Manufacturing and Nonmanufacturing Costs

8/7/2019 Manufacturing and Nonmanufacturing Costs

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Manufacturing andNonmanufacturing Costs

Manufacturing (direct materials, direct labor, factory overhead) and non-manufacturing 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) overhead2.1. 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.

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Direct materials always have a variable nature. Recall from other lectures that variable costs change in

proportion to production. For instance, in our example of Friends Corporation, the company purchases metal

parts (raw material) to produce valves. The more valves are produced, the more parts Friends Corporation has

to acquire. Therefore, parts have a variable nature; the amount of raw materials bought and used changes in

direct proportion to amount of valves created. For Friends Corporation, 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 Direct Materials

Publishing company Paper, ink, book covers, etc

Automobile manufacturer Tires, automobile metal parts, etc.

Computer manufacturer Hard drives, monitors, etc.

From the table you can see that direct materials are the integral part and a significant portion of finished goods.

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 cost

of their remuneration and benefits represents direct labor.

Direct laboris 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 Corporation. 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 production

of the finished good.

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 levels. 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

Depreciation

Property taxes

Property insurance

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Variable Factory Overhead

Examples

Fixed Factory Overhead

Examples

Indirect Materials

Indirect Labor

Salaries for non-productionemployees

Most items in the above table are self-explanatory, so they don't require further explanation, while indirectmaterials 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 Corporation 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 Indirect Materials

Publishing company Glue, printing press lubricants, etc

Automobile

manufacturer

Factory light bulbs, drill bits etc.

Computer manufacturer Assembly line lubricants, screwdrivers,

polishers, etc.

As you can see form the table, indirect materials are an insignificant portion or not an integral part of the

finished goods.

Indirect laboris 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 intofinished goods.

Illustration below shows 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

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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 firms, 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 balance sheet (expensed) and matched with sales revenue. As

product costs are assigned to inventory accounts, 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 (usually monthly) 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 Illustration below for examples of period

costs.

Illustration 6: Examples of period costs (selling and administrative expenses)

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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 Corporation 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 Corporation records the following

journal entries for these costs:

Account Titles Debit Credit

Marketing Expense 500

Accounts Payable 500


Sales Personnel Salaries 1,200Office Salaries 1,800

Salaries Payable 3,000


Office Depreciation Expense 1,400

Accumulated Depreciation 1,400

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 flow from the beginning to

the end of the manufacturing process.4. Inventories in 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 Corporation 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 maynot be 100% correct; however, for the purpose of our lecture it should be fine.)

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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, orfinished goods. The below

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 Corporation 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 Corporation 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 Corporation 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:


Raw Materials Inventory 9,500

Accounts Payable 9.500The Raw Materials Inventory T-account includes the following information (also refer to the below illustration

with the T-account):

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Amount of raw materials available at the beginning of an accounting period (i.e. beginning balance as a debitbecause 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 endingbalance 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 Corporation 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 following journal entry is posted:

2) Use of direct raw materials in production:


Work-in-Process Inventory 5,000

Raw Materials Inventory 5,000In addition, assume that Friends Corporation used $100 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:


Factory Overhead 100

Raw Materials Inventory 100Let's see how the above amounts are reflected in the Raw Materials Inventory T-account. In our example, on

March 1, 20X9 Friends Corporation 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 Corporation raw materials inventory T-account

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As we can see from the T-account above, Friends Corporation debited $9,500 for materials purchased (i.e. cost

added) and credited $5,100 for materials used (i.e. cost transferred out (debited) to the Work-in-Process

Inventory account).

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 ofproduction 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 Corporation 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 drilling station, but not assembly or painting station, or some raw

materials that have gone through drilling station and assembly, but not 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

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To record these costs, Friends Corporation makes the following entries:

4) Use of equipment in production (depr.):



Accumulated Depreciation 6005) Use of factory utilities in production:



Cash 400

As we noted earlier, the balance in the Factory Overhead account is transferred to the Work-in-Process

Inventory account at period end. Thus, at the end of March, Friends Corporation transfers the balance from the

Factory Overhead account to the Work-in-Process Inventory account. The accumulated overhead and journal

entry are presented below (also refer to the illustration of the T-account):

Entry # Factory Overhead Description Amount

(3) Bulbs (indirect materials) 100

(4) Use of equipment (depreciation) 600

(5) Factory utilities 400

Total $1,1006) Transfer factory overhead to work-in-process:



Factory Overhead 1,100Illustration 11: Friends Corporation factory overhead T-account

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

After we have seen 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:

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Amount of work-in-process inventory available at the beginning of an accounting period (i.e. beginning balanceas a debit because inventory is an asset account). The balance represents manufacturing costs for unfinishedproduction at the beginning of the period.

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

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

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

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

Let us continue with our example of Friends Corporation. Some transactions that have already taken place and

a new transaction for direct labor are summarized below.

Friends Corporation 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 (entry

from the Raw Materials topic repeated here for convenience):

2) Use of direct raw materials in production:



Raw Materials Inventory 5,000Factory overhead costs in amount of $1,100 were transferred to the Work-in-Process Inventory account during

March 20X9 (entry from the Factory Overhead topic repeated here for convenience):

6) Transfer overhead to work-in-process:



Factory Overhead 1,100In addition, let's assume that during March Friends Corporation also incurred $2,000 on account for direct labor

costs, which is recorded as follows:

7) Use of direct labor in production:

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Wages Payable 2,000The above entries 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 in the Finished Goods Inventory account shows the cost of goods ready

to be sold.

