Managers trace costs to cost objects to develop a fairly accurate measurement of costs
Cost objects include
Products or services
Sales territories
Departments
Operating activities
Both direct and indirect measures of costs are used to support
Pricing decisions
Decisions to reallocate resources to other cost objects
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the preparation of financial statementsCopyright © Houghton Mifflin Company. All rights reserved.Cost TraceabilityManagers trace costs to cost objects to develop a fairly accurate measurement of costsCost objects includeProducts or servicesSales territoriesDepartmentsOperating activitiesBoth direct and indirect measures of costs are used to supportPricing decisionsDecisions to reallocate resources to other cost objectsCopyright © Houghton Mifflin Company. All rights reserved.Direct Costs are costs that can be conveniently and economically traced to a cost objectExampleCost objectA Southwest Airlines flightDirect costsWages of the flight crewTime worked and hourly wages are shown on time cards and payroll recordsJet fuel costsCopyright © Houghton Mifflin Company. All rights reserved.Indirect Costs are costs that cannot be conveniently and economically traced to a cost objectExamplesNails used in furnitureSalt used in cookiesRivets used in airplanesCopyright © Houghton Mifflin Company. All rights reserved.Indirect Costs (cont’d)Must be included in the cost of a product or serviceFor the sake of accuracyAre assigned using a formulaExampleInsurance costs for Southwest AirlinesA portion is assigned to each flight flownCopyright © Houghton Mifflin Company. All rights reserved.Illustrations of Cost TraceabilityService organizationCost objectPreparation of tax returnsDirect costsPaper, computer usage, and accountant's laborIndirect costsSupplies, office rental, utilities, secretarial labor, telephone usage, and depreciation of office furnitureCopyright © Houghton Mifflin Company. All rights reserved.Illustrations of Cost TraceabilityRetail organizationCost objectShoe departmentDirect costsShoes and wages of employees working in shoe departmentIndirect costsUtilities, insurance, property taxes, storage, and handlingCopyright © Houghton Mifflin Company. All rights reserved.Illustrations of Cost TraceabilityManufacturing organizationCost objectProductDirect costsCosts of materials and laborIndirect costsUtilities, depreciation of plant equipment, insurance, property taxes, inspection, supervision, maintenance of machinery, storage, and handlingCopyright © Houghton Mifflin Company. All rights reserved.Cost Behavior is the way costs respond to changes in volume or activityManagers analyze the patterns of cost behavior to gain informationHow changes in selling prices or operating costs affect net incomeAdjustments can then be made to obtain a certain level of profitCosts can be separated into fixed and variable costsCopyright © Houghton Mifflin Company. All rights reserved.Cost Behavior (cont’d)Variable costA cost that changes in direct proportion to a change in productive output (or any other measure of output)Fixed costA cost that remains constant within a defined range of activity or time periodCopyright © Houghton Mifflin Company. All rights reserved.Examples of Variable and Fixed CostsLandscaping businessVariable costsLandscaping materials and labor to plant the materialsFixed costsDepreciation on trucks and equipment, rent, insurance, and property taxesAs more trees are planted, variable costs will increase proportionallyFixed costs will remain the same for a specified periodCopyright © Houghton Mifflin Company. All rights reserved.Examples of Variable and Fixed Costs (cont’d)Used-car dealerVariable costsCars sold and sales commissionsFixed costsBuilding and lot rental, depreciation on office equipment, and receptionist’s and accountant’s salariesAs more cars are sold, variable costs will increase proportionallyFixed costs will remain the same for a specified periodCopyright © Houghton Mifflin Company. All rights reserved.Examples of Variable and Fixed Costs (cont’d)Lawn-mower manufacturerVariable costsDirect materials, direct labor, indirect materials, and indirect laborFixed costsSupervisor's salaries and depreciation on office buildingsAs the output of products is increased, variable costs will increase proportionallyFixed costs will remain the same for a specified periodCopyright © Houghton Mifflin Company. All rights reserved.Value-Adding Versus Nonvalue-Adding CostsValue-adding costThe cost of an activity that increases the market value of a product or serviceNonvalue-adding costThe cost of an activity that adds cost to a product or service but does not increase its market valueExample – Depreciation of a machine that shapes a part used in the final productExample – Depreciation of a car used by the sales departmentCopyright © Houghton Mifflin Company. All rights reserved.Value-Adding Versus Nonvalue-Adding Costs (cont’d)Managers examine value-adding attributes of operating activitiesWherever possible, reduce or eliminate nonvalue-adding activitiesIdentify characteristics of products or services customers are willing to pay forThis information influences the design of future products or servicesCopyright © Houghton Mifflin Company. All rights reserved.Value-Adding Versus Nonvalue-Adding Costs (cont’d)Costs incurred to improve the quality of a productAre value-adding only if the customer is willing to pay more for the higher-quality productOtherwise, are nonvalue-adding costs Because they do not increase the product’s market valueCopyright © Houghton Mifflin Company. All rights reserved.Value-Adding Versus Nonvalue-Adding Costs (cont’d)Costs of administrative activities (such as accounting and human resources)Are nonvalue-adding costsBut, are necessary for the operation of the business and cannot be eliminatedCopyright © Houghton Mifflin Company. All rights reserved.Cost Classification for Financial ReportingManagers classify costs as product or period costs for financial reporting purposesCopyright © Houghton Mifflin Company. All rights reserved.Cost Classification for Financial Reporting (cont’d)Product costsCosts assigned to inventoryInclude direct materials, direct labor, and manufacturing overheadAlso called inventoriable