Chapter 2

Building Blocks of Managerial Accounting

1
Key Differences Between Service, Merchandising
and Manufacturing Companies

• Service companies sell intangible services – healthcare,

insurance, banking, consulting.
• Merchandisers include retailers and wholesalers have one
inventory account.
• Manufacturers convert raw materials (which may be
another firm's finished products) into new finished products.
They have three types of inventory:
• Raw materials
• Work in process
• Finished goods

2
 Customers Give Businesses Money Because

• They have a compelling customer value proposition:

1. Low-cost provider

2. Product leadership

3. Customer intimacy

3
Every Customer Value Proposition Has
Four Components
Cost: Price paid relative to features and
competition.

Quality: Actual performance compared to

customer’s expectations.

Functionality and features: Product performance

and capabilities.

Service: Sales and after-sales service experience.

4
 The Value Chain is How a Firm
Delivers Its Value Proposition
A firm’s value chain consists of all the activities that add
value to the company’s products. It extends outside the
formal boundary of the firm back to suppliers and forward
to customers receiving services from the firm.

5
Different Types of Value-Added Activities
• Non-value-added activities: Those activities (and their costs) that, if
eliminated, would not reduce a customer’s perceived value of a
product or service. Customers are unwilling to pay for these activities.
• Threshold attributes: Absence of these attributes leads to customer
dissatisfaction. Presence of these attributes does not increase
customer satisfaction.
• Performance attributes: Most products and services compete on
performance attributes. When customers decide what price they are
prepared to pay, they generally compare performance attributes.
• Excitement attributes: Attributes that customers did not even know
they wanted, but are so delighted when they find them
that their presence leads to high customer satisfaction.

6
Clarify the Meaning of “Cost”
• “Cost” has different
meanings because
managers use
different costs for
different purposes

• Because costs are

used for different
purposes, there is no
single way of
computing cost.
Organizing Cost Concepts
1st Use: Use on the Financial Statements
 General Cost Classifications
Manufacturing Costs - Product costs
Raw materials - materials that are used in manufacturing the product
Direct materials - those materials that become part of the finished product
whose cost can be economically traced to the product.
Indirect materials - those materials that become part of the finished
product whose cost cannot be economically traced to the product.
Labor - cost of factory wages and salaries
Direct labor - manufacturing labor costs that can be economically traced
to the product.
Indirect labor - manufacturing labor costs that cannot be economically
traced to the product.
Manufacturing overhead (aka indirect manufacturing costs, factory overhead
and factory burden) - all manufacturing costs other than direct materials and
direct labor, e.g., indirect materials, indirect labor, factory insurance, factory
depreciation, factory utilities, factory maintenance.
Nonmanufacturing costs - Period costs
Selling costs - all costs incurred to secure customer orders and get the
finished product to the customer, e.g., advertising showroom rental, sales
commissions, salesforce travel and entertainment costs.
General and administrative costs - costs associated with the general
management of the firm, e.g., senior management, legal, human resources,
accounting, investor relations.
All Costs Other than Product Costs are
Treated as Period Costs Under GAAP

Research Post-Sales
and Design and Customer General and
Development Engineering Production Marketing Distribution Service Administrative
Costs Costs Costs Costs Costs Costs Costs Profit

Product costs
inventoriable on
financial
statements

Product costs reimbursable under

government contracts
Costs included in performance evaluations
Costs that must be recovered from revenue generated by product sales

11
Product Costs: Prime and Conversion Costs

Product costs, as defined in chapters 2 and 3, include

• Direct materials
• Direct labor
• Manufacturing overhead

Manufacturing overhead is defined as all manufacturing

costs other than direct materials and direct labor.

12
Total manufacturing cost per unit is $ 25
Total conversion cost per unit is $ 17

How much is direct material cost per unit?

A $ 7.00
B $ 8.00
C $ 9.00
D $ 10.00

13
Total manufacturing cost per unit is $ 20
Total conversion cost per unit is $ 10

How much is direct material cost per unit?

A $ 7.00
B $ 8.00
C $ 9.00
D $ 10.00

14
Total manufacturing cost per unit is $ 36
Total conversion cost per unit is $ 24

How much is direct material cost per unit?

A $ 10.00
B $ 11.00
C $ 12.00
D $ 13.00

15
 2nd Use: Predicting Cost Behavior

• Within the relevant range, a variable cost varies, in total, in

proportion to changes in the level of some particular activity
usually called a cost driver.
• Within the relevant range, a fixed cost remains constant, in
total, despite changes in levels of total activity.

