Chapter One

Overview of Cost and Management Accounting

Chapter Synopsis

Cost and Management Accounting I shows the importance of cost accounting data in
making managerial decisions. Unlike the remainder of the course, this chapter has no
“number crunching.” Its main purpose is to emphasize the management accountant’s role
in providing information for managers
Distinction is made between financial accounting and managerial accounting. Financial
accounting information is reported to external users, following prescribed standards and
formats, and used by investors, lenders, suppliers, and other external stakeholders to
evaluate and compare companies. In contrast, managerial accountants provide financial
and non-financial information to internal users using whatever format or costing
approach will allow managers to make the best possible business decisions in today’s
competitive environment. Cost accounting provides information for both financial
accounting and management accounting.
Successful management accounting systems capture and report information that helps
managers make decisions to fulfill organizational goals in an effective and efficient
manner. Management accounting also provides information critical to the planning and
control decisions of managers. Guidelines used by management accountants to assist
managers in the planning and control process include the cost-benefit approach, giving
full recognition to both behavioral and technical considerations, and using different costs
for different purposes.
Three common roles of the management accountant are problem solving, scorekeeping,
and attention directing. Different decisions place different emphases on the three roles,
and it can be difficult to distinguish the roles because management accountants are often
engaged in overlapping activities. In addition to their traditional costing and reporting
roles, management accountants are also playing an increasingly important role in helping 2
to develop and implement strategy.
INTRODUCTION

 As a financial information system, Accounting is defined as a process of identifying,

measuring and communicating economic information to permit informed judgments
and decisions by users of the information

 Accounting as a language of business can be viewed as an information system that

provides essential information about economic activities of an entity to various
individuals and groups.
  Accounting as information system plays an important role in our economic and social
system. The decisions made by individuals, governments, and other entities determine
the use of the nation’s scarce resources.

 The goal (objective) of accounting is to: identify record, analyze, report, and interpret
(communicate) economic data for use by decision makers

Investors, Bankers, Labor

union, employees, Labor
Identification of users union, employees,
governmental agencies,
management, etc.

suppliers,
User’s information
needs

Reports User’s decisions

Economic Accounting (Outputs)
data System
(Input)

Financial reports
Special reports  Investing
Tax returns  Approving loans
 Assessing taxes
Regulatory reports
 Negotiating labor contracts
Management reports  Establishing budgets
 Other decisions
Exhibit 1.1. Accounting as an Information System

Management Accounting, Financial Accounting and Cost Accounting

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In a global marketing the contemporary economic environment, business organizations need
relevant and appropriate information system both quantitative and qualitative that helps to
survive and grow in a market. All business must have a management information system
which includes from simple information to a complex statistical, analytical and decision
support system. The management information system or the sub-component, management
accounting gives regular financial report to management at all levels regarding performance
measures in financial and non-financial performance criteria

All accounting systems are designed to provide information to decision makers. However, it
is convenient to classify accounting systems based on the primary user of the information.
Investors (or potential investors), creditors, government agencies, tax authorities, and so on
are outside the organization. Managers are inside the organization. The classification of
accounting systems into financial and cost (or managerial) systems captures this distinction
between decision makers.

Management Accounting can be defined as the process of identification, measurement,

accumulation, analysis, preparation, interpretation, and communication of financial as well as
non -financial information used by management to plan, evaluate, control within the
organization and to assure appropriate use and accountability for its resources. Management
accounting consists of accounting techniques and procedures of gathering and reporting
financial data in order to meet management’s information needs. The management
accountant is expected to provide timely, accurate information- including budgets, standard
cost, variance analysis, support day-to-day operating decisions, analyses of expenditures.

Management accounting measures and reports financial information as well as other types of
information that assist managers in fulfilling the goals of the organization. Management
accounting enables the organization to understand and identify weakness in terms of
efficiency and quality improvement of its products and services compared to the major
competitors and suggest cost effective measures to improve organizations flexibility and
innovative potential to meet competitive pressure. As well, it gives the organization the
capacity to grow with the minimum volatility in its profitability and performance. The
management accounting system is cost accounting systems is a cost control system as well
as a tool for planning and controlling operation and suggest solutions to improve
organizational efficiency and productivity of the organizational as a whole

Individual’s managers often require the information in an accounting system to be presented

and reported differently. Consider, for example, sales order information. A sales manager
may be interested in the total birr number of sales to determine the commission paid. A
distribution manager may be interested in sales order quantities by geographical regions and
by customers requested delivery dates to ensure timely delivery. This indicates that the
financial information required by different bodies is not the same.