costsFinancial reporting of product costsIncome statementAppear as cost of goods soldBalance sheetAppear as finished goods inventoryCopyright © Houghton Mifflin Company. All rights reserved.Cost Classification for Financial Reporting (cont’d)Period costsCosts of resources used during the accounting periodInclude selling and administrative costsAlso called noninventoriable costsFinancial reporting of period costsIncome statementAppear as operating expensesCopyright © Houghton Mifflin Company. All rights reserved.Copyright © Houghton Mifflin Company. All rights reserved.DiscussionWhat is the difference between a direct cost and an indirect cost?Direct cost Can be easily and economically traced to a specific product Indirect cost Cannot be easily and economically traced to a specific productCopyright © Houghton Mifflin Company. All rights reserved.Elements of Product CostsObjective 3Define and give examples of the three elements of product cost and compute the unit cost of a productCopyright © Houghton Mifflin Company. All rights reserved.Elements of Product CostDirect materialsDirect laborManufacturing overhead Indirect costsCopyright © Houghton Mifflin Company. All rights reserved.Direct Materials Costs are the costs of materials used in making a product that can be conveniently and economically traced to specific units of the productExamplesIron ore used in making steelSheet metal used in making automobilesSugar used in making candyCopyright © Houghton Mifflin Company. All rights reserved.Direct Labor Costs are the costs of labor needed to make a product that can be conveniently and economically traced to specific units of the productExamplesWages of machine operators and production-line workersCopyright © Houghton Mifflin Company. All rights reserved.Manufacturing Overhead Costs are production-related costs that cannot be conveniently and economically traced to specific units of the productAlso called factory overhead, factory burden, or indirect manufacturing costsCopyright © Houghton Mifflin Company. All rights reserved.Manufacturing Overhead Costs (cont’d)IncludeIndirect materials costsNails, rivets, lubricants, and small toolsIndirect labor costsLabor for machinery and tool maintenance, inspection, engineering design, supervision, and materials handlingOther indirect manufacturing overhead costsBuilding maintenance, property taxes, property insurance, depreciation on plant and equipment, rent, and utilitiesManufacturing overhead costs are indirect costs that are allocated to a product’s cost using traditional or activity-based costing methodsCopyright © Houghton Mifflin Company. All rights reserved.Illustration of Product Costs and the Manufacturing ProcessThe following elements of the product cost of one candy bar have been identified for Candy Company, Inc.Direct materials costsSugar, chocolate, and wrapperDirect labor costsCosts of labor in making the candy barManufacturing overhead costsIndirect materials costsSalt and flavoringsIndirect labor costsMoving materials to production area and inspection during productionOther indirect overhead costsDepreciation on building and equipment, utilities, property taxes, and insuranceCopyright © Houghton Mifflin Company. All rights reserved.Computing Product Unit CostProduct unit costThe cost of manufacturing a single unit of a productIncludesCosts of direct materials, direct labor, and manufacturing overheadThese costs are accumulated as a batch of products is being producedComputed when batch is completed by one of two waysDividing total accumulated costs by the total number of units producedDetermining the cost per unit for each element of the product costs and summing those per-unit costsCopyright © Houghton Mifflin Company. All rights reserved.Computing Product Unit Cost (cont’d)Unit cost information helps managers price products and calculate gross margin and net incomeProduct unit cost can be calculated using Actual costingNormal costing Standard costing methodsCopyright © Houghton Mifflin Company. All rights reserved.Copyright © Houghton Mifflin Company. All rights reserved.Actual Costing Method uses the costs of direct materials, direct labor, and manufacturing overhead at the end of an accounting period or when actual costs become known to calculate the product unit costThe actual product unit cost is assigned to The finished goods balance on the balance sheet Cost of goods sold on the income statementCopyright © Houghton Mifflin Company. All rights reserved. Illustration of Actual Costing MethodCandy Company, Inc. produced 3,000 candy bars on December 28, 20x6, for a customer in Seattle. The company’s accountant calculated that the actual costs for the order were direct materials, $540; direct labor, $420; and manufacturing overhead, $240Calculate the actual product unit cost for the orderCopyright © Houghton Mifflin Company. All rights reserved.Illustration of Actual Costing MethodIn this case, the job was completed and all cost information was knownIf production were still underway and actual manufacturing overhead costs are uncertain, use an estimate of manufacturing overhead costsThe normal costing methodCandy Company, Inc. produced 3,000 candy bars on December 28, 20x6, for a customer in Seattle. The company’s accountant calculated that the actual costs for the order were direct materials, $540; direct labor, $420; and manufacturing overhead, $240Copyright © Houghton Mifflin Company. All rights reserved.Normal Costing Method combines actual direct costs of materials and labor with estimated manufacturing overhead costs to determine a product unit costCopyright © Houghton Mifflin Company. All rights reserved.Normal Costing MethodIs simpleAllows smoother, more even assignment of manufacturing overhead costs to production during the accounting period than with the actual costing methodContributes to better pricing decisions and profitability estimatesCopyright © Houghton Mifflin Company. All rights reserved. Illustration of Normal Costing MethodCandy Company, Inc. produced 3,000 candy bars on December 28, 20x6, for a customer in Seattle. The company’s accountant calculated that the actual costs for the order were direct materials, $540, and direct labor, $420. Manufacturing overhead is applied using an estimated rate of 