Slide 1

Fundamentals of Productand Service CostingChapter 6Edited by Dr. Charles Bailey for ACCT3310

PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPACopyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin6-#Chapter 6: Fundamentals of Product and Service Costing

This chapter provides an overview of alternative cost systems for product and service costing. Details and extensions to the basic models described here are presented in the following three chapters.

6-#Learning ObjectivesLO 6-1Explain the fundamental themes underlyingthe design of cost systems.LO 6-2Explain how cost allocation is used in a costmanagement system.LO 6-3Explain how a basic product costing system works.LO 6-4Understand how overhead cost is allocated to products.LO 6-5Explain the operation of a two-stage allocation systemfor product costing.LO 6-6Describe the three basic types of product costing systems:job order, process, and operations.

6-#After studying this chapter, you should be able to: 1. Explain the fundamental themes underlying the design of cost systems. 2. Explain how cost allocation is used in a cost management system. 3. Explain how a basic product costing system works. 4. Understand how overhead cost is allocated to products. 5. Explain the operation of a two-stage allocation system for product costing. And, 6. Describe the three basic types of product costing systems: job order, process and operations.6-#Cost Management SystemKeys to a good cost management system: Oriented to the needs of the decision makers Designed so that benefits exceed costs

6-#A good cost management system is oriented to the needs of the decision makers and designed so that benefits exceed costs.6-#Cost Management SystemsLO 6-1Explain the fundamental themes underlyingthe design of cost systems. The objective of the cost management systemis to provide information about costs relevantfor decision making. The cost management system accumulates and reports costsabout processes, products, and services.LO 6-1

6-#A well-designed cost management system accumulates and reports costs that are relevant to the decisions that managers make.6-#Reasons to Calculate Productor Service Costs For decision making For deciding what to sell For setting prices For knowing the cost of goods sold For knowing the cost of inventoryLO 6-1

6-#What decisions do managers make? In Chapter 4, you saw examples of many of the decisions managers make using information about product costs. What to sell? At what price? What is the cost of the goods sold? What is the cost of inventory?

6-#Cost Allocation and Product CostingLO 6-2Explain how cost allocation is usedin a cost management system.Basic Cost Flow DiagramDirectmaterialsDirectlaborManufacturingoverheadAlphaBetaCostpoolsCostobjectsCostallocationruleIndirect (allocated by direct labor cost)DirectLO 6-2

6-#Chapter 1 introduced cost allocation and product costing. We know that costs that are common to two or more cost objects are likely to be allocated to those cost objects on a somewhat arbitrary basis. A manufacturing or service firm that buys different resources (materials, labor, supplies, etc.) and combines them into two or more finished products must allocate the cost of the resources to the finished products. Suppose a company produces two products, Product A and Product B, and uses direct materials, direct labor, and overhead to make these products. This cost flow diagram shows that the direct materials and direct labor are traced directly to the products. We can observe a link between these resources and the products. However, overhead is an indirect cost and cannot be traced directly to the products. Therefore, it must be allocated.6-#Fundamental Themes Underlyingthe Design of Cost Systems for Managerial PurposesCost systems should have a decision focus.Different cost information is used fordifferent purposes.Cost information for managerial purposesmust meet the cost-benefit test.LO 6-2

6-#Cost systems should have a decision focus that meets the needs of decision makers, the customers of the cost system. Remember what works for one purpose will not necessarily work for another purpose. Cost information can always be improved. However, the benefits of improvement (i.e., better decision making) must outweigh the cost of making the improvements.6-#Basic Cost Flow ModelLO 6-3Explain how a basic product costing system works.How costs and units move through inventories:BeginningbalanceTransfersinTransfersoutEndingbalance+=BBTITOEB+=This is true for the following accounts: Raw Materials (RM) Work-in-Process (WIP) Finished Goods (FG)LO 6-3

6-#The basic cost flow model: beginning balance plus transfers in minus transfers out equals ending balance is true for all three inventory accounts: Raw Materials (RM), Work-In-Process (WIP), and Finished Goods (FG).

6-#Note what all inventory calculations have in common [My added slide from Ch. 2 Lecture]Raw Material: PurchasesWork in Process: Mfg. cost incurred Finished Goods: Cost of Goods Mfd.BIPool of CostsEICost AddedCost transferredout to WIP, FGCGS, etc.