Specifically, the following are the purposes of Management Accounting: 2

 Formulating over all strategies and long-range plans

 Resource allocation decisions such as a product and customer emphasis pricing
 Cost planning and cost control operations and activities
 Performance measurement and evaluation
Financial Accounting refers to accounting information developed for the use of external
parties such as stock holders, suppliers, banks, and government agencies. Financial
Accounting includes all the principles that regulate the accounting and reporting for financial
information that must be disclosed to people outside the company.
Management and financial accounting have different goals. Management accounting
measures, analyses, and reports financial and non-financial information that helps managers
makes decision to fulfill the goals of an organization. Managers use management accounting
information to choose, communicate, and implement strategies. They also use management
accounting information to coordinate product design, production, and marketing.
Management accounting focuses on internal reporting. Financial accounting focuses on
reporting to external parties such as, investors, government agencies, banks and supplier. It
measures and records business transaction and provides financial statement that are based on
International Financial Reporting Standard (IFRS). A Manager’s compensation can be
affected by the numbers in this financial statement. Consequently, managers are interested
in both management accounting and financial accounting.

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The following table summarizes the major differences between Management accounting and financial accounting

Exhibit 1.2 Major difference between Management and Financial Accounting (Fundamentals of Cost Accounting 3e,
William N. Lanen, Shannon W. Anderson, Michael W. Maher)

Area of Comparison Financial Accounting Management Accounting

Primary Users of Persons and Organization outside the Various levels of internal management
Information business entity
Purpose of the Communicate organization’s financial and Help Managers make decision to fulfill an organization goal
information operating information to investors, banks,
regulators and other outside parties
Type of Not Restricted to double entry system; any useful system can
Accounting Systems Double entry System be used
Restrictive guidelines Adherence to IFRS No formal guidelines or restrictions, only criteria is usefulness
Units of Measurement Historical (past) Monetary unit Any Useful monetary (historical and future) or physical
measure such as machine hours, labor hours, etc.
Focal point for analysis Business entity as a whole Various segments of the business entity
Report Summarized report; concerned primarily Detailed report; concerned about details of parts of the entity
with the entity as a whole products, department, territories
Frequency of Reporting Periodical on a regular basis Whenever needed; may not be on a regular basis
Degree of objectivity Demands objectivity; historical in nature Heavily subjective for planning purposes; but objective data
are used when relevant and future in nature.

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Function of the Management accounting

Management accountant provides a staff functions. He/she gives advice and assistance to line
managers. Management accountants contribute to the company’s decision about strategy,
planning, and control by scorekeeping, attention directing and problem solving.

1) Score keeping function: is a function of accumulating data and reporting reliable result
to all levels of the management describing how the organization is doing and how well it
is implementing its strategies. The collection, classification, and reporting of
scorekeeping information is the task that dominates day to day accounting. The following
are some of the scorekeeping functions an accountant will provide

 Recording sales, purchase and payroll data

 Preparing financial reports
 Preparing depreciation schedules

2) Attention directing question: is reporting and interpreting information that helps

managers to focus of operating problems, imperfections, inefficiency and opportunities.
This aspect of accounting helps managers to concentrate on the importance of operation
promptly enough for effective action. Attention directing is commonly associated with
current planning and control, and with the analysis and investigation of recurring routine
internal accounting reports. What opportunities and problems should managers focus on?
Making visible both opportunities and problems on which managers need to focus. For
example, the following are attention directing functions provided by an accountant.

 Highlighting rapidly growing market opportunity

 Variance analysis and interpretation
 Explaining performance report

3) Problem Solving Functions; the problem solving aspects of accounting quantifies the
likely results of possible courses of actions and often recommends the best course to
follow. Problem solving is commonly associated with non-recurring decision, situations
that requires special accounting analysis or report. Comparison and analysis to identify
the best alternative in relation to the organization objectives is a problem solving
function. The following are some of the decision are in which the management
accountant gives problem solving function.

 Make or buy decision

 Add or drop decision
 Sell at split off or process further

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Cost accounting is an accounting information system that records, measures and reports
information about cost. Every business operates with the objective of making profits for its
owners, which is revenue generated less cost of producing that revenue. Cost accounting
deals with accumulating cost of manufacturing a product and other functional processes and
identifying these costs with units produced or some other cost object to enable the
determination of profit. Cost accounting measures and reports financial and other information
related to the organization’s acquisition or consumption of resources. Cost accounting can be
applied in any type of organization but primarily applied in manufacturing organization that
combine and process raw material in to the finished product. Cost accounting includes those
parts of both management accounting and financial accounting in which cost information is
collected and analyzed.

