A primer on cost flows
Flow of money
Firms spend money on lots of things
Materials, labor, rent, managers, equipment, transportation, advertising,
warranties, …
These are costs … we have given up money to get these resources /
benefits
Recorded value = OC = Money given up = historical cost
Some questions
How does the firm (its accounting system) keep track of these costs?
When and where do these amounts show up in the income statement?
In the balance sheet?
How are they reported to managers?
How do managers use these data for decisions?
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Costs and expenses
Accounting for costs
Labor
Materials
Incur cost to buy materials. Store this cost as inventory (in the B/S) if the
item is in inventory. Amount in B/S reflects value of items on hand
Machines
Incur cost to buy time. Store this cost in a “labor control account.” Balance is
zeroed out every period
Incur cost to buy machine. Show as asset in B/S
When a cost shows up in the I/S, it is an expense
When and where do these costs show up in the I/S?
Flow of costs
Costs flow to income statement (i.e., become expenses) in
two ways
The distinction is relevant only for valuing inventory
Product costs
Period costs
Dictated by GAAP
Profit = (revenue – expenses) flows from the income
statement to the balance sheet
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What is included in product cost?
Anything that is required “to make a product or service ready
for sale”
Materials, labor and manufacturing overhead
Manufacturing overhead is the cost of providing the manufacturing
capacity
Might be clearer to call overhead as “capacity costs”
Examples: factory rent, lighting, machine depreciation, power, salaries, ….
Can be fixed (rent) or variable (power to run machines)
Can be direct (dedicated machine) or indirect (general purpose
machine)
Types of product costs
Some product costs are directly traceable to a given product or even a unit
Easy to trace direct costs such as materials to individual units
Can typically trace direct labor cost to individual products
Some overhead can be direct (e.g., salary of supervisor dedicated to a product)
Some product costs are indirect
Some materials (e.g., supplies) are indirect
Some labor (e.g., shift supervisor) are indirect
Most capacity costs are indirect (e.g., depreciation on machine)
We pool all these items into “overhead” and allocate these indirect costs to
individual units of each product
Capacity costs are the bulk of overhead costs
Whether we trace or allocate, we attach a portion of cost to each specific
unit of each product
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Product costs -- continued
Once we attach the cost, product costs “travel” with the
individual units of products
Visualize these costs as being “attached with velcro” onto the
physical units
Where the units are is where the cost is
For units are being worked on, cost is in Work in process inventory
For units are in finished goods, cost is in FG inventory
For units are sold, cost is in Cost of Goods Sold (an expense)
Costs flow through inventory accounts and are expensed (as
part of COGS) only when the units are sold
What is included in period cost?
Anything that is not a product cost is a period cost
Any selling, general and administration cost qualifies
Some period costs are direct and others are indirect
Cost to “transport out” finished goods is a period cost
Sales commissions are direct
SGA related overhead is indirect
Regardless, we expense these costs to the income statement
The entirety of these costs shows up in the income statement
There is no need for allocations for valuing inventory. There is no
portion that shows up in the balance sheet.
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Cost flows
Illustrations in different industries
Illustrations of cost flows
Let us apply these concepts to several settings
Service
Merchandising
Accounting, advertising, consulting, IT firms, transportation
Retailers, car dealers,
Manufacturing
Consumer goods, industrial goods, ….
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Service firms
Products are not tangible or storable
Hotels, restaurants, consulting, airlines, gyms, universities, museums,…
Generally, there is no inventory of their final product
Exceptions exist
We can inventory costs of software projects that go across accounting
periods
They might have long-term assets
Buildings, ships, computers, …
A portion of the cost of these assets is expensed (as depreciation) each
period
Flow of costs: service firms
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Merchandising firms
Examples include JC Penney, Sears, Kroger, Office Depot,
Staples,…
These firms
Sell substantively the same product they purchase
Carry inventory to make goods available in the quantities, varieties and
delivery schedules demanded by customers
Flow of costs in merchandising
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Inventory equation
Need to flow costs via inventory account
We can capture flow as:
+
–
=
Cost of purchase is NOT the cost of goods sold
Cost of beginning inventory
Cost of goods purchased during the period
Cost of ending inventory
Cost of goods sold (COGS) during the period
Make inventory cost flow assumption
First In First Out (FIFO)
Last In First Out (LIFO)
Manufacturing firms
These firms (physically) transform their inputs into outputs
Inputs usually classified into three varieties
General Motors uses labor to convert steel, plastic, leather and electronics
into an automobile
Materials
Labor
Capacity costs (overhead)
The three items can and will used anywhere in the production
process (often in all three places)
Pre production
During production
Post production
(can be product or period costs)
(these are product costs)
(these are period costs)
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Flow of product costs: overview
As we work on units, we
attach costs to units
Materials (detail)
Purchase
cost
RM
RM
inventory
WIP
inventory
FG
inventory
As part of OH
rate
Indirect
materials
Supplies
inventory
Overhead
control
RM
WIP
FG
OH
= Raw materials
= Work in process
= Finished goods
= Overhead
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Labor costs (detail)
Labor
cost
(salaries)
Labor
cost
(benefits)
Labor
cost
(FICA)
Direct
labor
Labor
control
Indirect
labor
WIP
inventory
FG
inventory
As part of
OH rate
Overhead
control
Labor
cost
(Other)
Overhead costs (detail)
Overhead
cost
(rents)
WIP
inventory
Overhead
cost
(utilities)
Allocated
using OH rate
Overhead
control
Overhead
cost
(depreciation)
Overhead
cost
(other)
FG
inventory
Indirect
materials
Many firms break
out separate
fixed and variable
rates.
Indirect labor
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Inventory flows: product costs
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