Costing Systems: Concepts and Design Issues

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Costing Systems:Concepts and Design Issues


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Learning Objective 1


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Product Costs

• Related to the purchase or manufacture of goods for resale.

• Assigned to inventory and cost of goods sold.

Period Costs• Related to selling and administrative operations.• Recognized as expenses in the same time period.

The Meaning of Cost

The use of valuable

resources, in order to achieve a stated purpose. In accounting, cost

is reported in monetary terms.


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Retailers . . . Buy finished goods.

Sell finished goods.

Manufacturers . . . Buy raw materials.

Produce and sell finished goods.

MegaLoMart

Comparing Service, Retail and Manufacturing Companies

Service firms . . . Provide a service that is

consumed when produced.

Have no inventories.


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Manufacturing Companies

The 3 major categories of manufacturing costs:

The 3 major categories of manufacturing costs:

Direct MaterialsRaw materials,

components, and other parts that

can be traced to a specific product.

Direct LaborPayments and

benefits for those employees who convert direct materials into

finished product.

Manufacturing Overhead

Indirect material

Indirect labor

Other overhead


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Prime Costs include:Prime Costs include:

Direct Materials Direct Labor Manufacturing Overhead


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Conversion Costs include:

Direct Materials Direct Labor Manufacturing Overhead


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Stages of Production and the Flow of Costs

Raw MaterialsBeg. Inventory

Add: Purchases= Raw Materials

Available for Production

Less: Raw Materials Transferred to Production

= Ending Inventory

Work-In-ProcessBeg. WIP Inventory

Add: Raw Materials Transferred InDirect LaborManufacturing Overhead

= Total Manufacturing Costs Incurred

Less: Cost of Goods Completed and Transferred to Finished Goods

= Ending WIP Inventory

Finished GoodsBeg. Inventory

Add: Cost of Goods Completed and Transferred from WIP

= Goods Available for Sale

Less: Cost of Goods Sold= Ending Inventory


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Stages of Production and the Flow of Costs - Example

Raw MaterialsBeg. Inventory

Add: Purchases= Raw Materials

Available for Production

Less: Raw Materials Transferred to Production

= Ending Inventory

What is Ending What is Ending Inventory in Inventory in February?February?

Axel Electronics makes toasters. On February 1, Axel has $15,000 of raw material on hand. Axel’s purchase and transfers to the production floor

are indicated below.

DateCost of

PurchasesCost of

TransfersFeb 3 $ 8,000 $ 5,000 Feb 10 12,000 11,000 Feb 15 14,000 7,000 Feb 20 6,000 Feb 22 9,000 Feb 27 16,000


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Axel Electronics makes toasters. On February 1, Axel has $15,000 of raw material on hand. Axel’s purchase and transfers to the production floor

are indicated below.


Now let’s look at Work-in-Process.

Raw Materials$15,000

Add: 43,000= $58,000

Less: 45,000= $13,000

DateCost of

PurchasesCost of

TransfersFeb 3 $ 8,000 $ 5,000 Feb 10 12,000 11,000 Feb 15 14,000 7,000 Feb 20 6,000 Feb 22 9,000 Feb 27 16,000


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What is the amount of cost transferred to

Finished Goods in February?

Work-In-ProcessBeg. WIP Inventory

Add: Raw Materials Transferred InDirect LaborManufacturing Overhead

= Total Manufacturing Costs Incurred

Less: Cost of Goods Completed and Transferred to Finished Goods

= Ending WIP Inventory


Add: 43,000= $58,000

Less: 45,000= $13,000

On February 1, Axel had WIP of $30,000 on the factory floor. During February,

Axel paid $92,000 in direct labor wages. Overhead is applied

at 150% of direct labor. On 2/28,

$22,000 is still in WIP.


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Work-In-Process$30,000

Add: 45,00092,000

138,000= $305,000

Less: 283,000= $22,000


Add: 43,000= $58,000

Less: 45,000= $13,000

Now let’s look at

Finished Goods.

Transferred to Finished

Goods

On February 1, Axel had WIP of $30,000 on the factory floor. During February,

Axel paid $92,000 in direct labor wages. Overhead is applied

at 150% of direct labor. On 2/28,

$22,000 is still in WIP.

150 % of $92,000


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Add: 45,00092,000

138,000= $305,000

Less: 283,000= $22,000

On February 1, Axel had Finished Goods of $125,000 on hand. At the end of February, a physical inventory count

revealed $96,000 in Finished Goods still on hand.What was Cost of Goods Sold for February?