You know that accounting information is vital for various decision-making purposes. Among
the information that management requires for decision making is cost information. Therefore,
cost data are usually available to users through an accounting system called cost accounting
system. Manages usually need summarized information. Therefore, the data should be
presented in the way the reader understand and uses them to make a decision. Accounting
information can be reported in different forms depending upon the needs of the users.

Both internal parties (managers) and external parties use accounting information but the ways
in which they use it differ. Therefore, the types of accounting information they demand may
also differ. In general accounting provides information for three major purposes.

Accounting systems are designed to process information from economic events into useful
information for managers and others. Accounting systems are designed to meet the needs of
those involved with routine internal reporting, non-routine internal reporting and external
reporting.

1. Routine Internal Reporting

Managers make daily decision regarding day to day operations of their organization. Such
organization requires accounting data. Accounting data provides the necessary information to
support these types of decisions. Such routine information is provided for decisions, the data
required in readily available in the records of the company.
2. Non-routine Internal Reporting
There are irregular decisions that require specific types of information. To support these
types of decisions, accountants will provide the necessary data generated through the
accounting system. Decisions that require such type of information are like adding or
deleting a product line, replacing a fixed asset, opening new sales outlets etc. you will discuss
such type of decisions in detail in the cost and management II of the next course

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 3. External Reporting
External reporting needs financial report. External users include investors, creditors,
customers, suppliers, the government and the public. The usual reports prepared by
accountants are Balance sheet, and income statements. The accounting system will generate
the necessary data to prepare these financial statements.
Each of the above major purposes of accounting information often requires a different way of
presenting and reporting the information in an accounting system. Accountants combine and
adjust the raw data to answer questions from particular internal or external users.

Cost Classification Concepts and Terms

In this section we have looked at some of the ways in which managers classify costs. How
the costs will be used—for preparing external reports, predicting cost behavior, assigning
costs to cost objects, or decision making—will dictate how the costs are classified.

For purposes of valuing inventories and determining expenses for the balance sheet and
income statement, costs are classified as either product costs or period costs. Product costs
are assigned to inventories and are considered assets until the products are sold. At the point
of sale, product costs become cost of goods sold on the income statement. In contrast, period
costs are taken directly to the income statement as expenses in the period in which they are
incurred.

In a merchandising company, product cost is whatever the company paid for its merchandise.
For external financial reports in a manufacturing company, product costs consist of all
manufacturing costs. In both kinds of companies, selling and administrative costs are
considered to be period costs and are expensed as incurred.

For purposes of predicting how costs will react to changes in activity, costs are classified into
two categories—variable and fixed. Variable costs, in total, are strictly proportional to
activity. The variable cost per unit is constant. Fixed costs, in total, remain at the same level
for changes in activity that occurs within the relevant range. The average fixed cost per unit
decreases as the number of units increases.

For purposes of assigning costs to cost objects such as products or departments, costs are
classified as direct or indirect. Direct costs can be conveniently traced to cost objects.
Indirect costs cannot be conveniently traced to cost objects.

For purposes of making decisions, the concepts of differential cost and revenue, opportunity
cost and sunk cost are vitally important. Differential costs and revenues are the costs and
revenues that differ between alternatives. Opportunity cost is the benefit that is forgone when
one alternative is selected over another. Sunk cost is a cost that occurred in the past and
cannot be altered. Differential costs and opportunity costs should be carefully considered in
decisions. Sunk costs are always irrelevant in decisions and should be ignored.

Cost concepts and Terminologies

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What does the word cost mean to you?
Is it the price you pay for something of value? A cash outflows? Something that affects
profitability? There are many different types of costs, and at different times organizations put
more or less emphasis on them. When times are good companies often focus on selling as
much as they can, with costs taking a backseat. But when times get tough, the emphasis
usually shifts to costs and cutting them, as General Motors tried to do. Unfortunately, when
times became really bad GM was unable to cut costs fast enough leading to Chapter 11
bankruptcy.
Many accounting reports contain several cost terminologies. A good understanding of the
different cost terminology is essential at least for the following two reasons.
 It enables accounting information users to best the information provided.
 Use of common terminologies avoids confusion and misunderstanding among the
users.
The traditional uses of accounting systems include the following.
a) Measuring performance
b) Justifying investment
c) Calculating products
d) Valuing inventories

Accountants define cost as a resource sacrificed or forgone to achieve a specific objective. A

cost (such as direct materials or advertising) is usually measured as the monetary amount that
must be paid to acquire goods or services. An actual cost is the cost incurred (a historical or
past cost), as distinguished from a budgeted cost, which is a predicted or forecasted cost (a
future cost). In the above definition, there are two important ideas included:
1. Cost measures the use of resources in terms of monetary units. This implies that cost is
quantitative information; cost tries to measure the use of labor hours, materials, machine
hours and other inputs in terms of monetary units. The monetary unit refers to the
currency of the country such as, Birr in Ethiopia, Nira in Nigeria, Nakifa in Eritrea, etc.

