1. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 1

2. CHAPTER 11 Accounting Decisions © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 2

3. Learning Objectives How do I distinguish between various types of costs, including product, period, direct, indirect, prime, conversion, and overhead costs? What risks are present when arbitrary methods of overhead allocation are used? How does activity-based costing create more accurate product costs? What is the difference between absorption and variable costing? What are two methods of writing off an overallocation or underallocation of overhead? © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 3

4. 4 Product and Period Costs Period costs relate to the accounting period (year, month) in which a cost was incurred Product costs relate to the cost of goods or services produced The calculation of profit is based on the separation of product and period costs  Revenues - Cost of goods sold = Gross profit – Selling and Administrative costs and other period costs = Operating profit

5. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 5 Product and Period Costs Cost of goods sold (product cost)  The cost of providing a service  The cost of buying goods sold by a retailer  The cost of raw materials and production costs for a manufacturer For a retailer  Cost of goods sold = Opening inventory + Purchases - Closing inventory For a manufacturer  Cost of goods sold = Opening inventory + Cost of production - Closing inventory

6. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 6 Calculation of Operating Profit

7. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 7 Direct and Indirect Costs Production costs  Direct  Indirect Direct costs  Traceable to product/ services  Direct materials or labour  Other direct costs Indirect costs (Overhead costs)  Necessary, but not readily traceable to particular product/ services  Indirect materials  Indirect labour  Other indirect costs

8. Other Cost Terms Prime cost refers to the total of all direct costs  Includes the total of direct materials and direct labour. Production overhead is all production costs other than direct costs  The total of all indirect material, indirect labour, and other indirect costs Conversion costs are the production costs, other than direct materials, used to make a product or provide a service.  Includes direct labour and production overhead © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 8

9. Calculating Product/Service Costs Company-wide overhead rate  An overhead rate calculated using the total of the overhead costs for the company, divided by the total of the allocation base for the overhead © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 9

10. Calculating Product/Service Costs Divisional-based overhead rate  Calculates the overhead for each division within the company and then uses an allocation base to assign the divisional overhead to jobs © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 10

11. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 11 Activity-Based Costing (ABC) Uses cost pools to accumulate the indirect costs of significant business activities and then assigns the costs from the cost pools to products based on cost drivers, which measure each product’s demand for activities

12. Cost Pools Cost pools accumulate the indirect cost of business processes Business process  A sales order from customer to delivery and invoicing  A purchase order on a supplier to receipt of goods and payment Collects the purchasing costs in all of the departments into a cost pool 12 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11

13. Cost Drivers The most significant cause of activity in a cost pool, e.g. Enable the cost of activities to be assigned from cost pools to cost objects 13 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11

14. 14 Activity-Based Costing (ABC) Three stage process  Trace costs for business processes to cost pools  Identify cost drivers for each cost pool  Determine number of activities for each cost driver  Transaction, frequency, intensity Cost driver rate Cost pool / Number of cost drivers  Apply cost driver rate to product/services based on number of cost drivers for each business process

15. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 15 Activity-Based Costing (ABC) In order to identify a cost driver, categorize costs as follows  Unit-level activities  Batch-related activities  Product-sustaining activities  Customer-sustaining activities  Facility-sustaining activities

16. Example of ABC © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 16 Accumulated overhead costs Cost drivers identified

17. Example of ABC © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 17 Calculation of Cost per Activity Allocation of Overhead to Products

18. Example of ABC © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 18 Overhead per Product Based on ABC Total Product Cost under ABC

19. Difference between Traditional Approach and ABC 19 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 Total Product Cost under Traditional Approach Difference between Traditional Approach and ABC

20. Absorption and Variable Costing Variable costing  A method of reporting in which only variable costs are treated as inventoriable  Direct materials, direct labour, and variable overhead costs are assigned to each product made during the period  Fixed overhead costs are treated as period expenses © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 20

21. Absorption and Variable Costing Absorption costing  A system where all production overhead costs (fixed and variable) are inventoriable  Variable costs (direct materials, direct labour, and variable overhead) are assigned directly to each unit made  Fixed overhead costs are assigned to each product/service based on an allocation base  Fixed production overhead is estimated and divided by the allocation base to calculate a budgeted overhead rate  Each and every product that is made at the plant is then assigned fixed production overhead costs based on this budgeted overhead rate © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 21

22. Absorption and Variable Costing Budgeted fixed overhead rate © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 22

23. Absorption and Variable Costing Compared © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 23 Company Data

24. Absorption and Variable Costing Compared © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 24

25. Overallocation or Underallocation of Overhead The overhead rate is normally established prior to the production year At the end of the year when actual cost and actual activity volumes are known, there is going to be a difference between the actual overhead and the budgeted overhead that was allocated throughout the period This is underallocation or overallocation of overhead © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 25

26. In order to adjust the records of the company, two approaches can be used 1. Assign overallocation or underallocation to cost of goods sold 2. Prorate overallocation or underallocation to cost of goods sold, work in progress inventory, and finished goods inventory © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 26 Overallocation or Underallocation of Overhead

27. Conclusions Cost terminology  Product/period  Direct/indirect  Other costs Activity-based costing Variable costing Absorption costing Comparison of approaches Overallocation or underallocation of overhead © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 27