Fundamentals of Product and Service Costing Chapter 6 Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Learning Objectives L.O. 1 Explain the fundamental themes underlying the design of cost systems. L.O. 2 Explain how cost allocation is used in a cost management system. L.O. 3 Explain how a basic product costing system works. L.O. 4 Understand how overhead cost is allocated to products. L.O. 5 Explain the operation of a two-stage allocation system for product costing. L.O. 6 Describe the three basic types of product costing systems: job order, process, and operations. 6-2

Cost System Keys to a good cost system: Oriented to the needs of the decision makers Designed so that benefits exceed costs 6-3

Cost Management Systems L.O. 1 Explain the fundamental themes underlying the design of cost systems. The objective of the cost management system is to provide information about costs relevant for decision making. The cost system accumulates and reports costs about processes, products, and services. 6-4

Reasons to Calculate Product or Service Costs For decision making For deciding what to sell For setting prices For knowing the cost of goods sold For knowing the cost of inventory LO1 6-5

Cost Allocation and Product Costing L.O. 2 Explain how cost allocation is used in a cost management system. Basic Cost Flow Diagram Direct materials Direct labor Manufacturing overhead AlphaBeta Cost pools Cost objects Cost allocation rule Indirect (allocated by direct labor cost) Direct 6-6

Fundamental Themes Underlying the Design of Cost Systems Cost systems should have a decision focus. Different cost information is used for different purposes. Cost information for managerial purposes must meet the cost-benefit test. LO2 6-7

Basic Cost Flow Model L.O. 3 Explain how a basic product costing system works. How costs and units move through inventories: Beginning balance Transfers in Transfers out Ending balance +–= BBTITOEB+–= This is true for the following accounts: – Raw Materials (RM) – Work-in-Process (WIP) – Finished Goods (FG) 6-8

Costing with No Work-in-Process Inventories Baxter Paint begins production on April 1. It starts and completes production of 100,000 gallons of paint in April and has no ending work-in-process inventory. Materials$ 400,000 Labor 100,000 Manufacturing overhead 500,000 Total$1,000,000 Cost of resources used in April: LO3 6-9

Costing with No Work-in-Process Inventories BBTITOEB+–= 0 100,000 gallons 100,000 gallons 0+–= FG LO3 6-10

Costing with No Work-in-Process Inventories What are the costs at the end of the period? $1,000,000 was added to work-in-process and then transferred out to finished goods. Since Baxter produced 100,000 gallons of paint, then the cost per gallon of paint is $10. LO3 6-11

Costing with Work-in-Process Inventories Beginning inventory-0- Started in May110,000 Total110,000 Ending WIP (50% complete) 20,000 Transferred out 90,000 Production for Baxter Paint for May follows (gallons): LO3 6-12

Costing with Work-in-Process Inventories BBTITOEB+–= 0 110,000 gallons 90,000 gallons 20,000 gallons (50% complete) +–= FG LO3 6-13

Costing with Work-in-Process Inventories How do we cost Baxter’s 20,000 gallons of paint that are only half finished? 20,000 gallons half finished is equivalent to 10,000 gallons finished. 90,000 gallons transferred out plus 10,000 equivalent gallons of finished paint equals 100,000 equivalent gallons of paint. Gallons of paint transferred out 90,000 Equivalent gallons of finished paint 10,000 Total equivalent gallons of paint100,000 LO3 6-14

Costing with Work-in-Process Inventories Materials$390,000 Labor 100,000 Manufacturing overhead 500,000 Total$990,000 Costs incurred in May: $990,000/100,000 gallons = $9.90 per gallon 90,000 gallons × $9.90/gallon = $891,000 LO3 6-15

Costing with Work-in-Process Inventories Direct material + Direct labor + Overhead ($990,000) Finished goods inventory $891,000 Work-in-process inventory $99,000 Equivalent gallons 90,000 gallons (90%) 10,000 gallons (10%) LO3 6-16

Costing in a Multiple Product, Discrete Process Industry Cost Flow Diagram: Cost Allocation Bases—Grange Boats Direct materials Direct labor Manufacturing overhead C-27sC-20s Cost pools Cost objects Indirect cost (allocated in proportion to direct labor-hours) Direct cost Direct cost LO3 6-17

Costing in a Multiple Product, Discrete Process Industry Data for January—Grange Boats Units produced Direct labor-hours Costs: Direct materials Direct labor Manufacturing overhead Total 10 2,000 $40,000 72, ,000 $36,000 78, ,000 $ 76, , ,000 $406,000 C-27sC-20sTotal LO3 6-18

