Following the Flow of Costs through a Manufacturing System
Costs flow through a manufacturing system, from buying materials for a product all the way to the customer sale. When you envision the flow of costs, you find it easier to collect all the product costs you need to price a product. When you know all the steps, you remember all the costs related to those steps!
Control starts with control accounts
Control accounts are temporary holding places for costs. Managing costs has to start somewhere, and in accounting, that process most often starts out with control accounts.
Labor, materials, and indirect costs start off in control accounts. It may sound strange, but these accounts and their balances don’t appear in the financial statements. That’s because the balances are eventually moved to other accounts. All the checks you write for manufacturing costs are posted first to control accounts.
For many manufacturers and retailers, inventory is the biggest investment; more cash is spent on inventory than any other asset. Because of that, a big part of operating a profitable business is to control the costs of inventory.
Inventory is an asset you eventually sell to someone. (That’s a little different, of course, from buildings and equipment.) For manufacturers, inventory has three components: raw materials, work-in-process, and finished goods, whereas retailers just have finished goods. Raw materials inventory is, broadly, products not yet started; work-in-progress inventory is partially completed products; and finished goods inventory is completed products.
The three kinds of inventory are assets, because you eventually sell the goods to a customer. When you do, the inventory asset becomes an expense — cost of goods sold. Managing inventory starts in a control account.
Table 4-3 lists control account titles for each component of inventory.
TABLE 4-3 Control Accounts for Inventory
| Type of Costs | Control Account |
|---|---|
| Materials | Materials control |
| Labor | Wages payable control |
| Indirect costs | Overhead control |
Here are what those types of costs in Table 4-3 refer to:
Materials: You buy materials (such as wood for making kitchen cabinets) in advance of making your products. Materials control is the term for the control account for material costs.
Labor: Consider labor costs. Employees report the hours they work on time cards each week. Those cards list hours worked on various projects. For custom cabinets, the time cards list customer jobs that employees completed, and the hours worked. Wages payable control is the term for the control account for labor.
Indirect costs: A business (such as the kitchen cabinet business) has indirect costs (for example, machine repair and maintenance). Your firm has some method to allocate those costs to clients (see “Budgeting for indirect costs”). However, you may not get to the allocation until after you write checks for the cost. Overhead control is the term for the control account for indirect costs.
Control accounts (materials, labor and overhead), work-in-process, and finished goods are inventory accounts, which are assets. Cost of goods sold (COGS) is an expense account. When you make a sale to a customer, you “use up” the asset. The asset becomes an expense. Figure 4-1 shows the flow of manufacturing costs:
Explaining the debit and credit process
You increase and decrease account balances using debits and credits. Business owners need to know these terms because they can’t understand your accounting process without them.
©John Wiley & Sons, Inc.
FIGURE 4-1: The flow of manufacturing costs.
Don’t be frustrated if you need to read this section a few times. I’ve taught the concept for years, and it requires some review before you fully understand it. Here are rules that never change:
Debits: Always posted on the left side of an account
Credits: Always posted on the right side of an account
All accounts are formatted like this:
| Material Control | |
| Debit | Credit |
In accounting, debit and credit don’t mean the same things they do in common talk. Debit can refer to an increase or a decrease. It depends on what type of account you’re working with. The same is true of a credit. Here are the rules for the purposes of this book:
Asset accounts:
Debits: Always increase the account balance. A big debit in the Cash account (an asset) is a good thing
Credits: Always decrease the account balance
Control accounts, work-in-process, and finished goods are all inventory accounts, making them asset accounts. Cost of goods sold is an expense account. Debiting increases all these accounts. The balance for any of these accounts is equal to debit balance less credit balance.
Liability accounts:
Debits: Always decrease the account balance
Credits: Always increase the account balance
Income accounts:
Debits: Always decrease the account balance
Credits: Always increase the account balance
