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A manufacturer's product costs are the direct materials, direct labor, and manufacturing overhead used in making its products. (Manufacturing overhead is also referred to as factory overhead, indirect manufacturing costs, and burden.) The product costs of direct materials, direct labor, and manufacturing overhead are also "inventoriable" costs, since these are the necessary costs of manufacturing the products.
Period costs are not a necessary part of the manufacturing process. As a result, period costs cannot be assigned to the products or to the cost of inventory. The period costs are usually associated with the selling function of the business or its general administration. The period costs are reported as expenses in the accounting period in which they 1) best match with revenues, 2) when they expire, or 3) in the current accounting period. In addition to the selling and general administrative expenses, most interest expense is a period expense.
A cost center is a subunit of a company that is responsible only for its costs. Example of cost centers are the production departments and the service departments within a factory and administrative departments such as IT and accounting.
A profit center is a subunit of a company that is responsible for revenues and costs. Often a division of a company is a profit center because it has control over its revenues, costs, and the resulting profits.
SG&A is the acronym for selling, general and administrative. SG&A are the expenses incurred to 1) promote, sell, and deliver a company's products and services, and 2) manage the overall company.
SG&A will appear as operating expenses on the income statement for the period in which the expenses occurred. Hence, SG&A expenses are said to period costs as opposed to product costs. This means that SG&A expenses are not assigned to the cost of goods sold or to the goods in inventory.
Examples of SG&A include sales commissions, advertising, promotional materials, compensation of the company's officers as well as the marketing, sales, finance and office staffs, the rent, utilities, supplies, computers, etc. that are outside of the manufacturing function. (SG&A will not include interest expense since interest expense is reported as a nonoperating expense.)
Cost allocation is the assigning of a common cost to several cost objects. For example, a company might allocate or assign the cost of an expensive computer system to the three main areas of the company that use the system. A company with only one electric meter might allocate the electricity bill to several departments in the company.
Allocation implies that the assigning of the cost is somewhat arbitrary. Some people describe the allocation as the spreading of cost, because of the arbitrary nature of the allocation. Efforts have been made over the years to improve the bases for allocation. In manufacturing, the overhead allocations have moved from plant-wide rates to departmental rates, from direct labor hours to machine hours to activity based costing. The goal is to allocate or assign the costs based on the root causes of the common costs instead of merely spreading the costs.
A cost center is often a department within a company. The manager and employees of a cost center are responsible for its costs but are not responsible for revenues or investment decisions.
A manufacturer's cost centers include each of its production departments as well as the manufacturing service departments such as the maintenance department or quality control department. Other examples of cost centers include the human resource department, the IT department, the accounting department, and so on.
Cost centers are not limited to departments. There might be several cost centers within a department. For example, each assembly line could be a cost center. Even a special machine could be a cost center.
Cost centers are usually associated with the topic of decentralization, responsibility accounting, and planning and control.
Direct costs can be traced directly to a cost object such as a product or a department. In other words, direct costs do not have to be allocated to a product, department, or other cost object.
For example, if a company produces artisan furniture, the cost of the wood and the cost of the craftsperson are direct costs—they are clearly traceable to the production department and to each item produced—no allocation was needed. On the other hand, the rent of the building that houses the production area, warehouse, and office is not a direct cost of either the production department or the items produced. The rent is an indirect cost—an indirect cost of operating the production department and an indirect cost of crafting the product.
To calculate the total cost of the production department or to calculate each product's total cost, it is necessary to allocate some of the rent (and other indirect costs) to the department and to the product.
Salaries and wages of the current accounting period are reported as expenses on a service company's current income statement.
Salaries and wages of a manufacturer are more complicated. The salaries and wages of people in the administrative and selling functions are reported as expenses on the current income statement. However, the salaries and wages of people in the production departments are assigned to the products manufactured. When the products are sold, their production costs (including the manufacturing salaries and wages) will appear on the income statement as part of the cost of goods sold. The products not sold are reported as inventory on the balance sheet at their production costs (including the manufacturing salaries and wages).
Responsibility accounting involves a company's internal accounting and budgeting. The objective is to assist in the planning and control of a company's responsibility centers—such as decentralized departments and divisions.
Responsibility accounting usually involves the preparation of annual and monthly budgets for each responsibility center. Then the company's actual transactions are classified by responsibility center and a monthly report is prepared. The reports will present the actual amounts for each budget line item and the variance between the budget and actual amounts.
Responsibility accounting allows the company and each manager of a responsibility center to receive monthly feedback on the manager's performance.
