1. 1 CHAPTER M2 Classifying Costs © 2007 Pearson Custom Publishing

2. 2 Learning Objective 1: Classify costs by cost objects, and distinguish between direct and indirect costs. © 2007 Pearson Custom Publishing

3. 3 Assigning Costs A cost object is any activity, product, or other item for which we can make a separate cost measurement. A cost object is any activity, product, or other item for which we can make a separate cost measurement. Examples: Examples: Product #102 Product #102 Minnesota sales territory Minnesota sales territory television advertising television advertising employee Barry Jones employee Barry Jones delivery van #45 delivery van #45 © 2007 Pearson Custom Publishing

4. 4 Direct Costs A direct cost is a cost that can easily be traced to an individual cost object. Examples: A direct cost is a cost that can easily be traced to an individual cost object. Examples: Wood used to make a wooden table. Wood used to make a wooden table. Carpenter’s wages who carves the wood. Carpenter’s wages who carves the wood. Decorative hardware used on the table. Decorative hardware used on the table. © 2007 Pearson Custom Publishing

5. 5 Indirect Costs An indirect cost or common cost is one that supports more than one cost object. An indirect cost or common cost is one that supports more than one cost object. Examples: Examples: Depreciation on a factory and its equipment that is used to manufacture many products. Depreciation on a factory and its equipment that is used to manufacture many products. Cost of glue used is very small amounts for many products. Cost of glue used is very small amounts for many products. Wages of supervisory personnel who direct many types of workers. Wages of supervisory personnel who direct many types of workers. © 2007 Pearson Custom Publishing

6. 6 Learning Objective 2: Distinguish between product costs and period costs, and contrast their accounting treatment. © 2007 Pearson Custom Publishing

7. 7 Product Cost The costs associated with the inventory items of a company are known as product costs or inventoriable costs including freight in. The costs associated with the inventory items of a company are known as product costs or inventoriable costs including freight in. Specifically, product costs are all costs that are needed to acquire a piece of inventory and make it ready to sell are product costs. Specifically, product costs are all costs that are needed to acquire a piece of inventory and make it ready to sell are product costs. © 2007 Pearson Custom Publishing

8. 8 Assets or Expenses? Product costs appear on the balance sheet as inventory (an asset account) until the product is sold. After sale, the cost is moved from the inventory account to the cost of goods sold (an expense account). Product costs appear on the balance sheet as inventory (an asset account) until the product is sold. After sale, the cost is moved from the inventory account to the cost of goods sold (an expense account). Product costs do not become business expenses until the product is sold, and the revenue is generated. Product costs do not become business expenses until the product is sold, and the revenue is generated. © 2007 Pearson Custom Publishing

9. 9 Period Costs All costs that do not qualify as product costs are considered period costs. All costs that do not qualify as product costs are considered period costs. This primarily includes the selling and administrative costs, including This primarily includes the selling and administrative costs, including freight out. freight out. © 2007 Pearson Custom Publishing

10. 10 Assets or Expenses? Most period costs are classified as operating expenses on the income statement in the period incurred. Most period costs are classified as operating expenses on the income statement in the period incurred. Noteworthy exceptions include the costs of long-lived assets. These costs need to be capitalized and depreciated over time. Noteworthy exceptions include the costs of long-lived assets. These costs need to be capitalized and depreciated over time. © 2007 Pearson Custom Publishing

11. 11 Product vs. Period Costs Assume that we have a small company that consists of two buildings, an office building and manufacturing space. Assume that we have a small company that consists of two buildings, an office building and manufacturing space. The office building has 4,000 square feet and the manufacturing building has 6,000 square feet. The office building has 4,000 square feet and the manufacturing building has 6,000 square feet. We employ a custodial team at a monthly cost of $5,000. We employ a custodial team at a monthly cost of $5,000. © 2007 Pearson Custom Publishing