6-#Costing with No Work-in-Process Inventories Baxter Paint begins production on April 1. It starts and completes production of 100,000gallons of paint in April and has no endingwork-in-process inventory.Materials$ 400,000Labor 100,000Manufacturing overhead 500,000Total$1,000,000Cost of resources used in April:LO 6-3

6-#The inventory equation is true for both units and costs. Lets look at Baxter Paint. At the beginning of April, Baxter Paint had no work-in-process inventory. 100,000 gallons of paint were started during the month of April. 6-#BBTITOEB+=0100,000gallons100,000gallons0+= Finished GoodsLO 6-3

Costing with No Work-in-Process Inventories

6-#All 100,000 gallons were finished and transferred out of Work-in-Process Inventory and in to Finished Goods.6-#What are the costs at the end of the period?$1,000,000 was added to work-in-process and then transferred out to finished goods.Since Baxter produced 100,000 gallons of paint, then the cost per gallon of paint is $10.LO 6-3

Costing with No Work-in-Process Inventories

6-#Look at work-in-process costs. Baxter Paint had no beginning balance. During April, Baxter added the following costs to work-in-process: direct materials of $400,000, direct labor of $100,000, and overhead of $500,000. Total costs added to work-in-process equaled $1 million. All of the paint, and therefore, all of the costs, were transferred out of work-in-process and in to finished goods. If Baxter Paint produced 100,000 gallons of paint at a cost of $1,000,000, the cost per gallon of paint is $10.6-#Beginning inventory-0-Started in May110,000Total110,000Ending WIP (50% complete) 20,000Transferred out 90,000Production for Baxter Paint for May follows (gallons):LO 6-3

Costing with Ending Work-in-Process Inventories

6-#Now lets look at an example where some product remains in ending inventory. 6-#BBTITOEB+=0110,000gallons90,000gallons20,000 gallons(50% complete)+=Finished goodsLO 6-3

Costing with Ending Work-in-Process Inventories

6-#Suppose during May Baxter Paint started 110,000 gallons of paint, completed and transferred out 90,000 gallons and had 20,000 gallons that were half finished still in work-in-process at the end of the month.6-#How do we cost Baxters 20,000 gallons of paint thatare only half finished?20,000 gallons half finished is equivalent to 10,000gallons finished.90,000 gallons transferred out plus 10,000 equivalent gallonsof finished paint equals 100,000 equivalent gallons of paint.Gallons of paint transferred out 90,000Equivalent gallons of finished paint 10,000Total equivalent gallons of paint100,000LO 6-3Costing with Ending Work-in-Process Inventories

6-#How much paint did Baxter Paint produce in May? 90,000 gallons was transferred to finished goods, but there are still 20,000 gallons in work in process that are only half finished. How do we account for Baxters 20,000 gallons of paint that are only half finished? 20,000 gallons of paint half finished are equivalent to 10,000 gallons of finished paint. When products remain in ending work-in-process inventory, we use equivalent units. 90,000 gallons of paint transferred out plus 10,000 equivalent gallons of finished paint in ending inventory equals 100,000 equivalent gallons of paint.6-#Materials$390,000Labor 100,000Manufacturing overhead 500,000Total$990,000Costs incurred in May Year 2:$990,000/100,000 gallons = $9.90 per gallonCosts transferred to finished goods:90,000 gallons $9.90/gallon = $891,000LO 6-3Costing with Ending Work-in-Process Inventories

6-#If Baxter Paint transferred in $990,000 of cost during the month of May the question we ask is: Where are those costs at the end of the period? What is the cost of the 90,000 gallons transferred to finished goods inventory?6-#LO 6-3Costing with Ending Work-in-Process Inventories

6-#Compute the cost per equivalent gallon of paint. Baxter incurred $990,000 of cost and produced 100,000 equivalents gallons of paint so the paint cost $9.90 per gallon ($990,000/100,000). Because 90,000 gallons were transferred out, assign $891,000 (90,000 gallons x $9.90) to the units transferred to finished goods and $99,000 (10,000 equivalent gallons x $9.90) to the ending work-in-process inventory.6-#Costing in a Multiple Product,Discrete Process IndustryLO 6-3Grange BoatsCost Flow Diagram: Cost Allocation BasesDirectmaterialsDirectlaborManufacturingoverheadC-27s27-foot sailboatC-20s20-foot sailboatCostpoolsCostobjectsIndirectcost (allocated inproportion todirect labor-hours)DirectcostDirectcost

6-#Now lets look at costing in a multiple-product process. Consider the costing system for Grange Boats, which makes a variety of products. For purposes of explanation, we will consider two products the C-20 (a 20-foot sailboat) and the C-27 ( a 27-foot sailboat). Unlike Baxter Paints, Grange Boats has a manufacturing process that takes place in a series of discrete steps that differ in detail, depending on the product. As this diagram shows, the cost system must take costs from three basic cost pools and allocate them to the two cost objects.6-#Product Costs for January Year 2Grange BoatsUnits producedDirect labor-hoursCosts:Direct materialsDirect laborManufacturing overheadTotal10 2,000

