It is important to identify the type of company you are working with in managerial accounting. Depending on the type of company, you will identify different costs and set up reports differently. There are three major types of companies we will deal with in this course:
- Service companies
- Merchandising companies
- Manufacturing companies
Service firms make up the largest business sector in the United States. Service companies are those that do not sell a physical product but instead provide services to their customers. Service firms include accounting firms, law firms, marketing firms, IT services firms, banks, dry cleaners, health care organizations, educational institutions and many other businesses we interact with on a daily basis.
One major difference between service companies and the other two types is that service companies do not have cost of goods sold because there is no product being sold. Service firms also do not have inventory, also because no physical product is being sold. There many be direct costs associated with providing the service, but no physical product.
Merchandising companies are those which sell products but do not make products. Merchandising companies are broken up into two different types: retailers and wholesalers.
Retailers sell products directly to the end user. Staples, Wal-Mart, Target, American Eagle, GAP, and Home Depot are all retailers. They sell products that consumers and businesses use, rather than resell.
Wholesalers buy products from manufacturers and sell them to other merchandising companies, usually retailers. For example, most small breweries will use a distributor to help get their beers into stores and restaurants. These distributors have established relationships with local stores and restaurants, making easier for small breweries to get their beers to the public. A distributor is a wholesaler. Wholesalers are sometimes referred to as “middlemen” because they act as an intermediary between a manufacturer and a retailer.
Merchandising companies purchase inventory (an asset) and sell that inventory. When inventory is sold, the asset is considered used up and the cost of that inventory is transferred from the balance sheet to the income statement as an expense. This expense is called cost of goods sold. For merchandising companies, the inventory account can also be referred to as merchandise inventory.
Manufacturing companies are companies that make make a product. Monster Beverages, Dell Computers, Boeing, and General Motors are all companies that produce a product. These companies use labor and machinery to turn materials into a product. Some manufacturing companies sell their products directly to the end user, like Boeing. Some companies like Dell, sell their product directly to consumers and to retailers. Monster Beverages and General Motors sell their products to retailers who sell the product to the end user.
All manufacturing companies have three different inventory accounts to account for the steps in the production process.
- Raw materials inventory – Raw materials are the components that companies use to produce their products. Don’t let the word “raw” lead you to think that this account is full of wood, plastic, metal or bolts of fabric. Many companies purchase components already manufactured and use them in their finished products. For example, Dell purchases processors from Intel to put in their computers. These processors are considered raw materials until those processors actually go into a computer. Raw materials are any materials that have not yet been used in the production process.
- Work-in-progress – Companies are continuously making products, which means that at the end of each day or week or month there are products that are not finished. These products have entered the manufacturing process but are not completed. Work-in-progress is inventory that has gone into the production process but has not yet been finished. Think of an aircraft at Boeing that does not have the seats or engines installed, but the rest of the plane is built. We cannot call this raw materials, but we also cannot say that it is finished. This plane would be considered part of work-in-process.
- Finished goods inventory – When a product is finished it is transferred to finished goods inventory. Typically when we think of inventory we think of finished goods inventory, the stuff that is ready to be sold to our customers. Once a product is classified as finished goods inventory, no additional costs can be added to the product. This is a very important concept when we start talking about types of costs.
Many companies do not fit neatly into one of these categories. For example, restaurants make a product (meals), sell products it does not make (wine and beer), and provides a service (serving the meal). These companies are considered hybrid companies. When classifying companies, make sure to consider that a company could fit into more than one of the categories above.
Considering the type of company you are working with can help you better identify the types of costs the company will incur, how those costs should be allocated and the types of reports that would be useful in the planning, decision making and controlling aspects of managerial accounting.