Cost Concepts and Cost Allocation

1
Chapter 20

• Cost Concepts and Cost Allocation

2
Cost Information and the Management Cycle

• Objective 1
• Describe how managers use information about costs
  in the management cycle

3
Use of Cost Information in the Management Cycle

• During the management cycle, managers use
  information about costs to
• Plan
• Execute
• Review
• Report

4
Planning

• Manufacturing companies
• Mangers use estimates of product costs to
• Develop budgets for production, materials, labor,
  and overhead
• Determine the selling price or sales level
  required to cover all costs (if thats within the
  companys control).

5
Planning (contd)

• Retail companies
• Managers use estimates of the cost of merchandise
  purchases to
• Develop budgets for purchases and net income
• Determine the selling prices or sales units
  required to cover all costs

6
Planning (contd)

• Service organizations
• Managers use the estimated costs of rendering
  services to
• Develop budgets
• Estimate revenues
• Manage the organization's work force

7
Executing

• Manufacturing companies
• Managers use estimated product costs to
• Predict the gross margin and operating income on
  sales
• Make decisions about matters such as
• Dropping a product line
• Outsourcing the manufacture of a part
• Bidding on a special order
• Negotiating a selling price

8
Executing (contd)

• Retail companies
• Managers use the estimated cost of merchandise
  purchases to
• Predict the gross margin, operating income, and
  the value of merchandise sold
• Make decisions about matters such as
• Reducing selling prices for clearance sales
• Lowering selling prices for bulk sales
• Dropping a product line

9
Executing (contd)

• Service organizations
• Managers use the estimated cost of services to
• Estimate profitability
• Make decisions about matters such as
• Bidding on future business
• Lowering or negotiating fees
• Dropping a service

10
Reviewing

• Managers want to know about significant
  differences between estimated costs and actual
  costs
• Identification of variances helps determine the
  causes of overruns
• Useful in order to avoid such problems in the
  future

11
Reporting

• Managers expect to see the following reports
• Income statements that show actual costs of
  operating activities
• Balance sheets that show the value of inventory
• Performance reports that summarize the variance
  analyses done in the reviewing stage

12
Cost Information and Organizations

• Manufacturing organizations
• Need information about the costs of manufacturing
  products
• Include costs of
• Direct materials (DM or RM raw materials)
• Direct labor (DL)
• Manufacturing overhead (MOH or just OH also
  known as Factory Overhead)

13
Cost Information and Organizations (contd)

• Retail organizations
• Need information about the costs of purchasing
  products for resale
• These costs include
• Adjustments for freight-in costs (Debit Inventory
  for these costs Freight-out costs, on the other
  hand, are usually a Selling Expense)
• Purchase returns and allowances
• Purchase discounts

14
Cost Information and Organizations (contd)

• Service organizations
• Need information about the costs of providing
  services
• These include costs of
• Labor
• Related overhead

15
Cost Information and Organizations (contd)

• Other costs these organizations incur include the
  costs of
• Marketing
• Distributing
• Installing and repairing a product
• Supporting the delivery of services

Ultimately, a company is profitable only when its
revenues from sales or services rendered exceed
all costs
16
Discussion

• During the reviewing stage of the management
  cycle, what information would managers want
  regarding product costs?

17
Discussion

• During the reviewing stage of the management
  cycle, what information would managers want
  regarding product costs?
• Managers want to know about significant
  differences between estimated costs and actual
  costs. This helps determine the causes of
  overruns and is useful in order to avoid such
  problems in the future

18
Cost Classifications and Their Uses

• Objective 2
• Explain how managers classify costs and how they
  use these cost classifications

19
Cost Classifications and Their Uses

• A single cost can be classified and used in
  several ways
• Depends on the purpose of the analysis

20
Overview of Cost Classifications
21
Cost Classifications and Their Uses

• These classifications enable managers to
• Control costs
• By determining which are traceable to a
  particular cost object, such as a service or
  product
• Calculate the number of units that must be sold
  (the volume) to obtain a certain level of profit
• Identify the costs of activities that do and do
  not add value to a product or service
• Classify the costs for the preparation of
  financial statements

22
Cost Traceability

• Managers trace costs to cost objects to develop a
  fairly accurate measurement of costs
• Cost objects include
• Products or services
• Sales territories
• Departments
• Operating activities
• Both direct and indirect measures of costs are
  used to support
• Pricing decisions
• Decisions to reallocate resources to other cost
  objects

23
Direct Costs

• are costs that can be conveniently and
  economically traced to a cost object
• Example
• Cost object
• A Southwest Airlines flight
• Direct costs
• Wages of the flight crew
• Time worked and hourly wages are shown on time
  cards and payroll records
• Jet fuel costs

24
Indirect Costs

• are costs that cannot be conveniently and
  economically traced to a cost object
• Examples
• Nails used in furniture
• Salt used in cookies
• Rivets used in airplanes

