Introduction to Management
Accounting (ACCT2105)
Chapter 2
Objective 1
Distinguish among service,
merchandising, and
manufacturing companies
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Three types of companies
● Companies typically generate profit through one of
three basic business models:
○ Service
○ Merchandizing
○ Manufacturing
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Service Companies
● Provide intangible services only (rather than tangible products).
● Examples
○ Advertising agencies
○ Banks
○ Law firms
○ Insurance companies
● No inventory (because inventory must be tangible goods).
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Merchandisers
● Buy and resell tangible products they purchase from suppliers.
● Examples
○ Walmart
○ Best Buy
○ [Link]
● Retailers vs. Wholesalers
● Only one inventory account
○ Called “Inventory” or “Merchandise Inventory”
○ Cost of inventory includes the cost merchandisers pay for the
goods plus all costs necessary to get the merchandise in place
and ready to sell (e.g., freight-in costs, import tariffs)
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Manufacturers
● Use labor, plant, and equipment to convert raw materials
into finished products.
● Examples
○ Procter & Gamble
○ General Mills
○ Dell Computer
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Manufacturers
● Three inventory accounts
○ Raw materials
■ All raw materials used in manufacturing.
○ Work in process
■ Goods that are partway through the manufacturing
process but not yet complete.
○ Finished goods
■ Completed goods that have not yet been sold.
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Objective 2
Describe the value chain
and its elements
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Value Chain
● Activities that add value to products and services and
cost money.
● Which business activities make up the value chain?
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Costs Incurred in Each Part of the Value Chain
● Research and Development (R&D): Researching and developing
new or improved products or services and the processes for
producing them.
○ E.g., new technologies to incorporate in vehicles (autonomous
driving systems) and in its manufacturing plants (efficient
manufacturing robotics)
● Design: Detailed engineering of products and services and the
processes for producing them.
○ E.g., update the design of older models to improve style and
features; design new prototypes on a regular basis
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Costs Incurred in Each Part of the Value Chain
● Production or Purchases: Resources used to produce a product or
service or to purchase finished merchandise intended for resale.
○ For manufacturers like Toyota, this means all the costs incurred
to make the product: raw materials (e.g., steel), plant labor (e.g.,
machine operators’ wages), and manufacturing overhead (e.g., factory
utilities and depreciation).
○ For merchandisers, this means the cost of purchasing the
inventory that the company plans to sell to customers AND all
costs associated with getting the inventory to the store (freight-in
costs, import duties and tariffs).
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Costs Incurred in Each Part of the Value Chain
● Marketing: Promotion and advertising of products or services.
○ E.g., advertisement in magazines; 2022 Super Bowl commercial
titled “The Joneses” showcasing the 2022 Toyota Tundra
● Distribution: Delivery of products or services to customers.
○ E.g., ship the cars to dealerships
● Customer Service: Support provided for customers after the sale.
○ E.g., warranty
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Let’s solve E2-18A together
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Objective 3
Distinguish between
direct and indirect costs
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Cost
● What is “cost”?
○ The monetary value of resources used to achieve a
specific objective.
○ A cost is usually measured as the amount that must be
paid to acquire the resources consumed.
○ Examples: labor, materials, electricity, and so on.
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Cost Object
● When thinking about costs, we must think of them in the context of
putting a monetary value on “something.”
● This “something” is called Cost Object.
○ Anything for which managers want a separate measurement of cost.
○ We cannot talk about costs without specifying a Cost Object.
● Depending on the decision making needs, a manager may need
information about the cost object at various levels:
Level Cost objects
Individual Units Custom-ordered Prius
Different Models Rav4, Prius, Corolla
Alternative Marketing Strategies dealership vs built-to-order web sale
Geographic Segment of the Business Japan, US
Department R&D, Manufacturing Department
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Direct vs Indirect Cost
● Direct cost:
○ Can be directly traced to the cost object.
● Indirect cost:
○ Relates to the cost object but cannot be directly traced to
the cost object.
○ Needs to be allocated to the cost object.
These classifications are dependent on the cost object!
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Direct vs Indirect Cost
● Example:
Suppose the cost object is a unit car.
○ Cost of tires is a direct cost. We can directly trace the cost
of tires for that car.
○ The factory in which the car was made required some
maintenance costs. No way to trace that cost to a single car.
We need to allocate part of this indirect cost to the unit car.
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Direct vs Indirect Cost
● In the same example:
If we suppose the cost object is a manufacturing plant,
○ Then, factory maintenance cost will be considered a direct
cost! We can directly trace this cost to a factory.
➢ Again, these classifications are dependent on the cost object.
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Let’s solve S2-4 together
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Direct vs Indirect Cost
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Objective 4
Identify the inventoriable product costs
and period costs of merchandising and
manufacturing firms
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Two definitions of product cost
● Total costs:
○ Include the costs of all resources used throughout the value
chain
Production Customer
R&D Design or purchases
Marketing Distribution Service
○ Only used for internal decision-making
○ Generally Accepted Accounting Principles (GAAP) does not
allow companies to use total costs to report inventory
balances or cost of goods sold in the financial statements.
