Final Paper Accounting 206

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chapter 3

Introduction to Managerial Accounting

Learning Objectives

• Be able to distinguish between financial and managerial accounting.

• Know how managerial accounting supports planning, directing, and controlling activities within an organization.

• Understand key terminology relating to managerial accounting.

• Comprehend and analyze important aspects of cost behavior. Prepare important calculations that are unique to reporting for a manufacturer.

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CHAPTER 3Chapter Outline

Chapter Outline

3.1 The Professional Managerial Accountant

3.2 Role of Management Accounting Planning Duties Directing/Controlling Duties

3.3 Cost Components Distinguishing Between Variable and Fixed Variable Costs Why Cost Behavior Matters Types of Fixed Costs and Relevant Range Thinking Deeper About Product and Period Costs Financial Statements for a Manufacturer

3.4 A Closer Look at Cost Accumulation Combining Schedules Tax and Accounting Rules

In the previous course, you learned that financial accounting is concerned primarily with reporting to external parties. Those external users include investors and potential inves- tors, lenders, governmental agencies, financial statement analysts, and others. The reports they receive are presented according to generally accepted accounting principles (GAAP) and represent a primary data source for making informed decisions about the business’s overall performance and financial condition. External users generally have very limited access to base-level information that is internal to the organization. They must rely on gen- eral reports and their own independent investigative skills and knowledge. It is important to note that GAAP-based reports are heavily summarized and standardized. This aggre- gated data would provide little basis for managing the day-to-day activities of a business. This is where the distinction between financial accounting and managerial accounting begins to be drawn.

Managerial accounting focuses on reporting in support of business management pro- cesses. These processes span many dimensions, such as marketing, operations, finance, and production. Managers need greater detail than is afforded by reports prepared under GAAP. Managers may request information that is customized to specific decision- making tasks. Managerial accounting information is centered on products, departments, and activities. Managerial accounting is more free-form; reporting rules are replaced by internally developed specifications about data accumulation and presentation.

Depending on the sophistication of a company’s information system, managerial account- ing data are accessible “on demand,” and the concept of periodic reports becomes less relevant. Historical data are used by management, but so are forecasted outcomes. Bud- gets and compliance with budgets take on a highly significant role. Furthermore, data are often disaggregated to allow focus on particular units of accountability, such as business segments, store locations, and specific products. A goal of managerial accounting is to develop information in support of good business decision making.

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CHAPTER 3Section 3.2 Role of Management Accounting

3.1 The Professional Managerial Accountant

You are likely familiar with the CPA (certified public accountant) designation. The process for obtaining this designation requires meeting education, examination, and experience requirements. The certification is usually accompanied by a state-issued license to practice public accounting. You may not know that there are similar designa- tions related to management accounting. CPAs with significant management accounting experience can gain an additional designation as a CMGA (Chartered Global Manage- ment Accountant). Those without the CPA might obtain a separate CMA (certified man- agement accountant) designation. The CMA also requires that its holders fulfill education, examination, and experience requirements. It is intended to represent expertise in topics applicable to those professionals working in the management accounting arena. One key distinction should be noted. The CMA is not accompanied by a state licensure process. As such, it is a designation of competency but does not otherwise confer specific legal rights to practice. There is not a legal requirement that must be met for a managerial accountant to work within the internal reporting structure of an organization.

3.2 Role of Management Accounting

Managing an organization requires solid decision making. These decisions cover a full spectrum of broad-based visionary/leadership-based issues and careful attention to detail relating to the procurement and mobilization of human and physical resources. Although some managers seem to have an intuitive sense of good decision making, the reality is that consistently proper decisions result from diligent accumulation and evalua- tion of information. Managers must plan, direct, and control an organization. These inter- related duties are all supported by information provided by the managerial accountant and serve to shape the role of a business’s internal accounting unit.

Planning Duties

Planning is the process of deciding on a course of action to reach a desired outcome. A business must plan its high-level strategy as well as operational details. To have any chance of being successful, a business’s planning activities must be congruent with its financial constraints. Managerial accountants are particularly useful in preparing busi- ness models and related budgets. Not to be overlooked is the need for plans to be com- municated throughout the organization. The communication of business information is often in the form of carefully prepared financial reports and targets. Plans are of no use if they are not communicated.

Employees sometimes find it difficult to see the value in long-term planning. They are often consumed with daily activities associated with servicing customers. Therefore, it becomes incumbent upon managerial accountants to help employees see the linkage between planning and business success. Business planning is not only about budgets. It also includes helping a business develop and communicate its mission and goals.

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CHAPTER 3Section 3.2 Role of Management Accounting

The mission of an organization provides the key point of focus around which ideas can be vetted and actions planned. The mission becomes a central planning element as it sets the business’s purpose and direction. The mission drives specific goals that are foundational for business success. Ultimately, a business will need to provide a return to its investors or cease to exist, and targeted goals keep the business oriented on its mission.

You may think the preceding paragraphs should only be in a business strategy book rather than an accounting text. It is good to have that thought because dispelling it helps you develop a proper frame of reference to begin your study of managerial accounting. It is very much about strategic thought. Indeed, some businesses refer to their manage- rial accounting units as departments of strategic finance. These departments are not only concerned with budgets and the like but also engage in activities such as monitoring and reporting on legislative compliance, environmental controls, tracking of hazardous waste, efficiency studies, operational engineering, quality control, and so forth. As you can see, the managerial accountant is heavily involved in all phases of planning and execution of corporate strategy.

