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3. C H A P T E R . Product Cost Flows and Business Organizations. Learning Objective 1. Understand the difficulty, yet importance, of having accurate product cost information. Direct materials materials that become part of the product and are traceable to it. Direct labor

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Product Cost Flows and Business Organizations

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  • C H A P T E R

Product Cost

Flows and



Learning Objective 1

  • Understand the difficulty, yet importance, of having accurate product cost information.

Direct materials

materials that become part of the product and are traceable to it.

Direct labor

wages paid to those who physically work on the direct materials to transform them to a finished product and are traceable to those products.

Manufacturing overhead

all costs incurred in the manufacturing process other than direct materials and direct labor.

Define the Three Manufacturing Product Costs

Difficult to assign to products.

Easily assigned to products.

Easily assigned to products.

Direct Materials Costs

Manufacturing Overhead Costs

Direct Labor Costs

- Total costs not known until the end of the period.

- Not usually assigned to specific products.

- “Lumped” costs don’t match production very well.

- Expenditure and use usually match production.

- Expenditure and use usually match production.

Assignment of Product Costs

Product Cost

Product Cost Systems

Why does management needs accurate product cost information?

To plan for the future.

To control current operations.

To evaluate past performance.

To deliver high-quality products to customers at the lowest price and at the fastest speed.

Product Cost Systems

What does accurate information allow management to do?

To determine the appropriate level at which to operate.

To assess the long-term profitability of various products.

To manage the costs of production activities.

Learning Objective 2

  • Explain the flow of goods and services in a manufacturing organization and follow the accumulation of product costs in its accounting system.


finished inventory



ending inventory

cost of goods sold

Review the Time Line of Business


raw materials or goods for resale


Measuring Cost

To accurately measure product costs, accountants must:

  • Determine which costs relate to manufacturing and which relate to administrative and selling functions.

  • Accurately identify and measure all costs associated with manufacturing.

  • Determine appropriate ways to assign costs incurred to products manufactured.

Raw Materials Inventory

Finished Goods Inventory


Work-In- Process Inventory

Direct Labor

Cost of Goods Sold

Factory Overhead

Outline the Flow of Cost in a Manufacturing Process

What are some difficulties in determining costs of manufactured products?

  • Multiple products produced in same facility.

  • Changing prices and labor rates.

  • Multiple manufacturing locations (perhaps international).

  • Individuals performing multiple tasks.

Determining Cost

Cost of raw materials used directly in the manufacture of products.

Kept in raw materials warehouse until used.

Examples: Rubber to make tires, steel to make cars, wood to make tables.

Costs of Manufacturing ProductsDiscuss the Nature of Raw Materials.

Direct materials

Example: Direct Materials Costs

Venus Vehicles purchased $2 million of steel for its new line of cars. What is the journal entry?

Raw Materials Inventory. . . . . . . . . . . 2,000,000Accounts Payable . . . . . . . . . . . .2,000,000

Half the new steel is requested from the warehouse for production. What is the journal entry?

Work-in-Process Inventory. . . . . . . . . .1,000,000 Raw Materials Inventory . . . . . . . .1,000,000

Indirect materials ($250,000 of glue and bolts) are requisitioned from the storeroom. What is the journal entry?

Manufacturing Overhead. . . . . . . . . . . . 250,000Raw Materials Inventory . . . . . . . . 250,000

Wages/payroll-related expenses of factory employees who work directly on products.

Cost of wages/benefits for assembly workers.

Does not include wages/benefits of those who do not work directly on making products.

Costs of Manufacturing ProductsDiscuss the Nature of Direct Labor.

Direct labor

Direct Labor Costs and Example

  • Time clocks, computer entries, time sheets—

    • - All allow production personnel to identify specific jobs worked on.

    • This information is revealed on the job cost sheet.

    • Labor costs can be direct or indirect.

    • Payroll records report direct labor of $50,000 and indirect labor of $50,000. Record the direct labor.

Work-in Process Inventory. . .50,000Wages Payable. . . . . . . . 50,000

Record the indirect labor.

Manufacturing Overhead. . . . 50,000Wages Payable. . . . .. . . . 50,000

All manufacturing costs not classified as direct materials or direct labor.

Miscellaneous materials used in production (such as glue or nails).

Costs such as utilities, depreciation, insurance, and property taxes.

