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Types of Cost Classifications Classification by Behavior
Activity Cost Cost behavior refers to how a cost will react to changes in the level of business activity. Total fixed costs do not change when activity changes. Total variable costs change in proportion to activity changes. Activity Cost Fixed versus Variable - At a basic level, a cost can be classified by how it behaves with changes in the volume of activity. Thus, a cost can be classified as fixed or variable. A fixed cost does not change with changes in the volume of activity (within a range of activity known as an activity’s relevant range). For example, straight-line depreciation on equipment is a fixed cost. A variable cost changes in proportion to changes in the volume of activity. Sales commissions computed as a percent of sales revenue are variable costs. C 2

Types of Cost Classifications Classification by Traceability
Direct costs Costs traceable to a single cost object. Examples: material and labor cost for a product. Indirect costs Costs that cannot be traced to a single cost object. Example: A maintenance expenditure benefiting two or more departments. A cost is often traced to a cost object, which is a product, process, department, or customer to which costs are assigned. Direct costs are traceable to a single cost object. Indirect costs cannot be easily and cost-beneficially traced to a single cost object. C 2

Types of Cost Classifications Classification by Function
Direct Material Direct Labor Manufacturing Overhead Product Period costs are expenses not attached to the product. Administrative costs are non-manufacturing costs of staff support and administrative functions. Selling costs are incurred to obtain orders and to deliver finished goods to customers. All production (or factory) costs are product costs. Product costs are those production costs necessary to create a product and consist of: direct materials, direct labor, and factory overhead. Overhead refers to production costs other than direct materials and direct labor. Product costs are capitalized as inventory during and after completion of the products; they are recorded as cost of goods sold when those products are sold. Period costs are non-production costs and are usually more associated with activities linked to a time period than with completed products. Common examples of period costs include salaries of the sales staff, wages of maintenance workers, advertising expenses, and depreciation on office furniture and equipment. Period costs and are expensed in the period when incurred either as selling expenses or as general and administrative expenses. C 3

Prime and Conversion Costs
Manufacturing costs are often combined as follows: Direct Material Direct Labor Manufacturing Overhead Prime costs are expenditures directly associated with the manufacture of finished goods, which includes both direct material costs and direct labor costs. Conversion costs are expenditures incurred in the process of converting raw materials to finished goods, which includes both direct labor costs and manufacturing overhead costs. Notice that direct labor costs are considered both prime costs and conversion costs. Prime Cost Conversion Cost C 3

Reporting Manufacturing Activities
Merchandisers . . . Buy finished goods. Sell finished goods. Manufacturers . . . Buy raw materials. Produce and sell finished goods. Companies with manufacturing activities differ from both merchandising and service companies. The main difference between merchandising and manufacturing companies is that merchandisers buy goods ready for sale while manufacturers produce goods from materials and labor. SaleMart C 4

Manufacturer’s Balance Sheet
MERCHANDISER Current Assets Cash Receivables Merchandise Inventory MANUFACTURER Current Assets Cash Receivables Inventories Raw Materials Goods in Process Finished Goods The primary difference in the Balance Sheet of a Merchandiser and a Manufacturer is the presentation of Inventory under the Current Assets section. Merchandisers have one category of inventory called Merchandise Inventory. Manufacturers have three major categories of inventory: Raw Materials, Goods in Process, and Finished Goods. The primary difference is inventory. C 4

Manufacturer’s Balance Sheet
Raw Materials Goods in Process Finished Goods Partially complete products. Material to which some labor and/or overhead have been added. Completed products for sale. Materials waiting to be processed. Can be direct or indirect. Manufacturers carry several unique assets and usually have three inventories instead of the single inventory that merchandisers carry. The three inventories are raw materials, work in process, and finished goods. C 4

Schedule of Cost of Good Manufactured
Summarizes the types and amounts of costs incurred in a company’s manufacturing process. Direct Materials Used + Direct Labor + Factory Overhead = Total Manufacturing Costs + Beginning Work in Process – Ending Work in Process = Cost of Goods Manufactured Managers of manufacturing firms typically analyze product costs in detail. Such analysis can help managers make better decisions about materials, labor, and overhead in order to reduce the cost of goods manufactured and maximize the company’s profits. A company’s manufacturing activities are described in a separate report, called a schedule of cost of goods manufactured. (It is also called a manufacturing statement, a statement of cost of goods manufactured, or a similar term.) By whatever name, the schedule of cost of goods manufactured summarizes the types and amounts of costs incurred in a company’s manufacturing process. P 2

Overhead Cost Flows Across Accounting Reports
This slide summarizes how product costs flow through the accounting system: Direct materials, direct labor, and overhead costs are summarized in the schedule of cost of goods manufactured; then the amount of the cost of goods manufactured from that statement is used to compute cost of goods sold on the income statement. Physical counts determine the dollar amounts of ending raw materials inventory and work in process inventory, and those amounts are included on the end-of-period balance sheet. (Note: This exhibit shows only partial reports.) Review what you have learned in the following NEED-TO-KNOW Slides. P 2

NEED-TO-KNOW Compute the following three measures using the information below. 1. Cost of materials used $70,900 Cost of Direct Materials transferred from Raw Materials Inventory to Work in Process Inventory. 2. Cost of goods manufactured $173,900 Cost of goods completed in the current period and transferred from Work in Process Inventory to Finished Goods Inventory. 3. Cost of goods sold $160,500 Cost of goods leaving Finished Goods Inventory and going to the customer. Expensed on the income statement. Beginning raw materials inventory $15,500 Ending raw materials inventory $10,600 Beginning work in process inventory 29,000 Ending work in process inventory 44,000 Beginning finished goods inventory 24,000 Ending finished goods inventory 37,400 Raw materials purchased 66,000 Direct labor used 38,000 Total factory overhead used 80,000 Raw Materials Inventory Work in Process Inventory Finished Goods Inventory Beg. Inv. 15,500 Beg. Inv. 29,000 Beg. Inv. 24,000 Purchases 66,000 Matls. Used 70,900 Cost of GM 173,900 Direct Labor 38,000 Fact. OH 80,000 Avail for Use 81,500 Avail for Mfg. 217,900 Avail for Sale 197,900 Matls. Used 70,900 Cost of GM 173,900 Cost of GS 160,500 Compute the following three measures using the accounting information below. Cost of materials used; Cost of goods manufactured, and Cost of goods sold. Cost of materials used is the cost of Direct Materials transferred from Raw Materials Inventory to Work in Process Inventory. Cost of goods manufactured is the cost of goods completed in the current period and transferred from Work in Process Inventory to Finished Goods Inventory. And Cost of goods sold is the cost of goods leaving Finished Goods Inventory and going to the customer. The cost of these goods are expensed on the income statement. So let's set up the T-accounts for Raw Materials, Work in Process and Finished Goods. End. Inv. 10,600 End. Inv. 44,000 End. Inv. 37,400 P1/P 2

