Assembling the Product Cost of Manufacturers Businesses that manufacture products have several additional cost problems to deal with, compared with retailers and distributors. I use the term manufac- ture in the broadest sense: Automobile makers assemble cars, beer companies brew beer, automobile gasoline companies refine oil, DuPont makes products through chemical synthesis, and so on. Retailers (also called merchandisers) and distributors, on the other hand, buy products in a condition ready for resale to the end consumer. For example, Levi Strauss manufactures clothing, and Macy’s is a retailer that buys from Levi Strauss and sells the clothes to the public. The following sections describe costs unique to manufacturers. Minding manufacturing costs Manufacturing costs consist of four basic types: ߜ Raw materials (also called direct materials): What a manufacturer buys from other companies to use in the production of its own products. For example, General Motors buys tires from Goodyear (or other tire manu- facturers) that then become part of GM’s cars. ߜ Direct labor: The employees who work on the production line. ߜ Variable overhead: Indirect production costs that increase or decrease as the quantity produced increases or decreases. An example is the cost of electricity that runs the production equipment: You pay for the electricity for the whole plant, not machine by machine, so you can’t attach this cost to one particular part of the process. But if you increase or decrease the use of those machines, the electricity cost increases or decreases accord- ingly. (In contrast, the monthly utility bill for a company’s office and sales space probably is fixed for all practical purposes.) ߜ Fixed overhead: Indirect production costs that do not increase or decrease as the quantity produced increases or decreases. These fixed costs remain the same over a fairly broad range of production output levels (see “Fixed versus variable costs,” earlier in this chapter). Three significant fixed manufacturing costs are • Salaries for certain production employees who don’t work directly on the production line, such as a vice president, safety inspectors, security guards, accountants, and shipping and receiving workers. • Depreciation of production buildings, equipment, and other manu- facturing fixed assets. • Occupancy costs, such as building insurance, property taxes, and heating and lighting charges. 232 Part III: Accounting in Managing a Business 17_246009 ch11.qxp 4/17/08 12:50 AM Page 232 Figure 11-1 presents an annual income statement for a manufacturer and includes information about its manufacturing costs for the year. The cost of goods sold expense depends directly on the product cost from the summary of manufacturing costs that appears below the income statement. A business may manufacture 100 or 1,000 different products, or even more, and the busi- ness must prepare a summary of manufacturing costs for each product. To keep our example easy to follow (but still realistic), Figure 11-1 presents a sce- nario for a one-product manufacturer. The multi-product manufacturer has some additional accounting problems, but I can’t provide that level of detail here. This example illustrates the fundamental accounting problems and methods of all manufacturers. Income Statement for Year Sales volume 110,000 units Per Unit Per Unit Totals Sales revenue $1,400 $154,000,000 Cost of goods sold expense (760) (83,600,000) Gross margin $640 $70,400,000 Variable operating expenses (300) (33,000,000) Margin $340 $37,400,000 Fixed operating expenses (195) (21,450,000) Earnings before interest and income tax (EBIT) $145 $15,950,000 Interest expense (2,750,000) Earnings before income tax $13,200,000 Income tax expense (4,488,000) Net income $8,712,000 Manufacturing Costs for Year Production capacity 150,000 units Actual output 120,000 units Production Cost Components Totals Raw materials $215 $25,800,000 Direct labor 125 15,000,000 Variable manufacturing overhead costs 70 8,400,000 Total variable manufacturing costs $410 $49,200,000 Fixed manufacturing overhead costs 350 42,000,000 Total manufacturing costs $760 $91,200,000 To 10,000 units inventory increase (7,600,000) To 110,000 units sold $83,600,000 Figure 11-1: Example for determining the product cost of a manu- facturer. 233 Chapter 11: Cost Concepts and Conundrums 17_246009 ch11.qxp 4/17/08 12:50 AM Page 233 The information in the manufacturing costs summary below the income statement (see Figure 11-1) is highly confidential and for management eyes only. Competitors would love to know this information. A company may enjoy a significant cost advantage over its competitors and definitely does not want its cost data to get into their hands. Classifying costs properly Two vexing issues rear their ugly heads in determining product cost for a manufacturer: ߜ Drawing a bright line between manufacturing costs and non- manufacturing operating costs: The key difference here is that manufac- turing costs are categorized as product costs, whereas non-manufacturing operating costs are categorized as period costs (refer to “Product versus period costs,” earlier in this chapter). In calculating product costs, you include only manufacturing costs and not other costs. Period costs are recorded right away as expenses — either in variable operating expenses or fixed operating expenses (see Figure 11-1). Here are some examples of each type of cost: • Wages paid to production line workers are a clear-cut example of a manufacturing cost. • Salaries paid to salespeople are a marketing cost and are not part of product cost; marketing costs are treated as period costs, which means they are recorded immediately to expense of the period. • Depreciation on production equipment is a manufacturing cost, but depreciation on the warehouse in which products are stored after being manufactured is a period cost. • Moving the raw materials and partially-completed products through the production process is a manufacturing cost, but transporting the finished products from the warehouse to customers is a period cost. The accumulation of direct and indirect production costs starts at the beginning of the manufacturing process and stops at the end of the produc- tion line. In other words, product cost stops at the end of the production line — every cost up to that point should be included as a manufacturing cost. If you misclassify some manufacturing costs as operating costs, your product cost calculation will be too low (see the following section, “Calculating product cost”). Also, the Internal Revenue Service may come knocking at your door if it suspects that you deliberately (or even inno- cently) misclassified manufacturing costs as non-manufacturing costs in order to minimize your taxable income. 234 Part III: Accounting in Managing a Business 17_246009 ch11.qxp 4/17/08 12:50 AM Page 234 ߜ Allocating indirect costs among different products: Indirect manufac- turing costs must be allocated among the products produced during the period. The full product cost includes both direct and indirect manufacturing costs. Creating a completely satisfactory allocation method is difficult; the process ends up being somewhat arbitrary, but it must be done to determine product cost. Managers should understand how indirect manufacturing costs are allocated among products (and, for that matter, how indirect non-manufacturing costs are allocated among organizational units and profit centers). Managers should also keep in mind that every allocation method is arbitrary and that a different allocation method may be just as convincing. (See the sidebar “Allocating indirect costs is as simple as ABC — not!”) 235 Chapter 11: Cost Concepts and Conundrums Allocating indirect costs is as simple as ABC — not! Accountants for manufacturers have developed many methods and schemes for allocating indi- rect overhead costs, most of which are based on a common denominator of production activ- ity, such as direct labor hours or machine hours. A different method has received a lot of press recently: activity-based costing (ABC). With the ABC method, you identify each sup- porting activity in the production process and collect costs into a separate pool for each iden- tified activity. Then you develop a measure for each activity — for example, the measure for the engineering department may be hours, and the measure for the maintenance department may be square feet. You use the activity measures as cost drivers to allocate costs to products. The idea is that the engineering department doesn’t come cheap; including the cost of their slide rules and pocket protectors, as well as their salaries and benefits, the total cost per hour for those engineers could be $200 or more. The logic of the ABC cost-allocation method is that the engineering cost per hour should be allocated on the basis of the number of hours (the driver) required by each product. So if Product A needs 200 hours of the engineering department’s time and Product B is a simple product that needs only 20 hours of engineering, you allocate ten times as much of the engineering cost to Product A. In similar fashion, suppose the cost of the mainte- nance department is $20 per square foot per year. If Product C uses twice as much floor space as Product D, it would be charged with twice as much maintenance cost. The ABC method has received much praise for being better than traditional allocation methods, especially for management decision making. But keep in mind that this method still requires rather arbitrary definitions of cost drivers, and having too many different cost drivers, each with its own pool of costs, is not too practical. Cost allocation always involves arbitrary meth- ods. Managers should be aware of which meth- ods are being used and should challenge a method if they think that it’s misleading and should be replaced with a better (though still somewhat arbitrary) method. I don’t mean to put too fine a point on this, but cost allocation essentially boils down to a “my arbitrary method is better than your arbitrary method” argument. 