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Product Costing Systems

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Developing a Costing System


Product costing is a general term that refers to the
process of assigning both direct and indirect costs to
products or services:
Direct costs are traced to a cost object (e.g., a job)
Indirect costs are allocated to a cost object (using one or
more cost-allocation bases/cost drivers)

A firms choice of costing system depends on the


firms industry and product or service, the firms
strategy and management information needs, and
the costs and benefits of acquiring, designing,
modifying, and operating a particular system

Developing a Costing System


(continued)
When developing a product-costing system,
there are three choices that must be made:
Cost accumulation method (i.e., job or process costing)
Cost measurement method (i.e., actual, normal, or
standard costing)
Overhead assignment method (i.e., volume-based or
activity-based)

Each product-costing system will reflect these


three choices
For example, an organizations cost system may be
characterized by: job costing with normalized costs, and
activity-based costing used to allocate indirect costs

Developing a Costing System


(continued)
Cost accumulation: Job or Process Costing?
In a job costing system, all manufacturing
costs incurred are assigned to jobs
This type of system is appropriate when cost can be
readily identified with specific customers, jobs, or
projects
Often found in small or medium firms that produce
customized products

Process costing is often found in large firms


that produce one or a few homogeneous
products through continuous mass production

Classifications of Production
Processes
Unit production (ship builder) Pure job shop or job
costing.
Batch (or lot) production batch of identical items
moves from one factory work station to another. (100
fuel injectors)
Assembly line production jobs are separately
identifiable but tend to be similar (automobiles,
computers, refrigerators)
Process production outputs are not identifiable as
separate units (petroleum, chemicals, steel) Pure
process costing.
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Product costing systems


Average some total costs to arrive at unit cost amounts.
2 basic types of costing systems:
Job order
Process

Job Order
Costing

Construction, printing, special equipment


manufacturing, shipbuilding, medical services,
custom furniture manufacturers, advertising
agencies, accounting firms, etc.

Process
Costing

Chemical industry, bottling companies, plastics,


food products, and paper products, cement
manufacturing, brick production, etc.
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Cost measurement: actual,


normal, or standard costing?
Cost measurement: actual, normal, or standard
costing?
An actual costing system uses actual costs incurred
as the measure of product cost
This type of cost measurement is rarely used
because unit costs fluctuate significantly, thereby
increasing the possibility of error in pricing,
adding/dropping product lines, and executing
performance evaluations
Under actual costing, factory overhead costs are
only known at or after the end of the period (thus,
cost information is not available on a timely basis)

Cost measurement: actual,


normal, or standard costing?
A normal costing system uses actual costs for direct
materials and direct labor but normal costs for
factory overhead:
Normal costing involves estimating a portion of overhead to
be assigned to each product as it is produced providing a
timely estimate of cost
Choice of an appropriate denominator activity level for
allocating fixed overhead costs is a key consideration

A standard costing system uses standard costs for


all cost elements, direct and indirect:
Standard costs are costs a firm should attain under
relatively efficient operating conditions
Standard costing systems provide a basis for cost control,
performance evaluation, and process improvement

Job order cost system


(or job cost system)
Collects costs for each job as it moves
through production process.
Each job: separate identification number;
entered on a separate job cost record.
DM entered from material requisitions
releasing materials from stockroom.
DL entered from employee time records.
Overhead charged using departmental rates.
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Job cost system


Sum of all charges for period are debited to
Work-in-process (WIP) Inventory and credited
to Materials Inventory, Wages Payable, and
Overhead Accounts.
Completed job: Transfer from WIP to FG (i.e.
dr. FG Inventory, cr. WIP Inventory).
When billed dr. AR, cr. Sales; using job cost
record amounts dr. Cost of Goods sold, cr.
FG inventory.
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Events in Job Order


Manufacturing
Receive
orders from
customers

Schedule
jobs.

Begin
production.

Order
materials.

Job Order Manufacturing


Activities
Indirect

Materials

Allocate

Indirect

Factory
Overhead

Direct

Labor

Direct

Goods in
Process

Finished
Goods

Cost of
Goods
Sold

Process cost system


Collects costs by process (i.e.
department).
Determine unit costs by dividing total costs
by total number of units worked on.

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Process Cost System:


Inventoriable Cost
Conversion cost per unit + DM = inventory or
total production cost.
Total conversion costs equivalent units of
production = conversion costs per unit.
Equivalent units of production = completed units
+ .5 * units in production.
Just one approach. Assumes on average units in
production are half finished (hence .5). Other
assumptions could be made (e.g. 0%).
If materials are added at beginning of process, then
calculations are done for materials first assuming all
units in WIP are 100% complete as far as materials.
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Types of Processes
Sequential processing requires that units pass through
one process before they can be worked on in the next
process in the sequence.

