What are Inventoriable Costs?
Inventoriable costs, also known as product costs, refer to the direct costs associated with the manufacturing of products for revenue generation. Often, inventoriable costs include direct labor, direct materials, factory overhead, and freight-in. Once a product is sold to a customer or disposed of in another way, the cost of the product is charged to the expense account. Before the inventory is sold, it is recorded on the balance sheet as an asset. The sale of these products moves inventory from the balance sheet to the cost of goods sold (COGS) expense line in the income statement.
Inventoriable costs sometimes vary from one industry to another, and they also differ from one supplier to another down the supply chain. Therefore, what a manufacturer considers as inventoriable costs may be different from what a retailer treats as inventoriable costs. For instance, for a retailer, the costs associated with inventoriable costs include all costs related to the acquisition of the product from the manufacturer all the way to its premises. However, for a manufacturer, these costs are associated with the direct material, direct labor, and all manufacturing overheads.
How to Calculate Production Unit Cost
When managers want to determine the production cost per unit, they narrow down all the costs related to the production of a given batch of products. They sum all the costs of producing a batch and divide the value obtained by the total units produced, as shown in the formula below:
Product unit cost = (Total direct labor + Total direct material + Consumable supplies + Freight-in + Total allotted overhead)/Total number of units
Once the managers determine the production unit cost, they use that information to develop a pricing model. The pricing model enables them to identify the number of units that they need to produce and sell to break even. It is important because, for a product line to be profitable, they need to determine a unit price that must cover the cost per unit while still leaving a reasonable profit margin. Failure to break even means that the production results in a loss and the manufacturer responds by increasing their sales price, cutting the number of units produced, or closing the entire product line.
Accounting for Inventoriable Costs
Accountants use the inventory assets account to record inventoriable costs. However, when the manufacturer sells the goods, the costs are transferred to the expense account. It allows accountants to monitor the revenues against the COGS in the income statement, which eventually end up in the company’s financial statements as net profits.
Example: Inventoriable Costs
Let’s say Company X assembles laptops for resell in Ontario, California. The company imports different parts of the computers from various parts of the world and different manufacturers. For example, the displays may be from CoolTouch Monitors, motherboards and casings from China, hard disks from Seagate, processors and RAM from Intel, with the rest of the components made in-house.
To aggregate the inventoriable costs of manufacturing, the manufacturer must account for all costs incurred from the point of acquisition up to the point when the goods are brought to their warehouse. It includes all costs incurred before and during assembly, such as the cost of acquiring each part, direct labor, freight-in, and any other manufacturing overheads.
Therefore, if producing 1,000 pieces of laptops costs the manufacturer $250,000, the production unit cost will be $250 ($250,000/1,000 units). To break even and make profits, a single unit/laptop must be sold for a price that is higher than $250. Initially, the company will record these costs in the inventory assets accounts. Once the product is sold to retailers, it is recorded as COGS on the income statement.
Inventoriable Costs vs. Period Costs
The cost of business is divided into two categories, based on whether the expense is capitalized to the cost of the goods sold. The two categories are inventoriable costs and period costs.
Inventoriable costs are the costs incurred in the manufacturing or acquisition of a product. These costs are initially recorded in the balance sheet as current assets and do not appear in the income statement until the first unit is sold. Once the products are sold, they are charged to the expense account, and this allows businesses to match the revenue from a product with its cost of goods sold. Examples of product costs are direct materials, direct labor, and factory overheads.
On the other hand, period costs are associated with the passage of time and are not included in the inventoriable costs. If a business does not have production or inventory purchasing activities, the business will not incur inventoriable costs, but will still incur period costs. Period costs are associated with the selling activities of the business, and they are treated as actual expenses in the actual year when they occur. The US GAAP requires that all selling and administrative expenses be treated as period costs. Example of period costs includes marketing costs, office rent, and indirect labor.
Definition of Terms
Direct materials – Refers to all raw materials and sub-assemblies built into the final product.
Direct labor – Refers to the costs of operation incurred when employees engage directly in the assembly and production of a product that is assigned either to a specific product, cost center, or work order. For instance, machine operators in a production line, employees at the assembly lines, or even technical officers operating and monitoring production operations.
Freight-in – Refers to the costs associated with the transportation of production inputs. It is charged when goods are delivered from the supplier to the manufacturer.
Manufacturing overheads – Refers to the manufacturing costs other than variable costs that a manufacturer incurs during a given period of production. They are fixed costs that are directly related to the manufacturing of a product. They include all cost related to direct material, and direct labor. For example, the cost of electricity required to operate manufacturing machinery is a manufacturing overhead cost.
CFI is a global provider of financial analyst training and certification for finance professionals. To learn more and expand your career, explore the additional relevant resources below.