CHAPTER 5.

COST MEASUREMENT, COST CONCEPTS AND BEHAVIOR

A. What is Cost?

Cost is the expenditure required to create and sell products and services, or to acquire assets. When sold or consumed, a
cost is charged to expense. In the case of an asset, the charge to expense could be significantly deferred. The cost concept
underlies the transition of assets from the balance sheet to expenses in the income statement. When a cost is designated
as an expense, it can be assigned to a wide range of possible expenses, such as:

 Cost of goods sold

 Selling expenses
 General and administrative expenses
 Financing costs

Thus, the nature of a cost drives the type of expense to which it is eventually assigned.

B. Presentation of Costs in Financial Statements

Financial Statements in a company or business are as follows:

 Balance Sheet
 Income Statement
 Statement of Cash Flows
 Statement of Changes in Equity

Costs are presented in the Income Statement. The following are illustrations of costs in the Income Statement depending on the
type of business: merchandising, manufacturing and service.

I. Service Business Financial Statements

Service companies have the most basic income statement of all the types of companies. Since service based companies do not
sell a product, the income statement will not contain cost of goods sold. Therefore, the income statement will be a basic
breakdown of income and expenses.

Begin with income. Then subtract all operating expenses. The difference between income and operating expenses is operating
income. In this case, all expenses are period costs. There are no product costs associate with a service company.
II. Merchandising Business Financial Statements

A merchandising company uses the same 4 financial statements we learned before: Income statement, statement of
retained earnings, balance sheet, and statement of cash flows. The balance sheet used is the classified balance sheet. The
income statement for a merchandiser is expanded to include groupings and subheadings necessary to make it easier for
investors to read and understand. We will look at the income statement only as the other statements have been discussed
previously.

Multi-Step (or classified) income statement

A multi-step income statement divides both revenues and expenses into operating and nonoperating (other) items. The
statement also separates operating expenses into selling and administrative expenses. A multi-step income statement is
also called a classified income statement.

The multi-step income statement shows important relationships that help in analyzing how well the company is
performing. For example, by deducting cost of goods sold from operating revenues, you can determine by what amount
sales revenues exceed the cost of items being sold. If this margin, called gross margin, is lower than desired, a company
may need to increase its selling prices and/or decrease its cost of goods sold. The classified income statement subdivides
operating expenses into selling and administrative expenses. Thus, statement users can see how much expense is incurred
in selling the product and how much in administering the business. Statement users can also make comparisons with other
years’ data for the same business and with other businesses. Nonoperating revenues and expenses appear at the bottom of
the income statement because they are less significant in assessing the profitability of the business.

Management chooses which income statement to present a company’s financial data. This choice may be based either on
how their competitors present their data or on the costs associated with assembling the data.

The major headings of the classified multi-step income statement are explained below:

 Net Sales are the revenues generated by the major activities of the business—usually the sale of products or services or
both less any sales discounts and sales returns and allowances.
 Cost of goods sold is the major expense in merchandising companies and represents what the seller paid for the
inventory it has sold.
 Gross margin or gross profit is the net sales – cost of goods sold and represents the amount we charge customers
above what we paid for the items. This is also referred to as a company’s markup.
 Operating expenses for a merchandising company are those expenses, other than cost of goods sold, incurred in the
normal business functions of a company. Usually, operating expenses are either selling expenses or administrative
expenses. Selling expenses are expenses a company incurs in selling and marketing efforts. Examples include salaries
and commissions of salespersons, expenses for salespersons’ travel, delivery, advertising, rent (or depreciation, if
owned) and utilities on a sales building, sales supplies used, and depreciation on delivery trucks used in
sales. Administrative expenses are expenses a company incurs in the overall
 Multi-step Income Statement

For the Year Ended December 31

Sales $275,000

Less: Sales Discounts 2,000

Sales Returns and allowances 1,000 3,000

Net Sales (275,000 – 3,000) $272,000

Cost of goods sold 159,000

Gross Profit (272,000 – 159,000) $113,000

Operating expenses:

Selling expenses

Commissions expense 10,000

Advertising expense 7,000

Sales Salaries expense 20,000

Rent expense – sales 12,000

Total Selling expenses 49,000

Administrative expenses

Rent expense – office 12,000

Office Salaries expense 40,000

Utilities expense 5,000

Total Admin. Expenses 57,000

Total Operating expenses (49,000 + 57,000) 106,000

Income from operations (113,000 – 106,000) 7,000

Other Revenue (Expense) 100

NET INCOME (7,000 + 100) 7,100

management of a business. Examples include administrative salaries, rent (or depreciation, if owned) and utilities on an
administrative building, insurance expense, administrative supplies used, and depreciation on office equipment.
 Income from Operations is Gross profit (or margin) – operating expenses and represents the amount of income directly earned
by business operations.
 Other revenues and expenses are revenues and expenses not related to the sale of products or services regularly
offered for sale by a business. This typically includes interest earned (interest revenue) and interest owed (interest
expense).
 Net Income is the income earned after other revenues are added and other expenses are subtracted.