NEED-TO-KNOW P1/P 2 Balance Sheet Current assets:
Raw Materials Inventory Work in Process Inventory Finished Goods Inventory Beg. Inv. 15,500 Beg. Inv. 29,000 Beg. Inv. 24,000 Purchases 66,000 Matls. Used 70,900 Cost of GM 173,900 Direct Labor 38,000 Fact. OH 80,000 Avail for Use 81,500 Avail for Mfg. 217,900 Avail for Sale 197,900 Matls. Used 70,900 Cost of GM 173,900 Cost of GS 160,500 End. Inv. 10,600 End. Inv. 44,000 End. Inv. 37,400 Balance Sheet Current assets: Raw Materials Inventory $10,600 Work in Process Inventory 44,000 Finished Goods Inventory 37,400 Income Statement Sales $XXXXX The beginning inventory of raw materials is $15,500. The beginning inventory of work in process is $29,000, and the beginning inventory of finished goods is $24,000. During the current period, the company purchased $66,000 of raw materials. These costs are debited to the Raw Materials Inventory account. Total cost of materials available for use is $81,500. At the end of the period, Raw materials has an inventory balance of $10,600. The difference between $81,500 of materials available for use and the amount on hand at the end of the period, $10,600, is the amount that was transferred to Work in Process; cost of materials used, $70,900. $70,900 of materials were transferred from the Raw Materials inventory to the factory, Work in Process. The cost of the direct materials are added to the beginning inventory, along with the cost of direct labor used, $38,000, and factory overhead, $80,000. The total cost of goods available for manufacture is $217,900. At the end of the period, Work in Process Inventory has a value of $44,000. The difference between $217,900 of goods available for manufacture, and $44,000 of goods on hand at the end of the period, represents the cost of completed units. Cost of goods manufactured is $173,900. $173,900 of goods were transferred from Work in Process into the Finished Goods inventory. The beginning inventory of Finished Goods plus cost of goods manufactured equals cost of goods available for sale, $197,900. The value of Finished Goods Inventory at the end of the period is $37,400. The difference between $197,900 available for sale and the ending inventory balance of $37,400 represents cost of goods sold, $160,500. $160,500 of merchandise was sold to the customer in the current period. The current asset section of the balance sheet will include the three ending inventory balances: Raw Materials Inventory, Work in Process Inventory and Finished Goods Inventory. The income statement will report Sales minus Cost of goods sold. Cost of Goods Sold (160,500) P1/P 2

Raw Materials Inventory Turnover
Raw materials used Average materials inventory A business manager can assess how effectively a company manages its raw materials inventory by computing the raw materials inventory turnover ratio as shown in this slide. This ratio reveals how many times a company turns over (uses in production) its raw materials inventory during a period. Generally, a high ratio of raw materials inventory turnover is preferred, as long as raw materials inventory levels are adequate to meet demand. A1

Important Stuff Raw materials Inventory turnover = Raw materials used / Average materials inventory Manufacturers cost of Goods Sold (COGS) = Beg. Inventory + Purchases Costs – End. Inventory = COGS Merchandisers Cost of Goods Sold = Beg. Inventory + Cost of Goods Manufactured – End. Inventory = COGS Cost of Goods Manufactured = Direct Materials + Direct Labors + Factory Overhead = Total Manufacturing Costs + Beg. Work in Progress - End. Work in Progress = Cost of Goods Manufactured Atef Abuelaish

Cost Accounting Systems
Process Costing Job Costing Chapter 7 Used for production of large, unique, or high-cost items. Built to order rather than mass produced. Many costs can be directly traced to each job. The two basic types of cost accounting systems are job order costing and process costing. Many companies produce products individually designed to meet the needs of a specific customer. Each customized product is manufactured separately and its production is called job order production. Process operations, also called process manufacturing or process production, is the mass production of products in a continuous flow of steps. Unlike job order production, where every product differs depending on customer needs, process operations are designed to mass-produce large quantities of identical products. C 1

NEED-TO-KNOW A manufacturing company purchased $1,200 of materials (on account) for use in production. The company used $200 of direct materials on Job 1 and $350 of direct materials on Job 2. Prepare journal entries to record the above transactions. General Journal Debit Credit Purchase Raw Materials Inventory 1,200 Accounts Payable 1,200 Use - DM Work in Process Inventory 550 Raw Materials Inventory 550 Raw Materials Inventory Work in Process Inventory Beg. Inv. XXX Beg. Inv. Purchases 1,200 Direct Materials 550 Direct Material 550 Direct Labor Factory OH A manufacturing company purchased $1,200 of materials (on account) for use in production. The company used $200 of direct materials on Job 1 and $350 of direct materials on Job 2. Prepare journal entries to record the above transactions. The journal entry to record the purchase of materials on account is a debit to Raw Materials Inventory, $1,200, and a credit to Accounts payable. The journal entry to record the use of direct materials on the jobs is a debit to Work in Process Inventory for the total, $550, and a credit to Raw Materials Inventory. $200 of direct materials was charged to Job 1 and $350 of direct materials was charged to Job 2. The job sheets act as a subsidiary ledger to Work in Process Inventory, the control account. Job 1 Job 2 Direct Materials 200 Direct Materials 350 Direct Labor Direct Labor Factory OH Factory OH P 1