Add: 43,000= $58,000

Less: 45,000= $13,000

Finished GoodsBeg. Inventory

Add: Cost of Goods Completed and Transferred from WIP

= Goods Available for Sale

Less: Cost of Goods Sold= Ending Inventory


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Add: 45,00092,000

138,000= $305,000

Less: 283,000= $22,000


Add: 43,000= $58,000

Less: 45,000= $13,000

Finished Goods$125,000

Add: 283,000= $408,000

Less: 312,000= $96,000

On February 1, Axel had Finished Goods of $125,000 on hand. At the end of February, a physical inventory count

revealed $96,000 in Finished Goods still on hand.What was Cost of Goods Sold for February?

Cost of goods sold


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Schedule of Cost of Goods Manufactured

Let’s look at aSchedule of Cost of

Goods Manufactured forCollegePak Company.


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CollegePak CompanySchedule of Cost of Goods Manufactured

Raw material used 850,000$ Direct labor 700,000 Total manufacturing overhead 1,850,000 Total manufacturing costs 3,400,000$ Add: Work-in-process inventory, January 1 350,000 Subtotal 3,750,000$ Deduct: Work-in-process inventory, December 31 400,000 Cost of goods manufactured 3,350,000$



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Computation of Cost of Raw Material Used

Raw-material inventory, January 1 200,000$ Add: Purchases of raw materials 800,000 Raw material available for use 1,000,000 Deduct: Raw material inventory, December 31 150,000 Raw material used 850,000$


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Include all direct labor costs incurred during the

current period.


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Beginning work-in-process inventory is carried over from the

prior period.


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Ending work-in-process inventory contains the cost of unfinished goods, and is reported in the current assets

section of the balance sheet.


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Now let’s look at an income statement for CollegePak.

Income Statement for a Manufacturer


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CollegePak CompanyIncome Statement

For the Year Ended December 31, 20X2Sales revenue 4,500,000$ Less: Cost of goods sold 2,810,000 Gross margin 1,690,000$ Selling and administrative expenses 1,440,000 Operating profit before taxes 250,000$


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CollegePak CompanyIncome Statement

For the Year Ended December 31, 20X2Sales revenue 4,500,000$ Less: Cost of goods sold 2,810,000 Gross margin 1,690,000$ Selling and administrative expenses 1,440,000 Operating profit before taxes 250,000$


CollegePak CompanySchedule of Cost of Goods Sold

For the Year Ended December 31, 20X2

Finished-goods inventory, Jan. 1 920,000$ Add: Cost of goods manufactured 3,350,000 Cost of goods available for sale 4,270,000 Deduct Finished-goods inventory, Dec. 31 1,460,000 Cost of goods sold 2,810,000$


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Production Costs in the Service Sector

A service provider cannot “inventory” its services.

The costs of providing the service can be identified and measured, just as occurs in manufacturing industries.

Managing and tracking the costs associated with value-chain activities can point to opportunities for improvement.


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Cost Drivers

An “activity” is any discrete task that an

organization undertakes to make or deliver a good or

service.A “cost driver” is

incurred.

A “cost driver” is some characteristic of the activity that causes costs to be

incurred.

Number ofcomputers made by

Dell in a day

Number offlights by Southwest

Airlines in a given market


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Cost behavior means how a cost will react to changes in the level of business activity. Total variable costs

change when activity level changes.

Total fixed costs remain unchanged when activity level changes.

Cost Behavior


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Your total long distance telephone billis based on how many minutes you talk.

Minutes Talked

Tota

l Lon

g D

ista

nce

Tele

phon

e Bi

ll

Total Variable Cost Example


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Minutes Talked

Per M

inut

eTe

leph

one

Cha

rge

The cost per long distance minute talked isconstant. For example, 5 cents per minute.

Variable Cost Per Unit Example


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Your monthly basic telephone bill probably does not change when you

make more local calls.

Number of Local Calls

Mon

thly

Bas

ic

Tele

phon

e Bi

ll

Total Fixed Cost Example


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Number of Local Calls

Mon

thly

Bas

ic T

elep

hone

Bi

ll pe

r Loc

al C

all

The average cost per local calldecreases as more local calls are made.

Fixed Cost Per Unit Example


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Summary of Variable and Fixed Cost BehaviorCost In Total Per Unit

Variable

Fixed

Changes proportionately with changes in activity within the

relevant range.

Remains constant for each additional unit as long as activity

is in the relevant range.

Remains the same even when activity changes within the

relevant range.

The per unit amount changes each time the level of activity

changes due to the fixed nature of the related costs.

Cost Behavior Summary


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Directly traceable to the decision toproduce the level

of output

Cost Hierarchy

Includes direct material, direct labor, utilities to run equipment, other overhead directly related to

the production process.

