Chapter 2 Cost Concepts and Cost Allocation

1. Chapter 2Cost Concepts and Cost Allocation

2. How Manager’s Use Cost Information -

3. Use of Cost Information

4. Type of Organization Manufacturing Retail Service Cost information Cost to Cost to Cost to needed by management manufacture purchase provide the product the product the service Uses of cost information: To measure historical or future profits Yes Yes Yes To decide the selling price for regular or special sales or services provided Yes Yes Yes To value finished goods or merchandise inventories Yes Yes N/A Examples of Types and Uses of Operating Cost Information

5. Cost Classifications and Their Uses Common Cost Classifications: ClassificationBreakdownPurpose Traceability Direct Control costs by tracing Indirect costs to a cost object Behavior Variable Calculate number of units that must be sold to obtain a certain profit. Fixed Activity Based Value adding Identify the costs that add value to the consumer. Non-value adding Financial Reporting Product Classify costs for the preparation of financial statements. Period

6. Overview of Cost Classification

7. Cost Traceability Direct Cost – conveniently traced to a cost object. Indirect Cost – cannot be conveniently traced to a cost object. [Cost Object: individual product, service, department, sales territory, etc.] Cost Behavior Variable Cost – changes in direct proportion to a change in volume. Fixed Cost – remains constant within a range of activity or for a defined time period.

8. Value-Adding Versus Non-Value Adding Costs Value Adding Cost – increases the market value of a product or service. Non-Value Adding Cost – adds cost to a product or service but does not increase its market value. Costs for Financial Reporting Product (Inventorial) Costs – costs such as direct materials, direct labor, and manufacturing overhead, that are assigned to inventory as an asset, until sold. Period (Non-inventorial) Costs – costs of resources consumed, expensed as incurred, during the accounting period and not assigned to products.

9. Elements of Product Costs • Direct materials: Material that become physical part of a finished product. Can be conveniently and economically traced to specific units of product. • Direct labor: labor costs the can be conveniently and economically traced to specific units of product. • Manufacturing overhead includes all manufacturing costs that are not direct materials or direct labor costs. Also called factory overhead or indirect manufacturing costs.

10. Inventoriable Product Costs Direct Materials Direct Labour Indirect Labour Indirect Materials Other Manufacturing Overhead

11. Manufacturing Overhead • The following are examples of manufacturing overhead: • Indirect materials. • Indirect labor. • Depreciation associated with manufacturing operations. • Machinery and tool maintenance, taxes, insurance, rent, and utilities relating to manufacturing.

12. Product Unit Cost • The manufacturing cost of a single unit of product. = Direct Material + Direct Labor + Mfg. Overhead Number of Units Produced Or = Sum of Costs per Unit for each Element

13. Product Cost Elements Actual Costing Normal Costing Standard Costing Direct materials Actual costs Actual costs Estimated costs Direct labor Actual costs Actual costs Estimated costs Manufacturing overhead Actual costs Estimated costs Estimated costs Summary of the Use of Actual or Estimated Costs inThree Cost-Measurement Methods

14. Relationships Among Product Costs

15. Document Flows Activity Documents Purchasing Materials Purchase Request Purchase Order Receiving Report Vendor’s Invoice Materials Requisition and Conversion Materials Request Time Card Job Order Cost Card Vendors’ Invoices for Overhead Product Completion and Sale Job Order Cost Card Sales Invoice Shipping Document

16. Cost Flows • Direct materials, labor, and overhead are accumulated in the Work in Process Inventory account. • When goods are completed the costs are transferred to Finished Goods Inventory. • When the goods are sold, the costs are transferred to Cost of Goods Sold.

17. Direct Materials Inventory Account Work in Process Inventory Account Balance 12/31/x3: Used during $10,000 20x4: Total direct $25,000 materials purchased during 20x4: 20,000 Balance 12/31/x4: $5,000 Balance 12/31/x3: Completed $ 2,000 during 20x4: $30,000 Direct materials used during 20x4: 25,000 Direct labor 20x4: 12,000 Manufacturing overhead 20x4: 6,000 Balance 12/31/x4 $15,000 Manufacturing Cost Flow

18. Factory Payroll Account Work in Process Inventory Account Direct labor 20x4: earned during $12,000 20x4: $12,000 Balance 12/31/x4: $ 0 Balance 12/31x3: Completed $ 2,000 during 20x4: $30,000 Direct materials used during 20x4: 25,000 Direct labor 20x4: 12,000 Manufacturing overhead 20x4: 6,000 Balance 12/31/x4 $15,000 Manufacturing Cost Flow