$40,000 72,000

30 3,000

$36,000 78,000

40 5,000

$ 76,000 150,000 180,000$406,000

C-27sC-20sTotalLO 6-3Costing in a Multiple Product,Discrete Process Industry

6-#In a firm with multiple products a manager making pricing decisions needs cost information at the product level. Look at Grange Boats. How do we cost these two individual products the C-27 and the C-20? 6-#DirectmaterialsDirectlaborC-27sC-20sCostpoolsCostobjectsDirect costDirect cost$76,000$150,000$40,000$36,000$72,000$78,000LO 6-3Costing in a Multiple Product,Discrete Process Industry

6-#We know that, by definition, direct materials and direct labor can be traced to the individual products. Of the $76,000 of direct materials, $40,000 is directly traceable to C-27s and $36,000 to C-20s. Of the $150,000 of direct labor, $72,000 is directly traceable to C-27s and $78,000 is directly traceable to the C-20s.6-#Predetermined Overhead RatesLO 6-4Understand how overhead cost is allocated to products.Indirect costs are allocated using a predeterminedoverhead rate (POHR).POHR is the cost per unit of the allocation base usedto charge overhead to products.POHR = $ BaseLO 6-4

6-#But what about overhead costs? Overhead is indirect. Should the indirect costs go to the C-27s or the C-20s? Indirect costs are allocated using a predetermined overhead rate. The predetermined overhead rate is the cost per unit of the allocation basis that is used to charge overhead to products. Lets see what this means.6-#Predetermined Overhead RatesPOHR=Estimated overhead $Estimated allocation baseWhat are the estimated costs?What activity drives the overhead costs?Why use estimates? Products need to have costs appliedduring the period. The exact amount of indirect costs arenot known until the end of the period.LO 6-4

6-#The predetermined overhead rate equals the estimated overhead costs divided by the estimated allocation basis. Recall from Chapter 2 that the allocation base will be the activity that drives the overhead cost. We use estimated costs and estimated allocation base because we need to cost the products during the period and we wont know the exact amount of the indirect costs or the actual activity until the end of the period.6-#Predetermined Overhead RatesDirect labor hoursEstimated overhead costs 2,000

3,000

5,000$180,000C-27sC-20sTotalPOHR = $180,000 5,000 = $36/DLHLO 6-4

6-#Suppose Grange Boats estimates overhead cost for the period of $180,000. Grange also estimates a total of 5,000 direct labor hours will be worked during the period. Granges predetermined overhead rate is $180,000 divided by 5,000 direct labor hours. The predetermined overhead rate is $36 per direct labor hour.6-#Product Costing of Multiple ProductsCostpoolCostobjectsCostallocationruleManufacturingoverhead$180,000C-27s$72,000(2,000 DLH $36)C-20s$108,000(3,000 DLH $36)Direct labor hours ($36/DLH)LO 6-4

6-#Now allocate overhead to the C-27s and C-20s. The cost pool is $180,000 of overhead. The cost allocation rule is $36 per direct labor hour. Producing C-27 required 2,000 direct labor hours and producing C-20s required 3,000 direct labor hours. Therefore, we allocate $72,000 (2,000 x $36) to C-27s and $108,000 (3,000 x $36) to C-20s.6-#Product Costs for JanuaryGrange Boats(allocation base is direct labor hours)Units producedDirect labor-hoursCosts:Direct materialsDirect laborManufacturing overhead(@ $36/hour)TotalCost per unit 10 2,000

$ 40,000 72,000

72,000$184,000$ 18,400 30 3,000

$ 36,000 78,000

108,000$222,000$ 7,400 40 5,000

$ 76,000 150,000

180,000$406,000

C-27sC-20sTotalLO 6-4Product Costing of Multiple Products

6-#The total cost of producing 10 C-27s was $184,000 or $18,400 per unit.The total cost of producing 30 C-20s was $222,000 or $7,400 per unit.6-#Choice of the Allocation BaseThe choice of the allocation base is somewhat arbitrary.What will be the result if management choosesdirect labor cost as the allocation base?The rate then becomes 120% ($180,000 $150,000)LO 6-4

6-#What will be the result if a different allocation base is chosen? Lets assume that management uses direct labor cost as the allocation base. The rate then becomes 120%.6-#Choice of the Allocation BaseProduct Costs for JanuaryGrange Boats(allocation base is direct labor dollars)Units producedDirect labor-hoursCosts:Direct materialsDirect laborManufacturing overhead(@ 120%)TotalCost per unit 10 2,000

$ 40,000 72,000

86,400$198,400$ 19,840 30 3,000

$ 36,000 78,000

93,600$207,600$ 6,920 40 5,000

$ 76,000 150,000

180,000$406,000

C-27sC-20sTotalLO 6-4

6-#The manufacturing overhead allocated to C-27s is $86,400 and to C-20s is $93,600.6-#Multiple Allocation Basesand Two-Stage SystemsLO 6-5Explain the operation of a two-stage allocationsystem for product costing.We can use two or more allocation bases to allocatemanufacturing overhead to products.

