managerial accounting, chapter 2 by crosson, needles

Chapter 2

Cost Concepts and Cost Allocation

Copyright © Houghton Mifflin Company. All rights reserved. 2 | 2

Cost Information and Managers

• Objective 1

– Describe how managers use information about costs.


Managers’ Use of Cost Information

– Owners expect to earn a profit– Managers have a responsibility to

• Use resources wisely• Generate revenues that will exceed the

costs of the company’s operating, investing, and financing activities

• One of a company’s primary goals is to be profitable


Managers’ Use of Cost Information (cont’d)

• Plan• Perform • Evaluate• Communicate

Managers use cost information to:


Planning

• Develop budgets for production, materials, labor, and overhead

• Determine selling price or sales levels required to cover all costs

• Develop budgets for purchases and net income

• Determine selling prices or sales units required to cover all costs

• Develop budgets

• Estimate revenues

• Manage the work force

Service firms: Retailers: Manufacturers:


Performing

• Predict gross margin and operating income

• Make decisions like dropping a product line, outsourcing manufacturing, bidding on a special order, or negotiating a selling price

• Predict gross margin and operating income

• Make decisions like reducing prices for clearance sales, or dropping a product line

• Monitor profitability

• Make decisions like bidding on jobs, lowering or negotiating fees, or dropping a service

Service firms: Retailers: Manufacturers:


Evaluating

• 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


Communicating

• External Reports– Income statements

that communicate actual costs of operating activities

– Balance sheets that show the value of inventory

• Internal Reports– Performance reports

that summarize plans, performance outcomes, and analysis of performance


Cost Information and Organizations

• Service organizations

– Need information about the costs of providing services

• Labor

• Related overhead


Cost Information and Organizations (cont’d)

• Retail organizations

– Need information about the costs of purchasing products for resale

• Adjustments for freight-in costs

• Purchase returns and allowances

• Purchase discounts


• Manufacturing organizations

– Need information about the costs of manufacturing products

• Direct materials

• Direct labor

• Overhead



• Other costs organizations incur: • 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



Stop & Review

Q. How do managers use information about costs?

A. To plan, perform, evaluate, and communicate


Cost Classifications and Their Uses

• Objective 2

– Explain how managers classify costs and how they use these cost classifications.



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

• Cost classification is important

• Select and use relevant information to improve efficiencies

• Provide quality products or services

• Satisfy customer needs


Overview of Cost Classifications



1. Control costs– By determining which are traceable to a

particular cost object, such as a service or product

2. Calculate the number of units that must be sold to obtain a certain level of profit

3. Identify the costs of activities that do and do not add value to a product or service

4. Classify costs for the preparation of financial statements

• These classifications enable managers to…


Cost Traceability

– 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

Managers trace costs to cost objects to develop a fairly accurate measurement of costs


Direct Costs

Southwest Airlines– 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

Costs that can be conveniently and economically traced to a cost object


Indirect Costs

Indirect Costs– Nails used in furniture– Salt used in candy– Rivets used in airplanes

Costs that cannot be conveniently and

economically traced to a cost object


Indirect Costs (cont’d)

• Are assigned using a formula

• Must be included in the cost of a product or service

Insurance costs for Southwest Airlines

A portion is assigned to each flight flown


Cost Traceability Illustrated

– Cost object• Preparation of tax returns

– Direct costs• Government reporting forms, computer

usage, and accountant's labor

– Indirect costs• Supplies, office rental, utilities, secretarial

labor, telephone usage, and depreciation of office furniture

Service Organization



– Cost object• Produce department

– Direct costs• Costs of fruits and vegetables, and

wages of employees working in that department

– Indirect costs• Utilities, storage, and handling

Retail Organization



– Cost object• Product

– Direct costs• Costs of materials and labor

– Indirect costs• Utilities, depreciation of plant and

equipment, insurance, property taxes, inspection, supervision, maintenance of machinery, storage, and handling

Manufacturing Organization


Cost Behavior

• 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

The way costs respond to changes in volume or activity


Cost Behavior (cont’d)

• Variable cost– A cost that

changes in direct proportion to a change in productive output (or any other measure of output)

