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E N D T O P I C S

highlighted and not lost in the avalanche of details. Control reports should focus on several negative factors that adversely affect sales prices, sales volume, and expenses.

Budgeting provides useful yardsticks and standards for management control. But budgeting is done for more than just control purposes. Budgeting is a broader management prac-

tice that encompasses strategic planning, communication throughout the organization, motivation of managers, and more. The brief overview in the chapter looks at the reasons for budgeting, as well as its inherent disadvantages.

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C H A P T E R 18

1

Manufacturing

Accounting

IIf you’re in the manufacturing business, this chapter is an absolute must. The chapter presents a concise explanation of the accounting methods used by virtually all manufacturers to determine and measure product cost. To set sales prices, to control costs, and to plan for the future, a business must know the costs of manufacturing its products.

But suppose you’re not in the business of manufacturing the products you sell. You may have your enthusiasm under control for this chapter. I would point out, however, that all managers use product cost information and that all products begin their life by being manufactured. Even if your company does not manufacture products, it’s important to understand how manufacturing costs are accumulated, how they are allocated to products, and how certain accounting problems are dealt with by manufacturers.

PRODUCT MAKERS VERSUS

PRODUCT RESELLERS

Manufacturers are producers—they make the products they sell. Retailers (as well as wholesalers and distributors) do not make the products they sell; they are channels of distribution.

Product cost is purchase cost for retailers; it comes on a purchase invoice. Product cost is much different for manufacturers;
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it’s the composite of diverse costs of production. It has to be computed.

The manufacturing process may be simple and short or complex and long. It may be either labor-intensive or capital-

(asset-) intensive. Products (e.g., breakfast cereal) may roll nonstop off the end of a continuous mass-production assembly line. These are called
process cost systems.
Or production may be discontinuous and done on a one-batch-at-a-time basis; these are called
job order systems.
Printing and binding 10,000 copies of a book is an example of a job order system.

The example in this chapter is for an established manufacturing business, one that has been operating for several years. Its managers have already assembled and organized machines, equipment, tools, and employees into a smooth-running production process that is dependable and efficient—a monumental task, to say the least. Plant location is critical; so is plant layout, employee training, materials procurement, complying with an ever broadening range of governmental regulations, employee safety laws, environmental protection laws, and so on. These points are mentioned only in passing to make you aware of the foundation that precedes product cost determination.

MANUFACTURING BUSINESS EXAMPLE

Some manufacturers determine their product costs monthly, others quarterly. There is no one standard period. It could be done weekly or even daily. The year is a natural time period for management planning and financial reporting. Thus, one year is the time period for this example.

In this example, the business manufactures one product in its one production plant. Figure 18.1 presents the company’s profit report for the year down through its operating profit line (earnings before interest and income tax expenses). It includes the manufacturing cost report, which is a supporting schedule that has not been presented before.

Manufacturing costs consist of four basic cost components or natural groupings.
Raw materials
are purchased parts and materials that become part of the finished product.
Direct
labor
refers to those employees who work on the production
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Management Profit Report for Year

Sales Volume = 11,000 Units

Per Unit

Total

Sales revenue

$1,400

$15,400,000

Cost-of-goods-sold expense

($ 685)

($ 7,535,000)

Gross margin

$ 715

$ 7,865,000

Variable operating expenses

($ 305)

($ 3,355,000)

Contribution margin

$ 410

$ 4,510,000

Fixed operating expenses

($ 2,300,000)

Operating profit (earnings before

interest and income tax)

$ 2,210,000

Manufacturing Costs for Year

Annual Production Capacity = 12,000 Units

Actual Output = 12,000 Units

Basic Cost Components

Per Unit

Total

Raw materials

$ 215

$ 2,580,000

Direct labor

$ 260

$ 3,120,000

Variable overhead

$

35

$

420,000

Fixed overhead

$ 175

$ 2,100,000

Total manufacturing costs

$ 685

$ 8,220,000

Distribution of Manufacturing Costs

11,000 units sold (see above)

$ 685

$ 7,535,000

1,000 units inventory increase

$ 685

$

685,000

Total manufacturing costs

$ 8,220,000

FIGURE 18.1
Profit report and manufacturing costs schedule for year.

line. Direct labor costs include fringe benefits, which typically add 30 to 40 percent to basic wages. For instance, employer Social Security and Medicare tax rates presently are 7.65 percent of base wages; also, there are unemployment taxes, employee retirement and pension plan contributions, health and medical insurance, worker’s compensation insurance, and paid vacations and sick leaves.

The company recorded $8,220,000 total manufacturing costs and produced 12,000 units during the year. Of this amount $7,535,000 is charged to cost-of-goods-sold expense
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for the 11,000 units sold during the year and $685,000 is allocated to the 1,000-unit inventory increase.* Thus $685,000 of the manufacturing costs for the year will not be expensed until next year or sometime further into the future when the inventory is sold.†

Manufacturing
overhead
refers to all other production costs.

Some of these costs vary with total output, such as electricity that powers machinery and equipment. These
variable overhead
costs are separated from
fixed overhead
costs. Over the short run, many manufacturing overhead costs are fixed in amount and do not depend on the level of production activity. Examples are property taxes, fire insurance on the production plant, and plant security guards who are paid a fixed salary.

