1. Fundamentals of Product & Service Costing
This chapter provides an overview of alternative cost systems for product and service costing. Details and extensions to the basic models described here are presented in the following three chapters.
Chapter 6
McGraw-Hill/Irwin

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

3. Cost System Keys to a good cost system
Oriented to the needs of the decision makers
A good cost system is oriented to the needs of the decision makers and designed so that benefits exceed costs.
Designed so that benefits exceed costs

4. Cost Management System
LO1 Explain the fundamental themes underlying the design of cost systems.
Provide information about costs relevant for decision making.
The cost system accumulates and reports costs about processes, products, and services.
A well-designed cost system accumulates and reports costs that are relevant to the decisions that managers make.

5. Why Calculate the Cost of a Product?
For Decision Making
What should we sell?
What sales price?
What is the cost of goods sold?
What decisions do managers make? In Chapter 4 you saw examples of many of the decisions managers make using information about product costs. What to sell? At what price? What is the cost of the goods sold? What is the cost of inventory?
What is the cost of inventory?

6. Designing a Cost System
Decision making
Focus
How will managers use the information?
Different information for different purposes
Financial
the past
Managerial
the future
Cost systems should have a decision focus that meets the needs of decision makers, the customers of the cost system. Remember what works for one purpose will not necessarily work for another purpose. Cost information can always be improved. However, the benefits of improvement (i.e. better decision making) must outweigh the costs of making the improvements.
What type of decisions will be made?
Test
Cost-benefit
Will benefits of improved decision making outweigh the costs of implementing the new cost system?

7. • Cost systems should have a decision focus
• Cost systems should have a decision focus. It is important to design the cost system to facilitate the decision making of the users (or customers) of the cost data provided by the cost system.
• Different cost information is used for different purposes. What works for one purpose will not necessarily work for another purpose. The cost information must provide the appropriate data for its intended purpose.
• Cost information for managerial purposes must meet the cost-benefit test. Cost information can always be improved. But the benefits of improvements (i.e., better decision making) must outweigh the costs of making the improvement.

8. Cost Allocation and Product Costing
LO2 Explain how cost allocation is used in a cost management system.
Cost Flow Diagram
$ Direct materials
$ Direct labor
$ Overhead DM DL OH
Chapter 1 introduced cost allocation and product costing. We know that costs that are common to two or more cost objects are likely to be allocated to those cost objects on a somewhat arbitrary basis. A manufacturing or service firm that buys different resources (materials, labor, supplies, etc.) and combines them into two or more finished products must allocate the cost of the resources to the finished products. Suppose a company produces two products, Product A and Product B, and uses direct materials, direct labor and overhead to make these products. This cost flow diagram shows that the direct materials and direct labor are traced directly to the products. We can observe a link between these resources and the products. However, overhead is an indirect cost and cannot be traced directly to the products. Therefore, it must be allocated.
Traced Directly
Allocated using Direct labor $
Product A
Product B

9. Why are cost flow diagrams useful in describing product costing system
They help describe how a cost management system works, just like a flow chart helps you understand how a process works.
Help managers identify and understand quickly the effect of changes in the system design on reported costs.

10. How are product costing and cost allocation related
Cost allocation is the assignment of costs in cost pools to cost objects.
The cost objects may be products, services, customers, processes, or anything for which we want to know the cost.
Product costing uses cost allocation to calculate product costs.
Product costing is an application of cost allocation where products are the cost objects.

11. The Inventory Accounts
Raw Materials
Work-In-Process
Finished Goods
Beg. Inventory
Beg. Inventory
Beg. Inventory
Cost of Goods Completed and Transferred from WIP + +
Purchases
Direct Materials Transferred from Raw Materials +
Raw Materials Available for Production =
Direct Labor +
Goods Available for Sale =
Manufacturing Overhead +
Raw Materials Transferred to WIP -
Raw Materials Transferred to WIP -
Cost of Goods Sold -
Total Manufacturing Costs =
Ending Inventory =
Ending Inventory =
Inventory accounts are assets on the balance sheet. Product costs go into inventory when the cost is incurred. Look at the three inventory accounts. To the raw materials beginning balance add purchases which gives you raw materials available for production. Purchasing material is a cost that goes into inventory when the cost is incurred. Subtract from raw materials available for production the raw materials that are transferred to work-in-process and you have your ending raw material inventory. When raw materials are transferred to work-in-process the cost of these materials is transferred from one inventory account to another inventory account. To beginning work-in-process inventory add the product costs; direct materials, direct labor and manufacturing overhead. From total manufacturing costs subtract the cost of goods completed and transferred to finished goods. The cost of goods completed and transferred to finished goods is called the cost of goods manufactured. Total manufacturing costs minus cost of goods manufactured equals ending work-in-process inventory. Again, note, product costs are transferred from one inventory account, work-in-process, to another inventory account, finished goods. Finally, beginning finished goods inventory plus the cost of goods manufactured equals the goods available for sale. Subtracting from the goods available for sale the cost of goods sold gives you the ending finished goods inventory. Remember, product costs become expenses when the goods are sold. The cost of goods sold, or the transfers out of finished goods goes to the income statement. At this time the product costs become an expense.
Cost of Goods Completed and Transferred to Finished Goods -
Cost of Goods Completed and Transferred to Finished Goods -
To the income statement
Ending Inventory =