Direct product costs such as raw materials are variable costs. Variable product costs increase in total as more units of products are manufactured.
Costs that are direct to a department could be variable or fixed. For example, a supervisor in the painting department would be a direct cost to the painting department. Since the supervisor's salary is likely to be the same amount each month regardless of the quantity of products manufactured, it is a fixed cost to the department. The supplies furnished to the painting department will be a direct cost to the department, but will be a variable cost to the department if the total amount of supplies used in the department increases as the volume or activity in the department increases.
An indirect product cost is the electricity used to operate a production machine. The cost of the electricity is variable because the total electricity used is greater when more products are manufactured on the machine. Depreciation on the production machine is also an indirect product cost, except it is usually a fixed cost. That is, the machine's total depreciation expense is the same each year regardless of volume produced on the machine.
As you can see, costs can be direct and indirect depending on the cost object: product, department, and others such as division, customer, geographic market. The cost is fixed if the total amount of the cost does not change as volume changes. If the total cost does change in proportion to the change in the activity or volume, it is a variable cost.
A responsibility center is a part or subunit of a company for which a manager has authority and responsibility. The company's detailed organization chart is a logical source for determining responsibility centers. The most common responsibility centers are the departments within a company.
When the manager of a responsibility center can control only costs, the responsibility center is referred to as a cost center. If a manager can control both costs and revenues, the responsibility center is known as a profit center. If a manager has authority and responsibility for costs, revenues, and investments the responsibility center is referred to as an investment center.
Elastic demand means that demand for a product is sensitive to price changes. For example, if the selling price of a product is increased, there will be fewer units sold. If the selling price of a product decreases, there will be an increase in the number of units sold. Elastic demand is also referred to as the price elasticity of demand.
The term inelastic demand means that the demand for a product is not sensitive to price changes.
Elastic demand is a major concern for a manufacturer that attempts to set product prices based on costs. For instance, if the manufacturer's production and sales have declined and it fails to cut fixed costs, the manufacturer could be worse off by increasing selling prices.
Use the search box on AccountingCoach.com for our Q&A on death spiral which is pertinent to elastic demand.
When a company incurs rent for its manufacturing operations, the rent is a product cost. It is common for the rent to be included in the manufacturing overhead that will be allocated or assigned to the products. That rent as part of the manufacturing overhead cost will cling to the products. If the products remain in inventory, the rent is included in the manufacturing overhead portion of the product's cost. When products are sold, the rent allocated to those products will be expensed as part of the cost of goods sold.
If the rent is for items involved in the selling function (rent for office space, equipment, autos, etc.) or if the rent is for items in the administrative function of the company, the rent is a period cost and will be expensed in the period when the expense is incurred. These rents will not be allocated to the products for external financial statements.
The distinction between product costs and period costs is important for 1) properly measuring net income during a period of time and 2) reporting the proper cost of inventory on the balance sheet.
Product costs cling to the units of products purchased or manufactured. If a unit is unsold, the product costs will be reported as inventory, a current asset on the balance sheet. The product costs for a retailer will be the amount paid to the supplier plus any freight-in. Product costs for a manufacturer will be the direct materials, direct labor, and manufacturing overhead. Product costs will be reported on the income statement as the cost of goods sold expense in the period that the units of product are sold.
Period costs do not cling or attach to the units of product and will not be included in the cost of inventory. For example, the interest incurred by a retailer to finance its operations will be expensed in the period in which the interest occurs. Interest is not deferred by adding it to the cost of the units in inventory. Similarly, selling expenses and general administrative salaries are expensed in the period that the employees earn those salaries, the same period in which the company incurs the salaries expense. The insurance premiums that a company pays for nonmanufacturing protection will be expensed in the period in which the insurance premiums expire. (Insurance premiums for the factory building will be included in the manufacturing overhead which will be part of the products' cost.)
The rental cost of a building used in manufacturing is part of manufacturing overhead. Manufacturing overhead is an indirect product cost. Indirect product costs are allocated or assigned to products on some reasonable basis. As a result, the rental cost of a manufacturing building will cling to the products manufactured. If the goods manufactured are in inventory, some of the rent of the manufacturing facility is in inventory. When a product is sold, the manufacturing rent that is included in the product cost will be part of the cost of goods sold.
The rental cost of a building that is not used for manufacturing (e.g. rent for a sales office, rent for the general administrative office) is not part of the manufacturing overhead. This rent does not cling to the products and will not be part of the cost of an item in inventory. The rent for nonmanufacturing facilities is immediately expensed in the accounting period when the building is rented.