Costs that are incurred for every unit of product manufactured or service produced.

Unit-level Costs

All unit level costs are variable, but notall variable costs are unit level costs.


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Batch-level Costs

Costs that are incurred for batch of product manufactured or service produced.

Includes setup costs, material-handling costs related to delivering raw material to the

production line, etc.

Cost Hierarchy


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Product-level Costs

Costs that are incurred for each line of product or service.

Includes design costs for product lines and marketing costs for each product line.

Cost Hierarchy


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Facility-level Costs

Costs that are incurred to maintain the organization’s overall facility and infrastructure.

Includes production manager’s salary, plant depreciation, and insurance on the facility and

equipment.

Cost Hierarchy


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DiscretionaryEasier to alter in the

short term by current managerial decisions.

CommittedLong-term obligations, difficult to change in

the short term.

Rental and/or Lease Financing of Buildings and

equipment

Advertising and Research and Development

Committed and Discretionary Costs


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The potential benefit that is given up whenone alternative is selected over another.

If you were not attendingcollege, you could beearning $20,000 per year.Your opportunity cost ofattending college forone year is $20,000.

Opportunity Costs


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Past payments for resources that cannot be changed by any current or future decision.

Sunk costs should not be considered in decisions.

Example: You bought an automobile for $12,000 two years ago. Whatever you do with the automobile in the future, you cannot nullify the original transaction. If it has a trade-in value, that value would become an opportunity cost in your future decisions.

Sunk Costs


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Direct Costs Costs that can be

traced easily and conveniently to a product or department.

Example: Cost of paint in the paint department of an automobile assembly plant.

Indirect Costs Costs that need to be

allocated, before they can be assigned to a product or department.

Example: Cost of national advertising for an airline is indirect to a given flight or route.

Traceability of Resources


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A system of accounting for costs in which both fixed and variable production costs

are included in product costs.

FixedCosts

VariableCosts

Product

Absorption (Full) Costing


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A system of cost accounting that assigns only the variable cost of production to products.

FixedCosts

VariableCosts

Product

Variable Costing


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Absorption Costing

Variable Costing

Direct materialsDirect labor Product costs

Product costs Variable mfg. overhead

Fixed mfg. overheadPeriod costs

Period costs Selling & admin. exp.

Absorption Costing vs. Variable Costing


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Let’s see what we can learn about the differences between absorption and variable costing by looking at a numerical example.

Absorption and Variable Costing


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Absorption Costing vs. Variable Costing - Example

Howell, Inc. produces a single product with a sales price of $40 and the following cost information:


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Unit product cost is determined as follows:

Selling and administrative expenses arealways treated as period expenses and deducted from

revenue as they are incurred.



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Absorption CostingSales (28,000 × $40) 1,120,000$ Less cost of goods sold: Beginning inventory -$ Add COGM (30,000 × $19) 570,000 Goods available for sale 570,000 Ending inventory (2,000 × $19) 38,000 532,000 Gross margin 588,000 Less selling & admin. exp. Variable (28,000 x $4) 112,000$ Fixed 250,000 362,000 Net income 226,000$


Howell, Inc. had no beginning inventory, produced 30,000 units and sold 28,000 units this year.


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Variable CostingSales (28,000 × $40) 1,120,000$ Less variable expenses: Beginning inventory -$ Add COGM (30,000 × $12) 360,000 Goods available for sale 360,000 Ending inventory (2,000 × $12) 24,000 Variable cost of goods sold 336,000 Variable selling & administrative expenses (28,000 × $4) 112,000 448,000 Contribution margin 672,000 Less fixed expenses: Manufacturing overhead 210,000$ Selling & administrative expenses 250,000 460,000 Net income 212,000$

Variablecostsonly.

All fixedmanufacturing

overhead isexpensed.



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Cost of Goods Sold

Ending Inventory

Period Expense Total

Absorption costing Variable mfg. costs 336,000$ 24,000$ -$ 360,000$ Fixed mfg. costs 196,000 14,000 - 210,000

532,000$ 38,000$ -$ 570,000$

Variable costing Variable mfg. costs 336,000$ 24,000$ -$ 360,000$ Fixed mfg. costs - - 210,000 210,000

336,000$ 24,000$ 210,000$ 570,000$

Comparing Absorption andVariable Costing

Let’s compare the methods.


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We can reconcile the difference between absorption and variable net income as follows:

Variable costing net income 212,000$ Add: Fixed mfg. overhead costs deferred in inventory (2,000 units × $7 per unit) 14,000 Absorption costing net income 226,000$

Fixed mfg. overhead $210,000Units produced 30,000 = $7.00 per unit=

Reconciling Income


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Let’s look at the second

year ofoperations

for Howell, Inc.

