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? 1 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 2 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 3 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. 4 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, …. 5 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 6 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 7 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) 8 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 9 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 10 Inventory flows: product costs 11
