Cost Classifications on Financial Statements:

Learning Objectives of this Article:

1. Prepare a schedule of cost of goods manufactured.
2. Prepare income statement including a schedule of cost of goods sold.

Merchandising and manufacturing firms, both prepare financial statement reports for creditors, stockholders, and others to show the financial condition of the firm and the firm’s earnings performance over some specified intervals. Merchandising companies simply purchase goods and resale them to customers. Financial statement reports are therefore simple in case of merchandising companies. The financial statements prepared by manufacturing companies are more complex than the statements prepared by a merchandising company. Manufacturing companies are more complex organizations than merchandising companies because the manufacturing companies must produce its goods as well as market them. The production process gives rise to many costs that do not exist in a merchandising company, and some how these costs must be accounted for on the manufacturing company’s financial statements. In this section, we focus our attention on how this accounting is carried out in the balance sheet and income statement.

Balance Sheet:

The balance sheet or statement of financial position of a manufacturing company is similar to that of a merchandising company. However, the inventory accounts differ between two types of companies. A merchandising company has only one type of inventory-goods purchased from suppliers that are awaiting resale to customers. In contrast manufacturing companies have three classes of inventories-raw materials, work-in-process, and finished goods.

Example:

We will use the data of two companies A and B-to illustrate the concept discussed in this section. Company A is involved in manufacturing a product Alpha and B is involved in purchasing books about business and finance from publishers and authors and reselling them to customers.

The footnotes to A’s annual reports reveal the following information concerning its inventories.

A’s inventory largely consists of  raw materials used in manufacturing product alpha. The work in process inventory consists of partially completed alpha. The finished goods inventory consists of alpha that is ready to be sold to the customers or whole sellers.

In contrast the inventory account at B–a book reseller– consists entirely of the costs of books the company has purchased from publishers for resale to the public. In merchandising companies like B these inventories may be called merchandising inventories. The beginning and ending balances in this account appears as follows:

Income Statement:

Following are comparative income statements of merchandising and manufacturing companies.

At first glance, the income statements of merchandising and manufacturing firms like A and B companies are very similar. The only apparent difference is in the labels of some of the entries in the computation of cost of goods sold. In this example, the computation of cost of goods sold relies on the following basic equation for the inventory accounts:

Basic Equation for Inventory Accounts:

Beginning balance + Additions to inventory = Ending balance + withdrawals from inventory

At the beginning of the period, the inventory contains some beginning balances. During the period, additions are made to the inventory through purchases or other means. The sum of the beginning balance and additions to the account is the total amount of inventory available. During the period, withdrawals are made from inventory. Whatever is left at the end of the period after these withdrawals is the ending balance.

These concepts are applied to determine the cost of goods sold for a merchandising company like B-bookstore as follows:

Cost of Goods Sold in a Merchandising Company:

Beginning merchandising inventory + Purchases = Ending merchandising inventory + Cost of goods sold

Or

Cost of goods sold = Beginning merchandising inventory + Purchases − Ending merchandising inventory

To determine the cost of goods sold in a merchandising company, we only need to know the beginning and ending merchandising inventory account and the purchases. Total purchases can be easily determined in a merchandising company by simply adding together all purchases from suppliers.

The cost of goods sold for a manufacturing company like A manufacturing company is determined as follows:

Cost of Goods Sold Equation in a Manufacturing Company:

Beginning finished goods inventory + Cost of goods manufactured = Ending finished goods inventory + Cost of goods sold

Or

Cost of goods sold = Beginning finished goods inventory + Cost of goods manufactured − Ending finished goods inventory

To determine the cost of goods sold in a manufacturing company like A manufacturing company, we need to know the cost of goods manufactured and the beginning and ending balances of finished goods inventory account. The cost of goods manufactured consists of the manufacturing costs associated with goods that were finished during the period. The cost of goods manufactured figure for A manufacturing company is derived from the schedule of  cost of goods manufactured below the comparative income statements.

Schedule of Cost of Goods Manufactured:

At first glance the schedule of cost of goods manufactured (below comparative income statements) appears complex and perhaps even intimating. However, it is all quite logical. The schedule of cost of goods manufactured contains the three elements of cost–direct materials, direct labor, and manufacturing overhead. The direct materials cost is not simply the cost of materials purchased during the period rather is the cost of materials used during the period. The purchase of raw materials are added to the beginning balance to determine the cost of the materials available for use. The ending materials inventory is deducted from this amount to arrive at the amount of materials used during the period. This is further explained by the following equation:

Materials available for use  =  Beginning balance of materials + materials purchased during the period

The sum of three cost elements (materials, labor and overhead) is the total manufacturing cost. See the following equation:

Manufacturing cost = Direct materials + Direct labor + Manufacturing overhead

This manufacturing cost is not equal to the cost of goods manufactured. Some of the materials, direct labor and manufacturing overhead costs incurred during the period relate to goods that are not yet completed. The cost of goods manufactured consists of the manufacturing costs associated with the goods that were finished during the period. Consequently adjustments need to be made to the total manufacturing cost of the period for the partially completed goods that were in process at the beginning and at the end of the period. Beginning work in process inventory must be added to the total manufacturing cost and ending work in process inventory must be deducted to arrive at the cost of goods manufactured. This is further explained by the following equation:

Cost of goods manufactured = Manufacturing cost + Beginning balance of work in process inventory − Ending balance of work in process inventory

You may also be interested in other useful articles from “cost terms, concepts and classifications” chapter:

1. Manufacturing and Non-manufacturing Costs
2. Product Costs Versus Period Costs
3. Cost Classifications on Financial Statement
4. Cost Classifications for Predicting Cost Behavior (Variable and Fixed cost)
5. Mixed or Semi variable Cost
6. Cost classification for Assigning Costs to Cost Objects (Direct and Indirect Cost)
7. Decision making costs – cost classification for decision making
8. Quality Costs
9. Further Classification of Labor Costs

Other Related Accounting Articles:

• Income Comparison of Variable and Absorption Costing
• Flow of Costs
• Product Cost VS Period Cost
• Product Cost or Manufacturing Cost
• Absorbed Cost Explained
• Cost Terms, Concepts, and Classifications
• Definition and Explanation of Process Costing System
• Controlling and Costing Materials – Questions and Answers
• Cost Classification as Manufacturing and Non-manufacturing
• Cost Classification as Manufacturing and Non-manufacturing