12. 12 Product vs. Period Costs Is the $5,000 a product cost or period cost? Is the $5,000 a product cost or period cost? The best answer is both! The cost of cleaning the office building is a selling and administrative cost. The cost of cleaning the manufacturing space is a production cost. The best answer is both! The cost of cleaning the office building is a selling and administrative cost. The cost of cleaning the manufacturing space is a production cost. Using square footage as a guide, $3,000 (60%) per month should be accounted for as a product cost and $2,000 (40%) as a period cost. Using square footage as a guide, $3,000 (60%) per month should be accounted for as a product cost and $2,000 (40%) as a period cost. © 2007 Pearson Custom Publishing

13. 13 Learning Objective 3: Explain the differences between product cost for a merchandiser and for a manufacturer. © 2007 Pearson Custom Publishing

14. 14 Product Costs for a Merchandising Firm A merchandiser buys a product, marks it up in price, and then sells it again. A merchandiser buys a product, marks it up in price, and then sells it again. A merchandiser can be either a wholesaler or a retailer. A merchandiser can be either a wholesaler or a retailer. © 2007 Pearson Custom Publishing

15. 15 Example of Online Bookseller A company that sells books over the Internet buys books from many different publishers. The books are ready to be sold to the public. A company that sells books over the Internet buys books from many different publishers. The books are ready to be sold to the public. At any time, the bookseller has thousands of books in inventory. New purchases are coming in and sales are going out on a daily basis. At any time, the bookseller has thousands of books in inventory. New purchases are coming in and sales are going out on a daily basis. © 2007 Pearson Custom Publishing

16. 16 Flow of Product Costs Invoice Cost of Merchandise Freight-in Other Costs to Prepare Merchandise for Sale Merchandise Inventory Cost of Goods Sold (Income Statement) Ending Inventory (Balance Sheet) Goods Sold This PeriodGoods Not Yet Sold © 2007 Pearson Custom Publishing

17. 17 Cost of Goods Sold Schedule Online Booksellers, Inc. Online Booksellers, Inc. Cost of Goods Sold Schedule Cost of Goods Sold Schedule For the Year Ended December 31, 2007 For the Year Ended December 31, 2007 Beginning inventory, Jan. 1, 2007 $ 50,000 Beginning inventory, Jan. 1, 2007 $ 50,000 Inventory purchases during 2007 350,000 Inventory purchases during 2007 350,000 Goods available for sale during 2007$400,000 Goods available for sale during 2007$400,000 Ending inventory, Dec. 31, 2007 80,000 Ending inventory, Dec. 31, 2007 80,000 Cost of goods sold during 2007$320,000 Cost of goods sold during 2007$320,000 © 2007 Pearson Custom Publishing

18. 18 Product Costs for a Manufacturing Firm To determine the cost to manufacture a product, the focus is typically on three major cost elements: To determine the cost to manufacture a product, the focus is typically on three major cost elements: direct materials cost direct materials cost direct labor cost direct labor cost manufacturing overhead cost manufacturing overhead cost © 2007 Pearson Custom Publishing

19. 19 Direct Materials The costs of those materials that can be directly and conveniently traced to a unit of product are called direct materials. The costs of those materials that can be directly and conveniently traced to a unit of product are called direct materials. Materials not directly traceable, and those extremely small in volume or dollar amounts, are typically called indirect materials. Materials not directly traceable, and those extremely small in volume or dollar amounts, are typically called indirect materials. © 2007 Pearson Custom Publishing

20. 20 Direct Labor The costs of production labor for those who cause the product to be transformed are called direct labor. The costs of production labor for those who cause the product to be transformed are called direct labor. Labor costs for those who support or supervise direct laborers are typically called indirect labor. Labor costs for those who support or supervise direct laborers are typically called indirect labor. © 2007 Pearson Custom Publishing

21. 21 Manufacturing Overhead All costs related to the manufacturing operations, except for direct materials and direct labor, are called manufacturing overhead, or indirect manufacturing costs, or factory overhead costs. All costs related to the manufacturing operations, except for direct materials and direct labor, are called manufacturing overhead, or indirect manufacturing costs, or factory overhead costs. © 2007 Pearson Custom Publishing

22. 22 Learning Objective 4: Describe the components of the costs included in each of the three types of inventory in a manufacturing operation. © 2007 Pearson Custom Publishing

