Cost Classification

 

Class Notes: Manufacturing Costs

Manufacturing companies classify costs into three broad categories:

1. Direct Materials

• Definition: Materials that are used in the final product.
• Raw Materials: Can be unprocessed natural resources or finished products from another company (e.g., plastics from Du Pont used in HP computers).
• Direct Materials: Become an integral part of the product and can be traced conveniently (e.g., aircraft seats in Airbus, motors in Panasonic DVD players).
• Indirect Materials: Minor items not worth tracing individually (e.g., solder in Sony TVs, glue in Ethan Allen chairs). These are included in Manufacturing Overhead.

2. Direct Labor

• Definition: Labor costs that can be physically and conveniently traced to products.
• Also called: Touch labor (workers directly involved in production).
• Examples: Assembly-line workers (Toyota), carpenters (KB Home), electricians (Bombardier Learjet).
• Indirect Labor: Labor costs that cannot be traced to specific products (e.g., janitors, supervisors, materials handlers, security guards). These costs are included in Manufacturing Overhead.

3. Manufacturing Overhead

• Definition: All manufacturing costs except direct materials and direct labor.
• Includes:
• Indirect materials (e.g., solder, glue)
• Indirect labor (e.g., janitors, supervisors)
• Other costs (e.g., maintenance, repairs, heat, light, property taxes, depreciation, insurance on production facilities).
• Exclusions: Selling and administrative costs (e.g., office utilities, insurance on non-manufacturing facilities).
• Alternative Names: Indirect manufacturing cost, factory overhead, factory burden.

Key Takeaways

• Direct materials and direct labor are easily traceable to the final product.
• Indirect materials and indirect labor are included in manufacturing overhead.
• Manufacturing overhead consists of all other costs related to factory operations but excludes selling and administrative expenses.

4. Nonmanufacturing Costs

Nonmanufacturing costs are divided into two main categories:

a. Selling Costs

·         Definition: Costs incurred to secure customer orders and deliver the product.

·         Also called: Order-getting and order-filling costs.

·         Examples: Advertising, shipping, sales travel, sales commissions, sales salaries, and costs of finished goods warehouses.

b. Administrative Costs

·         Definition: Costs associated with general management rather than manufacturing or selling.

·         Examples: Executive compensation, general accounting, secretarial expenses, public relations, and similar general administration costs.

·         Alternative Names for Nonmanufacturing Costs: Selling, general, and administrative (SG&A) costs or simply selling and administrative costs.

Product Costs vs. Period Costs

Product Costs vs. Period Costs: Understanding the Matching Principle

In addition to classifying costs as manufacturing or nonmanufacturing, another fundamental way to categorize costs is as product costs or period costs. Understanding this distinction requires an examination of the matching principle from financial accounting.

The Matching Principle

The matching principle is an essential concept in accrual accounting, ensuring that expenses are recognized in the same period as the revenues they help generate. For instance, when a company prepays for liability insurance covering two years, it does not expense the entire amount in the year of payment. Instead, the cost is allocated evenly over the two years because both years benefit from the insurance coverage. The portion of the payment that has not yet been expensed is recorded as an asset (prepaid insurance) on the balance sheet until it is recognized as an expense in the appropriate period.

a. Product Costs

·         Definition: All costs incurred to acquire or manufacture a product.

·         Includes: Direct materials, direct labor, and manufacturing overhead.

·         Accounting Treatment:

o    Initially recorded as inventory on the balance sheet.

o    Expensed as cost of goods sold (COGS) when the product is sold.

o    Also called inventorial costs.

b. Period Costs

·         Definition: Costs that are not included in product costs and are expensed in the period they are incurred.

·         Includes: Selling and administrative expenses (e.g., sales commissions, advertising, executive salaries, public relations, office rent).

·         Accounting Treatment:

o    Expensed directly on the income statement when incurred.

o    Not included in the cost of goods.

·         Key Concept: The matching principle in accounting ensures that costs are recognized in the same period as the revenue they help generate. This means that costs incurred to produce inventory are only expensed when the inventory is sold, whereas period costs are expensed as they occur.

·         Product costs are capitalized as inventory until sold, while period costs are expensed in the period incurred.

Example of a Period Cost: Advertising Expense

Scenario:

A retail company, Fashion Trends Inc., launches a nationwide advertising campaign to promote its new clothing line. The company spends $500,000 on television commercials, online ads, and billboards in January 2024 to drive customer traffic and increase sales throughout the year.

Explanation:

The $500,000 advertising expense is a period cost because:

1. It is not directly tied to the production of goods. Unlike product costs (such as fabric or factory labor), advertising expenses support sales rather than manufacturing.
2. It is expensed in the period it is incurred. Regardless of when the increased sales occur, the full $500,000 is recorded as an expense in January 2024, when the advertisement was run.
3. It appears on the income statement under operating expenses. Advertising costs fall under selling, general, and administrative expenses (SG&A) rather than inventory or cost of goods sold (COGS).

Accounting Treatment (Journal Entry):

When the company incurs the advertising expense in January:

📌 Journal Entry (January 2024):

Dr. Advertising Expense      $500,000  

   Cr. Cash (or Accounts Payable)    $500,000  

• Debit (Dr.) Advertising Expense to recognize the cost.
• Credit (Cr.) Cash (if paid immediately) or Accounts Payable (if paid later).

