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Cost flows clarified: three stages to introducing inventory accounting for manufacturing.
Abstract:
This article's contribution is to highlight the differences in the presentation of manufacturing cost flows among five leading managerial and cost accounting textbooks, and to propose a single model that has been effective in easing students' grasp of those cost flows, along with a set of learning objectives for that model.

Keywords: flows of costs in manufacturing companies, schedules of costs, Bloom's taxonomy, redesigning the learning objectives

Article Type:
Report
Subject:
Manufacturing costs (Analysis)
Manufacturing industry (Economic aspects)
Inventories (Accounting and auditing)
Inventories (Analysis)
Authors:
Mutju, Alexandra
McDougall, Duncan C.
Pub Date:
06/22/2011
Publication:
Name: European Journal of Management Publisher: International Academy of Business and Economics Audience: Academic Format: Magazine/Journal Subject: Business, international Copyright: COPYRIGHT 2011 International Academy of Business and Economics ISSN: 1555-4015
Issue:
Date: Summer, 2011 Source Volume: 11 Source Issue: 2
Geographic:
Geographic Scope: United States Geographic Code: 1USA United States
Accession Number:
260791898
Full Text:
1. INTRODUCTION

Financial Accounting and Accounting Principles texts generally use service firms as models to introduce the accounting equation, the accounting cycle, and the four financial statements. The revenues, expenses, assets and liabilities in service firms are relatively simple, and thus easy to explain to beginning students of business or accounting. These introductory courses later introduce a merchandising model to bring in the concept of inventory as a current asset whose purchase is not necessarily an expense in the period of purchase, and to explain the schedule of cost of goods sold. A manufacturing firm's complexities may be mentioned, but rarely is the flow of costs in manufacturing fully covered in preliminary accounting courses.

Thus, it is typically in the management accounting (or cost accounting) course that students are first introduced to the manufacturing environment. The flow of costs through a manufacturing company's three classes of inventory and three stages of operations presents an added complexity which students must grasp before tackling such basic management accounting subjects as: job order costing and process costing, budgeting, standard costing, and production variance analysis.

This paper examines the way the flow of costs through the manufacturing process is presented in five leading management accounting and/or cost accounting texts, and considers how the related learning objectives found in those texts match with their content. We then propose a model of the flow of costs through the manufacturing process which we believe improves upon the teaching approaches that we found in those five textbooks.

In presenting our pedagogical approach, which we call "The Rule of Threes," our intent is not to deliver a chapter explaining each step of accounting for the flow of costs. Rather, it is to present a simple diagram of that flow which we consider to be effective as a classroom tool with which to accomplish the first level of Bloom's taxonomy: knowledge, and two parts of the second level: intellectual abilities and skills. Based on the proposed diagram, we also suggest corresponding learning objectives for the flow of costs through the manufacturing process.

2. THE MODEL AND METHODOLOGY

Our methodology, represented graphically, is as follows:

[FIGURE 1 OMITTED]

In the first stage of the research we identified the way the flow of costs in manufacturing process is approached in current accounting textbooks. The conclusions from this stage made us draw our attention on the learning objectives presented at the beginning of each examined chapter. Here, we analyzed if the learning objectives were linked with the text's content for the flows of costs. By analyzing comparatively the flows of costs and the learning objectives attached to them, we concluded that the way the flows of costs are presented in the textbooks could be improved. We developed a revised (and we believe improved) approach. This generated a need to restate the learning objectives for some of the textbooks analyzed.

Further, we present the methodology we used in this research:

We based our work on some of the world's best-known books in Managerial and Cost Accounting:

1. Anthony Robert T., Hawkins David F., Merchant Kenneth A., Accounting, Text and Cases, 12th Edition, McGraw-Hill, International Edition, 2007

2. Hilton Ronald W., Managerial Accounting: Creating Value in a Dynamic Business Environment, 10th Edition, McGraw-Hill, 2009

3. Hilton Ronald W., Maher Michael W., Selto Frank H., Cost Management. Strategies for Business Decisions, McGraw-Hill, 2003

4. Horngren C. T., Datar S. M., Foster G., Cost Accounting, A Managerial Emphasis, 11th Edition, Pearson Education, 2003

5. Garrison Ray H., Noreen Eric W, Brewer Peter C., Managerial Accounting, 12th Edition, McGrawHill, 2008.

Our research model comprises the following steps:

Step 1. We analyzed the authors' approach on the flow of costs in a manufacturing company. For this, we used the following criteria:

1. A description of the flows of costs is given for a manufacturing company.

2. Schedule of Cost of Goods Manufactured (SCGM) is presented.

3. Statement of Cost of Goods Sold (SCGS) is presented.

4. The link between SCGM/SCGS and Income Statement (IS) is presented.

5. Costs' computation is shown for each representative stage of the costs' flows.

Step 2. We analyzed the learning objectives for the topic examined.