2. The second idea is that cost measurement is related to a particular purpose or activity.
This purpose is referred to as a cost object. Cost object is defined as anything in which
a separate measurement of costs is desired. To quite their decisions, managers want to
know how much a particular thing (such as a product, service, machine, or process) costs,
we call this thing cost object. This idea makes the definition of cost meaningful. For
instance, if one says to you that the cost is Br 10,000, do you understand what he/she
means? Surely you will ask a cost of what? Therefore, Birr 10,000 is not a cost data
because it is not related to a particular cost object. If it is said that the cost of office
furniture is Br 10,000, this will be meaningful. The term cost object may refer a narrow
level of activity or broad level of activity. For example, the cost object can be the
organization as a whole or it may refer to a particular product produced during a specific
period of time. The following table illustrates some possible cost object.

Cost Object Illustrations

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Product Arm chair for use in office
Project Research and Development project to test the validity and marketability of
a specific item
Service Telephone line installed to provide to telephone service to the public
Department Cost of running Department of Accounting in Hawassa University
Activity Frequency of movement of raw material from the store to the production
place
Customer Import and wholesale Company which purchase in large quantities

Costs and Expenses

In accounting the difference between costs and expenses is important. Costs as defined
above, refers to economic resources sacrificed or give up to acquire goods and services
that is all disbursement of cash or the commitment to pay cash in the future for the
purpose of generating revenues. So cost is incurred on benefits to be used in the future.
When the benefits are used up, the cost becomes an expense. All costs initially, represent
assets to the enterprise. As the assets are used in generating revenues, the cost of the
assets must be recognized as expenses in order to match revenues and expenses properly
in the process of determining the net income of the period. To simplify the recording
process, costs that will benefit only for the current period are often initially recorded as
expenses rather than assets. For example, the payment of birr 400 for the current month
insurance will be recorded by most companies as an expenses (insurance expense) rather
than as an asset (prepaid Insurance). In general, cost is incurred on benefit to be used in
the future, on the other hand, an expense is a cost that have given a benefit and then
expired.
The distinction between cost and expenses is essential for the preparation of financial
statement for service, merchandising and manufacturing firms. In fact, it has more
importance relatively for manufacturing enterprises, this is because, cost incurred in the
manufacturing process don’t become an expense until the product is sold and thus, items
that are fully or partially manufactured represent costs and should be recognized as assets
on the balance sheet. Therefore, financial reporting in manufacturing firms has some
complication as compared to financial reporting in the service and merchandising
business. Sometimes, a firm may incur a cost that produces neither immediate nor future
benefit. This is called a loss. For example, damage caused by fire or flood on property
held is a loss.
Cost Accumulation and Cost Assignment
A costing system typically account for costs in two basic stages, accumulation followed
by assignment. Cost accumulation is the collection of cost data in some organized means
of accounting system and cost assignment is a general term encompasses both (1) tracing
accumulated cost that have direct relationship to the cost object and (2) allocating cost
that have an indirect relationship to the cost object.
Cost driver: is any factor that affects total cost. That affects total cost. That is change in
the cost driver will cause a change in the level of the cost of a related cost object.
Examples:

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  Mile driven for transport cost
 Length of time of call for telephone cost
 Meter cub of water consumed for water cost
 Unit sold for cost of goods sold
Cost management: is the set of action that a manager takes to satisfy customers while
continuously reducing and controlling cost. Cost reduction efforts frequently focus on
two key areas
 Doing only value-added activities, that is those activities that customers perceive
as adding value to the product or service they purchase
 Efficiently managing the use of the cost drivers in the value-added activities.

Classifications of Cost
There are several standard cost classifications and each classification has its own unique
terminology. In this subunit, we present a comprehensive list of ways costs may be grouped, the
concepts underlying each, and the terminology commonly used. Remember that the same cost
may be included in several or in all of the following classifications.

1. Time Period for Which the Cost is computed

Time can be broadly classified in to past and future. Costs can also be classified according to
these time periods. Historical costs are those costs that were incurred in past period. Future costs,
generally called budgeted costs, are those costs that are expected to be incurred in the future
period. For example, the Br.8,000 cost of a computer acquired in 2008 is a historical cost in the
financial statement of 2009. How ever, the Br.10, 000 cost to acquire a new computer in 2011 to
replace the existing computer is a future cost.

2. Management Function

An organization may be separated into functional areas. A manufacturing company’s functional

areas generally include manufacturing, marketing, and general administration. One individual,
such as a vice president of manufacturing or a vice president of marketing, has primary
responsibility for a specific functional area. To evaluate the effectiveness of the functional area
and the individual in charge of it, costs also must be grouped by functional area as follows.

