McGraw-Hill/I rwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2
Product
Costing Systems:
Concepts and
Design Issues
2-2
Learning Objective 1
2-3
Product Costs
Related to the
purchase or
manufacture of
goods for resale.
Assigned to
inventory and cost
of goods sold.
Period Costs
Related to selling
and administrative
operations.
Recognized as
expenses in the
same time period.
The Meaning of Cost
The use of
valuable
resources, in
order to achieve a
stated purpose. In
accounting, cost
is reported in
monetary terms.
2-4
Learning Objective 3
2-5
Retailers . . .
Buy finished goods.
Sell finished goods.
Manufacturers . . .
Buy raw materials.
Produce and sell finished goods.
MegaLoMart
Comparing Service, Retail and
Manufacturing Companies
Service firms . . .
Provide a service that is
consumed when produced.
Have no inventories.
2-6
Manufacturing Companies
The 3 major categories of
manufacturing costs:
Direct Materials
Raw materials,
components, and
other parts that
can be traced to a
specific product.
Direct Labor
Payments and
benefits for those
employees who
convert direct
materials into
finished product.
Manufacturing
Overhead
Indirect material
Indirect labor
Other overhead
2-7
Manufacturing Companies
Prime Costs include:
Direct Materials

Direct Labor

Manufacturing
Overhead
2-8
Manufacturing Companies
Conversion Costs include:
Direct Materials