NEED-TO-KNOW A manufacturing company used $5,400 of direct labor in production activities in May. Of this amount, $3,100 of direct labor was used on Job A1 and $2,300 of direct labor was used on Job A2. Prepare the journal entry to record direct labor used. General Journal Debit Credit Work in Process Inventory 5,400 Factory Wages Payable 5,400 Work in Process Inventory Factory Wages Payable Beginning Inv. Direct Materials 5,400 Direct Labor 5,400 Factory OH A manufacturing company used $5,400 of direct labor in production activities in May. Of this amount, $3,100 of direct labor was used on Job A1 and $2,300 of direct labor was used on Job A2. Prepare the journal entry to record direct labor used. The journal entry for direct labor is a debit to Work in Process Inventory, $5,400, and a credit to the liability account, Factory Wages Payable. $3,100 of direct labor was charged to Job A1, and $2,300 of direct labor is charged to Job A2. The job sheets act as subsidiary ledgers to the control account, Work in Process. Total direct labor charged to the job sheets will always agree with the total charged to Work in Process. Job A1 Job A2 Direct Materials Direct Materials Direct Labor 3,100 Direct Labor 2,300 Factory OH Factory OH P 2

Overhead Cost Flows and Predetermined Overhead Rate
We turn now to overhead costs. Unlike direct materials and direct labor, overhead costs cannot be traced directly to individual jobs. Instead, the accounting for overhead costs follows the four-step process shown in this slide. Overhead accounting requires managers to first estimate what total overhead costs will be for the coming period. We cannot wait until the end of a period to allocate overhead to jobs, because a job order costing system uses perpetual inventory records that require up-to-date costs. This estimated overhead cost, even if it is not exactly precise, is needed to estimate a job’s total costs before its completion. Such estimated costs are useful for managers in many decisions, including setting prices and identifying costs that are out of control. At the end of the year, the company adjusts its estimated overhead to the actual amount of overhead incurred for that year, and then considers whether to change its predetermined overhead rate for the next year. P 3

Predetermined Overhead Rate
Road Warriors uses a predetermined overhead rate (POHR) based on direct labor cost to apply overhead to jobs. Being able to estimate overhead in advance requires a predetermined overhead rate, also called predetermined overhead allocation (or application) rate. The predetermined overhead rate requires an estimate of total overhead cost and an allocation factor such as total direct labor cost before the start of the period. This slide shows the usual formula for computing a predetermined overhead rate (estimates are commonly based on annual amounts). This rate is used during the period to allocate estimated overhead to jobs. Some companies use multiple activity (allocation) bases and multiple predetermined overhead rates for different types of products and services. To illustrate, Road Warriors applies (also termed allocates, assigns, or charges) overhead by linking it to direct labor. At the start of the current year, management estimates total direct labor costs of $125,000 and total overhead costs of $200,000. Using these estimates, management computes its predetermined overhead rate as 160% of direct labor cost ($200,000 / $125,000). P 3

NEED-TO-KNOW A manufacturing company estimates it will incur $240,000 of overhead costs in the next year. The company allocates overhead using machine hours, and estimates it will use 1,600 machine hours in the next year. During the month of June, the company used 80 machine hours on Job 1 and 70 machine hours on Job 2. 1. Compute the predetermined overhead rate to be used to apply overhead during the year. Predetermined Overhead Rate = Estimated Overhead Costs $240,000 Estimated Activity Base 1,600 machine hours = $150 per machine hour 2. Determine how much overhead should be applied to Job 1 and to Job 2 for June. Machine Hours Used x Predetermined OH rate = OH Applied Job 1 80 hours x $150 per hour = $12,000 OH applied Job 2 70 hours x $150 per hour = $10,500 OH applied Total 150 hours x $150 per hour = $22,500 OH applied 3. Prepare the journal entry to record overhead applied for June. General Journal Debit Credit A manufacturing company estimates it will incur $240,000 of overhead costs in the next year. The company allocates overhead using machine hours, and estimates it will use 1,600 machine hours in the next year. During the month of June, the company used 80 machine hours on Job 1 and 70 machine hours on Job 2. 1. Compute the predetermined overhead rate to be used to apply overhead during the year. The predetermined overhead rate is calculated by taking the estimated overhead costs and dividing by the estimated activity base. This company has determined that machine hours drive the overhead costs; the base is the estimated machine hours used. $240,000 in estimated overhead costs divided by 1,600 machine hours is a predetermined overhead rate of $150 per machine hour. 2. Determine how much overhead should be applied to Job 1 and to Job 2 for June. Job 1 used a total of 80 machine hours. 80 machine hours multiplied by the predetermined overhead rate of $150 per hour is total overhead applied to Job 1 of $12,000. Job 2 used fewer machine hours. 70 machine hours multiplied by $150 per hour results in a lower amount of overhead applied, $10,500. The total for the month, 150 hours multiplied by $150 per hour, is a total of $22,500. 3. Prepare the journal entry to record overhead applied for June. Debit Work in Process Inventory for the total applied, $22,500, and credit Factory Overhead. Work in Process Inventory 22,500 Factory Overhead 22,500 P 3

NEED-TO-KNOW A manufacturing company used $400 of indirect materials and $2,000 of indirect labor during the month. The company also incurred $1,200 of depreciation on factory equipment, $500 of depreciation on office equipment, and $300 of factory utilities. Prepare the journal entry to record actual factory overhead costs incurred during the month. General Journal Debit Credit Factory Overhead 3,900 Raw Materials Inventory 400 Factory Wages Payable 2,000 Accumulated Depreciation - Factory Equipment 1,200 Utilities Payable 300 Factory Overhead Actual OH Incurred OH Applied to Production Ind. Materials 400 Ind. Labor 2,000 Fact. Deprec. 1,200 A manufacturing company used $400 of indirect materials and $2,000 of indirect labor during the month. The company also incurred $1,200 of depreciation on factory equipment, $500 of depreciation on office equipment, and $300 of factory utilities. Prepare the journal entry to record actual factory overhead costs incurred during the month. The Factory Overhead account is debited for actual overhead incurred and credited for overhead applied to production. This journal entry is to record the actual factory overhead costs; we'll be debiting the Factory Overhead account. Indirect materials result in a debit to Factory Overhead and a credit to Raw Materials Inventory. Indirect labor is a debit to Factory Overhead and a credit to Factory Wages Payable. Depreciation on Factory Equipment is a debit to Factory Overhead, and a credit to Accumulated Depreciation - Factory Equipment. Factory utilities of $300 result in a debit to Factory Overhead and a credit to Utilities payable. Total actual Factory Overhead incurred is $3,900; the total debit to Factory Overhead. Note that the depreciation on office equipment is not a product cost; this is a period cost and will be expensed in the month incurred. Fact. Utilities 300 3,900 P 3