Parallel processing is another processing pattern that


requires two or more sequential processes to produce a
finished good.

Types of Processes
(continued)
Partially completed units (e.g., two subcomponents) can
be worked on simultaneously in different processes and
then brought together in a final process for completion.

Job-Order Vs. Process Costing

Job-Order Costing

Many jobs are worked on


during each period, with each
job having different
production requirements.

Costs are accumulated by job.


The job cost sheet is the key
document for accumulating
costs.
Units costs are computed by
job on a job cost sheet.

Process Costing
A homogeneous product is
produced on a continuous basis
or for long periods of time.
Costs are accumulated by
department.
The departmental production
report is the key document
showing the accumulation and
disposition of costs.
Unit costs are computed by
department on production
reports.

Choice of a system
Process cost: less bookkeeping.
Costs cannot be traced to specific units.
Less record keeping.

Job cost system, costs traced to specific


units.
Easier to identify existence of and source of
cost problems.

Variations used in practice.


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Backflush Accounting
No WIP inventory accounts.
Material charged to FG based on bill of
materials.
All conversion costs charged directly to
FG inventory.

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Measurement of direct costs


Direct labor costs = quantity of labor * price per
unit of labor.
Time card is used to measure quantity of labor.
Labor rate could be actual or average labor rate.
Some companies add labor related/fringe costs to Direct
Labor (others consider fringes as overhead).

Direct material cost = quantity of material * price


per unit.
Quantity determined from requisitions from
stockroom.
Price may be invoice or invoice plus material related
cost.
Cost flow assumptions (LIFO, FIFO, avg. cost) must also be
considered.

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Direct & Indirect vs.


Variable & Fixed
Some variable costs are direct costs.
Some fixed costs are indirect costs.
Direct Vs indirect:
Refers to traceability.
Accounting concept.

Variable vs. fixed:


Refers to cost behavior.
Economic concept.
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Allocation of Indirect Costs


Desirable to classify a cost as direct.
Indirect cost assignment is more
roundabout & less accurate.
Reasons for not tracing directly:
Impossible to do so; Not feasible because
too costly; Mgmt chooses not to do so.

How to determine fair share of indirect


costs?
Based on causal relationship.
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Traditional Allocation Method


Indirect costs allocated to cost object
based on the cost objects consumption of
some measure of activity, usually labor
hours
$10,000,000 total indirect cost
400,000 total labor hours

= $25 per hour rate

A product consuming 6 labor hours would


be charged $150 of indirect costs
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Criticisms of Traditional
Overhead Allocation
Assumes all overhead is volume-related
Factory-wide or departmental rates
All related to single activity measure

Departmental focus, not process focus


Focus on costs incurred, not cause of
costs

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Activity-Based Costing
Purpose
Allocation of indirect costs based on causal
activities
Attempts to identify direct link between cost and
cost object

Results in better allocation


Does not provide true cost

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Activity-Based Costing
Traditional allocation method
Costs

Products

Activity-based allocation method


Costs

Activities
First stage

Products
Second stage
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Overview of ABC
Identifies activities required to produce the
product or service
Determines the cost of the activities
Allocates costs to the cost object based
on the objects consumption of activities

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When is ABC Most Useful?

High amounts of overhead cost


Multiple products
Complex products
Complex production system
Significant variation in volume between high and low
volume products
Different products place different demands on resources
Problems with current cost allocations due to changes in
products or processes
Better cost information is needed
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Operation of an ABC System


Assign costs to activity pools
First stage allocation
Identify the costs incurred to perform various
activities

Determine the measure of activity best


related to each cost pool
Cost drivers

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Allocation of Indirect Costs


Process of assigning indirect costs to
individual cost objects.
Overhead rate = absorption rate = allocation
rate = burden rate = means of allocating
indirect costs to products.

All costs are assigned to cost objects.


Costs are assigned directly or
Or indirectly, that is, allocated.
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Cost and responsibility


centers
Cost center = cost object for which costs of
one or more related functions or activities are
accumulated.
In a product costing system, items of indirect
(overhead) cost are first accumulated in cost
centers and then assigned to products.
Cost center = intermediate cost object.
Product is a final cost object.

Responsibility center = an organization unit


headed by a manager.
Could be one or more cost centers.
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Types of Cost Centers


Production cost center:
Produces a product or a component or
Performs a distinct step or task of production.

Service cost center = all other cost centers.