25
Indirect Costs (contd)

• Must be included in the cost of a product or
  service
• For the sake of accuracy
• Are assigned using a formula
• Example
• Insurance costs for Southwest Airlines
• A portion is assigned to each flight flown

26
Illustrations of Cost Traceability

• Service organization
• Cost object
• Preparation of tax returns
• Direct costs
• Paper, computer usage, and accountant's labor
• Indirect costs
• Supplies, office rental, utilities, secretarial
  labor, telephone usage, and depreciation of
  office furniture

27
Illustrations of Cost Traceability

• Retail organization
• Cost object
• Shoe department
• Direct costs
• Shoes and wages of employees working in shoe
  department
• Indirect costs
• Utilities, insurance, property taxes, storage,
  and handling

28
Illustrations of Cost Traceability

• Manufacturing organization
• Cost object
• Product
• Direct costs
• Costs of materials and labor
• Indirect costs
• Utilities, depreciation of plant equipment,
  insurance, property taxes, inspection,
  supervision, maintenance of machinery, storage,
  and handling

29
Cost Behavior

• is the way costs respond to changes in volume,
  i.e. activity (the x-axis see slide 32)
• Managers analyze the patterns of cost behavior to
  gain information
• How changes in selling prices or operating costs
  affect net income
• Adjustments can then be made to obtain a certain
  level of profit

Costs can be separated into fixed and variable
costs
30
Income Statement

• Sales Revenue
• - COGS (product costs see slide 42)
• _____________
• GM (or GP)
• - Operating Expenses (period costs, see slide 43)
• _____________
• Net Income

31
Cost Behavior (contd)

• Variable cost
• A cost that changes in direct proportion to a
  change in productive output, i.e. volume or
  activity (or any other measure of output)
• Fixed cost
• A cost that remains constant within a defined
  range of activity or time period

32
Variable CostsNote a straight line has a
constant slope (cost per unit slope (y2-y1) /
(x2-x1))
33
Fixed Costs Note fixed costs are always the
same (100 here, within the relevant range)
34
Examples of Variable and Fixed Costs

• Landscaping business
• Variable costs
• Landscaping materials and labor to plant the
  materials
• Fixed costs
• Depreciation on trucks and equipment, rent,
  insurance, and property taxes

As more trees are planted, variable costs will
increase proportionally
Fixed costs will remain the same for a specified
period
35
Examples of Variable and Fixed Costs (contd)

• Used-car dealer
• Variable costs
• Cars sold and sales commissions
• Fixed costs
• Building and lot rental, depreciation on office
  equipment, and receptionists and accountants
  salaries

As more cars are sold, variable costs will
increase proportionally
Fixed costs will remain the same for a specified
period
36
Examples of Variable and Fixed Costs (contd)

• Lawn-mower manufacturer
• Variable costs
• Direct materials, direct labor, indirect
  materials, and indirect labor
• Fixed costs
• Supervisor's salaries and depreciation on office
  buildings

As the output of products is increased, variable
costs will increase proportionally
Fixed costs will remain the same for a specified
period
37
Value-Adding Versus Nonvalue-Adding Costs

• Value-adding cost
• The cost of an activity that increases the market
  value of a product or service
• Nonvalue-adding cost
• The cost of an activity that adds cost to a
  product or service but does not increase its
  market value

Example Depreciation of a machine that shapes a
part used in the final product
Example Depreciation of a car used by the sales
department
38
Value-Adding Versus Nonvalue-Adding Costs (contd)

• Managers examine value-adding attributes of
  operating activities
• Wherever possible, reduce or eliminate
  nonvalue-adding activities
• Identify characteristics of products or services
  customers are willing to pay for

This information influences the design of future
products or services
39
Value-Adding Versus Nonvalue-Adding Costs (contd)

• Costs incurred to improve the quality of a
  product
• Are value-adding only if the customer is willing
  to pay more for the higher-quality product
• Otherwise, are nonvalue-adding costs
• Because they do not increase the products market
  value

40
Value-Adding Versus Nonvalue-Adding Costs (contd)

• Costs of administrative activities (such as
  accounting and human resources)
• Are nonvalue-adding costs
• But, are necessary for the operation of the
  business and cannot be eliminated

41
Cost Classification for Financial Reporting

• Managers classify costs as product or period
  costs for financial reporting purposes

42
Cost Classification for Financial Reporting
(contd)

• Product costs
• Costs assigned to inventory
• Include direct materials, direct labor, and
  manufacturing overhead
• Also called inventoriable costs
• Financial reporting of product costs
• Income statement
• Appear as cost of goods sold (see slide 30)
• Balance sheet
• Appear as finished goods inventory (i.e., e.b. of
  Inventory)

43
Cost Classification for Financial Reporting
(contd)

• Period costs
• Costs of resources used during the accounting
  period
• Include selling and administrative costs
• Also called noninventoriable costs
• Financial reporting of period costs
• Income statement
• Appear as operating expenses (see slide 30)

