Chapter 11 Product Costing in Service and Manufacturing Entities

3 Distinct Inventory Accounts (1.) Raw Material Inventory – includes lumber, metals, paints, and chemicals that will be used to make the company’s products (2.) Work in Process Inventory – includes products that have been started but not completed (3.) Finished Goods Inventory – includes completed products that are ready for sale

BALANCE SHEET RAW MATERIALS WORK IN PROCESS FINISHED GOODS Materials Labor Overhead

Pearson Frame Co. Makes and sells jewelry boxes The frames are homogenous i.e. All the frames are the same and require the same amount of labor and materials. Let’s go through the events that happen during the year.

Event 1 Issued $5,000 of Common Stock Debit (Increase) - Cash Credit – Common Stock

Event 2 Paid $1,200 for raw materials This event is an asset exchange.

Event 3 Pearson placed $900 of raw materials into production in the process of making frames.

Event 4 Pearson paid production workers $8 per hour to work 120 hours. Total Labor = $8 * 120 = $960

Event 5 Paid $1,560 for annual insurance premium on the manufacturing facility. We are going to accumulate overhead costs in the “Manufacturing Overhead” account. Debit = Actual Credit = Applied

Event 6 Pearson paid $160 cash to purchase production supplies such as glue, nails, and sandpaper. These supplies cannot be directly traced to each frame. So we are going to use a production supplies account for record- keeping purposes. This is an asset account.

Flow of Overhead Costs Overhead costs accumulate through-out the year. We are not able to accurate allocated them until the end of the year. But we need to know an estimate during the year So we calculate a predetermined overhead rate to use through out the year

Overhead Pearson’s accountants estimated overhead costs of $12,750. It expects to use 1,500 DLH.

Predetermined OH Rate Total indirect OH = $12,750 Pearson expects to use 1,500 DLH Predetermined OH Rate = – $12,750 / 1,500 = $8.50 DLH For January – 120 DLH Jan OH = 120 * $8.50 = $1,020

Event 8 Pearson recognized $1,020 of estimated manufacturing overhead costs at the end of January.

Event 8 The entry is: Debit – Work in Process Credit – Manufacturing Overhead

Manufacturing Overhead The credit to this account is applied OH. This account is a temporary asset account. i.e. It is closed out to a zero balance at the end of the year. If there is a remaining balance at the end of the year that means overhead was either overapplied or underapplied.

Manufacturing Overhead The balance at the end of the year is closed out to COGS. Overapplied OH – more OH had been applied than was actually incurred – i.e. COGS was charged too much Underapplied OH – less OH had been applied than was incurred – i.e. COGS was not charged enough

Event 9 Pearson completed 576 boxes in January, that were started during the month. $900 materials $960 labor $1,020 OH Cost per Frame = $2,880 / 576 frames = $5 $2,880 COST OF GOODS MANUFACTURED

Event 10 Pearson sold 500 picture frames COGS = $5 * 500 = $2,500 Revenue = $9 * 500 = $4,500

Event 11 Paid $490 for general, selling, and admin expenses

Event 22 Year-end count of production supplies indicated $150 EOY balance.

Event 23 Close out manufacturing overhead Actual OH = $11,580 Applied OH = $12,155 Too much OH was applied (i.e. – Overapplied OH) Must debit Manufacturing OH to get balance to zero DR - Manufacturing OH $575 CR – COGS $575

Schedule of Goods Manufactured & Sold The schedule reflects the transaction data in the ledger accounts. The schedule includes the actual amount of overhead cost

Absorption Costing Absorption (Full) Costing – all product costs, both variable and fixed, be reported as inventory until the products are sold – once sold the costs are expensed as cost of goods sold

Absorption Costing Example – Roberts Manufacturing Co. incurs $18,000 variable costs and $12,000 fixed costs to produce 2,000 units of inventory. Cost per Unit Fixed = $12,000 / 2,000 = $6 Variable = $18,000 / 2,000 = $9 So for each item sold $15 is charged to COGS

Absorption Costing If 3,000 units are produced the fixed cost are still $12,000 but the per unit is now $4 per unit $12,000 / 3,000 units = $4 / unit Variable cost is still $9 / unit Total cost per unit is now $13

Absorption Costing Who cares? What difference does it make? Let assume 2,000 are sold Scenario 1 = 2,000 * $15 / unit = $30,000 Scenario 2 = 2,000 * $13 / unit = $26,000 The more units made the lesser the total COGS

Absorption Costing Why do company’s use absorption costing? Overproducing spreads the fixed costs over more units, thereby reducing the cost per unit and the amount charged cost of goods sold. Overproducing is not good. It is not good to have too much inventory. It is very risky. Inventory is subject to obsolescence, damage, theft, and/or destruction.

Variable Costing Under variable costing, inventory includes only variable product costs. Fixed manufacturing costs are expensed in the period in which they are incurred regardless of when inventory is sold. Increases in production have no effect on the amount of reported profit.