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The "Not Ready for Income Statement" Accounts
Thomas J. Grant, CMA
Assistant Professor of Accounting
Kutztown University

     When 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:
  1. the three inventory accounts
  2. the three manufacturing costs
  3. the three key cost calculations

     Most 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.

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     When 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.

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     I 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.

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     Working 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.

     Finally, 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.

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     Using 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.

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