44
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45
Discussion

• What is the difference between a direct cost and
  an indirect cost?
• Direct cost
• Can be easily and economically traced to a
  specific product
• Indirect cost
• Cannot be easily and economically traced to a
  specific product

46
Elements of Product Costs

• Objective 3
• Define and give examples of the three elements of
  product cost and compute the unit cost of a
  product

47
Elements of Product Cost

• Direct materials (DM)
• Direct labor (DL)
• Manufacturing overhead (OH)
• Indirect costs

48
Direct Materials Costs

• are the costs of materials used in making a
  product that can be conveniently and economically
  traced to specific units of the product
• Examples
• Iron ore used in making steel
• Sheet metal used in making automobiles
• Sugar used in making candy

49
Direct Labor Costs

• are the costs of labor
  needed to make a product that can be conveniently
  and economically traced
  to specific units of the product
• Examples
• Wages of machine operators and production-line
  workers

50
Manufacturing Overhead Costs

• are production-related costs that cannot be
  conveniently and economically traced to specific
  units of the product
• Also called factory overhead, factory burden, or
  indirect manufacturing costs

51
Manufacturing Overhead Costs (contd)

• Include
• Indirect materials costs
• Nails, rivets, lubricants, and small tools
• Indirect labor costs
• Labor for machinery and tool maintenance,
  inspection, engineering design, supervision, and
  materials handling
• Other indirect manufacturing overhead costs
• Building maintenance, property taxes, property
  insurance, depreciation on plant and equipment,
  rent, and utilities

Manufacturing overhead costs are indirect costs
that are allocated to a products cost using
traditional or activity-based costing methods
52
Illustration of Product Costs and the
Manufacturing Process

• The following elements of the product cost of one
  candy bar have been identified for Candy Company,
  Inc.
• Direct materials costs
• Sugar, chocolate, and wrapper
• Direct labor costs
• Costs of labor in making the candy bar
• Manufacturing overhead costs
• Indirect materials costs
• Salt and flavorings
• Indirect labor costs
• Moving materials to production area and
  inspection during production
• Other indirect overhead costs
• Depreciation on building and equipment,
  utilities, property taxes, and insurance

53
Computing Product Unit Cost, i.e. Product Cost
per Unit

• Product unit cost
• The cost of manufacturing a single unit of a
  product
• Includes
• Costs of direct materials, direct labor, and
  manufacturing overhead
• These costs are accumulated as a batch of
  products is being produced
• Computed when batch is completed by one of two
  ways
• Dividing total accumulated costs by the total
  number of units produced
• Determining the cost per unit for each element of
  the product costs and summing those per-unit costs

54
Computing Product Unit Cost (contd)

• Unit cost information helps managers price
  products and calculate gross margin and net
  income
• Product unit cost can be calculated using
• Actual costing
• Normal costing
• Standard costing methods

55
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56
Actual Costing Method

• uses the costs of direct materials, direct
  labor, and manufacturing overhead at the
  end of an accounting period or when
  actual costs become known to calculate the
  product unit cost
• The actual product unit cost is assigned to
• The finished goods balance on the balance sheet
• Cost of goods sold on the income statement

57
Illustration of Actual Costing Method
Candy Company, Inc. produced 3,000 candy bars on
December 28, 20x6, for a customer in Seattle.
The companys accountant calculated that the
actual costs for the order were direct materials,
540 direct labor, 420 and manufacturing
overhead, 240
Calculate the actual product unit cost for the
order



58
Illustration of Actual Costing Method
Candy Company, Inc. produced 3,000 candy bars on
December 28, 20x6, for a customer in Seattle.
The companys accountant calculated that the
actual costs for the order were direct materials,
540 direct labor, 420 and manufacturing
overhead, 240

• In this case, the job was completed and all cost
  information was known
• If production were still underway and actual
  manufacturing overhead costs are uncertain, use
  an estimate of manufacturing overhead costs
• The normal costing method

59
Normal Costing Method

• combines actual direct costs of materials and
  labor with estimated manufacturing overhead costs
  to determine a product unit cost

60
Normal Costing Method

• Is simple
• Allows smoother, more even assignment of
  manufacturing overhead costs to production during
  the accounting period than with the actual
  costing method
• Contributes to better pricing decisions and
  profitability estimates

61
Illustration of Normal Costing Method
Candy Company, Inc. produced 3,000 candy bars on
December 28, 20x6, for a customer in Seattle.
The companys accountant calculated that the
actual costs for the order were direct materials,
540, and direct labor, 420. Manufacturing
overhead is applied using an estimated rate of 60
percent of direct labor costs
Calculate the product unit cost for the order
Estimated manufacturing overhead cost is 252
(420 DL cost x 60)



62
Illustration of Normal Costing Method
Candy Company, Inc. produced 3,000 candy bars on
December 28, 20x6, for a customer in Seattle.
The companys accountant calculated that the
actual costs for the order were direct materials,
540, and direct labor, 420. Manufacturing
overhead is applied using an estimated rate of 60
percent of direct labor costs