• Fixed cost– A cost that

remains constant within a defined range of activity or time period


• Southwest Airlines– Variable costs

• Cost of peanuts and beverages

– Fixed costs• Depreciation on the plane and salaries and benefits

of the flight and ground crews

Variable and Fixed Costs Illustrated



• Good Foods Store– Variable costs

• Cost of groceries sold and sales commissions

– Fixed costs• Costs of building and lot rental, depreciation on

store equipment, and the manager’s salary


• The Choice Candy Company– Variable costs

• Direct materials, direct labor, indirect materials (e.g., salt), and indirect labor (e.g., inspection and maintenance labor)

– Fixed costs• Supervisors’ salaries and depreciation on buildings



Value-Adding Versus Nonvalue-Adding Costs

• Nonvalue-adding cost– The cost of an activity that adds cost to a

product or service but does not increase its market value

• Value-adding cost– The cost of an activity that increases the market

value of a product or service


Value-Adding Versus Nonvalue-Adding Costs (cont’d)

• Managers examine value-adding attributes of operating activities– Wherever possible, reduce or eliminate

activities that do not directly add value to the company’s products or services

This information influences the design of future products or services


• 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

Value-Adding Versus Nonvalue-Adding Costs (cont’d)


Cost Classifications for Financial Reporting

Financial reporting of product costs– Appear as cost of goods sold on the income

statement– Appear as finished goods inventory on the

balance sheet

Product costsCosts assigned to inventory– Include direct materials, direct labor, and

overhead– Also called inventoriable costs


Cost Classifications for Financial Reporting (cont’d)

– Costs of resources used during the accounting period

• Include selling and administrative expenses

• Also called noninventoriable costs

Period costs

Financial reporting of period costs– Appear as operating expenses on the

income statement


Stop & Review

Q. What is the difference between a direct cost and an indirect cost?

A. Direct costCan be easily and economically traced to a specific product

Indirect costCannot be easily and economically traced to a specific product


Financial Statements and the Reporting of Costs

• Objective 3– Compare how service, retail, and

manufacturing organizations report costs on their financial statements and how they account for inventories.


Different Organizations, Different Financial Statements

Service, retail, and manufacturing organizations have differing operations; therefore, the accounts represented in the

financial statements differ


• Sell services, not products– No inventory accounts 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

Service 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

Retail Organizations


• Make products for sale• Maintain three inventory accounts on the balance

sheet– Materials Inventory

• 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

Manufacturing Organizations


Manufacturing Organizations

• Use the following equation to calculate cost of goods sold


Accounting in Service, Retail, and Manufacturing Organizations

– 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

inventory

• Income statement– All organizations use the following format


Financial Statements of Service, Retail, and Manufacturing Organizations


Statement of Cost of Goods ManufacturedTo prepare an income statement for a

manufacturing firm, cost of goods manufactured must first be computed

The statement of cost of goods manufactured contains the dollar amount

of the cost of goods manufactured

This report, the statement of cost of goods manufactured, is based on an analysis of the Work in

Process Inventory account.


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

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.

The statement of cost of goods manufactured must be prepared before the income statement.


Statement of Cost of Goods Manufactured

Summarizes the flow of all

manufacturing costs incurred

during an accounting period


Statement of Cost of Goods Manufactured

The Choice Candy Company Statement of Cost of Goods Manufactured

For the Year Ended December 31, 20x9

Direct materials used Materials inventory, December 31, 20x8 $100,000 Direct materials purchased 200,000 Cost of direct materials available for use $300,000 Less materials inventory, December 31, 20x9 50,000 Cost of direct materials used $250,000 Direct labor 120,000 Overhead 60,000 Total manufacturing costs $430,000 Add work in process inventory, December 31, 20x8 20,000 Total cost of work in process during the year $450,000 Less work in process inventory, December 31, 20x8 150,000 Cost of goods manufactured $300,000

It is helpful to think of the statement of cost of goods manufactured as being developed in three steps

Step 1

Step 2

Step 3


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


Steps in Developing the Statement of Cost of Goods Manufactured (cont’d)

Step 2• Calculate total manufacturing costs for the

period


Steps in Developing the Statement of Cost of Goods Manufactured (cont’d)

Step 3

• Determine the cost of goods manufactured for the period


Comparison of Total Manufacturing Costs and 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 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

Total Manufacturing Costs Cost of Goods Manufactured


Stop & Review

Q. What is the difference between total manufacturing costs and cost of goods manufactured?

A. Total manufacturing costsAll manufacturing costs incurred during an accounting period, regardless of whether units were completed or not

Cost of goods manufacturedTotal manufacturing costs attached to units completed during an accounting period


Inventory Accounts in Manufacturing Organizations

• Objective 4– Describe the flow of costs through a

manufacturer's inventory accounts.


