Manufacturing and Nonmanufacturing Costs

Manufacturing (direct materials, direct labor, factory overhead) and Nonmanufacturing costs; product and period costs; raw materials, work-in-process and finished goods; cost of goods manufactured and cost of goods sold; cost accounting cycle.

1. Introduction to manufacturing and nonmanufacturing costs

A manufacturing company incurs both manufacturing costs (also called product costs) and nonmanufacturing costs or expenses (also called selling and administrative expenses). In the illustration below you can see the difference between manufacturing and nonmanufacturing costs and their classification: Illustration 1: Manufacturing vs. nonmanufacturing costs

Let us review these types of manufacturing and nonmanufacturing costs in more detail. 2. Manufacturing costs and their classification Manufacturing costs are the costs that a company incurs in producing a product. From the managerial accounting standpoint, there are three types of manufacturing costs: 1. Direct materials 2. Direct labor 3. Factory (or manufacturing) overhead 2.1. Direct materials as a type of manufacturing costs Direct materials are raw materials that become an integral part of the finished goods. Direct materials should be distinguished from indirect materials (part of overhead costs), about which we will talk later. Direct materials always have a variable nature. Recall from other tutorials that variable costs change in proportion to production. For instance, in our example of Friends Company, the company purchases metal parts (raw material) to produce valves. The more valves are produced, the more parts Friends Company has to acquire. Therefore, parts have a variable nature; the amount of raw materials bought and used changes in direct proportion to the amount of valves created. For Friends Company, other direct materials would include, for example, plastic parts and paint. Different manufacturing companies will have different direct material costs depending on the types of finished goods they produce. The table below provides a few examples: Illustration 2: Examples of direct material costs

Examples Publishing company

Direct Materials Paper, ink, book covers

Automobile manufacturer Tires, automobile metal parts Computer manufacturer Hard drives, monitors From the table you can see that direct materials are the integral part and a significant portion of finished goods. 2.2. Direct labor as a type of manufacturing costs Almost any production plant or factory requires employees to operate equipment, move raw materials from the warehouse to equipment, and so on. These employees are directly involved in the production process and the cost of their remuneration and benefits represents direct labor: Direct labor is the cost of wages to be paid to individuals who work on specific products or in other words, the cost of wages of employees who are directly involved in converting raw materials into finished goods. Usually direct labor is a variable cost. In most situations the amount of direct labor required is directly correlated with the amount of finished goods produced. For example, wages and related benefits of employees who operate machinery to produce valves represent direct labor costs for Friends Company. The more valves are to be produced, the more employees will be required to operate machinery, paint, assemble, etc. Direct materials and direct labor, when added together, represent the prime cost. Direct materials and direct labor are called prime costs because they are directly (physically, "primarily") associated with the finished goods production.

2.3. Factory overhead as a type of manufacturing costs Factory overhead is any manufacturing cost that is not direct materials or direct labor. Factory overhead can have variable or fixed nature, depending on whether overhead changes in direct proportion with production volumes. The following are some examples of factory overhead costs: Illustration 3: Examples of fixed and variable factory overhead costs

Variable Factory Overhead Examples

Fixed Factory Overhead Examples

Electricity Heating Water Indirect Materials Indirect Labor

Depreciation Property taxes Property insurance Salaries for nonproduction employees

Most items in the table above are self-explanatory, so they don't require further explanation, while indirect materials and labor may benefit from further explication. Indirect materials are materials that are (a) not an integral (physical) part of the finished goods, or (b) a minor part of the finished goods to be economically traced to the finished good or have a very small physical association with the finished product. For example, Friends Company would treat the following costs as indirect materials: oil lubricants and light bulbs used in manufacturing equipment, package boxes, wrenches, etc. Other companies will have different types of indirect materials depending on their manufacturing processes. The table below provides a few examples:

Illustration 4: Examples of indirect materials cost (overhead cost)