Reporting Cost of Goods Sold

Cost of goods sold can be reported two ways: as a single line item or as detailed section showing net purchases and
calculating cost of goods sold. When using the perpetual inventory method, cost of goods sold is reported as a single line
item (as illustrated in video and example above).

Under the periodic method, you can use a single line item in the multi-step income statement with a separate schedule of cost
of goods sold OR you can report the cost of goods sold within the income statement itself. The following video reviews the
periodic method entries and shows how to complete the cost of goods sold section with in the multi-step income statement.
 Hanlon Food Store

Cost of Goods Sold Statement

For the year ended December 31

Merchandise Inventory, January 1 24,000

Purchases 167,000

Less: Purchase discount 3,000

Purchase returns and allowances 8,000 11,000

Net Purchases (167,000 – 156,000) 156,000

Add: Transportation In 10,000

Net cost of purchases (156,000 + 10,000) 166,000

Cost of goods available for sale (24,000 + 166,000) 190,000

Less: Merchandise Inventory, December 31 31,000

Cost of goods sold (190,000 – 31,000) 159,000

III. Manufacturing Companies Financial Statements

A manufacturer reports its product costs as one of three types of inventory in the Current Assets section of its balance
sheet, depending on stages of completion. Materials consist of items in inventory that have not yet been entered into
production or used. Work-in-process includes manufactured products that have been started but are not yet completed. In
other words, they are currently in production. Finally, finished goods are manufactured products that have been
completed but not yet sold to customers.

Assume you own a bicycle store and purchase bicycles and accessories to sell to customers. To determine your
profitability, you would subtract the cost of bicycles and accessories from your gross sales as cost of goods sold. However,
if you owned the manufacturing company that made the bicycles, you would base your cost of goods sold on the cost of
manufacturing those bicycles. Accounting for manufacturing costs is more complex than accounting for costs of
merchandise purchased that is ready for sale.

Perhaps the most important accounting difference between merchandisers and manufacturers relates to the differences in
the nature of their activities. A merchandiser purchases finished goods ready to be sold. On the other hand, a
manufacturer must purchase raw materials and use production equipment and employee labor to transform the raw
materials into finished products.

While a merchandiser has only one type of inventory—merchandise available for sale—a manufacturer has three types:
unprocessed materials, partially complete work in process, and ready-for-sale finished goods. Instead of one inventory
account, three different inventory accounts are necessary to show the cost of inventory in various stages of production.
Looking at Exhibit 2, you can see how the inventory cost flows differ between manufacturing and merchandising
companies.

We compare a manufacturer’s “cost of goods sold” section of the income statement to that same section of the
merchandiser’s income statement in the chart below. There are two major differences in these cost of goods sold sections:
(1) goods ready to be sold are referred to as merchandise inventory by a merchandiser and finished goods inventory by a
manufacturer, and (2) the net cost of purchases for a merchandiser is equivalent to the cost of goods manufactured by a
manufacturer.
 Merchandiser
Cost of goods sold:
Merchandise inventory, Beginning
Net cost of purchases
Cost of goods available for sale
Merchandise inventory, Ending
Cost of goods sold
Manufacturer
Cost of goods sold:
$ 25,000Finished goods inventory, Beginning $ 50,000
165,000Double lineCost of goods manufactured 1,100,000Double line
$ 190,000Cost of goods available for sale $ 1,150,000
30,000Double lineFinished goods inventory, Ending 60,000Double line
$ 160,000Cost of goods sold $ 1,090,000

Unlike a merchandiser’s balance sheet that reports a single inventory amount, the balance sheet for a manufacturer
typically shows materials, work in process, and finished goods inventories separately. The video and chart will explain
these concepts further.

Account Account Type Description

Raw Materials Inventory Current Asset All materials to be used in production (including direct and indirect materials)
Work in Process InventoryCurrent Asset Direct Material + Direct Labor + Overhead applied to items started but not completed
Finished Goods Inventory Current Asset Direct Material + Direct Labor + Overhead applied to items completed BUT not sold
Cost of Goods Sold Expense Direct Material + Direct Labor + Overhead applied to items completed AND sold