Summary of Cost Flows This slide shows that direct materials used, direct labor used, and factory overhead applied flow through the Work in Process Inventory and Finished Goods balance sheet accounts. The cost of goods manufactured (COGM) is computed and shown on the schedule of cost of goods manufactured. When goods are sold, their costs are transferred from Finished Goods Inventory to the income statement as cost of goods sold. Period costs do not impact inventory accounts. As a result, they do not impact cost of goods sold, and they are not reported on the schedule of cost of goods manufactured. They are reported on the income statement as operating expenses. . P 3

NEED-TO-KNOW A manufacturing company applied $300,000 of overhead to its jobs during the year. For the independent scenarios below, prepare the journal entry to adjust over- or underapplied overhead. Assume the adjustment amounts are not material. 1. Actual overhead costs incurred during the year equal $305,000. Factory Overhead Actual OH Incurred OH Applied to Production 305,000 300,000 Underapplied OH 5,000 General Journal Debit Credit Cost of Goods Sold 5,000 Factory Overhead 5,000 A manufacturing company applied $300,000 of overhead to its jobs during the year. For the independent scenarios below, prepare the journal entry to adjust over- or underapplied overhead. Assume the adjustment amounts are not material. In the first scenario, actual overhead costs incurred during the year equal $305,000. The Factory Overhead account is debited for actual overhead incurred and credited for overhead applied to production. In this scenario, actual overhead incurred is $305,000 but the amount applied to production is only $300,000. The Factory Overhead account has a debit balance of $5,000. Since the amount applied to production is less than the actual costs, this is referred to as an underapplied balance of $5,000. Each job produced during the period has been somewhat undercharged for overhead. This amount is not considered material however, so at the end of the period, we simply close the overhead balance to Cost of goods sold. Credit Factory Overhead, $5,000, and debit Cost of goods sold. P 4

NEED-TO-KNOW A manufacturing company applied $300,000 of overhead to its jobs during the year. For the independent scenarios below, prepare the journal entry to adjust over- or underapplied overhead. Assume the adjustment amounts are not material. 2. Actual overhead costs incurred during the year equal $298,500. Factory Overhead Actual OH Incurred OH Applied to Production 298,500 300,000 Overapplied 1,500 General Journal Debit Credit Factory Overhead 1,500 Cost of Goods Sold 1,500 Assume instead that actual overhead costs incurred during the year equal $298,500. The total amount applied to production remains at $300,000, but now the debits to Factory Overhead, actual overhead incurred, is only $298,500. The balance in the Factory Overhead account at the end of the period is a credit balance of $1,500. Since the amount of overhead applied to production exceeds the actual overhead incurred, this is referred to as an overapplied balance. To close the balance at the end of the period, assuming the amount is not material, we debit Factory Overhead, $1,500, and credit Cost of goods sold. P 4

Process Operations Used for production of small, identical, low-cost items. Mass produced in automated continuous production process. Costs cannot be directly traced to each unit of product. Process operations involve the mass production of similar products in a continuous flow of sequential processes. A key feature of process operations is the high level of standardization needed if the system is to produce large volumes of products. Thus, process operations use a standardized process to make similar products; job order operations use a customized process to make unique products. C 1

Comparing Job Order and Process Operations
Job Order Systems Custom orders Heterogeneous products Low production volume High product flexibility Low to medium standardization Process Systems Repetitive operations Homogeneous products High production volume Low product flexibility High standardization Both job order costing systems and process costing systems track direct materials, direct labor, and overhead costs. The measurement focus in a job order costing system is on the individual job or batch, whereas in a process costing system, it is on the individual process. Regardless of the measurement focus, we are ultimately interested in determining the cost per unit of product (or service) resulting from either system. While both measure costs per unit, these two accounting systems differ in terms of how they do so. A job order system measures cost per unit upon completion of a job, by dividing the total cost for that job by the number of units in that job. As we showed in the previous chapter, job cost sheets accumulate the costs for each job. In a job order system, the cost object is a job. A process costing system measures unit costs at the end of a period (for example, a month) by combining the costs per equivalent unit from each separate department. In process costing, the cost object is the process. A 1

NEED-TO-KNOW Complete the following table with either a yes or no regarding the attributes of job order and process costing systems. Job Order Process Use direct materials, direct labor, and overhead costs Yes Yes Use job cost sheets to accumulate costs Yes No Typically use several Work in Process Inventory accounts No Yes Yield a cost per unit of product Yes Yes Complete the following table with either a yes or no regarding the attributes of job order and process costing systems. Use direct materials, direct labor, and overhead costs. This is true for both job order and process costing systems. Use job cost sheets to accumulate costs. This is only true for job order costing; process costing does not use job sheets. Typically use several Work in Process Inventory accounts. This is not true for job order costing. Instead, the detail of the Work in Process is held on the various job cost sheets. Under process costing, it is very common to have several Work in Process Inventory accounts. And, both job order and process costing systems yield a cost per unit of product. A 1

Equivalent Units of Production (EUP)
EUP must be calculated for the Work in Process account. Companies with process operations typically end each period with inventories of both finished goods and work in process. A key idea in process costing is that of Equivalent Units of Production (EUP), a term that refers to the number of units that could have been started and completed given the costs incurred during the period. C 2