Direct Labor

Manufacturing
Overhead
2-9
Stages of Production and the Flow
of Costs
Raw Materials
Beg. Inventory
Add: Purchases
= Raw Materials
Available for
Production
Less: Raw Materials
Transferred to
Production
=
Ending Inventory
Work-In-Process
Beg. WIP Inventory
Add: Raw Materials
Transferred In
Direct Labor
Manufacturing
Overhead
= Total Manufacturing
Costs Incurred
Less: Cost of Goods
Completed and
Transferred to
Finished Goods
=
Ending WIP
Inventory
Finished Goods
Beg. Inventory
Add: Cost of Goods
Completed and
Transferred from
WIP
= Goods Available for
Sale
Less: Cost of Goods Sold
=
Ending Inventory
2-10
Stages of Production and the Flow
of Costs - Example
Raw Materials
Beg. Inventory
Add: Purchases
= Raw Materials
Available for
Production
Less: Raw Materials
Transferred to
Production
=
Ending Inventory
What is Ending
Inventory in
February?
Axel Electronics makes toasters. On
February 1, Axel has $15,000 of raw
material on hand. Axels purchase
and transfers to the production floor
are indicated below.
Date
Cost of
Purchases
Cost of
Transfers
Feb 3 $ 8,000 $ 5,000
Feb 10 12,000 11,000
Feb 15 14,000 7,000
Feb 20 6,000
Feb 22 9,000
Feb 27 16,000
2-11
Axel Electronics makes toasters. On
February 1, Axel has $15,000 of raw
material on hand. Axels purchase
and transfers to the production floor
are indicated below.
Stages of Production and the Flow
of Costs - Example
Now lets look at
Work-in-Process.
Raw Materials
$15,000
Add: 43,000
= $58,000
Less: 45,000
=
$13,000
Date
Cost of
Purchases
Cost of
Transfers
Feb 3 $ 8,000 $ 5,000
Feb 10 12,000 11,000
Feb 15 14,000 7,000
Feb 20 6,000
Feb 22 9,000
Feb 27 16,000
2-12
Stages of Production and the Flow
of Costs - Example
What is the
amount of cost
transferred to
Finished Goods
in February?
Work-In-Process
Beg. WIP Inventory
Add: Raw Materials
Transferred In
Direct Labor
Manufacturing
Overhead
= Total Manufacturing
Costs Incurred
Less: Cost of Goods
Completed and
Transferred to
Finished Goods
=
Ending WIP
Inventory
Raw Materials
$15,000
Add: 43,000
= $58,000
Less: 45,000
=
$13,000
On February 1, Axel
had WIP of $30,000
on the factory floor.
During February,
Axel paid $92,000 in
direct labor wages.
Overhead is applied
at 150% of direct
labor. On 2/28,
$22,000 is still in
WIP.
2-13
Stages of Production and the Flow
of Costs - Example
Work-In-Process
$30,000
Add: 45,000
92,000
138,000
= $305,000
Less: 283,000
=
$22,000
Raw Materials
$15,000
Add: 43,000
= $58,000
Less: 45,000
=
$13,000
Now lets
look at
Finished
Goods.
Transferred
to Finished
Goods
On February 1, Axel
had WIP of $30,000
on the factory floor.
During February,
Axel paid $92,000 in
direct labor wages.
Overhead is applied
at 150% of direct
labor. On 2/28,
$22,000 is still in
WIP.
150 % of $92,000
2-14
Stages of Production and the Flow
of Costs - Example
Work-In-Process
$30,000
Add: 45,000
92,000
138,000
= $305,000
Less: 283,000
=
$22,000
On February 1, Axel had Finished Goods of $125,000 on
hand. At the end of February, a physical inventory count
revealed $96,000 in Finished Goods still on hand.
What was Cost of Goods Sold for February?
Raw Materials
$15,000
Add: 43,000
= $58,000
Less: 45,000
=
$13,000
Finished Goods
Beg. Inventory
Add: Cost of Goods
Completed and
Transferred from
WIP
= Goods Available for
Sale
Less: Cost of Goods Sold
=
Ending Inventory
2-15
Stages of Production and the Flow
of Costs - Example
Work-In-Process
$30,000
Add: 45,000
92,000
138,000
= $305,000
Less: 283,000
=
$22,000
Raw Materials
$15,000
Add: 43,000
= $58,000
Less: 45,000
=
$13,000
Finished Goods
$125,000
Add: 283,000
= $408,000
Less: 312,000
=
$96,000
On February 1, Axel had Finished Goods of $125,000 on
hand. At the end of February, a physical inventory count
revealed $96,000 in Finished Goods still on hand.
What was Cost of Goods Sold for February?
Cost of goods sold
2-16
Learning Objective 2
2-17
Schedule of Cost of Goods
Manufactured
Lets look at a
Schedule of Cost of
Goods Manufactured for
CollegePak Company.
2-18
CollegePak Company
Schedule of Cost of Goods Manufactured
Raw material used 850,000 $
Direct labor 700,000
Total manufacturing overhead 1,850,000
Total manufacturing costs 3,400,000 $
Add: Work-in-process inventory, January 1 350,000