23. 23 Inventory Classifications The manufacturing firm has three types of inventory: The manufacturing firm has three types of inventory: raw materials inventory raw materials inventory work-in-process inventory work-in-process inventory finished goods inventory finished goods inventory © 2007 Pearson Custom Publishing

24. 24 Raw Materials Inventory The raw materials inventory or materials stores account contains the cost of all materials not yet used in the manufacturing operations. The raw materials inventory or materials stores account contains the cost of all materials not yet used in the manufacturing operations. © 2007 Pearson Custom Publishing

25. 25 Work-in-Process Inventory The work-in-process inventory account includes all costs associated with the units of production that have been started, but not yet completed. The work-in-process inventory account includes all costs associated with the units of production that have been started, but not yet completed. This account will include the direct materials, direct labor, and manufacturing overhead costs related to partially completed units. This account will include the direct materials, direct labor, and manufacturing overhead costs related to partially completed units. © 2007 Pearson Custom Publishing

26. 26 Finished Goods Inventory The finished goods inventory account includes the costs associated with those units that are available to be sold. The finished goods inventory account includes the costs associated with those units that are available to be sold. This account will include the full production cost of the completed, but unsold units; comparable to the inventory cost of goods purchased by a merchandiser. This account will include the full production cost of the completed, but unsold units; comparable to the inventory cost of goods purchased by a merchandiser. © 2007 Pearson Custom Publishing

27. 27 Learning Objective 5: Calculate cost of goods manufactured and cost of goods sold. © 2007 Pearson Custom Publishing

28. 28 Flow of Manufacturing Product Costs Managers of a manufacturing company need product cost information for all of the same reasons that managers for merchandisers do. Managers of a manufacturing company need product cost information for all of the same reasons that managers for merchandisers do. Additionally, they must also keep an eye on the cost efficiency and quality of production. Additionally, they must also keep an eye on the cost efficiency and quality of production. © 2007 Pearson Custom Publishing

29. 29 The Flow of Manufacturing Costs Raw Materials Purchases Raw Materials Inventory Manufacturing Overhead Cost Indirect Material Indirect Labor All Factory-related Costs Direct Labor Cost Direct Materials Cost Ending Raw Materials Inventory Ending Work in Process Inventory Ending Finished Goods Inv. Cost of Goods Sold Balance Sheet Income Statement Work-in- Process Inventory Finished Goods Inventory © 2007 Pearson Custom Publishing

30. 30 Detailed Analysis of Materials As raw materials are purchased from suppliers, their cost is first entered into the raw materials inventory. As raw materials are purchased from suppliers, their cost is first entered into the raw materials inventory. Recall that raw materials inventory represents the cost of those materials not yet used in production. Recall that raw materials inventory represents the cost of those materials not yet used in production. Raw Materials Purchases Raw Materials Inventory © 2007 Pearson Custom Publishing

31. 31 Detailed Analysis of Materials Raw Materials Inventory Manufacturing Overhead Cost: Indirect Material All Factory-related Costs Direct Materials Cost Ending Raw Materials Inventory Work-in- Process Inventory Notice that the cost of direct materials flows directly into WIP, but the cost of indirect materials used in production flows into the manufacturing overhead cost pool. © 2007 Pearson Custom Publishing

32. 32 Detailed Analysis of Labor Similar to materials, the cost of direct labor is added to WIP and the cost of indirect labor is added to the manufacturing overhead cost pool. Similar to materials, the cost of direct labor is added to WIP and the cost of indirect labor is added to the manufacturing overhead cost pool. Manufacturing Overhead Cost Indirect Material Indirect Labor All Factory-related Costs Direct Labor Cost Work-in- Process Inventory Total Factory Labor Cost Incurred Indirect Labor Cost © 2007 Pearson Custom Publishing

33. 33 Detailed Analysis of Overhead Adding the manufacturing (factory) overhead costs to work in process completes the flow of cost into that account. Adding the manufacturing (factory) overhead costs to work in process completes the flow of cost into that account. Factory Overhead Cost Indirect Material Indirect Labor All Factory-related Costs Work-in-Process Inventory Direct Materials Direct Labor Factory Overhead © 2007 Pearson Custom Publishing

