1 PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University © Copyright 2005 South-Western, a division of Thomson Learning. All rights reserved. Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc. 4 Chapter M2 Cost Categories and Flows

2 Objective 1 Differentiate between product costs and period expenses. Once you have completed this chapter, you should be able to:

3 Pine Belt Furniture Company manufactures and sells mid-priced furniture to retailers. The Production Process at Pine Belt

4 Exhibit 1 ContinuedContinued

5ContinuedContinued

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7 Product Costs Versus Period Expense Product costs include the cost of materials, labor, and manufacturing overhead consumed in producing the goods.

8 Product Costs Versus Period Expenses Period expenses are the costs of selling and administrative activities, such as rent, interest, and taxes.

9 Period Expenses Depreciation of Office Equipment Office Supplies Used Administrative Support Salaries

10 Direct Material Costs The costs of significant raw materials from which a product is manufactured are classified as direct material costs.  Lumber  Wooden knobs  Brass drawer pulls Examples from Pine Belt Lumber Company:

11 Direct Labor Costs Direct labor costs are the wages of workers who add value to a product through their direct involvement in the production process.  Wages of those who sand the wood  Wages of those who apply stain and polyurethane finish Examples from Pine Belt Lumber Company:

12 Manufacturing Overhead Costs Manufacturing overhead costs result from activities that support a manufacturing process but often are not directly related to any specific product.  Cost of saw blades, glue, screws, etc.  Electricity for the manufacturing equipment  Fire insurance on factory assets Examples from Pine Belt Lumber Company:

13 Objective 2 Explain how direct materials, direct labor, and manufacturing overhead costs flow though an accounting system. Once you have completed this chapter, you should be able to:

14 Cost Flows Through the Accounting System of a Manufacturing Company Raw materials inventory (Direct materials) Work-in- Process Direct labor Manufacturing overhead All of these items are assets ContinuedContinued Finished Goods Exhibit 2

15 Cost Flows Through the Accounting System of a Manufacturing Company Manufacturing overhead Raw materials inventory (Direct materials) Work-in- Process Direct labor Finished Goods Exhibit 2 Cost of Goods Sold Expenses

16 Manufacturing Cost Flow Raw Materials $10,000 The beginning balances of Raw Materials Inventory, Work-in- Process Inventory, and Finished Goods Inventory are $10,000, $40,000, and $15,000, respectively. Work-in Process $40,000 Finished Goods $15,000

17 Manufacturing Cost Flow Entry (a): Raw materials costing $50,000 are purchased. Raw MaterialsWork-in ProcessFinished Goods $10,000$40,000$15, ,000 (a)

18 Manufacturing Cost Flow Entry (b): Raw materials costing $20,000 are placed into production. Raw MaterialsWork-in ProcessFinished Goods $10,000$40,000$15, ,000 (a) – 20,000 (b)+ 20,000 (b)

19 Manufacturing Cost Flow Entry (c): Pine Belt incurred direct labor costs of $8,000 while manufacturing its products. Raw MaterialsWork-in ProcessFinished Goods $10,000$40,000$15, ,000 (a) – 20,000 (b)+ 20,000 (b) + 8,000 (c)

20 Manufacturing Cost Flow Entries (d), (e), and (f): Pine Belt incurred various types of overhead costs during the production process. Raw MaterialsWork-in ProcessFinished Goods $10,000$40,000$15, ,000 (a) – 20,000 (b)+ 20,000 (b) + 8,000 (c) (d) + 1,000 (e) + 5,000 (f)

21 Manufacturing Cost Flow Raw MaterialsWork-in ProcessFinished Goods $10,000$40,000$15, ,000 (a) – 20,000 (b)+ 20,000 (b) + 8,000 (c) Entry (g): During the accounting period, $40,200 of merchandise is completed and transferred to finished goods. – 40,200 (g) (d) + 1,000 (e) + 5,000 (f) + 40,200 (g)

22 Manufacturing Cost Flow Raw MaterialsWork-in ProcessFinished Goods $10,000$40,000$15, ,000 (a) – 20,000 (b)+ 20,000 (b) + 8,000 (c) Entry (h): Merchandise costing $45,000 to manufacture is sold for $70, (d) + 1,000 (e) + 5,000 (f) – 40,200 (g) + 40,200 (g) – 45,000 (h) Entry (h) results in Cost of Goods Sold increasing by $45,000

23 Manufacturing Cost Flow Raw MaterialsWork-in ProcessFinished Goods $10,000$40,000$15, ,000 (a) – 20,000 (b)+ 20,000 (b) + 8,000 (c) Ending balances (d) + 1,000 (e) + 5,000 (f) – 40,200 (g) + 40,200 (g) – 45,000 (h) $40,000 $34,100 $10,200 Cost of Goods Sold + 45,000 (h) $45,000