19. Manufacturing Overhead Control Account Work in Process Inventory Account Total 20x4: manufacturing $ 6,000 overhead incurred during 20x4: $ 6,000 Balance 12/31/03: $ 0 Balance 12/31/x3: Completed $2,000 during 20x4: $30,000 Direct materials used during 20x4: 25,000 Direct labor 20x4: 12,000 Manufacturing overhead 20x4: 6,000 Balance 12/31/x4 $15,000 Manufacturing Cost Flow

20. Work in Process Inventory Account Finished Goods Inventory Account Balance 212/31/x3: Completed $2,000 during 20x4: $30,000 Direct materials used during 20x4: 25,000 Direct labor 20x4: 12,000 Manufacturing overhead 20x4: 6,000 Balance 12/31/x4 $15,000 Balance 12/31/x3: Sold during 20x4: $6,000$24,000 Completed during 20x4: 30,000 Balance 12/31/x4: $12,000 Manufacturing Cost Flow

21. Finished Goods Inventory Account Cost of Goods Sold Account Balance 12/31x3: Sold during 20x4: $6,000$24,000 Completed during 20x4: 30,000 Balance 12/31/x4: $12,000 Sold during 20x4: $24,000 Manufacturing Cost Flow

22. Cost of Goods Manufactured • Cost of goods manufactured is a key component of the income statement for a manufacturing company. • Costs of Goods Manufactured Account (for a manufacturing co.) replaces Purchases Account (for a merchandising co.) • Finished Goods Inventory replaces Merchandise Inventory.

23. Cost of Goods Manufactured • Determining the cost of goods manufactured involves three steps. • Computing the cost of materials used. • Computing direct labor and manufacturing overhead. • Computing cost of goods manufactured, adjusting for beginning and ending work in process.

24. Statement of Cost of Goods Manufactured: Step 1 Angelo’s Rolling Suitcases, Inc. Statement of Cost of Goods Manufactured For the Year Ended December 31, 20x4 Direct Materials Used: Direct Materials Inventory, 12/31/x3 $10,000 Direct Materials Purchased 20,000 Cost of Direct Materials Available for Use $30,000 Less Direct Materials Inventory, 12/31/x4 5,000 Cost of Direct Materials Used $25,000

25. Statement of Cost of Goods Manufactured: Step 2 Angelo’s Rolling Suitcases, Inc. Statement of Cost of Goods Manufactured For the Year Ended December 31, 20xx Cost of Direct Materials Used $25,000 Direct Labor 12,000 Manufacturing Overhead 6,000 Total Manufacturing Costs $43,000 Note: Total Manufacturing Costs ¹ Cost of Goods Manufactured = Product Costs added during the manufacturing period.

26. Total Manufacturing Costs $43,000 Add Work in Process Inventory, 12/31/x3 2,000 Total Cost of Work in Process During the Year $45,000 Less Work in Process Inventory, 12/31/x4 15,000 Cost of Goods Manufactured $30,000 Statement of Cost of Goods Manufactured: Step 3 Angelo’s Rolling Suitcases, Inc. Statement of Cost of Goods Manufactured For the Year Ended December 31, 20x4

27. Sales $50,000 Cost of Goods Sold: Finished Goods Inventory, 12/31/x3 $ 6,000 Cost of Goods Manufactured 30,000 Total Cost of Finished Goods Available for Sale $36,000 Less Finished Goods Inventory, 12/31/x4 12,000 Cost of Goods Sold 24,000 Gross Margin $26,000 Selling & Administrative Expenses 16,000 Net Income $10,000 Income Statement Angelo’s Rolling Suitcases, Inc. Income Statement For the Year Ended December 31, 20x4

28. Cost Allocation • Cost allocation is the process of assigning collected indirect costs to specific cost objects • A cost object is a: product, process, department, activity • A cost pool is a pool of overhead costs related to a cost object. • A cost driver is an activity that causes the cost pool to increase in amount as the cost driver increases.