• In this case
• Direct materials and labor costs were actual
  costs
• Manufacturing overhead costs were estimated
• If actual costs are not available for direct
  materials and direct labor, the standard costing
  method must be used

63
Standard Costing Method

• uses estimated, or standard, costs of direct
  materials, direct labor, and manufacturing
  overhead to calculate the product unit cost
• Useful when product cost information is desired
  before the accounting period begins to
• Control the cost of operating activities
• Price a proposed product for a customer

64
Illustration of Standard Costing Method
Candy Company, Inc. is placing a bid to
manufacture 2,000 candy bars for a new customer.
The companys accountant estimated the following
costs direct materials, .20 per unit direct
labor, .15 per unit. Manufacturing overhead is
applied using an estimated rate of 60 percent of
direct labor costs
Calculate the product unit cost for the order
Est. manufacturing overhead cost is .09 per unit
(.15 DL cost x 60)



65
Prime Costs and Conversion Costs

• Prime costs
• The costs of production
• Direct materials costs
• Direct labor costs
• Conversion costs
• The costs of converting direct materials into a
  finished product
• Direct labor costs
• Manufacturing overhead costs

66
Prime Costs and Conversion Costs (contd)
Below are the per-unit prime costs and conversion
costs for Candy Company, using figures for actual
unit cost
67
Relationships Among Product Cost Classifications
68
Discussion

• What are the differences between the actual
  costing, normal costing, and standard costing
  methods for calculating product unit cost?

69
Discussion

• What are the differences between the actual
  costing, normal costing, and standard costing
  methods for calculating product unit cost?
• Actual costing
• Costs used for direct materials, direct labor,
  and manufacturing overhead are all actual costs
• Normal costing
• Costs used for direct materials and direct labor
  are actual costs and an estimate is used for
  manufacturing overhead
• Standard costing
• Costs used for direct materials, direct labor,
  and manufacturing overhead are all estimated costs

70
Inventory Accounts in Manufacturing Organizations

• Objective 4
• Describe the flow of costs through a
  manufacturer's inventory accounts

71
Inventory Accounts in Manufacturing Organizations

• Production and production-related activities
  include
• Purchasing, receiving, inspecting, storing, and
  moving materials
• Converting materials into finished products using
  labor, equipment, and other resources
• Moving, storing, and shipping finished products

Materials Inventory account
Work in Process account
Finished Goods Inventory account
A manufacturing organizations accounting system
tracks these activities as product costs flowing
through inventory accounts
72
Inventory Accounts in Manufacturing Organizations
(contd)

• Materials Inventory account
• Shows the balance of the cost of unused materials
• Work in Process account
• Shows the manufacturing costs that have been
  incurred and assigned to partially completed
  units of product
• Finished Goods Inventory account
• Shows the costs assigned to all completed
  products that have not been sold

73
Inventory T-accounts for a Manufacturer
Manufacturing Cost Flow
74
Activities, Documents, and Cost Flows Through the
Inventory Accounts of a Manufacturing Organization
75
The Manufacturing Cost Flow

• is the flow of manufacturing costs through the
  Materials Inventory, Work in Process Inventory,
  and Finished Goods Inventory accounts into the
  Cost of Goods Sold account (see slide 73)
• A defined, structured manufacturing cost flow is
  the foundation for product costing, inventory
  valuation, and financial reporting

Manufacturing costs include direct materials,
direct labor, and manufacturing overhead
76
The Manufacturing Cost Flow also note the
beginning balances
100,000
250,000
200,000
50,000
During the period, direct materials that cost
200,000 are purchased, increasing the account
Because there are no indirect materials in this
case, the Materials Inventory account shows the
balance of unused direct materials
20,000
Direct materials that cost 250,000 are used in
production, decreasing the account
78,000
77
The Manufacturing Cost Flow
100,000
250,000
120,000
120,000
200,000
50,000
0
20,000
As direct materials and direct labor are used,
their costs are added to the Work in Process
Inventory account
The Work in Process account records the balance
of partially completed units of the product
250,000
120,000
78,000
78
The Manufacturing Cost Flow
100,000
250,000
120,000
120,000
60,000
60,000
200,000
50,000
0
0
Total manufacturing costs equal the total costs
of direct materials, direct labor, and
manufacturing overhead transferred to work in
process inventory during an accounting period
20,000
The cost of manufacturing overhead incurred
during an accounting period is also added to the
Work in Process Inventory account
250,000
120,000
60,000
78,000
Also called current manufacturing costs
79
The Manufacturing Cost Flow
100,000
250,000
120,000
120,000
60,000
60,000
200,000
50,000
0
0
Total manufacturing costs are equal to the total
costs of direct materials, direct labor, and
manufacturing overhead transferred to work in
process inventory during an accounting period
20,000
Total manufacturing costs for the current period
equal 430,000 (250,000 120,000 60,000)
250,000
120,000
60,000
78,000
80
The Manufacturing Cost Flow
100,000
250,000
120,000
120,000
60,000
60,000
200,000
50,000
0
0
Cost of goods manufactured for the period
decreases the Work in Process Inventory account
and increases the Finished Goods Inventory account
Cost of goods manufactured is the cost of all
units completed and moved to finished goods
storage during an accounting period
20,000
300,000
250,000
120,000
60,000
150,000
78,000
300,000
81
The Manufacturing Cost Flow
100,000
250,000
120,000
120,000
60,000
60,000
200,000
50,000
0
0
As units of product are sold, the cost of the
goods sold decreases the Finished Goods Inventory
account and increases the Cost of Goods Sold
account
The Finished Goods Inventory account holds the
balance of costs assigned to all completed units
of product that have not yet been sold
20,000
300,000
250,000
120,000
60,000
150,000
240,000
78,000
240,000
300,000
138,000
82
The Manufacturing Cost Flow
100,000
250,000
120,000
120,000
60,000
60,000
200,000
50,000
0
0
As units of product are sold, the cost of the
goods sold decreases the Finished Goods Inventory
account and increases the Cost of Goods Sold
account
The Finished Goods Inventory account holds the
balance of costs assigned to all completed units
of product that have not yet been sold
20,000
300,000
250,000
120,000
60,000
150,000
240,000
78,000
240,000
300,000
138,000
83
Manufacturing Cost Flow An Example Using Actual
Costing for Candy Company, Inc.
84
Discussion