 Manufacturing Costs - include costs from the acquisition of raw materials through
production, until the product is turned over to the marketing division to be sold.
Manufacturing costs include the cost of the raw materials, payroll costs for people
working on the product, and incidental costs such as taxes, power, depreciation, and
repairs associated with manufacturing the product.
 Selling Costs - are all costs associated with marketing and selling a product. They
include all costs incurred by the marketing division from the time the manufacturing
process is complete until the product is delivered to the customer. These costs include

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 advertising, promotional offers, freight to deliver the product, and warehouse costs while
the product is waiting to be sold.
 Administrative Costs are all costs associated with the management of the company and
include expenditures for accounting, legal, and administrative activities. Interest costs are
also included among administrative costs.
3. Generally Accepted Accounting Treatment

The alternatives in accounting for a cost are to expense it or to capitalize it.

 Periodic Costs are costs that are expensed in the period in which they are incurred.
Periodic costs possess no future benefit and are generally associated with a non-
manufacturing area of the business. Examples of periodic costs include advertising,
Interest, president’s salary and sales commissions.
 Product Costs consist of all costs associated with the manufacturing function of the
business. They include materials, labor, and 0ther factory overhead costs associated with
assembling and processing the units. Because the company still holds the product and its
usefulness has not yet expired, it is not appropriate to expense these costs. They are
capitalized as inventory and held as unexpired until they are sold.
 Capital Costs are similar to product costs in that they are also capitalized as assets.
However, capital cost is the term used to describe the equipment, building and land held
permanently for making business. These items are capitalized as tangible fixed assets and
are depreciated over their useful lives. Product costs are reserved for inventorable costs
associated with the manufacturing process
4. Traceability to Products

From traceability point of view, cost is divided in to direct and Indirect cost:

 Direct Cost: is a cost that can be economically traced to a single unit of finished product.
For example; direct material & direct labor are direct costs
 Indirect Cost: is one that is not directly traceable to the manufactured product.It is
associated with the manufacture of two or more units of finished product, or is an immaterial
cost that cannot be economically traced to single units of finished product. For example:
Cost of electricity, Depreciation of equipment, indirect labor, indirect material, Cost of
different utilities, Cost of repair and maintenance, Insurance for the factory are indirect costs.
A comparison of the labor cost of an assembly worker and a repair person in a cabinet shop will
illustrate the difference between a direct and an indirect cost. The assembly worker’s salary is
typically classified as a direct cost because, it is a significant portion of the cabinet’s total cost
and because it is easy to trace the assembly worker’s efforts to a particular set of cabinets. The
machine repair person’s salary would probably be classified as an indirect cost because; it is
difficult or impossible to trace that individual’s efforts to a unit of output. The repairperson is
responsible for keeping all machines running properly. Since he or she work on several machines
and the machines work on several different cabinets each day, we cannot trace this person’s
salary to a particular set of cabinets. The lack of traceability requires that it should be classified as
an indirect cost. The economics of tracing a cost to a particular unit of finished product is an
important distinction between direct costs and indirect costs. Take a table that requires a few
screws and a little glue to complete the assembly. Both of these items can be traced to a particular

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unit of finished product and would, therefore, qualify as direct costs. However, these items are
usually classified as indirect costs if their amounts are immaterial when compared to the other
materials going into the product. Also, the cost involved in tracing and recording the items as
direct costs would be greater than the benefit of having that information .
5. Cost Behavior

Cost behavior describes how a cost changes with time or with changes in volume. Variable costs
are costs that vary proportionately in total as the volume of production or sales changes. For
example, if it takes Br.100 of lumber to make one unit of table and if five units are produced, the
total cost of the lumber is Br. 50. The total variable cost increases in proportion with the number
of unit’s produced, but the cost of each unit remains the same. Fixed cost remains constant in
amount as volume of production or sales changes. Straight-line depreciation on a plant asset is an
example of a fixed cost. The amount of depreciation is the same regardless of the number of units
produced.

6. Decision Significance

A decision involves making choices among alternative courses of action. The decision maker
generally collects cost information to assist in making the decision. Relevant cost is future costs
that differ with the various decision alternatives. They are costs that make a difference in a
decision-making process. Irrelevant Costs do not relate to any of the decision alternatives, are
historical in nature or are the same under all decision alternatives. Irrelevant costs are generally
excluded from the analysis.

