Chapter Summary

First, management accounting systems help to decide who has the decision-making authority over company assets. Second, accounting information produced or created from the management accounting system supports planning and decision making. Finally, management accounting reports provide a means of monitoring, evaluating, and rewarding performance.

Direct materials used consist of the parts and materials that become part of the finished products. Direct labor cost consists of the wages paid to factory employees who work directly on the products being manufactured. Manufacturing overhead includes all manufacturing costs other than the cost of materials used and direct labor. Examples of manufacturing overhead include depreciation of machinery and the plant security service.

Product costs are the costs of creating inventory. They are treated as assets until the related goods are sold, at which time the product costs are deducted from revenue as the cost of goods sold. Thus goods manufactured this year but not sold until next year are deducted from next year's revenue.

Period costs are charged to expense in the accounting period in which they are incurred. Period costs are not related to production of goods; consequently, they are deducted from revenue on the assumption that the benefits obtained from the expenditures are received in the same period as the costs are incurred. Period costs include general and administrative expense, selling expense, and income taxes expense.

Manufacturing costs originally are recorded in three controlling accounts: Materials Inventory, Direct Labor, and Manufacturing Overhead. As these costs become applicable to goods placed into production, they are transferred from these manufacturing cost accounts to the Work in Process Inventory account. As units are completed, their cost is transferred from the Work in Process account to Finished Goods Inventory. Then, when units are sold, their costs are transferred from Finished Goods Inventory to the Cost of Goods Sold account.

Direct manufacturing costs (direct materials and direct labor) can be identified with specific products. Indirect manufacturing costs are the many elements of manufacturing overhead that apply to factory operations as a whole and cannot be traced to specific products.

An overhead application rate is a device used to assign appropriate amounts of overhead costs to specific units of output (manufactured products). Overhead is an indirect cost, which cannot be directly associated with specific output. However, the overhead application rate expresses the relationship between overhead costs and some activity base that can be traced directly to specific units. The activity base should be the major driver (causal factor) of overhead costs; if the activity base is not the cost driver, the relative production cost of different products may be significantly distorted.

This schedule summarizes the flow of manufacturing costs into and out of the Work in Process Inventory account. Its purpose is to assist management in understanding and evaluating manufacturing costs incurred in the period.

To prepare this schedule, we start by listing the work in process inventory at the beginning of the year. To this amount we add the materials used, direct labor costs, and overhead for the period. Combining these four items indicates the total cost of all work in process during the period. A final step is deducting the cost of work still in process at the end of the period. This gives us the cost of finished goods manufactured during the period.

The terminology and concepts introduced in this chapter will be used extensively throughout the remaining chapters in this text.