• Define total manufacturing costs
• The total costs of direct materials, direct
  labor, and manufacturing overhead transferred
  into work in process inventory during an
  accounting period

85
Financial Statements and the Reporting of Costs

• Objective 5
• Compare how service, retail, and manufacturing
  organizations report costs on their financial
  statements and how they account for inventories

86
Financial Statements and the Reporting of Costs

• Statement of goods manufactured
• A special report based on an analysis of the Work
  in Process Inventory account
• Used to calculate the dollar amount of the cost
  of goods manufactured
• This amount is key to preparing an income
  statement for a manufacturing organization

87
Statement of Cost of Goods Manufactured

• summarizes the flow of all manufacturing costs
  incurred during an accounting period
• Is prepared at the end of the period

88
Statement of Cost of Goods Manufactured (same as
slide 73)
Step 1
Step 2
Step 3
It is helpful to think of the statement of cost
of goods manufactured as being developed in three
steps
89
Steps in Developing the Statement of Cost of
Goods Manufactured

• Step 1
• Compute the cost of direct materials used during
  the accounting period

Cost of Materials Available for Use During the
Period (sum of b.b. in RM and purchases on slide
73)
90
Step 1
91
Steps in Developing the Statement of Cost of
Goods Manufactured

• Step 2
• Calculate total manufacturing costs for the period

92
Step 2
93
Steps in Developing the Statement of Cost of
Goods Manufactured

• Step 3
• Determine total cost of goods manufactured for
  the period

94
Step 3
95
Big Picture

• Put slides 90, 92, and 94 together and the COGS
  T-account, too !!!!

96
Comparison of Total Manufacturing Costs and Cost
of Goods Manufactured
Total Manufacturing Costs
Cost of Goods Manufactured

• All manufacturing costs incurred during an
  accounting period, regardless of whether units
  were completed or not
• Is equal to direct materials, direct labor, and
  manufacturing overhead costs incurred during
  production for a period

• Total manufacturing costs attached to units
  completed during an accounting period
• Is equal to total manufacturing costs for the
  period plus the cost of beginning work in process
  less the cost of ending work in process

97
Cost of Goods Sold and a Manufacturing
Organizations Income Statement
The statement of cost of goods manufactured must
be prepared before the income statement
The total amount of cost of goods manufactured
during a period is then carried over to the
income statement
On the income statement, it is used to compute
the cost of goods sold
98
Cost Reporting and Accounting for Inventories in
Service, Retail, and Manufacturing Organizations

• Service, retail, and manufacturing organizations
  have differing operations therefore, the
  accounts represented in the financial statements
  differ.

99
Service Organizations

• Sell services, not products
• No inventory on balance sheet
• Calculate cost of sales rather than cost of goods
  sold

Cost of Sales Net Cost of Services Sold
Includes expenses such as wages and salaries of
personnel, expenses of any equipment used, and
supplies
100
Retail Organizations

• Purchase product ready for resale
• Only one inventory account on the balance sheet
• Merchandise Inventory account
• Use the following equation to calculate cost of
  goods sold

The Merchandise Inventory account reflects the
cost of goods held for resale
101
Manufacturing Organizations

• Make products for sale
• Maintain three inventory accounts on the balance
  sheet
• Materials Inventory (RM)
• Shows the balance of the cost of materials
  purchased but not yet used in production
• Work in Process Inventory
• Accumulates the costs of manufacturing the
  product
• Finished Goods Inventory
• Shows the cost of unsold, completed units of
  product

