cost concepts and cost allocation

Cost Concepts and Cost Allocation19

Cost Information

OBJECTIVE 1: Explain how managers classify costs and how they use these cost classifications.

Figure 1: Overview of Cost Classifications

Table 1: Examples of Cost Classifications for a Candy Manufacturer

Cost Information

• Managers’ use of cost information– Different organizations have different

operating costs• Service industries use the estimated costs of

services

• Retail organizations work with the estimated cost of merchandise

• Manufacturing use estimated product costs

Cost Information

• All organizations use cost information to determine profits and selling prices and to value inventory.

Cost Information

• A single cost can be classified as– Direct or indirect, depending on its traceability.– Variable or fixed, depending on its behavior.– Value-adding or nonvalue-adding, depending

on whether it adds value to a product or service.

– Product or period, depending on whether it is inventoriable.

Cost Information

• Managers use cost classifications to– Control costs by determining which are

traceable to a particular cost object.– Calculate the number of units that must be sold

to obtain a certain level of profit.

Cost Information

• Managers use cost classifications to (cont.)– Identify the costs of activities that do and do

not add value to a product or service.– Prepare financial statements.

Financial Statements and the Reporting of Costs

OBJECTIVE 2: Compare how service, retail, and manufacturing organizations report costs on their financial statements and how they account for inventories.

Figure 2: Financial Statements of Service, Retail, and Manufacturing Organizations

Exhibit 1: Statement of Cost of Goods Manufactured and Partial Income Statement for a Manufacturing Organization


• A manufacturer maintains three inventory accounts on its balance sheet: Materials Inventory, Work in Process Inventory, and Finished Goods Inventory.– Because a service organization sells services

rather than products, it maintains no inventory accounts.


• A manufacturer maintains three inventory accounts on its balance sheet: Materials Inventory, Work in Process Inventory, and Finished Goods Inventory. (cont.)– A retail organization, which purchases

products ready for resale, maintains only a Merchandise Inventory account.


• Cost of goods manufactured is a key component of a manufacturing company’s income statement.– Determining the cost of goods manufactured

involves three steps:• Computing the cost of direct materials used during

the period

• Computing total manufacturing costs for the period

• Computing cost of goods manufactured, adjusting for beginning and ending work in process inventory


• The cost of goods manufactured is used on the income statement to compute the cost of goods sold.– Manufacturing, retail, and service

organizations use the same income statement format.

Inventory Accounts in Manufacturing Organizations

OBJECTIVE 3: Describe the flow of costs through a manufacturer’s inventory accounts.

Figure 3: Activities, Documents, and Cost Flows Through the Inventory Accounts of a Manufacturing Organization

Figure 4: Manufacturing Cost Flow: An Example Using Actual Costing for The Choice Candy Company


• Transforming materials into finished products ready for sale requires a number of production and production-related activities, including the following:– Purchasing, receiving, inspecting, storing, and

moving materials– Converting materials into finished products using

labor, equipment, and other resources– Moving, storing, and shipping the finished products


• Manufacturing cost flow begins when costs are incurred for direct materials, direct labor, and overhead.– Materials costs flow first into the Materials

Inventory account.– All manufacturing-related costs then flow into

the Work in Process Inventory account.


• Manufacturing cost flow begins when costs are incurred for direct materials, direct labor, and overhead.– When goods are completed, their costs are

transferred to the Finished Goods Inventory account.

– When goods are sold, their costs are transferred to the Cost of Goods Sold account.


• Documents used to track the flow of manufacturing costs include the following:– Purchase request– Purchase order– Receiving report– Vendor’s invoice– Materials request form


• Documents used to track the flow of manufacturing costs include the following: (cont.)– Time cards– Job order cost card– Sales invoice– Shipping document

Elements of Product Costs

OBJECTIVE 4: Define product unit cost, and compute the unit cost of a product or service.

Figure 5: Relationships Among Product Cost Classifications

Table 2: Use of Actual and Estimated Costs in Three Cost-Measurement Methods


• The three elements of product cost are direct materials costs, direct labor costs, and overhead costs.– Direct materials costs can be conveniently and

economically traced to specific units of a product.

– Direct labor costs can be conveniently and economically traced to specific units of a product.


• The three elements of product cost are direct materials costs, direct labor costs, and overhead costs. (cont.)– Overhead costs are all manufacturing costs not

classified as direct materials or direct labor costs. They include the following:

• Indirect materials costs• Indirect labor costs• The costs of property taxes, depreciation on plant and

equipment, insurance, rent, and utilities


• The three elements of manufacturing costs can be classified as prime costs or conversion costs.