7. Managerial Influence

Managerial influence refers to the ability of a manager to control a particular cost. Remember that
all costs are controlled by some one at some level in the organization if the time period is long
enough. However, when we see for a particular manager at a particular level in the organization
and for a short period of time, there are some costs that can be influenced and some that cannot.
Controllable costs are subject to significant influence by a particular manager within the time
period under consideration. Uncontrollable costs are those costs over which a given manager does
not have a significant influence.

8. Commitment to Cost Expenditure

Commitment to a cost expenditure focuses on fixed costs as opposed to variable costs and on
budgeted costs as opposed to historical costs. Budgeted fixed costs can be broadly classified as
committed costs and discretionary costs.

Committed cost is one that is an inevitable consequence of a previous commitment. Property tax
budgeted for the coming year is an example of a committed cost. Suppose top management made
the decision two years ago to construct a new warehouse. After it was completed, the tax
commission placed an assessed value on it, and a property tax notice is now recapped annually
according to the tax law. The property tax must be paid or the warehouse will be seized by the tax

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authority and sold to cover the unpaid taxes. Property tax is a committed cost that resulted from
the decision to construct the warehouse.

Discretionary Cost, also called a programmed cost or a managed cost, is one for which the
amount or the time of incurrence is a matter of choice. There are some nonrecurring costs for
which a final commitment has not yet been made and that can be postponed until a future period
or cancelled entirely. Replacing the carpet in the demolished offices and repainting the walls of
the factory are examples of discretionary costs where the right timing is a matter of judgment.
Even though the carpet is beginning to show some wear, it could continue to be used for several
months without any interruption to normal operations.

9. Other Cost Classifications

Several other cost classifications are frequently used in discussing cost accounting and
management decisions. Their primary usefulness is in helping to place correct perspective of the
potential benefit of a possible course of action. These classifications include marginal costs, out –
of –pocket costs, sunk costs, and opportunity costs.

Marginal Costs, also called incremental costs, are the costs that are associated with the next unit
or the next project. The term marginal cost is widely used in economics to refer to the added cost
associated with the production of an additional unit of output.

Out- of – Pocket Cost: is a cost that must be met with a current expenditure. Generally an out –
of – pocket cost is a cash expenditure associated with a particular decision alternative.

Sunk Costs: are defined as past costs that have already been incurred. Because sunk costs are
historical costs, they are generally irrelevant to decisions affecting the current or future use of the
asset.

Opportunity Cost: is defined as the cost or value of an opportunity forgone when one course of
action is chosen over another. Opportunity cost is not an out-of –pocket cost, or even a future cost
associated with the selected alternative, but represents the lost opportunity associated with each
of the alternatives that are rejected.

Product Costs

For financial accounting purposes, product costs include all costs involved in
acquiring or making a product. In the case of manufactured goods, these costs
consist of direct materials, direct labor, and manufacturing overhead. Product
costs “attach” to units of product as the goods are purchased or manufactured and
they remain attached as the goods go into inventory awaiting sale. Product costs
are initially assigned to an inventory account on the balance sheet. When the
goods are sold, the costs are released from inventory as expenses (typically called
cost of goods sold) and matched against sales revenue. Since product costs are
initially assigned to inventories, they are also known as inventoriable costs.

We want to emphasize that product costs are not necessarily treated as expenses
in the period in which they are incurred. Rather, as explained above, they are

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 treated as expenses in the period in which the related products are sold. This
means that a product cost such as direct materials or direct labor might be
incurred during one period but not recorded as an expense until a following period
when the completed product is sold.

Period Costs

Period costs are all the costs that are not product costs. For example, sales
commissions and the rental costs of administrative offices are period costs. Period
costs are not included as part of the cost of either purchased or manufactured
goods; instead, period costs are expensed on the income statement in the period in
which they are incurred using the usual rules of accrual accounting. Keep in mind
that the period in which a cost is incurred is not necessarily the period in which
cash changes hands. For example, as discussed earlier, the costs of liability
insurance are spread across the periods that benefit from the insurance—
regardless of the period in which the insurance premium is paid. As suggested
above, all selling and administrative expenses are considered to be period costs.
Advertising, executive salaries, sales commissions, public relations, and other
nonmanufacturing costs discussed earlier are all examples of period costs. They
will appear on the income statement as expenses in the period in which they are
incurred.

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Types of Manufacturing Inventories

Manufacturing companies purchase materials and components and convert them into
various finished goods. They have at least three inventories. These are the raw material
inventory, the work in process inventory, and the finished goods inventory. Knowing
these inventories will help you to properly understand the cost flows in a manufacturing
company. Examples are automotive companies such as Jaguar, cellular phone producers
such as Nokia, food-processing companies such as Heinz, computer companies such as
Toshiba soft Drink companies such as Moha Soft Drink companies, and Brewery Factory
like BGI, Harar and Meta.