60 percent of direct labor costsCalculate the product unit cost for the orderEstimated manufacturing overhead cost is $252 ($420 DL cost x 60%)Copyright © Houghton Mifflin Company. All rights reserved.Illustration of Normal Costing MethodCandy Company, Inc. produced 3,000 candy bars on December 28, 20x6, for a customer in Seattle. The company’s accountant calculated that the actual costs for the order were direct materials, $540, and direct labor, $420. Manufacturing overhead is applied using an estimated rate of 60 percent of direct labor costsIn this caseDirect materials and labor costs were actual costsManufacturing overhead costs were estimatedIf actual costs are not available for direct materials and direct labor, the standard costing method must be usedCopyright © Houghton Mifflin Company. All rights reserved.Standard Costing Method uses estimated, or standard, costs of direct materials, direct labor, and manufacturing overhead to calculate the product unit costUseful when product cost information is desired before the accounting period begins toControl the cost of operating activitiesPrice a proposed product for a customerCopyright © Houghton Mifflin Company. All rights reserved.Illustration of Standard Costing MethodCandy Company, Inc. is placing a bid to manufacture 2,000 candy bars for a new customer. The company’s accountant estimated the following costs: direct materials, $.20 per unit; direct labor, $.15 per unit. Manufacturing overhead is applied using an estimated rate of 60 percent of direct labor costsCalculate the product unit cost for the orderEst. manufacturing overhead cost is $.09 per unit ($.15 DL cost x 60%) Copyright © Houghton Mifflin Company. All rights reserved.Prime Costs and Conversion CostsPrime costsThe costs of productionDirect materials costsDirect labor costsConversion costsThe costs of converting direct materials into a finished productDirect labor costsManufacturing overhead costsCopyright © Houghton Mifflin Company. All rights reserved.Prime Costs and Conversion Costs (cont’d)Below are the per-unit prime costs and conversion costs for Candy Company, using figures for actual unit costNotice that direct labor is a component of both prime costs and conversion costsCopyright © Houghton Mifflin Company. All rights reserved.Relationships Among Product Cost ClassificationsCopyright © Houghton Mifflin Company. All rights reserved.DiscussionWhat are the differences between the actual costing, normal costing, and standard costing methods for calculating product unit cost?Actual costing Costs used for direct materials, direct labor, and manufacturing overhead are all actual costs Normal costing Costs used for direct materials and direct labor are actual costs and an estimate is used for manufacturing overhead Standard costing Costs used for direct materials, direct labor, and manufacturing overhead are all estimated costsCopyright © Houghton Mifflin Company. All rights reserved.Inventory Accounts in Manufacturing OrganizationsObjective 4Describe the flow of costs through a manufacturer's inventory accountsCopyright © Houghton Mifflin Company. All rights reserved.Inventory Accounts in Manufacturing OrganizationsProduction and production-related activities includePurchasing, receiving, inspecting, storing, and moving materialsConverting materials into finished products using labor, equipment, and other resourcesMoving, storing, and shipping finished productsA manufacturing organization’s accounting system tracks these activities as product costs flowing through inventory accountsMaterials Inventory accountWork in Process accountFinished Goods Inventory accountCopyright © Houghton Mifflin Company. All rights reserved.Inventory Accounts in Manufacturing Organizations (cont’d)Materials Inventory accountShows the balance of the cost of unused materialsWork in Process accountShows the manufacturing costs that have been incurred and assigned to partially completed units of productFinished Goods Inventory accountShows the costs assigned to all completed products that have not been soldCopyright © Houghton Mifflin Company. All rights reserved.Document Flows and Cost Flows Through the Inventory AccountsPurchase, receive, inspect, move, and store materialsPurchase requestPurchase orderReceiving reportVendor’s invoiceCost of materials purchased increases account balancePurchase of MaterialsPurchase request is prepared for materials needed but not currently available in storeroomPurchase order is sent to supplier by the Purchasing DepartmentReceiving report is prepared when materials arriveVendor’s invoice is received requesting payment for materialsThe Materials Inventory account increases by the cost of materials purchasedCopyright © Houghton Mifflin Company. All rights reserved.Purchase, receive, inspect, move, and store materialsPurchase requestPurchase orderReceiving reportVendor’s invoiceCost of materials purchased increases account balanceDocument Flows and Cost Flows Through the Inventory AccountsMove materials to production areaMaterials requestCost of direct and indirect materials used in production decreases account balanceCost of direct materials used in production increases account balanceMaterials request form is given to storeroom clerk when production is scheduled Materials handler moves materials to production floorThe Materials Inventory account decreases by the cost of direct and indirect materials transferredThe Work in Process account increases by the cost of direct materials transferredThe cost of indirect materials transferred increases the balance of the Manufacturing Overhead account, which will be discussed later in this chapterProduction of GoodsCopyright © Houghton Mifflin Company. All rights reserved.Purchase, receive, inspect, move, and store materialsPurchase requestPurchase orderReceiving reportVendor’s invoiceCost of materials purchased increases account balanceMove materials to production areaMaterials requestCost of direct and indirect materials used in production decreases account balanceCost of direct materials used in production increases account balanceDocument Flows and Cost Flows Through the Inventory AccountsConvert materials into finished productPackage some types of productTime cardJob order cost cardVendor’s invoices for