For example, during March Friends Corporation finished producing valves with the manufacturing cost of $8,600

and posted the following the journal entry:

8) Transfer finished goods from work-in-process:


Finished Goods Inventory 8,600

Work-in-Process Inventory 8,600The 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 Corporation 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 illustration below):

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Costs of finished goods inventory available at the beginning of an accounting period (i.e. beginning balance asa debit because inventory is an asset account). The balance represents finished goods available for sale at thebeginning of the period.

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

Cost of goods sold (COGS) during the period (credit side).

Costs of finished goods available at the end of the account period.Illustration 14: Finished goods inventory T-account

In our example, Friends Corporation will classify completed valves ready to be sold as finished goods. As we

stated earlier, at the end of March 20X9 Friends Corporation finished manufacturing valves that cost $8,600,

and the journal entry to record that was as follows (entry from the Work-in-Process topic repeated here for

convenience):

8) Transfer finished goods from work-in-process:

Account Titles Debit CreditFinished Goods Inventory 8,600

Work-in-Process Inventory 8,600To continue our example, let's assume that during March 20X9 Friends Corporation 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 illustration under the journal

entry):

9) Record cost of goods sold:


Cost of Goods Sold (COGS) 7,900Finished Goods Inventory 7,900

Let's look at the Finished Goods Inventory T-account. Assume that at the beginning of March Friends

Corporation had a balance of $6,000 in this account.

Illustration 15: Friends Corporation finished goods inventory T-account

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From other lectures, we recall that when finished goods are sold, two entries are posted: One to record the cost

of goods sold and the other to record the sales revenue. The COGS entry is shown above (entry # 9). The sale

revenue journal entry is presented below:

10) Record sales revenue:


Accounts Receivable 15,000

Sales Revenue 15,000Note that COGS decreases (credits) the Finished Goods Inventory account. COGS is recorded in the income

statement after 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 lecture.4.7. Cost accounting cycle with T-accounts (summary of how costs flow)

The below illustration shows the full cost accounting cycle (from raw materials to finished goods) for Friends

Corporation during March 20X9. For simplicity, T-accounts only show activity for the month and don't showbeginning and ending account balances.

Illustration 16: Cost flow from raw materials to work-in-process to finished goods

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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 below illustrations 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 FGInventory

(+) Cost of Goods Manufactured

() Ending Balance of FG Inventory

(=) Cost of Goods Sold

Manufacturing companies have to 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 Corporation for the month of March 20X9:

Illustration 19: Schedule of cost of goods manufactured for Friends Corporation

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Friends Corporation

Statement of Cost of Goods Manufactured

For the Month Ended March 31, 2009

Direct Materials Beginning Inventory $ 0 Purchases 9,000

Direct Materials Available 9,000 Ending Direct Materials Inventory (4,000) Direct Materials Used 5,000Direct Labor 2,000Factory Overhead 1,100Total Manufacturing Cost 8,100Add: Beginning Work-in-Process Inventory 5,000Total Manufacturing Cost to Account for 13,100Less: Ending Work-in-Process Inventory 4,500Cost of Goods Manufactured $ 8,600A few notes in relation to the above table are presented below:

Direct material purchases included $2,000 of paint and $7,000 of plastic and metal parts.

Friends Corporation also purchased some light bulbs. The $500 of light bulbs purchased was included in theRaw Materials Inventory account, but since the bulbs are not direct materials, they were not recorded as part ofthe direct materials cost. Later, Friends Corporation 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 Corporation could use a slightly different format as well, refer to the below illustration:

Illustration 20: Schedule of cost of goods manufactured for Friends Corporation

Friends Corporation



Beginning Working-in-Process Inventory $ 5,000Direct Materials Beginning Inventory 0 Purchases 9,000 Direct Materials Available 9,000 Ending Direct Materials Inventory (4,000) Direct Materials Used 5,000 Direct Labor 2,000 Factory Overhead Indirect Materials 100 Depreciation of factory equipment 400

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Friends Corporation



Factory Utilities 600 Total Factory Overhead 1,100 Total Manufacturing Costs

8,100

Total Cost of Work-in-Process 13,100Less: Ending Work-in-Process Inventory (4,500)Cost of Goods Manufactured 8,600Note that the resulting cost of goods manufacturing does not change between the two formats. The only

difference is the order of accounts presentation.

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 cost of goods manufactured), Friends

Corporation prepared the below income statement:

Illustration 21: Income statement for Friends Corporation

Friends Corporation

Income Statement


Sales $15,000Cost of Goods Sold Beginning Finished Goods Inventory 6,000 Cost of Goods Manufactured 8,600 Cost of Goods Available for Sale 14,600 Ending Finished Goods Inventory (6,700) 7,900

Gross Margin 7,100Selling and Administrative Expenses 4,900Operating Income 2,200Note 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.

UnlimitedShoesInc Company's books show the following information for December 20X9:

Account Dec 1 Dec 31

Raw Materials Inventory $ 500 $ 1,100

Work-in-Process Inventory $ 630 $ 420

Finished Goods Inventory $ 170 $ 860

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Additional information about UlimitedShoesInc Company for the same period is presented below:

1 Direct raw materials purchased $ 6,700

2 Indirect raw materials purchased 400

3 Direct labor costs incurred 4,300

4 Factory depreciation recognized 1,400

5 Office building depreciation recognized 7506 Factory utilities recognized (paid in cash) 2,400

7 Office building utilities recognized 300

8 Indirect materials used in production 500Top of Form

What was the cost of direct materials transferred to the Work-in-Process Inventoryaccount?

a)$6,700

b)$7,100

c)

$600

d)

$6,000Bottom of Form

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