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Accounting Terminology

Accounting Terminology

Listed below are eight technical accounting terms introduced or emphasized in this chapter: Listed below are eight technical accounting terms introduced or emphasized in this chapter:

1) Work in Process
2) Inventory
3) Cost of finished goods manufactured
4) Conversion costs
5) Cost of Goods Sold
6) Period costs
7) Management accounting
8) Product costs
9) Manufacturing overhead

Each of the following statements may (or may not) describe one of these technical terms. For each statement, indicate the accounting term described, or answer “None” if the statement does not correctly
describe any of the terms.

a. The preparation and use of accounting information designed to assist managers in planning and controlling the operations of a business.

b. All manufacturing costs other than direct materials used and direct labor.

c. Direct materials and direct labor used in manufacturing a product.

d. A manufacturing cost that can be traced conveniently and directly to manufactured units of product.

e. The account debited at the time that the Manufacturing Overhead account is credited.

f. The amount transferred from the Work in Process Inventory account to the Finished Goods Inventory account.

g. Costs that are debited directly to expense accounts when the costs are incurred.

EXERCISE 16.2 (LO16-2)
Basic Types of
Manufacturing Costs

Into which of the three elements of manufacturing cost would each of the following be classified?

a. Tubing used in manufacturing bicycles.

b. Wages paid by an automobile manufacturer to employees who test-drive completed automobiles.

c. Property taxes on machinery.

d. Gold bullion used by a jewelry manufacturer.

e. Wages of assembly-line workers who package frozen food.

f. Salary of plant superintendent.

g. Electricity used in factory operations.

h. Salary of a nurse in a factory first-aid station.

EXERCISE 16.3 (LO16-3 & LO16-5)
Product Costs
and Period Costs

Indicate whether each of the following should be considered a product cost or a period cost. If you identify the item as a product cost, also indicate whether it is a direct or an indirect cost. For example, the answer to item 0 is “indirect product cost.” Begin with item a.

0. Property taxes on factory building.

a. Cost of disposal of hazardous waste materials to a chemical plant.

b. Amounts paid by a mobile home manufacturer to a subcontractor who installs plumbing in each mobile home.

c. Depreciation on sales showroom fixtures.

d. Salaries of security guards in an administrative office building.

EXERCISE 16.6 (LO16-3 & LO16-5)

Flow of Costs through
Manufacturing Accounts

The Ryde and Rowe Inc. had the following account balances as of January 1:

Direct Materials Inventory . . . .. . . . . . . . . . . . . . . . . . . . . . . . . $ 89,200
Work in Process Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178,400
Finished Goods Inventory . . . . . .. . . . . . . . . . . . . . . . . . . . . . . 253,600
Manufacturing Overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . –0–

During the month of January, all of the following occurred:

1. Direct labor costs were $442,000 for 18,000 hours worked.

2. Direct materials costing $335,750 and indirect materials costing $13,500 were purchased.

3. Sales commissions of $216,500 were earned by the sales force.

4. $326,000 worth of direct materials were used in production.

5. Advertising costs of $36,300 were incurred.

6. Factory supervisors earned salaries of $22,000.

7. Indirect labor costs for the month were $23,000.

8. Monthly depreciation on factory equipment was $24,500.

9. Utilities expense of $17,800 was incurred in the factory.

10. Equipment with manufacturing costs of $970,100 were transferred to finished goods.

11. Monthly insurance costs for the factory were $4,200.

12. $5,000 in property taxes on the factory were incurred and paid.

13. Equipment with manufacturing costs of $1,089,000 were sold for $1,550,000.


a. If Ryde and Rowe assigns manufacturing overhead of $84,400, what will be the balances in the Direct Materials, Work in Process, and Finished Goods Inventory accounts at the end of January?

b. As of January 31, what will be the balance in the Manufacturing Overhead account?

c. What was Ryde and Rowe’s operating income for January?

