Chapter 18

Introduction to
Managerial Accounting
Guitar-Making Operations of Legend Guitars

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Direct Costs of Legend Guitars

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Indirect Costs of Legend Guitars

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Classifying Direct and Indirect Costs

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 Manufacturing Costs of Legend Guitars

• The cost of the wood • The wages of employees • Heating and lighting the factory
used in producing a who cut guitars out of • Repairing and maintaining
guitar raw lumber and factory equipment
• The cost of electronic assemble them • Property taxes on factory
components for a • Mechanics’ wages for buildings and land
television repairing an automobile • Insurance on factory buildings
• Tires for an automobile • Assemblers’ wages for • Depreciation of factory plant
assembling a laptop and equipment
computer

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Prime Costs and Conversion Costs

Conversion costs are the costs

of converting the materials
into a finished product.

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Examples of Product Costs and Period Costs—Legend Guitars

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Product Costs, Period Costs, and the Financial Statements

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Financial Statements for a Manufacturing Business

• The retained earnings and cash flow

statements for a manufacturing business are
similar to those for service and merchandising
businesses.
• However, the balance sheet and income
statement for a manufacturing business are
more complex.
• This is because a manufacturer makes the products
that it sells and, thus, must record and report product
costs.

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Balance Sheet Presentation of Inventory in Manufacturing and
Merchandising Companies

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Income Statement in Manufacturing and Merchandising Companies

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Income Statement for a Manufacturing Business

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Income Statement for a Manufacturing Business

• The statement of cost of goods manufactured is

prepared using the following three steps:
• Step 1. Determine the cost of materials used.
• Step 2. Determine the total manufacturing costs incurred.
• Step 3. Determine the cost of goods manufactured.

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Example Exercise: Cost of Goods Sold, Cost of Goods
Manufactured

• Gauntlet Company has the following information for January:

• For January, determine (a) the cost of goods manufactured and (b)
the cost of goods sold.

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instructions
1. Prepare the statement of cost of goods manufactured.
2. Determine the cost of goods sold.
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Definitions

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 Direct and Indirect Costs
• Costs identified with cost objects are either direct costs or indirect costs

• Direct costs
 Identified with and can be traced to a cost object
• For example, the cost of wood used to make guitars is a direct cost

• Indirect costs
 Cannot be identified with or traced to a cost object
• For example, the salaries of production supervisors are indirect
costs of producing a guitar because their salaries cannot be
identified with or traced to any individual guitar

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 Manufacturing Costs
• The cost of a manufactured product includes the cost of
materials used in making the product.
• In addition, the cost of a manufactured product includes
the cost of converting the materials into a finished
product.
• The cost of a finished product includes:
• Direct materials cost
• Direct labor cost
• Factory overhead cost

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Direct Materials Cost
• Manufactured products begin with raw materials
that are converted into finished products.
• To be classified as a direct materials cost, the
cost must be both of the following:
• An integral part of the finished product
• A significant portion of the total cost of the product
• Examples of direct materials costs include the
following:
• The cost of the wood used in producing a guitar
• The cost of electronic components for a television
• Tires for an automobile

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Direct Labor Cost
• Most manufacturing processes use employees to convert
materials into finished products.
• The cost of employee wages that is an integral part of the
finished product is classified as direct labor cost.
• A direct labor cost must meet both of the following criteria:
• An integral part of the finished product
• A significant portion of the total cost of the product
• Examples of direct labor costs include the following:
• The wages of employees who cut guitars out of raw lumber and
assemble them
• Mechanics’ wages for repairing an automobile
• Assemblers’ wages for assembling a laptop computer

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Factory Overhead Cost
• Costs other than direct materials cost and direct labor that
are incurred in the manufacturing process are combined
and classified as factory overhead cost
• All factory overhead costs are indirect costs of the product.
• Some factory overhead costs include the following:
• Heating and lighting the factory
• Repairing and maintaining factory equipment
• Property taxes on factory buildings and land
• Insurance on factory buildings
• Depreciation of factory plant and equipment

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 Factory Overhead Cost
• Factory overhead cost also includes materials and labor
costs that do not enter directly into the finished product.
• Examples include the cost of oil used to lubricate machinery
and the wages of janitorial and supervisory employees.
• Also, if the costs of direct materials or direct labor are
not a significant portion of the total product cost, these
costs may be classified as factory overhead costs.

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Prime Costs and Conversion Costs
• Prime costs, which consist of direct materials and direct
labor costs
• Conversion costs, which consist of direct labor and factory
overhead costs
• Conversion costs are the costs of converting the materials
into a finished product.
• Direct labor is both a prime cost and a conversion cost.

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 Product Costs and Period Costs
• For financial reporting purposes, costs are
classified as product costs or period costs

• Product costs

 Consist of manufacturing costs: direct materials,

direct labor, and factory overhead

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Product Costs and Period Costs
• For financial reporting purposes, costs are classified
as product costs or period costs

• Period costs

 Consist of selling and administrative costs

 Selling expenses are incurred in marketing the product
and delivering the product to the customer
 Administrative expenses are incurred in managing the
company and are not directly related to the
manufacturing or selling functions
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Product Costs and Period Costs
• As product costs are incurred, they are
recorded and reported on the balance sheet as
inventory. When the inventory is sold, the cost
of the manufactured product sold is reported as
cost of goods sold on the income statement.
• Period costs are reported as expenses on the
income statement in the period in which they
are incurred, and, thus, they never appear on
the balance sheet.

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Balance Sheet for a Manufacturing Business
• A manufacturing business reports three types
of inventory on its balance sheet as follows:
• Materials inventory (sometimes called raw
materials inventory) consists of the costs of the
direct and indirect materials that have not yet
entered the manufacturing process.
• Work in process 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).
• Finished goods inventory consists of completed
(or finished) products that have not been sold.

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