17_246009 ch11.qxp 4/17/08 12:50 AM Page 235 Calculating product cost The basic equation for calculating product cost is as follows (using the exam- ple of the manufacturer given in Figure 11-1): $91,200,000 total manufacturing costs ÷ 120,000 units production output = $760 product cost per unit Looks pretty straightforward, doesn’t it? Well, the equation itself may be simple, but the accuracy of the results depends directly on the accuracy of your manufacturing cost numbers. The business example we’re using in this chapter manufactures just one product. Even so, a single manufacturing process can be fairly complex, with hundreds or thousands of steps and operations. In the real world, where businesses produce multiple products, your accounting systems must be very complex and extraordinarily detailed to keep accurate track of all direct and indirect (allocated) manufacturing costs. In our example, the business manufactured 120,000 units and sold 110,000 units during the year, and its product cost per unit is $760. The 110,000 total units sold during the year is multiplied by the $760 product cost to compute the $83.6 million cost of goods sold expense, which is deducted against the company’s revenue from selling 110,000 units during the year. The company’s total manufacturing costs for the year were $91.2 million, which is $7.6 mil- lion more than the cost of goods sold expense. The remainder of the total annual manufacturing costs is recorded as an increase in the company’s inventory asset account, to recognize that 10,000 units manufactured this year are awaiting sale in the future. In Figure 11-1, note that the $760 product cost per unit is applied both to the 110,000 units sold and to the 10,000 units added to inventory. Note: The product cost per unit for our example business is determined for the entire year. In actual practice, manufacturers calculate their product costs monthly or quarterly. The computation process is the same, but the frequency of doing the computation varies from business to business. Product costs likely will vary each successive period the costs are deter- mined. Because the product costs vary from period to period, the business must choose which cost of goods sold and inventory cost method to use. (If product cost happened to remain absolutely flat and constant period to period, the different methods would yield the same results.) Chapter 7 explains the alternative accounting methods for determining cost of goods sold expense and inventory cost value. 236 Part III: Accounting in Managing a Business 17_246009 ch11.qxp 4/17/08 12:50 AM Page 236 Examining fixed manufacturing costs and production capacity Product cost consists of two very distinct components: variable manufacturing costs and fixed manufacturing costs. In Figure 11-1, note that the company’s variable manufacturing costs are $410 per unit, and its fixed manufacturing costs are $350 per unit. Now, what if the business had manufactured ten more units? Its total variable manufacturing costs would have been $4,100 higher. The actual number of units produced drives variable costs, so even one more unit would have caused the variable costs to increase. But the company’s total fixed costs would have been the same if it had produced ten more units, or 10,000 more units for that matter. Variable manufacturing costs are bought on a per-unit basis, as it were, whereas fixed manufacturing costs are bought in bulk for the whole period. Fixed manufacturing costs are needed to provide production capacity — the people and physical resources needed to manufacture products — for the period. After the business has the production plant and people in place for the year, its fixed manufacturing costs cannot be easily scaled down. The business is stuck with these costs over the short run. It has to make the best use it can from its production capacity. Production capacity is a critical concept for business managers to stay focused on. You need to plan your production capacity well ahead of time because you need plenty of lead-time to assemble the right people, equipment, land, and buildings. When you have the necessary production capacity in place, you want to make sure that you’re making optimal use of that capacity. The fixed costs of production capacity remain the same even as production output increases or decreases, so you may as well make optimal use of the capacity provided by those fixed costs. For example, you’re recording the same depreciation amount on your machinery regardless of how you actually use those machines, so you should be sure to optimize the use of those machines (within limits, of course — overworking the machines to the point where they break down won’t do you much good). The burden rate The fixed cost component of product cost is called the burden rate. In our man- ufacturing example, the burden rate is computed as follows (see Figure 11-1 for data): $42,000,000 fixed manufacturing costs for period ÷ 120,000 units production output for period = $350 burden rate Note that the burden rate depends on the number divided into total fixed manufacturing costs for the period — that is, the production output for the period. 