Accounting Principles – Cost of Sales

The cost of sales may be generally divided into .three elements, namely: materials and supplies, labor, and manufacturing overhead. This group corresponds to the expense-of-operation group in organizations other than a manufacturing concern.

The materials and supplies include, in addition to the gross purchases, inward freight and inward cartage, the latter item being either a direct charge for drayage or a proportion of the stable expense. The salaries and expenses of the purchasing department are also properly chargeable to materials and supplies.

The labor is divided into direct and indirect, the latter constituting the wages of foremen, laborers and helpers. Generally speaking, nothing is gained by classifying labor as direct and indirect. Where a cost system obtains, however, it is desirable that this classification should be made, because of the fact that one of the prime objects in cost accounting is to charge direct to jobs as many items as possible. The direct labor, constituting the work of the employees directly engaged in working upon the product, is something which can be specifically allocated to jobs; the indirect labor, such as the work of foremen, laborers and helpers, cannot be specifically allocated. Such division of labor facilitates the work of the cost department and permits of agreeing the cost records with the general books, by reason of the fact that indirect labor is thrown into the manufacturing overhead. Manufacturing overhead, or factory expense, as it is frequently called, includes superintendence, salaries of clerks keeping the factory records, factory office expense, heat, light and power, factory supplies, repairs and renewals of shop tools and minor operating equipment, depreciation of machinery and other major operating equipment, etc.

In cost accounting, materials and supplies and direct labor are combined, and constitute what is known as prime cost. Prime cost plus manufacturing overhead equals manufacturing cost. As was previously pointed out, one of the items included in the cost of materials was inward freight. Theoretically, inward freight is a part of the cost of materials; practically, it becomes almost impossible to connect the inward freight with the items of materials and supplies which it covers. To do so it would be necessary, perhaps, to distribute the freight corresponding to a certain way bill over several different invoices. The share of freight thus pro-rated to the various invoices would have, in return, to be distributed over the various classes of items making up the invoice. The distribution to classes of items having been accomplished, it would then be necessary to divide the amount so ascertained by the number of units pertaining to the particular class in question, in order to obtain a unit cost for freight. The amount of clerical labor involved in such calculations is so great that it is probable that most concerns do not attempt such a distribution in practice. It is a widespread custom to include inward freight in the overhead rather than attempt to load it to materials and supplies. The same remarks apply, possibly with greater force, to inward cartage. Theoretically, it is very properly included in the cost of materials; practically, it becomes a difficult matter to do so. The situation will be affected proportionately by the conditions which exist. If a concern has its own stable organization, and does all its own hauling, the stable expense must first be distributed to inward cartage and outward cartage. The proportion corresponding to inward cartage will then have to be pro-rated, presumably on a tonnage basis, over the incoming invoices, since it is next to impossible to connect in any other way the service rendered by the stable with the materials and supplies hauled.

Much discussion has arisen in the past as to the proper allocation of the salaries and expenses of the purchasing department. It has been contended, on the one hand, that the purchasing officer was an administrative officer, charged with exercising his judgment as to purchases, and in no way connected with the technical or operating department of the organization. As such, the salaries and expenses of his department would very properly be charged to administrative expenses. On the other hand, it is contended that the services of this office are rendered entirely for the benefit of the manufacturing or technical department; that the concern in question is not engaged in buying and selling materials and supplies, and that the salaries and expenses of the purchasing department should be charged into the cost of materials and supplies, because of the fact that such services and expenses were incurred in connection with the materials and supplies to be used in the manufacture of goods. The latter point of view would seem to be the most logical one. It is true that the purchasing officer exercises, in a way, both of the functions above described. The latter, however, seems to very greatly overshadow the former. The remarks which were made with regard to inward freight and cartage apply with equal force to the salaries and expenses of the purchasing department. Theoretically, they add to the cost of materials and supplies; practically, it is inexpedient, on account of the clerical work involved, to pro-rate them on a unit basis. They are, accordingly, included in the overhead.

In connection with purchases there are several classes of items which should be mentioned. Prominent among these are purchase returns, trade discounts, allowances and rebates. These items bear the same relation to gross purchases that sales returns, etc., bear to gross sales. In short, they are deductions from the gross purchases which result in arriving at the true cost of the purchases. It will probably not be necessary to discuss them here, since similar items relating to sales were discussed in the preceding chapter. Neither is it proposed to discuss here cash discount, rent of factory, taxes and insurance on factory property, etc., for the reason that such items will be discussed under a separate group, entitled “deductions from income.”

