cpa excel - bec - manufacturing costs text

7/29/2019 CPA Excel - BEC - Manufacturing Costs Text

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Manufacturing Costs

I. Cost Terminology

A. Two fundamental cost classifications exist within a manufacturing organization: product costs and

period costs.

1. Product costs -- Can be associated with the production of specific revenues (i.e., cost of

goods sold). They generally attach to physical product units and are expensed in the period

in which the goods are sold. Product costs are also known as inventoriable costs or

manufacturing costs.

2. Period costs -- Cannot be matched with specific revenues (i.e., accountant's salary) and

are expensed in the period incurred. These costs are also called selling and

administrative costs.

B. This division of costs can be seen in the format of the income statement:

Net Sales

- Cost of Goods Sold (product costs)

= Gross Profit

-Selling & Administrative Expenses (period costs)

= Net Profit(Loss)

II. Manufacturing (or Inventoriable) Costs

Include all costs associated with the manufacturing of a product split. Manufacturing costs are split intothe "three factors of production," which are:

A. Direct material -- The cost of significant raw materials and components that are directly

incorporated in the finished product. For example, direct material costs of a leather briefcase

include cost of leather (raw material) as well as buckles and zippers (purchased components).

B. Direct labor -- The wages and salaries paid for work that directly converts raw materials into a

finished product. Continuing with our leather briefcase example, the direct labor costs associated

with the manufacture of a leather briefcase include wages paid to workers who cut the leather,

finish the leather, and sew the briefcase.

C. Factory overhead -- The cost of indirect labor, indirect materials, and other manufacturing

costs other than direct material and direct labor that are necessary to support the productionprocess but are not easily traceable to the finished product. For example, factory overhead

associated with production of a leather briefcase includes salaries paid to the production line

supervisors, wages paid to mechanics who maintain the equipment, wages paid to custodians who

maintain the factory, thread used to sew the briefcase together, electricity used to power the

equipment and provide lighting to the factory, and depreciation on the factory building and

equipment.

1. Factory overhead can be variable (the total cost changes with the quantity produced) or

fixed (the total cost remains the same regardless of the quantity produced, within

reasonable limits). In the example above, the cost of thread is variable overhead because

with the production of more briefcases, more thread is used; the depreciation on the



factory building is fixed because the depreciation stays the same regardless of how many

briefcases are produced.

2. In highly automated manufacturing environments, direct labor costs are frequently so

insignificant a part of total production costs that they are not separately tracked but simply

added to factory overhead costs.

III. Other Manufacturing Cost Classifications

Several other ways of classifying costs are tested on the CPA exam.

A. Direct costs and indirect costs -- This classification looks at the behavior of the cost in regards

to how it is traced to the product:

B. Direct costs -- Costs that can be traced to specific units of production. Direct materials are

actually incorporated into the product. Direct labor is comprised of the salary costs of workers who

fabricate the product.

C. Indirect costs -- (Note: the term "indirect costs" is often treated synonymously with the term

"manufacturing overhead.") Necessary costs of the manufacturing process that cannot be easily

associated with specific units. These include all manufacturing costs other than direct material and

direct labor. Indirect materials such as custodial and maintenance supplies, depreciation, and

scrap are also overhead. Indirect labor including salaries for supervisors, custodians, and

maintenance and repair personnel are overhead as well. Indirect costs can be either variable

(e.g., supplies) or fixed (e.g., depreciation).

1. Note that th e distinction between direct and indirect costs is often one of convenience or

feasibility. Traditional cost allocation classifies many costs as indirect because they are

insignificant or not feasible to trace to products. For example, the cost of thread used to

sew a briefcase together could be calculated and assigned to the briefcase as a direct cost.However, because the cost of the thread is so insignificant, it is usually treated as an

indirect cost and allocated to each briefcase along with other overhead. (Note: Most

companies allocate all overhead costs, but as an exception to the diagram above some

variable overhead costs can be traced directly to production. Although accuracy can be

increased by this treatment, this distinction will likely not be tested.)

D. Prime costs and Conversion costs -- These overlapping cost classifications are likely to be

tested on the exam. Prime costs are direct labor and direct materials, while conversion costs are

direct labor and manufacturing overhead. You can think of prime costs as being the "primary"

costs (i.e., direct materials and direct labor) of the product. You can think of conversion costs as

the "costs of converting" direct materials into a product by using direct labor and overhead.



Note:

Direct labor is included as a prime cost and as a conversion cost. This

overlap in classifications is likely to be tested on the exam.

E. Value-added costs and Nonvalue-added costs --

1. Value-added costs -- Product costs that enhance the value of the product in the eyes of

the consumer. Most direct costs are value-added costs. Continuing with the briefcase

example, the leather that the briefcase is made of and the labor required to cut the pieces

and sew them together are value-added costs.

2. Nonvalue-added costs -- Costs that could be eliminated without deterioration of

product quality, performance, or perceived value to the consumer. Many nonvalue-added

costs are essential to production and cannot be completely eliminated. For example, oiling

the machine that is used to sew the briefcase together is a nonvalue-added cost from the

customer's viewpoint. However, if the machine wasn't oiled, sooner or later, it would stopsewing. Oiling the machine is an essential, but nonvalue-added, cost. Most, though not

all, overhead costs are nonvalue-added costs. For example, the thread used to sew

the briefcase together is usually an overhead cost, but most consumers would see it as a

value-added cost.

IV. Overhead Allocation

Direct materials and direct labor are traced to the Work-in-Process (WIP) account, but overhead must be

allocated to WIP. Since overhead costs are typically not directly traceable to specific units of production,

an estimated overhead amount is applied to production based on a predetermined rate. Actual overhead

costs are accumulated separately. At the end of the period, the applied overhead is compared to the

actual overhead and an entry is made to adjust any difference.

