Traditional product costing methods
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TRADITIONAL PRODUCT COSTING METHODS. Accounting Principles II AC 2102 - Fall Semester, 1999. Unit Product Costs. The unit cost is the total costs associated with the units divided by the number of units produced The concept is deceptively simple

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Accounting Principles II

AC 2102 - Fall Semester, 1999

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Unit Product Costs

  • The unit cost is the total costs associated with the units divided by the number of units produced

  • The concept is deceptively simple

  • The practical reality of the computation, however, can be somewhat more complex

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Key Issues Which Must Be AddressedWhen Calculating A Unit Cost

1st: What costs are included in total cost?

  • Does this total only include production costs?

  • Or only production costs plus marketing costs?

  • Or all the costs of the organization?

    2nd: Should actual or estimated costs be used in the calculation?

    3rd: How do we associate indirect costs with the product?

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Determining The Costs To Include In The Unit Cost Calculation

  • The product cost definition depends on the managerial objective under consideration

  • Example: “Product Cost” is defined as production costs (direct material, direct labor & manufacturing overhead) only for external financial reporting

  • Note that “Product Cost” is often defined more broadly in comtemporary accounting, particularly for value-chain analysis, evaluating efficiencies, and long-term pricing

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Determining How The Costs To Be Included Should Be Measured & Assigned To Products

  • Cost Measurement - determining the dollar amounts of direct material, direct labor & manufacturing overhead used in production

  • Actual or Estimated Amounts - the dollar amounts included in cost measurement can be actual or estimated amounts

    • Estimated amounts may be used to improve timeliness of cost information or to control costs

  • Cost Assignment - The process of associating costs, once measured, with the units produced

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Importance of Unit Costs & Assigned To ProductsTo Manufacturing Firms

  • Unit cost is a critical piece of information for a manufacturer

  • Unit costs are essential for valuing inventory, determining income, and making a number of important decisions

  • Whether the unit cost is defined using manufacturing costs or variable costs or total organization costs depends on the purpose for which the information is going to be used

    • Different costs are needed for different purposes

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Importance of Unit Costs & Assigned To ProductsTo Service Firms

  • Conceptually, the way we measure and assign costs is the same regardless of the nature of the firm

    • i.e., manufacturing or nonmanufacturing firm

  • The service firm must first identify the service “unit” that is being provided

    • Examples: a repair job, a surgery, a processed insurance claim, a laboratory test

  • Use costs to determine profitablity, evaluating the feasibility of providing a new service, making pricing decisions, etc.

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Two Basic Ways To Measure Production Costs & Assigned To Products

  • Actual Costing

    • The actual costs of all resources used in production are included in determining product costs

    • While intuitively reasonable, this method has serious drawbacks

  • Normal Costing

    • The actual costs of direct materials & direct labor and overhead is applied using predetermined overhead rates are included in determining product costs

    • Is the most widely used in practice

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Actual Costing & Assigned To Products

  • An actual cost system includes actual costs for direct material, direct labor & factory overhead.

  • Pure actual cost systems are rarely used in practice

    • Because such systems cannot provide accurate unit costs on a timely basis

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Direct Material & Direct Labor & Assigned To ProductsIn An Actual Costing System

  • Amount of actual direct materials and direct labor used by a product can be physically observed as the units are produced

  • Actual prime costs can be assigned using direct tracing

  • These two costs can be assigned on a timely basis

  • No significant problem with either accuracy or timeliness for costing purposes

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Two Major Disadvantages & Assigned To ProductsOf Actual Cost Systems

(1) Delays in collecting (or determining) actual overhead costs impedes producing unit cost data on a timely basis

(2) Substantial fluctuations result in the calculated monthly unit costs of product

Note: Both these disadvantages are caused by the process of assigning actual overhead costs to products

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Delays In Collecting Or Determining Overhead Costs & Assigned To Products

  • Many of the costs included in overhead costs are not known immediately at the end of each month

  • Examples:

    • Electricity, gas (must wait for bills from utility)

    • Property Taxes (only receive figure once per year)

    • Outside service (must wait until bill for charges is received)

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Fluctuations In Calculated & Assigned To ProductsMonthly Unit Costs

  • Occurs for two major reasons:

    (1) Monthly fluctuations in the amount of overhead incurred by the company

    - sometimes called the “numerator problem”

    (2) Monthly fluctuations in the level of production, i.e.., the number of units produced

    - sometimes called the “denominator problem”

  • Often such variations in monthly unit cost figures do not signal differences in the underlying cost structure

  • Often these variations cause great confusion

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Normal Costing & Assigned To Products

  • Product costs include actual material, actual labor and overhead based on predetermined rates

  • The predetermined overhead rate is calculated as follows:

    Budgeted OH $/ Bugeted Activity Usage

    Note: once the rate is determined, overhead is mechanically charged just as it would if an actual cost rate was being applied

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Overhead-Related Differences Between Actual and Calculated Unit Costs

  • The predetermined rate is usually set once per year right before the new fiscal year begins

  • This predetermined rate is likely to differ from the actual rate (which later results)

  • Either actual overhead costs differ from the estimated costs or the actual level of production differs from the expected level, or both

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Assigning Product Costing In A Traditional Costing System Unit Costs

  • Assigns only manufacturing costs to products

  • Can assign direct materials and direct labor to products using either direct tracing or very accurate driver tracing

  • The physically-observable relationships that exist between direct materials, direct labor and products is simply not available for overhead

    • Assignment of overhead must rely on driver tracing and/or allocation

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Traditional Product Costing System Unit Costs

  • Only unit-level activity drivers are used to assign costs to products

  • Unit-level activity drivers:

    • are factors that cause changes in cost as units produced change

  • The use of only unit-based drivers to assign overhead to products assumes that the overhead consumed by products is highly correlated with the number of units produced

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How Unit-Based Activity Drivers Unit CostsAssign Overhead Costs To Products

  • Either plantwide or departmental overhead rates are used to charge overhead to jobs and products

  • Commonly used unit-level drivers:

    • Units produced

    • Direct labor hours

    • Direct labor dollars

    • Machine hours

    • Direct material

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The Four Possible Levels of Activity Unit CostsReflected In The Driver

  • Expected activity level

    • The activity output expected in the next year

  • Normal activity level

    • The average activity output that a firm experiences in the long term (more than one year)

  • Theoretical activity level

    • The absolute maximum activity output if everything operates perfectly

  • Practical activity level

    • The maximum output that can be realized if everything operates efficiently

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Selecting An Activity Level Unit CostsOn Which To Base The Rate

  • The most often chosen activity level for calculating the overhead rate is either the expected level or the normal level of activity

  • The expected level has the advantage that the total overhead charged to products will more likely closely approximate the actual overhead incurred over a year

  • The normal level has the advantage of using the same activity level each year

    • It produces less fluctuations from year to year in the assignment of per unit overhead costs

    • It better reflects the long-run average cost being incurred

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Calculating Steps For Unit CostsPlantwide Overhead Rates

  • 1st: Accumulate factory overhead costs in a single cost pool

  • 2nd: Select a single unit-level cost driver - direct labor hours is the most frequently-used driver

  • 3rd: Select activity level to use in calculating rate

  • 4th: Divide total overhead costs in pool by total activity level for selected driver

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Overhead Costs Unit Costs

Assign Costs

Plantwide Pool

Cost Assignment


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Applying Overhead To Unit CostsJobs & Products

  • To apply overhead means to charge, assign or “attach it” to a job, product, service, etc.

  • The total overhead assigned to actual production at any point in time is called “applied overhead”

  • Applied overhead is calculated as follows:

    Total Applied = Overhead Rate x Actual Activity Output

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Overapplied & Underapplied Overhead Unit Costs

  • Overhead Variance

    - The difference between the total actual overhead incurred and the total applied overhead assigned to production

  • Underapplied Overhead

    - If the actual overhead is greater than the the total applied overhead

  • Overapplied Overhead

    - If the actual overhead is less than the the total applied overhead

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Calculation of Per Unit Costs Unit Costs

  • 1st Step: Add total prime costs (direct materials and direct labor) plus assigned overhead

  • 2nd Step: Divide the total costs calculated in the first step by the total number of units produced

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Calculating Steps For Unit CostsDepartmental Overhead Rates

  • 1st: Assign factory overhead costs to the production departments

    - Use direct tracing, driver tracing and cost allocation to assign (distribute) overhead costs to departments

  • 2nd: Select the most appropriate single unit- level cost drivers for each department - different drivers often are used for each department

  • 3rd: Select activity levels to use in calculating each department’s rate

  • 4th: Divide total overhead costs in each pool by total activity levels for selected drivers

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Total Applied Overhead Unit CostsWhen Departmental Rates Are Used

  • Total applied overhead for the year is simply the sum of the amounts applied in each department

  • In the case of a normal cost system, the applied overhead will equal the budgeted overhead only when the actual level of activity output measures are the same as the expected activity output measures

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Limitations of Traditional Unit CostsCost Accounting Systems

  • The use of plantwide and departmental overhead rates continue to work satisfactorily for many companies

  • But for companies operating in an advanced manufacturing environment traditional cost systems often are inadequate and cause the company to operate with severe competitive disadvantages

  • Activity-Based Costing is a contemporary approach that has been developed to deal with this new and challenging environment