Illustrating the Flow of Inventoriable Costs and Period Costs

Learning Objective 6 Illustrate the flow of inventoriable and period costs in financial accounting

• in manufacturing settings, inventoriable costs flow through work in process and finished goods accounts and are expensed when goods are sold; period costs are always expensed as incurred

We continue our discussion in section 5 on how cost accounting is used to achieve the objectives of financial accounting. In this section, we illustrate the flow of inventoriable costs and period costs through the income statement of a manufacturing company, where the distinction between inventoriable costs and period costs is most complex.

Manufacturing-Sector Example

Follow the flow of costs for Cellular Products in Exhibits 2-7 and 2-8. Exhibit 2-7 visually highlights the differences in the flow of inventoriable and period costs for a manufacturing-sector company. Note how, as described in the previous section, inventoriable costs go through the balance sheet asset accounts of work-in-process inventory and finished-goods inventory before entering the income statement as the expense item cost of goods sold. Period costs are expensed directly in the income statement. Exhibit 2-8 takes the visual presentation in Exhibit 2-7 and shows how inventoriable costs and period expenses would appear in the income statement and the schedule of cost of goods manufactured of a manufacturing company.

We start by tracking the flow of direct materials shown on the left in Exhibit 2-7 and in Panel B in Exhibit 2-8. To keep things simple, all numbers are expressed in thousands, except for the per unit amounts.

1. Step 1: COST OF DIRECT MATERIALS USED IN 2020. Note how the arrows in Exhibit 2-7 for beginning inventory, $11,000, and direct material purchases, $73,000, “fill up” the direct materials inventory box and how direct materials used, $76,000, “empties out” direct material inventory, leaving an ending inventory of direct materials of $8,000 that becomes the beginning inventory for the next year. 

1. The cost of direct materials used is calculated in Exhibit 2-8, Panel B (light blue-shaded area), as follows:

1. Step 2: TOTAL MANUFACTURING COSTS INCURRED IN 2020. Total manufacturing costs for 2020 refers to all direct manufacturing costs and manufacturing overhead costs incurred during 2020 for all goods worked on during the year. Cellular Products classifies its manufacturing costs into the three categories described earlier.

1. Note how in Exhibit 2-7 these costs increase work-in-process inventory.

1. Step 3: COST OF GOODS MANUFACTURED IN 2020. Cost of goods manufactured refers to the cost of goods brought to completion during the period, regardless of whether they were started before or during the current accounting period. 
2. Note how the work-in-process inventory box in Exhibit 2-7 has a very similar structure to the direct materials inventory box described in Step 1. Beginning work-in-process inventory of $6,000 and total manufacturing costs incurred in 2020 of $105,000 “fill up” the work-in-process inventory box. Some of the manufacturing costs incurred during 2020 are held back as the cost of the ending work-in-process inventory. The ending work-in-process inventory of $7,000 becomes the beginning inventory for the next year, and the $104,000 cost of goods manufactured during 2020 “empties out” the work-in-process inventory while “filling up” the finished-goods inventory box. 
3. The cost of goods manufactured in 2020 (shaded green) is calculated in Exhibit 2-8, Panel B, as follows:

1. Step 4: COST OF GOODS SOLD IN 2020. The cost of goods sold is the cost of finished-goods inventory sold to customers during the current accounting period. Looking at the finished-goods inventory box in Exhibit 2-7, we see that the beginning inventory of finished goods of $22,000 and cost of goods manufactured in 2020 of $104,000 “fill up” the finished-goods inventory box. The ending inventory of finished goods of $18,000 becomes the beginning inventory for the next year, and the $108,000 cost of goods sold during 2020 “empties out” the finished-goods inventory. 
2. This cost of goods sold is an expense that is matched against revenues. The cost of goods sold for Cellular Products (shaded olive green) is computed in Exhibit 2-8, Panel A, as follows:

1. Exhibit 2-9 shows related general ledger T-accounts for Cellular Products’ manufacturing cost flow. Note how the cost of goods manufactured ($104,000) is the cost of all goods completed during the accounting period. These costs are all inventoriable costs. Goods completed during the period are transferred to finished-goods inventory. These costs become cost of goods sold in the accounting period when the goods are sold. Also note that the direct materials, direct manufacturing labor, and manufacturing overhead costs of the units in work-in-process inventory ($7,000) and finished-goods inventory ($18,000) as of December 31, 2020, will appear as assets in the balance sheet. These costs will become expenses when the work-in-process inventory is converted to finished goods and the finished goods are sold.

We can now prepare Cellular Products’ income statement for 2020. The income statement of Cellular Products is shown on the right side in Exhibit 2-7 and in Exhibit 2-8, Panel A. Revenues of Cellular Products are (in thousands) $210,000. Inventoriable costs expensed during 2020 equal cost of goods sold of $108,000.

The $70,000 of operating costs composed of R&D, design, marketing, distribution, and customer-service costs are period costs of Cellular Products. These period costs include, for example, salaries of salespersons, depreciation on computers and other equipment used in marketing, and the cost of leasing warehouse space for distribution. Operating income equals total revenues from operations minus cost of goods sold and operating (period) costs (excluding interest expense and income taxes) or, equivalently, gross margin minus period costs. The operating income of Cellular Products is $32,000 (gross margin, $102,000 – period costs, $70,000). Recall from your financial accounting class that period costs are typically summarized under the term selling, general, and administrative expenses (SG&A) in the income statement.

Newcomers to cost accounting frequently assume that indirect costs such as rent, telephone, and depreciation are always costs of the period in which they are incurred and are not associated with inventories. When these costs are incurred in marketing or in corporate headquarters, they are period costs. However, when these costs are incurred in manufacturing, they are manufacturing overhead costs and are inventoriable.

Because costs that are inventoried are not expensed until the units associated with them are sold, a manager can produce more units than are expected to be sold in a period without reducing a firm’s net income. In fact, building up inventory in this way defers the expensing of (part of) the current period’s fixed manufacturing costs as manufacturing costs are inventoried and not expensed until the units are sold in a subsequent period. This in turn actually increases the firm’s current period gross margin and operating income even though there is no increase in sales, causing outsiders to believe that the company is more profitable than it actually is. We will discuss this risky accounting practice in greater detail in Chapter 9.