Chapter 3

Organizational Cost Flows

Cost AccountingTraditions and Innovations

Barfield, Raiborn, Kinney

Learning Objectives (1 of 2)

• List the cost classifications

• Describe the conversion process in service and manufacturing companies

• Explain assumptions about cost behavior

• Analyze mixed costs– high-low method – least squares regression analysis

Learning Objectives (2 of 2)

• List product cost categories

• Allocate overhead costs

• Describe the cause and treatment of underapplied and overapplied overhead

• Prepare Statements of Cost of Goods Manufactured and Sold

Cost

Monetary measure of resources

given up to attain an objective

(such as acquiring a good or service)

Cost Categories

• Time of incidence

• Reaction to changes in activity

• Classification on the financial statements

• Impact on decision making

Cost Categories

• Time of incidence– Historical– Budgeted

Cost Categories

• Time of incidence

• Reaction to changes in activity– Variable– Fixed– Mixed – Step

Cost Categories

• Time of incidence

• Reaction to changes in activity

• Classification on the financial statements– Unexpired – Expired– Product– Period

Product Costs• Direct material

– Part of a product

• Direct labor– Labor used to manufacture a product or

perform a service

• Overhead– Indirect production cost

Period Costs• Selling and administrative costs

• Distribution costs– Cost to warehouse, transport, and/or deliver a

product or service– Major impact on managerial decision making

Purchaseraw materialsor supplies

Input

Product orService

Output

Conversion ProcessChange Inputs into Outputs

CONVERSION

Low Degree of Conversion

• Department stores

• Gas stations

• Jewelry stores

• Travel agencies

Moderate Degree of Conversion

• Florists

• Meat markets

• Oil-change businesses

High Degree of Conversion

• Manufacturing

• Construction

• Agriculture

• Architecture

• Auditing

• Mining

• Printing

• Restaurants

Service CompanySignificant amount of laborTangible or intangible output

Purchasesupplies

Use supplies,labor, overhead

to provide serviceSell to

customer

Input

Output

Retail CompanyPurchase finished goodsResell to customers

Purchaseproductsfor resale

Warehouseand/or display

Sell tocustomer

InputOutput

ManufacturerSignificant amount of labor and machinery Tangible output

Purchaseraw materialsand supplies

Finishedproduct

Sell tocustomer

Input Output

Production Center

add labor and overhead

Cost Accumulation in aManufacturing Company

MaterialsInventory

Work in ProcessInventory

FinishedGoods

Inventory

Cost of GoodsSold

Balance SheetIncome

Statement

Fixed Cost

Variable Cost

Cost Reaction to Changes in Activity

Unit Total

$

Units

$

$

$

Units

Units Units

Within the relevant range

Step Cost

Mixed Cost

Cost Reaction to Changes in Activity

$

$

Units

Unitsfixed

Within the relevant range

variable

Determining Cost Behavior

• Cost Predictor– Activity accompanied

by consistent, observable changes in a cost item

– Predicts but may not cause the cost to change

• Cost Driver– Activity that has a direct

cause-effect relationship on cost

– Directly causes the cost to change

Separating Mixed Costs

y = a + bX

y = total costa = fixed portion of total costb = variable costX = activity base to which y is related

Use formula for a straight line

Separating Mixed Costs

• High-Low Method– Actual cost observations– Considers only two data points

• highest and lowest levels of activity– Outliers should be disregarded when analyzing

mixed costs

CostVolumeHighLow

10,0002,000

$25,0009,000

Difference 8,000 $16,000

= $2/unit Variable cost per unit$16,000

8,000

25,000 = a + (2)(10,000) a = 5,000 Fixed cost

Y = 5,000 + 2X

Using the High Low Method

Product Cost

• Cost object - anything to which costs are attached or related

• Direct cost - traceable to a cost object

• Indirect cost - not conveniently or practically traceable to a cost object– treated as overhead

