Study Unit 3

1. Study Unit 3 COST Allocation Techniques Overhead Normal Costing

2. 3.4 OH and Normal Costing • All manufacturing costs that are not DM/DL • MOH = Factory OH = Indirect Pdt Cost (Indirect Materials, Indirect Labor, Supplies, Utilities, Insurance, Taxes, Depreciation) • Costs outside the product cost (G&A, Selling) are not inventoriable in COGS = P&L • DL and DM are purely variable costs • OH contains both Variable and Fixed costs

3. What is Normal Costing? Normal costing is used to derive the cost of a product. It includes the following components: Actual cost of materials Actual cost of labor A standard overhead rate that is applied using the product's actual usage of whatever allocation base is being used (such as direct labor hours or machine time) If there is a difference between the standard overhead cost and the actual overhead cost, then you can either charge the difference to the cost of goods sold (for smaller variances) or prorate the difference between the cost of goods sold and inventory. Normal costing is designed to yield product costs that do not contain the sudden cost spikes that can occur when you use actual overhead costs; instead, it uses a smoother long-term estimated overhead rate. It is acceptable under generally accepted accounting principles and international financial reporting standards to use normal costing to derive the cost of a product. Normal costing varies from standard costing, in that standard costing uses entirely predetermined costs for all aspects of a product, while normal costing uses actual costs for the materials and labor components.

4. Other Definition Normal costinguses a predetermined annual overhead rate to assign manufacturing overhead to products. In other words, the overhead rate under normal costing is based on the expected overhead costs for the entire accounting year and the expected production volume for the entire year. Under actual costingeach month’s actual costs and each month’s actual production volume are used to assign overhead costs. Since most companies will experience month to month fluctuations in activity, the actual monthly overhead rates will likely vary from month to month. Normal costing will result in an overhead rate that is more uniform and realistic for all of the units manufactured during an accounting year.

5. MOH = definition Manufacturing overhead (also referred to as factory overhead, factory burden, and manufacturing support costs) refers to indirect factory-related costs that are incurred when a product is manufactured. Along with costs such as direct material and direct labor, the cost of manufacturing overhead must be assigned to each unit produced so that Inventory and Cost of Goods Sold are valued and reported according to generally accepted accounting principles (GAAP). Manufacturing overhead includes such things as the electricity used to operate the factory equipment, depreciation on the factory equipment and building, factory supplies and factory personnel (other than direct labor). How these costs are assigned to products has an impact on the measurement of an individual product's profitability. Nonmanufacturing costs (sometimes referred to as “administrative overhead”) represent a manufacturer’s expenses that occur apart from the actual manufacturing function. In accounting and financial terminology, the nonmanufacturing costs include Selling, General and Administrative (SG&A) expenses, and Interest Expense. Since accounting principles do not consider these expenses as product costs, they are not assigned to inventory or to the cost of goods sold. Instead, nonmanufacturing costs are simply reported as expenses on the income statement at the time they are incurred.

6. On financial statements, each product must include the costs of the following: • Direct material • Direct labor • Manufacturing (or factory) overhead According to generally accepted accounting principles (GAAP), manufacturing overhead must be included in the cost of Work in Process Inventory and Finished Goods Inventory on a manufacturer’s balance sheet, as well as in the Cost of Goods Sold on its income statement. As their names indicate, direct material and direct labor costs are directly traceable to the products being manufactured. Manufacturing overhead, however, consists of indirect factory-related costs and as such must be divided up and allocated to each unit produced. For example, the property tax on a factory building is part of manufacturing overhead. Although the property tax covers an entire year and appears as one large amount on just one tax bill, GAAP requires that a portion of this amount be allocated or assigned to each product manufactured during that year.

7. Examples: • Material handlers (forklift operators who move materials and units). • People who set up the manufacturing equipment to the required specifications. • People who inspect products as they are being produced. • People who perform maintenance on the equipment. • People who clean the manufacturing area. • People who perform record keeping for the manufacturing processes. • Factory management team. • Electricity, natural gas, water, and sewer for operating the manufacturing facilities and equipment. • Computer and communication systems for the manufacturing function. • Repair parts for the manufacturing equipment and facilities. • Supplies for operating the manufacturing process. • Depreciation on the manufacturing equipment and facilities. • Insurance and property taxes on the manufacturing equipment and facilities. • Safety and environmental costs.