EUP for Materials and Conversion Costs
In many processes, the equivalent units of production for direct materials are not the same with respect to direct labor and overhead. For example, direct materials, like rubber for tennis ball cores, might enter production entirely at the beginning of a process; direct labor and overhead, in contrast, might be used continuously throughout the process. How does a manufacturer account for these timing differences? Again, by measuring equivalent units of production. For example, if all of the direct materials to produce 10,000 units have entered the production process, but those units have received only 20% of their direct labor and overhead costs, equivalent units would be computed as shown in this slide. C 2

Weighted Average versus FIFO
The weighted-average method combines units and costs across two periods in computing equivalent units. The FIFO method computes equivalent units based only on production activity in the current period. The objectives, concepts, and journal entries (but not amounts) are the same under the weighted-average and FIFO methods; the computations of equivalent units differ. While the FIFO method is generally considered to be more precise than the weighted-average method, it requires more calculations. Often, the differences between the two methods are not large. When using a just-in-time inventory system, these different methods will yield very similar results because inventories are immaterial. FIFO C 2

Process Costing Illustration
GenX uses a weighted average cost flow system with the following four steps: Determine physical flow of units. Compute equivalent units of production. Compute cost per equivalent unit. Assign and reconcile costs. As with all situations involving inventory costs, we must choose a cost flow method. We will use the weighted average method for GenX. Process cost applications can be overwhelming if we do not use a well-planned approach. The four-step procedure will enable us to solve a process cost application in manageable parts. The four steps are: 1. Determine physical flow of units. 2. Compute equivalent units of production. 3. Compute cost per equivalent unit. 4. Assign and reconcile costs. C3

Process Operations – GenX
Here we see the units processed and the completion percentages. Take a minute to become familiar with these numbers before moving on to the cost information. Process costing applications include lots of numbers and in the first process (roasting department), GenX roasts, oils, and salts organically grown peanuts. These peanuts are then passed to the blending department, the second process. In the blending department, machine blends organic chocolate pieces and organic dried fruits with the peanuts from the first process. The blended mix is then inspected and packaged for delivery. In both departments, direct materials enter production at the beginning of the process, while conversion costs occur continuously throughout each department’s processing. Exhibit 3.5 presents production data (in units) for GenX’s roasting department. This exhibit includes the percentage of completion for both materials and conversion; for example, beginning work in process inventory is 100% complete with respect to materials but only 65% complete with respect to conversion. The bottom graphic represents production cost data for GenX’s roasting department. We will use the data to illustrate the four-step approach to process costing. C 3

Step 1: Determine Physical Flow of Units
A physical flow reconciliation is a report that reconciles (1) the physical units started in a period with (2) the physical units completed in that period. A physical flow reconciliation for GenX’s roasting department is shown in this slide for April. C 3

Step 2: Compute Equivalent Units of Production
The second step is to compute equivalent units of production for direct materials and conversion costs for April. Since direct materials and conversion costs typically enter a process at different rates, departments must compute equivalent units separately for direct materials and conversion costs. The top graphic shows the formula to compute equivalent units under the weighted-average method for both direct materials and conversion costs. For GenX’s roasting department, we must convert the 120,000 physical units measure to equivalent units based on how each input has been used. The roasting department fully completed its work on 100,000 units, and partially completed its work on 20,000 units. Equivalent units are computed by multiplying the number of units accounted for (from Step 1) by the percentage of completion for each input—see the second graphic. The first row of the second graphic reflects units transferred out in April. The roasting department entirely completed its work on the 100,000 units transferred out. These units have 100% of the materials and conversion required, or 100,000 equivalent units of each input (100,000 x 100%). GenX ended the month with 20,000 partially completed units. For direct materials, the units in ending work in process inventory include all materials required, so there are 20,000 equivalent units (20,000 x 100%) of materials in the unfinished physical units. Regarding conversion, the units in ending work in process inventory include 25% of the conversion required, which implies 5,000 equivalent units of conversion (20,000 x 25%). The final row reflects the total equivalent units of production, which is whole units of product that could have been manufactured with the amount of inputs used to create some complete and some incomplete units. For GenX, the amount of inputs used to produce 100,000 complete units and to start 20,000 additional units is equivalent to the amount of direct materials in 120,000 whole units and the amount of conversion in 105,000 whole units. Review what you have learned in the following NEED-TO-KNOW Slide. C 3

NEED-TO-KNOW A department began the month with 8,000 units in work in process inventory. These units were 100% complete with respect to direct materials and 40% complete with respect to conversion. During the month, the department started 56,000 units and completed 58,000 units. Ending work in process inventory includes 6,000 units, 100% complete with respect to direct materials and 70% complete with respect to conversion. Use the weighted-average method of process costing to: 1. Compute the department’s equivalent units of production for the month for direct materials. 64,000 2. Compute the department’s equivalent units of production for the month for conversion. 62,200 Work in Process Inventory - Units Beginning Units 8,000 Started 56,000 Total Units 64,000 Transferred out 58,000 Ending Units 6,000 Units Schedule (Physical Flow Reconciliation) Units in Beginning Inventory 8,000 Units completed and transferred out 58,000 Units Started 56,000 Units in Ending Inventory 6,000 A department began the month with 8,000 units in work in process inventory. These units were 100% complete with respect to direct materials and 40% complete with respect to conversion. During the month, the department started 56,000 units and completed 58,000 units. Ending work in process inventory includes 6,000 units, 100% complete with respect to direct materials and 70% complete with respect to conversion. Use the weighted-average method of process costing to: 1. Compute the department’s equivalent units of production for the month for direct materials. 2. Compute the department’s equivalent units of production for the month for conversion. Before we do the calculations, I think it's really helpful to set up a T-account in terms of units. We had 8,000 units in beginning inventory and the department started an additional 56,000 units. There are 64,000 units to account for. By the end of the month, the department has completed and transferred out 58,000 units, leaving 6,000 units in ending inventory. This units T-account is very helpful to create the units schedule, the physical flow reconciliation. 8,000 units in beginning inventory plus 56,000 units started equals 64,000 units to account for. We account for the units by describing their location at the end of the period. By the end of the period, 58,000 units have been transferred out and 6,000 units remain in ending inventory. Total units accounted for, 64,000. Using the weighted average method of process costing, we focus on the condition of the units at the end of the period. To calculate the equivalent units of production, we take the physical units, 58,000 units that have been transferred out and 6,000 units in ending inventory, a total of 64,000, and we multiplied by the percentage of completion to calculate the equivalent units of production (abbreviated as EUP). Since the units have been transferred out, they must be 100% complete with respect to materials and 100% complete with respect to conversion; otherwise the subsequent department would have rejected those units! To calculate the equivalent units of production, we multiply the physical units by the percentage of completion. 58,000 units multiplied by 100% is 58,000 equivalent units of materials. 58,000 physical units that are 100% complete with respect to conversion is the equivalent of 58,000 units of production. The 6,000 units in ending inventory are 100% complete with respect to materials; 6,000 units multiplied by 100% is 6,000 equivalent units of materials. The ending inventory units are only 70% complete with respect to conversion; 6,000 units multiplied by 70% is 4,200 equivalent units of production. The 64,000 units represent 64,000 equivalent units of materials and 62,200 equivalent units of conversion. Total Units to Account For 64,000 Total Units Accounted For 64,000 % Completion EUP Physical Units Materials Conversion Materials Conversion Transferred out 58,000 100% 100% 58,000 58,000 Ending Inventory 6,000 100% 70% 6,000 4,200 Total units 64,000 64,000 62,200 C 3

