Chapter 5 Special Addendum

1. Chapter 5 Special Addendum Job-Order Costing & Process Costing

2. Overview of Cost Accumulation Systems • Is the process of identifying the costs associated with various organization activities • Cost accumulation systems provide the unit cost of producing a product or service. • It is important to both: • The internal decision making process (managerial accountants) and • In evaluating the performance of individuals in the organization (financial accountants)

3. Overview of Cost Accumulation Systems (Continued) • The system should be flexible enough to provide different cost figures as needed for different purposes: Purpose Reported costs Make or buy decision Incremental costs (e.g., continuing a production line) Financial statements Full absorption costs (e.g., determining (Cost of Inventory the real cost of manufacturing a is shown on B/S & product or selling a product or COGS on the I/S) service) Long-term pricing Full costs of all value chain functions (helps determine price product should be sold for)

4. Job-Order Costing Systems versus Process Costing Systems • Objective of both systems is to compute unit costs • The choice between the two types of systems is dictated by the type of product/service being provided or manufactured • Job-Order Costing Systems • Process Costing Systems • Job-Order costing - • Used by companies with a distinct, identifiable unit of a product or service/companies with a discrete manufacturing process • Costs accumulated by job • Examples: home builders, Dell (computers), GM (cars), Walt Disney (movies) and Boeing (airplanes)

5. Job-Order Costing Systems versus Process Costing Systems (continued) • Process costing - • Is used to assign costs equally to homogeneous units within a particular time period • Is used in continuous flow production processes (beverages, paints, printed circuit boards, etc.) • Costs are collected by department or process, not by individual unit. • Costs assigned to products represent an average cost of all units processed through the department. • Examples: a gallon of gas or any chemical made in batches • Products with both characteristics often use a hybrid of the two approaches.

6. Job-Order Costing

7. Characteristics of Job Costing Systems • Costs are accumulated by job • There is a subsidiary account, or job cost record, for each job • The costs of each inventory control account (e.g., Work in Process, Finished Goods) equals the sum of the costs accumulated for each job in that inventory • Job-Costing Systems are widely used in construction companies, manufacturers, service providers, and nonprofit organizations

8. Why Accumulate Costs by Job? • Managers can use their knowledge of the costs of prior and current jobs to estimate the costs of prospective jobs • Managers can compare actual job costs to the estimated (or budgeted) job costs in order to control costs • Since the actual costs of jobs sometime deviate from estimated costs, managers can use job cost information to renegotiate contracts with customers

9. Attaching Costs to Jobs 1. Identify the job requiring cost measurement 2. Identify the direct cost categories for the job 3. Identify the indirect cost pool(s) associated with the job and an appropriate allocation base 4. Trace the direct costs to the jobs 5. Allocate the indirect costs to the job using the chosen allocation base

10. Cost Tracing versus Cost Allocation • Direct costs are traced to the specific job • E.g., direct labor and direct materials • Are accumulated in “Work in Process” Inventory • Work in Process is shown on the B/S as an Asset • Indirect costs are allocated to the specific job • E.g., overhead costs • Companies calculate a predetermined overhead rate by estimating total O/H costs and dividing it by some expected level of activity • Note: Costs are allocated to jobs because jobs consume costly resources that cannot be traced in an economically feasible manner

11. Computing/Using PredeterminedOverhead Rates • Predetermined Overhead Rates are calculated to provide management with timely information concerning overhead rates associated with a particular job • Predetermined overhead rates are computed by estimating the total overhead costs and dividing this by some expected level of activity (Cost Driver) • The Cost Driver represents the activity that causes overhead costs to change within the relevant range

12. Computing/Using PredeterminedOverhead Rates (Steps) • Identify the indirect costs to be allocated • Estimate the amount of these costs expected to be incurred during the period, based on the estimated level of operations • Select an appropriate cost allocation base • Estimate the level of the allocation base expected to be consumed, based on the estimated level of operations • Compute the predetermined overhead (MOH) rate: MOH Rate = Est. annual MOH costs/Est. level of allocation base • During the period, measure the actual amount of the allocation base consumed by a given job • Allocate overhead to that job by multiplying the predetermined rate by the actual amount of the allocation base consumed by the job

13. The Flow of Manufacturing Costs • Three inventory control accounts: • Materials Inventory, • Work-In-Process Inventory, • Finished Goods Inventory • Materials Inventory - • Contains both direct and indirect materials • Purchase of materials requires a debit to the account • Usage of materials requires a credit.