237 Chapter 11: Cost Concepts and Conundrums 17_246009 ch11.qxp 4/17/08 12:50 AM Page 237 Now, here’s a very important twist on my example: Suppose the company had manufactured only 110,000 units during the period — equal exactly to the quantity sold during the year. Its variable manufacturing cost per unit would have been the same, or $410 per unit. But its burden rate would have been $381.82 per unit (computed by dividing the $42 million total fixed manu- facturing costs by the 110,000 units production output). Each unit sold, there- fore, would have cost $31.82 more simply because the company produced fewer units. (The burden rate is $381.82 at the 110,000 output level but only $350 at the 120,000 output level.) If only 110,000 units were produced, the company’s product cost would have been $791.82 ($410 variable costs plus the $381.82 burden rate). The com- pany’s cost of goods sold, therefore, would have been $3.5 million higher for the year ($31.82 higher product cost × 110,000 units sold). This rather signifi- cant increase in its cost of goods sold expense is caused by the company pro- ducing fewer units, even though it produced all the units that it needed for sales during the year. The same total amount of fixed manufacturing costs is spread over fewer units of production output. Idle capacity The production capacity of the business example in Figure 11-1 is 150,000 units for the year. However, this business produced only 120,000 units during the year, which is 30,000 units fewer than it could have. In other words, it operated at 80 percent of production capacity, which is 20 percent idle capacity: 120,000 units output ÷ 150,000 units capacity = 80% utilization, or 20% idle capacity This rate of idle capacity isn’t unusual — the average U.S. manufacturing plant normally operates at 80 to 85 percent of its production capacity. The effects of increasing inventory Looking back at the numbers shown in Figure 11-1, the company’s cost of goods sold benefited from the fact that it produced 10,000 more units than it sold during the year. These 10,000 units absorbed $3.5 million of its total fixed manufacturing costs for the year, and until the units are sold this $3.5 million stays in the inventory asset account (along with the variable manufac- turing costs, of course). It’s entirely possible that the higher production level was justified — to have more units on hand for sales growth next year. But production output can get out of hand, as I discuss in the following section, “Puffing Profit by Excessive Production.” 238 Part III: Accounting in Managing a Business 17_246009 ch11.qxp 4/17/08 12:50 AM Page 238 Managers (and investors as well) should understand the inventory increase effects caused by manufacturing more units than are sold during the year. In the example shown in Figure 11-1, the cost of goods sold expense escaped $3.5 million of fixed manufacturing costs because the company produced 10,000 more units than it sold during the year, thus pushing down the burden rate. The company’s cost of goods sold expense would have been $3.5 million higher if it had produced just the number of units it sold during the year. The lower output level would have increased cost of goods sold expense and would have caused a $3.5 million drop in gross margin and earnings before income tax. Indeed, earnings before income tax would have been 27 percent lower ($3.5 million ÷ $13.2 million = 27 percent decrease). 239 Chapter 11: Cost Concepts and Conundrums The actual costs/actual output method and when not to use it The product cost calculation for the business example shown in Figure 11-1 is based on the actual cost/actual output method, in which you take your actual costs — which may have been higher or lower than the budgeted costs for the year — and divide by the actual output for the year. The actual costs/actual output method is appro- priate in most situations. However, this method is not appropriate and would have to be modi- fied in two extreme situations: ߜ Manufacturing costs are grossly excessive or wasteful due to inefficient production operations: For example, suppose that the business represented in Figure 11-1 had to throw away $1.2 million of raw materials during the year. The $1.2 million should be removed from the calculation of the raw material cost per unit. Instead, you treat it as a period cost — meaning that you take it directly into expense. Then the cost of goods sold expense would be based on $750 per unit instead of $760, which lowers this expense by $1.1 million (based on the 110,000 units sold). But you still have to record the $1.2 million expense for wasted raw materi- als, so EBIT would be $100,000 lower. ߜ Production output is significantly less than normal capacity utilization: Suppose that the Figure 11-1 business produced only 75,000 units during the year but still sold 110,000 units because it was working off a large inventory carryover from the year before. Then its production output would be 50 per- cent instead of 80 percent of capacity. In a sense, the business wasted half of its pro- duction