24 First, when direct materials are placed into production, their costs become part of Work-in-Process Inventory. Key Points to Remember About Manufacturing Costs Flow

25 Second, direct labor and overhead costs become part of Work-in- Process Inventory as labor and overhead are used. Key Points to Remember About Manufacturing Costs Flow

26 Direct labor and overhead often are referred to as conversion costs because they are the costs of activities required to convert materials into products. Key Points to Remember About Manufacturing Costs Flow

27 Excerpt from the Vulcan Materials Company 2002 Annual Report Inventories at December 31 were as follows (in thousands of dollars): Finished product$189,378$176,940$155,258 Raw materials10,19113,28415,578 Products in process ,020 Operating supplies and others 39,531 37,627 27,188 Total inventories$239,586$228,415$199,044 Exhibit 4 NOTE 2 INVENTORIES

28 Objective 3 Discuss methods for proactively managing inventory levels and manufacturing costs. Once you have completed this chapter, you should be able to:

29 Value Chain Reliable delivery of quality material and components from supplier is necessary for a business to meet obligations to its customers.

30 Value Chain 30 The value chain is the set of value-creating activities that extends from the production of raw materials, to the sale and servicing of finished goods, to servicing customers after the sale.

31 The Value Chain Value Chain for Vehicle Carpets COOL INTERIOR

32 Just-in-Time Manufacturing 32 Just-in-Time (JIT) is a manufacturing philosophy that attempts to improve efficiency by reducing inventory levels.

33 Just-in-Time Manufacturing Just-in-Time (JIT) is a manufacturing philosophy that attempts to improve efficiency by reducing inventory levels.

34 Just-in-Time Manufacturing The goal of just-in-time systems is to reduce the length of time it takes to manufacture and deliver a product. Reducing the time required to respond to customer demands such as cashing checks at banks Moving finished products faster to reduce inventory Reducing distribution time once products leave the factory

35 Proactively Controlling Costs Using Target Costing Traditional Cost-Based Pricing 1.A product and manufacturing process are designed. 2.The product is manufactured. 3.Manufacturing costs are accumulated. 4.The unit cost plus markup determines the selling price. 5.The company tries to sell the product.

36 Proactively Controlling Costs Using Target Costing Unit manufacturing cost x markup percentage = markup Pine Belt’s management estimates that materials, labor, and overhead cost per unit is $475. Pine Belt generally adds 30% markup to the unit cost when quoting prices. $ x 0.30 = markup $ = markup Traditional Cost-Based Pricing

37 Proactively Controlling Costs Using Target Costing Unit manufacturing cost + markup = selling price $ $ = $ The wholesale price is set at $618, which means that when the retailer adds a markup, the chest would sell for approximately $1,000. Traditional Cost-Based Pricing

38 Proactively Controlling Costs Using Target Costing Retailers are not interested in carrying the line because consumers are not willing to pay $1,000 for pine furniture. What went wrong?

39 Proactively Controlling Costs Using Target Costing Pine Belt failed to analyze the market before developing their new product.

40 Proactively Controlling Costs Using Target Costing The Target Costing Process 1. Determine the quality and functionality consumers want in a new product and the price they are willing to pay for that product. Market research for Pine Belt sets the wholesale price of the chest at $400. Management has a determined margin of 23%.

41 Proactively Controlling Costs Using Target Costing The Target Costing Process 1. Determine the quality and functionality consumers want in a new product and the price they are willing to pay for that product. Margin = selling price x 0.23 Margin = $400 x 0.23 Margin = $92

42 Proactively Controlling Costs Using Target Costing The Target Costing Process 2. Subtract the manufacturer’s required profit margin from the price to determine what the manufacturer can spend to produce the product. Selling price$400 Less required margin – 92 Target cost$308

43 3. Study the feasibility of the new product. Can the company produce a product consumers want at a price the market will accept? Proactively Controlling Costs Using Target Costing The Target Costing Process To market the chest successfully, the company must reduce the unit cost of producing the chest from $475 to $308.

44 Cost Plus and Target Costing Philosophies Cost-plus philosophy Cost + Markup = Selling price Exhibit 5 Cost is the starting point (given) Markup is added (given) The firm puts the product on the market and hopes the selling price is accepted ContinuedContinued Implications:

45 Cost Plus and Target Costing Philosophies Markets determine prices (given) Required margin must be sustained for survival (given) Target cost is the residual, the variable to be managed Target costing philosophy Selling price – Required margin = Target cost Implications: Exhibit 5

46 THE END Chapter M2

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