12. A Product Costing System at Work
LO3 Explain how a basic product costing system works.
How costs and units move through inventories.
Beginning Balance
Transfers In
Transfers Out
Ending Balance BB TI TO EB BB TI TO EB
True for
Raw Materials RM
The basic cost flow model: beginning balance plus transfers in minus transfers out equals ending balance is true for all three inventory accounts: Raw Materials (RM), Work-In-Process (WIP), and Finished Goods (FG).
Work-In-Process
WIP
Finished Goods FG
Inventory account
Beginning balance (BB)
Less: Transfer out (TO)
Plus: Transfer in (TI)
Ending balance (EB)

13. The basic cost flow model appears as follows:
Beginning balance + Transfers in – Transfers out = Ending balance
Beginning balance is the balance of inventory at the beginning of the period.
Transfers in represent inventory purchased or transferred in from another department (for example, raw materials would be goods transferred in to work in process) for the period.
Transfers out are goods transferred from one department to another (for example, work in process would be transferred out to finished goods).
Ending balance represents the amount of inventory in a department at the end of the accounting period.

14. Product Costing System, Continued. . .
How costs and units move through inventories. RM
DM to WIP BB
Purchases EB
IM to OH
WIP DM
Transfers to FG BB DL EB OH
Let’s look at the costs that flow through each of the three inventory accounts. What are the transfers in and the transfers out of the inventory accounts? Transfers in to raw materials are purchases. Direct materials transfer out of the raw material inventory account into work-in-process and indirect materials transfer out of raw materials into overhead. Transfers in to work-in-process include direct materials, direct labor, and overhead. When goods are completed they are transferred out of work-in-process and in to finished goods. So the cost of goods manufactured and transferred into finished goods are the goods transferred out of work-in-process. When goods are sold, the cost of those goods transfer out of finished goods onto the income statement. FG
Transfers from WIP EB BB
Cost of goods sold
To income statement

15. Product Costing System, Continued. . .
Baxter Paint
April WIP Inventory
Units – gallons of paint BB TO EB TI
100,000 gallons
100,000 gallons
The inventory equation is true for both units and costs. Let’s look at Baxter Paint. At the beginning of April, Baxter Paint had no work-in-process inventory. 100,000 gallons of paint were started during the month of April. All 100,000 gallons were finished and transferred out of work-in-process and in to finished goods. FG

16. A Product Costing System at Work
Baxter Paint
April WIP Inventory
Costs BB TI TO EB DM
$400,000 $0
$1,000,000 $0 DL
$100,000 OH
$500,000
Look at work-in-process costs. Baxter Paint had no beginning balance. During April Baxter added the following costs to work-in-process: direct materials of $400,000, direct labor of $100,000, and overhead of $500,000. Total costs added to work-in-process equaled $1 million. All of the paint, and therefore, all of the costs, were transferred out of work-in-process and in to finished goods. If Baxter Paint produced 100,000 gallons of paint at a cost of $1,000,000, the cost per gallon of paint is $10.
$1,000,000 FG
Cost per gallon
$1,000,000
$10 per gallon
100,000

17. Work-In-Process Costs
Let’s rewrite the basic cost flow model BB TI TO EB
What are the costs?
Where are the costs at the end of the period? DM DL OH
$400,000
$100,000
$500,000
$1,000,000
At this time it might be helpful to rewrite the basic cost flow model. Beginning balance plus transfers in equals transfers out plus ending balance. The questions we ask are: What are the costs? And, where are the costs at the end of the period? At the end of the period the costs are either transferred out or are still in the ending inventory balance. For Baxter Paint the costs are $1 million. At the end of the period the $1 million has been transferred out to finished goods. None of it remains in ending work-in-process inventory. $0
$1,000,000 $0 FG

