1. April 7, 2010 Starting to Build the Income Statement
To build the Income Statement, we must know COGS
To know COGS for a manufacturing company, we must know Cost of Goods Manufactured
Build up and calculation of Cost of Goods Manufactured
Fixed versus Variable Costs
Other cost distinctions

2. Setting up the Income Statement
Revenues –
Relatively straight forward, from your Financial Accounting
Less Cost of Goods Sold (COGS)

3. Inventory Flows Calculating inventory balances
Beginning inventory, plus
Additions to inventory, less
Withdrawals from inventory, equals
Ending balance
This straight forward formula holds true
For a simple merchandising situation where inventory is in a single account,
For each inventory account of a manufacturing company
Raw Materials, Work in Progress and Finished Goods

4. Inventory Flow - Example
Pick a merchandising company
It has $50 million of inventory on Jan 1, 2010
It purchased $10 million on Jan 13, 2010
By Jan 31, 2010, its sold $42 million of its finished goods stock
What was the company’s opening inventory on Feb 1, 2010?

5. Inventory Flow - Example
Pick a manufacturing company
It has $10 million of raw materials inventory on Feb 1, 2010
It purchased $5 million of additional raw materials on Feb 2
It started working on converting $7 million of raw materials during Feb
By Feb 28, 2010, its sold $15 million of its finished goods
What was the company’s opening raw materials inventory on Feb 1, 2010?

6. Calculating Cost of Goods Manufactured
A Merchandiser does not manufacture, so there is no Cost of Goods Manufactured
COGS are simply the costs of what inventory it purchased
(Note this is a bit simplified as some companies may add some processing costs)
For a manufacturer, in order to calculate COGS, we need to know the costs of what the company has produced that is available and for sale and sold
By definition, these must be Finished Goods only
Therefore, we must calculate the flows and balances through each inventory account

7. Schedule of Cost of Goods Manufactured
As items are removed from raw materials inventory and placed into the production process, they are called direct materials.
At first glance, the schedule of cost of goods manufactured appears complex. However, it is all quite logical. The schedule of cost of goods manufactured contains the three types of product costs that we discussed earlier—direct materials, direct labor, and manufacturing overhead.
The raw materials cost is not simply the cost of raw materials purchased during the period—rather it is the cost of materials used during the period. Raw material purchases made during the period are added to the beginning raw materials inventory balance to determine the cost of materials available for use during the period. The ending materials inventory is deducted from this amount to arrive at the cost of raw materials used in production. As items are removed from raw materials inventory and placed into the production process, they are called direct materials.

8. Schedule of Cost of Goods Manufactured
Conversion costs are costs incurred to convert the direct material into a finished product.
After we calculated the raw materials used in production, we take that amount and add the conversion costs (direct labor and manufacturing overhead) to get total manufacturing costs for the period.
As items are removed from raw materials inventory and placed into the production process, they are called direct materials.

9. Schedule of Cost of Goods Manufactured
After we calculate our total manufacturing costs, we take beginning work in process inventory, add to that, total manufacturing costs, and we get the total work in process for the period.
All manufacturing costs incurred during the period are added to the beginning balance of work in process.

10. Schedule of Cost of Goods Manufactured
Finally, we subtract ending work-in-process inventory from work in process for the period to get cost of goods manufactured. Completed goods are transferred to finished goods inventory.
Costs associated with the goods that are completed during the period are transferred to finished goods inventory.

11. Cost of Goods Sold
You can see that the cost of goods manufactured is added to the beginning finished goods inventory to get the cost of goods available for sale. The ending finished goods inventory is subtracted to arrive at the cost of goods sold.

12. Cost of Goods Manufactured – Example
At year end, a manufacturing company has the following inventory balances:
RM - $12m, WIP - $20m, FG - $10m
Assume the following:
$12m of RM materials are purchased
$10m of RM are drawn into production
DL of $10m, MOH of $3m in the period
WIP closing balance was $10m
FG closing balance was $12m
Prepare a schedule of Cost of Goods Manufactured and calculate COGS for the period
Assume revenues of $50m, S&A of $10m – Prepare an I/S

13. Cost of Goods Manufactured – Example
Which of these accounts are Balance Sheet Accounts?
Which are Income Statement Accounts?

14. Income Statement – Example
Is this a profitable company?
Would you invest in this company?
At what valuation?

15. Income Statement – Investment Decisions
Is this a profitable company?
Yes, of course
Look to the margin %
Is it profitable enough?
What industry is it in?
What are its competitors’ results?
Would you invest in this company?
What are the trends in the industry and with the company?
At what valuation?
What levels of returns would are reasonable to expect from taking on this level of risk?

16. Fixed and Variable Costs
Fixed Costs
Total Fixed Costs do not change with changes in activity
Variable Costs
Total Variable Costs change with changes in activity
Plot cost on the X axis, and activity on the Y axis for the following cost examples:
Factory lease
Direct labour
Machinery depreciation
Learning objective number 5 is to define and give examples of variable costs and fixed costs.

17. Fixed and Variable Cost Classifications for Predicting Cost Behavior
It is helpful to think about variable and fixed cost behavior in a two by two matrix, as illustrated here. Take a few minutes and review this summary of cost behavior for variable and fixed costs.

18. Other Cost Classifications
Differential Costs and Differential Revenues
Used for decisions among alternatives
Sunk Costs
Opportunity Costs
These are in addition to:
Fixed versus Variable
Direct versus Indirect
Period versus Product
Of course any cost item can fit into a number of these categories
Learning objective number 3 is to prepare an income statement including calculation of the cost of goods sold.

19. Purpose of Cost Classifications
We have seen there are many ways of classifying costs
Each type falls into one or more of the following purposes:
Financial Reporting
Inventory on Balance Sheet
COGS and S&A on Income Statement
Predicting Cost Behaviour
Fixed and variable costs
Assigning Costs to Objects
Product costs
Decision Making
Differential costs and revenues
We have looked at the cost classifications used for financial reporting, predicting cost behavior, assigning costs to cost objects, and making business decisions.

20. Review Starting to Build the Income Statement
Understand how inventories flow through the income statement
Build up and calculation of Cost of Goods Manufactured
Only for manufacturing companies
Fixed versus Variable Costs
Businesses can control variable costs in the shorter term
Other cost distinctions

21. Tutorial
Introduction to Group Project

22. Group Project - 20% You will be divided into groups
Select a public company of your choice and submit financial statements
Describe the company and explain why the company was selected; what kind of accounting systems might the company use?
Write and present during tutorial – Monday, April 12th
Together, we will simplify the accounts for modeling purposes – April 15th
Make your own assumptions and forecast/budget (I/S, B/S, C/F) for three years
Conduct ratio analysis and draw conclusions about the company
Each group is to present final results – May 5th
Each individual is to select a role (CEO, CFO, Sales, Production Manager, etc) and present minutes of observations – May 5
Audience to prepare questions for presenters
Submit and present final results – May 5th in lecture