Question

1. Explain in detail why it is important to distinguish product cost from period cost and the impact an error will have on the income statement and balance sheet if manufacturing overhead is incorrectly labeled as a period cost.  

2. Explain what is meant by 'activity base' when dealing with variable cost. Provide at least one example of an activity base and how it affects the variable cost.

3. Explain the difference in cost breakdown between a traditional format income statement and a contribution format income statement? What benefit do you see in using one over the other? Which format is required by GAAP?

Answer 1

1) The distinction between product costs and period costs is important for

• properly measuring net income during a period of time and
• reporting the proper cost of inventory on the balance sheet.

Product costs are related to the units of product purchased or manufactured. If a unit is unsold, the product costs will be reported as inventory, a current asset on the balance sheet. Product costs will be reported on the income statement as cost of goods sold expense in the period that the units of product are sold.

Period costs do not attach to the units of product and will not be included in the cost of inventory. For example, the interest incurred will be expensed in the period in which the interest occurs.

If manufacturing overhead is incorrectly labeled as a period cost, then in the income statement the cost of goods sold expense of the units of product sold will be undervalued and in the balance sheet also, the inventory balance reported as current assets will be undervalued.

2) An activity base is a measure of whatever causes the incurrence of a variable cost. Some of the more common activity bases consist of direct labor hours, machine hours, units produced and units sold. Other examples include the number of miles driven by salespersons, the number of pounds of laundry cleaned by a hotel, the number of calls handled by technical support staff at a software company, and the number of beds occupied in a hospital.

3) The traditional income statement format uses absorption costing, in which variable and fixed manufacturing costs are part of the inventory costs, and thus part of the cost of goods sold calculation. The contribution margin format uses variable costing, in which fixed manufacturing cost are part of the overhead costs of the accounting period and not part of the product costs.

The contribution margin format allows stakeholders to determine the breakeven point of individual products or product categories. Manufacturing operations benefit from the contribution margin format.

Generally Accepted Accounting Principles (GAAP) require companies to use the traditional income statement format for external reporting.