Examples Publishing company

Indirect Materials Glue, printing press lubricants

Automobile manufacturer Factory light bulbs, drill bits Computer manufacturer Assembly line lubricants, screwdrivers, polishers As you can see form the table, indirect materials are an insignificant portion or not an integral part of the finished goods. Indirect labor is the cost of production employees who are involved in the manufacturing process, but do not work on a specific product. For example, wages of custodians, maintenance people, supplies room supervisors, etc. are considered indirect labor. Direct labor and factory overhead, when added together, represent the conversion cost. Direct labor and factory overhead are called conversion costs because they are involved in converting raw materials into finished goods. The illustration below shows the relationship between direct materials, direct labor, overhead, prime cost, and conversion cost: Illustration 5: Relationship between direct materials, direct labor, overhead, prime cost, and conversion cost

3. Prod 3. Product (manufacturing) costs and period (nonmanufacturing) costs 3. Product (manufacturing) costs and period (nonmanufacturing) costs
Product costs are the manufacturing costs that are considered to be a cost of a product. For manufacturing companies, product costs are only costs that are necessary to produce a finished product. As discussed earlier in the tutorial, product costs (i.e. manufacturing costs) consist of direct materials, direct labor, and factory overhead. Product costs are assigned to an inventory account on the balance sheet, initially. When finished goods are sold, the cost of goods sold is transferred to the income statement (expensed) and matched with the sales revenue. As product costs are assigned to inventory accounts initially, sometimes they are called inventoriable costs. Important to note, that product costs are not always expensed in the period they are incurred. They are rather expensed in the period when finished goods are sold: that is, the cost of goods sold expense is matched with the sales revenue. For instance, if in a company produced 50,000 units costing $10,000 in May 20X9, and in June 20X9 the company sold the aforementioned 50,000 units, the company would record the expense (i.e. cost of goods sold) of $10,000 in June 20X9, not in May 20X9.

Period costs (also called nonmanufacturing costs) are costs necessary to maintain business operations but are not a necessary or integral part of the manufacturing process. They are matched with the revenues of a specific time period rather than included in the cost of the goods sold. The most common example of period costs is selling and administrative expenses (S&A). S&A expenses are deducted from revenues in the period in which they are incurred. See the illustration below for examples of period costs: Illustration 6: Examples of period costs (selling and administrative expenses)

We will review accounting for manufacturing costs later in greater detail. Accounting for nonmanufacturing costs is described here. Let's assume that in March 20X9 Friends Company incurred on account $500 of marketing expense, $1,200 of sales salaries, $1,800 of office salaries, and $1,400 of office building depreciation expenses. After adding up these costs the total period cost is $ 4,900. Friends Company records the following journal entries for these costs in March 20X9: Account Titles Marketing Expense Accounts Payable Debit 500 500 Credit

Account Titles Sales Personnel Salaries Office Salaries Salaries Payable

Debit 1,200 1,800

Credit

3,000

Account Titles Office Depreciation Expense Accumulated Depreciation

Debit 1,400

Credit 1,400

All these expenses are recorded in the period they were incurred.

4. Inventories in manufacturing process

Overall, so far we have covered different types of product (manufacturing) and period (nonmanufacturing) costs. Now, we will look in more detail how product costs are recorded by a company and how they flow from the beginning to the end of the manufacturing process. Let us begin by remembering the definition of inventory for manufacturing companies: Inventory in a manufacturing company is items purchased (or created) by a company for (a) production of other parts (raw materials or work-in-process) or (b) selling to customers (finished goods). In our example of Friends Company what will be inventory? Items such as plastic parts, metal parts and paint can be examples of manufacturing inventory. (For people with technical background, we guessed what parts go into production of a valve. The guess may not be 100% correct; however, for the purpose of our tutorial it should be fine.)

4.1. Inventories at different manufacturing stages

When a company manufactures a product, inventories go through the manufacturing process. The manufacturing process has different stages. Depending on where inventory is (at what manufacturing stage) at a point in time, it can be classified as raw materials, work-in-process, or finished goods. The following illustration shows the sequence of inventory classification at different manufacturing stages: Illustration 7: Inventory at different manufacturing stages

4.2. Raw materials inventory, T-accounts and related accounting

Raw materials inventory represents items that the manufacturer has purchased or produced to use in manufacturing a product. The cost of all raw materials at any point in time comprises raw materials inventory. Raw materials can be classified as direct or indirect materials. As we have discussed earlier, direct materials are raw materials that can be physically and directly associated with the finished product. For example, Friends Company will classify plastic parts, paint, and metal parts as direct materials because those can be directly associated with a valve (or batch of valves) produced.