manufacturing overhead itemsCosts of direct labor and manufacturing overhead increase account balanceA time card is prepared by each production employee recording the number of hours worked A job order cost card is used to record all costs incurred as the product moves through productionProduction of GoodsThe Work in Process account increases by the costs of direct labor and manufacturing overhead used in the manufacturing processCopyright © Houghton Mifflin Company. All rights reserved.Purchase, receive, inspect, move, and store materialsPurchase requestPurchase orderReceiving reportVendor’s invoiceCost of materials purchased increases account balanceMove materials to production areaMaterials requestCost of direct and indirect materials used in production decreases account balanceCost of direct materials used in production increases account balanceDocument Flows and Cost Flows Through the Inventory AccountsConvert materials into finished productPackage some types of productTime cardJob order cost cardVendor’s invoices for manufacturing overhead itemsCosts of direct labor and manufacturing overhead increase account balanceMove completed units to finished goods storage areaJob order cost cardCost of completed units decreases account balanceCost of completed units increases account balanceProduct CompletionThe completed product is packaged and moved to the finished goods storeroomAll production costs have been recorded on the job order cost cardThe Finished Goods Inventory account increases by the cost of the completed productThe Work in Process account decreases by the cost of the completed productCopyright © Houghton Mifflin Company. All rights reserved.Purchase, receive, inspect, move, and store materialsPurchase requestPurchase orderReceiving reportVendor’s invoiceCost of materials purchased increases account balanceMove materials to production areaMaterials requestCost of direct and indirect materials used in production decreases account balanceCost of direct materials used in production increases account balanceDocument Flows and Cost Flows Through the Inventory AccountsConvert materials into finished productPackage some types of productTime cardJob order cost cardVendor’s invoices for manufacturing overhead itemsCosts of direct labor and manufacturing overhead increase account balanceMove completed units to finished goods storage areaJob order cost cardCost of completed units decreases account balanceCost of completed units increases account balanceSell units of product; pack and ship productSales invoiceShipping documentCost of goods sold decreases account balanceProduct SaleWhen the product is sold, a sales invoice is preparedThe product is removed from the storeroom, packaged, and shipped along with a shipping documentThe Finished Goods Inventory account decreases by the cost of the product soldThe Cost of Goods Sold account increases by the cost of the product soldCopyright © Houghton Mifflin Company. All rights reserved.Activities, Documents, and Cost Flows Through the Inventory Accounts of a Manufacturing OrganizationCopyright © Houghton Mifflin Company. All rights reserved.The Manufacturing Cost Flow is the flow of manufacturing costs through the Materials Inventory, Work in Process Inventory, and Finished Goods Inventory accounts into the Cost of Goods Sold accountA defined, structured manufacturing cost flow is the foundation for product costing, inventory valuation, and financial reportingManufacturing costs include direct materials, direct labor, and manufacturing overheadCopyright © Houghton Mifflin Company. All rights reserved.The Manufacturing Cost FlowWork in Process InventoryCost of Goods SoldFinished Goods InventoryManufacturing OverheadFactory PayrollMaterials Inventory50,000100,000200,000250,00020,00078,000Because there are no indirect materials in this case, the Materials Inventory account shows the balance of unused direct materialsDuring the period, direct materials that cost $200,000 are purchased, increasing the accountDirect materials that cost $250,000 are used in production, decreasing the accountCopyright © Houghton Mifflin Company. All rights reserved.The Manufacturing Cost FlowWork in Process InventoryCost of Goods SoldFinished Goods InventoryManufacturing OverheadFactory PayrollMaterials Inventory50,000100,000200,000250,000250,00020,00078,000120,000120,000120,000–0–As direct materials and direct labor are used, their costs are added to the Work in Process Inventory accountThe Work in Process account records the balance of partially completed units of the productCopyright © Houghton Mifflin Company. All rights reserved.The Manufacturing Cost FlowWork in Process InventoryCost of Goods SoldFinished Goods InventoryManufacturing OverheadFactory PayrollMaterials Inventory50,000100,000200,000250,000250,00020,00078,000120,000120,000120,000–0––0–60,00060,00060,000The cost of manufacturing overhead incurred during an accounting period is also added to the Work in Process Inventory accountTotal manufacturing costs equal the total costs of direct materials, direct labor, and manufacturing overhead transferred to work in process inventory during an accounting period Also called current manufacturing costsCopyright © Houghton Mifflin Company. All rights reserved.The Manufacturing Cost FlowWork in Process InventoryCost of Goods SoldFinished Goods InventoryManufacturing OverheadFactory PayrollMaterials Inventory50,000100,000200,000250,000250,00020,00078,000120,000120,000120,000–0––0–60,00060,00060,000Total manufacturing costs for the current period equal $430,000 ($250,000 + $120,000 + $60,000)Total manufacturing costs are equal to the total costs of direct materials, direct labor, and manufacturing overhead transferred to work in process inventory during an accounting period Copyright © Houghton Mifflin Company. All rights reserved.The Manufacturing Cost FlowWork in Process InventoryCost of Goods SoldFinished Goods InventoryManufacturing OverheadFactory PayrollMaterials Inventory50,000100,000200,000250,000250,00020,00078,000120,000120,000120,000–0––0–60,00060,00060,000150,000300,000300,000Cost of goods manufactured is the cost of all units completed and moved to finished goods storage during an accounting periodCost of goods manufactured for the period decreases the