Inventory refers to accumulated items for some purpose (to be used in the future though
sales or consumption). Manufacturing companies purchase raw materials and convert
them in to different goods. They typically have the following types of inventories.
1. Raw Material inventories.
These refers to all material purchased to be used in the production process. The raw
material inventory account is used to show the value of materials available for use on the
date of reporting. The raw materials are waiting for use in the manufacturing process.
Whenever, there is a purchase of raw material, it is recorded in raw materials account.
The cost of the raw material is composed of:
The invoice price of the material
The transportation cost of the material
The insurance in transit cost of the material
Loading and unloading costs
All other cost incurred on the raw material to make ready for consumption

2. Work -In-Process Inventory

Raw materials are not accumulated for accumulation purposes. They must go to
production process and can be processed into finished goods. When materials go out of
the store, their value is no more reported on raw materials inventory account. They will
go to the work-in-process inventory account. The work-in process inventory refers to all
items that are still in process on the date of reporting. These items are not completed to be
reported as finished goods inventory. The Work in process inventory account consists
of:-
The costs of raw material charged to production
The cost of labor incurred on items in process
The manufacturing overhead costs.

3. Finished Goods Inventory

When the manufacturing process is completed, finished products will be sent to ware
house so that they will be available for selling. Therefore, the costs accumulated in the
work-in-process- inventory account must be transferred to finished goods inventory
account. The finished goods inventory account is used to record cost fully completed
goods inventory account is used to record cost of fully completed goods but not yet sold
to customers. The cost is composed of:-
Applicable costs of raw material
Applicable cost of labor

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 Applicable cost of manufacturing overhead
Note that these costs are the total required costs to complete the production process. So
to finish the process there is no further cost required.
Merchandising Sector Companies purchase and then sell tangible products without
changing their basic form. They hold only one type of inventory which is the product in
its original purchased form. Merchandise purchased from suppliers but not sold at the
end of an accounting period is held as stock. The merchandising sector includes
companies engaged in retailing (such as book stores or department stores), distributing or
wholesaling.

Service –Sector Companies provide only service or intangible products to their

customers and hence do not hold inventories of tangible products for sale. These
companies do not have any stock of tangible product at the end of an accounting period.
Examples include law firms, accounting firms, advertising agencies and television
stations.

Merchandising and manufacturing companies differ from service companies in their

holding of stocks. Stock-related costs (also called ‘inventoriable’ costs) are those costs
associated with the purchase of goods for resale (in the case of merchandise stock) or
costs associated with the acquisition and conversion of materials and all other
manufacturing inputs into goods for sale (in the case of manufacturing stocks).
Inventoriable costs become part of cost of goods sold in the period in which the stock
item is sold. Operating costs are all costs associated with generating revenues, other than
cost of goods sold. (The term operating costs is sometimes used to include cost of goods
sold. In this book, we do not include costs of books sold in operating costs.) We now
consider the financial statements for Cellular Products, a manufacturer of telephone
systems for large enterprises.

2.4 Financial Statement for Manufacturing Organization

Financial statement of a manufacturing company is more complex as compared to
financial statement of merchandising and service giving companies. Particularly, the
balance sheet and income statement of a manufacturing enterprise are somewhat different
from their merchandising and service counterpart. All costs mentioned above should be
properly accounted for and reported in the financial statement for a manufacturing firm.
Manufacturing organizations perform selling and administrative functions similar to
merchandising firms. However, instead of purchasing goods that are ready for resale, a
manufacturing firm buys raw materials, labor, and other components needed to perform
the manufacturing function of converting the raw materials into finished products. This
difference is shown in the cost-of-goods-sold statements. In addition, the balance sheet at
the end of the period will show ending inventories for raw materials, work-in-process,
and finished goods. My objective here is to explain the computation of cost of goods
manufactured and to illustrate the development of external financial statements for a
manufacturing organization.

Balance Sheet of a Manufacturing and Merchandising Firm

The Balance sheet of a manufacturing firm differs from the balance sheet of a
merchandising firm principally by the type of inventories reported. A manufacturing firm