Key Takeaways:

✅ Period costs are always expensed in the period they are incurred, regardless of revenue generation.
✅ They do not become part of inventory or cost of goods sold (COGS).
✅ Other examples include rent, executive salaries, and office supplies.

 

Prime Cost and Conversion Cost

Two additional cost categories are commonly used in manufacturing:

a. Prime Cost

·         Definition: The sum of direct materials cost and direct labor cost.

·         Formula:

b. Conversion Cost

·         Definition: The sum of direct labor cost and manufacturing overhead cost.

·         Formula:

·         Explanation: The term “conversion cost” is used because these costs are incurred to convert raw materials into finished products.

MCQs on Manufacturing and Nonmanufacturing Costs

1. Which of the following is NOT a broad category of manufacturing costs?

a) Direct materials
b) Direct labor
c) Administrative costs
d) Manufacturing overhead

Answer: c) Administrative costs

2. Which of the following is an example of direct material?

a) Lubricant used in machines
b) Glue used in furniture assembly
c) Steel used in car manufacturing
d) Cleaning supplies for the factory

Answer: c) Steel used in car manufacturing

3. Indirect materials are included in which cost category?

a) Direct labor
b) Manufacturing overhead
c) Administrative expenses
d) Selling expenses

Answer: b) Manufacturing overhead

4. What is another term for direct labor?

a) Office labor
b) Touch labor
c) Indirect labor
d) Executive labor

Answer: b) Touch labor

5. Which of the following is an example of indirect labor?

a) Assembly-line workers at Toyota
b) Carpenters at a home-building company
c) Janitors in a factory
d) Electricians installing aircraft equipment

Answer: c) Janitors in a factory

MCQs on Nonmanufacturing Costs

6. Selling costs include which of the following?

a) Depreciation on factory machinery
b) Advertising expenses
c) Raw material costs
d) Factory maintenance costs

Answer: b) Advertising expenses

7. Which of the following is an administrative cost?

a) Depreciation on factory equipment
b) Insurance for production facilities
c) Executive salaries
d) Wages of assembly-line workers

Answer: c) Executive salaries

8. What is another name for nonmanufacturing costs?

a) Prime costs
b) Inventoriable costs
c) Selling, General, and Administrative (SG&A) costs
d) Conversion costs

Answer: c) Selling, General, and Administrative (SG&A) costs

MCQs on Product Costs vs. Period Costs

9. Which of the following is a product cost?

a) Sales commissions
b) Factory maintenance
c) Advertising costs
d) Office rent

Answer: b) Factory maintenance

10. When are product costs expensed on the income statement?

a) When they are incurred
b) When the related product is sold
c) At the beginning of the accounting period
d) When cash is paid for the expenses

Answer: b) When the related product is sold

11. What is the alternative name for product costs?

a) Inventoriable costs
b) Period costs
c) SG&A costs
d) Nonmanufacturing costs

Answer: a) Inventoriable costs

12. Period costs are expensed in which period?

a) When the product is sold
b) Over multiple periods
c) In the period they are incurred
d) When raw materials are purchased

Answer: c) In the period they are incurred

MCQs on Prime Cost and Conversion Cost

13. Which of the following costs are included in prime cost?

a) Direct materials and manufacturing overhead
b) Direct labor and manufacturing overhead
c) Direct materials and direct labor
d) Direct labor and administrative costs

Answer: c) Direct materials and direct labor

14. What is the formula for conversion cost?

a) Direct materials + Direct labor
b) Direct labor + Manufacturing overhead
c) Direct materials + Manufacturing overhead
d) Selling costs + Administrative costs

Answer: b) Direct labor + Manufacturing overhead

15. Why is the term “conversion cost” used?

a) It represents costs required to convert raw materials into finished products
b) It includes all costs incurred during sales
c) It only applies to service industries
d) It refers to changing fixed costs into variable costs

Answer: a) It represents costs required to convert raw materials into finished products

 

 

 

 

 

 

                                                                                                                                                                             

EXERCISE 2–1 Classifying Manufacturing Costs [LO1] Your Boat, Inc., assembles custom sailboats from components supplied by various manufacturers. The company is very small and its assembly shop and retail sales store are housed in a Gig Harbor, Washington, boathouse. Some of the costs that are incurred at the company are listed below. Required: For each cost, indicate whether it would most likely be classified as direct labor, direct materials, manufacturing overhead, selling, or administrative cost. 1. The wages of employees who build the sailboats. 2. The cost of advertising in the local newspapers. 3. The cost of an aluminum mast installed in a sailboat. 4. The wages of the assembly shop’s supervisor. 5. Rent on the boathouse. 6. The wages of the company’s bookkeeper. 7. Sales commissions paid to the company’s salespeople. 8. Depreciation on power tools

Here is the classification of each cost:

1. The wages of employees who build the sailboats → Direct Labor
2. The cost of advertising in the local newspapers → Selling Cost
3. The cost of an aluminum mast installed in a sailboat → Direct Materials
4. The wages of the assembly shop’s supervisor → Manufacturing Overhead
5. Rent on the boathouse → Manufacturing Overhead (if used for production); Administrative Cost (if used for general operations)
6. The wages of the company’s bookkeeper → Administrative Cost
7. Sales commissions paid to the company’s salespeople → Selling Cost
8. Depreciation on power tools → Manufacturing Overhead