18. Another Example: Costing with Ending WIP Inventory
Given:
Gallons
Beginning WIP
-0-
Started in May
Total
110,000
Ending WIP (50% Complete)
20,000
Transferred Out
90,000
Baxter Paint
May WIP
Units BB TI TO EB
110,000 gallons
90,000 gallons
Now let’s look at an example where some products remain in ending inventory. Suppose during May Baxter Paint started 110,000 gallons of paint, completed and transferred out 90,000 gallons and had 20,000 gallons that were half finished still in work-and-process at the end of the month.
20,000 gallons
These gallons are half finished. FG

19. Equivalent Units Ending WIP Inventory
How do we cost Baxter’s 20,000 gallons of paint that are only half finished?
20,000 gallons
½ finished
Equivalent to
10,000 gallons finished
20,000 .5
How much paint did Baxter Paint produce in May? 90,000 gallons transferred to finished goods, but there are still 20,000 gallons in work-in-process that are only half finished. How do we account for Baxter’s 20,000 gallons of paint that are only half finished? 20,000 gallons of paint half finished are equivalent to 10,000 gallons of finished paint. When products remain in ending work-and-process inventory we use equivalent units. 90,000 gallons of paint transferred out plus 10,000 equivalent gallons of finished paint in ending inventory equals 100,000 equivalent gallons of paint.
90,000
To FG
10,000
Ending WIP, 50% Complete
Total equivalent units
100,000

20. Costing a Product, Continued. . .
Baxter Paint
May WIP
Costs BB TI TO EB DM
$390,000 ? ? $0 DL
$100,000 OH
$500,000
$990,000
If Baxter Paint transferred in $990,000 of cost during the month of May the question we ask is: where are those costs at the end of the period? What is the cost of the 90,000 gallons transferred to finished goods and what is the cost of the 20,000 gallons still in work-in-process? FG
Where is the $990,000?
What is the cost of the 90,000 gallons transferred to FG and the 20,000 gallons still in WIP?

21. Costing a Product, Continued. . .
Cost Flow Diagram
Product Costing at Baxter Paints DM DL OH
$390,000
$100,000
$500,000
Total $990,000
90,000 gallons
10,000 gallons
Equivalent Gallons
Compute the cost per equivalent gallon of paint. Baxter incurred $990,000 of cost and produced 100,000 equivalents gallons of paint so the paint cost $9.90 per gallon ($990,000/100,000). Because 90,000 gallons were transferred out, assign $891,000 (90,000 gallons x $9.90) to the units transferred to finished goods and $99,000 (10,000 equivalent gallons x $9.90) to the ending work-in-process inventory.
(90%)
(10%)
100,000 FG
WIP
$891,000
$99,000

22. Costing Multiple Products
Grange Boats
Units
C27s
C20s
Total
Units produced 10 30 40
Direct labor hours
2,000
3,000
5,000
Machine Hours
1,000
3,000
4,000
Costs
In a firm with multiple products a manager making pricing decisions needs cost information at the product level. Look at Grange Boats. Grange produces two boat models: C-27s and the C-20s. How do we cost these two individual products?
Direct Material
$40,000
$36,000
$76,000
Direct Labor
$72,000
$78,000
$150,000

23. Costing Multiple Products
Direct Materials
Direct Labor
$76,000
$150,000
Cost Pools
Direct
Direct
Cost Objects
We know that, by definition, direct materials and direct labor can be traced to the individual products. Of the $76,000 of direct materials, $40,000 is directly traceable to C-27s and $36,000 to C-20s. Of the $150,000 of direct labor, $72,000 is directly traceable to C-27s and $78,000 is directly traceable to the C-20s.
C27s
C20s
$40,000
$36,000
$72,000
$78,000

24. Predetermined Overhead Rates
LO4 Understand how overhead cost is allocated to products.
OH is indirect. Where do indirect costs belong?
With C27s?
Or with C20s?
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.
But what about overhead costs? Overhead is indirect. Should the indirect costs go to the C-27s or the C-20s? Indirect costs are allocated using a predetermined overhead rate. The predetermined overhead rate is the cost per unit of the allocation basis that is used to charge overhead to products. Let’s see what this means. $
POHR
Base

25. Predetermined Overhead Rates, Continued. . .
What are the estimated costs?
Estimated overhead $
POHR
Estimated allocation base
What activity drives the overhead costs?
Why use estimates?
The predetermined overhead rate equals the estimated overhead costs divided by the estimated allocation basis. Recall from Chapter 2 that the allocation base will be the activity that drives the overhead cost. We use estimated costs and estimated allocation base because we need to cost the products during the period and we don’t know the exact amount of the indirect costs or the actual activity until the end of the period.
Products need to have costs applied during the period.
The exact amount of indirect costs are not known until the end of the period.

