Fundamentals of Product and Service Costing

1. Fundamentals of Productand Service Costing Chapter 6 Edited by Dr. Charles Bailey for ACCT3310

2. Learning Objectives LO 6-1Explain the fundamental themes underlying the design of cost systems. LO 6-2Explain how cost allocation is used in a cost management 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 system for product costing. LO 6-6Describe the three basic types of product costing systems: job order, process, and operations.

3. Cost Management System Keys to a good cost management system: • Oriented to the needs of the decision makers • Designed so that benefits exceed costs

4. LO 6-1 Cost Management Systems LO 6-1Explain the fundamental themes underlying the design of cost systems. The objective of the cost management system is to provide information about costs relevant for decision making. The cost management system accumulates and reports costs about processes, products, and services.

5. LO 6-1 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 inventory

6. LO 6-2 Cost Allocation and Product Costing LO 6-2Explain how cost allocation is used in a cost management system. Basic Cost Flow Diagram Cost pools Direct materials Direct labor Manufacturing overhead Cost allocation rule Indirect (allocated by direct labor cost) Direct Cost objects Alpha Beta

7. LO 6-2 Fundamental Themes Underlyingthe Design of Cost Systems for Managerial Purposes Cost systems should have a decision focus. Different cost information is used for different purposes. Cost information for managerial purposes must meet the cost-benefit test.

8. LO 6-3 Basic Cost Flow Model LO 6-3Explain how a basic product costing system works. How costs and units move through inventories: Beginning balance + Transfers in – Transfers out = Ending balance BB + TI – TO = EB This is true for the following accounts: – Raw Materials (RM) – Work-in-Process (WIP) – Finished Goods (FG)

9. Note what all inventory calculations have in common [My added slide from Ch. 2 Lecture] Raw Material: Purchases Work in Process: Mfg. cost incurred Finished Goods: Cost of Goods Mfd. BI EI Pool of Costs Cost transferred out to WIP, FG CGS, etc. Cost Added

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

11. LO 6-3 Costing with No Work-in-Process Inventories BB + TI – TO = EB 0 + 100,000 gallons – 100,000 gallons = 0 Finished Goods

12. LO 6-3 Costing with No Work-in-Process Inventories 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.

13. LO 6-3 Costing with Ending Work-in-Process Inventories Production for Baxter Paint for May follows (gallons): Beginning inventory -0- Started in May 110,000 Total 110,000 Ending WIP (50% complete) 20,000 Transferred out 90,000

14. LO 6-3 Costing with Ending Work-in-Process Inventories BB + TI – TO = EB 0 + 110,000 gallons – 90,000 gallons = 20,000 gallons (50% complete) Finished goods

15. LO 6-3 Costing with Ending Work-in-Process Inventories How do we cost Baxter’s 20,000 gallons of paint that are only half finished? 20,000 gallons half finished is equivalent to 10,000 gallons finished. 90,000 gallons transferred out plus 10,000 equivalent gallons of finished paint equals 100,000 equivalent gallons of paint. Gallons of paint transferred out 90,000 Equivalent gallons of finished paint 10,000 Total equivalent gallons of paint 100,000

16. LO 6-3 Costing with Ending Work-in-Process Inventories Costs incurred in May Year 2: Materials $390,000 Labor 100,000 Manufacturing overhead 500,000 Total $990,000 $990,000/100,000 gallons = $9.90 per gallon Costs transferred to finished goods: 90,000 gallons × $9.90/gallon = $891,000

17. LO 6-3 Costing with Ending Work-in-Process Inventories

18. LO 6-3 Costing in a Multiple Product,Discrete Process Industry Grange Boats Cost Flow Diagram: Cost Allocation Bases Cost pools Direct materials Direct labor Manufacturing overhead Direct cost Direct cost Indirect cost (allocated in proportion to direct labor-hours) Cost objects C-27s 27-foot sailboat C-20s 20-foot sailboat

19. LO 6-3 Costing in a Multiple Product,Discrete Process Industry Product Costs for January Year 2—Grange Boats C-27s C-20s Total Units produced Direct labor-hours Costs: Direct materials Direct labor Manufacturing overhead Total 10 2,000 $40,000 72,000 30 3,000 $36,000 78,000 40 5,000 $ 76,000 150,000 180,000 $406,000