In arriving at the cost of sales it must be borne in mind that manufacturing cost is not cost of goods sold. Manufacturing cost is affected by the difference in inventory of goods in process and the difference in inventory of finished goods. The cost of sales is arrived at logically by beginning with materials and supplies, adding labor and manufacturing overhead, allowing these three items to represent goods in process, which, when completed, will be transferred to finished goods. As goods are sold they are charged to cost. This method, which may be called the direct method, becomes possible only when there is a cost system. Where no cost system obtains, and it is necessary to procure the information concerning the cost of sales from the general books, it is obtained by what is known as the inventory or indirect method. The respective accounts for materials and supplies, labor and overhead are closed into the account for manufacturing. This account represents the goods in process. If at the end of the period an inventory of goods in process is taken, and this inventory is applied to the manufacturing account, the difference will constitute the cost of goods transferred to finished stock. In the same way, if an inventory is taken of the finished goods, and this inventory applied at the end of the period to the finished goods account in the general ledger, the difference in the account will then represent the cost of the goods sold.
An ideal manner of closing the books where a statement of income and profit and loss is to be prepared is to open an account called “cost of sales,” and to close into it the items included in this group. Beginning with the account for materials and supplies, the first item will constitute the difference in inventory of materials and supplies. The subsequent charges pertaining to materials and supplies will be gross purchases, inward freight, inward cartage and the salaries and expenses of the purchasing department. The credits pertaining to materials and supplies will be purchase returns, trade discounts on purchases, purchase allowances and purchase rebates.

At this point it may be advisable to pause for a moment to discuss a point with regard to the inventory of materials and supplies. There will frequently be instances in which the item of inward freight is sufficiently large to justify setting up a part of this freight in the inventory. For example: A foundry buying large quantities of pig iron, and having to pay the inward freight, would be justified (if at inventory time there remained— out of purchases of a hundred thousand tons—eighty thousand tons,) in setting up in the inventory eight-tenths of the inward freight on the pig iron. Theoretically, the same thing applies to inward cartage, although the items are usually so small as not to warrant this procedure.
Resuming now with the items making up the cost of sales, the account for direct labor will be closed into the account “cost of sales.” The various items of factory expenses will be treated likewise. The account for goods in process inventory, which showed the inventory on hand at the beginning of the period, will be treated with the inventory on hand at the end of the period. The difference in this account will be closed into the cost of sales. In a similar way, the account for finished goods inventory, which showed on the debit side, the inventory at the beginning of the period and on the credit side, the inventorv at the end of the period, will be closed out to the cost of sales.

It will thus be seen that the cost-of-sales account will contain the precise information necessary to prepare the second section of the statement of income and profit and loss, as follows: Materials and supplies:
Gross purchases $75,500.00
Less-purchase returns 500.00
Net purchases $75,000.00
Add—Inward freight 400.00
Inward cartage 200.00
Salaries and expenses purchasing
department 1,400.00
Total cost of purchases $77,000.00
Deduct—Trade discounts on purchases.. $500.00
Purchase allowance 400.00
Purchase rebates 100.00
Total deductions $1,000.00
Net cost of purchases $76,000.00
(Add or) deduct difference in inventory
materials and supplies 5,000.00
Cost of mat’ls and supplies consumed $71,000.00
Labor—Direct 25,000.00
Factory expense:
Superintendence 5,000.00
Labor, indirect 600.00
Salaries of clerks 2,000.00
Factory office expense 400.00
Heat, light and power 75000
Factory supplies 250.00
Repairs and renewals 50.00
Depreciation of machinery, etc 950.00
Total manufacturing cost $106,000.00
Add (or deduct increase or) decrease in inventory of goods in process 10,000.00
(Add or) deduct increase (or decrease) in
inventry of finished goods 85,000.00
Total cost of sales $31,000.00

The second section of the income statement will not always appear in as great detail as the above, for various reasons. Fundamentally, however, whether shown in detail or condensed, the cost of sales remains as indicated.

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