Costing in a Multiple Product, Discrete Process Industry Direct materials Direct labor C-27sC-20s Cost pools Cost objects Direct cost $76,000$150,000 $40,000$36,000 $72,000$78,000 LO3 6-19

Predetermined Overhead Rates L.O. 4 Understand how overhead cost is allocated to products. Indirect costs are allocated using a predetermined overhead rate (POHR). POHR is the cost per unit of the allocation base used to charge overhead to products. POHR = $ ÷ Base 6-20

Predetermined Overhead Rates POHR= Estimated overhead $ Estimated allocation base What are the estimated costs? What activity drives the overhead costs? Why use estimates? Products need to have costs applied during the period. The exact amount of indirect costs are not known until the end of the period. LO4 6-21

Predetermined Overhead Rates Direct labor hours Estimated overhead costs 2,000 3,000 5,000 $180,000 C-27sC-20sTotal POHR = $180,000 ÷ 5,000 = $36/DLH LO4 6-22

Product Costing of Multiple Products Cost pool Cost objects Cost allocation rule Manufacturing overhead $180,000 C-27s $72,000 (2,000 DLH × $36) C-20s $108,000 (3,000 DLH × $36) Direct labor hours ($36/DLH LO4 6-23

Product Costing of Multiple Products Product Costs for January—Grange Boats (allocation base is direct labor hours) Units produced Direct labor-hours Costs: Direct materials Direct labor Manufacturing overhead $36/hour) Total Cost per unit 10 2,000 $ 40,000 72,000 $184,000 $ 18, ,000 $ 36,000 78, ,000 $222,000 $ 7, ,000 $ 76, , ,000 $406,000 C-27sC-20sTotal LO4 6-24

Choice of the Allocation Base The choice of the allocation base is somewhat arbitrary. What will be the result if management chooses direct labor cost as the allocation base? The rate then becomes 120% ($180,000 ÷ $150,000) LO4 6-25

Choice of the Allocation Base Product Costs for January—Grange Boats (allocation base is direct labor dollars) Units produced Direct labor-hours Costs: Direct materials Direct labor Manufacturing overhead 120%) Total Cost per unit 10 2,000 $ 40,000 72,000 86,400 $198,400 $ 19, ,000 $ 36,000 78,000 93,600 $207,600 $ 6, ,000 $ 76, , ,000 $406,000 C-27sC-20sTotal LO4 6-26

Multiple Allocation Bases and Two-Stage Systems L.O. 5 Explain the operation of a two-stage allocation system for product costing. We can use two or more allocation bases to allocate manufacturing overhead to products. 6-27

Multiple Allocation Bases and Two-Stage Systems Manufacturing overhead Machine-related costs Direct labor-related costs C-27sC-20s Cost pool Cost objects Cost allocation rules Indirect costs (allocated in proportion to machine hours) (allocated in proportion to direct labor costs) Second stage First stage LO5 6-28

Multiple Allocation Bases and Two-Stage Systems Cost pool Cost allocation rule Intermediate cost pools Overhead $180,000 Labor-related $108,000 Machine-related $72,000 Direct labor costs Machine hours LO5 6-29

Multiple Allocation Bases and Two-Stage Systems Burden rates: $72,000 ÷ 4,000 machine hours = $18 $108,000 ÷ $150,000 labor costs = 72% LO5 6-30

Two-Stage Cost Allocation— Grange Boats Intermediate cost pools Cost Allocation Cost Objects Allocated overhead Labor-related $180,000 Machine-related $72,000 $150,000 Direct labor cost 72% DLC 4,000 Machine hours $18/MH C-27s $51,840 DL cost $18,000 MH C-20s $ 56,160 DL cost $ 54,000 MH $69,840 Total$110,160 Total LO5 6-31

Two-Stage Cost Allocation— Grange Boats Costs: Direct materials Direct labor Overhead: direct labor cost Total cost Unit cost $ 40,000 72,000 18,000 51,840 $ 69,840 $181,840 $ 18,184 $ 36,000 78,000 54,000 56,160 $110,160 $224,160 $ 7,472 $ 76, ,000 72, ,000 $180,000 $406,000 C-27sC-20sTotal LO5 6-32

Product Costing Systems L.O. 6 Describe the three basic types of product costing systems: job order, process, and operations. Job costing: –An accounting system that traces costs to individual units or to specific jobs, contracts, or batches of goods. (custom homes, movies, services) Process costing: –An accounting system used when identical units are produced through a series of uniform production steps. (cornflakes, facial tissues, paint) 6-33

Product Costing Systems Operation costing: –A hybrid costing system often used in manufacturing of goods that have some common characteristics plus some individual characteristics. (automobiles, computers, clothing) LO6 6-34

End of Chapter 6 Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin