What you will learn to do: describe the flow of manufacturing costs
A manufacturer reports its product costs as one of three types of inventory in the current assets section of its balance sheet, depending on stages of completion. Materials consist of items in inventory that have not yet been entered into production or used. Work-in-process includes manufactured products that have been started but are not yet completed. In other words, they are currently in production. Finally, finished goods are manufactured products that have been completed but not yet sold to customers.
Many of you will work in manufacturing companies or provide services for them. Others will work in retail or service organizations that do business with manufacturers. This section will help you understand how manufacturing companies work and how to read both their internal and external financial statements.
Assume you own a bicycle store and purchase bicycles and accessories to sell to customers. To determine your profitability, you would subtract the cost of bicycles and accessories from your gross sales as cost of goods sold. However, if you owned the manufacturing company that made the bicycles, you would base your cost of goods sold on the cost of manufacturing those bicycles. Accounting for manufacturing costs is more complex than accounting for costs of merchandise purchased that is ready for sale.
Perhaps the most important accounting difference between merchandisers and manufacturers relates to the differences in the nature of their activities. A merchandiser purchases finished goods ready to be sold. On the other hand, a manufacturer must purchase raw materials and use production equipment and employee labor to transform the raw materials into finished products.
While a merchandiser has only one type of inventory—merchandise available for sale—a manufacturer has three types—unprocessed materials, partially complete work in process, and ready-for-sale finished goods. Instead of one inventory account, three different inventory accounts are necessary to show the cost of inventory in various stages of production. Looking at Exhibit 2, you can see how the inventory cost flows differ between manufacturing and merchandising companies.
We compare a manufacturer’s “cost of goods sold” section of the income statement to that same section of the merchandiser’s income statement in the chart below. There are two major differences in these cost of goods sold sections: (1) goods ready to be sold are referred to as merchandise inventory by a merchandiser and finished goods inventory by a manufacturer, and (2) the net cost of purchases for a merchandiser is equivalent to the cost of goods manufactured by a manufacturer.
| Merchandiser | Manufacturer | ||
| Cost of goods sold: | Cost of goods sold: | ||
| Merchandise inventory, Beginning | $ 25,000 | Finished goods inventory, Beginning | $ 50,000 |
| Net cost of purchases | 165,000Double line | Cost of goods manufactured | 1,100,000Double line |
| Cost of goods available for sale | $ 190,000 | Cost of goods available for sale | $1,150,000 |
| Merchandise inventory, Ending | 30,000Double line | Finished goods inventory, Ending | 60,000Double line |
| Cost of goods sold | $ 160,000 | Cost of goods sold | $1,090,000 |
Unlike a merchandiser’s balance sheet that reports a single inventory amount, the balance sheet for a manufacturer typically shows materials, work in process, and finished goods inventories separately. The video and chart will explain these concepts further.
You can view the transcript for “Raw Materials, Work in Process, and Finished Goods Inventory (Cost Accounting Tutorial #23)” here (opens in new window).
| Account | Account Type | Description |
| Raw Materials Inventory | Current Asset | All materials to be used in production (including direct and indirect materials) |
| Work in Process Inventory | Current Asset | Direct Material + Direct Labor + Overhead applied to items started but not completed |
| Finished Goods Inventory | Current Asset | Direct Material + Direct Labor + Overhead applied to items completed BUT not sold |
| Cost of Goods Sold | Expense | Direct Material + Direct Labor + Overhead applied to items completed AND sold |
When you are done with this section, you will be able to:
- Describe the flow of costs for a manufacturing company
- Create cost statements for a manufacturing company
- Differentiate between service, merchandising, and manufacturing cost accounting requirements
Learning Activities
The learning activities for this section include the following:
- Reading: Cost of Goods Manufactured
- Self Check: Cost of Goods Manufactured
- Reading: Cost of Goods Sold
- Self Check: Cost of Goods Sold
- Reading: Cost Accounting Systems Compared
- Self Check: Cost Accounting Systems Compared