In this example, the company’s annual production capacity is 12,000 units. Its $2.1 million total fixed overhead costs provide the physical facilities and human resources to produce 12,000 units under normal, practical operating conditions.

Actual production output for the year in the example equals the company’s production capacity. In actual practice, actual output usually falls somewhat below capacity. How accountants deal with the difference between capacity and output is discussed later in the chapter.

Computation of Unit Product Cost

Unit product cost is determined by dividing the total manufacturing costs for the period by total production output for the period:

*During the production process, which can take several weeks or months, manufacturing costs are first accumulated in an inventory account called
work-in-process.
When production is completed, the cost of the completed units is transferred to the
finished goods
inventory account.

†A manufacturing business may select either the FIFO or the LIFO method for assigning product costs to cost-of-goods-sold expense and to the inventories asset. This choice of costing methods is available to manufacturers as well as retailers and wholesalers. Product costs usually vary from period to period. Thus the cost-of-goods-sold expense and the amount allocated to the inventory increase are different between the two methods. The FIFO and LIFO methods are explained in Chapter 20 of my book,
How to Read a
Financial Report,
5th ed., (New York: John Wiley & Sons, 1999).

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$8,220,000 total manufacturing costs

ᎏᎏᎏᎏᎏ

12,000 units total output

= $685 unit product cost

Notice immediately three things about unit product cost. First, it’s a calculated amount. It doesn’t exist until it’s computed. Clearly, both the numerator and the denominator of the computation must be correct or else the unit product cost would be wrong. Second, unit product cost is an average. Total cost over a period of time is divided by total output over that same period, one year in this example. Costs and quantities may vary daily, weekly, or monthly—but the definition and computation of unit product cost is the average over a certain period of time.* Third, only manufacturing costs are included, not the nonmanufacturing expenses of operating the business such as marketing (sales promotion, advertising, etc.), delivery costs, administration and general management costs, legal costs, and interest expense. A so-called Chinese wall should be built between manufacturing costs and all other, nonmanufacturing costs. The proper classification and separation between costs is critical.

Sales and marketing costs, such as advertising, are not included in product cost; these are viewed as

costs of making sales, not making products. Research and development (R&D) costs are not classified as product cost, even though these costs may lead to new products, new methods of manufacture, new compounds of materials, or other technological improvements.

Raw materials and direct labor costs are clearly manufacturing costs. Taken together, they are called
prime costs.
Direct materials and direct labor are matched with or traced to particular products being manufactured. Variable overhead, on the other hand, presents problems of matching with particular products. And fixed overhead is a real headache. The term
overhead
refers to indirect costs of manufacturing the products.

*In job order costing systems, the total cost of each job (one batch or group of products that is manufactured as a separate lot) is divided by the total number of units in the job to determine unit product cost.

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Consider, for example, the print order for the production of 10,000 copies of a book. The paper and ink costs (raw materials) can be identified to each production run. Likewise, the employees who set up and operate the presses (direct labor) can be identified and matched to the job. However, variable overhead costs cannot be directly identified with particular press runs; instead, these costs must be allocated. For instance, the cost of electricity to power the presses can be allocated on the basis of the machine hours of each print run.

Much more troublesome are fixed manufacturing overhead costs, which include a wide variety of costs such as property taxes on the production plant, depreciation of the production equipment, fixed salaries of plant nurses and doctors, the fixed salary of the vice president of production, and so on. Fixed manufacturing overhead costs have to be allocated according to some basis for sharing these costs among the different products manufactured by the company. The company in this example makes only one product. So fixed overhead and variable overhead costs are all assigned to this one product. (Cost allocation issues and methods are discussed in Chapter 17.)
MISCLASSIFICATION OF MANUFACTURING COSTS

To minimize taxable income, some manufacturers have been known to intentionally misclassify some of their costs. Certain costs were recorded as marketing or as general and administration expenses that should have been booked as manufacturing costs. These misclassified costs were not included in the calculation of unit product cost. The purpose was to maximize costs that are charged off immediately to expense. By minimizing current taxable income, the business could delay payment of income taxes.

The Internal Revenue Code takes a special interest in the problem of manufacturing overhead cost classification. The Internal Revenue Service noticed that many manufacturers were misclassifying some of their costs. The income tax law spells out in some detail which costs must be classified as manufacturing overhead costs and therefore capitalized.
Capitalize
means to put the cost into an inventories asset account by including the cost in the calculation of unit
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product cost. Remember that the cost of products held in inventory remains an asset and is not charged to expense until the products are sold.

The following costs should definitely be classified as manufacturing costs: production employee benefits

costs; rework, scrap, and spoilage costs; quality control costs; and routine repairs and maintenance on production machinery and equipment. Of course, depreciation of production machinery and equipment and property taxes on the production plant should be classified as manufacturing overhead costs.

To illustrate the effects of misclassifying manufacturing costs, suppose that $480,000 of the company’s manufacturing fixed overhead costs had been recorded in fixed operating expenses instead of in fixed manufacturing overhead costs.

Otherwise, everything else remains the same as shown before in the company example. Figure 18.2 shows the effects of this misclassification error. Pay particular attention to the operating profit line, which is taxable income before the interest expense deduction.