Costs of Manufacturing ProductsDiscuss the Nature of Factory Overhead.

Manufacturing overhead

Describe Some of the Characteristics of Manufacturing Overhead Costs

  • Involves more complex accounting procedures and estimation problems.

  • Must often be estimated in advance of their occurrence.

  • Cannot be traced directly to individual items produced during the period.

  • Managers need current product cost information:

    • - for pricing similar jobs.

    • - for estimating costs for next period.

Therefore, each job is assigned a share of estimated overhead.


overhead rate

Actual activity

level per job

Allocated manufacturing

overhead assigned to job



Describe the Two-Step Process to Apply Manufacturing Overhead to Products

Step One

Annual expected (budgeted)

manufacturing overhead

Annual expected (budgeted) activity level

(e.g., direct labor hours)


overhead rate


Step Two

Total estimated manufacturing overhead costs

Selected activity base (machine hours)





Example: Determining Manufacturing Overhead Rate

Steel Works estimates annual variable manufacturing overhead costs of $10,000 and fixed manufacturing overhead of $20,000. What is the predetermined overhead rate if the company expects to use the machines 10,000 hours?

$3.00 per machine hour






10 hours






Example: Determining Manufacturing Overhead Rate

Steel Works used 10 machine hours in the production of Job No. 12. Using the $3.00 predetermined overhead rate, what overhead costs will be applied to manufacturing overhead (MOH) for this job? What is the journal entry to apply this MOH to Job No. 12?

Work-in-Process Inventory. . . . . . . . . . .30Manufacturing Overhead . . . . . . . .30

Job Cost Sheet

Job No. 12

Direct Materials$100

Direct Labor200



Example: Transferring Completed Products to Finished Goods Inventory and then Selling the Products

Steel Works used $100 in direct materials in Job No. 12’s production as well as 10 hours of direct labor at $20 per hour. Using a job cost sheet, determine the job’s total cost. Now that the job is complete, prepare the entries for its transfer to Finished Goods and its sale.

Finished Goods Inventory . . 330

Work-in Process. . . . . . . . . . . . 330

Cost of Goods Sold. . . . . . . 330

Finished Goods Inventory. . . 330

Learning Objective 3

  • Understand the process of accounting for overhead.

Actual versus Applied Manufacturing Overhead

  • Actual Overhead

    • Actual annual manufacturing overhead costs.

    • Needed for accurate determination of income.

    • Recorded as debit to Manufacturing Overhead.

  • Applied Overhead

    • Amount of overhead applied to products using the predetermined overhead rate.

    • Recorded as credit to Manufacturing Overhead.

Manufacturing Overhead

Manufacturing Overhead









Disposition of Over- and Underapplied MOH

  • Overapplied Manufacturing Overhead:

  • The excess of applied overhead costs over actual overhead costs for a period.

(Cost of job is overstated)

(Cost of job is understated)

Underapplied Manufacturing Overhead:

The excess of actual overhead costs over applied overhead costs for a period.

- Close over- or underapplied overhead directly to Cost of Goods Sold.

- Easier and more commonly used, especially if amount is small.

- Debit MOH, Credit COGS.

- Allocate over- or underapplied manufacturing overhead to Work-in-Process Inventory, Finished Goods Inventory, and Cost of Goods Sold on the basis of the ending balances in these three accounts.

- More accurate; any difference is allocated proportionately.

- More complicated; requires detailed calculations.

Treating Applied Overhead

Two methods for treating over- and underapplied MOH:

Learning Objective 4

  • Explain the flow of goods and services in a merchandising organization and follow the accumulation of product costs in its accounting system.

The Distribution Channel

  • The process of wholesalers purchasing from manufacturers and supplying retailers who sell to final customers.

Manufacturer Brand A


Brand A Customers

Manufacturer Brand B

Brand B Customers

Manufacturer Brand C

Brand C Customers



Manufacturer Brand D

Brand D Customers

Manufacturer Brand E

Brand E Customers


Manufacturer Brand F

Brand F Customers

A Typical Channel of Distribution


  • Receive goods in bulk shipments; break them down for smaller shipments to retailers.

  • Profit—the difference between price at which they buy goods and price at which they sell goods to retailers.

  • Quality and timelines are also important performance measures.