Reference Information for Each Exercise If needed.

Explain the three principles
guiding the design of
management accounting

To achieve organizational goals, managers are assigned decision-making authority for some of the firm’s assets. For example, plant managers typically are responsible for decisions about equipment in the plant, employees at the plant, the physical plant layout, and sources of raw
materials, among other things. Within the plant, the materials inventory manager may be delegated decision-making responsibility for reordering materials, and the production supervisor may be delegated decision-making responsibility for assigning employees to jobs on the production
line. The point is that all members of an organization have some decision-making authority. Employees within a corporation know their decision-making responsibilities because they are outlined in a variety of ways, such as in job descriptions, verbal instructions from their supervisors, and management accounting system documents and reports. Just as you have
received a course syllabus that outlines your instructor’s standards for you to follow to earn an A or B in this course, managers receive management accounting reports that outline expected outcomes to help achieve the organization’s goals. Just as you have decision-making responsibility over the “assets” necessary to achieve an A or B (the time you allocate to studying), managers have decision-making responsibility over the assets included in their management accounting reports

Managers need reliable and timely information on which to base their decisions. For example, the plant manager needs information to help assess if equipment is inefficient or if certain work arrangements and plant layouts are more productive than others. Thus, managers need
both historical information (for example, the current equipment’s cost and productivity) and projected information (for example, the productivity and cost of other available equipment). They need information oriented both toward their specific operations and toward other parts of the organization’s value chain. A value chain is the linked set of activities and resources necessary to create and deliver the product or service to the customer. Therefore, plant managers will require information from other parts of the value chain such as engineering or sales. They need information from both internal operations and externally oriented benchmark sources. More and more organizations are sharing information. It is very common for organizations to participate in and undertake benchmark studies . Independent consulting companies
often create benchmark reports by collecting information from companies in the same industry. These studies show an organization how its costs and processes compare with others in its industry. Organizations also share information with customers and suppliers in their value chain. For example, in order for shipments from suppliers to arrive at the exact
time they are needed for use in production, buyers and suppliers share their production information. Customers often require or are voluntarily provided quality information. As shown in Exhibit 16–1 , the management accounting system provides past-, current-, and future- oriented information for users both inside and outside the firm.

LO16-2 Describe the three basic types of
manufacturing costs.

A typical manufacturing company purchases raw materials and converts these materials into finished goods through the process of production. The costs of converting raw materials into finished goods, specifically the direct labor and overhead costs, are called conversion costs. In contrast, the direct materials and direct labor that are consumed in production are referred to as prime costs. Thus, direct labor is both a prime cost and a conversion cost. These cost classifications are illustrated in Exhibit 16–3 and described below.

The manufacturing costs are often divided into three broad categories:

1. Direct materials —the raw materials and component parts used in production whose costs are directly traceable to the products manufactured.

2. Direct labor —wages and other payroll costs of employees whose efforts are directly traceable to the products they manufacture.

3. Manufacturing overhead —a catchall classification, which includes all manufacturing costs other than the costs of direct materials and direct labor. Examples include factory utilities, supervisor salaries, equipment repairs, and depreciation on production machinery.

Note that manufacturing costs are not immediately recorded as current period expenses. Rather, they are costs of creating inventory, and they remain on the balance sheet until the inventory is sold. For this reason, manufacturing costs are often called product costs (or inventoriable costs).

LO16-3 Distinguish between product costs and
period costs.

The terms product costs and period costs are helpful in explaining the difference between manufacturing costs and operating expenses. In a manufacturing environment, product costs are those costs incurred to manufacture inventory. Thus, until the related goods are sold, product
costs represent inventory. As such, they are reported in the balance sheet as an asset. When the goods are ultimately sold, product costs are transferred from the balance sheet to the income statement, where they are deducted from revenue as the cost of goods sold. Operating expenses associated with time periods, rather than with the production of inventory, are referred to as period costs . Period costs are charged directly to expense accounts on the assumption that their benefit is recognized entirely in the period when the cost is incurred. Period costs include all selling expenses, general and administrative expenses, interest
expense, and income tax expense. In short, period costs are classified in the income statement separately from cost of goods sold, as deductions from a company’s gross profit.