14. The Flow of Manufacturing Costs (Cont’d) • Work-In-Process Inventory - • Direct materials, direct labor, and allocated manufacturing overhead are debited to the account, • Transfer of completed goods (cost of goods manufactured) requires a credit to the account. • Finished Goods Inventory - • The cost of completed goods is debited to Finished Goods • Cost of goods sold is credited to the account.

15. Accounting for Materials • To record material purchases on account ($38,000): Materials inventory $38,000 Accounts payable $38,000 • To record usage of materials (assume $10,000 direct and $1,750 indirect materials costs): Work in process inventory $10,000 Manufacturing overhead $1,750 Materials inventory* $11,750 * completed goods

16. Accounting for Labor • Assume $28,000 in direct labor, $1,350 in indirect labor and $1,650 in supervisory salaries: Work in process inventory $28,000 Manufacturing overhead $3,000 Wages/salaries payable $31,000

17. Accounting for Actual Manufacturing Overhead Costs • Actual and applied costs of manufacturing overhead are typically accumulated in an account called Manufacturing Overhead. • Actual costs of overhead items are debited to this account. • Assume that, in addition to the costs previously debited to Manufacturing Overhead, additional overhead costs of $6,000 for depreciation on factory equipment, $2,500 in factory utilities, and $1,000 in property taxes. • Entry: Manufacturing overhead $9,500 Accumulated depreciation $6,000 Accounts payable $2,500 Property taxes payable $1,000

18. Accounting for Allocated Manufacturing Overhead • Allocation of overhead is accounted for independently of the incurrence of overhead • Work-In-Process Inventory is debited for allocated overhead and Manufacturing Overhead is credited with the amount of the allocation • Assume overhead is allocated at the rate of $10 per direct labor hour, and 1,400 direct labor hours have been consumed during the period. The entry to allocate overhead is: Work in process inventory $14,000 Manufacturing overhead $14,000

19. Completing the Operating Cycle • Transfer of completed jobs to Finished Goods Inventory (assume jobs with costs of $24,000 are completed): Finished goods inventory 24,000 Work in process inventory 24,000 • Sale of completed jobs on account (assume jobs costing $21,000 are sold for $37,000): Cost of goods sold 21,000 Finished goods inventory 21,000 Accounts receivable 37,000 Sales revenue 37,000

20. Cost of Goods Manufactured Statement • The Cost of Goods Manufactured Statement represents a reconciliation of the company’s beginning and ending work-in-process inventories and includes the following information: • Beginning and ending balances in work-in-process inventory. • Total manufacturing costs incurred during the period. • Cost of goods manufactured.

21. Cost of Goods Sold Statement • The Cost of Goods Sold Statement represents a reconciliation of the company’s beginning and ending finished goods inventories and includes the following information: • Beginning and ending balances in finished goods inventory. • Cost of Goods Manufactured for the period. • Cost of Goods Sold.

22. The Flow of Manufacturing Costs (Summary) • Three inventory control accounts: Materials Inventory, Work-In-Process Inventory, and Finished Goods Inventory. • Materials Inventory - Contains both direct and indirect materials. Purchase of materials requires a debit to the account. Usage of materials requires a credit. • Work-In-Process Inventory - Direct materials, direct labor, and allocated manufacturing overhead are debited to the account, and transfer of completed goods (cost of goods manufactured) requires a credit to the account. • Finished Goods Inventory - The cost of completed goods is debited to Finished Goods, and cost of goods sold is credited to the account.

