McGraw-Hill/Irwin 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. 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. 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 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. 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

2-10 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.

2-11 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.

2-12 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.

2-13 Stages of Production and the Flow of Costs - Example Now let’s 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 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?

2-15 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? Cost of goods sold

2-16 Learning Objective 2

2-17 Schedule of Cost of Goods Manufactured Let’s look at a Schedule of Cost of Goods Manufactured for CollegePak Company.

2-18 Schedule of Cost of Goods Manufactured

2-19 Schedule of Cost of Goods Manufactured

2-20 Schedule of Cost of Goods Manufactured Include all direct labor costs incurred during the current period.

2-21 Schedule of Cost of Goods Manufactured Beginning work-in- process inventory is carried over from the prior period.

2-22 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 let’s look at an income statement for CollegePak. Income Statement for a Manufacturer

2-24 Income Statement for a Manufacturer

2-25 Income Statement for a Manufacturer

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 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 Total Long Distance Telephone Bill Total Variable Cost Example

2-31 Minutes Talked Per Minute Telephone Charge 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 Monthly Basic Telephone Bill Total Fixed Cost Example

2-33 Number of Local Calls Monthly Basic Telephone Bill per Local Call The average cost per local call decreases as more local calls are made. Fixed Cost Per Unit Example

2-34 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 organization’s overall facility and infrastructure. Includes production manager’s 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. 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. 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 vs. Variable Costing

2-49 Let’s 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 vs. Variable Costing - Example Howell, Inc. had no beginning inventory, produced 30,000 units and sold 28,000 units this year.

2-53 Variable costs only. All fixed manufacturing overhead is expensed. Absorption Costing vs. Variable Costing - Example

2-54 Comparing Absorption and Variable Costing Let’s compare the methods.

2-55 We can reconcile the difference between absorption and variable net income as follows: Fixed mfg. overhead $210,000 Units produced 30,000 = $7.00 per unit = Reconciling Income

2-56 Let’s 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 Howell’s cost structure. Howell Inc., Year 2

2-59 Units in ending inventory from the previous period. 30,000 units produced in the current period. Howell Inc., Year 2

2-60 Howell Inc., Year 2

2-61 In the first period, production (30,000 units) was greater than sales (28,000). 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 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 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