As you progress through the remaining chapters, you will study a number of distinct top- ics. All are within the domain of managerial accounting, and several can be thought of as specifically related to corporate planning. Table 3.1 highlights planning-related topics you will study in later chapters.

Table 3.1: Planning-related topics

Planning topics Brief introduction

Operating budgets Budgets outline the financial plans for an organization. An operating budget identifies the anticipated revenues and expenses of an organization. These plans become very detailed, including information about specific inventory purchases, staffing plans, etc.

Capital budgets Longer term expenditure decisions must be evaluated to determine whether an investment is justified and the expected rate of return.

Financial budgets Financing needs must be mapped to ensure adequate capital. Financial budgets are usually necessary to demonstrate to investors and lenders why (and when) additional funding is justified.

Cost2volume2profit analysis Managers must understand the nature of cost behavior and how changes in volume impact profitability. You will learn about calculating break-even points and how to manage so as to achieve target income levels.

Directing/Controlling Duties

Planning alone does not equate to business success. The realization of a business plan requires careful coordination, execution, and timing of actions. Business managers need to ensure that resources and authorizations are all in place to function in concert. The mana- gerial accountant plays a major part. The role of the management accountant is expan- sive and includes duties such as development of necessary information systems. These

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CHAPTER 3Section 3.2 Role of Management Accounting

systems must support detailed information needs that go well beyond just bookkeeping. They must provide for customer/client relationship management, inventory ordering/ tracking, production management, scheduling, logistics, contract administration, and myriad other topics. Tools should also allow for exploration of alternative corrective strat- egies to remedy unfavorable situations. All of these elements are an important part of the process of directing and controlling an organization.

Many companies designate a corporate controller as the person responsible for provid- ing leadership over the cost and managerial accounting duties. This person may work closely with a chief financial officer (CFO), who is usually responsible for external reporting and cash management. The efforts of the accounting and finance units may be subject to independent review by an internal audit group. Internal auditors monitor and report on organizational effectiveness and integrity, and they customarily report to the highest levels of corporate leadership.

It is actually quite difficult to describe the full range of duties that a managerial accoun- tant might be asked to perform. In one way, this shows the dynamic nature of this profes- sion and perhaps makes such a career path seem more appealing. On the other hand, it makes it a bit difficult to fully describe and catalog all of these activities.

An important dimension of the directing/controlling functions of the managerial accoun- tant is to cost products. As you study subsequent chapters, you will be enlightened as to the importance and complexity of cost determination. Business decisions about what to sell and how to price are often driven by cost studies and measures. Thus, a firm grasp of costing is essential. Table 3.2 provides a brief introduction to key costing concepts that will be fully covered in subsequent chapters.

Table 3.2: Key costing concepts

Directing/controlling topics Brief introduction

Costing Management must understand how costs are accumulated and assigned to products and services. Costing can become complex, and it is a significant subset of management accounting. Some people simply refer to this task as cost accounting, which is the collection, assignment, and interpretation of costs.

Costing methods Costs may be captured by individual job, by allocating the cost of a process to units of output, or by tracing costs to activities that are consumed by the production cycle. Each of these approaches (i.e., job costing, process costing, and activity-based costing) involves unique methodologies.

Costing is not the only role filled by the managerial accountant. Additional effort is needed to direct and control an organization. The remaining tasks can be generally described as relating to production management and process control. You will probably be surprised at the scope of work and may find it especially appealing because much of it is “hands on” in nature. These tasks closely overlap with industrial engineering duties

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CHAPTER 3Section 3.2 Role of Management Accounting

and afford the accountant a true opportunity to help fine-tune the organization’s pro- duction activities. Table 3.3 highlights key topics that you will learn much more about in subsequent chapters.

Table 3.3: Key topics in managerial accounting

Directing/ controlling topics

Brief introduction

Production management

Production management entails numerous tools for supporting production and logistics. Costs must be minimized and efficiency maximized while preserving standards related to output quality and quantity. This is a complex process requiring constant decision making driven by robust information flow. This is especially true for inventory control, where overstocking or out-of-stock situations will result in waste or lost sales. Management accountants deploy techniques such as just-in-time inventory management and economic order quantity mathematics.

Responsibility assignment

Enabling and motivating employees is an important managerial role. Managerial accounting includes measures of efficiency and quality. It also measures segment performance and reports by areas of responsibility. Managerial accountants are called on to assist in compliance roles, especially for public companies that must provide certifications as to the accuracy of financial reports.

Monitoring and analysis

Managerial accounting provides “standards” for assessing utilization of labor, materials, and overhead. It detects “variances” that identify areas for corrective action. Flexible budgeting tools compensate for shifts in the operating environment. Analysis methods are used to determine the viability of outsourcing and special orders.

Balance, quality, and improvement

Total quality management methods focus on customer service and systematic problem solving. Teams benchmark performance against other businesses. Many sweeping changes are suggested by accountants who engage in process reengineering. Various techniques are used to measure and control quality. Balanced scorecards focus on financial and nonfinancial components of performance that can be measured and improved. The goal is to find and implement elements that better the organization as an ongoing process.

