Chapter 11

1. Chapter 11 Product Costing in Service and Manufacturing Entities

2. 3 Distinct Inventory Accounts (1.) Raw Material Inventory – includes lumber, metals, paints, and chemicals that will be used to make the company’s products (2.) Work in Process Inventory – includes products that have been started but not completed (3.) Finished Goods Inventory – includes completed products that are ready for sale

3. BALANCE SHEET FINISHED GOODS RAW MATERIALS WORK IN PROCESS Materials Labor Overhead

4. Pearson Frame Co. • Makes and sells jewelry boxes • The frames are homogenous i.e. All the frames are the same and require the same amount of labor and materials. • Let’s go through the events that happen during the year.

5. Event 1 • Issued $5,000 of Common Stock • Debit (Increase) - Cash • Credit – Common Stock

6. Event 2 • Paid $1,200 for raw materials • This event is an asset exchange.

7. Event 3 • Pearson placed $900 of raw materials into production in the process of making frames.

8. Event 4 • Pearson paid production workers $8 per hour to work 120 hours. • Total Labor = $8 * 120 = $960

9. Event 5 • Paid $1,560 for annual insurance premium on the manufacturing facility. • We are going to accumulate overhead costs in the “Manufacturing Overhead” account. • Debit = Actual • Credit = Applied

10. Event 6 • Pearson paid $160 cash to purchase production supplies such as glue, nails, and sandpaper. • These supplies cannot be directly traced to each frame. So we are going to use a production supplies account for record-keeping purposes. This is an asset account.

11. Flow of Overhead Costs • Overhead costs accumulate through-out the year. We are not able to accurate allocated them until the end of the year. • But we need to know an estimate during the year • So we calculate a predetermined overhead rate to use through out the year

12. Overhead • Pearson’s accountants estimated overhead costs of $12,750. • It expects to use 1,500 DLH.

13. Predetermined OH Rate • Total indirect OH = $12,750 • Pearson expects to use 1,500 DLH • Predetermined OH Rate = • $12,750 / 1,500 = $8.50 DLH • For January – 120 DLH • Jan OH = 120 * $8.50 = $1,020

14. Event 8 • Pearson recognized $1,020 of estimated manufacturing overhead costs at the end of January.

15. Event 8 • The entry is: • Debit – Work in Process • Credit – Manufacturing Overhead

16. Manufacturing Overhead • The credit to this account is applied OH. • This account is a temporary asset account. • i.e. It is closed out to a zero balance at the end of the year. • If there is a remaining balance at the end of the year that means overhead was either overapplied or underapplied.

17. Manufacturing Overhead • The balance at the end of the year is closed out to COGS. • Overapplied OH – more OH had been applied than was actually incurred • i.e. COGS was charged too much • Underapplied OH – less OH had been applied than was incurred • i.e. COGS was not charged enough

18. Event 9 • Pearson completed 576 boxes in January, that were started during the month. • $900 materials • $960 labor • $1,020 OH • Cost per Frame = $2,880 / 576 frames = $5 COST OF GOODS MANUFACTURED $2,880

19. Event 10 • Pearson sold 500 picture frames • COGS = $5 * 500 = $2,500 • Revenue = $9 * 500 = $4,500

20. Event 11 • Paid $490 for general, selling, and admin expenses

21. Event 22 • Year-end count of production supplies indicated $150 EOY balance.

22. Event 23 • Close out manufacturing overhead • Actual OH = $11,580 • Applied OH = $12,155 • Too much OH was applied (i.e. – Overapplied OH) • Must debit Manufacturing OH to get balance to zero • DR - Manufacturing OH $575 • CR – COGS $575

23. Schedule of Goods Manufactured & Sold • The schedule reflects the transaction data in the ledger accounts. • The schedule includes the actual amount of overhead cost

24. Absorption Costing • Absorption (Full) Costing – all product costs, both variable and fixed, be reported as inventory until the products are sold – once sold the costs are expensed as cost of goods sold

25. Absorption Costing • Example – Roberts Manufacturing Co. incurs $18,000 variable costs and $12,000 fixed costs to produce 2,000 units of inventory. • Cost per Unit • Fixed = $12,000 / 2,000 = $6 • Variable = $18,000 / 2,000 = $9 • So for each item sold $15 is charged to COGS

26. Absorption Costing • If 3,000 units are produced the fixed cost are still $12,000 but the per unit is now $4 per unit • $12,000 / 3,000 units = $4 / unit • Variable cost is still $9 / unit • Total cost per unit is now $13

27. Absorption Costing • Who cares? • What difference does it make? • Let assume 2,000 are sold • Scenario 1 = 2,000 * $15 / unit = $30,000 • Scenario 2 = 2,000 * $13 / unit = $26,000 • The more units made the lesser the total COGS

28. Absorption Costing • Why do company’s use absorption costing? • Overproducing spreads the fixed costs over more units, thereby reducing the cost per unit and the amount charged cost of goods sold. • Overproducing is not good. It is not good to have too much inventory. It is very risky. Inventory is subject to obsolescence, damage, theft, and/or destruction.

29. Variable Costing • Under variable costing, inventory includes only variable product costs. • Fixed manufacturing costs are expensed in the period in which they are incurred regardless of when inventory is sold. • Increases in production have no effect on the amount of reported profit.