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products you sell. You may have your enthusiasm under con-
trol for this chapter. I would point out, however, that all man-
agers 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 pur-
chase 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 assem-
bly 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 bind-
ing 10,000 copies of a book is an example of a job order
system.
The example in this chapter is for an established manu-
facturing 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 per-
cent 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 allo-
cated 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 over-
head 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 activ-
ity. Examples are property taxes, fire insurance on the pro-
duction 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 pro-
vide 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 account-
ants 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 manufac-
turing 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 invento-
ries 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
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 clas-
sification 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 meth-
ods of manufacture, new compounds of materials, or other
technological improvements.
Raw materials and direct labor costs are clearly manufactur-
ing costs. Taken together, they are called prime costs. Direct
materials and direct labor are matched with or traced to partic-
ular 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 materi-
als) 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 prod-
ucts manufactured by the company. The company in this
example makes only one product. So fixed overhead and vari-
able 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 adminis-
tration expenses that should have been booked as manufac-
turing costs. These misclassified costs were not included in
the calculation of unit product cost. The purpose was to maxi-
mize 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 classifi-
cation. The Internal Revenue Service noticed that many man-
ufacturers 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 cap-
italized. 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 machin-

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