Step 3: Compute Cost per Equivalent Unit
Under the weighted-average method, the computation of EUP does not separate the units in beginning inventory from those started this period, as shown above. Similarly, the weighted average method combines the costs of beginning work in process inventory with the costs incurred in the current period. This total cost is then divided by the equivalent units of production (from Step 2), to compute the average cost per equivalent unit. This process is illustrated in this slide. For direct materials, the cost averages $3.00 per EUP. For conversion, the cost per equivalent unit averages $4.62 per unit. C 3

Step 4: Assign and Reconcile Costs
The EUP from Step 2 and the cost per EUP from Step 3 are used in Step 4 to assign costs to units that the roasting department completed and transferred to the blending department (100,000 units), and (b) units that remain in process in the roasting department (20,000 units). This is illustrated in this slide. Cost of Units Completed and Transferred - The 100,000 units completed and transferred to the blending department required 100,000 EUP of direct materials and 100,000 EUP of conversion. Thus, we assign $300,000 (100,000 EUP x $3.00 per EUP) of direct materials cost to those units. Similarly, we assign $462,000 (100,000 EUP x $4.62 per EUP) of conversion to those units. The total cost of the 100,000 completed and transferred units is $762,000 ($300,000 + $462,000) and their average cost per unit is $7.62 ($762,000 / 100,000 units). Cost of Units for Ending Work in Process - There are 20,000 incomplete units in work in process inventory at period-end. For direct materials, those units have 20,000 EUP of material (from Step 2) at a cost of $3.00 per EUP (from Step 3), which yields the materials cost of work in process inventory of $60,000 (20,000 EUP x $3.00 per EUP). For conversion, the in-process units reflect 5,000 EUP (from Step 2). Using the $4.62 conversion cost per EUP (from Step 3) we obtain conversion costs for in-process inventory of $23,100 (5,000 EUP x $4.62 per EUP). Total cost of work in process inventory at period-end is $83,100 ($60,000 + $23,100). Review what you have learned in the following NEED-TO-KNOW Slide. C 3

NEED-TO-KNOW A department began the month with conversion costs of $65,000 in its beginning work in process inventory. During the month, the department incurred $55,000 of conversion costs. Equivalent units of production for conversion for the month was 15,000 units. The department completed and transferred 12,000 units to the next department. 1. Compute the department’s cost per equivalent unit for conversion for the month. $8.00 2. Compute the department’s conversion cost of units transferred to the next department for the month. $96,000 Work in Process Inventory Beginning Inventory 65,000 DL and OH 55,000 120,000 Transferred out 96,000 Ending Inventory 24,000 EUP Cost Allocated Conversion per EUP Cost Transferred out 12,000 $8.00 $96,000 Ending Inventory 3,000 $8.00 24,000 A department began the month with conversion costs of $65,000 in its beginning work in process inventory. During the month, the department incurred $55,000 of conversion costs. Equivalent units of production for conversion for the month was 15,000 units. The department completed and transferred 12,000 units to the next department. 1. Compute the department’s cost per equivalent unit for conversion for the month. To calculate the cost per equivalent unit, we take the cumulative costs and divide by the total equivalent units of production. The cumulative costs include the beginning inventory cost of $65,000 plus the current month's cost of $55,000, a total of $120,000. When we divide by the total equivalent units of production, 15,000 equivalent units of conversion, the cost per equivalent unit of conversion is $8. 2. Compute the department’s conversion cost of units transferred to the next department for the month. Of the total 15,000 equivalent units of conversion, 12,000 units have been transferred out. 12,000 equivalent units of production multiplied by $8 per unit is a total allocated cost of $96,000. The remaining 3,000 equivalent units of production relate to the ending inventory, 3,000 equivalent units of production multiplied by $8 per unit is an allocated cost of $24,000. All $120,000 has been allocated. $96,000 of the conversion costs have been transferred out, with $24,000 of conversion costs remaining in ending inventory. Total units 15,000 $120,000 Cost per Equivalent Unit Cumulative Costs $120,000 Total EUP 15,000 $8.00 per equivalent unit of conversion C 3