23. Process Costing

24. Characteristics of Process Costing • Process costing is used to assign costs equally to homogeneous units within a particular time period • Process costing is used in continuous flow production /continuous manufacturing processes (beverages, paints, printed circuit boards, etc.). • Costs are collected by department or process, not by individual unit/“item-by-item” basis • Costs assigned to products represent an average cost of all units processed through the department (in batches) • Amounts and costs of materials, labor & O/H are similar across products • Examples: Coca-Cola, ExxonMobil (gas), Ben & Jerry’s (ice cream), Johnson & Johnson (band-aids)

25. Purposes of Process Costing • To determine inventory values for financial reporting purposes • The preparation of journal entries and financial statements is identical to those prepared for Job Order Costing • The only difference is the method of accumulating manufacturing costs with inventory as it is manufactured • To evaluate the efficiency of production operations and aid in identifying non-value-added activities

26. Continuous Flow Manufacturing Example • Plywood manufacturing: • Manufacturing steps: - Receive, cut to length, and cure logs - Debark and clean logs - Cut logs into wood veneer sheets - Glue and press veneer sheets together - Heat, pressure-treat unfinished plywood; allow to cure - Cut sheets to standard length and width - Sand to final finish - Stack, mark, and package for wholesale distribution - Move finished inventory to shipping warehouses

27. Points to Note in Example • Each department must account for: • That department’s costs, and • The costs of all prior departments through which the product has traveled • Direct materials are usually added at discrete points in the production process (cured logs, glues) • Conversion costs are usually added uniformly through the process • With automated processes, direct labor is often a small portion of of total costs

28. Equivalent Units • Costs to account for in each department consist of: • Costs in beginning inventory + costs added during period • These total costs must be assigned to two components of inventory: • Costs transferred out + costs in ending inventory • How are these costs assigned? • On the basis of equivalent units • Equivalent units (EU) - • The amount of work actually performed on products with varying degrees of completion, translated to the work required to complete an equivalent number of whole units • EU are a measure of the amount of work done in a period, assuming all work went toward completed units

29. Equivalent Units -- Formulas • DO NOT PANIC OVER THE FORMULAS YOU ARE ABOUT TO SEE!!!!! • THEY ARE ACTUALLY ONE MAIN FORMULA WRITTEN SEVERAL DIFFERENT WAYS!!!!

30. Equivalent Units -- Formulas • Basic Formula for accounting for units produced is: • Beginning Work in Process (WIP) + Units Started -Units Completed = Ending Work in Process (WIP) • Can be rewritten: • Beginning WIP + Units Started = Ending WIP + Units Completed • Units in Beginning WIP + Units Started = Units Available for Completion • Or, • Units Completed + Units in Ending WIP = Total Units Accounted For • Units Available for Completion = Total Units Accounted For

31. Equivalent Units -- Formulas Continued • Units Completed & Transferred - Units in Beginning WIP = Units Started & Completed that Period • Units Started & Completed that Period + Ending WIP = Equivalent Units (EU) Produced in Current Period • Or: • Units Completed +Ending WIP - Beginning WIP = Equivalent Units (EU) Produced in Current Period

32. Examples of Equivalent Units • A firm begins production on 50 units on Jan. 1 • At Dec. 31, none of these units is complete, but, on average, the 50 units are 40% complete • During the year, the firm produced 20 equivalent units (50 units x 0.40) • A firm begins production on 50 units on Jan. 1 • At Dec. 31, 20 of these units are complete, and the remaining 30 units are 60% complete • During the year, the firm produced 38 equivalent units (20 units completed + 30 units x 0.60).

