1. Product Costing Systems: Concepts and Design Issues2
Product Costing Systems:
Concepts and Design Issues

2. Learning Objective 1

3. The Meaning of Cost
The use of valuable resources, in order to achieve a stated purpose. In accounting, cost is reported in monetary terms.
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.

4. Learning Objective 3

5. Comparing Service, Retail and Manufacturing Companies
Service firms . . .
 Provide a service that is consumed when produced.
 Have no inventories.
Retailers . . .
 Buy finished goods.
 Sell finished goods.
MegaLoMart
Manufacturers . . .
 Buy raw materials.
 Produce and sell finished goods.

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 Labor
Payments and benefits for those employees who convert direct materials into finished product.
Manufacturing Overhead
Indirect material
Indirect labor
Other overhead

7. Manufacturing Companies
Prime Costs include:
Direct Materials
Direct Labor
Manufacturing Overhead

8. Manufacturing Companies
Conversion Costs include:
Direct Materials
Direct Labor
Manufacturing Overhead .

9. Stages of Production and the Flow of Costs

10. Stages of Production and the Flow of Costs - Example
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.
What is Ending Inventory in February?

11. Stages of Production and the Flow of Costs - Example
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.
Now let’s look at Work-in-Process.

12. 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.
What is the amount of cost transferred to Finished Goods in February?

13. 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

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?

15. Stages of Production and the Flow of Costs - Example
Cost of goods sold
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?

16. Learning Objective 2

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

18. Schedule of Cost of Goods Manufactured

19. Schedule of Cost of Goods Manufactured

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

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

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.

23. Income Statement for a Manufacturer
Now let’s look at an income statement for CollegePak.

24. Income Statement for a Manufacturer

25. Income Statement for a Manufacturer

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.

27. Cost Drivers
An “activity” is any discrete task that an organization undertakes to make or deliver a good or service.
Number of computers made by Dell in a day
Number of flights by Southwest Airlines in a given market
A “cost driver” is some characteristic of the activity that causes costs to be incurred.

28. Learning Objective 4

29. Cost Behavior Total variable costs change 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.

30. Total Variable Cost Example
Your total long distance telephone bill is based on how many minutes you talk.
Total Long Distance Telephone Bill
Minutes Talked

31. Variable Cost Per Unit Example
The cost per long distance minute talked is constant. For example, 5 cents per minute.
Per Minute Telephone Charge
Minutes Talked

32. Total Fixed Cost Example
Your monthly basic telephone bill probably does not change when you make more local calls.
Monthly Basic Telephone Bill
Number of Local Calls

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

34. Cost Behavior Summary

35. Cost Hierarchy Unit-level Costs
Directly traceable
to the decision to
produce the level
of output
Unit-level Costs
Costs that are incurred for every unit of product manufactured or service produced.
Includes direct material, direct labor, utilities to run equipment, other overhead directly related to the production process.
All unit level costs are variable, but not all variable costs are unit level costs.

36. Cost Hierarchy 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.

37. Costs that are incurred for each line of product or service.
Cost Hierarchy
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.

38. Cost Hierarchy 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.

39. Learning Objective 5

40. Committed and Discretionary Costs
Long-term obligations, difficult to change in the short term.
Discretionary
Easier to alter in the short term by current managerial decisions.
Rental and/or Lease Financing of Buildings and equipment
Advertising and Research and Development

41. Opportunity Costs
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.

42. Sunk Costs Sunk costs should not be considered in decisions.
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.

43. Traceability of Resources
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.

44. Learning Objective 6

45. Absorption (Full) Costing
A system of accounting for costs in which both fixed and variable production costs are included in product costs.
Fixed
Costs
Product
Variable
Costs

46. Variable Costing
A system of cost accounting that assigns only the variable cost of production to products.
Fixed
Costs
Product
Variable
Costs

47. Learning Objective 7

48. Absorption Costing vs. Variable Costing

49. Absorption and Variable Costing
Let’s see what we can learn about the differences between absorption and variable costing by looking at a numerical example.

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

51. Absorption Costing vs. Variable Costing - Example
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.

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

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

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

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

56. Extending the Example Let’s look at the second year of operations
for Howell, Inc.

57. Howell Inc., Year 2
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.

58. Unit product cost is determined as follows:
Howell Inc., Year 2
Unit product cost is determined as follows:
There has been no
change in Howell’s
cost structure.

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

60. Howell Inc., Year 2

61. Summary 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.

62. Summary

63. Learning Objective 8

64. Variable versus Absorption Costing
All manufacturing costs must be assigned to products to properly match revenues and costs.
Fixed costs are not really the costs of any particular product.
Variable Costing
Absorption Costing

65. Variable versus Absorption Costing
Depreciation, taxes, insurance and salaries are just as essential to products as variable costs.
These are capacity costs and will be incurred even if nothing is produced.
Absorption Costing
Variable Costing

66. Variable versus Absorption Costing
They are the numbers that appear on our external reports.
Absorption
costing product costs
are misleading for
decision making.
Absorption Costing
Variable Costing

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.

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.
Variable versus Absorption Costing

69. Unit-level spending for direct costs
Throughput Costing
Unit-level spending for direct costs
Product cost
Indirect, past
or committed
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.

70. Throughput Costing Advantages
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

71. Learning Objective 9

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.

73. End of Chapter 2