• 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

A manufacturing organization’s accounting system tracks these activities as product costs flowing through inventory accounts

Materials Inventory account

Work in Process Inventory account

Finished Goods Inventory account

Inventory Accounts in Manufacturing Organizations


Inventory Accounts in Manufacturing Organizations (cont’d)

• Materials Inventory account– Shows the balance of the cost of unused materials

• Work in Process Inventory 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


Document Flows and Cost Flows Through the Inventory Accounts

Purchase of Materials

Production of Goods

Product Completion

Product Sale

Activities

Documents

Materials Inventory

Work in Process Inventory

Inv

ento

ry A

cco

un

t A

ffec

ted

/

Ch

an

ge

in B

ala

nce

Finished Goods Inventory

Purchase, receive, inspect, move, and store materials

Purchase requestPurchase orderReceiving reportVendor’s invoice

Cost of materials purchased increases account balance


1. Purchase request is prepared for materials needed but not currently available in storeroom2. Purchase order is sent to supplier by the Purchasing Department3. Receiving report is prepared when materials arrive4. Vendor’s invoice is received requesting payment for materials

The Materials Inventory account increases by the cost of materials purchased



Production of Goods

Product Completion

Product Sale

Activities

Documents

Materials Inventory


Inv

ento

ry A

cco

un

t A

ffec

ted

/

Ch

an

ge

in B

ala

nce





Document Flows and Cost Flows Through the Inventory Accounts (cont’d)

Move materials to production area

Materials request

Cost of direct and indirect materials used in production decreases account balance

Cost of direct materials used in production increases account balance

1. Materials request form is given to storeroom clerk when production is scheduled 2. Materials handler moves materials to production floor

The Materials Inventory account decreases by the cost of direct and indirect materials transferred

The cost of indirect materials transferred increases the balance of the Overhead account, which will be discussed later in this chapter

Production of Goods

The Work in Process Inventory account increases by the cost of direct materials transferred



Production of Goods

Product Completion

Product Sale

Activities

Documents

Materials Inventory


Inv

ento

ry A

cco

un

t A

ffec

ted

/

Ch

an

ge

in B

ala

nce






Materials request



Convert materials into finished productPackage some types of product

Time cardJob order cost cardVendor’s invoices for overhead items

Costs of direct labor and overhead increase account balance

1. A time card is prepared by each production employee recording the number of hours worked 2. A job order cost card is used to record all costs incurred as the product moves through

production

Production of Goods

The Work in Process Inventory account increases by the costs of direct labor and overhead used in the manufacturing process




Production of Goods

Product Completion

Product Sale

Activities

Documents

Materials Inventory


Inv

ento

ry A

cco

un

t A

ffec

ted

/

Ch

an

ge

in B

ala

nce






Materials request






Move completed units to finished goods storage area

Job order cost card

Cost of completed units decreases account balance

Cost of completed units increases account balance

Product Completion

1. The completed product is packaged and moved to the finished goods storeroom2. All production costs have been recorded on the job order cost card

The Finished Goods Inventory account increases by the cost of the completed product

The Work in Process Inventory account decreases by the cost of the completed product




Production of Goods

Product Completion

Product Sale

Activities

Documents

Materials Inventory


Inv

ento

ry A

cco

un

t A

ffec

ted

/

Ch

an

ge

in B

ala

nce






Materials request






Move completed units to finished goods storage area

Job order cost card

Cost of completed units decreases account balance

Cost of completed units increases account balance

Sell units of product; pack and ship product

Sales invoiceShipping documentJob order cost card

Cost of goods sold decreases account balance

Product Sale

1. When the product is sold, a sales invoice is prepared2. The product is removed from the storeroom, packaged, and shipped along with a shipping

documentThe Finished Goods Inventory account decreases by the cost of the product sold

The Cost of Goods Sold account increases by the cost of the product sold



Activities, Documents, and Cost Flows Through the Inventory Accounts of a

Manufacturing Organization


The Manufacturing Cost Flow

The flow of manufacturing costs through the Materials Inventory, Work in Process

Inventory, and Finished Goods Inventory accounts into the Cost of Goods Sold

accountManufacturing costs include direct materials, direct

labor, and overhead

A defined, structured manufacturing cost flow is the foundation for product costing, inventory valuation,

and financial reporting



Cost of Goods SoldFinished Goods Inventory

OverheadFactory PayrollMaterials Inventory

50,000

100,000

200,000

250,000

20,000

78,000

Because there are no indirect materials in this case, the Materials Inventory account shows the balance of unused direct materials.

