Inventoriable Costs

Linked to the manufacturing of a product and assuring that it is ready for sale.

Also known as product costs, inventoriable costs are linked to the manufacturing of a product and assuring that it is ready for sale. Manufacturing overhead consists of indirect materials and indirect labor.

Product costs include a variety of expenses, such as wages and salaries for factory personnel, depreciation of equipment, and utilities. 

Every company wants to break even, so the sales price must cover the cost per unit. This is where it is important only to include the costs necessary for calculating product costs.

Accountants use these costs to record an entry in the Cost of Goods Sold (COGS) at the time of sale. They are included under the finished goods inventory account. 

Recording the entry under Cost of Goods Sold (COGS) helps the accountant easily match revenues with expenses.

Product costs include direct materials, direct labor, and manufacturing overhead, whereas COGS only includes direct material, direct labor, and variable manufacturing overhead.

COGS

Product costs are included under the balance sheet as an asset, whereas the COGS are included in the income statement.

Product costs become a part of three inventories, consisting of raw materials, work in progress, and finished goods, whereas the other does not become a part of any inventory.

Understanding inventoriable costs

These costs are used in the manufacturing of a product. They are regarded as assets and listed under the cost of goods sold (COGS) at the time of sale. Direct materials, direct labor, and manufacturing overhead are the components required to compute it. 

Manufacturing overhead consists of indirect materials and indirect labor. Product costs include heterogeneity of expenses, such as wages and salaries for factory personnel, depreciation of equipment, and utilities. They are required to list under GAAP and IFRS

The product costs for manufacturing and retailing are different. The accounting technique and components used by both the manufacturing and retailing segments are unique.

Every company wants to break even at least, so the sales price must cover the cost per unit. This is where it is important only to include the costs necessary for calculating product costs.

Certain costs are unnecessary when calculating product costs, like marketing, sales, general, and administrative costs. 

Accounting for inventoriable costs

Accountants use them to record an entry in the Cost of Goods Sold (COGS) at the time of sale. They are included under the finished goods inventory account. 

Recording the entry under Cost of Goods Sold (COGS) helps the accountant easily match revenues with expenses.

Accounting

To account for product costs, the following steps should be followed:

  • Count the number of products produced or purchased throughout the period.
  • The cost variables should be itemized.
  • Add the number of new goods to the total number of unsold products on the balance sheet, including all unsold items as assets.
  • Determine the total cost of each product sold.
  • Transfer the product cost data for sold items to an income statement.
  • Changes to the balance sheet should be reflected.

Various departments in a corporation compute product costs, such as cost engineering, industrial engineering, design, and production; the methodologies and applications of their conclusions vary.

Product cost data should be utilized to guide what management pays attention to rather than just for decision-making. Attention-directing information is utilized to show areas of concern that may cause decisions to be made after conducting research.

Even though these costs are expenses, and all expenses should come under the income statement, these costs do not appear under the income statement. Instead, they should appear under the Cost of Goods Sold (COGS) account.

The reasoning behind this is the matching principle, which states that expenses should be reported in the same period as the matching revenue. 

If you review revenue from a particular purchase in January 2022, you should report the Cost of Goods Sold (COGS) regarding the sale in that same period. This is how the accountants track the revenue and expenses of the business concerning the COGS.

Many managers instinctively recognize that their accounting methods skew product costs and make informal modifications to compensate. However, few can foresee the exact adjustments they should make.

When product costs are seriously skewed, managers may pick a losing competitive strategy by de-emphasizing and overpricing highly-lucrative items and extending commitments to complicated, unproductive lines.

While manufacturing costs may include non-manufacturing expenses, product costs may omit marketing, sales, rent, auditing, and utility expenses.

Another concern is that it may overlook some product costs during its lifespans, such as marketing, advertising, and research and development.

Inventoriable costs vs. period costs

Business costs can be categorized into two types:

  1. Inventoriable costs
  2. Period costs

Inventoriable costs are incurred in one period and eliminated in another, whereas period costs are expensed as they are incurred.

Product costs include components such as direct materials, direct labor, and manufacturing overhead, whereas only includes direct materials, direct labor, and variable manufacturing overhead.

Product costs are included under the balance sheet as an asset, whereas COGS are included in the income statement.

Product costs become a part of three inventories, consisting of raw materials, work in progress, and finished goods, whereas the other does not become a part of any inventory.

Since the advantage of product costs applies to future periods, the portion of costs that applies to future revenues is carried forward to the next period and archived in the balance sheet. In contrast, period costs typically benefit the current period.

By splitting these two categories of expenses, you may more quickly discover possible production problems, such as inefficient labor, poor machinery, or obsolete methods, while also examining production costs, such as raw materials and direct labor.

The main advantage of categorizing costs as products or periods is that it helps managers understand where their costs are being incurred and how they are utilized.

Advantages

Controlling costs is one of the important elements of understanding what types of costs should be taken into consideration and what type of costs should be expensed.

 Comparing costs helps identify a product's actual price in the given period. This will enable a comparison of the current period with a different period.

Product cost also helps to determine the productivity and efficacy of the production process.

It can also be used in the form of decision-making. When business management makes decisions, they frequently take a return on investment and how much profit a company can gain from a specific activity into account. Product costing may be used as a basis to make these judgments.

It helps in finding out the cost associated with each product, thus allowing one to find the actual price and profit of a product.