capacity, and you can argue that half of its fixed manufacturing costs should be charged directly to expense on the income statement and not included in the calculation of product cost. 17_246009 ch11.qxp 4/17/08 12:50 AM Page 239 Puffing Profit by Excessive Production Whenever production output is higher than sales volume, be on guard. Excessive production can puff up the profit figure. How? Until a product is sold, the product cost goes in the inventory asset account rather than the cost of goods sold expense account, meaning that the product cost is counted as a positive number (an asset) rather than a negative number (an expense). Fixed manufacturing overhead cost is included in product cost, which means that this cost component goes into inventory and is held there until the products are sold later. In short, when you overproduce, more of your total of fixed man- ufacturing costs for the period is moved to the inventory asset account and less is moved into cost of goods sold expense for the year. You need to judge whether an inventory increase is justified. Be aware that an unjustified increase may be evidence of profit manipulation or just good old-fashioned management bungling. Either way, the day of reckoning will come when the products are sold and the cost of inventory becomes cost of goods sold expense — at which point the cost impacts the bottom line. Shifting fixed manufacturing costs to the future The business represented in Figure 11-1 manufactured 10,000 more units than it sold during the year. With variable manufacturing costs at $410 per unit, the business expended $4.1 million more in variable manufacturing costs than it would have if it had produced only the 110,000 units needed for its sales volume. In other words, if the business had produced 10,000 fewer units, its variable manufacturing costs would have been $4.1 million less — that’s the nature of variable costs. In contrast, if the company had manufac- tured 10,000 fewer units, its fixed manufacturing costs would not have been any less — that’s the nature of fixed costs. Of its $42 million total fixed manufacturing costs for the year, only $38.5 mil- lion ended up in the cost of goods sold expense for the year ($350 burden rate × 110,000 units sold). The other $3.5 million ended up in the inventory asset account ($350 burden rate × 10,000 units inventory increase). The $3.5 million of fixed manufacturing costs that are absorbed by inventory is shifted to the future. This amount will not be expensed (charged to cost of goods sold expense) until the products are sold sometime in the future. Shifting part of the fixed manufacturing cost for the year to the future may seem to be accounting slight of hand. It has been argued that the entire amount of fixed manufacturing costs should be expensed in the year that 240 Part III: Accounting in Managing a Business 17_246009 ch11.qxp 4/17/08 12:50 AM Page 240 these costs are recorded. (Only variable manufacturing costs would be included in product cost for units going into the increase in inventory.) Generally accepted accounting principles require that full product cost (variable plus fixed manufacturing costs) be used for recording an increase in inventory. However, as the example in Figure 11-1 shows, producing more than you sell does boost profit. Let me be very clear here: I’m not suggesting any hanky-panky in the example shown in Figure 11-1. Producing 10,000 more units than sales volume during the year looks — on the face of it — to be reasonable and not out of the ordi- nary. Yet at the same time, it is naïve to ignore that the business did help its pretax profit to the amount of $3.5 million by producing 10,000 more units than it sold. If the business had produced only 110,000 units, equal to its sales volume for the year, all its fixed manufacturing costs for the year would have gone into cost of goods sold expense. The expense would have been $3.5 million higher, and EBIT would have been that much lower. Cranking up production output Now let’s consider a more suspicious example. Suppose that the business manufactured 150,000 units during the year and increased its inventory by 40,000 units. It may be a legitimate move if the business is anticipating a big jump in sales next year. On the other hand, an inventory increase of 40,000 units in a year in which only 110,000 units were sold may be the result of a serious overproduction mistake, and the larger inventory may not be needed next year. In any case, Figure 11-2 shows what happens to production costs and — more importantly — what happens to the profit lines at the higher production output level. The additional 30,000 units (over and above the 120,000 units manufactured by the business in the original example) cost $410 per unit. (The precise cost may be a little higher than $410 per unit because as you start crowding pro- duction capacity, some variable costs per unit may increase a little.) The business would need $12.3 million more for the additional 30,000 units of pro- duction output: $410 variable manufacturing cost per unit × 30,000 additional units produced = $12,300,000 additional variable manufacturing costs invested in inventory Again, its fixed manufacturing costs would not have increased, given the nature of fixed costs. Fixed costs stay put until capacity is increased. Sales volume, in this scenario, also remains the same. 241 Chapter 11: Cost Concepts and Conundrums 17_246009 ch11.qxp 4/17/08 12:50 AM Page 241 [...]