During the period, direct materials that cost $200,000 are purchased, increasing the account

Direct materials that cost $250,000 are used in production, decreasing the account

The Manufacturing Cost Flow





50,000

100,000

200,000

250,000

250,000

20,000

78,000

120,000 120,000

120,000

–0–

As direct materials and direct labor are used, their costs are added to the Work in Process Inventory account.

The Work in Process Inventory account records the balance of partially completed units of the product

The Manufacturing Cost Flow (cont’d)






50,000

100,000

200,000

250,000

250,000

20,000

78,000

120,000 120,000

120,000

–0– –0–

60,000

60,000 60,000

The cost of manufacturing overhead incurred during an accounting period is also added to the Work in Process Inventory account

Total manufacturing costs equal the total costs of direct materials, direct labor, and overhead transferred to work in process inventory during an accounting period

Also called current manufacturing costs





50,000

100,000

200,000

250,000

250,000

20,000

78,000

120,000 120,000

120,000

–0– –0–

60,000

60,000 60,000

Total manufacturing costs for the current period equal $430,000 ($250,000 + $120,000 + $60,000)

Total manufacturing costs are equal to the total costs of direct materials, direct labor, and overhead transferred to work in process inventory during an accounting period




50,000

100,000

200,000

250,000 120,000 120,000

–0– –0–

60,000 60,000




250,000

20,000

78,000

120,000

60,000

150,000

300,000

300,000

Cost of goods manufactured is the cost of all units completed and moved to finished goods storage during an accounting period

Cost of goods manufactured for the period decreases the Work in Process Inventory account and increases the Finished Goods Inventory account




50,000

100,000

200,000

250,000 120,000 120,000

120,000

250,000

150,000

20,000 300,000

60,000

60,000 60,000

–0– –0–



240,00078,000

138,000

300,000

240,000

The Finished Goods Inventory account holds the balance of costs assigned to all completed units of product that have not yet been sold

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


Stop & Review

Q. What elements make up costs of manufacturing?

A. Direct materials, direct labor, and overhead


Elements of Product Costs

• Objective 5

– Define product or service cost and compute the unit cost of a product or service.


Direct Material Costs

Costs of materials used in making a product that can be conveniently and economically

traced to specific units of the product

• Iron ore used to make steel

• Sheet metal used to make automobiles

• Sugar used to make candy


Direct Labor Costs

Costs of labor needed to make a productthat can be conveniently and economically

traced to specific units of the product

•Wages of production workers


Overhead Costs

Production-related costs that cannot beconveniently and economically traced

to specific units of the product

• Also called service overhead, factory overhead, factory burden, manufacturing overhead, or indirect manufacturing costs


Overhead Costs (cont’d)

• 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 overhead costs• Building maintenance, property taxes, property insurance,

depreciation on plant and equipment, rent, and utilities

Overhead costs are indirect costs that are allocated to a product’s cost using traditional or activity-based costing methods


Illustration of Product Costs and the Manufacturing ProcessThe following elements of the product cost of one candy bar have been identified for The Choice Candy Company: – Direct materials costs

• Sugar, chocolate, and wrapper

– Direct labor costs• Costs of labor in making the candy bar

– 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


Prime Costs and Conversion Costs

Prime Costs Direct materials costs + direct labor costs

Conversion Costs

Direct labor costs + overhead costs


Computing Product Unit Cost

• The cost of manufacturing a single unit of a product– Costs of direct materials, direct labor, and overhead– These costs are accumulated as a batch or production

run of products is being produced• Computed when batch or run 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 cost and summing those per-unit costs

Product unit cost


Computing Product Unit Cost (cont’d)

• 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


Actual Costing Method

Uses the costs of direct materials, direct labor, and 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 inventory on the balance sheet

–Cost of goods sold on the income statement


Actual Costing Method Illustrated

The Choice Candy Company produced 3,000 candy bars on December 28 for Good Foods Store. Sara Kearney, the company’s accountant, calculated that the actual costs for the order were direct materials, $540; direct labor, $420; overhead, $240.