NEED-TO-KNOW Tower Mfg. estimates it will incur $200,000 of total overhead costs during the year. Tower allocates overhead based on machine hours; it estimates it will use a total of 10,000 machine hours during the year. During February, the assembly department of Tower Mfg. uses 375 machine hours. In addition, Tower incurred actual overhead costs as follows during February: indirect materials, $1,800; indirect labor, $5,700; depreciation on factory equipment, $8,000; factory utilities, $500. 1. Compute the company’s predetermined overhead rate for the year. $20 per machine hour Predetermined Overhead Rate = Estimated Overhead Costs $200,000 Estimated Activity Base 10,000 machine hours = $20 per machine hour Machine Hours Used x Predetermined OH rate = OH Applied Assembly Dept. 375 hours x $20 per hour = $7,500 OH applied Factory Overhead Actual OH Incurred OH Applied to Production Tower Mfg. estimates it will incur $200,000 of total overhead costs during the year. Tower allocates overhead based on machine hours; it estimates it will use a total of 10,000 machine hours during the year. During February, the assembly department of Tower Mfg. uses 375 machine hours. In addition, Tower incurred actual overhead costs as follows during February: indirect materials, $1,800; indirect labor, $5,700; depreciation on factory equipment, $8,000; factory utilities, $500. 1. Compute the company’s predetermined overhead rate for the year. The predetermined overhead rate is calculated by taking the estimated overhead costs and dividing by the estimated activity base. $200,000 in estimated overhead costs divided by 10,000 machine hours is a predetermined overhead rate of $20 per machine hour. The predetermined overhead rate is used to assign overhead costs to production. During February, the assembly department used 375 machine hours. For each machine hour used, the production will be charged with $20 of overhead. The total amount of overhead applied to the units produced during February is $7,500. The Factory Overhead account is debited for the actual overhead costs incurred, and credited for the overhead applied to production. P 3

NEED-TO-KNOW Tower Mfg. estimates it will incur $200,000 of total overhead costs during the year. Tower allocates overhead based on machine hours; it estimates it will use a total of 10,000 machine hours during the year. During February, the assembly department of Tower Mfg. uses 375 machine hours. In addition, Tower incurred actual overhead costs as follows during February: indirect materials, $1,800; indirect labor, $5,700; depreciation on factory equipment, $8,000; factory utilities, $500. 2. Prepare journal entries to record (a) overhead applied for the assembly department for the month and (b) actual overhead costs used during the month. General Journal Debit Credit a) Work in Process Inventory 7,500 Factory Overhead (375 machine hours x $20 per MH) 7,500 b) Factory Overhead 16,000 Raw Materials Inventory 1,800 Factory Wages Payable 5,700 Accumulated Depreciation - Factory Equipment 8,000 Utilities Payable 500 The journal entry to apply overhead to the assembly department for the month is a debit to Work in Process Inventory, $7,500, and a credit to Factory Overhead. The Factory Overhead account is credited for $7,500. The journal entry to record actual overhead costs used during the month will result in debits to the Factory Overhead account. Indirect materials result in a debit to Factory Overhead and a credit to Raw Materials Inventory. Indirect labor costs are debits to Factory Overhead and credits to Factory Wages Payable. Depreciation on factory equipment results in a debit to Factory Overhead and a credit to Accumulated Depreciation - Factory Equipment. And factory utilities result in debits to Factory Overhead and credits to Utilities Payable. The total actual overhead incurred is $16,000. For the month of February, actual overhead costs incurred exceed the amount of overhead applied. This results in an underapplied balance of $8,500. Factory Overhead Actual OH Incurred OH Applied to Production Ind. Materials 1,800 Ind. Labor 5,700 Fact. Deprec. 8,000 Fact. Utilities 500 16,000 7,500 Underapplied 8,500 P 3

Appendix 3A: FIFO Method of Process Costing
In computing cost per equivalent unit, the FIFO method ignores the cost of beginning work in process inventory. Instead, FIFO uses only the costs incurred in the current period. This slide shows selected information from GenX’s roasting department for the month of April. Accounting for a department’s activity for a period includes four steps: (1) determine physical flow, (2) compute equivalent units, (3) compute cost per equivalent unit, and (4) determine cost assignment and reconciliation. The same GenX data for April will also be used to illustrate the FIFO method. C 4

Determine Physical Flow of Units
A physical flow reconciliation is a report that reconciles (1) the physical units started in a period with (2) the physical units completed in that period. The physical flow reconciliation for GenX’s roasting department is shown in this slide for April. C 4

Compute Equivalent Units of Production
In computing the equivalent units of production, the roasting department must consider these three distinct groups of units: Units in beginning work in process inventory (30,000). Units started and completed during the month (70,000). Units in ending work in process inventory (20,000). GenX’s roasting department then computes equivalent units of production under FIFO as shown in this slide. We compute EUP for each of the three distinct groups of units, and sum them to find total EUP. Review what you have learned in the following NEED-TO-KNOW Slide. * Units completed this period 100,000 Less units in beginning goods in process 30,000 Units started and completed this period 70,000 C 4