Product Cost - Direct

• Direct Material– Distinctly and conveniently traced to cost object

• Direct Labor – to manufacture a product or perform a service – includes wages paid to direct labor employees,

production bonuses, payroll taxes– may include holiday and vacation pay,

insurance, retirement benefits

Product Cost - Indirect

• Overhead - indirect production costs– Fringe benefits, if cannot be easily traced to

product– Overtime, if due to random scheduling– Cost of quality

Product Cost Behavior

• Direct Material Variable

• Direct Labor Variable

• Overhead Variable, fixed, mixed

Overhead Cost AllocationAssign indirect costs to one

or more cost objects• To determine full cost (GAAP)• To motivate management• To compare alternative courses of action for

planning, controlling, and decision making

Allocation process should be

rational and systematic

Allocating OverheadActual Cost System

Product Cost

• Direct Materials

• Direct Labor

• Overhead

Cost Used

• Actual

• Actual

• Actual

Allocating OverheadActual Cost System

• The Actual Cost System is not timely

• All costs must be known before calculating product cost

Allocating OverheadActual vs. Normal

Product Cost

Direct Materials

Direct Labor

Overhead

Actual Cost System

Actual

Actual

Actual

Normal Cost System

Actual

Actual

Predetermined

Overhead Rate

Predetermined Overhead Rate

• Allows overhead to be assigned during the period

• Compensates for fluctuations– that are not related to activity level– in activity level that do not affect fixed

overhead

Predetermined Overhead Rate

Total budgeted overhead

Activity level(Volume)

A budgeted, constant charge per unit of activity used to assign overhead to

production or services

Predetermined Overhead Rate

Total budgeted overhead

Activity level(Volume)

$500,000

100,000machine hours

= $5 per machine

hour

The Activity Level(The Denominator)

• Relationship between the overhead cost and the activity– production volume– direct labor hours– direct labor cost– machine hours

Overhead Account(Combined)

Actual Overhead Applied Overhead

Record actual overhead

Variable Overhead 15,000

Fixed Overhead 10,000

Various Accounts 25,000

Variable 15,000

Fixed 10,000

Recording and Applying Overhead

Overhead Account(Combined)

Actual Overhead Applied Overhead

Applying overhead

Work in Process 23,000

Variable Overhead 12,000

Fixed Overhead 11,000

Variable 15,000

Fixed 10,000

Variable 12,000

Fixed 11,000

Recording and Applying Overhead

Overhead Account(Combined)

Actual Overhead Applied Overhead

Variable 15,000

Fixed 10,000

25,000

Variable 12,000

Fixed 11,000

23,000

Recording and Applying Overhead

Overhead is underapplied$25,000 of overhead was incurred Only $23,000 was applied to Work in Process

Disposing of Overhead Differences

• Immaterial– Cost of Goods Sold

• Material– Work in Process– Finished Goods– Cost of Goods Sold

Alternative Capacity Level

• Capacity measure of volume or some other activity base

• Alternative measures:– Theoretical– Practical– Normal– Expected

Flow of Product Costs

Raw Materials Inventory

Accounts Payable

Work in Process Inventory

Raw Materials Inventory

Work in Process Inventory

Salaries/Wages Payable

Flow of Product Costs

Fixed Overhead Control (actual)

Salaries/Wages Payable

Variable Overhead Control (actual)

Utilities Payable

Work in Process Inventory

Variable Overhead Control (applied)

Fixed Overhead Control (applied)

Flow of Product Costs

Finished Goods Inventory

Work in Process Inventory

Accounts ReceivableSales

Cost of Goods SoldFinished Goods Inventory

Statement of Cost of Goods Manufactured

• Beginning work in process xxxx– Raw materials used xxx– Direct labor xxx– Variable overhead xxx– Fixed overhead xxx

• Current period manufacturing costs xxxx

• Total costs to account for xxxx

• Ending work in process <xxxx>

• Cost of goods manufactured xxxx

Statement of Cost of Goods Manufactured

Raw Materials Used

Beginning raw materials xxx

Purchases of raw materials xxx

Raw materials available xxx

Ending raw materials <xxx>

Total raw materials used xxx

To Statement of Cost of Goods Manufactured

Schedule of Cost of Goods Sold

Beginning Finished Good xxxx

Cost of Goods Manufactured xxxx

Cost of Goods Available for Sale xxxx

Ending Finished Goods xxxx

Cost of Goods Sold xxxx

From Schedule of Cost of Goods Manufactured

Questions

• What is the difference in the conversion process for a service company and a manufacturing company?

• In a normal cost system, how are overhead costs allocated to products and services?

• How is cost of goods manufactured calculated?