Calculate the actual product unit cost for the order:

Product cost per candy bar


Actual Costing Method Illustrated (cont’d)

• In this case, the job was completed and all cost information was known

• If production were still underway and actual overhead costs are uncertain, use an estimate of overhead costs– The normal costing method

The Choice Candy Company produced 3,000 candy bars on December 28 for Good Foods Store. Sara Kearney, the company’s accountant, calculated that the actual costs for the order were direct materials, $540; direct labor, $420; and overhead, $240.


Normal Costing Method

Combines actual direct costs of materials

and labor with estimated overhead costs to

determine a product unit cost

• Is simple

• Allows smoother, more even assignment of overhead costs to production during the accounting period than with the actual costing method

• Contributes to better pricing decisions and profitability estimates


Normal Costing Method Illustrated

The Choice Candy Company produced 3,000 candy bars on December 28 for Good Foods Store. Sara Kearney, the company’s accountant, calculated that the actual costs for the order were direct materials, $540, and direct labor, $420. Overhead is applied using an estimated rate of 60 percent of direct labor costs.

Calculate the product unit cost for the order:Estimated overhead cost is $252 ($420 DL cost x 60%)


Normal Costing Method Illustrated (cont’d)

The Choice Candy Company produced 3,000 candy bars on December 28 for Good Foods Store. Sara Kearney, the company’s accountant, calculated that the actual costs for the order were direct materials, $540, and direct labor, $420. Overhead is applied using an estimated rate of 60 percent of direct labor costs.

• In this case– Direct materials and direct labor costs were actual costs– Overhead costs were estimated

• If actual costs are not available for direct materials and direct labor, the standard costing method must be used


Standard Costing Method

Useful when product cost information is

desired before the accounting period begins – To control the cost of operating activities– To price a proposed product for a customer

Uses estimated, or standard, costs of directmaterials, direct labor, and overhead to

calculate the product unit cost


Standard Costing Method Illustrated

The Choice Candy Company is placing a bid to manufacture 2,000 candy bars for a new customer. Kearney estimated the following costs: direct materials, $0.20 per unit; direct labor, $0.15 per unit. Overhead is applied using an estimated rate of 60 percent of direct labor costs.

Calculate the product unit cost for the order.

Estimated overhead cost is $0.09 per unit ($0.15 DL cost x 60%)


Computing Service Unit Cost

Fresh Express is a grocery delivery service in New York City. The company charges a $15 per home delivery fee. Home deliveries usually total 1,000 each month. Only 25% of the overhead costs of the Delivery Department were applicable to home deliveries.

Calculate the cost of one home delivery based on this information: Monthly salaries $10,000

Total overhead costs 20,000

Direct labor $10,000/1,000 $10.00Overhead $20,000 x .25 / 1,000 5.00 Service cost per home delivery $15.00

Cost of one home delivery:


Stop & Review

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

A. Actual costingCosts used for direct materials, direct labor, and overhead are all actual costs

Normal costingCosts used for direct materials and direct labor are actual costs and an estimate is used for overhead

Standard costingCosts used for direct materials, direct labor, and overhead are all estimated costs


Cost Allocation

• Objective 6– Define cost allocation and explain how cost

objects, cost pools, and cost drivers are used to assign overhead costs.


Cost Allocation

Requires:– The pooling of indirect costs that are affected

by a common activity– Selecting a cost driver whose activity level

causes a change in the cost pool

The process of assigning overhead costs to the product (cost object) during an

accounting period


Cost Allocation (cont’d)

• 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


Cost Allocation (cont’d)

The Choice Candy Company has a candy machine-maintenance cost pool. The cost pool consists of overhead costs for the supplies and labor needed to maintain the candy 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)


Allocating the Costs of Overhead

Four-step process– Corresponds to the four stages of the management

processPlanning

1. Managers estimate overhead costs and calculate a rate at which to assign those costs to products or services

Performing2. This rate is applied to products or services as overhead costs are

incurred and recorded during production

Evaluating3. Actual overhead costs are recorded as they are incurred and

managers calculate the difference between the estimated and actual costs

Communicating4. Managers report on this difference


Planning the Overhead Rate

• Before an accounting period begins– Determine cost drivers and cost pools– Calculate an overhead rate

• Cost pool of total estimated overhead costs ÷ Total estimated cost driver level