If a rented building is used for both manufacturing and nonmanufacturing activities, the rent should be allocated to each (perhaps on the basis of square footage).
Worker comp insurance premiums should be charged to the areas where the related wages and salaries are charged.
Let's assume that the net cost of worker comp insurance after discounts and dividends is 5% of the wages and salaries of direct and indirect manufacturing employees. If for the month of January the direct labor is $40,000, then $2,000 of the worker comp cost should be included as direct labor. If indirect labor for January is $60,000 then $3,000 of worker comp cost should be included as the cost of the indirect labor.
If the general office worker comp rates are 0.2% of the general office wages and salaries, then 0.2% of January's general office wages and salaries will be expensed as worker comp insurance expense.
If the employer remits each month's worker comp cost to its insurance company each accounting period, there will be no prepaid insurance nor will there be a liability for accrued worker comp expense.
If the employer remits worker comp premiums to the insurance company in advance of the cost associated with wages and salaries, the amount that is prepaid as of the balance sheet date should be reported as Prepaid Insurance, a current asset. If the employer has remitted less than the worker comp cost associated with the wages and salaries, the amount owed to the insurance company as of the balance sheet date is reported as a current liability such as Accrued Worker Comp Payable.
Many (perhaps most) accountants use the term full cost to mean the full manufacturing or production cost of a product. To these accountants this means a product's cost of materials, labor, and both variable and fixed manufacturing overhead. These accountants do not include selling, administrative, or interest costs in their definition of the full cost of a product. Their view is consistent with the way that inventory and the cost of goods sold are reported on a company's financial statements.
Some accountants use the term full cost to mean more than a product's manufacturing or production costs (including fixed manufacturing overhead). These accountants use full cost to mean the manufacturing cost plus an allocated portion of the company's selling, administrative, and interest costs. These accountants are concerned that some products require a larger portion of selling and administrative costs while other products require a small portion. Only when a product's selling and administrative costs are combined with the product's manufacturing costs will they be able to determine whether each product's selling price is sufficient or is aligned with its "full cost".
Nonmanufacturing overhead costs are the business expenses that are outside of a company's manufacturing operations. These are often referred to as the selling, general and administrative (SG&A) expenses plus the company's interest expense. Examples of the nonmanufacturing overhead costs include the salaries and other expenses for the following business activities: selling, distribution, marketing, finance, IT, human resources, legal, and so on. (We have additional examples within our AccountingCoach.com topic Nonmanufacturing Overhead.)
Since these costs are outside of the manufacturing function, they are not considered to be costs of the products. As a result, the nonmanufacturing costs are not allocated to the products for determining the costs for inventory or for the cost of goods sold. Instead, the nonmanufacturing costs are immediately expensed in the accounting period in which they are incurred. That is why accountants say that the nonmanufacturing costs are period costs or period expenses. (Only the manufacturing costs of direct materials, direct labor and manufacturing overhead are product costs.)
While the nonmanufacturing overhead costs are not allocated to the products, the company must have its selling prices and sales revenues sufficient to cover both the product costs and the period expenses in order to avoid a negative net income.
The cost of the insurance premiums for a company's property insurance is likely to be a fixed cost. The cost of worker compensation insurance is likely to be a variable cost. Whether a cost is a fixed cost, a variable cost, or a mixed cost depends on the independent variable.
Let's illustrate this by looking at the cost of property insurance. The cost of insuring the factory building is a fixed cost when the independent variable is the number of units produced within the factory. In other words, the factory's property insurance might be $6,000 per year whether its output is 2 million units, 3 million units, or 5 million units. On the other hand, if the independent variable is the replacement cost of the factory buildings, the insurance cost will be a variable cost. The reason is the insurance cost on $12 million of factory buildings will be more than the insurance cost on $9 million of factory buildings, and less than the insurance premiums on $18 million of factory buildings.
In the case of worker compensation insurance, the cost will vary with the amount of payroll dollars (excluding overtime premium) in each class of workers. For example, if the worker comp premiums are $5 per $100 of factory labor cost, then the worker comp premiums will be variable with respect to the dollars of factory labor cost. If the units of output in the factory correlate with the direct labor costs, then the worker compensation cost will also be variable with respect to the number of units produced. On the other hand, the worker compensation cost for the office staff is usually a much smaller rate and that worker compensation cost will not be variable with respect to the number of units of output in the factory. However, the worker compensation cost of the office staff will be variable with respect to the amount of office staff salaries and wages.
As you have seen, determining which costs are fixed and which are variable can be a bit tricky.