Work in Process Inventory account and increases the Finished Goods Inventory accountCopyright © Houghton Mifflin Company. All rights reserved.The Manufacturing Cost FlowWork in Process InventoryCost of Goods SoldFinished Goods InventoryManufacturing OverheadFactory PayrollMaterials Inventory50,000100,000200,000250,000120,000120,000120,000250,000150,00020,000300,000240,00078,000138,000300,000240,00060,00060,00060,000–0––0–The Finished Goods Inventory account holds the balance of costs assigned to all completed units of product that have not yet been soldAs units of product are sold, the cost of the goods sold decreases the Finished Goods Inventory account and increases the Cost of Goods Sold accountCopyright © Houghton Mifflin Company. All rights reserved.Manufacturing Cost Flow: An Example Using Actual Costing for Candy Company, Inc.Copyright © Houghton Mifflin Company. All rights reserved.DiscussionDefine total manufacturing costsThe total costs of direct materials, direct labor, and manufacturing overhead transferred to work in process inventory during an accounting periodCopyright © Houghton Mifflin Company. All rights reserved.Financial Statements and the Reporting of CostsObjective 5Compare how service, retail, and manufacturing organizations report costs on their financial statements and how they account for inventoriesCopyright © Houghton Mifflin Company. All rights reserved.Financial Statements and the Reporting of CostsStatement of goods manufactured A special report based on an analysis of the Work in Process Inventory accountUsed to calculate the dollar amount of the cost of goods manufacturedThis amount is key to preparing an income statement for a manufacturing organizationCopyright © Houghton Mifflin Company. All rights reserved.Statement of Cost of Goods Manufactured summarizes the flow of all manufacturing costs incurred during an accounting periodIs prepared at the end of the periodCopyright © Houghton Mifflin Company. All rights reserved.Statement of Cost of Goods ManufacturedIt is helpful to think of the statement of cost of goods manufactured as being developed in three stepsStep 1Step 2Step 3Copyright © Houghton Mifflin Company. All rights reserved.Steps in Developing the Statement of Cost of Goods ManufacturedStep 1Compute the cost of direct materials used during the accounting periodCost of Materials Available for Use During the PeriodCopyright © Houghton Mifflin Company. All rights reserved.Steps in Developing the Statement of Cost of Goods ManufacturedStep 2Calculate total manufacturing costs for the periodCopyright © Houghton Mifflin Company. All rights reserved.Steps in Developing the Statement of Cost of Goods ManufacturedStep 3Determine total cost of goods manufactured for the periodCopyright © Houghton Mifflin Company. All rights reserved.Comparison of Total Manufacturing Costs and Cost of Goods ManufacturedAll manufacturing costs incurred during an accounting period, regardless of whether units were completed or notIs equal to direct materials, direct labor, and manufacturing overhead costs incurred during production for a periodTotal manufacturing costs attached to units completed during an accounting periodIs equal to total manufacturing costs for the period plus the cost of beginning work in process less the cost of ending work in processTotal Manufacturing CostsCost of Goods ManufacturedCopyright © Houghton Mifflin Company. All rights reserved.Cost of Goods Sold and a Manufacturing Organization’s Income StatementThe total amount of cost of goods manufactured during a period is then carried over to the income statementOn the income statement, it is used to compute the cost of goods soldThe statement of cost of goods manufactured must be prepared before the income statementCopyright © Houghton Mifflin Company. All rights reserved.Cost Reporting and Accounting for Inventories in Service, Retail, and Manufacturing OrganizationsService, retail, and manufacturing organizations have differing operations; therefore, the accounts represented in the financial statements differCopyright © Houghton Mifflin Company. All rights reserved.Sell services, not productsNo inventory on balance sheetCalculate cost of sales rather than cost of goods soldCost of Sales = Net Cost of Services SoldIncludes expenses such as wages and salaries of personnel, expenses of any equipment used, and suppliesService OrganizationsCopyright © Houghton Mifflin Company. All rights reserved.Purchase product ready for resaleOnly one inventory account on the balance sheetMerchandise Inventory accountUse the following equation to calculate cost of goods soldThe Merchandise Inventory account reflects the cost of goods held for resaleRetail OrganizationsCopyright © Houghton Mifflin Company. All rights reserved.Make products for saleMaintain three inventory accounts on the balance sheetMaterials InventoryShows the balance of the cost of materials purchased but not yet used in productionWork in Process InventoryAccumulates the costs of manufacturing the productFinished Goods InventoryShows the cost of unsold, completed units of productManufacturing OrganizationsCopyright © Houghton Mifflin Company. All rights reserved.Manufacturing OrganizationsUse the following equation to calculate cost of goods soldCopyright © Houghton Mifflin Company. All rights reserved.Cost Reporting and Accounting for Inventories in Service, Retail, and Manufacturing OrganizationsIncome statementAll organizations use the following formatProduct costs, or inventoriable costs, appear as cost of goods soldPeriod costs, or noninventoriable costs, are reflected in the operating expensesBalance sheetProduct costs, or inventoriable costs, appear as finished goods inventoryCopyright © Houghton Mifflin Company. All rights reserved.Financial Statements of Service, Retail, and Manufacturing OrganizationsCopyright © Houghton Mifflin Company. All rights reserved.DiscussionWhat is the difference between total manufacturing costs and cost of goods manufactured?Total manufacturing costs All manufacturing costs incurred during an accounting period, regardless of whether units were completed or not Cost of goods manufactured Total manufacturing costs attached to units completed during an accounting periodCopyright © Houghton Mifflin Company. All