A. Predetermined overhead application rate -- The first step in applying overhead to WIP is to

calculate the rate that will be used to apply overhead to production. The rate is based on an

estimated overhead amount divided by an estimated allocation base amount, (for example,

machine hours or direct labor hours). The measure of activity or volume should have some

plausible relationship to the overhead charges. For example, if production is highly automated,

then machine hours would be a likely choice. Where production is more labor paced, direct labor

hours might be a reasonable allocation base.

1. The formula for developing the overhead rate is:



estimated total overhead costs / estimated activity volume

2. The result of this calculation is the Overhead Allocation Rate (or Overhead

Application Rate). The Overhead Allocation Rate is normally established prior to the

beginning of the period. That is, it is a predetermined rate.

Note:

Estimated amounts based on currently attainable capacity are

always used for this formula - not historical, ideal, or theoretical

amounts. This is likely to be a frequently tested concept on the CPA

exam.

B. Applied overhead -- The amount of estimated overhead charged to production. Applied

overhead is calculated by multiplying the predetermined overhead rate by the actual number of

units used in production (e.g., direct labor hours or machine hours).

1. Applied overhead is included in the cost of work-in-process by the following entry:

DR: Work-in-Process XXX

CR: Factory Overhead Applied XXX

C. Actual overhead -- The amount actually paid for overhead expenses. These costs are initially

charged to the specific expense account (i.e., supplies inventory, utilities, maintenance,

supervision, etc.) and to the Factory Overhead Control account. For example:

DR: Factory Overhead Control Utilities Expense XXX

CR: Accounts Payable XXX

D. Closing out the overhead accounts -- At the end of the period the Factory Overhead Control

account (which contains the actual overhead costs) and the Factory Overhead Applied account

(which contains the overhead costs that were applied to production using the Predetermined

Overhead Rate) are closed out.

1. For example, assume that the actual overhead costs were $50,000 and the overhead costs

applied to production were also $50,000. The following entry would close (zero out) the

overhead accounts:

DR: Factory Overhead Applied $50,000

CR: Factory Overhead Control $50,000

2. Of course, it is unusual for the estimated overhead applied to production and the actual

overhead costs to be equal. Usually there are differences between the amount of applied

overhead and the amount of actual overhead.

a. Immaterial differences between the two amounts are usually allocated to Cost

of Goods Sold;



b. If the difference is material, it should be prorated to Work-in-Process,

Finished Goods, and Cost of Goods Sold based on their respective ending

balances.

3. The treatment of material differences between actual and applied overhead is likely to be

tested on the exam.

E. Overapplied factory overhead -- When more overhead costs are applied to products than areactually incurred, factory overhead is said to be overapplied. When the accounts are closed at the

end of the period, overapplied overhead reduces Cost of Goods Sold.

Question:

Priceless Products incurs $20,000 in actual overhead costs during the

period. Using their predetermined overhead allocation formula, Priceless

applied $21,000 to products as overhead costs, resulting in $1,000 of

overapplied overhead. Priceless regards this amount as immaterial and charges

over/underapplied overhead to Cost of Goods Sold at the end of the period when

the accounts are closed. How will this entry affect Cost of Goods Sold?

Answer:

Cost of Goods Sold will decrease when the accounts are closed:

DR: Factory Overhead Applied $21,000


CR: Cost of Goods Sold $1,000

F. Underapplied factory overhead -- When more overhead costs are actually incurred during

the period than are applied to products, factory overhead is said to be underapplied. When the

accounts are closed at the end of the period, underapplied overhead increases Cost of Goods Sold.

Question:

Cost Conscious Products incurs $10,000 in actual overhead costs during

the period. Using their predetermined overhead allocation formula, Cost

Conscious applied $9,500 to products as overhead costs. If Cost

Conscious charges over/underapplied overhead to Cost of Goods Sold at the end

of the period when the accounts are closed, how will this affect Cost of Goods?

Answer:

Cost of Goods Sold will increase when the accounts are closed:

DR: Factory Overhead Applied $9,500DR: Cost of Goods Sold $500


G. Summary of Overhead Application -- There are three steps to allocation of overhead and

they take place at different times during the year.

1. At the beginning of the year, we calculate the predetermined overhead allocation rate

(POR ). For example, estimated overhead is divided by estimated direct labor hours.



2. During the year, we periodically allocate overhead by multiplying the overhead allocation

rate (POR) by the actual units of the allocation base.

3. At the end of the year we dispose of over/underapplied overhead by taking the difference

between actual overhead and applied overhead to Cost of Goods Sold.

4. Numerical Example --

Example:

Assume the following data and assume overhead is applied based

on direct labor hours (DLH):

Estimated direct labor hours $100,000

Estimated Overhead dollars 200,000

Actual direct labor hours 300,000

Actual overhead dollars 400,000

Steps are as follows:

1. Calculate the POR: $200,000 / 100,000 DLH = $2 per DLH

2. Apply OH: $2 (300,000 DLH) = $600,000

3. Dispose of the difference in applied v. actual overhead:

$600,000 - $400,000 = $200,000 to Cost of Goods Sold

H. Additional points --

1. Make sure that you know which type of overhead to use in these calculations and when

to use them. There are three different types - estimated, applied, and actual.

2. Make sure that you multiply the POR by "ACTUAL" units in step 2.

3. Make sure you know what happens during the different times of the year and which

overhead amounts are relevant.

4. The terms "budgeted" and "estimated" mean the same thing. Also, the terms "allocated"

and "applied" mean the same thing.

5. Be sure to MEMORIZE this 3-step process. It is one of the most widely used calculations

you are likely to see on the exam!

cpa excel - bec - manufacturing costs text

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