➢ What cost to use for such external reporting purposes?
➔ Inventoriable product costs
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Two definitions of product cost
● Inventoriable product costs:
○ Include only the costs incurred during the “production or
purchases” stage of the value chain
Production Customer
R&D Design or purchases
Marketing Distribution Service
○ For external reporting, inventoriable product costs are
■ “Inventorized” on balance sheet (inventory) when the costs
are incurred
■ Transferred to cost of goods sold (COGS) on income
statement when the product is sold
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Two definitions of product cost
● Period Costs
○ All costs incurred in the other stages of the value chain; Non-
inventoriable Costs
○ Must be expensed in the period in which they are incurred;
Never become part of an inventory account
○ Often called “operating expenses” or “selling, general, and
administrative expenses” (SG&A)
Production Customer
R&D Design or purchases
Marketing Distribution Service
Period cost Inventoriable Period cost
cost
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Inventoriable Product Costs and Period Costs
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Inventoriable Product Costs — Merchandiser
● Merchandising companies’ inventoriable product costs include
○ Purchase price from suppliers AND
○ Cost to get ready for sale: freight-in; import duties or tariffs
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Inventoriable Product Costs — Manufacturer
● Manufacturing companies incur three types of inventoriable
product costs
Direct Direct Manufacturing
Materials Labor Overhead
The Product
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Direct Materials
Primary materials that become a physical
part of the finished product.
Example: A radio installed in an automobile
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Direct Labor
Cost of compensating employees who
physically convert raw materials into the
company’s products.
Example: Wages paid to automobile assembly workers
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Manufacturing Overhead
● Indirect costs related to manufacturing that are not direct
materials or direct labor
○ Indirect materials: materials used in the plant that are not
easily traced to individual units
Example: glue, stapler pins, other small items that are too hard to trace
○ Indirect labor: the cost of all employees in the plant other than
those employees directly converting the raw materials into the
finished product
Example: salaries and company-paid fringe benefits (e.g., health
insurance) of plant supervisor and plant janitor
○ Other indirect (plant-related) manufacturing costs:
Example: cost of running and repairing the automated plant machines
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Inventoriable Product Costs — Manufacturer
Indirect Costs that
cannot be easily
Direct Costs that can be easily traced to individual
traced to individual units of product units of product
Direct Direct Manufacturing
Materials Labor Overhead
The Product
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Let’s solve S2-8 together
Period Cost or If an Inventoriable
[cost object is the entire DairyPlains Company]
Inventoriable Product Cost: Is it
COSTS
Product Cost? DM, DL, or MOH?
1. Cost of milk purchased from local dairy farmers Product DM
2. Depreciation on Marketing Department’s computers Period
3. Property tax on dairy processing plant Product MOH
4. Gasoline used to operate refrigerated trucks delivering
finished dairy products to grocery stores
5. Company president’s annual bonus
6. Depreciation on refrigerated trucks used to collect raw
milk from local dairy famers
7. Plastic gallon containers in which milk is packaged
8. Research and development on improving milk
pasteurization process
9. Television advertisements for Dairy Plain’s products
10. Lubricants used in running bottling machines
11. Wages and salaries paid to machine operators at dairy
processing plant
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Prime and Conversion Costs
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Objective 5
Prepare the financial statements
for service, merchandising, and
manufacturing companies
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The Flow of Inventoriable and Period Costs
● How do managers record costs on financial statements?
○ Need to track all the transactions that occurred along
the production and sales processes.
● The difference between inventoriable product costs and
period costs is important because these costs are treated
differently in the financial statements.
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Prepare Income Statements — Service Company
● Simplest income statement
○ No inventory
○ All costs are period costs – expensed in the current
period as “operating expenses”
Service revenues
Income
– Operating expenses Statement
= Operating income
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Prepare Income Statements — Merchandiser
● Different from service companies, a merchandiser’s income
statement has cost of goods sold as the major expense.
○ Merchandise inventory - transferred to COGS when the
product is sold
○ period costs – expensed in the current period as “operating
expenses”
Sales
– Cost of goods sold
Income
= Gross profit Statement
– Operating expenses
= Operating Income
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Cost of Goods Sold Calculation — Merchandiser
Note: inventory has a beginning balance (BB) and ending balance (EB)
Beginning Additions Ending Withdrawals
+ = +
balance to inventory balance from inventory
Beginning inventory
+ Purchases
+ Import duties or tariffs
+ Freight-in COGS
calculation
= Cost of goods available for sale
– Ending inventory
= Cost of goods sold
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Let’s look at S2-10
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Let’s look at S2-10
Income Statement
Year Ended December 2013
Service revenue $368,000
Less: Operating expenses
Marketing expense $28,000
Rental $18,000
Salary and benefit $100,000
Equipment depreciation expense $12,000
Website maintenance $5,000
Electricity $9,000
Supplies $12,000
Telephone bill $4,000
Total operating expenses $188,000
Operating Income $180,000
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Let’s look
at E2-25A
Calculation of Cost of Goods Sold
Beginning inventory $66,400
Plus: Purchases
Freight-in and import duty 31,200
Cost of goods available for sale
Less: Ending inventory
Cost of goods sold $149,000
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Now turn to E2-26A
Padini
Income Statement
Sales revenue $357,500
Less: Cost of goods Sold 149,000
Gross profit $208,500
Less: Operating expenses 67,650
Operating income $140,850
Units sold = $149,000 / $50 = 2,980 units
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Prepare Income Statements — Manufacturer
● The income statement for a manufacturer is essentially
identical to that of a merchandising company.