LO 6-5

6-#Now lets look at two allocation bases to allocate manufacturing overhead.6-#Manufacturing overheadMachine-relatedcostsDirect labor-relatedcostsC-27sC-20sCostpoolCostobjectsCostallocationrulesIndirect costsIndirect costs(allocated in proportionto machine hours)(allocated in proportionto direct labor costs)SecondstageFirst stageLO 6-5Multiple Allocation Basesand Two-Stage Systems

6-#Lets look a little closer at the overhead costs for Grange. A closer inspection of the overhead accounts suggest that some of the overhead seems to be related more to machine utilization than direct labor. If this is the case, we can use two allocation bases to allocate overhead to the products.6-#CostpoolCost allocationruleIntermediatecost poolsOverhead$180,000Labor-related$108,000Machine-related$72,000Direct laborcostsMachinehoursLO 6-5Multiple Allocation Basesand Two-Stage Systems

6-#First we will assign the overhead cost pool of $180,000 to the intermediate cost pools. $108,000 of overhead is labor-related and $72,000 is machine-related. The labor-related costs will be allocated using direct labor costs and the machine-related costs will be allocated using machine hours.6-#LO 6-5$72,000 4,000 machine hours = $18$108,000 $150,000 labor costs = 72%Burden Rates:

Multiple Allocation Basesand Two-Stage SystemsDoes this word appear in the text? (Alternate word for overhead.)

6-#Machine-related costs of $72,000 divided by 4,000 machine hours will be allocated at the rate of $18 per machine hour. Labor-related overhead costs of $108,000 divided by $150,000 direct labor costs will be allocated at the rate of 72% of direct labor cost. 6-#Two-Stage Cost AllocationGrange BoatsIntermediatecost poolsCostAllocationCostObjectsAllocatedoverheadLabor-related$180,000Machine-related$72,000$150,000Direct labor cost72% DLC4,000Machine hours$18/MHC-27s$51,840 DL cost$18,000 MHC-20s$ 56,160 DL cost$ 54,000 MH$69,840 Total$110,160 TotalLO 6-5

6-#The $108,000 of labor-related costs are allocated $51,840 to the C-27s and $56,160 to the C-20s.The $72,000 of machine-related costs are allocated $18,000 to the C-27s and $54,000 to the C-20s.6-#Costs:Direct materialsDirect laborOverhead:Machine-related@$18/machine-hourLabor-related@72% direct labor costTotal costUnit cost$ 40,000 72,000

18,000 51,840$ 69,840$181,840$ 18,184$ 36,000 78,000

54,000 56,160$110,160$224,160$ 7,472$ 76,000 150,000

72,000 108,000$180,000$406,000C-27sC-20sTotalLO 6-5Two-Stage Cost AllocationGrange Boats

6-#Using the two-stage allocation process we see the total cost allocated to C-27s is $181,840. The total cost allocated to C-20s is $224,160. The cost per unit changed substantially from the examples where only one allocation base was used. 6-#Product Costing SystemsLO 6-6Describe the three basic types of product costingsystems: job order, process, and operations.Job costing:An accounting system that traces costs to individual unitsor to specific jobs, contracts, or batches of goods.(custom homes, movies, services)Process costing:An accounting system used when identical units areproduced through a series of uniform production steps.(cornflakes, facial tissues, paint)LO 6-6

6-#Different companies have different production and costing systems. A job costing system is used when costs can be traced to a specific job, for example, building custom homes, making a movie, or providing a service. But imagine a company making corn flakes or facial tissues. Here it would be very difficult to trace costs to an individual box of corn flakes or box of facial tissues. This company would use process costing, an accounting system that traces costs to a production process. The details of these two costing systems are discussed in Chapters 7 and 8.6-#Product Costing SystemsOperation costing:A hybrid costing system often used in manufacturingof goods that have some common characteristicsplus some individual characteristics.(automobiles, computers, clothing)LO 6-6

6-#Operation costing is a hybrid of job and process costing. An operation is a standardized method that is performed repeatedly in production. However, materials can be different for each product.6-#End of Chapter 6

6-#End of Chapter 6.6-#