Let’s take a look at GBC, Inc., a hypothetical company that makes gift baskets.
Here is the information for the month of July:
What you can discern from this statement is that although the company has gross profit, it’s not enough to cover the selling, general, and administrative costs, which results in an operating loss.
Let’s assume two things:
- If you increase the selling price of the baskets, the volume will drop because your customers will buy from your competitors.
- Selling, general, and administrative expenses have already been reduced as far as they can go.
As managerial accountants, let’s take a look at manufacturing costs to see if we can do anything there.
The number we are focusing on is Cost of Goods Sold. That represents the cost to manufacture the baskets. If we sold 16,200 baskets and the cost of those baskets was $469,192, then the average cost of each basket we produced was $28.96.
Let’s see if we can reconstruct how that number came to be.
We’ll start with the basic raw materials—baskets. Here is the schedule of baskets available and used during the month:
The company had 1,200 baskets on July 1, bought 16,800, and counted 2,000 on July 31, which means they put 16,000 baskets onto the assembly line during the month.
They also transferred 17,400 fruit and nut packages into work-in-process (assume each basket is packed with one pre-packaged fruit and nut sampler).
In addition to direct materials, the company has on hand packaging and stuffing materials—like plastic wrap and shredded paper—that it does not allocate directly to each basket.
Therefore, the completed schedule of Raw Materials Inventory for the month looks like this:
Checking in with the production department, you are able to reconstruct the following report:
Production started with 1,800 empty baskets. To that, they added 16,000 more empty baskets (see the direct materials report). Thus they had 17,800 baskets to fill. Over the course of the month, they filled 17,400 baskets (see direct materials report for fruit and nut packages transferred in) and had 400 empty baskets left to fill the following month, which means that the ending work-in-process inventory was $5,120 (the cost of 400 empty baskets).
You may not be able to decipher all of this report just yet, but we’ll be looking at this kind of cost report in more detail as the course progresses.
To the cost of raw materials included in the 17,400 baskets the company completed, we add the labor that it took to fill the baskets and the indirect costs that we call manufacturing overhead (including the $432 in packaging from the raw materials report).
Here’s a question you may be able to answer though: if it takes a person a half-hour to complete a basket, what is the total direct labor cost per hour?
17,400 baskets completed * 0.5 hours per basket = 8,700 labor hours
$122,250 direct labor divided by 8,700 hours of labor = $14.08 per hour
So, we calculate that the total cost of all the baskets the company finished in July was $510,921. Divided by the 17,400 baskets, we get a cost per basket of $29.36.
Here is the final computation:
The company started the month with 6,000 unsold baskets and completed another 17,400 during the month. The company sold 16,200 baskets, leaving 7,200 unsold at the end of July. Notice that the cost per basket went up a bit in July, from $27.80 to $29.36. That may be a clue about what is driving the overall loss, but we’d have to dig into the data a bit more to find out if that is something we can control or not. It may be due to increased labor or raw materials costs.
In any case, the bottom line of that report gives us the cost of goods sold, which carries forward to the income statement.
Let’s look at the entire flow one more time, just to get the big picture. Raw materials flow to work-in-process, where direct labor and manufacturing overhead convert the prime costs to finished goods, which are then either sold or held as inventory for sale in subsequent periods.
As you progress through the rest of this course, you will find ways to delve deeper into these numbers, not just to understand them, but to be able to plan for the future and to direct and control current operations. For instance, automating the stuffing process could significantly decrease direct labor costs, but the cost of the equipment would increase manufacturing overhead. Perhaps there are other ways to decrease direct and indirect manufacturing costs. Finding solutions to these sticky issues is your job as a managerial accountant and is the crux of this course.