16
 Relevant Range
The relevant range for the firm described below lies
between 40% and 80% of capacity. It is the activity level
over which variable costs remain constant on a per unit
basis (slope) and fixed costs remain constant in total.

17
 Contribution Margin Format:
An Income Statement Based on Cost Behavior
Traditional Format
(GAAP view with costs organized by function)
Sales $ 12,000
Cost of Goods Sold $ 6,000
Gross margin $ 6,000
Selling and administrative expenses
Selling expenses $ 3,100
Administrative expenses $ 1,900 $ 5,000
Operating Income $ 1,000

Contribution Margin Format

(Managerial accounting view with costs organized by behavior)
Sales $ 12,000
Variable expenses
Variable production $ 2,000
Variable selling 600
Variable administrative 400 3,000
Contribution margin $ 9,000
Fixed expenses
Fixed production $ 4,000
Fixed Selling 2,500
Fixed administrative 1,500 8,000
Operating Income $ 1,000
18
3rd Use: Assigning Costs to Cost Objects

• Cost object: Anything for which managers want to know

the cost
• Product, service, sales channel, customer,
department, marketing strategy
• Direct cost: A cost that can be economically traced to a
cost object
• Indirect cost: A cost that cannot be economically traced
to a cost object so it is allocated to the cost object

A cost can be direct with respect to one cost object

and indirect with respect to another cost object.

19
Different Ways to Allocate Indirect Costs

20
Depending on the Cost Object, the Same
Cost Can Be Direct or Indirect
Jane earns $125,000 per year supervising
the Machining Department.
• Her salary is a direct cost of the
machining department because she
works only in that department.
• Her salary is an indirect cost
allocated to all the products machined
in her department because it is not
economically worthwhile to trace her
salary to each machined product.

21
Allocation of Indirect Costs Generally Does
Not Lead to Better Decisions . . .
• . . . because the association between indirect cost
incurrence and the cost object is so weak as to add
little value.
• But indirect costs are allocated anyway because:
1. GAAP mandates such allocations for external financial
statements.
2. These allocations make managers aware of the total cost
of providing products or services.
3. Customers see lower markups on cost.
4. Useful for reimbursements on cost-plus contracts.

22
 How Are Allocation Bases Chosen?

• Criteria
1. Cause-and-effect relationship
2. Benefits received
3. Fairness or equity
4. Ability to bear
• The ideal allocation basis reflects a strong cause-and-
effect relationship between the cost and the cost object.
In this course we will generally use machine hours,
direct labor hours or direct labor dollars as allocation
bases and assume such a relationship exists.

23
 4th Use: for Decision-Making
1. Relevant (aka avoidable, incremental or differential)
revenues and costs differ between alternatives under
consideration.
2. Opportunity costs: The contribution to operating
income that is foregone or rejected by not using a
limited resource in its next best alternative use.
3. Sunk costs: A cost that has already been incurred and
that cannot be changed by any decision now or in the
future. Irrelevant to decisions, sunk costs should
always be ignored.

Relevant cost analysis and the contribution approach provides a powerful

tool for making decisions as is specially emphasized in chapter 8.
24
 Trace the Flow of Costs Through the
Accounts of A Manufacturer
Smetana Corporation, a calendar-year company, buys all its raw materials on credit.
Accounts Payable, Trade is used exclusively to record the purchase of raw materials.
The firm uses an actual cost system and never has an ending balance in work in process.
Eighty percent of total sales are made on credit. The balance of sales are made for cash.
All GS&A expenses except bad debt expense are paid as incurred.

Beginning account balances, January 1, 2021

Cash $ 123,450
Accounts Receivable 678,000
Allowance for Uncollectible Accounts, January 1, 2021 (2,340)
Raw materials 93,000
Work in Process -
Finished Goods 40,000
Factory Machinery & Equipment 4,000,000
Accumulated Depreciation, Machinery & Equipment (2,400,000)
Total assets $ 2,532,110

Accounts Payable, Trade $ 64,000

Wages Payable 98,760
Common Stock 100,000
Additional Paid-in Capital 900,000
Retained Earnings 1,369,350
Total Liabilities and Stockholders' Equity $ 2,532,110
25
 Units produced 620,000
Units sold 600,000

