The "Not Ready for Income Statement" Accounts
Thomas J. Grant, CMA
Assistant Professor of Accounting
I am teaching an Introductory Accounting course that requires the presentation
of manufacturing operations, I like to use the following approach. I want students
to grasp the three sets of three:
students at this level have only dealt with inventory as it applies to a merchandising
business, with all goods being purchased when they are ready for sale. I attempt
to get them to visualize how a manufacturer needs three separate inventory accounts
to trace the production process from the delivery of the raw material until
the ultimate sale of the completed product. I begin by asking the students to
think of each of the three individual inventory accounts as being located in
their own distinct building, thus Raw Material is kept in a storeroom, Work
in Process in a factory, and Finished Goods in a warehouse or store.
the students can picture these three distinct accounts, I then go through the
cost flow sequence by showing these flows entering and leaving the different
buildings. Purchases enter the storeroom and remain there until a requisition
from the factory moves the needed materials into the factory. Upon their arrival
in the factory, these materials must be transformed into the desired completed
product. This requires keeping factory records of the direct labor and overhead
costs that are being incurred while this work is being performed. Upon completion
of the work, the finished product is shipped to the warehouse to await its ultimate
sale to a customer.
emphasize to the students that while all these costs have been accumulated for
materials bought and used, direct labor costs incurred, and factory overhead
costs, we have not yet determined the correct amount to expense for that time
period. I impress upon the students the difference between costs and expenses
by pointing out that each of the three inventory accounts represents assets
to the business. Each of these three inventory accounts represents goods at
various levels of completion that are still owned by the business and, thus,
cannot be expensed. I use the term "not yet" accounts. Material has
been bought but "not yet" used, thus it is an asset. Work in process
has been started but "not yet" completed, thus it is an asset. Finished
goods have been completed but "not yet" sold, thus they are an asset.
I reinforce the point that any amounts in those three accounts represent what
is still owned by the business and thus cannot be expensed. When the completed
products that are sitting in the warehouse or store are eventually sold to a
customer, then we have the crossover to an expense. Now we have cost of goods
sold, which will appear on the income statement.
back to my introduction of the three inventory accounts, I then try to get the
students to focus their attention on the Work in Process account. It is within
this account that the three manufacturing costs are accumulated. I discuss the
concepts of direct material, direct labor, and factory overhead (without at
this point complicating matters by bringing up actual versus allocated overhead).
I impress on the students the easily traceable nature of both direct material
and direct labor, as each one has a measurable quality, whether it happens to
be in pounds, gallons, or feet for material, or in hours or minutes for labor.
I then ask the students to imagine what could be accomplished in that factory
without electricity or heat or air conditioning. How much work could be done
if the machinery and the building were not properly maintained? I want them
to begin to envision the concept of overhead and to see why it is such an important
factor in determining the manufacturing cost for the business.
I zero in on the three key calculations that arise as we trace the cost flows
through the manufacturing process. I begin with Total Manufacturing Costs, those
costs that are added directly into Work in Process during a specific time period.
Since I have just discussed the three individual manufacturing costs in detail,
this first calculation follows logically from that. Next, I move on to the calculation
of Cost of Goods Manufactured. I want the students to understand that not everything
that goes into the factory always gets completed in the same time period. I
want them to understand that "manufactured" only means completed,
it does not mean sold. I stress the point that this is the cost that is transferred
from the factory to the warehouse or store as the work is completed. It may
or may not be sold in that same time period. Then, I move over to the Finished
Goods account. I demonstrate the flow of costs entering the account, or the
Cost of Goods Manufactured. These represent goods that are available for sale.
They also represent the future Cost of Goods Sold, depending on the actual time
period when the actual sale takes place. As I stated earlier, it is very important
for students to realize that only those units of product that are sold in a
given time period can be classified as Cost of Goods Sold, and thus included
on the income statement for that specific time period. I go back to the matching
principle, to get students to remember that we have to match revenues and expenses
with the time period in which they occur. I again want them to understand that
not all costs are always expenses and I use the ending balances in the three
inventory accounts as proof of that point.
this approach, I have found that students seem to be able to understand the
basics of manufacturing operations. By simplifying things with the three groups
of three and the concept of the "not yet" accounts, I believe that
students can more easily grasp the sequence of cost flows in a production environment.
- the three inventory
- the three manufacturing
- the three key