Provides services to production cost centers, to
other cost service centers, or for benefit of the
organization as a whole.
e.g. maintenance department, general factory office,
occupancy cost center.
Also called indirect cost pools or overhead pools.
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Calculating overhead rates


Series of steps
Direct materials and direct labor costs
are assigned directly to product costs.
Allocation of overhead costs to product
cost objects involves 3 steps:
All overhead costs are assigned to
production (PC) or service centers (SC).
SC costs are reassigned to PCs.
Costs allocated to products from PCs.
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First Allocation Step


All overhead costs for an accounting
period are assigned to service and
production cost centers.
Some costs are directly charged to center.
Overhead costs that benefit several centers
are jointly allocated to those centers.
Examples of allocation bases:
Square footage, headcount.

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Second Allocation Step


Cost accumulated in each service cost
center is reassigned to production cost
centers.
Step down order:
Allocating service costs in a prescribed order
(following assumes 2 service cost centers).
First allocate either costs of service center that
provides the most services to other cost centers or
costs of the service center that receives fewest
services from other service centers.
Then allocate costs of remaining service cost center
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Final Allocation Step


Allocate from production cost centers to
products that pass through.
In a process cost system: Overhead per unit
= total overhead divided by number of
equivalent units.
In a job cost system: overhead is assigned to
product by using some activity measure (e.g.
direct labor hours, machine hours).
Rate is determined by dividing total overhead costs
by activity measure.
For each job, overhead costs are allocated to it or
applied to it or absorbed by it by multiplying activity
measure by rate.

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Cost drivers (allocation bases)


Causal relationship between cost & object.

Payroll related (social security taxes, fringe benefits).


Headcount related (human resource related).
Material related (purchasing receiving, counting).
Space related (facility related).
Transaction or activity related (scheduling, set up costs).
Also called a batch-level driver.
Product related (tools and dies, engineering change
orders)
Overall drivers - covers a mixture of activities. (direct labor
hours or costs)- default drivers.
Customer related (sales calls, customer service,
advertising).
Business related (CEO, CFO).
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Establishing predetermined
rates
Prepare overhead budgets for various levels
of activity.
Identify costs as variable, fixed, semi-variable.

Estimate average level of activity expected in


each cost center for coming year.
Calculate each production centers overhead
rate by dividing budgeted overhead cost at
standard volume by standard volume.
Some companies use a plant wide overhead
rate instead of by production cost center.
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The ABC Model


1st Stage Allocation

Activity
Centre A

Indirect Cost
Pool

Activity
Centre B

Resource Drivers

Activity
Centre C

2nd Stage
Allocation

Activity
Centre D

Activity
Drivers
Product 1

Product 2

Product 3

Why use predetermined


overhead rates?
Actual monthly rates affected by
conditions peculiar to month.
Permits more prompt calculation of
product costs.
Calculating once a year is less effort than
going through the calculation every month.

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Under-absorbed and
over-absorbed overhead
Actual overhead costs are charged to cost
center overhead clearing account.
Overhead clearing account is credited for the
amounts determined from predetermined
overhead rate.
Amount absorbed by product > actual costs,
overhead: over-absorbed (under-absorbed).
If over-absorbed (under-absorbed): credit (debit)
balance in overhead clearing account.
Balance is transferred to Overhead variance
account. Adjusts COGS or Inv.
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Accuracy of Costing
GAAP requires aggregate inventory and
COGS (not by product), to be materially
accurate.
For better decision making:
Some companies use activity based costing
primarily to estimate costs for profitability
analysis.

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Cross Subsidies
If actual cost structure is complex and a
simple overhead allocation approach is
used, some products costs will be
understated and some overstated.

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Steps of Activity Based


Costing
Many more service center cost pools
(called activities or activity centers).
Activitys costs can be assigned directly
to product rather than through a
production cost center.
ABC uses unit-level, batch-level and
product-level cost drivers.
Each activity is allocated based on the
cost driver determined to be most
appropriate for that pool of costs.
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Examples of Drivers
Unit level drivers (number of units, direct labor hours,
direct labor dollars, machine hours) the more units the
more costs assigned to the product. Costs per unit stay
the same regardless of number of units.
Batch level drivers (number of orders processed, number
of production batches run) used to allocate costs
associated with setting up production or processing
orders. The larger the production run or order, the lower
the costs per unit.
Product level drivers (number of products) costs required
to design or maintain products are assigned based on
number of products.

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Steps in an ABC Costing


Approach
Cost drivers are identified for each activity.
All costs for period are assigned either directly to
product (e.g. direct material) or to a cost pool
associated with each activity and cost driver.
Costs assigned to product based on cost driver.
Cost per unit determined by dividing total costs
assigned to product by number of units of
product.

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