NEED-TO-KNOW A department began the month with 50,000 units in work in process inventory. These units were 60% complete with respect to direct materials and 40% complete with respect to conversion. During the month, the department started 286,000 units; 220,000 of these units were completed during the month. The Remaining 66,000 units are in ending work in process inventory, 80% complete with respect to direct materials and 30% complete with respect to conversion. Use the FIFO method of process costing to: 1. Compute the department’s equivalent units of production for the month for direct materials. 292,800 2. Compute the department’s equivalent units of production for the month for conversion. 269,800 Work in Process Inventory - Units Beginning Units 50,000 Beginning Units 50,000 Started 286,000 Started and Completed 220,000 Total units 336,000 Transferred out 270,000 Ending Units 66,000 Units Schedule (Physical Flow Reconciliation) Units in Beginning Inventory 50,000 Units completed and transferred out 270,000 Units Started 286,000 Units in Ending Inventory 66,000 A department began the month with 50,000 units in work in process inventory. These units were 60% complete with respect to direct materials and 40% complete with respect to conversion. During the month, the department started 286,000 units; 220,000 of these units were completed during the month. The remaining 66,000 units are in ending work in process inventory, 80% complete with respect to direct materials and 30% complete with respect to conversion. Use the FIFO method of process costing to: 1. Compute the department’s equivalent units of production for the month for direct materials. 2. Compute the department’s equivalent units of production for the month for conversion. The department began the month with 50,000 units in inventory. They started an additional 286,000 units, for a total of 336,000 units to account for. At the end of the month, there are 66,000 units which remain in ending inventory; the remaining 270,000 units must have been transferred out. Under the FIFO method, we assume that the first items in are the first items out. The 270,000 units transferred out consist of the 50,000 units from beginning inventory and 220,000 of the units that were started in the current month. We can use the work in process units T-account to create the units schedule, the physical flow reconciliation. 50,000 units in beginning inventory plus 286,000 units started equals 336,000 units to account for. We account for the 336,000 units by describing their location at the end of the month; 270,000 units have been transferred out, and 66,000 units remain in ending inventory. Total units accounted for, 336,000. To calculate the equivalent units of production, we take the total of 336,000 units, and then describe the type of work that was done in the current month. The first order of business, at the beginning of the month, was to finish the beginning inventory; 50,000 units. Once the 50,000 units were finished, they started, and were able to complete, 220,000 units. And, toward the end of the month, they were able to start (but not finish) the 66,000 units in ending inventory. Typically, the most error-prone calculation is in the number of units started and completed. Another way to calculate this amount is to take the total of 336,000 units, and subtract the 116,000 units in beginning and ending inventory; 220,000 units are started and completed. We then multiply by the percentage work done in the current month. The 50,000 units in beginning inventory had 60% of the materials work and 40% of conversion work added in the prior month. To finish these units, then, we take the difference between 100% and the amount of work done in the prior month. 100%-60% equals 40% of the materials work added in the current month. 100%-40% equals 60% of the conversion work added in the current month. Units that are started and completed received 100% of the materials and conversion effort. And the units in ending inventory are 80% complete with respect to materials and 30% complete with respect to conversion. This is the amount of work done in the current month. To calculate the equivalent units of production, we multiply the number of physical units by the percentage of work done in the current month. 50,000 units multiplied by 40% is 20,000 equivalent units of materials. 220,000 multiplied by 100% is 220,000 equivalent units of materials, and 66,000 units multiplied by 80% is 52,800 units. Total equivalent units of materials is 292,800. We repeat the process for conversion. 50,000 units multiplied by 60% is 30,000 equivalent units of production. 220,000 multiplied by 100% is 220,000, and 66,000 units multiplied by 30% is 19,800. Total equivalent units of production, 269,800. Total Units to Account For 336,000 Total Units Accounted For 336,000 Physical Units % Done in Current Month EUP Materials Conversion Materials Conversion Finish Beginning Inventory 50,000 40% 60% 20,000 30,000 Start and Complete 220,000 100% 100% 220,000 220,000 Start Ending Inventory 66,000 80% 30% 52,800 19,800 Total units 336,000 292,800 269,800 C 4

 Compute Cost Per Equivalent Unit – FIFO
To compute cost per equivalent unit, we take the direct materials and conversion costs added in April and divide by the equivalent units of production from Step 2. This slide illustrates these computations. It is essential to compute costs per equivalent unit for each input because production inputs are added at different times in the process. The FIFO method computes the cost per equivalent unit based solely on this period’s EUP and costs (unlike the weighted-average method, which adds in the costs of the beginning work in process inventory). Review what you have learned in the following NEED-TO-KNOW Slide. C 4

NEED-TO-KNOW A department started the month with beginning work in process inventory of $130,000 ($90,000 for direct materials and $40,000 for conversion). During the month, the department incurred additional direct materials costs of $700,000 and conversion costs of $500,000. Assume that, using the FIFO method, equivalent units for the month were computed as 250,000 for materials and 200,000 for conversion. 1. Compute the department’s cost per equivalent unit of production for the month for direct materials. 2. Compute the department’s cost per equivalent unit of production for the month for conversion. Cost per Equivalent Unit of Direct Materials: Direct Material costs added in the current month $700,000 Equivalent units of Production - Current Month 250,000 $2.80 per equivalent unit of direct materials Cost per Equivalent Unit of Conversion: Conversion costs added in the current month $500,000 A department started the month with beginning work in process inventory of $130,000 ($90,000 for direct materials and $40,000 for conversion). During the month, the department incurred additional direct materials costs of $700,000 and conversion costs of $500, Assume that, using the FIFO method, equivalent units for the month were computed as 250,000 for materials and 200,000 for conversion. 1. Compute the department’s cost per equivalent unit of production for the month for direct materials. 2. Compute the department’s cost per equivalent unit of production for the month for conversion. Using the FIFO method, cost per equivalent unit of production is calculated by taking the cost added in the current month and dividing by the equivalent units of production. The cost per equivalent unit of direct materials is calculated by taking the direct material costs added in the current month and dividing by the equivalent units of production; materials work done in the current month. $700,000 divided by 250,000 equivalent units of materials is a cost of $2.80 per equivalent unit of direct materials. To calculate the cost per equivalent unit of conversion, we take the conversion costs added in the current month and divide by the equivalent units of production. $500,000 divided by 200,000 equivalent units is a cost of $2.50 per equivalent unit of conversion. Notice that the costs of beginning Work in Process Inventory are not included in the calculation of cost per equivalent unit when using the FIFO method. Equivalent units of Production - Current Month 200,000 $2.50 per equivalent unit of conversion C 4

Assign and Reconcile Costs
The equivalent units determined in Step 2 and the cost per equivalent unit computed in Step 3 are both used to assign costs (1) to units that the production department completed and transferred to the blending department and (2) to units that remain in process at period-end. In this slide, under the section for cost of units transferred out, we see that the cost of units completed in April includes the $189,900 cost carried over from March for work already applied to the 30,000 units that make up beginning work in process inventory, plus the $46,200 incurred in April to complete those units. This section also includes the $525,000 of cost assigned to the 70,000 units started and completed this period. Thus, the total cost of goods manufactured in April is $761,100. The average cost per unit for goods completed in April is $7.611 ($761,100 / 100,000 completed units). The computation for cost of ending work in process inventory is in the lower part of the graphic. That cost of $84,000 ($62,000 + $22,000) also is the ending balance for the Work in Process Inventory— Roasting account. C 4

Assign and Reconcile Costs
We reconcile the costs accounted for in Step 3 to the costs that production was charged for as shown in this slide. C 4

Thank you and See You GOOD LUCK, Take Care
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