As you can see from Table 3.3, the role of the managerial accountant is significantly dif- ferent from that of the financial accountant. The financial accountant’s work is centered on measurement and reporting, often tied to a “rules-based” approach. The managerial accountant’s work is operationally hands on and supports management decision making. The managerial accountant is not tied to defined accounting rules and must use innovation and judgment to assemble methods and measures that help drive organization success.

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CHAPTER 3Section 3.3 Cost Components

3.3 Cost Components

Some people describe managerial accounting as free-form—an anything goes type approach. Although it is true that managerial accountants are not bound to a specific rules set, they do share common jargon. Also, there are selected techniques that have proven the test of time. The following chapters will introduce you to a number of ideas and internal accounting approaches that are foundational to most successful businesses. We begin by considering some of the common terminology that is necessary to communi- cate within the managerial accounting environment.

Begin by understanding that manufacturers face unique accounting issues. A manufac- turer must consider the accounting concerns arising from the acquisition and processing of raw materials into a finished product. Manufactured goods are said to contain or con- sist of three key cost elements.

Direct materials are the costs of all significant physical ingredients that become an inte- gral part of a finished product. In other words, they are materials that have a physical presence identifiable within a completed unit. For example, an automobile’s direct mate- rial cost would include steel, tires, paints, engines, windows, seats, carpets, gauges, and so forth. For expediency, insignificant components are excluded. These relate to nuts, small pieces of wire, soldering, and so forth. Those components may not be cost-effective to trace to a finished unit and would instead be classified as indirect materials. The cost of indirect materials is not ignored. It is instead accumulated as part of manufacturing over- head, which is discussed later.

Direct labor consists of wages attributable to those who are physically and directly working on a manufactured product. Wages paid to a painter, assembler, or welder in an automobile factory are prime examples. However, indirect labor relating to the wages of factory maintenance personnel, supervisors, guards, and so forth is instead accumulated as part of manufacturing overhead.

Manufacturing overhead is basically any manufacturing cost other than direct materials and direct labor. Examples include indirect materials, indirect labor, factory depreciation/ maintenance, and factory insurance/taxes/utilities. Components of factory overhead are difficult to identify within a finished unit but are a significant cost of production. Thus, the cost of overhead is accumulated and allocated systematically to finished units. Businesses deploy various allocation techniques, which include consideration of under- or overallo- cated overhead amounts. Depending on the business, overhead is also known as factory burden or indirect manufacturing cost.

By classifying specific examples of various costs, Table 3.4 may help you frame your over- all awareness and understanding of the key manufacturing terms just introduced. Assume these costs all relate to the company that manufactured your computer.

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CHAPTER 3Section 3.3 Cost Components

Table 3.4: Key manufacturing terms

Examples Cost type Justification

Semiconductors

Screens

Keyboard

Plastic housing

Direct materials

Raw materials that become integral to a finished product

Screws

Screen cover for shipping

Small wires and solder

Indirect materials

Materials used in the production of a product that are either immaterial in nature or are not otherwise visible in the final product

Assembler

Inspector and repair

Material handler

Direct labor Amounts paid to those who are physically and directly engaged with the production of inventory

Shop janitor

Cafeteria worker

Factory nurse

Indirect labor Production-related labor costs that are either immaterial or are not “hands on” with the inventory under production

Indirect material (from above)

Indirect labor (from above)

Factory utilities

Equipment rentals

Tooling

Manufacturing overhead

Any manufacturing costs that do not qualify as direct materials and direct labor

The preceding costs should not be confused with nonmanufacturing costs. Broadly, non- manufacturing costs are known as SG&A, or selling, general, and administrative costs. Selling costs include advertising, sales commissions, warehousing, and shipping. General and administrative amounts pertain to office staff salaries, accounting functions, human resources, information technology, and the like.

When you hear the term prime cost, it is meant to describe the combination of direct mate- rials and direct labor (i.e., the components that are direct in nature). The term conversion cost is meant to describe the combination of direct labor and manufacturing overhead (i.e., the components necessary to change raw materials to finished goods).

Distinguishing Between Variable and Fixed Variable Costs

An important dimension in business decision making is to understand the behavior of a particular cost. Variable costs are those that vary in direct proportion to changes in the level of an activity. The activity base is the item or event that causes the incurrence of a variable cost. It is easy to visualize the activity base in the context of direct materials. A car manufacturer will use one steering wheel per vehicle produced; thus, the number of cars manufactured also determines the number of steering wheels needed. Steering wheels are variable and driven by production of cars (i.e., the activity base). An activity base can also

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CHAPTER 3Section 3.3 Cost Components

be linked to things unrelated to output. Some manufacturers will maintain an in-house clinic for minor injuries and other health care matters. If all employees get an annual flu shot, then the number of employees is the activity driver related to the cost of the vaccine. However, injuries may drive the number of x-rays. There are countless potential activity bases that can be observed as the driver of specific types of variable costs.

Direct material, direct labor, and sales commissions are all examples of costs that will increase or decrease proportionate to a change in units produced. Conversely, fixed costs do not fluctuate with changes in the level of activity. There are numerous examples of fixed costs, including administrative salaries, rents, property taxes, and security.

To illustrate, assume that Splash manufactures a sports drink. The manufacturing facility is rented for $100,000 per year. The rent is a fixed cost because it will be the same regard- less of the number of units produced. The ingredients (i.e., the direct material) cost $0.25 per unit of output, including water, sugar, flavors, and bottles. It is probably apparent why the fixed cost is fixed and how the variable cost varies. Yet, let’s look closer at the cost behavior patterns over a relevant range of production.