8. Steps for Analysis • Cost Driver  allocation base (cause-and-effect relationship) • It can be direct machine or labor hours • Calculating the application rate • Recording Actual Overhead Costs • Allocating OH to WIP • Over and Under applied Overhead

9. Over – Under applied: • If variance is immaterial: directly allocated to COGS • If variance is material: allocated based on relative values of WIP, Finished goods, COGS

10. Activity-Based Costing • Indirect costs are attached to activities rather than simply dumped in one or two indirect cost pools • More accuracy and greater detail regarding OH • More complex and costly to implement

11. Examples • Page 106 – review example • Page 123 # 24: quick calculation • Page 123 # 25

12. SU 3.4 Question 1 Question 1 - CMA1 Study Unit 3: Cost Allocation Techniques

13. SU 3.4 Question 1 (continued)

14. SU 3.4 Question 1 Answer Correct Answer: C Theoretical (ideal) capacity is the maximum capacity given continuous operations with no holidays, downtime, etc. It assumes perfect efficiency at all times. Consequently, it can never be attained and is not a reasonable estimate of actual volume. Incorrect Answers: A: Normal capacity is the long-term average level of activity that will approximate demand over a period that includes seasonal, cyclical, and trend variations. B: Expected annual activity is an approximation of actual volume levels for a specific year. D: Master-budget capacity is the expected level of activity used for budgeting for a given year.

15. SU 3.4 Question 2 Question 2 - CMA1 Study Unit 3: Cost Allocation Techniques Annual overhead application rates are used to

16. SU 3.4 Question 2 Answer Incorrect Answers: A: Overhead must be budgeted before a rate can be calculated. C: Overhead application rates are used to smooth seasonal variability of overhead costs. D: An overhead rate applies overhead to the product.

17. SU 3.5 Question 1 Question 1 - CMA1 Study Unit 3: Cost Allocation Techniques Pane Company uses a job costing system and applies overhead to products on the basis of direct labor cost. Job No. 75, the only job in process on January 1, had the following costs assigned as of that date: direct materials, $40,000; direct labor, $80,000; and factory overhead, $120,000. The following selected costs were incurred during the year:

18. SU 3.5 Question 1 (continued)

19. SU 3.5 Question 1 (continued) Pane’s profit plan for the year included budgeted direct labor of $320,000 and overhead of $448,000. Assuming no work-in-process on December 31, Pane’s overhead for the year was

20. SU 3.5 Question 1 Answer Correct Answer: B Pane applies overhead to products on the basis of direct labor cost. The rate is 1.4 ($448,000 budgeted OH ÷ $320,000 budgeted DL cost). Thus, $483,000 ($345,000 actual DL cost × 1.4) of overhead was applied, of which $24,000 ($483,000 – $459,000 actual OH) was overapplied. Incorrect Answers: A: The amount of $11,000 equals the difference between budgeted and actual overhead. C: The amount of $11,000 equals the difference between budgeted and actual overhead. D: The overhead was overapplied.

21. SU 3.5 Question 2

22. SU 3.5 Question 2 Answer

23. SU 3.5 Question 2 Answer (continue) Incorrect Answers: A: The amount of $25,000 excludes the indirect materials. C: The amount of $45,000 is the total labor cost. D: The amount of $50,000 is the direct materials cost.

24. Service Department Costs • Direct Method • Step-Down Method • Reciprocal Method • Single-rate Vs. Dual-Rate Allocation

25. Key concepts: • Service Depart. = OH = not traced to cost object = must be allocated to operating Departs. • Cause-&-effect relationship and/or benefits received • Review examples • Page 128 #3.7

26. SU 3.6 Question 1

27. SU 3.6 Question 1 Answer Correct Answer: C Service department costs are considered part of factory overhead and should be allocated to the production departments that use the services. A basis reflecting cause and effect should be used to allocate service department costs. For example, the number of kilowatt hours used by each producing department is probably the best allocation base for electricity costs. Incorrect Answers: A: Making allocations on the basis of units sold may not meet the cause-and-effect criterion. B: The salary of service department employees is the cost allocated, not a basis of allocation. D: Making allocations on the basis of materials usage may not meet the cause-and-effect criterion.

28. SU 3.6 Question 2

29. SU 3.6 Question 2 Answer Correct Answer: D The dual-rate method of allocating costs from one department to another involves classifying the costs to be allocated into two pools, one variable and one fixed. Incorrect Answers: A: The dual-rate method is used with exactly two cost pools, one for fixed costs and one for variable costs. B: Use of the dual-rate depends on cost behavior, not the number of departments. C: Use of the dual-rate depends on cost behavior, not the number of products.