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The balance sheet and income statement are two financial statements prepared by
a company. The balance sheet is a statement of unexpired costs (assets) and equities
(liabilities and owners’ capital); the income statement is a statement of revenues
and expired costs (expenses and losses). The concept of matching revenues
and expenses on the income statement is central to financial accounting. The matching
concept provides a basis for deciding when an unexpired cost becomes an expired
cost and is moved from an asset category to an expense or loss category.
Expenses and losses differ in that expenses are intentionally incurred in the
process of generating revenues, and losses are unintentionally incurred in the context
of business operations. Cost of goods sold and expired selling and administrative
costs are examples of expenses. Costs incurred for damage related to fires,
for abnormal production waste, and for the sale of a machine at below book value
are examples of losses.
Costs can also be classified as either product or period costs. Product costs
are related to making or acquiring the products or providing the services that directly

generate the revenues of an entity; period costs are related to other business
functions such as selling and administration.
Product costs are also called inventoriable costs and include the cost of direct
material, direct labor, and overhead. Any readily identifiable part of a product
(such as the clay in a vase) is a direct material. Direct material includes raw
materials, purchased components from contract manufacturers, and manufactured
subassemblies. Direct labor refers to the time spent by individuals who work
specifically on manufacturing a product or performing a service. At WF&B, the
people handling the polyethylene material for storage bags are considered direct
labor and their wages are direct labor costs. Any factory or production cost that is
indirect to the product or service and, accordingly, does not include direct material
and direct labor is overhead. This cost element includes factory supervisors’
salaries, depreciation on the machines producing plastic food storage bags, and insurance
on the production facilities. The sum of direct labor and overhead costs
is referred to as conversion cost.
Direct material, direct labor, and overhead are discussed in depth later in the
chapter. Precise classification of some costs into one of these categories may be
difficult and judgment may be required in the classification process.
Period costs are generally more closely associated with a particular time period
rather than with making or acquiring a product or performing a service. Period
costs that have future benefit are classified as assets, whereas those deemed
to have no future benefit are expensed as incurred. Prepaid insurance on an administration
building represents an unexpired period cost; when the premium period
passes, the insurance becomes an expired period cost (insurance expense).
Salaries paid to the sales force and depreciation on computers in the administrative
area are also period costs.
Mention must be made of one specific type of period cost: distribution. A distribution
cost is any cost incurred to warehouse, transport, or deliver a product
or service. Although distribution costs are expensed as incurred, managers should
remember that these costs relate directly to products and services and should not
adopt an “out-of-sight, out-of-mind” attitude about these costs simply because they
have been expensed for financial accounting purposes. Distribution costs must be
planned for in relationship to product/service volume, and these costs must be
controlled for profitability to result from sales. Thus, even though distribution costs
are not technically considered part of product cost, they can have a major impact
on managerial decision making In general, product costs are incurred in the production or conversion area and
period costs are incurred in all nonproduction or nonconversion areas.2 To some
extent, all organizations convert (or change) inputs into outputs. Inputs typically
consist of material, labor, and overhead. The output of a conversion process is
usually either products or services. Exhibit 3–1 compares the conversion activities
of different types of organizations. Note that many service companies engage in a
high degree of conversion. Firms of professionals (such as accountants, architects,
attorneys, engineers, and surveyors) convert labor and other resource inputs (material
and overhead) into completed jobs (audit reports, building plans, contracts,
blueprints, and property survey reports).
Firms that engage in only low or moderate degrees of conversion can conveniently
expense insignificant costs of labor and overhead related to conversion.
The savings in clerical cost from expensing outweigh the value of any slightly improved
information that might result from assigning such costs to products or services.
For example, when employees open shipping containers, hang clothing on
racks, and tag merchandise with sales tickets, a labor cost for conversion is incurred.
Retail clothing stores, however, do not try to attach the stockpeople’s wages
to inventory; such labor costs are treated as period costs and are expensed when
they are incurred.
In contrast, in high-conversion firms, the informational benefits gained from
accumulating the material, labor, and overhead costs of the output produced significantly
exceed the clerical accumulation costs. For instance, to immediately expense
labor costs incurred for workers constructing a building would be inappropriate;
these costs are treated as product costs and inventoried as part of the cost
of the construction job until the building is completed.
For convenience, a manufacturer is defined as any company engaged in a
high degree of conversion of raw material input into other tangible output. Manufacturers
typically use people and machines to convert raw material to output that
has substance and can, if desired, be physically inspected. A service company
refers to a firm engaged in a high or moderate degree of conversion using a significant
amount of labor. A service company’s output may be tangible (an architectural
drawing) or intangible (insurance protection) and normally cannot be inspected
prior to use. Service firms may be profit-making businesses or not-for-profit
organizations.Firms engaging in only low or moderate degrees of conversion ordinarily have
only one inventory account (Merchandise Inventory). In contrast, manufacturers
normally use three inventory accounts: (1) Raw Material Inventory, (2) Work in
Process Inventory (for partially converted goods), and (3) Finished Goods Inventory.
Service firms will have an inventory account for the supplies used in the conversion
process and may have a Work in Process Inventory account, but these
firms do not normally have a Finished Goods Inventory account because services
typically cannot be warehoused. If collection is yet to be made for a completed
service engagement, the service firm has a receivable from its client instead of Finished
Goods Inventory.