting company
- Cost flows in a service firm (LO2). The following data pertain to Skogg Consulting
- LO4 (Advanced). GAAP excludes most research and development costs from its definition of inventori-
- LO5. “Depreciation is nothing but an allocation of the purchase price over different accounting
- Product versus period cost (LO1, LO3). The following are some of the costs incurred by a merchandising firm
- Cost categories in manufacturing firms (LO4). Consider the following expenses frequently incurred by manufacturing firms
- Allocation mechanics (LO5). Casey Corporation is organized into three divisions
- Merchandising cost flows, two product lines (LO3). The Great Plains Cooperative Society (GPC) offers a wide range of gourmet foods (including organic foods) as well
- Allocated costs and decision making (LO5). “I was losing my shirt on field service calls
- Unit costs and decisions (LO4, LO5). Sheridan Manufacturing provides the following data about its three products
- Chapter 7 examines operating budgets. Budgets incorporate planning decisions on how and where to
Merchandising companies use the inventory equation to determine the cost of goods sold during a period. Cost of goods sold value of beginning inventory cost of acquisition value of ending inventory. This amount, along with the cost of direct labor and manufacturing overhead, is the input to the work in progress (WIP) account.
Cost of goods manufactured Cost of goods available for sale Beginning balance in finished goods. Beginning WIP inventory materials used labor cost manufacturing overhead ending WIP inventory Cost of goods manufactured. Cost of goods sold Cost of goods available for sale Ending balance in finished goods.
MegaLo Mart charges the entire shipping cost to the income statement for the period. What was the cost of materials issued to work in process during the year. What was the cost of finished goods and transferred to finished goods during the year.
Determine (a) the cost of goods manufactured and (b) the cost of goods sold for the most recent year. The firm informs you that it has traditionally written off the cost of transport in the cost of goods sold account. Allocate the carrying costs between ending inventory and cost of goods sold, using the account values as the allocation base.