EntryNo entry is requiredNo business activity has taken place


Applying the Overhead Rate

• During the accounting period as units of product or service are produced– Apply overhead costs to production

• Predetermined overhead rate for each cost pool x cost pool’s actual cost driver level

• Assigns a consistent overhead cost to each unit produced during the accounting period

EntryIncrease (debit) Work in Process Inventory Decrease (credit) Overhead


Recording Actual Overhead Costs

• During the accounting period as costs are incurred– Record actual overhead costs when incurred

• Include costs of indirect materials, indirect labor, depreciation, property taxes, and other productioncosts

EntryIncrease (debit) Overhead Decrease (credit) asset account or increase (credit) contra-asset or liability accounts


Reconciling the Applied and Actual Overhead Amounts

• At the end of the accounting period– Calculate and record the difference between

the applied and actual overhead amounts


Reconciling the Applied and Actual Overhead Amounts (cont’d)

• Applied OH > Actual OH – Overapplied overhead costs

• If difference is immaterial, increase (debit) Overhead and decrease (credit) Cost of Goods Sold

• If material, adjustments are made to the affected accounts

– Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold


Reconciling the Applied and Actual Overhead Amounts (cont’d)

• Applied OH < Actual OH – Underapplied overhead costs

• If difference is immaterial, increase (debit) Cost of Goods Sold and decrease (credit) Overhead

• If material, adjustments are made to the affected accounts

– Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold


The Importance of Good Estimates

• A predetermined, or estimated, overhead rate has two main uses

1. Enables managers to make decisions about pricing products or services and controlling costs before some of the actual costs are known

2. Allows managers to apply overhead costs to each unit or service produced in an equitable and timely manner


The Importance of Good Estimates (cont’d)

• The successful allocation of overhead costs depends on two factors

1. A careful estimate of the total overhead costs

2. A good forecast of the cost driver level



• If the estimate of total overhead costs is wrong, the overhead rate will be wrong

– Results in over- or understatement of the product or service unit cost

• Overstated product or service unit cost may result in failure to bid on profitable projects

• Understated product or service unit cost may result in accepting projects that are not as profitable as expected



• An underestimated cost driver level will cause an overstatement of the predetermined overhead rate

– The cost is spread over a lesser level

• An overestimated cost driver level will cause an understatement of the predetermined overhead rate

– The cost is spread over a greater level


Stop & Review

Q. What is cost allocation?

A. The process of assigning overhead costs to the product during an accounting period. Overhead costs are accumulated in a cost pool and assigned to the cost object using the cost driver.


Allocating Overhead: The Traditional Approach

• Objective 7– Using the traditional method of allocating

overhead costs, calculate product or service unit cost.


• Traditional approach– Uses a single predetermined overhead rate

– Useful when companies produce• One product or service

• A few similar products requiring the same production processes and production-related activities

– Total overhead costs constitute one cost pool

– A traditional activity base is the cost driver• Direct labor hours, direct labor costs, machine hours, units

of production

Allocating Overhead: The Traditional Approach


Allocating Overhead: The Traditional Approach (cont’d)The Choice Candy Company will be selling two product lines in the coming year—plain candy bars and candy bars with nuts. Sara Kearney has decided that the cost driver will be direct labor hours, and estimates that total overhead costs for the next year will be $20,000 and total direct labor hours worked will be 400,000 hours.

• Step 1– Estimate overhead costs and calculate a rate at which to assign

those costs to products.

$20,000Overhead Rate $0.05 per DLH

400,000 DLH


During the year, The Choice 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 overhead costs are

incurred and recorded during production.

Overhead applied to plain candy bars

$0.05 250,000 DLH $12,500 $12,500 100,000 units $0.125 per unit

Overhead applied to candy bars with nuts

$0.05 150,000 DLH $7,500 $7,500 50,000 units $0.15 per unit

Allocating Overhead: The Traditional Approach (cont’d)


Actual direct materials costs per unit for regular candy bars and candy bars with nuts were $0.18 and $0.21, respectively, and actual direct labor costs per unit were $0.14 and $0.16, respectively.