Exhibit 3.1 reveals total variable costs, which increase in a linear manner as total produc- tion rises. This also means that the “per unit” cost basis is constant, as shown in the lower graph. In other words, the variable cost is constant at $0.25 per unit. Volume changes do not change the per-unit cost but do change total cost.

Exhibit 3.1

$140,000

$120,000

$100,000

$80,000

$60,000

$40,000

$20,000

$0 100,000 200,000 300,000

UNITS PRODUCED

TOTAL VARIABLE COST

400,000 500,000

VARIABLE COST PER UNIT

UNITS PRODUCED

100,000 200,000 300,000 400,000 500,000

$1.25

$1.00

$0.75

$0.50

$0.25

$0.00

Units

100,000

200,000

300,000

400,000

500,000

Ingredients

$25,000

$50,000

$75,000

$100,000

$125,000

Ingredients per unit

$0.25

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CHAPTER 3Section 3.3 Cost Components

Exhibit 3.2 shows total fixed costs, which do not change as total production rises. This also means that the “per unit” cost basis is dropping with volume increases, as shown in the lower graph. In other words, the fixed cost is constant at $100,000, regardless of produc- tion. Volume fluctuations change the per-unit cost but do not change total cost.

Exhibit 3.2

Why Cost Behavior Matters

Why does cost behavior matter so much in managing a business? For one thing, it allows management to evaluate the ability to grow a business successfully. Let’s give added thought to the concept of fixed costs. Ideally, one attempts to run at full capacity. This produces the lowest fixed cost per unit and the highest opportunity for profit. Such is the case with an airline, for example. It costs very little to add one more passenger to a flight; any added revenue translates to higher profits. This is true for most businesses with excess capacity, high fixed costs, and low variable costs. The key to profit growth is volume growth (as long as additional capacity is not needed). There is an opposite type of business model involving low fixed costs but higher variable costs. Changes in volume do not readily translate into changes in profit because increasing volume also increases over- all costs. An operator of a feedlot might fall into this camp. Most of the cost of operating pertains to animals and feed. Increasing the number of cattle on feed would bring about a corresponding increase in costs, and vice versa. Such businesses tend to see changes in their income more closely correlated to changes in their business volume.

$120,000

$100,000

$80,000

$60,000

$40,000

$20,000

$0 100,000 200,000 300,000

UNITS PRODUCED

TOTAL FIXED COST

400,000 500,000

FIXED COST PER UNIT

UNITS PRODUCED

100,000 200,000 300,000 400,000 500,000

$1.25

$1.00

$0.75

$0.50

$0.25

$0.00

Units

100,000

200,000

300,000

400,000

500,000

Factory Rent

$100,000

Rent per unit

$1.00

$0.50

$0.33

$0.25

$0.20

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CHAPTER 3Section 3.3 Cost Components

There is no ideal cost structure, and the nature of a product or process often defines the intrinsic model. It is incumbent upon management to understand and manage within its cost structure. The interplay between all of the different costs emphasizes the importance of good planning. Optimization of a business squeezes maximum benefit from each fixed cost while attempting to minimize the variable cost rate via negotiation, elimination of waste, and prudent purchasing plans. You have probably experienced volume discounts, and businesses frequently must assess the correct order quantity to achieve lowest vari- able cost with minimum waste.

Sometimes a business can restructure to modify the relationship between fixed and vari- able cost. Such would be the case for businesses that expected increases or decreases in business volume. If a business foresees growth, it may desire to avoid anticipated escala- tions of total variable costs by instead converting some variable cost elements to a fixed. For instance, direct labor might be replaced with a robotic machine that can operate 24 hours per day. Conversely, at other times a business may find it beneficial to convert a large fixed cost to variable. An example is a credit card company that decides to outsource its customer support. Rather than having a fixed staff that is either idle or overloaded at any point in time, the company might pay a per-call fee to an independent support com- pany. The effect is to transform a fixed cost to variable and better insulate the bottom line from fluctuations in volume. However, if volume soars, this plan could result in greater overall cost. The management accountant must provide careful analysis to guide decision making in selection of the strategy that results in the best opportunity for the company.

Types of Fixed Costs and Relevant Range

You have probably considered that some fixed costs can be avoided in the long run. Fac- tories can be sold. Employees can be reassigned or find alternative employment. Thus, it becomes necessary to identify the persistence of a fixed cost. Some fixed costs are committed fixed costs. These arise from an organization’s commitment to operate. Key elements include costs such as depreciation, rent, and insurance. Such costs are not easily avoided in the event of a slowdown in business activity. Other discretionary fixed costs depend on periodic spending decisions. These costs are avoidable with relatively short amounts of lead time. Examples include advertising, training, and travel.

Another dimension to be considered is the relevant range. Simply stated, the relevant range is the expected level of production. You should recognize that additional fixed costs may become necessary to increase production beyond a certain level. Additional plant, machinery, and staffing are sometimes needed to increase production. Thus, when man- agerial accountants evaluate cost structure, they must be mindful of these constraints. When constraints are exceeded, fixed costs can step up to a higher level. In other words, fixed costs are only fixed over a relevant range of activity. To try to produce beyond that level will significantly alter a business’s cost structure.