rights reserved.Cost AllocationObjective 6Define cost allocation and explain how cost objects, cost pools, and cost drivers are used to assign manufacturing overhead costsCopyright © Houghton Mifflin Company. All rights reserved.Cost Allocation is the process of assigning manufacturing overhead costs to the product (cost object) during an accounting periodRequiresThe pooling of manufacturing costs that are affected by a common activitySelecting a cost driver whose activity level causes a change in the cost poolCopyright © Houghton Mifflin Company. All rights reserved.Cost Allocation (cont’d)Cost objectAnything to which costs attach or are relatedProduct, service, department, operating activity, etc.Cost driverAny activity that causes a cost to be incurredDirect labor hours, direct labor costs, units produced, etc.Cost poolThe collection of indirect costs assigned to a cost objectCost allocationThe process of assigning the costs in a cost pool to the cost object using the cost driverCopyright © Houghton Mifflin Company. All rights reserved.Cost Allocation (cont’d)Candy Company has a machine-maintenance cost pool. The cost pool consists of overhead costs for the supplies and labor needed to maintain the machinesMachine hours increase during the accounting period as candy is producedAs machine hours increase, the costs in the machine maintenance cost pool increase in amountThe result is increased costs assigned to the product (candy)Copyright © Houghton Mifflin Company. All rights reserved.Allocating the Costs of Manufacturing OverheadFour-step processCorresponds to the four stages of the management cyclePlanning stageManagers estimate manufacturing overhead costs and calculate a rate at which to assign those costs to productsExecuting stageThis rate is applied to products as manufacturing overhead costs are incurred and recorded during productionReviewing stageActual manufacturing overhead costs are recorded as they are incurred and managers calculate the difference between the estimated and actual costsReporting stageManagers report on this differenceCopyright © Houghton Mifflin Company. All rights reserved.Planning the Overhead RateBefore an accounting period beginsDetermine cost drivers and cost poolsCalculate a manufacturing overhead rateCost pool of total estimated overhead costs ÷ Total estimated cost driver levelJournal EntryNo journal entry is requiredNo business activity has taken placeCopyright © Houghton Mifflin Company. All rights reserved.Applying the Overhead RateDuring the accounting period as units are producedApply manufacturing overhead costs to productionPredetermined overhead rate for each cost pool x Cost pool’s actual cost driver levelAssigns a consistent manufacturing overhead cost to each unit produced during the accounting periodJournal EntryIncrease (debit) Work in Process Inventory Decrease (credit) Manufacturing OverheadCopyright © Houghton Mifflin Company. All rights reserved.Recording Actual Overhead CostsDuring the accounting period as costs are incurredRecord actual manufacturing overhead costs when incurredInclude costs of indirect materials, indirect labor, depreciation, property taxes, and other production costsJournal EntryIncrease (debit) Manufacturing Overhead Decrease (credit) asset account or increase (credit) contra-asset or liability accountsCopyright © Houghton Mifflin Company. All rights reserved.Reconciling the Applied and Actual Overhead AmountsAt the end of the accounting periodCalculate and record the difference between the applied and actual manufacturing overhead (MOH) amountsCopyright © Houghton Mifflin Company. All rights reserved.Reconciling the Applied and Actual Overhead AmountsApplied MOH > Actual MOH Overapplied overhead costsIf difference is immaterial, increase (debit) Manufacturing Overhead and decrease (credit) Cost of Goods SoldIf material, adjustments are made to the affected accountsWork in Process Inventory, Finished Goods Inventory, and Cost of Goods SoldCopyright © Houghton Mifflin Company. All rights reserved.Reconciling the Applied and Actual Overhead AmountsApplied MOH < Actual MOH Underapplied overhead costsIf difference is immaterial, increase (debit) Cost of Goods Sold and decrease (credit) Manufacturing Overhead If material, adjustments are made to the affected accountsWork in Process Inventory, Finished Goods Inventory, and Cost of Goods SoldCopyright © Houghton Mifflin Company. All rights reserved.The Importance of Good EstimatesA predetermined, or estimated, manufacturing rate has two main usesEnables managers to make decisions about pricing products and controlling costs before some of the actual costs are knownAllows managers to apply manufacturing overhead costs to each unit produced in an equitable and timely mannerCopyright © Houghton Mifflin Company. All rights reserved.The Importance of Good EstimatesThe successful allocation of manufacturing overhead costs depends on two factorsA careful estimate of the total manufacturing overhead costsA good forecast of the cost driver levelCopyright © Houghton Mifflin Company. All rights reserved.The Importance of Good Estimates (cont’d)If the estimate of total manufacturing overhead costs is wrong, the overhead rate will be wrongResults in over- or understatement of the product unit costOverstated product unit cost may result in failure to bid on profitable projectsUnderstated product unit cost may result in accepting projects that are not as profitable as expectedCopyright © Houghton Mifflin Company. All rights reserved.The Importance of Good Estimates (cont’d)An underestimated cost drive level will cause an overstatement of the predetermined manufacturing rateThe cost is spread over a lesser levelAn overestimated cost drive level will cause an understatement of the predetermined manufacturing rateThe cost is spread over a greater levelCopyright © Houghton Mifflin Company. All rights reserved.DiscussionWhat is cost allocation?The process of assigning manufacturing overhead costs to the product during an accounting period Manufacturing overhead costs are accumulated in a cost pool and assigned to the cost object using the cost driver Copyright © Houghton Mifflin Company. All rights reserved.Allocating Manufacturing Overhead Using the Traditional ApproachObjective 