A manufacturer may never be able to determine the precise cost of its individual products. The reason is that most of the manufacturing costs (other than materials and some labor) are indirect costs. This means that most of the manufacturing costs are not directly traceable to individual products and will need to be allocated to them. Examples of indirect manufacturing costs include the rent, property taxes, depreciation, heat, lighting, indirect production workers pay and benefits, repairs, maintenance, and others that occur in the factory.
In addition to the manufacturing costs, there are selling, general and administrative (SG&A) expenses and perhaps interest expense. Generally, accountants do not consider these expenses to be product costs. As a result these expenses are reported on the income statement when they occur and without any allocation to the products. However, these expenses are associated with some or all of the products.
The manufacturer can attempt to calculate the costs and expenses of each of its products, but I don't think the result will be the true, precise cost. In addition to the allocations (which are viewed as arbitrary), consider that changes in volume will affect a product's cost. For example, if a company's total fixed costs remain constant but its volume of products decreases by 20%, the cost of each product will increase. If volume increases, the cost of each product will decrease.
Activity-based costing (ABC) is an attempt to improve the allocation of costs by identifying more of the root causes of the costs (rather than merely spreading costs to products based on machine hours). Even with ABC there will be arbitrary allocations which will prevent knowing each product's precise cost.
A manufacturer's selling prices should not be based on costs alone. One reason is that the actual cost of each product is not known with precision. At best, each product's cost is an average that resulted from allocations of the indirect manufacturing costs. In addition, there are selling, general and administrative expenses that are even more difficult to associate with individual products.
A more compelling reason that selling prices should not be based solely on costs is the market for a product. If a product is unique, protected by a patent and trademark, and the demand for the product is high, customers may accept a selling price that is unusually high. In other words, the value of the product is much greater than the costs identified with the product plus a normal profit or markup.
At other times the market will include competitors offering a similar product at lower selling prices because of efficiencies, lower costs, or inaccurate cost calculations. Perhaps another competitor will sell a similar product at a lower selling price in hopes of attracting customers who will buy additional, more profitable products. These situations will likely prevent the manufacturer from achieving significant sales at selling prices that are based on costs plus a desired profit.
Given the complexity of a manufacturer's operations and the competition in the market place, it is rare for a manufacturer to have selling prices based on its true costs plus a uniform rate of profit.
Here are the meanings of the components or symbols used in the least squares equation of y = a + bx:
y is the dependent variable, such as the estimated or expected total cost of electricity during a month. The amount of y is dependent upon the amounts of a and bx.
a is the estimated total amount of fixed electricity costs during the month. It is the value of y, when x is zero. If the total cost line intersects the y-axis at $1,000 then it is assumed that the total fixed costs for a month are $1,000.
b is the estimated variable cost per unit of x. It determines the slope of the total cost line. If b is $5, this means that the variable cost portion of electricity is estimated to be $5 for every unit of x.
x is the independent variable. For example, x could represent the known number of machine hours used in the month.
bx is the total variable cost of electricity. If the company's electricity cost is estimated to be $5 per unit of x, and x is 4,000 machine hours, then the total variable cost of electricity for the month is estimated to be $20,000.
In our example the total estimated cost of electricity (y) in a month when x is 4,000 machine hours will be $21,000.
The cost system for inventory valuation may have been developed to provide a reasonable total cost of inventory and a reasonable total cost of goods sold in order to have reasonably accurate financial statements. If a company has small inventory amounts and significant sales, a simple cost system that spreads manufacturing overhead costs solely on the basis of machine hours can result in a reasonably accurate balance sheet and income statement.
While a simple cost system using just one cost driver (machine hours) may result in accurate financial statements, it often fails to provide the true cost of individual products that vary in complexity. For example, one product might require very few machine hours but will require many hours of special handling. The costs assigned on the basis of machine hours alone will be too low in relationship to the true cost of manufacturing this product. Another product might require many machine hours but no other activities. This product's cost will be overstated because the rate assigned via the machine hours will include an amount for other activities that generally occur for the other products manufactured.
A cost system developed for inventory valuation is limited to the cost of direct materials, direct labor, and manufacturing overhead. The total cost of providing products to a customer will also include nonmanufacturing expenses. One customer might require a company to incur additional selling, delivering, storing, and administrative expenses. Another customer might not require any of those activities and their related expenses.
Activity based costing attempts to calculate the true cost of a product and customer by assigning costs and expenses based on their root causes. Because there are many root causes, the company will assign costs based on many cost drivers. This results in more accuracy for the cost and expense of a specific product for a specific customer than simply spreading the manufacturing costs on the basis of one cost driver such as machine hours.
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