Chapter 18

Additional Aspects of Product Costing Systems

McGraw-Hill/Irwin

Copyright 2011. The McGraw-Hill Companies. All Rights Reserved.

Classifications of Production Processes

Unit production.
Physically identifiable job (e.g., shipbuilder, consulting job).

Batch (or lot) production.

Batch of identical items moves from one factory work station to another (e.g., 100 fuel injectors).

Assembly line production.

Jobs are separately identifiable but tend to be similar (e.g., automobiles, computers).

Process production.
Outputs are not identifiable as separate units (e.g., petroleum, chemicals, steel).
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Product Costing Systems

Two basic types of costing systems:
Job order costing. Process costing.

Goal:
Arrive at full production cost for one unit of product. Requires averaging some total costs.
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Job Order Costing

Collects costs for each job as it moves through production process.
Job can be a single unit or a batch of identical units.

Costs are collected on a job cost record.

Direct materials (based on material requisitions). Direct labor (from employee time records). Overhead (charged using departmental rates).

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Job Order Costing

Job cost records are the basis for entries into the accounting records. Total of unfinished jobs = balance in WIP.
Materials Inventory
Wages Payable Overhead
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Work in Process Inventory

Finished Goods Inventory

Cost of Sales

Process Costing
Collects costs by process (i.e. department). Use of equivalent units of production.
6 physical units halfway completed would be 3 equivalent units of production. Unit cost = total production costs equivalent units of production.

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Process Costing
Direct materials may be accounted for separately from conversion costs (i.e., direct labor plus overhead).
When? Direct materials is added at a point in time rather than continuously. Total unit cost is materials equivalent unit cost plus conversion equivalent unit cost.

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Choice of a System
Nature of production process usually determines system choice. Variations used in practice.
Hybrid systems. Backflush accounting (i.e., no work in process inventory account, charge production costs directly to finished goods inventory).

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Choice of a System
Job cost system.
Use when requires costs traced to specific units (e.g., repair shop). Easier to identify existence of and source of cost problems.

Process cost system.

Use when costs cannot be traced to specific units (e.g., ice cream production). Less record keeping.
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Measurement of Direct Costs

Direct material cost.
1. Determine quantity of material used.
Use requisitions from stockroom.

2. Determine price per unit of material quantity.

Invoice cost. May include material-related costs (e.g., purchasing, moving , inspection, storing). Cost flow assumptions must also be considered (i.e., LIFO, FIFO, average cost).
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Measurement of Direct Costs

Direct labor cost.
1. Determine quantity of labor used.
Use time cards.

2. Determine price per unit of labor quantity (i.e., labor rate).

Labor rate could be actual or average labor rate. May include labor-related costs (i.e., fringe benefits such as holiday/vacation pay, pension, health care, etc.).
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Cost Classification Distinctions

Direct vs. indirect:
Refers to traceability to cost objects. Accounting concept.

Variable vs. fixed:

Refers to cost behavior. Economic concept.

Summary: Direct costs can be variable or fixed. Indirect costs can be variable or fixed.
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Allocation of Indirect Costs

Direct costs are preferable (i.e., directly traceable to cost object). Reasons for not tracing directly:
Impossible to do so. Not feasible because too costly. Management chooses not to do so.

Solution: Allocate fair share of indirect costs.

How? Determine causation.
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Allocation of Indirect Costs

How indirect costs are allocated.
Use an overhead rate (aka, absorption rate, allocation rate, burden rate). First, accumulate indirect costs in cost centers (i.e., intermediate cost object). Then, assign cost center costs to product/service (i.e., final cost object).

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Cost Center vs. Responsibility Center

Cost center.
Cost object for which costs of one or more related functions or activities are accumulated.

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

Production cost center. Service cost center.
Produces a product or a component, or Performs a distinct step or task of production.
All other cost centers. Provides services to production cost centers, other service centers, or for benefit of 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

Overall Process
1. Initial Assignment. Overhead costs are assigned to production centers or service centers. Reassignment. Service center costs are reassigned to production centers. Allocation to Products. Production center costs are allocated to products.
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2.