Calculate product unit cost using normal costing:

Plain Candy

Bars Candy Bars with Nuts

Actual direct materials cost per unit $0.18 $0.21 Actual direct labor cost per unit 0.14 0.16 Prime cost per unit $0.32 $0.37 Applied overhead 0.13 0.15 Product unit cost $0.45 $0.52

The product unit cost of the candy bars with nuts is higher because they required more expensive materials and more labor time

Allocating Overhead: The Traditional Approach (cont’d)


Stop & Review

Q. What types of companies might use the traditional approach of product costing?

A. Because only one cost pool is used for overhead costs, only companies that produce one product or a few similar products requiring the same production processes and production-related activities would use the traditional approach.


Allocating Overhead: The ABC Approach

• Objective 8– Using activity-based costing to assign

overhead costs, calculate product or service unit cost.


Allocating 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 overhead costs

• Traditional approach uses only one cost pool

– Improves accuracy of product or service cost estimates for companies

• Selling many different types of products

• That use many varying, significant amounts of different production-related activities


Activity Based-Costing

A way of assigning cost that identifies all of a company’s 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


• ABC categorizes all indirect costs by activity

• The indirect costs are traced to those activities

• Activity costs are assigned to products or services using cost drivers related to the cause of the cost

Allocating Overhead Using ABC (cont’d)


• 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 overhead cost pool used in the traditional approach



• An overhead rate is calculated for each activity pool

• The portion of overhead costs assigned to a product or service is determined using that rate and a cost driver amount

An overhead rate is also called an activity cost rate



• 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



Planning Overhead RatesThe Choice Candy Company will be selling two product lines in the coming year—plain candy bars and candy bars with nuts. ABC will be used to assign overhead costs to four activity pools: setup, inspection, packaging, and building. Estimated total overhead costs are $20,000.

Activity Overhead Costs

Estimated Total Activity

Costs Setup Indirect labor and indirect materials used

in preparing machines for each batch of production $ 7,000

Inspection Salaries and costs of indirect materials, indirect labor, and depreciation on testing equipment 6,000

Packaging Indirect materials, indirect labor, and equipment depreciation 5,000

Building Building depreciation, maintenance, janitorial wages, property taxes, insurance, security, and all other costs not related to the first three activities 2,000

$20,000

Total activity costs are estimated for each activity pool


Planning Overhead Rates (cont’d)

• Step 1– Calculate activity cost rate for cost pool

LevelDriver Cost Total Estimated

CostsActivity Total Estimated PoolCost for RateCost Activity

Activity Estimated Total Activity Costs

Estimated Total Cost Driver Level Activity Cost Rate for Cost Pool

Setup $ 7,000 700 setups $7,000 ÷ 700 = $10 per setup Inspection 6,000 500 inspections $6,000 ÷ 500 = $12 per inspection Packaging 5,000 2,000 packaging hours $5,000 ÷ 2,000 = $2.50 per packaging hour Building 2,000 10,000 machine hours $2,000 ÷ 10,000 = $0.20 per machine hour $20,000


Planning Overhead Rates (cont’d)

• Step 2– Apply predetermined activity cost rates to products

UnitsofNumber

AppliedCost per Unit Cost Overhead Applied

$7,100 ÷ 100,000 = $0.07 $12,900 ÷ 50,000 = $0.26


Applying Overhead Rates (cont’d)

Actual direct materials costs per unit for regular candy bars and candy bars with nuts were $0.18 and $0.21, respectively, and actual direct labor costs per unit were $0.14 and $0.16, respectively.

Calculate product unit cost using normal costing

Plain Candy

Bars Candy Bars with Nuts

Actual direct materials cost per unit $0.18 $0.21 Actual direct labor cost per unit 0.14 0.16 Applied overhead 0.07 0.26 Product unit cost $0.39 $0.63

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.


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

Applying Overhead Rates (cont’d)


Stop & Review

Q. What is one advantage and one disadvantage of using ABC over the traditional approach?

A. AdvantageMore accurate because more cost pools are used

DisadvantageMore costly to implement. Because more cost pools are used, more estimates and calculations are required


Chapter Review

1. Describe how managers use information about costs.

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

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


Chapter Review (cont’d)

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

5. Define product or service cost and compute the unit cost of a product or service.

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


Chapter Review (cont’d)

7. Using the traditional method of allocating overhead costs, calculate product or service unit cost.

8. Using activity-based costing to assign overhead costs, calculate product or service unit cost.

managerial accounting, chapter 2 by crosson, needles

Documents

costs organizations

estimated costs

cost concepts

costs sales levels

operating income

managers objective

profit managers

services labor