Indirect materials do not physically become part of the final product or their association with the final product is too small to be easily traced to the final product. For example, Friends Company will classify janitorial supplies for the factory, grease for the machinery, and light bulbs as indirect materials because they do not physically become part of the final product. When materials (both direct and indirect) are purchased, they are recorded in the Raw Materials Inventory account. For example, during March 20X9 Friends Company purchased $2,000 of paint, $7,000 of plastic and metal parts, and $500 of light bulbs on account ($2,000 + $ 7,000 + $500 = $9,500). The journal entry to record the purchase is as follows: 1) Purchase of raw materials: Account Titles Raw Materials Inventory Accounts Payable Debit 9,500 9,500 Credit

The Raw Materials Inventory T-account includes the following information (also refer to the T-account illustration presented below): Amount of raw materials available at the beginning of an accounting period (i.e., beginning balance as a debit because inventory is an asset account).

Cost of materials purchased during the accounting period (debit side). Cost of materials used in the manufacturing process (credit side).

Available (not used) raw materials at the end of the accounting period (ending balance as a debit). The ending balance in this accounting period becomes the beginning balance in the following accounting period. Illustration 8: Raw materials inventory T-account

When a manufacturing company uses raw materials in the production process, the Raw Material Inventory account is credited (decreased) and the Work-in-Process Inventory account is debited (increased). Therefore, raw materials used in production (both direct and indirect) are the cost transferred out of the Raw Materials Inventory account and the cost added to the Work-in-Process Inventory account. Going back to our Friends Company example, assume that in March 20X9 the company used $1,000 of paint and $4,000 of plastic and metal parts for a total of $5,000. The journal entry to record this inventory consumption is posted as follows: 2) Use of direct raw materials in production: Account Titles Work-in-Process Inventory Raw Materials Inventory Debit 5,000 5,000 Credit

In addition, assume that Friends Company used $100 worth of light bulbs (indirect materials or overhead) during the same period. The journal entry to record their use is presented below: 3) Use of indirect raw materials in production: Account Titles Factory Overhead Raw Materials Inventory Debit 100 100 Credit

Let's see how the amounts above are reflected in the Raw Materials Inventory T-account. In our example, on March 1, 20X9 Friends Company had the beginning balance (BB) in the Raw Materials Inventory account of zero ($0). The raw materials purchased and raw materials used are recorded in the T-account format as follows: Illustration 9: Friends Company raw materials inventory T-account

As we can see from the T-account above, Friends Company debited $9,500 for materials purchased (i.e., the cost added) and credited $5,100 for materials used (i.e., the cost transferred out (debited) to the Work-in-Process Inventory account). The ending balance in the account is $4,400.

4.3. Introduction to work-in-process inventory

Raw materials are used in manufacturing finished goods. The conversion of raw materials into a final product is not usually immediate and at a point in time, some raw materials inventory is being used at different stages of production: Started but not finished production is called work-in-process inventory. Work-in-process normally includes not only raw material costs, but also other related costs, such as costs of production employee wages, electricity, water and others that can be attributed to the production process. Therefore, work-in-process inventory includes the following costs:

Direct materials

Direct labor Factory overhead

For example, Friends Company will have work-in-process because the valve manufacturing process takes some time (raw materials are not converted into finished goods immediately). If there are three production stages (e.g. drilling holes, attaching plastic seals, and applying paint), then at a point in time, there will be some raw materials that have gone through the drilling station, but not the assembly or painting stations, and some raw materials that have gone through the drilling station and assembly, but not the painting station. Because all of the mentioned raw materials are in production already, but have not gone through all manufacturing processes, they represent work-in-process inventory. Direct materials and direct labor are recorded in the Work-in-Process Inventory account directly, while factory overhead is initially recorded in the Factory Overhead account and then transferred to the Work-in-Process Inventory account at the end of the period. Let us review the Factory Overhead account and then we will return to the Work-in-Process Inventory account.

4.4. Factory overhead, T-account and related accounting

The Factory Overhead account includes the following information (also refer to the Taccount illustration presented below):

Zero beginning balance.