Transactions for 2021

1 Purchased raw materials on credit 1,325,000
2 Paid for raw materials 1,322,750
3 Direct materials placed into production 1,240,000
4 Indirect materials placed into production 62,000
5 Direct labor wages earned 7,440,000
6 Indirect labor wages earned 1,318,000
7 Factory supervisors' salaries earned 400,000
8 Paid direct and indirect wages and factory supervisors' salaries 9,165,180
9 Depreciation on factory machinery and equipment 240,000
10 Rent on the factory accrued and paid 1,250,000
11 Factory utilities accrued and paid 450,000
12 Under actual cost system, all manufacturing overhead is closed to work in process
13 Cost of goods manufactured 12,400,000
14 Ending finished goods inventory 440,000
15 Gross margin expressed as a percent of sales 20%
16 Bad debt expense 3% of credit sales
17 Accounts receivable written off as uncollectible 359,200
18 Cash collections on accounts receivable 11,718,800
19 All GS&A expenses excluding bad debt expense 1,140,000

Required: Prepare the yearend 2021 financial statements of Smetana Corporation including the statement of
cash flows.
26
 Permanent Accounts Temporary Accounts

Assets Liabilities Owners' Equity

Cash Accounts Payable, Trade Common Stock Sales

BB 123,450 BB 64,000 BB 100,000 CJE1 15,000,000 15 15,000,000
15 3,000,000 2 1,322,750 2 1,322,750 1 1,325,000
18 11,718,800 8 9,165,180
10 1,250,000
11 450,000
19 1,140,000
EB 1,514,320 EB 66,250 EB 100,000

Accounts Receivable Wages Payable Additional Paid-In Capital Cost of Goods Sold
BB 678,000 BB 98,760 BB 900,000 14 12,000,000 CJE2 12,000,000
15 12,000,000 17 359,200 8 9,165,180 5 7,440,000
18 11,718,800 6 1,318,000
7 400,000
EB 600,000 EB 91,580 EB 900,000

Allowance for Uncollectibles Retained Earnings Bad Debt Expense

BB 2,340 BB 1,369,350 16 360,000 CJE2 360,000
17 359,200 16 360,000 CJE2 13,500,000 CJE1 15,000,000
EB 3,140 EB 2,869,350

Raw Materials GS&A Expenses, Other

BB 93,000 19 1,140,000 CJE2 1,140,000
1 1,325,000 3 1,240,000
4 62,000
EB 116,000

Work in Process GM as a % of sales GM as a % of CGS

BB - Sales 15,000,000 100% 125.000%
3 1,240,000 Cost of Goods Sold 12,000,000 80% 100.000%
5 7,440,000 Gross Margin 3,000,000 20% 25.000%
12 3,720,000 13 12,400,000
EB - Sales = CGS / (1 - 20%) or Sales = CGS x 125%

Finished Goods Cost of Goods Manufactured and Cost of Goods Sold Schedule
BB 40,000
13 12,400,000 14 12,000,000 Work in Process, BI 0
EB 440,000 Raw Materials, BI 93,000
Purchases 1,325,000
Factory Machinery & Equip Raw Materials available for use 1,418,000
BB 4,000,000 Indirect materials placed into production 62,000
EB 4,000,000 Raw Materials, EI 116,000
Direct materials placed into production 1,240,000 1,240,000
Accum Dep'n, Factory M & E Direct labor 7,440,000
BB 2,400,000 Manufacturing overhead 3,720,000
9 240,000 Total manufacturing cost incurred this period 12,400,000 12,400,000
EB 2,640,000 Total manufacturing costs to account for 12,400,000
Work in Process, EI -
Manufacturing Overhead Cost of Goods Manufactured (CGM) 12,400,000
4 62,000 Finished Goods, BI 40,000
6 1,318,000 Cost of Goods Available for Sale 12,440,000
7 400,000 Ending Finished Goods Inventory 440,000
9 240,000 Cost of Goods Sold 12,000,000
10
11
1,250,000
450,000 12 3,720,000
27
-
* Cash paid for wages during 2021 $ 8,000,000
* Direct labor expressed as a percent of total conversion costs 64%
* Indirect labor expressed as a percent of total 2021
manufacturing labor 25%
* Manufacturing labor expressed as a percent of total
wages earned by all employees during 2021 80%
* Total manufacturing costs incurred this period $ 12,000,000
* Wages Payable, 01/01/21 $ 800,000
* Wages Payable, 12/31/21 $ 920,000

What is the cost of direct materials used in 2021?