The flow of product costs and period costs through The Home Depot, Inc. financial statements is shown in Exhibit 16–4 .

EXHIBIT 16–4 “Flow” of Costs Through Financial Statements

To further illustrate the distinction between product and period costs, consider two costs that, on the surface, appear quite similar: the depreciation of a warehouse used to store raw materials versus depreciation of a warehouse used to store finished goods. Depreciation of the raw materials warehouse is considered a product cost (a component of manufacturing overhead) because the building is part of the manufacturing process. Once the manufacturing process
is complete and the finished goods are available for sale, all costs associated with their storage are considered selling expenses. Thus, the depreciation of the finished goods warehouse is a period cost.


In the preceding example, assume all 10 houses were completed by the end of the year. In this case, the developer’s inventory consists only of finished goods. Most manufacturing companies, however, typically account for three types of inventory:

1. Materials inventory —raw materials on hand and available for use in the manufacturing process.

2. Work in process inventory —partially completed goods on which production activities have been started but not yet completed.

3. Finished goods inventory —unsold finished products available for sale to customers. All three of these inventories are classified on the balance sheet as current assets. The cost of the materials inventory is based in its purchase price. The work in process and finished goods inventories are based on the costs of direct material, direct labor, and manufacturing
overhead assigned to them

Distinguish between direct
and indirect costs.

The costs of direct materials and direct labor may be traced conveniently and directly to specific units of product. At Conquest, for example, it is relatively easy to determine the cost of the metal tubing and the cost of the direct labor that go into making a particular bicycle. For this reason, accountants call these items direct manufacturing costs. Overhead, however, is an indirect manufacturing cost . Consider, for example, the types of costs that Conquest classifies as overhead. These costs include property taxes on the factory, depreciation on tools and equipment, supervisors’ salaries, and repairs to equipment.

How much of these indirect costs should be assigned to each bicycle? There is no easy answer to this question. By definition, indirect costs cannot be traced easily and directly to specific units of production. While these costs are often easier to view as a whole than on a per-unit basis, we will see that both financial and management accountants require unit cost information. Therefore, manufacturing companies must develop methods of allocating an appropriate portion of total manufacturing overhead to each product manufactured. These methods will be discussed in detail in Chapter 17.

We have devoted much of this chapter to discussing the three types of manufacturing costs direct materials, direct labor, and manufacturing overhead. We will now shift our attention to the three accounts that provide the structure for the flow of these costs—the Work in Process
Inventory account, the Finished Goods Inventory account, and the Cost of Goods Sold account.

The Work in Process Inventory account is used (1) to record the accumulation of manufacturing costs associated with the units of product worked on during the period and (2) to allocate these costs between those units completed during the period and those that are only partially completed.

Because direct materials, direct labor, and manufacturing overhead are consumed in production, their related costs are debited to the Work in Process Inventory account. The flow of costs into this inventory account (rather than into a corresponding expense account) is consistent
with the idea that manufacturing costs are product costs, not period costs.
As specific units are completed, the cost of manufacturing them is transferred from the Work in Process Inventory account to the Finished Goods Inventory account. Thus, the balance in the Work in Process account represents only the manufacturing costs associated with
units still “in process.”

It is important to realize that once products are classified as finished goods, no additional costs are allocated to them. Therefore, the costs of storing, marketing, or delivering finished goods are regarded as selling expenses, not manufacturing costs. When units of finished goods are sold, their related costs must “flow” from the balance sheet through the income statement in compliance with the matching principle. Accordingly, as products are sold, their costs are transferred from the Finished Goods Inventory account to the Cost of Goods Sold account.


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