3.

1. Initial Assignment
Directly assign any cost item uniquely associated with cost center (e.g., cost center supervisors). Overhead costs that benefit several centers are jointly allocated to those centers (e.g., heating cost).
Utilize different allocation bases for different costs (e.g., square footage, headcount).

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2. Reassignment
Step down method.
Allocate service costs in a prescribed order.
E.g., first allocating costs of service centers that provides the most services to others. E.g., first allocating costs of service centers that receives the fewest services from others.

Direct method.
Service centers costs are only allocated to production centers (ignoring services provided to other service centers).
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3. Allocation to Products
In a process cost system: In a job cost system:
Total overhead Equivalent units of production = Overhead cost per unit.
More complex; may use multiple overhead rates. Overhead is assigned to product using some activity measure (e.g., direct labor hours, machine hours). Overhead rate: Total overhead costs Total units of activity measure. For each job: Overhead costs allocated (applied) = Overhead rate x Units of activity measure used by job.
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Cost Drivers (Allocation Bases)

Should reflect a causal relationship between cost and cost object. Cost driver categories:
1. Payroll related (e.g., social security taxes, fringe benefits). 2. Headcount related (e.g., human resource cost related to number of employees, not what they are paid). 3. Material related (e.g., costs related to purchasing, receiving, inspecting, weighing, counting).
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Cost Drivers (Allocation Bases)

Cost driver categories (continued):
4. Space related (e.g., floor area occupied). 5. Transaction or activity related (e.g., costs related a batch such as scheduling, set up costs). 6. Product related (e.g., tools and dies, engineering change orders). 7. Customer related (e.g., sales calls, customer service, advertising). 8. Business related (e.g., costs of CEO, CFO, HR manager).
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Using Predetermined Overhead Rates

An estimated, annual overhead rate (instead of a monthly actual overhead rate). Why?
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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Establishing Predetermined Overhead Rates

Prepare overhead budgets for each production cost center at various levels of activity.
Identify costs as variable, fixed, semi-variable.

Estimate average level of activity expected in each production cost center for coming year (i.e., standard volume). Calculate an overhead rate for each production center (i.e., Budgeted overhead cost at standard volume Standard volume). Some companies use a plantwide overhead rate instead of by individual production cost center.
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Overhead (Clearing Account)

Debit for actual overhead costs incurred. Credit for overhead amounts absorbed (applied) to products.
Predetermined overhead rate X Activity incurred (for each job).

If absorbed costs are greater (less) than actual costs, overhead is overabsorbed (underabsorbed). Balance is transferred to Overhead Variance account.

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Plantwide Overhead Rate

GAAP only requires aggregate inventory and cost of goods sold to be materially accurate -- not by individual product. Can create some products to be undercosted, others overcosted. Can create cross-subsidies when used in pricing and other decisions based on individual product cost.
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Activity-Based Costing
Minimizes cross-subsidization among products. Recognizes that complexity is the single largest driver of cost. Utilizes more service center cost pools (called activities or activity centers). Utilizes more cost drivers (i.e., unit-level, batch-level and product-level).

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Activity-Based Costing
Examples of cost drivers used:
Unit level drivers.
E.g., number of units, direct labor hours, direct labor dollars, machine hours. Costs per unit stay the same regardless of number of units.

Batch level drivers.

E.g., number of orders processed, number of production batches run. The larger the production run or order, the lower the costs per unit.

Product level drivers

Costs required to design or maintain products. Are assigned based on number of products.
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Activity-Based Costing
Each activity is allocated based on the cost driver determined to be most appropriate for that pool of costs. Activitys costs may be assigned directly to product (rather than through a production cost center). Pitfall? Increased recordkeeping. Time-based activity-based costing.

Focuses on amount of time spent in performing activities.

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Activity-Based Management
Supported by activity-based costing. Purpose is to focus company on finding more profitable businesses or finding ways to perform tasks better, faster, and cheaper. May involve:
Total quality management. Quality function deployment. Process improvement. Reengineering. Elimination of non-value-added activities.
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