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 carries three types of inventories. Namely, Raw material inventory, work-in-process
inventory and finished Goods inventory.
[A] Materials inventory (sometimes called raw materials inventory). This inventory
consists of the costs of the direct and indirect materials that have not entered the
manufacturing process.
a. Examples for Deluxe Furniture: Wood (timber), nails, glue, varnish, etc.
[B] Work in process inventory. This inventory consists of the direct materials, direct
labor, and factory overhead costs for products that have entered the manufacturing
process, but are not yet completed (in process).
a. Example for Deluxe Furniture: Unfinished (partially assembled) Office Table.
[C] Finished goods inventory. This inventory consists of completed (or finished)
products that have not been sold.
Example for Deluxe Furniture: Unsold office Table.
Exhibit 2.2 illustrates the reporting of inventory on the balance sheet for a merchandising
and a manufacturing business. Bambies Super Market a whole seller of several cosmetics
and shampoos, confectionaries and packed juices., reports one type of inventory (i.e.
merchandising inventory) Deluxe Furniture, a manufacturer of innovative wooden made
office and room furniture , reports Finished Goods, Work in Process, and Materials
inventories.
Deluxe Furniture
Balance Sheet
December 31, 19X1
Current Assets
Cash Br 21,000
Accounts Receivables 120,000
Inventory
Raw Material 62,500
Work-in-Process 24,000
Finished Goods 35,000 121,500
Supplies 2,000
Total Current Assets Br.264,500

Income statement of a Manufacturing Firm

The income statements for merchandising and manufacturing businesses differ primarily
in the reporting of the cost of merchandise (goods) available for sale and sold during the
period. These differences are shown below.

Merchandising Business Manufacturing Business

Sales $ xxx Sales $ xxx
Beg. Mercha. goods inventory $xxx Beginning finished inventory xxx
Plus Net purchase xxx Plus, cost of goods manufactured xxx
Merchandise available for sale xxx Cost of finished goods available xxx
for sale

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Less ending merchandising inventory xxx Less ending finished goods xxx
inventory
Cost of Merchandise sold xxx Cost of goods sold xxx
Gross profit xxx Gross profit xxx

A merchandising business purchases merchandise ready for resale to customers. The total
cost of the merchandise available for sale during the period is determined by adding the
beginning merchandise inventory to the net purchases. The cost of merchandise sold is
determined by subtracting the ending merchandise inventory from the cost of
merchandise available for sale.

A manufacturer makes the products it sells, using direct materials, direct labor, and
factory overhead. The total cost of making products that are available for sale during the
period is called the cost of goods manufactured. The cost of finished goods available
for sale is determined by adding the beginning finished goods inventory to the cost of
goods manufactured during the period. The cost of goods sold is determined by
subtracting the ending finished goods inventory from the cost of finished goods available
for sale. Cost of goods manufactured is required to determine the cost of goods sold, and
thus to prepare the income statement. The cost of goods manufactured is often
determined by preparing a statement of cost of goods manufactured. In general, the
following four steps are required to prepare income statement of a manufacturing firm.

Step 1: The Schedule of Direct Material Used In Production

The cost of direct material used is equivalent to the beginning inventory of direct material
plus purchase made during that period less the direct material left at the end of the period.
Schedule 1: Cost of Direct Material Used
Beginning materials inventory xxx
Add: purchase in the period xxx
Direct material available for use xxx
Less: ending direct material inventory xxx
Cost of goods sold xxx

Step 2: The Schedule of Cost of Goods Manufactured

Cost of goods manufactured refers to the cost of goods brought to completion whether
they were started before or during the accounting period. To determine the cost of goods
manufactured, three factors are necessary; cost of direct material used, cost of direct labor
and manufacturing overhead. In addition, work in process at the beginning and at the end
should be incorporated in the calculation. The following is the schedule used to calculate
the cost of goods manufactured.

Schedule 2: Cost of Goods Manufactured

Work in process at the beginning xxx
Add: cost of direct material used xxx
Direct labor cost xxx

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 Manufacturing overhead cost xxx
Cost incurred in current period xxx
Total cost incurred to date xxx
Less : work in process ending xxx
Cost of goods manufacturing xxx

Step 3: The Schedule of costs of Goods Sold

The cost of goods sold represents the cost of goods that are sold during a given period. In
computing the costs of goods sold amount, cost of finished goods at the beginning, cost
of goods manufactured in the period and cost of finished goods at the end will be taken in
to account. The following is the schedule used to compute cost of goods sold.
Schedule 3: Cost of Goods Sold
Finished goods beginning xxx
Add: cost of goods Manufactured xxx
Cost of goods available for sale xxx
Less: finished goods ending xxx
Cost of goods sold xxx

Step 4 Income statement

All of the above schedules are inputs one to the other. The ultimate goal of making all the
schedules is to prepare the income statement. The income statement contains three main
elements. These are sales, cost of goods sold and operational expense. The cost of goods
sold is deducted from sales to arrive at gross profit. From gross profit, operational
expense is deducted to arrive at operating income. The following is the schedule used to
calculate operating income.

Schedule 4: Income statement

Revenues xxx
Cost of goods sold xxx
Gross profit xxx
Operating expense xxx
Operating income xxx