Subtotal 3,750,000 $
Deduct: Work-in-process inventory, December 31 400,000
Cost of goods manufactured 3,350,000 $
Schedule of Cost of Goods
Manufactured
2-19
CollegePak Company
Schedule of Cost of Goods Manufactured
Raw material used 850,000 $
Direct labor 700,000
Total manufacturing overhead 1,850,000
Total manufacturing costs 3,400,000 $
Add: Work-in-process inventory, January 1 350,000
Subtotal 3,750,000 $
Deduct: Work-in-process inventory, December 31 400,000
Cost of goods manufactured 3,350,000 $
Schedule of Cost of Goods
Manufactured
Computation of Cost of Raw Material Used
Raw-material inventory, January 1 200,000 $
Add: Purchases of raw materials 800,000
Raw material available for use 1,000,000
Deduct: Raw material inventory, December 31 150,000
Raw material used 850,000 $
2-20
CollegePak Company
Schedule of Cost of Goods Manufactured
Raw material used 850,000 $
Direct labor 700,000
Total manufacturing overhead 1,850,000
Total manufacturing costs 3,400,000 $
Add: Work-in-process inventory, January 1 350,000
Subtotal 3,750,000 $
Deduct: Work-in-process inventory, December 31 400,000
Cost of goods manufactured 3,350,000 $
Schedule of Cost of Goods
Manufactured
Include all direct labor
costs incurred during the
current period.
2-21
CollegePak Company
Schedule of Cost of Goods Manufactured
Raw material used 850,000 $
Direct labor 700,000
Total manufacturing overhead 1,850,000
Total manufacturing costs 3,400,000 $
Add: Work-in-process inventory, January 1 350,000
Subtotal 3,750,000 $
Deduct: Work-in-process inventory, December 31 400,000
Cost of goods manufactured 3,350,000 $
Schedule of Cost of Goods
Manufactured
Beginning work-in-
process inventory is
carried over from the
prior period.
2-22
CollegePak Company
Schedule of Cost of Goods Manufactured
Raw material used 850,000 $
Direct labor 700,000
Total manufacturing overhead 1,850,000
Total manufacturing costs 3,400,000 $
Add: Work-in-process inventory, January 1 350,000
Subtotal 3,750,000 $
Deduct: Work-in-process inventory, December 31 400,000
Cost of goods manufactured 3,350,000 $
Schedule of Cost of Goods
Manufactured
Ending work-in-process inventory
contains the cost of unfinished goods,
and is reported in the current assets
section of the balance sheet.
2-23
Now lets look at an income
statement for CollegePak.
Income Statement for a
Manufacturer
2-24
Income Statement for a
Manufacturer
CollegePak Company
Income Statement
For the Year Ended December 31, 20X2
Sales revenue 4,500,000 $
Less: Cost of goods sold 2,810,000
Gross margin 1,690,000 $
Selling and administrative expenses 1,440,000
Operating profit before taxes 250,000 $
2-25
CollegePak Company
Income Statement
For the Year Ended December 31, 20X2
Sales revenue 4,500,000 $
Less: Cost of goods sold 2,810,000
Gross margin 1,690,000 $
Selling and administrative expenses 1,440,000
Operating profit before taxes 250,000 $
Income Statement for a
Manufacturer
CollegePak Company
Schedule of Cost of Goods Sold
For the Year Ended December 31, 20X2
Finished-goods inventory, Jan. 1 920,000 $
Add: Cost of goods manufactured 3,350,000
Cost of goods available for sale 4,270,000
Deduct Finished-goods inventory, Dec. 31 1,460,000
Cost of goods sold 2,810,000 $
2-26
Production Costs in the Service
Sector
A service provider cannot
inventory its services.
The costs of providing the
service can be identified and
measured, just as occurs in
manufacturing industries.
Managing and tracking the
costs associated with value-
chain activities can point to
opportunities for improvement.
2-27
Cost Drivers
An activity is any
discrete task that an
organization
undertakes to make
or deliver a good or
service.
A cost driver is
some characteristic
of the activity that
causes costs to be
incurred.
Number of
computers made by
Dell in a day
Number of
flights by Southwest
Airlines in a given market
2-28
Learning Objective 4
2-29
Cost behavior means how
a cost will react to
changes in the level of
business activity.
Total variable costs
change when activity
level changes.
Total fixed costs remain
unchanged when activity
level changes.
Cost Behavior
2-30
Your total long distance telephone bill
is based on how many minutes you talk.
Minutes Talked
T
o
t
a
l