102
Manufacturing Organizations

• Use the following equation to calculate cost of
  goods sold

103
Cost Reporting and Accounting for Inventories in
Service, Retail, and Manufacturing Organizations

• Income statement
• All organizations use the following format
• Product costs, or inventoriable costs, appear as
  cost of goods sold
• Period costs, or noninventoriable costs, are
  reflected in the operating expenses
• Balance sheet
• Product costs, or inventoriable costs, appear as
  finished goods inventory

104
Financial Statements of Service, Retail, and
Manufacturing Organizations
105
Cost Allocation

• Objective 6
• Define cost allocation and explain how cost
  objects, cost pools, and cost drivers are used to
  assign manufacturing overhead costs

106
Cost Allocation

• is the process of assigning manufacturing
  overhead costs to the product (cost object)
  during an accounting period
• Requires
• The pooling of manufacturing costs that are
  affected by a common activity
• Selecting a cost driver whose activity level
  causes a change in the cost pool

107
Cost Allocation (contd)

• Cost object
• Anything to which costs attach or are related
• Product, service, department, operating activity,
  etc.
• Cost driver
• Any activity that causes a cost to be incurred
• Direct labor hours, direct labor costs, units
  produced, etc.
• Cost pool
• The collection of indirect costs assigned to a
  cost object
• Cost allocation
• The process of assigning the costs in a cost pool
  to the cost object using the cost driver

108
Cost Allocation (contd)
Candy Company has a machine-maintenance cost
pool. The cost pool consists of overhead costs
for the supplies and labor needed to maintain the
machines

• Machine hours increase during the accounting
  period as candy is produced
• As machine hours increase, the costs in the
  machine maintenance cost pool increase in amount
• The result is increased costs assigned to the
  product (candy)

109
Allocating the Costs of Manufacturing Overhead

• Four-step process
• Corresponds to the four stages of the management
  cycle
• Planning stage
• Managers estimate manufacturing overhead costs
  and calculate a rate at which to assign those
  costs to products
• Executing stage
• This rate is applied to products as manufacturing
  overhead costs are incurred and recorded during
  production
• Reviewing stage
• Actual manufacturing overhead costs are recorded
  as they are incurred and managers calculate the
  difference between the estimated and actual costs
• Reporting stage
• Managers report on this difference

110
Planning the Overhead Rate

• Before an accounting period begins
• Determine cost drivers and cost pools
• Calculate a manufacturing overhead rate
• Cost pool of total estimated overhead costs
  Total estimated cost driver level

Journal Entry No journal entry is required No
business activity has taken place
111
Applying the Overhead Rate

• During the accounting period as units are
  produced
• Apply manufacturing overhead costs to production
• Predetermined overhead rate for each cost pool x
  Cost pools actual cost driver level
• Assigns a consistent manufacturing overhead cost
  to each unit produced during the accounting period

Journal Entry Increase (debit) Work in Process
Inventory Decrease (credit) Manufacturing
Overhead
112
Recording Actual Overhead Costs

• During the accounting period as costs are
  incurred
• Record actual manufacturing overhead costs when
  incurred
• Include costs of indirect materials, indirect
  labor, depreciation, property taxes, and other
  production costs

Journal Entry Increase (debit) Manufacturing
Overhead Decrease (credit) asset account or
increase (credit) contra-asset or liability
accounts
113
Reconciling the Applied and Actual Overhead
Amounts

• At the end of the accounting period
• Calculate and record the difference between the
  applied and actual manufacturing overhead (MOH)
  amounts
• OH T-account _____OH_______--
• Actual
  Applied

114
Reconciling the Applied and Actual Overhead
Amounts - p. 853, Step 4

• Applied MOH gt Actual MOH
• Overapplied overhead costs
• If difference is immaterial, increase (debit)
  Manufacturing Overhead and decrease (credit) Cost
  of Goods Sold (works similarly to zeroing out
  accounts from financial accounting)
• If material, adjustments are made to the affected
  accounts
• Work in Process Inventory, Finished Goods
  Inventory, and Cost of Goods Sold

115
Reconciling the Applied and Actual Overhead
Amounts - p. 853, Step 4

• Applied MOH lt Actual MOH
• Underapplied overhead costs
• If difference is immaterial, decrease (credit)
  Manufacturing Overhead and increase (debit) Cost
  of Goods Sold (works similarly to zeroing out
  accounts from financial accounting)
• If material, adjustments are made to the affected
  accounts
• Work in Process Inventory, Finished Goods
  Inventory, and Cost of Goods Sold

116
The Importance of Good Estimates

• A predetermined, or estimated, manufacturing rate
  has two main uses
• Enables managers to make decisions about pricing
  products and controlling costs before some of the
  actual costs are known
• Allows managers to apply manufacturing overhead
  costs to each unit produced in an equitable and
  timely manner