To be profitable, wholesalers must be sure the right goods are received and shipped in the right manner to the right retailer for the right price at the right time.

Retailers – Define Risk and Stockturns

  • Often work with many wholesalers (and some manufacturers) to obtain inventory mix.

  • Risk is having money tied up in inventory that is not selling (opportunity cost).

  • Stockturns—the faster stock (inventory) can be turned, the sooner the money is available to purchase more inventory.

Second-tier merchants who typically purchase products from wholesalers to distribute to customers. Many will often bypass wholesalers to purchase inventory directly from the original manufacturers.

Inventory is purchased

Inventory is sold

Costs incurred to ship in inventory

Inventory is returned

Describe Merchandise Cost Flows

Accounts Payable







Cost of Goods Sold

xx x


Jan. 1Cost of Goods Sold. . . . . . . . . 475

Merchandise Inventory . . . .475

Sold inventory to customers.

Describe Accounting for Inventory

  • In merchandising, accounting is fairly straightforward: no raw materials, inventory, manufacturing overhead, or work-in-process accounts.

  • Inventory costs are often expensed as a period cost, included in Selling and General Administrative Expenses.

  • Prepare journal entry for when $465 inventory is sold.

Learning Objective 5

Explain the flow of goods and services in a service organization and follow the accumulation of product costs in its accounting system

Important for service firms to develop useful management accounting systems that support managing costs, quality, and timeliness in creating and delivering their product.

An organization whose main economic activity involves producing a nonphysical product that provides value to a customer.

Define a Service Company

What are the Effects of Deregulation?

  • In service sector, deregulation has changed pricing and profitability.

  • Now the most efficient producers establish prices.

  • Service providers who don’t know their costs will:

    • not be able to aggressively set prices.

    • not be responsive to consumer

    • demands.

    • not make enough money to

    • stay in business.

List Similarities Between Service and Manufacturing Firms

  • Both prepare product for sale and delivery.

  • Both involve direct labor and overhead.

  • Both create a high-quality product that must be delivered in a timely manner while keeping costs low.

  • Creative process requires highly paid skilled labor or expensive capital equipment and buildings.

  • Large overhead must be allocated to the direct product provided to the customer.

Differences Between Service and Manufacturing Firms

  • Distribution channel not as prevalent in service firms.

  • Most service firms deal directly with end-user.

  • More customization in service firms.

  • Most service firms use a job order approach rather than a process approach to cost accounting.

  • Raw material inventories are insignificant or nonexistent in service firms.

  • Difficult in service industry to store finished service in anticipation of later sale.

Work-in-Process Inventory

  • At period’s end, there may be situations where significant effort and resources have been invested in a service product that is not yet completed.

  • Revenue is not yet earned; therefore, costs should not be recognized yet as expenses. This work in process is an asset, referred to asWork-in-Process Services.

  • When service is completed and delivered, service costs (overhead costsand work-in-process services) are transferred to Cost of Services.

Learning Objective 6

  • Understand the impact of e-business on product costing.

What Impact Has e-business Had on Product Costs?

  • Reduced cost of materials, since businesses can search for the best price.

  • Better management of direct labor costs.

  • In some cases, customers interact with technology instead of employees.

  • Significant changes in the structure of companies which greatly affects overhead costs.

Expanded MaterialLearning Objective 7

  • Use the FIFO method to do process costing.

The activity performed in each process center must be identical for all units.

The units produced as a result of passing through the process centers must be basically the same.

Process Costing

Process costing is appropriate if what two general conditions are met?

What are the 5 Steps in Process Costing?

  • Step 1Identify units that went into the process and identify where those units are at the end of the processing time. Determine the amount of work done during the processing time period.

  • Step 2Determine the amount of production costs that went into the process and compute the product costs per unit for the processing time period.

  • Step 3Compute the total cost of units completed and transferred out during the processing time period.

  • Step 4Compute the total cost of units remaining in process at the end of the processing time period.

  • Step 5Prepare the production cost report.

Step 1: Compute Equivalent Units of Production

Step 2: Compute Product Costs per Unit

Step 3: Compute the Costs Transferred Out

Step 4: Compute Costs of Ending Work-in Process Inventory

Step 5: Prepare the Production Cost Report

The production cost report contains the information prepared and presented in steps 1 through 4.

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