26. Grange Boats, Continued. . .
2,000
3,000
5,000
Direct Labor hours
C27s
C20s
Total
Estimated Overhead Costs
$180,000
POHR
$180,000
5,000
$36 / DLH
Suppose Grange Boats estimates overhead cost for the period of $180,000. Grange also estimates a total of 5,000 direct labor hours will be worked during the period. Grange’s predetermined overhead rate is $180,000 divided by 5,000 direct labor hours. The predetermined overhead rate is $36 per direct labor hour.

27. Allocating OH to the Products
Cost Pool OH
$180,000
Cost Allocation Rule
$36/DLH
Direct Labor Hours
Now allocate overhead to the C-27s and C-20s. The cost pool is $180,000 of overhead. The cost allocation rule is $36 per direct labor hour. Producing C-27 required 2,000 direct labor hours and producing C-20s required 3,000 direct labor hours. Therefore, we allocate $72,000 (2,000 x $36) to C-27s and $108,000 (3,000 x $36) to C-20s.
Cost Objects
C27s
$72,000
2,000DLH
$36
C20s
$108,000
3,000DLH
$36

28. Grange Boats, Continued. . .
Units produced 10 30 40
Direct Labor hours
2,000
3,000
5,000
C27s
C20s
Total
Units
Machine hours
1,000
4,000
Direct Material
$40,000
$36,000
$76,000
Direct Labor
72,000
78,000
150,000 OH
108,000
180,000
Costs
The total cost of producing 10 C-27s was $184,000 or $18,400 per unit. The total cost of producing 30 C-20s was $222,000 or $7,400 per unit.
Cost per unit
$18,400
$7,400
Total
$184,000
$222,000
$406,000

29. Two-Stage Allocation Systems
LO5 Explain the operation of a two-stage allocation system for product costing.
Cost Pool
Overhead
$180,000
Intermediate Cost Pools
Labor-related
$108,000
$72,000
Machine-related
Let’s look a little closer at the overhead costs for Grange. A closer inspection of the overhead accounts suggest that some of the overhead seems to be related more to machine utilization than direct labor. If this is the case, we can use two allocation bases to allocate overhead to the products. First we will assign the overhead cost pool of $180,000 to the intermediate cost pools. $108,000 of overhead is labor-related and $72,000 is machine-related. The labor-related costs will be allocated using direct labor costs and the machine-related costs will be allocated using machine hours.
Cost Allocation Rule
Direct Labor Costs
Machine Hours

30. Two-Stage Allocation Systems, Continued. . .
Intermediate Cost Pools
Labor-related
Machine-related
$108,000
$72,000
Cost Allocation
Direct Labor Cost
Machine Hours
72% DLC
$18/MH
4,000
$150,000
Cost Objects
C27s
C20s
$51,840
$56,160
DLCost
$18,000
$54,000 MH
Labor-related overhead costs of $108,000 divided by $150,000 direct labor costs will be allocated at the rate of 72% of direct labor cost. Machine-related costs of $72,000 divided by 4,000 machine hours will be allocated at the rate of $18 per machine hour. The $108,000 of labor-related costs are allocated $51,840 to the C-27s and $56,160 to the C-20s. The $72,000 of machine-related costs are allocated $18,000 to the C-27s and $54,000 to the C-20s.
$110,160
$69,840
Allocated Overhead

31. Grange Boats, Revisited. . .
Costs
C27s
C20s
Total
Cost per unit
$18,184
$7,472
$181,840
$224,160
$406,000
Direct Material
$40,000
$36,000
$76,000
Direct Labor
72,000
78,000
150,000
72% DLC
51,840
56,160
108,000
$18/MH
18,000
54,000
Using the two-stage allocation process we see the total cost allocated to C-27s is $181,840. The total cost allocated to C-20s is $224,160. The cost per unit changed substantially.

32. Product Costing Systems
LO6 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.
Operation Costing
A hybrid costing system often used in manufacturing of goods that have some common characteristics plus some individual characteristics.
Process Costing
An accounting system used when identical units are produced through a series of uniform production steps.
Custom Homes
Movies
Services
Different companies have different production and costing systems. A job costing system is used when costs can be traced to a specific job, for example, building custom homes or making a movie or providing a service. But imagine a company making corn flakes or facial tissues. Here it would be very difficult to trace costs to an individual box of corn flakes or box of facial tissues. This company would use process costing, an accounting system that traces costs to a production process. The details of these two costing systems are discussed in Chapters 7 and 8.
Cornflakes
Facial Tissues
Paint
Automobiles
Computers
Clothing

33. 6-31
Use direct labor hours to allocate overhead costs

34. 6-38
Use 6-31 data to compute individual cost per unit using machine hours to allocate overhead costs

35. 6-43

37. 6-27