117
The Importance of Good Estimates

• The successful allocation of manufacturing
  overhead costs depends on two factors
• A careful estimate of the total manufacturing
  overhead costs
• A good forecast of the cost driver level

118
The Importance of Good Estimates (contd)

• If the estimate of total manufacturing overhead
  costs is wrong, the overhead rate will be wrong
• Results in over- or understatement of the product
  unit cost
• Overstated product unit cost may result in
  failure to bid on profitable projects
• Understated product unit cost may result in
  accepting projects that are not as profitable as
  expected

119
The Importance of Good Estimates (contd)

• An underestimated cost drive level will cause an
  overstatement of the predetermined manufacturing
  rate
• The cost is spread over a lesser level
• An overestimated cost drive level will cause an
  understatement of the predetermined manufacturing
  rate
• The cost is spread over a greater level

120
Discussion

• What is cost allocation?
• The process of assigning manufacturing overhead
  costs to the product during an accounting period
• Manufacturing overhead costs are accumulated in
  a cost pool and assigned to the cost object using
  the cost driver

121
Allocating Manufacturing Overhead Using the
Traditional Approach

• Objective 7
• Using the traditional method of allocating
  manufacturing overhead costs, calculate product
  unit cost

122
Allocating Manufacturing Overhead Using the
Traditional Approach

• Traditional approach
• Uses a single predetermined overhead rate
• Useful when companies manufacture
• One product
• A few similar products requiring the same
  production processes and production-related
  activities
• Total manufacturing costs constitute one cost
  pool
• A traditional activity base is the cost driver
• Direct labor hours, direct labor costs, machine
  hours, units of production

123
Allocating Manufacturing Overhead Using the
Traditional Approach (contd)
Candy Company will be selling two product lines
in 20x7plain candy bars and candy bars with
nuts. The company accountant has decided that
the cost driver will be direct labor hours, and
estimates that total manufacturing overhead costs
for the next year will be 20,000 and total
direct labor hours worked will be 400,000 hours

• Step 1
• Estimate manufacturing overhead costs and
  calculate a rate at which to assign those costs
  to products

124
Allocating Manufacturing Overhead Using the
Traditional Approach (contd)
During the year, Candy Company used 250,000
direct labor hours to produce 100,000 plain candy
bars and 150,000 direct labor hours to produce
50,000 candy bars with nuts

• Step 2
• Apply the overhead rate to products as
  manufacturing overhead costs are incurred and
  recorded during production

Manufacturing overhead applied to plain candy bars
Manufacturing overhead applied to candy bars with
nuts
125
Allocating Manufacturing Overhead Using the
Traditional Approach (contd)
Actual direct materials costs per unit for
regular candy bars and candy bars with nuts were
.18 and .21, respectively, and actual direct
labor costs per unit were .14 and .16,
respectively
Calculate product unit cost using normal costing
The product unit cost of the candy bars with nuts
is higher because they required more expensive
materials and more labor time
126
Discussion

• What types of companies might use the traditional
  approach of product costing?
• Because only one cost pool is used for
  manufacturing overhead costs, only companies that
  manufacture one product or a few similar products
  requiring the same production processes and
  production-related activities would use the
  traditional approach

127
Allocating Manufacturing Overhead Using ABC

• Objective 8
• Using activity-based costing to assign
  manufacturing overhead costs, calculate product
  unit cost

128
Allocating Manufacturing Overhead Using ABC

• Activity-based costing (ABC)
• Is a more accurate method of assigning overhead
  costs to products than the traditional approach
• Uses several smaller cost pools for manufacturing
  overhead costs
• Traditional approach uses one cost pool
• Improves accuracy of product cost estimates for
  companies
• Selling many different types of products
• That use many varying, significant amounts of
  different production-related activities

129
Activity Based-Costing

• is a way of assigning cost that identifies all
  of a companys major operating activities, traces
  costs to those activities, reduces or
  eliminates nonvalue-adding activities, and then
  determines which products use the resources and
  services supplied by those activities

130
Allocating Manufacturing Overhead Using ABC
(contd)

• ABC categorizes all indirect costs by activity
• The indirect costs are traced to those activities
• Activity costs are assigned to products using
  cost drivers related to the cause of the cost

131
Allocating Manufacturing Overhead Using ABC
(contd)

• Companies using ABC identify production-related
  activities and the events and circumstances that
  cause (drive) those activities
• Production-related activities
• Setup, inspections, building, etc.
• Events and circumstances that cause (drive) those
  activities
• Number of setups, number of inspections, machine
  hours, etc.

