In a manufacturing organization:
Materials start in raw materials inventory. These materials are withdrawn at the beginning of manufacturing.> Costs are moved to the WIP Work In Progress account. Labor and overhead items are consumed in production and these costs are added to WIP.> Manufacturing is complete and costs transfer from WIP to finished goods.> Once sold, costs are transferred to the income statement as part of the COGS Cost of Goods Sold account.
In a retail organization:
Goods are purchased and costs are accumulated in a cost of merchandise account.> Retail stores have overhead such as wages, electricity, gas, security, etc.> Sale is made and cost transfer to COGS account.
In a service organization:
Service organizations are similar to manufacturing organizations, except service organizations see most costs from labor and not materials. Service organizations start with an overhead account that covers salaries, electricity, office supplies, etc.> During production of the service, costs are attributed to a WIP Services account.> Once the service production is complete, costs are transferred to a Cost of Services account.
I am a Contract Specialist for the federal government and I went back and forth about whether we are most similar to retail organizations or service organizations. Our department makes purchases on behalf of our command, but I do not think we are a retail organization because we do not hold and re-sell the items. Our items that we procure are for us so they are immediately fed into the command; we are not a middleman. I think we are most similar to a service organization with the service we provide being procurement. Additionally, our department costs are made up entirely of salaries, electricity, office supplies, etc. We do not maintain a budget for purchasing items that are then sold to the command. So, I think our overhead account would cover our internal costs (salaries, electricity, office supplies, etc.). I think our WIP Services account would maintain any active procurements that we have received but not completed, such as procurements being actively worked. Once a procurement is completed then the costs are transferred to a Cost of Services account. Because we are the government and our department exists within a command, we do not directly see this movement from one account to the next, but I feel we most closely represent a services organization.
The flow of costs from raw materials to cost of goods sold (the flow all the way through the production process until they are sold to a customer) in a manufacturing organization.
In a manufacturing organization, there are three types of costs: Direct Materials, Direct Labor, and Manufacturing Overhead. As the production of inventory begins, the costs of these raw materials will move from a raw materials account to the work in progress (WIP) account. As the manufacturing process is underway, labor, materials, and overhead are consumed. At this time, they are added to WIP inventory. Upon the completion of manufacturing, the costs move from the WIP account to the finished goods account. At this point, the products are ready for sale. When products are sold, they will be removed from the balance sheet to an income statement.
How the cost flows differ depending on the type of business (retail organization, service organizations, and manufacturing organizations).
Costs flow differs according to the type of business – whether retail, service, or manufacturing- in order to align logically with the processes associated with the business. Manufacturing tends to have the most complicated cost flow due to the increased work in manufacturing the products to be sold. Retail, on the other hand, purchases the products which they will sell, but not manufacture. Service organizations sell primarily time and labor, and costs are tracked in the form of human resources.
Within the retail industry, the initial costs of purchased inventory are entered into the cost of merchandise/inventory account. In addition, there are overhead costs associated with the brick and mortar store, including lighting, heating, depreciation of the building and equipment, and labor. Once sales are completed, costs are transferred from the merchandise/inventory account to cost of goods sold.
Within service organizations, the primary expense is employee pay, whether hourly or salary. These costs can be easier to predict and manage than manufacturing organizations. The amount of time it takes to fill positions is somewhat predictable and there is some notice prior. Costs do not frequently change except in the case of hiring new personnel or working new deals. Costs are generally easily dedicated to a particular project or service.
How costs flow in your organization based on your understanding of the material.
I work in an organization that assists customers in the migration of their IT applications from data centers to the cloud. We are a service organization. Though we deal with understanding the expenses of compute and store in order to estimate costs for cloud hosting according to fees set by the cloud service provider, our costs internally are
driven from personnel. Our expenses primarily reflect salary rates and personnel equipment and laptops. These costs do not “flow” in the same manner as manufacturing companies.
In my previous role in another IT service organization, I supported leadership by accounting for the costs allocated to individual teams. Managers would report to me any staffing changes. I would track the hourly and salary rate for each individual along with if they were primary full time employees or if they were subcontractors. It is important to be detailed, as the costs of each employee vary according to the differences in fringe. If an employee vacated a position, the months that position was not be filled would be counted towards cost savings or what we called productivity. This is why organizations temporarily hold hiring freezes. Tracking what positions were vacant and for how long helped us to forecast costs. It was my job to track and understand all this information for the forecast, but also to hold managers to a specific budget as they backfilled positions. As stated in this chapter, service organizations often bucket costs according to project. I tracked where employees were actually billing their time against the project tor programs total budget (which may fall across multiple teams). As a monthly exercise, I would pull all billing reports to validate employees were billing correctly and appropriately. Unlike in manufacturing organizations, our costs did not change between financial accounts- if a project ended, those employees would find new projects or programs. I agree that service organizations are likely the easiest to track from an accounting perspective. I am happy to say that I was generally within a very small margin from our monthly forecast to actuals!
As a side note, there were pros and cons to being dedicated to direct billing vs indirect. Working in the Operations organization, all of our folks were considered dedicated costs. Direct costs meant that as long as that project existed, you could be directly attributed to that specific business/project and had a “home”. Indirect costs/personnel could be squeezed when budgets were tight. At the same time, those employees billing direct to a project would be at higher risk for cuts if that specific project suddenly ended. At one point, my role as a business/financial analyst was moved from direct (reporting to the program manager) to indirect (an overall financial organization leveraged to multiple projects). I personally preferred supporting the program manager directly.
In a manufacturing organization, the flow of costs starts from when raw materials are purchased. From there, more costs are added, such as direct labor and overhead costs. Once the product is produced and ready, it will then be shipped or moved to be stored until it is sold. The cost flows may look slightly different, depending on the type of business. If an organization is not physically making anything and just offering a service, then the flow will be a bit different. There may still be overhead costs and direct labor costs. For example, a plumbing service. They may be coming out to repair plumbing issues, but they aren’t physically building something, so their flow of costs will look a bit different. My company physically builds satellites, so the flow of costs mirrors the manufacturing flow of costs. The engineers at my company need to purchase raw materials in order to build the satellite. From there, there will be direct labor costs and other overhead costs. Once the satellite is ready, they need a place to store it or else they will need to continue to store it in our lab (which will force us to delay other launches since other satellites can’t always be built at the same time). Once we are able to launch the satellite, we can then begin to build the next one.
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