• A product’s unit cost equals the sum of direct materials, direct labor, and overhead costs divided by the number of units produced.– The actual costing method uses actual cost

information available at the end of an accounting period or at the end of a job to calculate the unit cost of a product.


• A product’s unit cost equals the sum of direct materials, direct labor, and overhead costs divided by the number of units produced. (cont.)– The normal costing method combines the

actual direct materials and direct labor costs with estimated overhead costs to calculate product unit cost.


• A product’s unit cost equals the sum of direct materials, direct labor, and overhead costs divided by the number of units produced. (cont.)– The standard costing method uses estimated

costs of direct materials, direct labor, and overhead to calculate product unit cost.


• A service business does not have a physical product that can be assembled, stored, and valued as inventory.– The most important cost in a service business

is the professional labor cost.– Service-related overhead is the other principal

component of the cost of services rendered.

Cost Allocation

OBJECTIVE 5: Define cost allocation and explain how the traditional method of allocating overhead costs figures into calculating product or service unit cost.

Figure 6: Allocating Overhead Costs: A Four-Step Process

Table 3: Allocating Overhead Costs and Calculating Product Unit Cost: Traditional Approach

Cost Allocation

• Cost allocation is the process of assigning a collection of indirect costs to a specific cost object using an allocation base known as a cost driver.– A cost object (the destination of an assigned

indirect cost) is a product, process, department, or activity that the organization wishes to cost.

Cost Allocation

• Cost allocation is the process of assigning a collection of indirect costs to a specific cost object using an allocation base known as a cost driver. (cont.)– A cost driver is a volume-related activity base,

such as direct labor hours, direct labor costs, or units produced.

Cost Allocation

• Cost allocation is the process of assigning a collection of indirect costs to a specific cost object using an allocation base known as a cost driver. (cont.)– As the cost driver increases in volume, it

causes the cost pool—the collection of indirect costs assigned to a cost object—to increase in amount.

Cost Allocation

• The allocation of overhead costs requires the following:– The pooling of overhead costs that are affected

by a common activity– The selection of a cost driver whose activity

level causes a change in the cost pool

Cost Allocation

• The allocation of overhead costs requires the following: (cont.)– Allocating overhead costs is a four-step process:

• Managers estimate overhead costs and calculate a predetermined overhead rate (a single, plantwide rate in traditional settings) at which those costs will be assigned to products.

• As units of the product or service are produced, the estimated overhead costs are assigned to the product or service’s costs at the predetermined rate.

Cost Allocation

• The allocation of overhead costs requires the following: (cont.)– Allocating overhead costs is a four-step

process: (cont.)• Actual overhead costs are recorded as they are

incurred.

Cost Allocation

• The allocation of overhead costs requires the following: (cont.)– Allocating overhead costs is a four-step process:

(cont.)• At the end of the accounting period, the difference

between the actual and applied overhead costs is calculated and reconciled.

– If the difference is immaterial, the Cost of Goods Sold account is adjusted.

– If the difference is material, adjustments are made to the Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts.

Cost Allocation

• The traditional approach to allocating overhead– The traditional approach to assigning overhead

costs to a product or a service’s cost is to use a single (plantwide) predetermined overhead rate.

• The total overhead costs constitute one cost pool.

Cost Allocation

• The traditional approach to allocating overhead (cont.)– The traditional approach is especially useful

when a company manufactures only one product or a few very similar products that require the same production processes and production-related activities.

Cost Allocation

• The traditional approach to allocating overhead (cont.)– The traditional approach assigns overhead

costs to a product’s cost by estimating a predetermined overhead rate and multiplying that rate by the actual level of the cost driver.

Cost Allocation

• The traditional approach to allocating overhead (cont.)– The total applied overhead cost is added to the

actual costs of direct materials and direct labor to determine the total product or service cost.

Cost Allocation

• The traditional approach to allocating overhead (cont.)– The product or service unit cost is calculated

by dividing total product or service cost by total units produced or by determining the cost per unit for each element of the product or service’s cost and summing those per-unit costs.

Cost Allocation

• Activity-based costing (ABC) is a method of assigning costs that calculates a more accurate product or service cost than the traditional approach by categorizing all indirect costs by activity, tracing the indirect costs to those activities, and assigning activity costs to products or services using a cost driver related to the cause of the cost.

cost concepts and cost allocation

Documents

statement of cost

cost informationa single

cost concepts

periodcomputing cost

cost of direct materials

particular cost object

value inventory

finished goods inventory