34. 34 The cost of units that have been completed is transferred into the finished goods inventory. The cost of units that have been completed is transferred into the finished goods inventory. The ending work-in- process inventory should then consist of the costs of the partially completed units. The ending work-in- process inventory should then consist of the costs of the partially completed units. Detailed Analysis of Work-in-Process Ending Work- in-Process Inventory Work-in- Process Inventory Finished Goods Inventory © 2007 Pearson Custom Publishing

35. 35 © 2007 Pearson Custom Publishing

36. 36 Learning Objective 6: Describe the components of the cost of services provided by a service firm. © 2007 Pearson Custom Publishing

37. 37 Product Costs for Service Firms Although the “product” for a service company has no physical substance, determining the costs of providing the service is still very important for the financial security of the firm. Although the “product” for a service company has no physical substance, determining the costs of providing the service is still very important for the financial security of the firm. © 2007 Pearson Custom Publishing

38. 38 Materials for Service Firm Most of the materials consumed by a service company are in the form of supplies. Most of the materials consumed by a service company are in the form of supplies. In comparison to a manufacturer, the cost of materials for a service organization are relatively insignificant. In comparison to a manufacturer, the cost of materials for a service organization are relatively insignificant. © 2007 Pearson Custom Publishing

39. 39 Labor for Service Firm Labor cost is usually a very significant cost category for a service firm, usually the primary service providers. Labor cost is usually a very significant cost category for a service firm, usually the primary service providers. Again, it is possible to make the distinction between direct labor costs (accountants, lawyers, etc.) and indirect labor (receptionists, for example). Again, it is possible to make the distinction between direct labor costs (accountants, lawyers, etc.) and indirect labor (receptionists, for example). © 2007 Pearson Custom Publishing

40. 40 Overhead for a Service Firm Overhead costs for a service organization are very similar to those for a manufacturer. Overhead costs for a service organization are very similar to those for a manufacturer. These are costs that are related to the provision of services, but cannot be directly traced to a particular job. These are costs that are related to the provision of services, but cannot be directly traced to a particular job. © 2007 Pearson Custom Publishing

41. 41 Flow of Service Costs Supplies Inventory Overhead Cost Indirect Supplies Indirect Labor Office Rent Depreciation Office Taxes Office Insurance Other Indirect Costs Direct Supplies Cost Ending Supplies Inventory Cost of Services Provided Income Statement Balance Sheet Direct Labor Cost

42. 42 © 2007 Pearson Custom Publishing

43. 43 Hybrid Firms Companies that generate significant revenues from both services and products are known as hybrid firms. Companies that generate significant revenues from both services and products are known as hybrid firms. General Motors manufacturers its cars, sells them to dealers, provides purchased goods to dealers for resale, and provides financing services for dealers’ customers. General Motors manufacturers its cars, sells them to dealers, provides purchased goods to dealers for resale, and provides financing services for dealers’ customers. © 2007 Pearson Custom Publishing

44. 44 Comparison of Merchandising, Manufacturing, and Service Organizations Balance Sheet: Current Assets Balance Sheet: Current Assets Merchandising firm: Merchandise Inventory Merchandising firm: Merchandise Inventory Manufacturing firm: Raw Materials Inventory Manufacturing firm: Raw Materials Inventory Work-in-Process Inventory Work-in-Process Inventory Finished Goods Inventory Finished Goods Inventory Service firm: Supplies Inventory Service firm: Supplies Inventory © 2007 Pearson Custom Publishing

45. 45 Comparison of Merchandising, Manufacturing, and Service Organizations Income Statement: Income Statement: Merchandising firm: Purchases in Cost of Goods Sold Merchandising firm: Purchases in Cost of Goods Sold Manufacturing firm: Cost of Goods Manufactured in Cost of Goods Sold Manufacturing firm: Cost of Goods Manufactured in Cost of Goods Sold Service firm: Cost of Services Service firm: Cost of Services © 2007 Pearson Custom Publishing

46. 46 The End of Chapter M2 © 2007 Pearson Custom Publishing