7Using the traditional method of allocating manufacturing overhead costs, calculate product unit costCopyright © Houghton Mifflin Company. All rights reserved.Allocating Manufacturing Overhead Using the Traditional ApproachTraditional approachUses a single predetermined overhead rateUseful when companies manufactureOne productA few similar products requiring the same production processes and production-related activitiesTotal manufacturing costs constitute one cost poolA traditional activity base is the cost driverDirect labor hours, direct labor costs, machine hours, units of productionCopyright © Houghton Mifflin Company. All rights reserved.Allocating Manufacturing Overhead Using the Traditional Approach (cont’d)Candy Company will be selling two product lines in 20x7—plain candy bars and candy bars with nuts. The company accountant has decided that the cost driver will be direct labor hours, and estimates that total manufacturing overhead costs for the next year will be $20,000 and total direct labor hours worked will be 400,000 hoursStep 1Estimate manufacturing overhead costs and calculate a rate at which to assign those costs to productsCopyright © Houghton Mifflin Company. All rights reserved.Allocating Manufacturing Overhead Using the Traditional Approach (cont’d)During the year, Candy Company used 250,000 direct labor hours to produce 100,000 plain candy bars and 150,000 direct labor hours to produce 50,000 candy bars with nutsStep 2Apply the overhead rate to products as manufacturing overhead costs are incurred and recorded during productionManufacturing overhead applied to plain candy barsManufacturing overhead applied to candy bars with nutsCopyright © Houghton Mifflin Company. All rights reserved.Allocating Manufacturing Overhead Using the Traditional Approach (cont’d)Actual direct materials costs per unit for regular candy bars and candy bars with nuts were $.18 and $.21, respectively, and actual direct labor costs per unit were $.14 and $.16, respectivelyCalculate product unit cost using normal costingThe product unit cost of the candy bars with nuts is higher because they required more expensive materials and more labor timeCopyright © Houghton Mifflin Company. All rights reserved.DiscussionWhat types of companies might use the traditional approach of product costing?Because only one cost pool is used for manufacturing overhead costs, only companies that manufacture one product or a few similar products requiring the same production processes and production-related activities would use the traditional approachCopyright © Houghton Mifflin Company. All rights reserved.Allocating Manufacturing Overhead Using ABCObjective 8Using activity-based costing to assign manufacturing overhead costs, calculate product unit costCopyright © Houghton Mifflin Company. All rights reserved.Allocating Manufacturing Overhead Using ABCActivity-based costing (ABC) Is a more accurate method of assigning overhead costs to products than the traditional approachUses several smaller cost pools for manufacturing overhead costsTraditional approach uses one cost poolImproves accuracy of product cost estimates for companies Selling many different types of productsThat use many varying, significant amounts of different production-related activitiesCopyright © Houghton Mifflin Company. All rights reserved.Activity Based-Costing is a way of assigning cost that identifies all of a company’s major operating activities, traces costs to those activities, reduces or eliminates nonvalue-adding activities, and then determines which products use the resources and services supplied by those activitiesCopyright © Houghton Mifflin Company. All rights reserved.ABC categorizes all indirect costs by activityThe indirect costs are traced to those activitiesActivity costs are assigned to products using cost drivers related to the cause of the costAllocating Manufacturing Overhead Using ABC (cont’d)Copyright © Houghton Mifflin Company. All rights reserved.Companies using ABC identify production-related activities and the events and circumstances that cause (drive) those activitiesProduction-related activitiesSetup, inspections, building, etc.Events and circumstances that cause (drive) those activitiesNumber of setups, number of inspections, machine hours, etc.Allocating Manufacturing Overhead Using ABC (cont’d)Many smaller activity pools are created from the single manufacturing cost pool used in the traditional approachCopyright © Houghton Mifflin Company. All rights reserved.An overhead rate is calculated for each activity poolThe portion of manufacturing overhead costs assigned to a product is determined using that rate and a cost driver amountAllocating Manufacturing Overhead Using ABC (cont’d)An overhead rate is also called an activity cost rateCopyright © Houghton Mifflin Company. All rights reserved.An appropriate number of activity pools must be selectedA system must be designed to capture the actual cost driver amountsThe benefit of greater accuracy from several smaller cost pools is offset by the additional costs of measuring many different cost driversAllocating Manufacturing Overhead Using ABC (cont’d)Copyright © Houghton Mifflin Company. All rights reserved.Using ABC to Assign Manufacturing Overhead Costs to ProductionCopyright © Houghton Mifflin Company. All rights reserved.Planning Overhead RatesCandy Company will be selling two product lines in 20x7—plain candy bars and candy bars with nuts. ABC will be used to assign manufacturing overhead costs to four activity pools: setup, inspection, packaging, and building. Estimated total manufacturing overhead costs are $20,000 Total activity costs are estimated for each activity poolCopyright © Houghton Mifflin Company. All rights reserved.Planning Overhead RatesCandy Company will be selling two product lines in 20x7—plain candy bars and candy bars with nuts. ABC will be used to assign manufacturing overhead costs to four activity pools: setup, inspection, packaging, and building. Estimated total manufacturing overhead costs are $20,000 Cost drivers are selected for each activity pool and the level of each is estimatedCopyright © Houghton Mifflin Company. All rights reserved.Planning Overhead RatesCandy Company will be selling two product lines in 20x7—plain