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Chapter 2

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York University
ACTG 2020
Ben Kelly

Chapter 2 Notes A. Manufacturing costs are the costs involved in making a product. Manufacturing costs can be divided into three basic elements: direct materials, direct labour, and manufacturing overhead. 1. Direct materials are those materials that become an integral part of a finished product and can be conveniently traced to it. a. An example of direct materials would be the screen on a laptop computer. b. Small material items, such as glue, are classified as indirect materials rather than as direct materials. It is too costly to trace such small costs to individual units. 2. Direct labour consists of those labour costs that can be easily traced to individual units of product. Direct labour is sometimes called touch labour. a. An example of direct labour would be a worker on a manufacturing assembly line. b. Other labour costs, such as supervisors and janitors, are treated as indirect labour rather than as direct labour. These costs cannot be easily traced to individual units of product since these individuals do not directly work on the product. 3. Manufacturing overhead consists of all manufacturing costs except direct materials and direct labour. a. Manufacturing overhead includes indirect materials, indirect labour, and other manufacturing costs such as factory rent, factory insurance, and depreciation on factory equipment and facilities. b. Synonyms for manufacturing overhead include factory overhead and indirect manufacturing costs. 4. The terms prime cost and conversion cost are also used to categorize manufacturing costs. a. Prime cost consists of direct materials plus direct labour. b. Conversion cost consists of direct labour plus manufacturing overhead. B. Labour costs can be broken down into five main categories: direct labour, indirect labour, idle time, overtime premium, and labour fringe benefits. 1. As mentioned earlier, direct labour consists of factory labour costs that can be easily traced to products. 2. Indirect labour consists of factory labour costs that are supportive or supervisory. These include the costs of supervisors, superintendents, custodians, maintenance persons, and others who do not work directly on the product. 3. Idle time represents the costs of direct labour workers who are unable to perform their assignments due to material shortages, power failures, and the like. Idle time is treated as part of manufacturing overhead. 4. Overtime premium consists of any amount paid above an employees base hourly rate for working beyond normal working hours. a. For example, if the base rate is $6 per hour and an employee is paid time-and-a-half for overtime, then the overtime premium would be $3 per hour. In other words, the total pay would be $9 per hour of overtime. b. An overtime premium ordinarily is not charged to specific jobs, but rather is included as part of manufacturing overhead. An exception is when a customer specifically requests a rush job that results in having to work overtime. In such a case, the overtime premium might be charged directly to that job. 5. Labour fringe benefits include employment-related costs paid by the employer, such as insurance, retirement plans, etc. a. Many companies include such costs as part of manufacturing overhead. b. The preferred method is to include only the labour fringe benefits relating to indirect labour as part of manufacturing overhead and treat the fringe benefits relating to direct labour as added direct labour costs. C. Non manufacturing costs are those costs involved with selling and administrative activities. 1. Selling, or marketing, costs include all costs associated with marketing finished products such as sales commissions, costs of delivery equipment, costs of finished goods warehouses, and advertising. 2. Administrative costs include all costs associated with the general administration of an organization, including accounting services, depreciation of general administrative facilities and equipment, and executive compensation. D. For purposes of external financial reports, costs can be classified as product costs or period costs. 1. Period costs are expensed on the income statement in the period in which they are incurred. (By incurred, we mean the period in which the cost is accrued, not necessarily when it is paid. For example, remember from financial accounting that salaries are counted as costs not when they are paid, but when they are earned by employees. The cost is incurred in the period in which it is earned. Continue to use the rules you learned in financial accounting.) 2. Product costs are matched with units of product and are recognized as an expense on the income statement only when the units are sold. Until that time, product costs are considered to be assets and are recognized on the balance sheet as inventory. 3. In a manufacturing company, product costs include direct materials, direct labour, and manufacturing overhead. Thus, in a manufacturing company, product costs and manufacturing costs are synonymous. 4. In a manufacturing company, period costs and non-manufacturing costs are synonymous terms. Thus, the period costs are selling and administrative costs. 5. In a merchandising company such as Canadian Tire or Chapters, product costs consist solely of the costs of products purchased from suppliers for resale to customers. All other costs are period costs. E. Income statements and balance sheets prepared by manufacturing firms differ from those prepared by merchandising firms. 1. The balance sheet of a manufacturing firm contains three inventory accounts: Raw Materials, Work in Process, and Finished Goods. By contrast, the balance sheet of a merchandising firm contains only one inventory account Merchandise Inventory. a. Raw Materials inventory consists of materials on hand in stockrooms that will be used to make products. b. Work in Process consists of products that have been started but not- yet-completed as of period end. c. Finished Goods consists of units of product that are completed and ready for sale. 2. The income statement of a manufacturing firm contains an element termed cost of goods manufactured. You should study the schedule of cost of goods manufactured in Exhibit 24 in the text very carefully. F. Manufacturing costs (direct materials, direct labour, and overhead) are also known as inventoriable costs.
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