Hilton Maher Selto

2 Product Costing Systems Concepts and Design Issues McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.

2-3 Product Costs The cost assigned to goods that were either purchased or manufactured for resale. Product Costs The cost assigned to goods that were either purchased or manufactured for resale. Period Costs Costs that are identified with the period in which they are incurred. Period Costs Costs that are identified with the period in which they are incurred. The Meaning of “Cost”? The sacrifice made, usually measured by the resources given up, to achieve a particular purpose.

2-4 Manufacturing Companies There are 3 major categories of manufacturing costs: Direct Materials resources that can be feasibly observed being used to make a specific product. Direct Materials resources that can be feasibly observed being used to make a specific product. Direct Labor The cost of paying employees who convert direct materials into finished product. Direct Labor The cost of paying employees who convert direct materials into finished product. Manufacturing Overhead Indirect material Indirect labor Other overhead

2-5 Manufacturing Companies Prime Costs include: Direct Materials Direct Labor Manufacturing Overhead

2-6 Manufacturing Companies Conversion Costs include: Direct Materials Direct Labor Manufacturing Overhead Nonmanufacturing Costs are all the costs not used to produce products.

2-7 Stages of Production and the Flow of Costs

2-8 Stages of Production and the Flow of Costs - Example What is Ending Inventory in February? Axel Electronics makes toasters. On February 1, Axel has $15,000 of raw material on hand. Axel’s purchase and transfers to the production floor are indicated below.

2-9 Axel Electronics makes toasters. On February 1, Axel has $15,000 of raw material on hand. Axel’s purchase and transfers to the production floor are indicated below. Stages of Production and the Flow of Costs - Example Now let’s look at Work-in-Process.

2-10 Stages of Production and the Flow of Costs - Example What is the amount of cost transferred to Finished Goods in February? 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.

2-11 Stages of Production and the Flow of Costs - Example 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. Now let’s look at Finished Goods. Transferred to Finished Goods

2-12 Stages of Production and the Flow of Costs - Example 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? 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?

2-13 Stages of Production and the Flow of Costs - Example 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? 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?

2-14 Production Costs in the Service Industry A service provider cannot “inventory” services. The costs of providing the service can be identified and accounted for just as in a manufacturing environment. Managing and tracking the costs associated with value- chain activities can provide opportunities for improvement.

2-15 Cost Drivers An “Activity” is any discrete task than an organization undertakes to make or deliver a good or service. A “cost driver” is an activity or event that causes costs to be incurred.

2-16 Cost Behavior Fixed vs. Variable

2-17 Your total long distance telephone bill is based on how many minutes you talk. Minutes Talked Total Long Distance Telephone Bill Cost Behavior Fixed vs. Variable

2-18 Minutes Talked Per Minute Telephone Charge The cost per minute talked is constant. For example, 10 cents per minute. Cost Behavior Fixed vs. Variable

2-19 Number of Local Calls Monthly Basic Telephone Bill Cost Behavior Fixed vs. Variable Your monthly basic telephone bill is probably fixed and does not change when you make more local calls.

2-20 Number of Local Calls Monthly Basic Telephone Bill per Local Call Cost Behavior Fixed vs. Variable The fixed cost per local call decreases as more local calls are made.

2-21 components labor energy parts materials Resources that are acquired specifically for individual units of product or service Resources that are acquired specifically for individual units of product or service Unit-level Resources Directly traceable to the decision to produce the level of output The Hierarchy of Costs

2-22 Acquired as a result of the decision to make a group, or batch of similar products. Acquired as a result of the decision to make a group, or batch of similar products. Batch-level Materials Equipment Applicable to the Batch Specialized Labor The Hierarchy of Costs

2-23 Acquired as a result of the decision to produce and sell a specific product or service. Acquired as a result of the decision to produce and sell a specific product or service. Product-level Software Personnel Applicable to that Product or Service Specialized Equipment The Hierarchy of Costs

2-24 Acquired as a result of the decision to serve specific customers. Acquired as a result of the decision to serve specific customers. Customer-level Software Personnel Dedicated to Specific Customers Specialized Equipment The Hierarchy of Costs

2-25 Labor Force Management Buildings Land Busines s Support Services Resources that are acquired specifically for individual units of product or service Resources that are acquired specifically for individual units of product or service Facility-level The Hierarchy of Costs

