How do Merchandising and Manufacturing firms report product costs and changes in Inventory?

RECOGNITION OF PRODUCT COSTS

A seller of goods can easily associate (or match) the consumption of the benefits of the asset sold with revenues from its sale. Specifically, at the time of sale and revenue recognition, the asset (inventory) leaves the seller's balance sheet. The seller recognizes revenue along with a reduction in an asset (inventory). The firm records the cost of goods sold expense in the same amount as the decrease in the asset, which is the amount by which inventory decreases.

Retail Firms and Merchandise Inventory

A merchandising firm purchases inventory for resale. The merchandiser does not change the physical form of the inventory, so it performs no incremental work and adds nothing to the acquisition cost of the inventory after it is purchased. The inventory appears on the merchandiser's balance sheet initially as an asset, measured at acquisition cost. When the firm sells the items, it recognizes the cost of the inventory as an expense (cost of goods sold) on the income statement.

Manufacturing Firms and Inventory

A manufacturing firm incurs costs as it produces goods by changing the physical form of raw materials. For a manufacturing firm, product costs are the costs incurred in manufacturing goods for sale. The costs to produce finished goods inventory do not become expenses until the firm sells the product; prior to sale, these costs represent the transformation of assets from one form into another. Three types of manufacturing costs become product costs: (1) direct material costs (or raw material costs), (2) direct labor costs, and (3) manufacturing overhead costs (sometimes called indirect manufacturing costs). Conceptually, a firm can readily associate direct material costs and direct labor costs with products. For example, one can measure both the cost of a specific quantity of aluminum used to make a lawn chair and the cost of the labor to make the chair. In contrast, manufacturing overhead includes costs that the firm cannot associate with particular products, for example, expenditures for supervisors' salaries, factory utilities, property taxes, insurance, and depreciation on manufacturing plant and equipment. The firm consumes the benefits of each of these items as it produces inventory for sale, so the costs are called indirect costs because they jointly benefit all goods produced during the period, not any one particular item. Once the firm has accumulated all the manufacturing costs incurred during a period in the product cost accounts, such as Work-in-Process, the firm applies allocation mechanisms to apportion the costs to specific products.

Inventory accounts accumulate or accrue the costs of direct material, direct labor, and manufacturing overhead. These inventory items are assets until the firm sells them to customers. The balance sheet reports the costs of incomplete items as Work-in-Process Inventory and the cost of goods ready for sale as Finished Goods Inventory.

To summarize, the direct material, direct labor, and manufacturing overhead costs incurred
to produce products for sale are product costs, which represent assets transformed from one
form to another, as the manufacturing process converts these assets into finished goods. The
cost of completed products remains on the balance sheet as Finished Goods assets until the
firm sells the products; upon sale, the cost of the assets becomes a cost of goods sold expense.