○ The only real difference is that the company is selling product
that it has made, rather than merchandise that it has purchased.
○ Therefore, the calculation of COGS is different.
Sales
– Cost of goods sold
Income
= Gross profit Statement
– Operating expenses
= Operating Income
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Flow of Costs Through a Manufacturer’s
Financial Statements
Direct Raw
Material (DM) Materials Revenue
Inventory
Direct Labor when
(DL) Finished Sales
WIP occurs Cost of Goods
Goods
Manufacturing Inventory Sold (COGS)
Inventory
Overhead
(MOH)
Operating
Period costs expenses
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Flow of Costs Through a Manufacturer’s
Financial Statements
Direct Raw
Material (DM) Materials Revenue
Inventory
Direct Labor when
(DL) Finished Sales
WIP occurs Cost of Goods
Goods
Manufacturing Inventory Sold (COGS)
Inventory
Overhead
(MOH)
Balance Sheet
Operating
Period costs expenses
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Flow of Costs Through a Manufacturer’s
Financial Statements Income
Statement
Direct Raw
Material (DM) Materials Revenue
Inventory
Direct Labor when
(DL) Finished Sales
WIP occurs Cost of Goods
Goods
Manufacturing Inventory Sold (COGS)
Inventory
Overhead
(MOH)
Balance Sheet
Operating
Period costs expenses
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Cost of Goods Sold Calculation—Manufacturer
➢ Step 1: Derive Direct Materials used
o Focus on Raw Materials Inventory account during the year
Beginning raw materials inventory
+ Purchases of raw materials
+ Freight in & import duties
DM used
= Materials available for use calculation
– Ending raw materials inventory
= Direct materials used
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Cost of Goods Sold Calculation—Manufacturer
➢ Step 2: Derive Cost of Goods Manufactured
o COGM is the cost of goods that are completed and moved to
Finished Goods Inventory during the period.
o Focus on Work in Process Inventory account
Beginning work in process inventory
+ Direct materials used (from step 1)
+ Direct labor
COGM
+ Manufacturing overhead calculation
= Total manufacturing costs to account for
– Ending work in process inventory
= Cost of goods manufactured
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Cost of Goods Sold Calculation—Manufacturer
➢ Step 3: Derive COGS
o Focus on Finished Goods Inventory account
Beginning finished goods inventory
+ Cost of goods manufactured (from step 2)
COGS
= Cost of goods available for sale calculation
– Ending finished goods inventory
= Cost of goods sold
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Product and Period Costs
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Balance Sheet Differences
Type of Company Inventory Accounts
Service Company None
Merchandiser Merchandise inventory
Raw materials, work in process,
Manufacturer
and finished goods inventory
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Objective 6
Describe costs that are relevant
and irrelevant for decision making
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Controllable and Uncontrollable Costs
Controllable Costs that management can influence or change
Costs that management cannot change or
Uncontrollable
influence in the short run; “locked-in” costs
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Relevant and Irrelevant Costs
● Relevant/Irrelevant to decision-making
Differential costs, which are the costs that
Relevant
differ between alternatives
Costs that do not differ between alternatives
or
Irrelevant
Sunk costs – costs incurred in the past that
cannot be changed
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Objective 7
Classify costs as fixed or variable
and calculate total and average
costs at different volumes
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Cost Behavior
Change in total cost in direct proportion to
Variable costs
changes in volume
Stay constant in total cost over a wide range
Fixed costs
of activity levels
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Total Variable Costs
● Total variable costs change in direct proportion to changes in
volume
○ Think about gasoline costs of driving a car:
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Total Fixed Costs
● Total fixed costs stay constant over a wide range of activity
levels
○ Think about insurance cost of driving a car:
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Total Cost
Total cost = Fixed costs + (Variable cost per unit x number of units)
Example:
o Fixed costs = $20,000
o Variable cost per unit = $50 per unit
o Number of units = 100
➢ Total cost = $20,000 + ($50 x 100) = $25,000
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Average Cost
Average cost = Total cost ÷ number of units
Example:
$25,000 = $250 per unit
100 units
● The average cost per unit is NOT appropriate for
predicting total costs at different levels of output.
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Marginal Cost
● The cost of making one more unit.
● As long as the factory is not running at 100% capacity,
making one more unit does not affect the fixed cost, and
the marginal cost is just the variable cost.
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