It is also important for management-related profitability and performance reports, which frequently lead to resource allocation decisions, transferring money from unprofitable activities to lucrative activities, and improving product-cost performance.

Since market-based information plays a vital role in this process, operating units use product costs as attention-directing information in decision-making.

Product cost factors

The term "product cost" refers to the whole cost of a product's life cycle, which includes product research and development, manufacturing, and after-sales servicing.

Product costs for manufacturing and retailing include different components. These components are necessary to calculate the costs under each segment.

a) Product cost factors related to manufacturing include components such as direct material costs, direct labor costs, indirect material costs, and indirect labor costs.

Direct material costs are raw material costs traced to the final product. For example, if a company is a toy manufacturer, the plastic needed to make the toy would be considered the raw material.

Direct labor costs are wages incurred to make a particular good or provide a service. For example, if a company is a table manufacturer, the people that put the table together, which are the workers and not the supervisor above them, will be considered direct labor costs.

Indirect material costs are costs that cannot be traced to the final product. For example, if a company is a shoe manufacturer, the indirect materials costs would be manufacturing and equipment costs, like hammers.

Indirect labor costs are wages paid to those not directly involved in producing the product. Some examples are security guards in a school and supervisors of a toy manufacturing company.

Manufacturing product unit cost = (Direct material costs + Direct labor costs + Manufacturing overhead) / Total Units

b) Product costs are related to retailing include supply, direct labor, and overhead costs.

Supply costs are referred to as the true cost of materials, ingredients, packaging, direct labor, and direct overhead, excluding any allocation or absorption of expenses for surplus or idle capacity. For example, factory supplies, such as rugs and solvents, or office supplies, such as paper, pens, and forms.

Manufacturing overhead costs are costs that cannot be associated with producing the final product. These costs include rent and property taxes.

Retailer Product Unit Cost = Manufacturer Product Unit Cost * 2

Inventoriable cost factors under absorption costing and variable costing

1. Absorption costing

Product costs under absorption costing include direct materials, direct labor, fixed manufacturing overhead, and variable manufacturing overhead.

Variable manufacturing overhead is manufacturing costs that change with an increase or decrease in production-for example, the handling and shipping of products

Fixed manufacturing overhead are manufacturing costs that remain constant, even if there is a change in production-for example, property tax, rent, depreciation on equipment, and salaries.

Absorption Costing

2. Variable costing

Product costs under variable costing include direct material, direct labor, and variable manufacturing overhead.

The main difference between these costing techniques is the treatment of fixed manufacturing overhead. Product costs under absorption costing keep fixed manufacturing overhead to calculate the profitability of the product

Under variable costing, however, the fixed manufacturing overhead is expensed, thus not affecting the product's profitability.

To check whether the product is profitable, all the components, such as direct material, direct labor, fixed manufacturing overhead, and variable manufacturing overhead, should be considered. 

Components 

The components that formulate the product costs are direct material, direct labor, and manufacturing overhead. Manufacturing overhead consists of indirect material and indirect labor.

1. Direct material

These materials can be effectively associated with a cost item and are priced per unit produced.

2. Direct labor

This pertains directly to supply chain workers who participate in producing goods or performing tasks or services and who are easily ascribable to a task, process, or production unit.

3. Manufacturing overhead

It is further categorized as:

  • Indirect material

The costs associated with sustaining and operating a business are included in indirect costs, which go beyond the expenditures you incur when manufacturing a product.

  • Indirect labor

Any employee whose work is not necessary to create a good is said to be engaged in indirect labor.

Formula

Inventoriable costs = total direct materials + total direct labor + manufacturing overhead

Manufacturing overhead = indirect materials + indirect labor

Inventoriable cost per unit = (total direct materials + total direct labor + manufacturing overhead)/total number of units

Absorption cost total = direct material + direct labor + fixed manufacturing overhead + variable manufacturing overhead

Variable cost total = direct material + direct labor + variable manufacturing overhead

Variable manufacturing overhead includes costs that change with a change in production levels. For example, material handling wages, equipment utilities, and supplies for production.

Fixed manufacturing overheads are costs that stay constant regardless of the change in production. For example, rent and production supervisory salaries.

Formulas for product costing under the absorption and variable costing techniques differ because of the treatment of fixed manufacturing overhead. 

Formula

Examples

Example 1

A toy manufacturing company has the following costs for the month:

  • Direct material costs = $1,000
  • Direct labor costs = $1,500
  • Manufacturing overhead costs = $1,100

100 toys were produced and sold.

The total cost of production = direct material costs + direct labor costs + manufacturing overhead costs

                                            = $1,000 + $1,500 + $1,100

                                            = $3,600

The total cost of production per unit = total cost of production/total number of units

                                                          = $3,600/100 

                                                          = $36

Examples

Example 2

A beer manufacturing company has the following costs for the month:

1000 units were produced and sold

  • Direct material costs = $2,000
  • Direct labor costs = $1,500
  • Marketing costs = $500
  • Selling, general, and administrative costs = $700
  •  Rent = $500
  • Salaries = $800

Total cost of production = direct material costs + direct labor costs + rent + salaries

                                             = $2,000 + $1,500 + $500 + $800

                                             = $4,800

The total cost of production per unit = total cost of production/total number of units

                                                             = $4,800/1000

                                                             = $4.8

Note marketing, selling, general, and administrative costs are not included in the calculation.

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Researched and authored by Ajay Kumar Sahoo | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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