CHAPTER M2
Classifying Costs
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Learning Objective 1:
Classify costs by cost
objects, and distinguish
between direct and
indirect costs.
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Assigning Costs
 A cost object is any activity, product, or
other item for which we can make a
separate cost measurement.
 Examples:
 Product #102
 Minnesota sales territory
 television advertising
 employee Barry Jones
 delivery van #45
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Direct Costs
 A direct cost is a cost that can easily be
traced to an individual cost object.
Examples:
 Wood used to make a wooden table.
 Carpenter’s wages who carves the wood.
 Decorative hardware used on the table.
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Indirect Costs
 An indirect cost or common cost is one
that supports more than one cost object.
Examples:
 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.
 Wages of supervisory personnel who direct
many types of workers.
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Learning Objective 2:
Distinguish between
product costs and period
costs, and contrast their
accounting treatment.
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Product Cost
 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.
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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 do not become business
expenses until the product is sold, and the
revenue is generated.
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Period Costs
 All costs that do not qualify as product
costs are considered period costs.
 This primarily includes the selling and
administrative costs, including
freight out.
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Assets or Expenses?
 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.
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Product vs. Period Costs
 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.
 We employ a custodial team at a monthly
cost of $5,000.
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Product vs. Period Costs
 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.
 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.
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Learning Objective 3:
Explain the differences
between product cost for
a merchandiser and for a
manufacturer.
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Product Costs for a
Merchandising Firm
 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.
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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.
 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.
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Flow of Product Costs
Invoice Cost of Merchandise
Freight-in
Merchandise
Inventory
Other Costs
to Prepare
Merchandise
for Sale
Cost of
Goods Sold
Ending
Inventory
(Income Statement)
(Balance Sheet)
Goods Sold This Period
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Goods Not Yet Sold
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Cost of Goods Sold Schedule
Online Booksellers, Inc.
Cost of Goods Sold Schedule
For the Year Ended December 31, 2007
Beginning inventory, Jan. 1, 2007
Inventory purchases during 2007
$ 50,000
350,000
Goods available for sale during 2007
Ending inventory, Dec. 31, 2007
$400,000
80,000
Cost of goods sold during 2007
$320,000
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Product Costs for a
Manufacturing Firm
 To determine the cost to manufacture a
product, the focus is typically on three
major cost elements:
 direct materials cost
 direct labor cost
 manufacturing overhead cost
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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.
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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.
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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.
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Learning Objective 4:
Describe the components
of the costs included in
each of the three types
of inventory in a
manufacturing operation.
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Inventory Classifications
 The manufacturing firm has three types of
inventory:
 raw materials inventory
 work-in-process inventory
 finished goods inventory
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Raw Materials Inventory
 The raw materials inventory or materials stores
account contains the cost of all materials not yet
used in the manufacturing operations.
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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.
 This account will include the direct materials,
direct labor, and manufacturing overhead costs
related to partially completed units.
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Finished Goods Inventory
 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.
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Learning Objective 5:
Calculate cost of goods
manufactured and
cost of goods sold.
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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.
 Additionally, they must also keep an eye on
the cost efficiency and quality of
production.
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The Flow of Manufacturing Costs
Raw Materials
Purchases
Direct Labor Cost
Raw Materials
Inventory
Direct Materials Cost
Manufacturing Overhead Cost
•Indirect Material
•Indirect Labor
•All Factory-related Costs
Ending Raw
Materials
Inventory
Ending Work
in Process
Inventory
Balance Sheet
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Ending
Finished
Goods Inv.
Work-inProcess
Inventory
Finished
Goods
Inventory
Cost of
Goods Sold
Income
Statement
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Detailed Analysis of
Materials
 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.
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Raw Materials
Purchases
Raw Materials
Inventory
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Detailed Analysis of
Materials
Raw Materials
Inventory
Direct Materials Cost
Work-inProcess
Inventory
Manufacturing Overhead Cost:
•Indirect Material
•All Factory-related Costs
Notice that the cost of direct
Ending Raw materials flows directly into WIP,
but the cost of indirect materials
Materials
used in production flows into the
Inventory
manufacturing overhead cost pool.
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Detailed Analysis of Labor
Total Factory Labor
Cost Incurred
Direct Labor Cost
Indirect Labor Cost
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.
Work-inProcess
Inventory
Manufacturing Overhead Cost
•Indirect Material
•Indirect Labor
•All Factory-related Costs
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Detailed Analysis of
Overhead
 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
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Work-in-Process
Inventory
Direct Materials
Direct Labor
Factory Overhead
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Detailed Analysis of
Work-in-Process
 The cost of units that have
been completed is
transferred into the
finished goods inventory.
 The ending work-inprocess inventory should
then consist of the costs
of the partially completed
units.
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Work-inProcess
Inventory
Finished
Goods
Inventory
Ending Workin-Process
Inventory
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Cost of Goods Manufactured Schedule
Direct materials:
Beginning direct materials inventory 1/1/07
Purchases of materials during 2007
Materials available during 2007
Ending direct materials inventory 12/31/07
$
13,000
400,000
$
413,000
(20,000)
Direct materials used during 2007
$
Direct labor during 2007
Manufacturing overhead cost:
Indirect materials
Indirect labor
Factory rent
Depreciation of equipment
Repairs on equipment
Factory utilities
Factory property taxes
393,000
220,000
$
5,000
20,000
144,000
250,000
40,000
39,000
15,000
Total manufacturing overhead during 2007
513,000
Manufacturing cost for 2007
Beginning work-in-process inventory 1/1/07
$
1,126,000
41,000
Cost of goods in production during 2007
Ending work-in-process inventory 12/31/07
$
1,167,000
(65,000)
Cost of goods manufactured during 2007
$
1,102,000
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Learning Objective 6:
Describe the
components of the
cost of services
provided by a service
firm.
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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.
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Materials for Service Firm
 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.
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Labor for Service Firm
 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).
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Overhead for a
Service Firm
 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.
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Flow of Service Costs
Supplies
Inventory
Direct Supplies Cost
Direct Labor Cost
Ending
Supplies
Inventory
Balance
Sheet
Overhead Cost
•Indirect Supplies
•Indirect Labor
•Office Rent
•Depreciation
•Office Taxes
•Office Insurance
•Other Indirect Costs
Cost of
Services
Provided
Income
Statement
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Cost of Services Schedule
Direct labor cost
Overhead cost:
Indirect supplies
Office rent
Depreciation
Office taxes
Office insurance
Other indirect costs
Total overhead cost
Direct supplies cost
Cost of services provided
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$
$
940,000
12,000
24,000
18,000
2,000
8,000
6,000
70,000
20,000
$ 1,030,000
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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.
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Comparison of Merchandising,
Manufacturing, and Service
Organizations
 Balance Sheet: Current Assets
 Merchandising firm: Merchandise Inventory
 Manufacturing firm: Raw Materials Inventory
Work-in-Process Inventory
Finished Goods Inventory
 Service firm: Supplies Inventory
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Comparison of Merchandising,
Manufacturing, and Service
Organizations
 Income Statement:
 Merchandising firm: Purchases in Cost of Goods
Sold
 Manufacturing firm: Cost of Goods Manufactured
in Cost of Goods Sold
 Service firm: Cost of Services
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The End of Chapter M2
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