Textbooks represent a learning resource, so each topic's approach has to fulfill the learning objectives presented at the beginning of each chapter.

Step 3. Finding ways to improve the topic's approach.

We identified a few "weak points" of the approaches found in Step 1, and tried to improve them in a helpful way for the learners. Thus, we synthesized a more comprehensive diagram (and pedagogical presentation) titled: "The Rules of Threes", which we have used in classes, and have found effective in easing the learners' comprehension.

Step 4. Defining a more comprehensive set of learning objectives for the flows of costs.

Based on including "The Rule of Threes" into the learning approach, we considered it necessary to revise the learning objectives in order to be sure they correspond clearly to the topic.

3. FINDINGS

Our findings refer to the first two steps of the research. In this section we present the way textbooks' authors approach the flow of costs in a manufacturing company and the learning objectives the authors state for the flow of costs. At the end of this section our findings are summarized in a table.

Anthony et al. in Accounting, Text and Cases, in Chapter 6, "Cost of sales and inventories", address the flow of costs. They describe the three types of companies: merchandising, manufacturing and service and then describe in detail the procedures of accounting for inventory and cost of sales in each type. For the merchandising companies they explain the acquisition cost and the formula used in calculating the cost of goods sold. Then, they move to manufacturing companies where they explain the inventory accounts: materials inventory, work in process and finished goods and illustrate the manufacturing flows.

In fact, they present in a very clear and simple way how material inventory is calculated in the first stage of the cost calculation process. In stage two, the conversion costs are added to material cost to form the work in process inventory. Then, in stage three, work in process inventory is transferred into finished goods when they are completed, then to cost of goods sold when they are sold. Further, they explain the terms materials used and materials inventory and explain the cost of goods manufactured and cost of goods sold and present the way these terms can be reflected in the accounts. Theirs impresses us as a very good presentation. However, this textbook does not present the learning objectives for the chapter.

In Managerial Accounting: Creating Value in a Dynamic Business Environment, in Chapter 2, "Basic Cost Management Concepts and Accounting for Mass Customization Operations", Hilton uses the next approach: he describes the company's case and then he presents the theory needed to move further: manufacturing costs, where he explains direct material, direct labor, manufacturing overhead (indirect material, indirect labor and other manufacturing costs) and then he presents manufacturing cost flows.

Hilton explains the terms Cost of Goods Manufactured and Cost of Goods Sold and presents in detail schedules for these two costs along with the income statement. In Chapter 3 "Product Costing and Cost Accumulation in a Batch Production Environment" and Chapter 4 "Process Costing and Hybrid Product-Costing Systems" he brings again into discussion the flow of cost, but this time he explains the flow through the manufacturing accounts used in production. Also, he presents a comparison of the way costs are accumulated in job order and process costing which help the reader to understand again how costs flow into, between and through the production stages.

Hilton's learning objectives for this topic require being able to give examples of the three types of manufacturing costs and to prepare a SCGM, SCGS and an IS for a manufacturer.

In Cost Management. Strategies for Business Decisions, Hilton et al. present a simplified version of the production process at a manufacturing company in Chapter 2, "Product Costing Systems: Concepts and Design Issues". They present the production stages using a clear and relevant exhibit. Then, they present and explain the way Schedule of Cost of Goods Manufactured and Sold (SCGM&S) is prepared. Separately, the Income Statement is presented in a similar way to SCGM&S.

The learning objectives for this topic require being able to explain the role of product costs, period costs and expenses in financial statement, to prepare an IS and a SCGM&S and to list the components of manufacturing costs, and diagram their flow through a production process.

In the textbook Cost Accounting, A Managerial Emphasis, Horngren et al. tackle in Chapter 2 "An introduction in costs terminology and their scope" the flow of production costs and the cost of goods sold. Regarding the schedules, they show how to prepare the Income statement and the Schedule of Cost of Goods Manufactured using a numeric example based on a company case.

The learning objectives for this topic are explaining the differences between the product costs and period costs and describing the three components of manufacturing costs.

Garrison et al. present in the textbook Managerial Accounting, in Chapter 2, "Cost Terms, Concepts, and Classifications" the Cost Flows and Classification in a manufacturing company and the Schedule of Cost of Goods Manufactured (SCGM)

using examples and explaining in detail the way it is prepared. The three basic manufacturing costs are presented. They present also the Cost of Goods Sold and the way it is prepared as a part of the IS.