Overhead costs debited (incurred) to the account during the accounting period (debit side). Overhead costs transferred (applied, credited) to the Work-in-Process Inventory account (credit side) during the accounting period. Zero ending balance (*).

(*) Note: The Factory Overhead account may have a balance other than zero after overhead costs are applied to the Work-in-Process Inventory account during the period. This may happen when actual overhead costs incurred are different from the overhead costs applied to the Work-in-Process Inventory account. However, the calculation of overhead application rate and determining how to treat the balance in the account after period end is beyond the scope of this tutorial. For this illustration, we assumed that the

entire balance in the Factory Overhead account is transferred to the Work-in-Process account and the ending account balance is zero. Illustration 10: Factory overhead T-account

From the illustration above we can see that the incurred overhead costs are recorded on the debit side with credits to various other accounts, such as:

Raw Materials Inventory (for indirect materials) Accounts Payable (for various overhead costs incurred on account) Cash (for various overhead costs paid with cash)

Accumulated Depreciation (for depreciation expense related to production fixed assets) Let's see how the Factory Overhead account looks like for Friends Company. The company used $100 of light bulbs during March 20X9. The bulbs represent indirect materials (i.e., factory overhead) and their use is recorded as follows (the entry for the Raw Materials is repeated here from an earlier discussion for convenience): 3) Use of indirect raw materials in production: Account Titles Factory Overhead Raw Materials Inventory Debit 100 100 Credit

To continue with the example, in March Friends Company recognized $400 of depreciation expense on factory equipment (overhead), and paid $600 in cash for factory utilities (overhead). To record these costs, Friends Company makes the following entries: 4) Use of equipment in production (depr.): Account Titles Factory Overhead Accumulated Depreciation 5) Use of factory utilities in production: Account Titles Factory Overhead Cash Debit 600 600 Credit Debit 400 400 Credit

As we noted earlier, the balance in the Factory Overhead account is transferred to the Work-in-Process Inventory account at the end of a period. Thus, at the end of March, Friends Company transfers the balance from the Factory Overhead account to the Work-inProcess Inventory account. The accumulated overhead and journal entry are presented below (also refer to the T-account illustration presented below): Entry Factory Overhead Description Amount # (3) (4) (5) Total Bulbs (indirect materials) Use of equipment (depreciation) Factory utilities 100 400 600 $1,100

6) Transfer factory overhead to work-in-process:

Account Titles Work-in-Process Inventory Factory Overhead

Debit 1,100

Credit 1,100

Illustration 11: Friends Company factory overhead T-account

4.5. Work-in-process inventory, T-accounts and related accounting

After we have seen the T-account and related accounting for factory overhead, let's look at the Work-in-Process Inventory account. The Work-in-Process Inventory account includes the following information: Amount of work-in-process inventory available at the beginning of an accounting period (i.e., beginning balance as a debit because inventory is an asset account). The balance represents manufacturing costs of unfinished production at the beginning of the period.

Manufacturing costs transferred to the account during the accounting period (debit side). The costs include direct materials, direct labor, and factory overhead. Such costs are for items added to the production process during the period.

Manufacturing costs transferred to the Finished Goods Inventory account (credit side). Such costs represent goods which were finished during the period and which became ready for sale.

Amount of work-in-process inventory available at the end of the account period. The balance represents manufacturing costs of unfinished production at the end of the period. This balance becomes the beginning balance for the following accounting period.

Illustration 12: Work-in-process inventory T-account

Let us continue with our example of Friends Company. Some transactions that have already taken place and a new transaction for direct labor are summarized below. Friends Company used $1,000 of paint and $4,000 of plastic and metal parts in the production. The journal entry to record the transfer of this $5,000 from direct raw materials to work-in-process was as follows (the entry for the Raw Materials is repeated here from an earlier discussion for convenience): 2) Use of direct raw materials in production: Account Titles Work-in-Process Inventory Raw Materials Inventory Debit 5,000 5,000 Credit

Factory overhead costs in amount of $1,100 were transferred to the Work-in-Process Inventory account during March 20X9 (the entry for the Factory Overhead is repeated here from an earlier discussion for convenience):

