TRADITIONAL PRODUCT COSTING METHODS

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TRADITIONAL PRODUCT COSTING METHODS

• 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 CostsTo 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 CostsTo 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

• 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

• 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 LaborIn 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 Of 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

• 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 CalculatedMonthly 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

• 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

• 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

• 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 Assign 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 ActivityReflected 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 LevelOn 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 ForPlantwide 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
Assign Costs
Plantwide Pool
Cost Assignment
Products
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Applying Overhead To Jobs 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

• 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

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

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Total Applied OverheadWhen 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 Cost 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

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