The importance of understanding the relevant range cannot be overstated. Exhibit 3.3 shows that fixed costs are only fixed over a specific range of activity. For example, if the fixed costs relate to the amount to be spent on machinery, and the activity level grows beyond the anticipated operating area identified as the relevant range, additional machinery will be

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CHAPTER 3Section 3.3 Cost Components

needed. This will require a large step-up in expenditures. Such expenditures can modify the economics of doing business. Thus, accounting analysis should be carefully tied to the cost structure related to the actual relevant range of production.

Exhibit 3.3

Thinking Deeper About Product and Period Costs

Costs that are related to manufacturing are termed product costs. To be considered as a product cost, an expenditure must arise from and be directly related to the manufactur- ing process. Direct materials, direct labor, and factory overhead are the key elements that make up product costs. What is the significance of this classification?

To answer this question requires consideration of the Inventory account. In a retail envi- ronment, the Inventory account represents the cost of goods purchased for resale and is carried on the balance sheet as an asset. That asset is transferred to cost of goods sold when the product is delivered to a customer. The same cost flow applies to a manufac- turer, but the goods are not acquired in a single purchase. Their cost is instead accumu- lated as money is spent on direct materials, direct labor, and manufacturing overhead. This accumulating cost is placed into an Inventory account on the balance sheet until the goods are sold. When sold, the cost is transferred from inventory to cost of goods sold. In this regard, there is little difference between a retailer and a manufacturer, except that the manufacturer is acquiring its inventory via a series of expenditures rather than a single purchase. As a result of this cost flow process, product costs are also known as invento- riable costs. Perhaps obvious from this description, it becomes apparent that the record keeping associated with the manufacturing of goods involves a more sophisticated cost accumulation technique.

Fixed costs are only fixed over a

relevant range. At some point

fixed capacity elements

must be increased.

UNITS OF PRODUCTION

F IX

E D

C O

S T

R e le

va n t R

a n g e

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CHAPTER 3Section 3.3 Cost Components

Costs that are not product costs are deemed to be period costs. Period costs generally relate to SG&A activities. These costs do not attach to inventory but are instead expensed in the period incurred. The distinction between product and period costs provides the founda- tion for thinking about the unique financial statement differences for manufacturers.

Financial Statements for a Manufacturer

There are several aspects to consider in thinking about the unique attributes for the financial statements of a manufacturer. For starters, you are likely to encounter several categories of inventory on the balance sheet (or related notes). Manufacturers acquire raw materials. These materials have not yet been put into production. You can imagine that they consist of the ingredients, parts, and components that will eventually be used in the production process. Prior to that time, they are reported as a separate inventory category.

As raw material is channeled into production, it is reclassified into a work in process. Work in process reflects the accumulating costs for products that are currently in produc- tion. This account will not only include direct material costs but also capture the other conversion cost elements. Once production is finished, the goods are ready for sale. These goods are termed finished goods. The accountant will find it necessary to prepare entries to transfer costs into this third inventory category from work in process.

Once sold, the cost carried in finished goods inventory becomes cost of goods sold for the income statement. You may be thinking that there is a striking amount of work that is needed to accumulate and transfer costs through the manufacturing process, and you are correct. Fortunately, modern information systems have automated much of the data accumulation and tracking. In any event, when you look at the balance sheet of a manu- facturer, you are apt to see a presentation similar to the following:

INVENTORIES

Raw materials $10,000,000

Work-in-process 25,000,000

Finished goods 15,000,000

The reason companies present this level of detail is to allow for careful monitoring of each category of inventory. One needs to know the various levels of inventory in the vari- ous stages. A business may have an exciting new product with great potential. This will require scaling up the production process and greater investments in raw materials and work in process. However, if the goods do not sell as hoped, there will be an eventual build-up in finished goods. Conversely, if there is a shortage of a raw material, it may signal a future problem in fulfilling sales orders on a timely basis. Thus, it is important to keep a keen eye on the composition of total inventory investment. It can signal positive or negative consequences for the business.

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CHAPTER 3Section 3.4 A Closer Look at Cost Accumulation

3.4 A Closer Look at Cost Accumulation

You previously learned that one can calculate cost of goods sold by subtracting ending inventory from the total cost of goods available for sale. Also recall that the total cost of goods available for sale is the sum of the beginning inventory and net purchases dur- ing the period. The following formulation is foundational for the discussion that follows:

Beginning inventory $AA,AAA

Plus: Purchases BB,BBB

Cost of goods available for sale $CC,CCC

Less: Ending inventory DD,DDD

Cost of goods sold $EE,EEE

These relationships are extended to all three categories of a manufacturer’s inventory. Separate calculations are necessary to determine raw material transferred to production, work in process transferred to finished goods, and finished goods transferred to cost of goods sold.

A schedule of raw materials is prepared to show the beginning raw materials and addi- tional purchases. The total raw materials available are then allocated between ending raw materials inventory and the amount transferred into production as part of work in prog- ress. Exhibit 3.4 is an example of such a schedule.

Exhibit 3.4

All the amounts in the preceding table should be verifiable in an actual business setting. For example, the beginning and ending inventory amounts would be confirmable by ref- erence to a physical count of goods on hand. In summary, this schedule shows the activ- ity for the period and concludes with the dollar amount attributed to raw materials that flowed into the production cycle. That same amount then appears in the schedule of work in process in Exhibit 3.5.

