Relationship Between Types of Costs and Inventory

The relationship between when cash is spent and when it is recognized as an expense is fairly complex in job order costing. Costs flow through the inventory accounts and finally become an expense when the sale is complete. This relationship and the complexities that arise have been tracked in this article.

Outlay vs Expenditure

To understand this relationship better we have to take a back track to financial accounting. There, we defined the difference between an outlay and expenditure. An outlay is when resources are utilized whereas expenditure is defined as a loss of value. Hence, when a firm spends money to create inventory it is not an expense. It is an outlay of cash. Cash has changed form and is now another asset called inventory. There is no loss of value, instead there is only transfer of value.

Classification of Costs

Also, in the previous article, we defined the types of costs that are likely to be incurred in a job costing scenario. They were direct materials, direct labor, manufacturing and non-manufacturing overhead. We classified non-manufacturing overhead as period costs and all others as product costs.

What Happens as Costs are Incurred?

When costs are incurred one of the two things happen depending upon the type of costs. If the cost is product related, we add it to the inventory. This cost is not recognized as an expense until the sale is complete and loss of value has occurred. On the other hand, when it comes to period costs, they are expensed immediately because they have no cause and effect relationship with production.

Why is it Important?

It is important because the treatment of two costs is very different. When direct materials are purchased, they are directly allocated to their respective jobs. Same is the case with manufacturing related overhead and direct labor. They can be seen immediately in the job cost sheet. On the financial statements, they are considered as inventory. Inventory shows up under assets and not under the expense column.

The problem does not end there. Firms have to carefully calculate the breakup of inventory. Inventory is a big account with 4 sub accounts viz. raw material, work in progress, cost of goods manufactured and cost of goods sold. Companies need to carefully check the manufacturing overheads to ensure that they are not overstating or understating the value of any of these assets.

How is it Done?

Once again, companies follow subjective treatments while allocating costs to separate sub inventory accounts. The amount of manufacturing overhead that is actually spent on work in progress cannot be precisely known. Accountants make estimates stating that relative proportions that they think have been spent on work in progress.

From an examination point of view, calculating the values of WIP, raw materials and finished goods may not be such a hassle since the percentage allocations are already given. However, in reality, determining these percentage allocations is a tough task that needs a lot of expertise and experience.