10/4/2019

Accumulating and Assigning

Costs to Products

Chapter 4

Cost Flows in Organizations

 In order to compute product costs, management
accounting systems should reflect the actual cost
flows in an organization
 Manufacturing, retail, and service organizations
have different patterns of cost flows resulting in
different management accounting priorities

Manufacturing Organization Cost Flows

• Manufacturing costs are classified into three groups:
1. Direct Materials
2. Direct Labor
3. Manufacturing Overhead
• Materials are taken from the stock as production begins,
the costs are moved from the raw materials inventory
account to the work in process account
• The manufacturing operation consumes labor and
overhead items and these costs are added to the work in
process inventory

1
 10/4/2019

Manufacturing Organization Cost Flows

 When manufacturing is completed, the costs are
transferred from work in process to the finished goods
account
 At this stage the goods are finished and are ready for sale
 When the goods are sold, their costs are moved from the
finished goods account on the balance sheet to the cost
of goods sold account on the income statement

Retail Organization Cost Flows

 As goods are purchased, the costs are entered into an
account that accumulates the cost of merchandise
inventory in the store
 Stores incur various overhead costs such as depreciation,
lighting, labor, and heating (which are not added to
inventory)
 Once the sale is made, the costs transfer to cost of goods
sold
 The primary focus in retail operations is the profitability
of product lines or departments

Service Organization Cost Flows

 The major expense in service organizations is often
employee pay
 In service organizations, the focus is on determining
the cost of a project or service
 The potential for cost system distortions is less for a
service organization than for a manufacturing
operation

2
 10/4/2019

Cost Terms
 Cost Object—is anything for which a cost is computed
 Consumable, or Flexible Resource—the cost depends
on the amount of resource that is used
– The cost of a consumable resource is often called a
variable cost because the total cost depends on how
much of the resource is consumed
– Direct material and direct labor are typically
classified as variable costs

Cost Terms
• Capacity-Related Resource: - the cost depends on the
amount of resource capacity acquired and not how
much of the capacity is used, (also called a fixed cost)
• Direct Cost: - a cost that is uniquely and unequivocally
attributable to a single cost object
• Almost all variable costs are direct costs
• Indirect Cost: - a cost that fails the test of being direct
is classified as indirect
• Most capacity-related costs are indirect

Cost System Overview

 Cost systems first classify costs as either direct or
indirect
 The classification of a resource as direct or indirect is
context specific, related to the cost object
 Direct costs are assigned to the appropriate cost
object
 Indirect costs are collected into cost pools and then
allocated to cost objects in a reasonable way and
should reflect a cause and effect relationship

3
 10/4/2019

Cost System Overview

 An appropriate portion of the indirect cost is then
allocated from the cost pool to the cost object
 Costing distortions can arise when indirect cost pools
include costs that have different cost drivers
 Costs that are pooled should behave in similar ways;
what increases one should increase the others in the
pool

10

Indirect Cost Pools

 The simplest structure in a manufacturing system is to
have a single indirect cost pool for the entire
manufacturing operation
 Indirect cost pools may have separate pools for variable
and fixed overhead costs and then allocated to the cost
object
 Organizations use a separate account, Indirect Cost
Applied, to record indirect costs applied as production
occurs during the year

11

Predetermined Overhead Rates

 Because the total indirect costs for the year are not
known until after the year end, organizations allocate
indirect costs to production during the year based on
predetermined indirect cost rates
 The first step is to determine the cost driver which
will be used to allocate the indirect costs to production
 Cost analysts try to choose a cost driver that best
explains the long run behavior of the indirect cost

12

4
 10/4/2019

Predetermined Overhead Rates

 Next, the indirect factory costs are divided based on the
number of cost drivers to generate the predetermined
overhead rate
 Most organizations use multiple-indirect cost pools in
order to more accurately cost the resources used by the
cost object
 Design of the indirect cost pools is considered to be
one of the most important choices in costing system
design and requires an understanding of the
manufacturing system

13

Cost Driver Level

 There are four commonly proposed activity levels used
to compute the cost driver rate:
1. Actual level of operations
2. Planned level of operations
3. Average level of operations
4. Practical capacity level of operations

14

1. Actual Level of Operations

 Using the actual level of operations is often called
actual costing
 The actual rate is developed after completion of the
period by taking the actual costs divided by the actual
level of the cost driver
 Many management accountants reject this approach
because it disguises operating problems

15

5
 10/4/2019

2. Planned Level of Operations

 Planned indirect costs are divided by the planned level
of the cost driver
 An attempt to allocate all indirect costs and provides
an appropriate basis for accurate product costing
 This approach has problems with capacity-related
costs as the planned level of production changes and
impacts product costs
 If they use cost-plus pricing, as demand decreases,
planned level of production goes down, the cost driver
rate will increase, causing price increases, which will
cause a decrease in demand, causing a ………..

16

3. Average Level of Operations

 Average use of capacity is the likely activity rate used
to justify the acquisition of the capacity and this
approach would seem to reflect the economic basis for
the level and cost of capacity
 A major problem with this approach is that it buries the
cost of idle capacity, so there is less incentive for
management to increase its use of idle capacity
 This will create a competitive advantage for a
competitor that has lower idle capacity costs

17

4. Practical Capacity Level of Operations

 Using practical capacity to estimate product costs
provides clear decision making insights and incentives
for relating to dealing with the cost of idle capacity
 Estimating practical capacity begins with an estimate
of the theoretical capacity available for a machine
 Next, the actual machine utilization is calculated
which recognizes equipment downtime to generate the
practical capacity
 Lost capacity utilization can be caused by maintenance
work, setup time, material shortages

18

6
 10/4/2019

Predetermined Overhead Rates

 One indirect cost pool collects the actual indirect costs
incurred for the period
 A second indirect pool accumulates the indirect costs
that has been applied to production for the same period
 The actual and applied indirect cost pools must be
reconciled at year end

19

Reconciling the Difference

 There are three options available to reconcile the
differences in the cost pools:
1. Charge the difference directly to cost of goods sold
2. Prorate the difference between work in process
inventory, finished goods inventory, and cost of
goods sold based on the ending balances for these
accounts
3. Decompose the difference between actual and
applied indirect costs based on an analysis of the
reasons for the difference between the actual and
applied rates

20

Job Order Costing

 Job order costing accumulates the costs for a specific
customer’s order because the orders tend to vary.
 Each job is assigned a unique job order number for
collecting costs
 The company collects the actual direct material and
direct labor used for a specific job.
 Indirect overhead costs are allocated to the job
 Once the work is completed, the collected costs are
summarized
 The purpose of job order costing is to accumulate the
cost of a specific job because each job is different
21

7
 10/4/2019

Process Costing
 Process costing is used when all products are identical
such as soda drinks and breakfast cereal
 Process costing systems use two different cost terms:
– Direct materials
– Conversion costs—all manufacturing costs that are
not direct material costs

22

Process Costing
 Equivalent number of units are calculated for the period,
(actual units in work in process are not identifiable)
– For completed units, the number of equivalent units
will equal the number of physical units
– Partially completed units, units in work in process,
are converted into equivalent completed units based
on the level of completed work

23

Process Costing
 The total cost of direct material is divided by
equivalent units of material
 The total conversion costs are divided by the equivalent
units of conversion
 The final step is to use the equivalent material and
conversion costs to allocate manufacturing costs to the
ending inventories

24