Beginning raw materials inventory, Jan. 1

Plus: Net purchase of raw materials

Raw materials available

Less: Ending raw materials inventory, Dec. 31

Raw materials transferred to work in process (to schedule of work in process)

WAINWRIGHT COMPANY Schedule of raw materials

For the year ending December 31, 20X4

$ 150,000

500,000

$ 650,000

200,000

$ 450,000

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CHAPTER 3Section 3.4 A Closer Look at Cost Accumulation

Exhibit 3.5

The work in process schedule is intended to show the flow of direct materials into pro- duction, along with the addition of direct labor and overhead. These new costs are added to the work in process from the beginning of the period to arrive at total manufacturing costs. The cost of completed units is transferred to the finished goods inventory. The next schedule in Exhibit 3.6 evaluates the changes to finished goods inventory, in similar man- ner, to determine the cost of goods sold.

Exhibit 3.6

You are already quite familiar with the income statement. This income statement for Wain- wright Company follows in Exhibit 3.7. Carefully note how the $900,000 cost of goods sold is drawn from the schedule of cost of goods sold.

Beginning work in process inventory, Jan. 1

Plus: Additions to work in process

Direct materials (from schedule of raw materials)

Direct labor

Factory overhead

Indirect materials

Indirect labor

Factory depreciation

Factory utilities

Factory maintenance

Total manufacturing costs

Less: Ending work in process, Dec. 31

Cost of goods manufactured

$ 450,000

325,000

155,000

$ 10,000

18,000

42,000

60,000

25,000

$ 500,000

930,000

$ 1,430,000

625,000

$ 805,000

WAINWRIGHT COMPANY Schedule of work in process

For the year ending December 31, 20X4

Beginning finished goods inventory, Jan. 1

Plus: Cost of goods manufactured (from schedule of work in process)

Goods available for sale

Less: Ending finished goods inventory, Dec. 31

Cost of goods sold (to income statement)

WAINWRIGHT COMPANY Schedule of cost of goods sold

For the year ending December 31, 20X4

$ 735,000

805,000

$ 1,540,000

640,000

$ 900,000

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CHAPTER 3Section 3.4 A Closer Look at Cost Accumulation

Exhibit 3.7

Combining Schedules

Often, the preceding schedules are not presented in financial statements. They may be reserved for internal use. External users may only have access to the income statement. At other times, a company may wish to share a greater amount of information with its share- holders and can provide additional supporting detail. Even internal use schedules come in different forms. The schedules of raw materials and work in process are often combined into a single schedule of cost of goods manufactured. This schedule represents a combina- tion and slight rearrangement of separate schedules presented previously (Exhibit 3.8).

Exhibit 3.8

Direct materials:

Beginning raw materials inventory, Jan. 1

Plus: Net purchases of raw materials

Raw materials available

Less: Ending raw materials inventory, Dec. 31

Raw materials transferred to production

Direct labor

Factory overhead

Indirect materials

Indirect labor

Factory depreciation

Factory utilities

Factory maintenance

Total manufacturing costs

Beginning work in process inventory, Jan. 1

Less: Ending work in process, Dec. 31

Cost of goods manufactured

$ 150,000

500,000

$ 650,000

200,000

$ 10,000

18,000

$ 450,000

325,000

155,000

$ 930,000

500,000

$ 1,430,000

625,000

$ 805,000

42,000

60,000

25,000

WAINWRIGHT COMPANY Schedule of cost of goods manufactured For the year ending December 31, 20X4

Sales

Cost of goods sold

Gross profit

Operating Expenses

Selling

General & administrative

Net income

$ 375,000

225,000

$1,700,000

900,000

$ 800,000

600,000

$ 200,000

WAINWRIGHT COMPANY Income Statement

For the year ending December 31, 20X4

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CHAPTER 3Concept Check

Tax and Accounting Rules

The preceding information has been presented in the context of information needed by management for decision making. However, external reporting standards and tax laws provide additional guidance on certain measurement aspects relating to the inventory accounting for a manufacturer. Both financial reporting rules and tax laws require prod- ucts to absorb the full cost of production, including overhead. Inventory accounts must reflect direct labor, direct materials, and indirect costs including indirect labor, employee benefits, indirect materials, purchasing, handling, depreciation, rent, and numerous other manufacturing costs.

Tax laws provide specific “uniform capitalization rules” (UNICAP) and even go a bit far- ther by requiring the capitalization of direct and indirect costs incurred through the pre- sale period. Table 3.5 highlights the scope of UNICAP:

Table 3.5: UNICAP

Preproduction costs to be capitalized

Production costs to be capitalized

Presale costs to be capitalized

Sale costs to be expensed

Design costs

Bidding expense

Purchasing

Direct materials

Direct labor

Direct production costs

Indirect production costs

Storage

Handling

Excise tax

Selling costs

Distribution costs

Income taxes

Warranty costs

Excise tax

Under GAAP, only amounts in the first two columns of Table 3.5 would be capitalized. UNICAP rules typically apply to larger manufacturers of inventory or other tangible property used in a trade or business. Indeed, these subtle distinctions in costing rules for internal, external, and tax reporting begin to highlight the complexity of applying costing concepts in today’s business environment!

Concept Check

The five questions that follow relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The correct answers can be found at the end of your text.)