L
o
n
g

D
i
s
t
a
n
c
e

T
e
l
e
p
h
o
n
e

B
i
l
l

Total Variable Cost Example
2-31
Minutes Talked
P
e
r

M
i
n
u
t
e

T
e
l
e
p
h
o
n
e

C
h
a
r
g
e

The cost per long distance minute talked is
constant. For example, 5 cents per minute.
Variable Cost Per Unit Example
2-32
Your monthly basic telephone bill
probably does not change when you
make more local calls.
Number of Local Calls
M
o
n
t
h
l
y

B
a
s
i
c

T
e
l
e
p
h
o
n
e

B
i
l
l

Total Fixed Cost Example
2-33
Number of Local Calls
M
o
n
t
h
l
y

B
a
s
i
c

T
e
l
e
p
h
o
n
e

B
i
l
l

p
e
r

L
o
c
a
l

C
a
l
l

The average cost per local call
decreases as more local calls are made.
Fixed Cost Per Unit Example
2-34
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit
Variable
Fixed
Changes proportionately with
changes in activity within the
relevant range.
Remains constant for each
additional unit as long as activity
is in the relevant range.
Remains the same even when
activity changes within the
relevant range.
The per unit amount changes
each time the level of activity
changes due to the fixed nature
of the related costs.
Cost Behavior Summary
2-35
Directly traceable
to the decision to
produce the level
of output
Cost Hierarchy
Includes direct material, direct labor, utilities to
run equipment, other overhead directly related to
the production process.
Costs that are incurred for every unit of product
manufactured or service produced.
Unit-level
Costs
All unit level costs are variable, but not
all variable costs are unit level costs.
2-36
Batch-level
Costs
Costs that are incurred for batch of product
manufactured or service produced.
Includes setup costs, material-handling costs
related to delivering raw material to the
production line, etc.
Cost Hierarchy
2-37
Product-level
Costs
Costs that are incurred for each line of product
or service.
Includes design costs for product lines and
marketing costs for each product line.
Cost Hierarchy
2-38
Facility-level
Costs
Costs that are incurred to maintain the
organizations overall facility and infrastructure.
Includes production managers salary, plant
depreciation, and insurance on the facility and
equipment.
Cost Hierarchy
2-39
Learning Objective 5
2-40
Discretionary
Easier to alter in the
short term by current
managerial decisions.
Committed
Long-term obligations,
difficult to change in
the short term.
Rental and/or
Lease Financing
of Buildings and
equipment
Advertising and
Research and
Development
Committed and Discretionary Costs
2-41
The potential benefit that is given up when
one alternative is selected over another.
If you were not attending
college, you could be
earning $20,000 per year.
Your opportunity cost of
attending college for
one year is $20,000.
Opportunity Costs
2-42
Past payments for resources that cannot be changed
by any current or future decision.
Sunk costs should not be considered in decisions.
Example: You bought an automobile for $12,000 two
years ago. Whatever you do with the automobile in
the future, you cannot nullify the original transaction. If
it has a trade-in value, that value would become an
opportunity cost in your future decisions.
Sunk Costs
2-43
Direct Costs
Costs that can be
traced easily and
conveniently to a
product or department.
Example: Cost of paint in
the paint department of
an automobile assembly
plant.
Indirect Costs
Costs that need to be
allocated, before they
can be assigned to a
product or department.
Example: Cost of
national advertising for
an airline is indirect to a
given flight or route.
Traceability of Resources
2-44
Learning Objective 6
2-45
A system of accounting for costs in which
both fixed and variable production costs
are included in product costs.
Fixed
Costs
Variable
Costs
Product
Absorption (Full) Costing
2-46
A system of cost accounting that assigns only the
variable cost of production to products.
Fixed
Costs
Variable
Costs
Product
Variable Costing
2-47
Learning Objective 7
2-48
Absorption
Costing
Variable
Costing
Direct materials
Direct labor Product costs
Product costs Variable mfg. overhead
Fixed mfg. overhead
Period costs
Period costs Selling & admin. exp.
Absorption Costing vs. Variable
Costing
2-49
Lets see what we can learn about the
differences between absorption and variable
costing by looking at a numerical example.
Absorption and Variable Costing
2-50
Absorption Costing vs. Variable
Costing - Example
Howell, Inc. produces a single product with a sales price
of $40 and the following cost information:
2-51
Unit product cost is determined as follows:
Selling and administrative expenses are
always treated as period expenses and deducted from
revenue as they are incurred.
Absorption Costing vs. Variable
Costing - Example
2-52
Absorption Costing
Sales (28,000 $40) 1,120,000 $
Less cost of goods sold:
Beginning inventory - $
Add COGM (30,000 $19) 570,000
Goods available for sale 570,000
Ending inventory (2,000 $19) 38,000 532,000
Gross margin 588,000
Less selling & admin. exp.
Variable (28,000 x $4) 112,000 $
Fixed 250,000 362,000
Net income 226,000 $
Absorption Costing vs. Variable
Costing - Example
Howell, Inc. had no beginning inventory, produced
30,000 units and sold 28,000 units this year.
2-53
Variable Costing
Sales (28,000 $40) 1,120,000 $
Less variable expenses:
Beginning inventory - $
Add COGM (30,000 $12) 360,000
Goods available for sale 360,000
Ending inventory (2,000 $12) 24,000
Variable cost of goods sold 336,000
Variable selling & administrative
expenses (28,000 $4) 112,000 448,000
Contribution margin 672,000
Less fixed expenses:
Manufacturing overhead 210,000 $
Selling & administrative expenses 250,000 460,000
Net income 212,000 $
Variable
costs
only.
All fixed
manufacturing
overhead is
expensed.
Absorption Costing vs. Variable
Costing - Example
2-54
Cost of
Goods
Sold
Ending
Inventory
Period
Expense Total
Absorption costing
Variable mfg. costs 336,000 $ 24,000 $ - $ 360,000 $
Fixed mfg. costs 196,000 14,000 - 210,000
532,000 $ 38,000 $ - $ 570,000 $
Variable costing
Variable mfg. costs 336,000 $ 24,000 $ - $ 360,000 $
Fixed mfg. costs - - 210,000 210,000
336,000 $ 24,000 $ 210,000 $ 570,000 $
Comparing Absorption and
Variable Costing
Lets compare the methods.
2-55
We can reconcile the difference between
absorption and variable net income as follows:
Variable costing net income 212,000 $
Add: Fixed mfg. overhead costs
deferred in inventory
(2,000 units $7 per unit) 14,000
Absorption costing net income 226,000 $
Fixed mfg. overhead $210,000
Units produced 30,000
= $7.00 per unit =
Reconciling Income
2-56
Lets look at
the second
year of
operations
for Howell, Inc.
Extending the Example
2-57
In its second year of operations, Howell started with an
inventory of 2,000 units, produced 30,000 units and sold
32,000 units at $40 each.
Howell Inc., Year 2
2-58
Unit product cost is determined as follows:
There has been no
change in Howells
cost structure.
Howell Inc., Year 2
2-59
Absorption Costing
Sales (32,000 $40) 1,280,000 $
Less cost of goods sold:
Beg. inventory (2,000 x $19) 38,000 $
Add COGM (30,000 $19) 570,000
Goods available for sale 608,000 $
Ending inventory - 608,000
Gross margin 672,000 $
Less selling & admin. exp.
Variable (32,000 $4) 128,000 $
Fixed 250,000 378,000
Net income 294,000 $
Units in ending inventory from the previous period.
30,000 units produced in the current period.
Howell Inc., Year 2
2-60
Variable Costing
Sales (32,000 $40) 1,280,000 $
Less variable expenses:
Beg. inventory (2,000 $12) 24,000 $
Add COGM (30,000 $12) 360,000
Goods available for sale 384,000 $
Ending inventory -
Variable cost of goods sold 384,000 $
Variable selling & administrative
expenses (32,000 $4) 128,000 512,000
Contribution margin 768,000 $
Less fixed expenses:
Manufacturing overhead 210,000 $
Selling & administrative expenses 250,000 460,000
Net income 308,000 $
Howell Inc., Year 2
2-61
In the first period, production (30,000 units)
was greater than sales (28,000).
Income Comparison
Costing Method 1st Period 2nd Period Total
Absorption 226,000 $ 294,000 $ 520,000 $
Variable 212,000 308,000 520,000
In the second period, production (30,000 units)
was less than sales (32,000).
For the two-year period, total absorption
income and total variable income are the same.
Summary
2-62
Summary
2-63
Learning Objective 8
2-64
Fixed costs are
not really the costs
of any particular
product.
Variable
Costing
Variable versus Absorption Costing
Absorption
Costing
All manufacturing
costs must be assigned
to products to properly
match revenues and
costs.
2-65
Absorption
Costing
These are capacity
costs and will be
incurred even if nothing
is produced.
Variable
Costing
Depreciation,
taxes, insurance and
salaries are just as
essential to products
as variable costs.
Variable versus Absorption Costing
2-66
Variable
Costing
Absorption
costing product costs
are misleading for
decision making.
They are the
numbers that
appear on our
external
reports.
Absorption
Costing
Variable versus Absorption Costing
2-67
Variable versus Absorption Costing
Variable cost $10
Fixed manufacturing overhead $100,000
Units sold 10,000
Units
Produced
Total Variable
Cost
Fixed
Manufacturing
Overhead
Total
Manufacturing
Cost
Average
Manufacturing
Cost
Cost of
Goods Sold
10,000 $100,000 $100,000 $200,000 20.00 $ 200,000 $
12,000 $120,000 $100,000 $220,000 18.33 $ 183,333 $
14,000 $140,000 $100,000 $240,000 17.14 $ 171,429 $
16,000 $160,000 $100,000 $260,000 16.25 $ 162,500 $
18,000 $180,000 $100,000 $280,000 15.56 $ 155,556 $
20,000 $200,000 $100,000 $300,000 15.00 $ 150,000 $
Absorption Costing
Cost of goods sold decreases because production
exceeds sales, leaving a portion of fixed
manufacturing costs in inventory.
2-68
Variable versus Absorption Costing
COGS for 10,000 units
$100,000
$150,000
$200,000
1
0
,
0
0
0
1
4
,
0
0
0
1
8
,
0
0
0
2
2
,
0
0
0
2
6
,
0
0
0
3
0
,
0
0
0
3
4
,
0
0
0
Number of units produced
C
O
G
S
Absorption Costing
Cost of goods sold decreases because production
exceeds sales, leaving a portion of fixed
manufacturing costs in inventory.
2-69
Throughput Costing
Product
cost
Unit-level
spending for
direct costs
Unit-level costs are incurred every time a unit of
product is manufactured and will not be incurred
again until the next unit is manufactured.
Indirect, past
or committed
costs
2-70
Example

In an automated process direct material may be
the only unit-level cost and so is the only product cost.

All other manufacturing costs are expensed as period costs.
Incentive to
overproduce
is reduced
Average unit cost does
not vary with changes
in production levels.
Advantages
Throughput Costing
2-71
Learning Objective 9
2-72
Intentional Overproduction of Inventory
Absorption costing: Excess inventory would
include more fixed production costs, so that gross
income for the period would be artificially higher.
An unethical manager would have an incentive to
produce for inventory at the end of a period, in
order to obtain a better looking bottom line.
Throughput costing: No such incentive would
exist, since fixed production costs would be
charged against operating income for the period.
2-73
End of Chapter 2