20. LO 6-3 Costing in a Multiple Product,Discrete Process Industry Cost pools Direct materials Direct labor $76,000 $150,000 Direct cost Direct cost Cost objects C-27s C-20s $40,000 $36,000 $72,000 $78,000

21. LO 6-4 Predetermined Overhead Rates LO 6-4Understand how overhead cost is allocated to products. Indirect costs are allocated using a predetermined overhead rate (POHR). POHR is the cost per unit of the allocation base used to charge overhead to products. POHR = $ ÷ Base

22. LO 6-4 Predetermined Overhead Rates What are the estimated costs? POHR = Estimated overhead $ Estimated allocation base What activity drives the overhead costs? Why use estimates? • Products need to have costs applied • during the period. • The exact amount of indirect costs are • not known until the end of the period.

23. LO 6-4 Predetermined Overhead Rates C-27s C-20s Total Direct labor hours Estimated overhead costs 2,000 3,000 5,000 $180,000 POHR = $180,000 ÷ 5,000 = $36/DLH

24. LO 6-4 Product Costing of Multiple Products Cost pool Manufacturing overhead $180,000 Direct labor hours ($36/DLH) Cost allocation rule Cost objects C-27s $72,000 (2,000 DLH × $36) C-20s $108,000 (3,000 DLH × $36)

25. LO 6-4 Product Costing of Multiple Products Product Costs for January—Grange Boats (allocation base is direct labor hours) C-27s C-20s Total Units produced Direct labor-hours Costs: Direct materials Direct labor Manufacturing overhead (@ $36/hour) Total Cost 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

26. LO 6-4 Choice of the Allocation Base The 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)

27. LO 6-4 Choice of the Allocation Base Product Costs for January—Grange Boats (allocation base is direct labor dollars) C-27s C-20s Total Units produced Direct labor-hours Costs: Direct materials Direct labor Manufacturing overhead (@ 120%) Total Cost 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

28. LO 6-5 Multiple Allocation Basesand Two-Stage Systems LO 6-5Explain the operation of a two-stage allocation system for product costing. We can use two or more allocation bases to allocate manufacturing overhead to products.

29. LO 6-5 Multiple Allocation Basesand Two-Stage Systems Cost pool Manufacturing overhead First stage Machine-related costs Direct labor-related costs Cost allocation rules Second stage Indirect costs Indirect costs (allocated in proportion to direct labor costs) (allocated in proportion to machine hours) Cost objects C-27s C-20s

30. LO 6-5 Multiple Allocation Basesand Two-Stage Systems Cost pool Overhead $180,000 Intermediate cost pools Labor-related $108,000 Machine-related $72,000 Cost allocation rule Direct labor costs Machine hours

31. LO 6-5 Multiple Allocation Basesand Two-Stage Systems Does this word appear in the text? (Alternate word for overhead.) Burden Rates: $72,000 ÷ 4,000 machine hours = $18 $108,000 ÷ $150,000 labor costs = 72%

32. LO 6-5 Two-Stage Cost Allocation—Grange Boats Intermediate cost pools Labor-related $180,000 Machine-related $72,000 Cost Allocation $150,000 Direct labor cost 72% DLC 4,000 Machine hours $18/MH Cost Objects C-27s $51,840 DL cost $18,000 MH C-20s $ 56,160 DL cost $ 54,000 MH Allocated overhead $69,840 Total $110,160 Total

33. LO 6-5 Two-Stage Cost Allocation—Grange Boats C-27s C-20s Total Costs: Direct materials Direct labor Overhead: Machine-related @$18/machine-hour Labor-related @72% direct labor cost Total cost Unit 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 $406,000

34. LO 6-6 Product Costing Systems LO 6-6Describe the three basic types of product costing systems: job order, process, and operations. Job costing: – An accounting system that traces costs to individual units or to specific jobs, contracts, or batches of goods. (custom homes, movies, services) Process costing: – An accounting system used when identical units are produced through a series of uniform production steps. (cornflakes, facial tissues, paint)

35. LO 6-6 Product Costing Systems Operation costing: – A hybrid costing system often used in manufacturing of goods that have some common characteristics plus some individual characteristics. (automobiles, computers, clothing)

36. End of Chapter 6