... profit performance and stock share prices: Shows financial performance for all four quarters in the year and stock price ranges for each quarter (required by the SEC) ߜ Management’s responsibility statement: A short statement indicating that management has primary responsibility for the accounting methods used to prepare the financial statements, for writing the footnotes to the statements, and for providing... highly confidential accounting information they need for identifying problems and opportunities Chapter 15 explains the reasons for audits of financial reports by independent CPAs Investors and lenders definitely should read the auditor’s report, which is explained in this chapter The chapter also discusses the ugly topic of accounting fraud Unfortunately, some businesses resort to accounting fraud,... source of information Chapter 13 explains financial statement ratios that investors use for interpreting profit performance and financial condition Serious investors must know these ratios The financial report is the end of the line for the outside investors and lenders of a business They can’t call the business and ask for more information But the financial statements are just the starting point for the... make profit forecasts for the business, and their buy-hold-sell recommendations are based largely on these earnings forecasts If a business fails to meet its own profit forecast or falls short of stock analysts’ forecasts, the market price of its stock shares usually takes a hit Stock option and bonus incentive compensation plans are also strong motivations for achieving the profit goals set for the business... problems regarding the timing for recording sales revenue, and a footnote should clarify their revenue recognition method Other accounting methods that have a material impact on the financial statements are disclosed in footnotes as well ߜ Other footnotes provide additional information and details for many assets and liabilities For example, during the asbestos lawsuits that went on for many years, the businesses... standards apply: ߜ The Financial Accounting Standards Board (FASB) and its predecessors have laid down many disclosure standards for businesses reporting under U.S generally accepted accounting principles ߜ The SEC mandates disclosure of a broad range of information for publicly owned corporations ߜ International businesses abide by disclosure standards adopted by the International Accounting Standards Board... a lot for granted about readers of financial reports Don’t expect to find friendly hand holding and helpful explanations in financial reports I don’t mean to put you off, but reading financial reports is not for sissies You need to sit down with a cup of coffee and be ready for serious concentration Staying on Top of Accounting and Financial Reporting Standards Standards and requirements for accounting. .. Both federal and state laws, as well as authoritative accounting standards, have to be observed in financial report disclosures Inadequate disclosure is just as serious as using wrong accounting methods for measuring profit and for determining values for assets, liabilities, and owners’ equity A financial report can be misleading because of improper accounting methods or because of inadequate or misleading... One or more footnotes are included to identify the major accounting policies and methods that the business uses (Chapter 7 explains that a business must choose among alternative accounting methods for recording revenue and expenses, and for their corresponding assets and liabilities.) The business must reveal which accounting methods it uses for booking its revenue and expenses In particular, the business... Promotional material: Information about the company, its products, its employees, and its managers, often stressing an overarching theme for the year Most companies use their annual financial report as an advertising opportunity ߜ Profiles: Information about members of top management and the board of directors Of course, everyone appears to be well qualified for his or her position Negative information (such . separate pool for each iden- tified activity. Then you develop a measure for each activity — for example, the measure for the engineering department may be hours, and the measure for the maintenance. not for sissies. You need to sit down with a cup of coffee and be ready for serious concentration. Staying on Top of Accounting and Financial Reporting Standards Standards and requirements for accounting. before. But how can cost of goods sold expense be less? The business sells 110, 000 units in both scenarios. And variable manufacturing costs are $ 410 per unit in both cases. Income Statement for