6) Transfer overhead to work-in-process:

Account Titles Work-in-Process Inventory Factory Overhead

Debit 1,100

Credit 1,100

In addition, let's assume that during March 20X9 Friends Company also incurred $2,000 on account for direct labor costs, which is recorded as follows: 7) Use of direct labor in production: Account Titles Work-in-Process Inventory Wages Payable Debit 2,000 2,000 Credit

The entries above show the added cost to the Work-in-Process Inventory account. Once the products are finished and transferred out to the Finished Goods Inventory account, the Work-in-Process Inventory account is credited (decreased) and the Finished Goods Inventory account is debited (increased). The credit to the Work-in-Process Inventory account represents the cost of the goods manufactured (COGM), while the debit to the Finished Goods Inventory account shows the cost of goods ready to be sold. For example, during March 20X9 Friends Company finished producing valves with the manufacturing cost of $8,600 and posted the following the journal entry to transfer these costs to the Finished Goods Inventory account: 8) Transfer finished goods from work-in-process: Account Titles Finished Goods Inventory Work-in-Process Inventory Debit 8,600 8,600 Credit

The summary of the Work-in-Process Inventory T-account activity for March 20X9 looks as follows. Assume that the beginning balance was $5,000: Illustration 13: Friends Company work-in-process inventory T-account

4.6. Finished goods inventory, T-accounts and related accounting

After raw materials have gone through the entire production process, they become finished goods: Finished goods are completed manufactured items that a company has produced for sale to customers. The Finished Goods Inventory account shows the following information (also refer to the Taccount illustration below): Cost of finished goods inventory available at the beginning of an accounting period (i.e. beginning balance as a debit because inventory is an asset account). The balance represents finished goods available for sale at the beginning of the period.

Cost of goods manufactured (COGM) that were transferred from work-inprocess inventory to finished goods during the accounting period (debit side).

Cost of goods sold (COGS) during the period (credit side). Cost of finished goods available at the end of the account period.

Illustration 14: Finished goods inventory T-account

In our example, Friends Company will classify completed valves ready to be sold as finished goods. As we stated earlier, at the end of March 20X9 Friends Company finished manufacturing valves that cost $8,600, and the journal entry to record that was as follows (the entry for the Work-in-Process is repeated here from an earlier discussion for convenience): 8) Transfer finished goods from work-in-process: Account Titles Finished Goods Inventory Work-in-Process Inventory Debit 8,600 8,600 Credit

To continue our example, let's assume that during March 20X9 Friends Company sold on account valves costing $7,900, and the sales price was $15,000. The $7,900 represents the Cost of Goods Sold (COGS). The journal entry to record the cost of goods sold is presented below (also refer to the T-account illustration below): 9) Record cost of goods sold: Account Titles Cost of Goods Sold (COGS) Finished Goods Inventory Debit 7,900 7,900 Credit

Let's look at the Finished Goods Inventory T-account. Assume that at the beginning of March Friends Company had a balance of $6,000 in this account: Illustration 15: Friends Company finished goods inventory T-account

From other tutorials, we can recall that two entries are posted when finished goods are sold:

One to record the cost of goods sold The other one to record the sales revenue

The COGS entry is shown above (entry # 9). The sales revenue journal entry is presented below: 10) Record sales revenue: Account Titles Accounts Receivable Sales Revenue Debit 15,000 15,000 Credit

Note that COGS decreases (credits) the Finished Goods Inventory account. COGS is recorded in the income statement below the Sales Revenue line; it is subtracted from Sales Revenue to calculate Gross Margin. We will discuss the income statement of a manufacturing company in more detail later in this tutorial.