1. Managerial accounting a. focuses primarily on reporting to regulatory agencies. b. is governed by generally accepted accounting principles. c. is highly discretionary and varies greatly from business to business. d. should be considered as a substitute for financial accounting.

2. Which of the following items is properly classified as factory overhead? a. Wages of a carpenter who builds fine wooden furniture b. The cost of sandpaper used in production of furniture

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CHAPTER 3Key Terms

c. The cost of plastic keys on a microcomputer’s keyboard d. Depreciation of office equipment used at a company’s corporate headquarters

3. Which of the following statements is correct? a. Period costs are properly inventoried on the balance sheet. b. Direct labor is a typical example of a period cost. c. Product costs are expensed as incurred. d. Direct material is a typical product cost.

4. Cost of goods manufactured a. is added to the cost of the beginning finished goods inventory on the income

statement. b. includes selling and administrative expenses. c. ignores the beginning and ending balances of the work in process account. d. is normally disclosed on a company’s balance sheet.

5. Which of the following is an example of a variable cost? a. Salary of a plant supervisor b. Advertising costs c. Direct materials d. Straight-line depreciation on a factory machine

Key Terms

activity base The item or event that causes the incurrence of a variable cost.

chief financial officer (CFO) Corporate officer who is usually responsible for exter- nal reporting and cash management.

committed fixed costs Those costs that arise from an organization’s commitment to operate; key elements include costs such as depreciation, rent, and insurance.

controller A person designated by a company who is responsible for providing leadership over the cost and managerial accounting duties.

cost accounting The collection, assign- ment, and interpretation of costs.

direct labor Wages attributable to those who are physically and directly working on a manufactured product.

direct materials The costs of all significant physical ingredients that become an inte- gral part of a finished product.

discretionary fixed costs Those costs that depend on periodic spending decisions.

finished goods Goods that have gone through production and are ready for sale.

fixed costs Those costs that do not fluctu- ate with changes in the level of activity.

indirect labor Wages of factory mainte- nance personnel, supervisors, guards, etc. accumulated as part of manufacturing overhead.

indirect materials Those components that may not be cost-effective to trace to a finished unit.

managerial accounting Focuses on report- ing in support of business management processes.

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CHAPTER 3Exercises

manufacturing overhead Basically any manufacturing cost other than direct mate- rials and direct labor.

product costs Those costs that are directly related to the manufacturing process.

raw materials Goods that have not been put into production that include ingredi- ents, parts, and components that will even- tually be used in the production process.

relevant range The expected level of production.

SG&A Selling, general, and administra- tive costs; nonmanufacturing costs.

variable costs Those costs that vary in direct proportion to changes in the level of an activity.

work in process A raw material that has been channeled into production; reflects the accumulating costs for products that are currently in production.

Critical Thinking Questions

1. Is managerial accounting solely concerned with reporting of past events? 2. What type of cost information might interest a company that is greatly concerned

about product quality? 3. What are the three cost elements of a manufactured product? 4. Why are indirect materials and indirect labor treated as part of manufacturing

overhead? 5. Differentiate among direct materials, direct labor, and manufacturing overhead in

terms of cost traceability to the finished product. 6. When does a product cost appear on a balance sheet? On an income statement?

Exercises

1. Product costs and period costs The costs that follow were extracted from the accounting records of several differ- ent manufacturers:

1. Weekly wages of an equipment maintenance worker 2. Marketing costs of a soft drink bottler 3. Cost of sheet metal in a Honda automobile 4. Cost of president’s subscription to Fortune magazine 5. Monthly operating costs of pollution control equipment used in a steel mill 6. Weekly wages of a seamstress employed by a jeans maker 7. Cost of compact discs (CDs) for newly recorded releases of Rush, Billy Joel, and

Bryan Adams

a. Determine which of these costs are product costs and which are period costs. b. For the product costs only, determine those that are easily traced to the finished

product and those that are not.

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CHAPTER 3Exercises

2. Definitions of manufacturing concepts Interstate Manufacturing produces brass fasteners and incurred the following costs for the year just ended:

Materials and supplies used

Brass $ 75,000

Repair parts 16,000

Machine lubricants 9,000

Wages and salaries

Machine operators 128,000

Production supervisors 64,000

Maintenance personnel 41,000

Other factory overhead

Variable 35,000

Fixed 46,000

Sales commissions 20,000

Compute the following:

a. Total direct materials consumed b. Total direct labor c. Total prime cost d. Total conversion cost

3. Understanding cost flows Executive Wares, which began business on January 1, 20X4, sells high-priced office accessories to executives. One of the company’s products, catalog item No. 12, consists of a leather appointment book and a matching pen-and-pencil set—all assembled and packaged in a gift box by Executive Wares.

During 20X4, the firm purchased 8,000 20X5 appointment books from its supplier at $14 each. The following data are available as of June 30:

Appointment books issued to the Packaging

Department from the storeroom 6,500

Gift sets completed 5,400

Completed gift sets in the warehouse 2,200

Completed gift sets given to customers as samples

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CHAPTER 3Exercises

If no errors or theft occurred during the period, determine the cost of the appoint- ment books that would appear

a. In the company’s (1) raw materials, (2) work in process, and (3) finished goods inventories as of June 30.

b. as cost of goods sold for the period ended June 30. c. as an operating expense for the period ended June 30.

