Full Costs and Their Uses

Cost & Cost Object Cost = a measurement, in monetary terms, of the amount of resources used for some purpose. Cost object = the product, project, organizational unit, or other activity or purpose for which costs are measured. Can be defined broadly or narrowly, e.g., one pair of jeans or a batch of a single style of jeans.

Cost Concepts Full cost = all the resources used for a cost object = direct costs + fair share of indirect costs. Technically should include both production and non-production costs Marketing Administrative

Direct Costs Direct costs of a cost object = items of costs that are specifically traced to, or caused by, that cost object.

Indirect Costs Costs that are associated with or caused by, 2 or more cost objects jointly but are not directly traced to each of them individually. Not possible or feasible to trace directly to a cost object. Terms direct and indirect are only meaningful in the context of a specific cost object.

Conversion Costs Direct labor costs of a cost object = labor quantities * unit price of direct labor. Usually only DM & DL are direct costs. Overhead costs = all indirect production costs. Conversion costs = direct labor cost + overhead cost = all production costs needed to convert direct material into finished goods.

Uses of full costs Financial reporting: inventory/COGS. Analysis of profitability: by product. product line, plant, division, sales territory. Cost plus contracts. Pricing

Product Pricing Setting regulated prices: utilities, cable. Differentiated product: Normal price = direct costs + applicable indirect costs + profit. Target pricing = price set and then product designed to cover full cost + profit, e.g., apparel industry. Undifferentiated product = commodities. Company does not set price, market does.

Product Costing Systems 2 basic types of costing systems: Job order Process

Job Order Cost System Collects costs for each job as it moves through the production process. Each job: separate identification number and 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.

Process Cost System Collects costs by process (i.e., department). Determine unit costs by dividing total costs by total number of units worked on in the period. Difficult part is determining how many units were worked on. What do you do with partially completed units?

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.

Allocation of Indirect Costs Desirable to classify a cost as direct. Assignment of indirect costs to product is more roundabout and less accurate. Reasons for not tracing directly: Impossible to do so; Not feasible because it is too costly; Mgmt chooses not to do so. How to determine fair share of indirect costs? Based on causal relationship.

Allocation of Indirect Costs Process of assigning indirect costs to individual cost objects. Overhead 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.

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.

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.

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.

First Allocation Step All overhead costs for an accounting period are assigned to the 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.

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 the costs of the service center that provides the most services to other cost centers or the costs of the service center that receives the fewest services from other service centers. Then allocate costs of remaining service cost center

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 the 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 the activity measure. For each job, overhead costs are allocated to it or applied to it or absorbed by it by multiplying the activity measure by the rate.

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). Space related (facility related).

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 the coming year. Calculate each production center’s 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.

Why Use Predetermined Overhead Rates? Actual monthly rates are unduly affected by conditions peculiar to the month. Permits more prompt calculation of product costs. Calculating once a year is less effort than going through the calculation every month.

Under-absorbed and Over-absorbed Overhead Actual overhead costs are charged to cost center overhead clearing account. Overhead clearing account is reduced for the amounts determined from predetermined overhead rate. Amount absorbed by product > actual costs, overhead is over-absorbed (under-absorbed). If overhead is over-absorbed (under-absorbed), there is a credit (debit) balance in the overhead clearing account. This balance is transferred to Overhead variance account. Adjusts COGS or Inv.

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.

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.

Steps of Activity Based Costing Many more service center cost pools (called activities or activity centers) are created. Activity’s costs can be assigned directly to product rather than through a production cost center. Each activity is allocated based on the cost driver determined to be most appropriate for that pool of costs.

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