candy bars and candy bars with nuts. ABC will be used to assign manufacturing overhead costs to four activity pools: setup, inspection, packaging, and building. Estimated total manufacturing overhead costs are $20,000 Step 1Calculate activity cost rate for cost poolCopyright © Houghton Mifflin Company. All rights reserved.Planning Overhead RatesCandy Company will be selling two product lines in 20x7—plain candy bars and candy bars with nuts. ABC will be used to assign manufacturing overhead costs to four activity pools: setup, inspection, packaging, and building. Estimated total manufacturing overhead costs are $20,000 Step 1Calculate activity cost rate for cost poolCopyright © Houghton Mifflin Company. All rights reserved.Planning Overhead RatesCandy Company will be selling two product lines in 20x7—plain candy bars and candy bars with nuts. During the year, Candy Company will produce 100,000 plain candy bars and 50,000 candy bars with nutsStep 2Apply predetermined activity cost rates to products$7,100 ÷ 100,000 = $.071$12,900 ÷ 150,000 = $.258Copyright © Houghton Mifflin Company. All rights reserved.Applying Overhead Rates (cont’d)Actual direct materials costs per unit for regular candy bars and candy bars with nuts were $.18 and $.21, respectively, and actual direct labor costs per unit were $.14 and $.16, respectivelyCalculate product unit cost using normal costingThe product unit cost of the candy bars with nuts is higher because the changes in ingredients require more setups and machine hours and because more inspections are needed to test the candy qualityCopyright © Houghton Mifflin Company. All rights reserved.Applying Overhead Rates (cont’d)Compare product unit cost using the traditional approach and ABC ABC is more accurateMore costs are assigned to the product line that uses more resourcesCopyright © Houghton Mifflin Company. All rights reserved.DiscussionWhat is one advantage and one disadvantage of using ABC over the traditional approach?Advantage More accurate because more cost pools are used Disadvantage More costly to implement. Because more cost pools are used, more estimates and calculations are requiredCopyright © Houghton Mifflin Company. All rights reserved.Cost Allocation in Service OrganizationsObjective 9Apply costing concepts to a service organizationCopyright © Houghton Mifflin Company. All rights reserved.Cost Allocation in Service OrganizationsServices performed in typical service organizationsProcessing loansRepresenting people in courts of lawSelling insurance policiesPreparing income tax returnsCopyright © Houghton Mifflin Company. All rights reserved.Cost Allocation in Service Organizations (cont’d)No products are manufacturedNo direct materials costsServices are performedIncur both labor and overhead costsThese are included in the cost of providing servicesDirect labor is most important costIs traceable to the service renderedIndirect costs are similar to those in manufacturing a productCopyright © Houghton Mifflin Company. All rights reserved.Cost Allocation in Service Organizations (cont’d)Indirect costs are classified as service overheadAre considered service costs rather than period costsAppear on income statement as cost of salesDirect labor is also a service cost that appears on the income statement as cost of salesCopyright © Houghton Mifflin Company. All rights reserved.Cost Allocation in Service Organizations (cont’d)The Loan Department of Campus Bank charges a $150 fee for processing a home loan application. The chief loan officer thinks the fee is too low and proposes that it be doubledCompute the cost of processing a typical home loan given the following informationThe department usually processes 100 loan applications per monthBecause the department performs other functions, only 25% of the overhead costs of the department are applicable to processinghome loan applicationsCopyright © Houghton Mifflin Company. All rights reserved.Cost Allocation in Service Organizations (cont’d)The Loan Department of Campus Bank charges a $150 fee for processing a home loan application. The chief loan officer thinks the fee is too low and proposes that it be doubledCompute the cost of processing a typical home loan given the following informationCopyright © Houghton Mifflin Company. All rights reserved.Cost Allocation in Service Organizations (cont’d)The Loan Department of Campus Bank charges a $150 fee for processing a home loan application. The chief loan officer thinks the fee is too low and proposes that it be doubledThe chief loan officer was correct—the fee is too lowDoubling the fee may be too extreme. To allow for a profit margin, the loan fee could be raised to $225 or $250Copyright © Houghton Mifflin Company. All rights reserved.DiscussionDoes the concept of product costs apply to service organizations?Yes. The concept is the same for both. However, service organizations do not manufacture a product and, therefore, do not have direct materials costs. They do incur direct labor costs (the most important cost in a service organization) and service overhead costs, which are similar to manufacturing overhead costsCopyright © Houghton Mifflin Company. All rights reserved.Time for ReviewDescribe how managers use information about costs in the management cycleExplain how managers classify costs and how they use these cost classificationsDefine and give examples of the three elements of product cost and compute the unit cost of a productCopyright © Houghton Mifflin Company. All rights reserved.More ReviewDescribe the flow of costs through a manufacturer's inventory accountsCompare how service, retail, and manufacturing organizations report costs on their financial statements and how they account for inventoriesDefine cost allocation and explain how cost objects, cost pools, and cost drivers are used to assign manufacturing overhead costsCopyright © Houghton Mifflin Company. All rights reserved.And FinallyUsing the traditional method of allocating manufacturing overhead costs, calculate product unit costUsing activity-based costing to assign manufacturing overhead costs, calculate product unit costApply costing concepts to a service organizationCopyright © Houghton Mifflin Company. All rights reserved.
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