Extending the Example


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In its second year of operations, Howell started with an inventory of 2,000 units, produced 30,000 units and sold

32,000 units at $40 each.

Howell Inc., Year 2


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Unit product cost is determined as follows:

There has been nochange in Howell’s

cost structure.

Howell Inc., Year 2


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Absorption CostingSales (32,000 × $40) 1,280,000$ Less cost of goods sold: Beg. inventory (2,000 x $19) 38,000$ Add COGM (30,000 × $19) 570,000 Goods available for sale 608,000$ Ending inventory - 608,000 Gross margin 672,000$ Less selling & admin. exp. Variable (32,000 × $4) 128,000$ Fixed 250,000 378,000 Net income 294,000$

Units in ending inventory from the previous period.

30,000 units produced in the current period.

Howell Inc., Year 2


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Variable CostingSales (32,000 × $40) 1,280,000$ Less variable expenses: Beg. inventory (2,000 × $12) 24,000$ Add COGM (30,000 × $12) 360,000 Goods available for sale 384,000$ Ending inventory - Variable cost of goods sold 384,000$ Variable selling & administrative expenses (32,000 × $4) 128,000 512,000 Contribution margin 768,000$ Less fixed expenses: Manufacturing overhead 210,000$ Selling & administrative expenses 250,000 460,000 Net income 308,000$

Howell Inc., Year 2


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In the first period, production (30,000 units)was greater than sales (28,000).

Income Comparison

Costing Method 1st Period 2nd Period TotalAbsorption 226,000$ 294,000$ 520,000$ Variable 212,000 308,000 520,000

In the second period, production (30,000 units)was less than sales (32,000).

For the two-year period, total absorptionincome and total variable income are the same.

Summary


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Summary


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Fixed costs arenot really the costs

of any particularproduct.

VariableCosting

Variable versus Absorption Costing

AbsorptionCosting

All manufacturingAll manufacturingcosts must be assignedcosts must be assignedto products to properlyto products to properlymatch revenues andmatch revenues and

costs.costs.


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AbsorptionCosting

These are capacitycosts and will be

incurred even if nothingis produced.

VariableCosting

Depreciation,taxes, insurance andsalaries are just as

essential to productsas variable costs.



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VariableCosting

Absorptioncosting product costs

are misleading fordecision making.

They are the numbers that appear on our

external reports.

AbsorptionCosting



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Variable cost $10Fixed manufacturing overhead $100,000Units sold 10,000

Units Produced

Total Variable Cost

Fixed Manufacturing

Overhead

Total Manufacturing

Cost

Average Manufacturing

CostCost of

Goods Sold10,000 $100,000 $100,000 $200,000 20.00$ 200,000$ 12,000 $120,000 $100,000 $220,000 18.33$ 183,333$ 14,000 $140,000 $100,000 $240,000 17.14$ 171,429$ 16,000 $160,000 $100,000 $260,000 16.25$ 162,500$ 18,000 $180,000 $100,000 $280,000 15.56$ 155,556$ 20,000 $200,000 $100,000 $300,000 15.00$ 150,000$

Absorption CostingCost of goods sold decreases because production

exceeds sales, leaving a portion of fixedmanufacturing costs in inventory.


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COGS for 10,000 units

$100,000

$150,000

$200,000

10,00

014

,000

18,00

022

,000

26,00

030

,000

34,00

0

Number of units produced

CO

GS

Absorption CostingCost of goods sold decreases because production

exceeds sales, leaving a portion of fixedmanufacturing costs in inventory.


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Throughput Costing

Productcost

Unit-levelspending fordirect costs

Unit-level costs are incurred every time a unit ofproduct is manufactured and will not be incurred

again until the next unit is manufactured.

Indirect, past or committed

costs


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Example

In an automated process direct material may bethe only unit-level cost and so is the only product cost.

All other manufacturing costs are expensed as period costs.

Incentive tooverproduceis reduced

Average unit cost doesnot vary with changesin production levels.

Advantages

Throughput Costing


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Intentional Overproduction of Inventory

Absorption costing: Excess inventory would include more fixed production costs, so that gross income for the period would be artificially higher.

An unethical manager would have an incentive to “produce for inventory” at the end of a period, in order to obtain a better looking bottom line.

Throughput costing: No such incentive would exist, since fixed production costs would be charged against operating income for the period.


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End of Chapter 2

Costing Systems: Concepts and Design Issues

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