4. Basic manufacturing computations Lyon Manufacturing reported total manufacturing costs (direct materials used, direct labor, and factory overhead) of $549,000 for 20X3. Sales and operating expenses were $759,200 and $142,500, respectively. The following information appeared on company balance sheets:

For the Year Ended

12/31/X3 12/31/X2

Finished goods $150,000 $153,700

Work in process 86,400 74,100

Compute cost of goods manufactured, cost of goods sold, and net income for 20X3.

5. Schedule of cost of goods manufactured, income statement The following information was taken from the ledger of Jefferson Industries Inc.:

Direct labor $ 85,000 Administrative expenses $59,000

Selling expenses 34,000 Work in. process

Sales 300,000 Jan. 1 29,000

Finished goods Dec. 31 21,000

Jan. 1 115,000 Direct material purchases 88,000

Dec. 31 131,000 Depreciation: factory 18,000

Raw (direct) materials Indirect materials used 10,000

on hand Indirect labor 24,000

Jan. 1 31,000 Factory taxes 8,000

Dec. 31 40,000 Factory utilities 11,000

Prepare the following: a. A schedule of cost of goods manufactured for the year ended December 31 b. An income statement for the year ended December 31

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CHAPTER 3Problems

6. Understanding cost behavior The planning department of Herzog Company has prepared budgets for three probable levels of operation for the upcoming year. Because of their significance, the following costs have been selected for study:

Level of activity (units)

10,000 12,000 15,000

Total Per unit Total

Per unit Total

Per unit

Direct materials $ 90,000 $ 9.00 $108,000 $ 9.00 $135,000 $ 9.00

Direct labor 120,000 12.00 144,000 12.00 180,000 12.00

Advertising 300,000 30.00 300,000 25.00 300,000 20.00

Management

Salaries 180,000 18.00 180,000 15.00 180,000 12.00

$690,000 $69.00 $732,000 $61.00 $795,000 $53.00

Addressing his executive staff, Herzog’s president commented: “It’s imperative that we implement cost-cutting programs to reduce advertising and management salaries. As shown by the per-unit costs, these variable expenditures are destroying our profit margins. Our fixed outlays of direct materials and direct labor (constant at $9.00 and $12.00 per unit, respectively) also need some improvement. I know our competitors are paying approximately $19.25 for these same two production factors.”

Comment on the president’s remarks.

Problems

1. Cost classification E. Turner & Sons manufactures barbecue grills. For each of the following costs, determine cost behavior (variable or fixed) and whether the cost is a product or a period cost. If a product cost, identify the cost as direct materials (DM), direct labor (DL), or factory overhead (FOH). Item (a) is presented as an example.

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CHAPTER 3Problems

Cost Variable/fixed Product/period DM/DL/FOH

a. Property taxes on the factory

Fixed Product FOH

b. Salary of the production supervisor

c. Freight costs on shipments to out-of-state customers

d. Wages of assem- bly personnel

e. Grill tops and frames

f. Straight-line depreciation on factory equip- ment

g. Paint used to touch up production scratches

h. Customer re- bate offered on grill No. 301

i. Heating costs for manufactur- ing facilities

j. Wheels at- tached to por- table models

k. Fees paid for plant security

l. Advertising costs for new product line

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CHAPTER 3Problems

2. Straightforward manufacturing statements The following information was extracted from the accounting records of Olympic Company for the year just ended:

Sales $628,000

Work in process, Jan. 1 56,700

Advertising expense 23,500

Direct material purchases 231,500

Finished goods, Dec. 31 67,800

Indirect materials used 12,300

Direct labor 85,600

Direct materials, Jan. 1 45,500

Finished goods, Jan. 1 55,900

Direct materials, Dec. 31 38,200

Sales staff salaries 33,300

Work in process, Dec. 31 47,400

Indirect labor 50,700

Utilities, taxes, insurance, and depreciation are incurred jointly by Olympic’s manufacturing, sales, and administrative facilities. The costs were as follows:

Utilities $40,000

Taxes 25,000

Insurance 10,000

Depreciation 36,000

The first three costs are allocated proportionately on the basis of square feet occu- pied by the three functional areas. A review of the company’s facilities revealed the following percentages would be appropriate: manufacturing, 50%; sales, 30%; and administrative, 20%. Depreciation is allocated 70, 20, and 10%, respectively.

Instructions a. Prepare a schedule of cost of goods manufactured in good form. b. Prepare an income statement in good form.

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CHAPTER 3Problems

3. Manufacturing statements and cost behavior Tampa Foundry began operations during the current year, manufacturing various products for industrial use. One such product is light-gauge aluminum, which the company sells for $36 per roll. Cost information for the year just ended follows:

Variable cost per unit Fixed cost

Direct materials $ 4.50 $ —

Direct labor 6.50 —

Factory overhead 9.00 50,000

Selling — 70,000

Administrative — 135,000

Production and sales totaled 20,000 rolls and 17,000 rolls, respectively. There is no work in process. Tampa carries its finished goods inventory at the average unit cost of production.

Instructions a. Determine the cost of the finished goods inventory of light-gauge aluminum. b. Prepare an income statement for the current year ended December 31. c. On the basis of the information presented, answer the following questions:

1) Does it appear that the company pays commissions to its sales staff? Explain. 2) What is the likely effect on the $4.50 unit cost of direct materials if next year’s

production increases? Why?

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