Many smaller activity pools are created from the
single manufacturing cost pool used in the
traditional approach
132
Allocating Manufacturing Overhead Using ABC
(contd)

• An overhead rate is calculated for each activity
  pool
• The portion of manufacturing overhead costs
  assigned to a product is determined using that
  rate and a cost driver amount

An overhead rate is also called an activity cost
rate
133
Allocating Manufacturing Overhead Using ABC
(contd)

• An appropriate number of activity pools must be
  selected
• A system must be designed to capture the actual
  cost driver amounts
• The benefit of greater accuracy from several
  smaller cost pools is offset by the additional
  costs of measuring many different cost drivers

134
Using ABC to Assign Manufacturing Overhead Costs
to Production
135
Planning Overhead Rates
Candy Company will be selling two product lines
in 20x7plain candy bars and candy bars with
nuts. ABC will be used to assign manufacturing
overhead costs to four activity pools setup,
inspection, packaging, and building. Estimated
total manufacturing overhead costs are 20,000
Total activity costs are estimated for each
activity pool
136
Planning Overhead Rates
Candy Company will be selling two product lines
in 20x7plain candy bars and candy bars with
nuts. ABC will be used to assign manufacturing
overhead costs to four activity pools setup,
inspection, packaging, and building. Estimated
total manufacturing overhead costs are 20,000
Cost drivers are selected for each activity pool
and the level of each is estimated
137
Planning Overhead Rates
Candy Company will be selling two product lines
in 20x7plain candy bars and candy bars with
nuts. ABC will be used to assign manufacturing
overhead costs to four activity pools setup,
inspection, packaging, and building. Estimated
total manufacturing overhead costs are 20,000

• Step 1
• Calculate activity cost rate for cost pool

138
Planning Overhead Rates
Candy Company will be selling two product lines
in 20x7plain candy bars and candy bars with
nuts. ABC will be used to assign manufacturing
overhead costs to four activity pools setup,
inspection, packaging, and building. Estimated
total manufacturing overhead costs are 20,000

• Step 1
• Calculate activity cost rate for cost pool

139
Planning Overhead Rates
Candy Company will be selling two product lines
in 20x7plain candy bars and candy bars with
nuts. During the year, Candy Company will produce
100,000 plain candy bars and 50,000 candy bars
with nuts

• Step 2
• Apply predetermined activity cost rates to
  products

7,100 100,000 .071
12,900 150,000 .258
140
Applying Overhead Rates (contd)
Actual direct materials costs per unit for
regular candy bars and candy bars with nuts were
.18 and .21, respectively, and actual direct
labor costs per unit were .14 and .16,
respectively
Calculate product unit cost using normal costing
The product unit cost of the candy bars with nuts
is higher because the changes in ingredients
require more setups and machine hours and because
more inspections are needed to test the candy
quality
141
Applying Overhead Rates (contd)
Compare product unit cost using the traditional
approach and ABC

• ABC is more accurate
• More costs are assigned to the product line that
  uses more resources

142
Discussion

• What is one advantage and one disadvantage of
  using ABC over the traditional approach?
• Advantage
• More accurate because more cost pools are used
• Disadvantage
• More costly to implement. Because more cost
  pools are used, more estimates and calculations
  are required

143
Cost Allocation in Service Organizations

• Objective 9
• Apply costing concepts to a service organization

144
Cost Allocation in Service Organizations

• Services performed in typical service
  organizations
• Processing loans
• Representing people in courts of law
• Selling insurance policies
• Preparing income tax returns

145
Cost Allocation in Service Organizations (contd)

• No products are manufactured
• No direct materials costs
• Services are performed
• Incur both labor and overhead costs
• These are included in the cost of providing
  services
• Direct labor is the most important cost
• Is traceable to the service rendered
• Indirect costs are similar to those in
  manufacturing a product

146
Cost Allocation in Service Organizations (contd)

• Indirect costs are classified as service overhead
• Are considered service costs rather than period
  costs
• Appear on income statement as cost of sales
• Direct labor is also a service cost that appears
  on the income statement as cost of sales

147
Cost Allocation in Service Organizations (contd)
The Loan Department of Campus Bank charges a 150
fee for processing a home loan application. The
chief loan officer thinks the fee is too low and
proposes that it be doubled
Compute the cost of processing a typical home
loan given the following information
The department usually processes 100 loan
applications per month
Because the department performs other functions,
only 25 of the overhead costs of the department
are applicable to processing home loan
applications
148
Cost Allocation in Service Organizations (contd)
The Loan Department of Campus Bank charges a 150
fee for processing a home loan application. The
chief loan officer thinks the fee is too low and
proposes that it be doubled
Compute the cost of processing a typical home
loan given the following information
149
Cost Allocation in Service Organizations (contd)
The Loan Department of Campus Bank charges a 150
fee for processing a home loan application. The
chief loan officer thinks the fee is too low and
proposes that it be doubled
The chief loan officer was correctthe fee is too
low
Doubling the fee may be too extreme. To allow
for a profit margin, the loan fee could be raised
to 225 or 250
150
Discussion

• Does the concept of product costs apply to
  service organizations?
• Yes. The concept is the same for both. However,
  service organizations do not manufacture a
  product and, therefore, do not have direct
  materials costs. They do incur direct labor
  costs (the most important cost in a service
  organization) and service overhead costs, which
  are similar to manufacturing overhead costs