Chapter 3

Product Costing Measurement Decisions

Topics to be Discussed

Introduction

Product Costing Systems

Basic Job-Order Costing for Manufacturing and Service Companies

Introduction

How do managerial accountants determine the cost of the products or services being produced and sold by a company?

Introduction

How is the cost of the product used?

Determining the selling price

Buying or making a component

Introduction

Pause and Reflect

As a reaction to decreasing sales in its restaurants, McDonald’s Corp. proposed a radical price reduction on its Big Mac in early 1997. The sandwich (usually priced around $1.90) would be offered for $.55 with the purchase of fries and a drink.

Introduction

Pause and Reflect

The proposal required the approval of a majority of franchisees. As an owner of a local McDonald’s, you estimate that the cost of making a Big Mac is $.63.

Would you vote for the proposal?

Product Costing Systems

Job CostingCustomized Production: Home, Furniture, Print Order

Customized Service: Tax Return, Audit, Patient

Product Costing Systems

Process Costing: A homogenous product being produced on a continuous basis.

Oil refineries, Breweries, Paint and Paper Manufacturers

Product Costing Systems

Operations Costing: A hybrid of job and process costing

Used by manufacturers who make products in batches

Automobiles, Clothing

Basic Job-Order Costing

Cost Sheet for Job 101

Northern Lights Custom CabinetsJob Number: 101Date Started: March 6Description: Smith House

Customer: Robyn GrayDate Finished: March 9

Direct Materials Direct Labor Manufacturing Overhead

Type Cost Employee Hrs. Amount Hours Rate Amount

Oak $875 Staley 12.6 $255.15 22.4 $16.67 $373.41

Basic Job-Order Costing

Cost Sheet for Job 101 Summary

Direct Materials

Direct Labor

Manufacturing Overhead

Total

$1883.00

453.61

373.41

$2,710.02

Cost Summary

Basic Job-Order Costing

Measuring and Tracking Direct Material

Normal Spoilage: Results from the regular operation of the production process

Abnormal Spoilage: Results from improper handling, poorly trained craftspeople, equipment that is in poor condition

Measuring and Tracking Direct Material

Concept Question

How would you treat the cost of abnormal spoilage? Would it be fair to treat it as part of the direct material cost for the job being produced? Should the cost of abnormal waste be passed on to the customer as an increase in the sales price?

Measuring and Tracking Direct Labor

Direct Labor is calculated by multiplying a wage rate for each employee by the number of hours that each employee works on each product.

Add Fringe Benefits such as employer’s cost for health, dental and other insurance, retirement plans, employer portion of social security tax and state and federal unemployment taxes (often 30-35% of the base wage).

Direct Labor or Overhead?

Idle time?

Overtime premiums?

Measuring and Tracking Manufacturing Overhead

Rent

Depreciation

Repairs and maintenance

Utilities

Indirect Labor

Indirect Materials

Measuring and Tracking Manufacturing Overhead

Key Concept

Overhead cannot be directly tracked to products and services but must instead be allocated using cost drivers.

Allocation of Manufacturing Overhead

The choice of an allocation base requires a thorough understanding of what causes overhead costs to be incurred.

Allocate based on the number of units produced.

Allocate based on the number of direct labor hours or machine hours.

More Topics to Discuss

The Role of Cost Pools and Cost Drivers

Departmental Overhead Rates

The Use of Estimates in Predetermined Overhead Rates

The Role of Cost Pools and Cost Drivers

Key Concept

Understanding what causes overhead costs to be incurred (what drives them) is the key to allocating overhead.

Cost Pools

Instead of identifying cost drivers for each component of overhead, companies have traditionally lumped overhead into similar Cost Pools to simplify the task.

May have one cost pool for the entire factory.

May have separate pools of overhead for each department.

May have a cost pool for each activity performed in making a product.

Cost Pools

Pause and Reflect

In a law firm, overhead costs consist of the cost of office space for attorneys, the salaries of secretaries, the cost of research material, and so on.

What allocation base might be used as a cost driver for overhead in a law firm?

Which Overhead Rate Do We Use?

Define the Problem

A new product requires substantial machine time to manufacture, but requires very little direct labor. Which is used to allocate overhead?

Which Overhead Rate Do We Use?

Identify Objectives

Develop a method of allocating overhead to products that will provide accurate costs for both their traditional labor-intensive product and their new product.

Which Overhead Rate Do We Use?

Should multiple overhead rates be used? What factors are likely to be relevant in their decision?

Identify and Analyze Available Options

Which Overhead Rate Do We Use?

Select the Best Option

Single Plant-wide Rate or Multiple Departmental Overhead Rates

The Use of Estimates

Key Concept

Accuracy in overhead application has become much more important as overhead costs have increased and make up a larger portion of the total costs of products.

Which Overhead Rate Do We Use?

Key Concept

In order to provide relevant information for decision making, overhead must often be estimated. Using estimates smoothes out or normalizes seasonal and random fluctuations in overhead costs.

Predetermined Overhead Rates

Key Formula

Predetermined Overhead Rate (for a Cost Pool)

=

Estimated Overhead for the Cost Pool

Estimated Units of the Cost Driver

Predetermined Overhead Rates

A company identifies overhead costs and estimates that these costs should total about $120,000 in the next year.

The company is very labor intensive and has chosen labor hours as the cost drive and estimates using 10,000 labor hours this year.

Estimated Overhead

Estimated Allocation Base

$120,000

10,000= = $12 per labor hour

Predetermined Overhead Rates

If a job required 24 labor hours, how much overhead would be allocated to that job?

$12 (overhead rate) x 24 (labor hours) = $288

The Problem of Over- and Underapplied Overhead

Overapplied Overhead: Applied overhead is greater than actual overhead

Underapplied Overhead: Applied overhead is less than actual overhead

The Problem of Over- and Underapplied Overhead

What do you do with the under- or over-applied overhead?

Allocate this amount to work in process, finished goods, and cost of goods sold or if the amount of the adjustment is small, adjust only the cost of goods sold account.

Additional Topics in Product Costing

Basic Process Costing

Backflush Costing

Basic Process Costing

Direct material and direct labor costs are tracked by department, and costs are assigned evenly to the products that pass through each department.

Overhead is applied to each department and assigned evenly to each product.

Basic Process Costing

Direct materials

Direct labor

Manufacturing Overhead

Process A

Process B

Process C

Finished Goods

Cost of Goods Sold

Basic Process Costing

+ =One Full

Glass

1/21/2

Equivalent Units

Basic Process Costing

Multiple WIP accounts are used: one for every process.

As products are moved from one process to another, the costs of the previous process are transferred to the next process.

Blending and pouring paint

Backflush Costing

For companies using JIT:

All manufacturing costs are flushed directly into cost of goods sold.

If the company has small amounts of inventory on hand at the end of the period, Manufacturing costs are backflushed into the appropriate materials inventory, WIP inventory or finished goods inventory.

End of Chapter 3

How much would the new product cost?