A Between $4,300,000 and $4,350,000

B Between $4,350,000 and $4,400,000
C Between $4,400,000 and $4,450,000
D Between $4,450,000 and $5,000,000

28
* Cash paid for wages during 2021 $ 9,000,000
* Direct labor expressed as a percent of total conversion costs 60%
* Indirect labor expressed as a percent of total 2021
manufacturing labor 25%
* Manufacturing labor expressed as a percent of total
wages earned by all employees during 2021 65%
* Total manufacturing costs incurred this period $ 15,000,000
* Wages Payable, 01/01/21 $ 700,000
* Wages Payable, 12/31/21 $ 920,000

What is the cost of direct materials used in 2021?

A Between $5,000,000 and $6,000,000

B Between $6,000,000 and $7,000,000
C Between $7,000,000 and $8,000,000
D Between $8,000,000 and $9,000,000

29
* Cash paid for wages during 2021 $ 8,500,000
* Direct labor expressed as a percent of total conversion costs 50%
* Indirect labor expressed as a percent of total 2021
manufacturing labor 40%
* Manufacturing labor expressed as a percent of total
wages earned by all employees during 2021 70%
* Total manufacturing costs incurred this period $ 8,400,000
* Wages Payable, 01/01/21 $ 700,000
* Wages Payable, 12/31/21 $ 920,000

What is the cost of direct materials used in 2021?

A Between $700,000 and $800,000

B Between $800,000 and $900,000
C Between $900,000 and $1,000,000
D Between $1,000,000 and 1,100,000

30
 Dr Cr Dr Cr
1 Raw Materials 1,325,000 11 Manufacturing Overhead 450,000
Accounts Payable, Trade 1,325,000 Cash 450,000
Purchase raw materials on credit. Pay factory utilities.

2 Accounts Payable, Trade 1,322,750 12 Work in Process 3,720,000

Cash 1,322,750 Manufacturing Overhead 3,720,000
Pay for raw materials. Apply actual overhead to work in process.

3 Work in Process 1,240,000 13 Finished Goods 12,400,000

Raw Materials 1,240,000 Work in Process 12,400,000
Put direct materials into production. Record cost of goods manufactured.

4 Manufacturing Overhead 62,000 14 Cost of Goods Sold 12,000,000

Raw Materials 62,000 Finished Goods 12,000,000
Put indirect materials into production. Record unadjusted cost of goods sold.

5 Work in Process 7,440,000 15 Cash 3,000,000

Wages Payable 7,440,000 Accounts Receivable 12,000,000
Record direct labor wages earned. Sales 15,000,000

6 Manufacturing Overhead 1,318,000 16 Bad Debt Expense 360,000

Wages Payable 1,318,000 Allowance for Uncollectible Accounts 360,000
Record indirect labor wages earned. Record bad debt expense.

7 Manufacturing Overhead 400,000 17 Allowance for Uncollectible Accounts 359,200

Wages Payable 400,000 Accounts Receivable 359,200
Record factory supervisors' salaries earned. Write off uncollectible accounts.

8 Wages Payable 9,165,180 18 Cash 11,718,800

Cash 9,165,180 Accounts Receivable 11,718,800
Pay factory wages and salaries. Cash collected on account.

9 Manufacturing Overhead 240,000 19 GS&A Expenses, Other 1,140,000

Accumulated Depreciation, Factory M & E 240,000 Cash 1,140,000
Record dep'n on factory machinery & equipment.

10 Manufacturing Overhead 1,250,000

Cash 1,250,000
Pay rent on factory.
80,910,930 80,910,930

31
Smetana Corporation Smetana Corporation
Income Statement Balance Sheet
Year ended December 31, 2021 as of December 31, 2021

Sales 15,000,000 Assets

Cost of Goods Sold 12,000,000 Cash 1,514,320
Gross Margin 3,000,000 Accounts Receivable 600,000
Bad Debt Expense 360,000 Allowance for Uncollectible Accounts (3,140)
Other GS&A Expenses 1,140,000 Raw Materials 116,000
Operating Income 1,500,000 Work in Process -
Finished Goods 440,000
Factory Machinery & Equipment 4,000,000
Smetana Corporation Accum Dep'n - Factory M & E (2,640,000)
Statement of Cash Flows Total Assets 4,027,180
Year ended December 31, 2021
Liabilities and Shareholders' Equity
Cash Provided by (used for) operations Liabilities
from customers 14,718,800 Accounts Payable, Trade 66,250
to suppliers (1,322,750) Wages Payable 91,580
to factory employees (9,165,180) Total Liabilities 157,830
to factory landlord (1,250,000)
to utility companies (450,000) Shareholders' Equity
to GS&A providers (1,140,000) Common Stock 100,000
Cash provided by operating activties 1,390,870 Additional Paid-in Capital 900,000
Cash, January 1 123,450 Retained Earnings 2,869,350
Cash, December 31 1,514,320 Total Shareholders' Equity 3,869,350
Total Liabilities and Shareholders' Equity 4,027,180

