Flow of Costs

We’ve defined product costs which include direct materials, direct labor, and manufacturing overhead. Product costs are expensed when the items are sold, and until then, they remain in inventory accounts.

The three inventory accounts are:

• Raw materials

• Work-in-process

• Finished goods

The raw materials inventory account tracks the value of materials that have been purchased but not yet used to manufacture a product. For instance, if $1,000,000 is spent on direct materials, a debit of $1,000,000 is recorded in the raw materials inventory and a corresponding credit is made to accounts payable for $1,000,000.

Study Tip 🙂

The raw materials account is for materials that have been purchased but not yet used to manufacture a product. Once they are used for manufacturing, the costs are moved into work-in-process.

When these materials start to be used in production, they are moved out of the raw materials inventory account. These costs then move into the next inventory account, work-in process. The work-in-process inventory account tracks all items that have been started but not yet finished. As work on the products begins, the raw materials costs are transferred to the work-in-process account, along with the other two product costs – direct labor and manufacturing overhead.

Study Tip 😀

The work-in-process inventory account tracks all items that have been started but not yet finished. This includes direct materials, direct labor, and manufacturing overhead. Once the goods are finished, the costs are moved into finished goods.

Upon completion of a product, costs are moved from work-in-process to the finished goods inventory account. The finished goods inventory account includes all products that have been completed but not yet sold. Remember, product costs are not expensed until they are sold, so they stay in the finished goods inventory account until then.

Once items are sold, they move out of finished goods and into the cost of goods sold expense account, which is an expense account on the income statement.

Study Tip 😀

Once the goods in finished goods are sold, they are moved out of finished goods and recorded as cost of goods sold expense.

Flow of Costs Example – Platinum Tech

Now, let’s illustrate this with a concrete example using Platinum Tech. Here, we’ll show how costs flow from the inventory accounts into the expense account. The company starts by purchasing $200,000 worth of aluminum and glass for laptops, which is recorded as a debit to the raw materials inventory account and a credit to accounts payable. The $200,000 cost sits in the raw materials account until the company starts producing laptops.

Assume the company manufactures 400 laptops, with each laptop requiring $350 worth of raw materials. This means the company uses a total of $140,000 worth of raw materials. As the business commences laptop manufacturing, the $140,000 is moved from raw materials (as a credit) to work-in-process (as a debit), leaving a balance of $60,000 in raw materials.

Factory workers spend 400 hours on laptops at $20 per hour, resulting in a total direct labor cost of $8,000. This $8,000 is recorded in the work-in-process account. At this point, we have recorded both direct materials and direct labor to the work-in-process account. The missing product cost is the manufacturing overhead.

For simplicity, assume that for every hour of direct labor, we allocate $10 of manufacturing overhead. With 400 direct labor hours, this leads to the allocation of $4,000 of manufacturing overhead, which is recorded in the work-in-process account.

To this point, we’ve recorded the following costs into the work-in-process account: $140,000 of direct materials, $8,000 of direct labor, and $4,000 of manufacturing overhead, totaling $152,000.

Assuming we have finished 50% of the laptops at this point, we cannot yet move the cost out of work-in-process as they must be 100% complete. To finish the laptops, the employees work another 400 hours. This results in an additional $8,000 recorded to work-in-process and the application of another $4,000 of manufacturing overhead.

At this point, we have recorded $140,000 of raw materials, $16,000 of direct labor, and $8,000 of applied manufacturing overhead to the work-in-process account, totaling $164,000. Upon full completion of all 400 laptops, the costs are moved from work-in-process to finished goods. This action zeros out the work-in-process balance and increases the finished goods balance to $164,000. The $164,000 remains in the finished goods account until the laptops are sold.

Assume that the company sells 100 laptops. These costs are moved out of finished goods (as a credit) and into the cost of goods sold (as a debit). Given that the costs were $164,000 for 400 units, the cost per unit is $410 ($164,000/400). Therefore, $41,000 worth of costs are moved out of finished goods and into the cost of goods sold ($410 per unit X 100 laptops).