29. The Manufacturing Overhead Allocation Process Step 1: Planning Description: Calculate a predetermined manufacturing overhead rate. When: Before accounting period. Procedure: Divide the cost pool of total estimated overhead costs by the total estimated cost driver level. Journal entry? No

30. The Manufacturing Overhead Allocation Process Step 2: Application Description: Apply manufacturing overhead costs to production. When: During accounting period as units are produced. Procedure: Multiply the predetermined overhead rate for each cost pool by the actual cost driver level. Journal entry? Yes Increase Work in Process Inventory account Decrease Manufacturing Overhead Control account

31. The Manufacturing Overhead Allocation Process Step 3: Recording Actual Costs Description: Record actual manufacturing overhead costs. When: During accounting period as costs are incurred. Procedure: Record actual manufacturing overhead costs when incurred. Journal entry? Yes Increase Manufacturing Overhead Control account Decrease asset accounts Increase contra-assets or liability accounts

32. The Manufacturing Overhead Allocation Process Step 4: Reconciliation Description: Calculate the difference between applied and actual manufacturing overhead costs. When: At the end of the accounting period. Procedure: Calculate and record the difference between the actual and applied manufacturing overhead costs. Journal entry? Yes

33. The Manufacturing Overhead Allocation Process Step 4: Reconciliation Journal entry? Yes If applied > actual, then increase Manufacturing Overhead Control account Decrease Cost of Goods Sold Account If applied < actual, then increase Cost of Goods Sold account Decrease Manufacturing Overhead Control account Note: If difference is material, allocate to Cost of Goods Sold, Finished Goods and Work-in-Process.

34. Year 2000 Year 2002 Year 2001 January 1 December 31 Step 1:Planning Step 4: Reconciliation Step 2:Application Step 3:Recording Actual Costs The Manufacturing Overhead Allocation Process

35. Allocation of Manufacturing Overhead • Successful allocation of manufacturing overhead costs depends on two factors: • A careful estimate of total manufacturing overhead costs. • A good forecast of the activity level used as the cost driver. • Errors result in bad pricing decisions. • Traditionally one overhead rate was used • Suitable only where a single product or similar family of products is manufactured

36. Traditional Activity Bases • Traditional activity bases are volume-related bases such as: • Direct labor hours. • Direct labor costs. • Machine hours. • Units of production.

37. Using the Traditional Approach to Assign Manufacturing Overhead Costs to Production

38. $200,000 40,000 Direct Labor Hours Predetermined Overhead Rate = $5 per Direct Labor Hour = Assignment of Manufacturing Overhead Costs:Traditional Approach Step 1: Calculate the predetermined overhead rate.

39. Assignment of Manufacturing Overhead Costs:Traditional Approach Step 2: Apply manufacturing overhead costs to production. Regular Cost Driver Level Cost Applied Overhead costs applied: Manufacturing overhead: $5 per DLH X 25,000 DLH $125,000 Number of units ¸ 10,000 Manufacturing overhead cost per unit $ 12.50

40. Assignment of Manufacturing Overhead Costs:Traditional Approach Step 2: Apply manufacturing overhead costs to production. Deluxe Cost Driver Level Cost Applied Overhead costs applied: Manufacturing overhead: X 15,000 DLH $ 75,000 $5 per DLH Number of units ¸ 5,000 Manufacturing overhead cost per unit $ 15.00

41. Product Unit Cost: Traditional Approach Step 3: Product Unit Cost Regular Deluxe Rolling Suitcase Rolling Suitcase Product costs per unit: Direct materials $40.00 $42.00 Direct labor 37.50 45.00 12.50 15.00 Manufacturing overhead Product unit cost $90.00 $102.00

42. ABC Approach • manufacturing costs are grouped into smaller activity cost pools • Because more cost pools are used, each with their own cost driver for allocation to products, a more accurate product cost is obtained.

43. Using ABC to Allocate Manufacturing Overhead Cost to Production

44. ABC Costing Systems • Problems with product costs produced by traditional volume-based costing systems include: • low volume products are under-costed and high volume products are over-costed. • Organizations face greater risk of making poor decisions when significant product cost distortions exist.

45. Estimated Cost Driver Level Cost Driver Regular Deluxe Total Number of setups 300 400 700 Number of inspections 150 350 500 Packaging hours 600 1,400 2,000 Machine hours 4,000 6,000 10,000 Step 1: Cost Driver Level

46. Step 1: (cont’d) Activity PoolCost Driver LevelActivity Cost Rate

47. Step 2: Apply Overhead Costs to Production Regular Suitcase Activity Cost Rate Cost Driver Level Cost Applied Total $71,000 ¸ 10,000 units = $7.10

48. Step 2: Apply Overhead Costs to Production (cont’d…) Deluxe Suitcase Activity Cost Rate Cost Driver Level Cost Applied Total $129,000 ¸ 5,000 units = $25.80

49. Step 3: Calculate Product Unit Cost

50. Service Organizations • The most important cost in a service organization is the professional labor cost (like product cost in manufacturing.) • Service related overhead is the other principal component of the cost of services rendered (like manufacturing overhead.)