The learning objectives for this topic require being able to identify and give examples of each or the three basic manufacturing cost categories, distinguish between product costs and period costs and give examples of each, prepare an IS including calculation of the CGS and a SCGM.

Comparison and Analysis

Regarding the learning objectives, we have structured our analysis based on Bloom's taxonomy. The original taxonomy of educational objectives related to cognitive domain has two levels: Knowledge, and Intellectual abilities and skills. (Bloom, 201)

The first level: knowledge, "involves the recall of specifics and universals, the recall of methods and processes, or the recall of a pattern, structure, or setting."(Bloom, 201)

The second level: Intellectual abilities and skills refer "to organized modes of operation and generalized techniques for dealing with materials and problems" (Bloom, 201). This level refers to the mental process of organizing and working with the materials and problems in order to achieve a purpose. In order to be able to work with information, this level is based on 5 sub-levels:

1. Comprehension of material and problem. Comprehension represents the lowest level of understanding. It is related with the ability of understanding what is being communicated and conveying the idea further without necessarily connecting it with other ideas or materials.

2. Application. This refers to the ability and skills needed to apply general rules, procedures, and methods called abstractions to a specific situation. To be applied, abstractions need to be remembered first.

3. Analysis, which implies to break the material and problem into parts and to analyze them separately and then in correlation with other factors. The scope of this phase is to understand how the initial material was build.

4. Synthesis represents the process of combining the material's parts using a new structure, clearer than before.

5. Evaluation represents the process of judging the materials for a given purpose. Usually, this phase requires quantitative and qualitative judgments and very often the given purpose is not indicated by the material ad has to be identified by the evaluator.

If we compare the structure of this taxonomy with the learning objectives analyzed in this research, we notice that overall the educational objectives of the flow of costs reach until the second level of the taxonomy, most specific the application level. But some of the textbooks define very poorly the learning objectives and some don't do this at all. As we can see from Exhibit 2, the most well defined learning objectives for this topic belongs to Garrison et al., followed closely by Hilton et al.

Therefore, all the texts examined cover the flow of costs in manufacturing, with varying degrees of detail and, in four of five cases, in pursuit of somewhat varying learning objectives. However, we have found in our teaching that students have had difficulty grasping this topic. And, between the authors, we have taught using all five of the examined texts. In our experience, the flow of costs can be made clearer, which leads to our proposed model.

4. CONCLUSION

All the textbooks considered in our research presented a general description of the flow of costs (criterion 1) and cost computation (criterion 5) with no significant differentiation in content. On the other hand, the differences in approaches are more obvious in respect with the second and the third criteria: Schedule of Cost of Goods Manufactured (SCGM) and Schedule of Cost of Goods Sold (SCGS).

Therefore, our preliminary conclusion is that the production stages are not made crystal clear through the schedules of Cost of Goods Manufactured, and Cost of Goods Sold. The arguments for this conclusion rely on the different ways in which SCGM and SCGS are presented:

1--One approach presents SCGM and SCGS separately, as two different reports. Hilton states very clearly that "manufacturers generally prepare a Schedule of Cost of Goods Manufactured and a Schedule of Cost of Goods Sold to summarize the flow of manufacturing costs during an accounting period" (Hilton, 48).

2--A combined approach of these two reports in a single report, which can be found in Hilton et al.

3--A hybrid approach where SCGM is presented separately but the SCGS is included in IS.

Even with these differences, all the five textbooks present the link that exists between the SCGM, SCGS and IS.

This preliminary conclusion is accompanied by our opinion that for clarity, the flow of costs in manufacturing might best be presented first as the focus of a single chapter.

As a contribution to the teaching of the flow of costs, we offer what we consider a comprehensive approach. Our formulation is built on Anthony et al.'s idea which we consider to be the clearest of all presented. They underline explicitly the three stages of the production process. We also acknowledge that Hilton et al. state clearly their opinion regarding the necessity of presenting the "the stages of production from the receipt of raw material through manufacturing to the storage of finished goods" (Hilton et al., 44).

Our proposed presentation of Manufacturing Cost Flows is as follows:

The Rule of Threes

In a manufacturing company the manufacturing cost accounts relate to the three stages of the process by which raw materials are converted into salable, and then sold, products. The accounts written in italics are the inputs to each stage. The direction of product flow is shown by the arrows.

[ILLUSTRATION OMITTED]

[ILLUSTRATION OMITTED]

[ILLUSTRATION OMITTED]

After presenting the Rule of Threes (often the old fashioned way, with chalk on a blackboard), we have found it helpful to show Exhibit 4, which explains how the three stages are presented in the Schedule of Cost of Goods Manufactured, and in the Statement of Cost of Goods Sold.