4.7. Cost accounting cycle with T-accounts (summary of how costs flow)
The following illustration shows the full cost accounting cycle (from raw materials to finished goods) for Friends Company during March 20X9. For simplicity, T-accounts only show activity for the month and don't show beginning and ending account balances. Illustration 16: Cost flow from raw materials to work-in-process to finished goods

4.8. Cost of goods manufactured and cost of goods sold

As we noted earlier, when finished goods are sold, their cost is called the cost of goods sold (COGS). The cost of goods sold is based on the cost of goods manufactured (COGM). Refer to the illustrations below showing how COGS and COGM are determined:

Illustration 17: Formula for cost of goods manufactured (COGM) (+) Beginning Balance of WIP Inventory (+) Direct Materials (+) Direct Labor (+) Factory Overhead () Ending Balance of WIP Inventory (=) Cost of Goods Manufactured

Illustration 18: Formula for cost of goods sold (COGS) (+) Beginning Balance of FG Inventory (+) Cost of Goods Manufactured () Ending Balance of FG Inventory (=) Cost of Goods Sold Manufacturing companies normally prepare the schedule of costs of goods manufactured before they prepare the income statement. Using the same data as in the previous sections, let's prepare the schedule of cost of goods manufactured for Friends Company for March 20X9: Illustration 19: Schedule of cost of goods manufactured for Friends Company Friends Company Statement of Cost of Goods Manufactured For the Month Ended March 31, 2009 Direct Materials Beginning Inventory Purchases Direct Materials Available Ending Direct Materials Inventory Direct Materials Used $0 9,000 9,000 (4,000) 5,000

Friends Company Statement of Cost of Goods Manufactured For the Month Ended March 31, 2009 Direct Labor Factory Overhead Total Manufacturing Cost Add: Beginning Work-in-Process Inventory Total Manufacturing Cost to Account For Less: Ending Work-in-Process Inventory Cost of Goods Manufactured A few notes in relation to the table are presented below: Direct material purchases included $2,000 of paint and $7,000 of plastic and metal parts.

2,000 1,100 8,100 5,000 13,100 4,500 $ 8,600

Friends Company also purchased some light bulbs. The $500 of light bulbs purchased was included in the Raw Materials Inventory account, but since the bulbs are not direct materials, they were not recorded as part of the direct materials cost. Later, Friends Company used $100 of light bulbs in the manufacturing process, and this cost was recorded as part of the Factory Overhead cost. Factory Overhead of $1,100 = $100 (light bulbs) + $400 (depreciation of factory equipment) + $600 (factory utilities).

Friends Company could use a slightly different format of the schedule as well, refer to the illustration below: Illustration 20: Schedule of cost of goods manufactured for Friends Company Friends Company Statement of Cost of Goods Manufactured For the Month Ended March 31, 2009 Beginning Working-in-Process Inventory Direct Materials Beginning Inventory Purchases 0 9,000 $ 5,000

Friends Company Statement of Cost of Goods Manufactured For the Month Ended March 31, 2009 Direct Materials Available Ending Direct Materials Inventory Direct Materials Used Direct Labor Factory Overhead Indirect Materials Depreciation of factory equipment Factory Utilities Total Factory Overhead Total Manufacturing Costs Total Cost of Work-in-Process Less: Ending Work-in-Process Inventory Cost of Goods Manufactured 100 400 600 1,100 8,100 13,100 (4,500) 8,600 9,000 (4,000) 5,000 2,000

Note that the resulting cost of goods manufactured does not change between the two formats. The only difference is the order of accounts presentation. The Raw Materials, Work-in-Process, and Finished Goods Inventory accounts are real accounts. That is, they are not temporary accounts and are not closed to Retain Earnings at the end of the accounting period. These inventory accounts are reported in the assets section of the balance sheet.

4.9. Income statement for manufacturing companies

Using information from the previous sections (including the schedules for the cost of goods manufactured), Friends Company prepared the following income statement:

Illustration 21: Income statement for Friends Company

Friends Company Income Statement For the Month Ended March 31, 2009 Sales Cost of Goods Sold Beginning Finished Goods Inventory Cost of Goods Manufactured Cost of Goods Available for Sale Ending Finished Goods Inventory Gross Margin Selling and Administrative Expenses Operating Income 6,000 8,600 14,600 (6,700) 7,900 7,100 4,900 2,200 $15,000

For the finished goods amounts refer to the section where we talked about the finished goods. For the selling and administrative expenses refer to the section where we discussed the selling and administrative expenses (i.e., nonmanufacturing or period costs). Note that the COGS account is a nominal account. That is, it is a temporary account that is closed to Retained Earnings at the end of the accounting period. The same is true for other income statement accounts.