32
Sales $ 8,250,000

Finished Goods Inventory, 01/01/21 $ 510,000

Cost of Goods Manufactured, 2021 $ 6,540,000
Gross Margin expressed as a percent of
cost of goods sold 25.00%

How much is finished goods inventory at 12/31/21?

A Between $300,000 and $400,000

B Between $400,000 and $500,000
C Between $500,000 and $600,000
D Between $600,000 and $700,000

33
Sales $ 7,600,000

Finished Goods Inventory, 01/01/21 $ 516,480

Cost of Goods Manufactured, 2021 $ 5,890,030
Gross Margin expressed as a percent of
cost of goods sold 25.00%

How much is finished goods inventory at 12/31/21?

A Between $300,000 and $400,000

B Between $400,000 and $500,000
C Between $500,000 and $600,000
D Between $600,000 and $700,000

34
Sales $ 6,400,000

Finished Goods Inventory, 01/01/21 $ 367,820

Cost of Goods Manufactured, 2021 $ 5,436,080
Gross Margin expressed as a percent of
cost of goods sold 25.00%

How much is finished goods inventory at 12/31/21?

A Between $300,000 and $400,000

B Between $400,000 and $500,000
C Between $500,000 and $600,000
D Between $600,000 and $700,000

35
During March, 2021, Bayer Corporation provides you with the following
information.

Materials purchased during March $ 14,000

Direct labor costs incurred in March $ 20,000
March total manufacturing overhead $ 36,000
Inventory information is as follows:

March 1 March 31
Materials $ 8,600 $ 2,300
Work-in-Process $ 1,700 $ 9,000
Finished Goods $ 7,000 $ 6,500

Assume there are no indirect materials

What was cost of goods sold for March?

A Between $60,000 and $62,500

B Between $62,500 and $65,000
C Between $65,000 and $67,500
D Between $67,500 and $70,000
36
During March, 2021, Bayer Corporation provides you with the following
information.

Materials purchased during March $ 12,000

Direct labor costs incurred in March $ 24,000
March total manufacturing overhead $ 36,000
Inventory information is as follows:

March 1 March 31
Materials $ 6,800 $ 4,900
Work-in-Process $ 8,100 $ 6,000
Finished Goods $ 12,600 $ 21,200

Assume there are no indirect materials

What was cost of goods sold for March?

A Between $60,000 and $62,500

B Between $62,500 and $65,000
C Between $65,000 and $67,500
D Between $67,500 and $70,000
37
During March, 2021, Bayer Corporation provides you with the following
information.

Materials purchased during March $ 21,000

Direct labor costs incurred in March $ 14,000
March total manufacturing overhead $ 28,000
Inventory information is as follows:

March 1 March 31
Materials $ 7,300 $ 9,100
Work-in-Process $ 4,500 $ 6,000
Finished Goods $ 3,800 $ 3,100

Assume there are no indirect materials

What was cost of goods sold for March?

A Between $60,000 and $62,500

B Between $62,500 and $65,000
C Between $65,000 and $67,500
D Between $67,500 and $70,000
38
 Actual Cost System
• In an actual cost system, work in process is debited with
the actual cost of direct materials, direct labor and
manufacturing overhead.
• Advantages: Product costs reflect allocation of each
period’s overhead to units produced that period.
• Disadvantages: Management does not know product
costs until the period is over. The shorter the period, the
more volatile product costs can be depending on the
relative size of overhead in relation to total product cost.
• Response: Because management cannot wait until the
year is over to know product costs, firms use normal cost
systems in place of actual cost systems. In chapter 3 we
will study normal cost systems.

39
“For the simplicity on this side of complexity, I
wouldn't give you a fig.
But for the simplicity on the other side of
complexity, for that I would give you anything I
have.”

Oliver Wendell Holmes

40