[ILLUSTRATION OMITTED]

We also use Exhibit 4 to show the Prime Costs (cost of material used in production plus direct labor cost) and the Conversion Costs (direct labor cost plus manufacturing overhead) by circling them on the diagram, which emphasizes that these cost concepts both include direct labor cost, and thus should never be added together.

We hereby offer the Rule of Threes model to all teachers of accounting and/or of management accounting, and encourage you to use it in class without compunction. However, if you use it in a book or in an article, we ask that this article be cited.

Therefore, the proposed Learning Objectives for a chapter on the Manufacturing Cost Flows are:

1. To diagram the three basic stages of manufacturing.

2. To relate the three classes of manufacturing inventory to their respective stages.

3. To identify the inputs and outputs to each stage.

4. To prepare a Schedule of Cost of Goods Manufactured

5. To prepare a Statement of Cost of Goods Sold for a manufacturing company

6. To prepare an Income Statement for a manufacturing company.

ACKNOWLEDGEMENTS:

This work was supported by CNCSIS-UEFISCSU, project number PNII--IDEI 2476/2008, "Study regarding the development process of the Romanian educational accounting system toward a global economic environment".

REFERENCES:

Anthony R. T., Hawkins D. F., Merchant K. A., Accounting, text and cases, 12th Edition, McGraw-Hill, International Edition, 2007

Bloom B.S., Taxonomy of Educational Objectives, Handbook 1. Cognitive domain, Longman Green and Co LTD, London, 1956

Hilton W., Maher M. W., Selto F. H., Cost management. Strategies for Business Decisions, McGraw-Hill, 2003

Hilton R. W., Managerial Accounting: Creating Value in a Dynamic Business Environment, 10th Edition, McGraw-Hill, 2009

Horngreen C. T., Datar S. M., Foster G., Cost accounting, a managerial emphasis, 11th Edition, Pearson Education, 2003

Garrison Ray H., Noreen Eric W, Brewer Peter C., Managerial Accounting, 12th Edition, McGraw-Hill, 2008

Alexandra Mutju, Babes-Bolyai University, Cluj-Napoca, Romania

Duncan C. McDougall, Plymouth State University, New Hampshire, USA

AUTHORS PROFILES:

Dr. Alexandra Muliu earned her PhD. at the Babes Bolyai University, Cluj-Napoca in 2003. Currently she teaches managerial accounting and controlling at Faculty of Economics and Business Administration, Babes Bolyai University.

Dr. Duncan C. McDougall earned his master's and doctoral degrees in business administration from Harvard Business School. He currently teaches operations management and managerial accounting at Plymouth State University, New Hampshire, USA.
TABLE 1. COMBINED RESULTS OF STEP 1 AND 2

                            Criteria

                 1        2     3      4        5

Author /      Descrip-   SCG   SCG   SCGM/     Cost    Learning
Textbook        tion      M     S     SCGS    compu-   objectives
               of the                and IS   tation   of the topic
              flows of
               costs

Anthony          1        1     1      1        1      N/A
et al.
Accounting,
text and
cases

Hilton           1        1     1      1        1      1. Give examples
Managerial                                             of three types
Accounting                                             of manufacturing
                                                       costs
                                                       2. Prepare a
                                                       SCGM, SCGS and
                                                       an IS for a
                                                       manufacturer

Hilton et        1           1         1        1      1. Explain the
al.                                                    role of product
Cost                                                   costs, period
management                                             costs and
                                                       expenses in
                                                       financial
                                                       statement
                                                       2. Prepare an IS
                                                       and a SCGM&S
                                                       3. List the
                                                       components of
                                                       manufacturing
                                                       costs, and
                                                       diagram their
                                                       flow through a
                                                       production
                                                       process

Horngreen        1        1    1 *     1        1      1. Explaining
et al.                                                 the differences
Cost                                                   between the
accounting                                             product costs
                                                       and period costs
                                                       2. Describing
                                                       the three
                                                       components of
                                                       manufacturing
                                                       costs

Garrison         1        1    1 *     1        1      1. Identify and
et al                                                  give examples of
Managerial                                             each or the
Accounting                                             three basic
                                                       manufacturing
                                                       cost categories
                                                       2. Distinguish
                                                       between product
                                                       costs and period
                                                       costs and give
                                                       examples of each
                                                       3. Prepare an IS
                                                       including
                                                       calculation of
                                                       the CGS
                                                       4. Prepare a
                                                       schedule of cost
                                                       of goods
                                                       manufactured

1 = positive, 0 = negative, * it is included in the IS
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