2-26 Committed costs are fixed costs that are not intended to vary with production or sales volume. If we get rid of John, we can replace him with a new professor making $20,000 a year less! That will certainly lower our budgeted fixed costs. Committed Costs, Opportunity Costs, & Sunk Costs

2-27 Well, team, it looks like we are gonna be working overtime all week on this job. Opportunity cost measures what is sacrificed when one alternative is chosen. And I passed up $95,000 with IBM for this? Committed Costs, Opportunity Costs, & Sunk Costs

2-28 Sunk costs are past payments for resources that cannot be undone. I don’t want to replace John. We just spent $30,000 to train him on the new equipment! But don’t you see? That $30,000 is gone. It is irrelevant to our decision. Committed Costs, Opportunity Costs, & Sunk Costs

2-29 Direct Costs Assigning resource costs to products and services through reliable observations and documentation of resource use. Direct Costs Assigning resource costs to products and services through reliable observations and documentation of resource use. Some products use more of a given resource than others. Tracing is often more effective than using Average Cost, which assumes that each product uses the same amount of each resource. Traceability of Resources

2-30 Indirect Costs Attaching or assigning indirect costs to products, services, or organizational units by some reasonable method of averaging. Indirect Costs Attaching or assigning indirect costs to products, services, or organizational units by some reasonable method of averaging. Applied to costs that cannot be efficiently traced. Methods such as Activity- Based Costing result in more tracing and less allocation. Example Traceability of Resources

2-31 Tracing versus Allocating Costs - Example Brickley, Inc. makes two products; bricks and play sand. The products are produced in two separate facilities, and the plant supervisors work at both plants. Allocate rent and salaries based on revenues. Brickley’s headquarters is downtown. Brickley, Inc. makes two products; bricks and play sand. The products are produced in two separate facilities, and the plant supervisors work at both plants. Allocate rent and salaries based on revenues. Brickley’s headquarters is downtown.

2-32 The brick operation consumes 70% of the material purchased. The play sand uses the remaining 30%. Labor has an average cost of $10 per hour. The brick operation uses 21,000 labor hours. The play sand operation uses 14,000 labor hours. The company pays all utilities on one bill that goes to the headquarters. Headquarters allocates 50% of the utilities cost to each product. The brick operation consumes 70% of the material purchased. The play sand uses the remaining 30%. Labor has an average cost of $10 per hour. The brick operation uses 21,000 labor hours. The play sand operation uses 14,000 labor hours. The company pays all utilities on one bill that goes to the headquarters. Headquarters allocates 50% of the utilities cost to each product. Tracing versus Allocating Costs - Example

2-33 Compute the missing values and information. Tracing versus Allocating Costs - Example

2-34 Sales Revenue is TRACED to each product based on the actual revenue each product generates. Example: Sand Revenue = 30,000 tons × $90 per ton Sales Revenue is TRACED to each product based on the actual revenue each product generates. Example: Sand Revenue = 30,000 tons × $90 per ton Tracing versus Allocating Costs - Example

2-35 Tracing versus Allocating Costs - Example Material and Labor are traced to each product based on how much of each resource each product uses. Example; Bricks labor = 21,000 hours × $10 per hour Material and Labor are traced to each product based on how much of each resource each product uses. Example; Bricks labor = 21,000 hours × $10 per hour

2-36 Tracing versus Allocating Costs - Example Supervisor salaries and rent are allocated on the basis of relative revenues. Approximately 35.7% goes to Bricks. Approximately 64.3% goes to Sand.

2-37 The utilities are allocated from the home office with 50% of the utilities being charged to each product. Tracing versus Allocating Costs - Example

2-38 Variable Costing measures product cost by the unit- level resources used. Absorption Costing allocates indirect costs to products along with unit-level and variable costs. Income-Reporting Effects of Alternative Product-Costing Methods

2-39 Income-Reporting Effects of Alternative Product-Costing Methods

2-40 Absorption Costing vs. Variable Costing - Example Howell, Inc. produces a single product with a sales price of $40 and the following cost information:

2-41 Unit product cost is determined as follows: Selling and administrative expenses are always treated as period expenses and deducted from revenue. Absorption Costing vs. Variable Costing - Example

2-42 Absorption Costing vs. Variable Costing - Example Howell, Inc. had no beginning inventory, produced 30,000 units and sold 28,000 units this year.

2-43 Absorption Costing vs. Variable Costing - Example Variable costs only. All fixed manufacturing overhead is expensed.

2-44 End of Chapter Hu-man! I will absorb you!