33. Examples of Equivalent Units (Continued) • A firm has 100 units in inventory on Jan. 1, that are 50% complete • Another 100 units are started during the year • There is no Dec. 31 inventory • Although the firm completed 200 units during the period, there are only 150 equivalent units of work (100 new units started and completed + 100 units x 0.50)

34. Methods for Calculating Equivalent Units of Production • Equivalent units can be calculated using either the Weighted Average (WA) or the FIFO (first-in, first-out) methods • The only difference between the two is in the treatment of units in beginning work in process inventory

35. Methods for Calculating Equivalent Units of Production (Continued) • Under WA, units in beginning inventory are treated as if they were started and completed in the current period • Under FIFO, only the work needed to complete the beginning inventory is included as part of the current period’s equivalent units of production • Thus FIFO reflects the “true” amount of work done in the current period

36. Weighted Average Method • Under WA, EU of work done consists of two numbers: • EU of work for all units completed in the period • EU of work for units in ending inventory Useful formulas: EUDM = Completed units transferred out + EUDM in ending WIP Inventory = Completed units + (Phys. units in ending WIP x DM % completion) EUCC = Completed units transferred out + EUCC in ending WIP Inventory = Completed units + (Phys. units in end. WIP x CC% completion) Note: EU Equivalent Units; DM Direct Materials; CC Conversion Costs

37. Steps Involved in Process Costing 1. Summarize the physical flow of units 2. Compute equivalent units of production for materials and conversion costs 3. Summarize the total costs to be accounted for, consisting of costs in beginning inventory and costs added during the period 4. Compute the cost per equivalent unit for materials and conversion costs 5. Assign costs to units transferred out and units in ending inventory on the basis of equivalent units contained in each (note: in example in text, went from canning department to packaging department)

38. Transferred-In Costs (aka Prior Department Costs) • Prior Department Costs (PDC) or Transferred-in Costs (TIC) are manufacturing costs incurred in some other department and transferred to a subsequent department in the manufacturing process • Assigning costs to units for inventory valuation requires that prior departments’ costs be included in a department’s product cost • Department managers are usually not held accountable for these costs • Units in a subsequent department are 100% complete in terms of prior department costs • PDC (or TIC) can be treated identically to direct materials added at the beginning of the process

39. Allocation of Costs to Joint Products • Joint Production Process - • A process that results in two or more products ( aka joint products) -- examples: bagged and canned carrots • Other products are called by-products or scrap and can be sold (example, scrap was sold as animal food) • These joint products are usually not identifiable as separate products until a discrete split-off point is reached • The Split-Off Point is the point at which joint processing stops and separate processing of individual products begins • Example of four products from processing a raw carrot: (1) bagged carrots, (2) canned carrots, (3) shredded carrots, and (4) carrot stems • Other examples - meat processing, oil refining

40. Allocation of Costs to Joint Products(Continued) • Joint products may be sold as-is at the split-off point, or they may be processed further, thus earning a higher price • The total cost of a joint product is the sum of • (1) the joint costs of producing the separate products • Costs not attributable or traceable to any of the separate products/ costs which cannot be associated with one item and must be allocated • Joint or common manufacturing costs • (2) the separable (i.e., traceable) costs incurred to finish each of the joint products and prepare them for sale (in example: the cost of plastic bags, wages, etc.)

41. Allocation of Costs to Joint Products(Continued) • Joint costs are allocated to the separate products using either the relative physical measures or some measure of the market values of the joint products • Total cost of producing a joint product consists of: • Separable manufacturing costs, and, • Allocated portion of the joint manufacturing costs

42. Just-In-Time Production Systems (JIT) • JIT is a philosophy of inventory production that minimizes the amount held in inventory to a level that meets needs • Reduces needs • Frees up working capital • Avoids spoilage • Reduces storage costs • Reduces cost of capital • In a JIT system, each component on a production line is produced immediately as needed by the next step in the production line

43. JIT Production Systems (Continued) • JIT systems are characterized by zero or near-zero inventories • The sale of a finished unit triggers the completion of a unit in work in process. This “demand-pull” continues all the way back to the purchase of raw materials

44. JIT Production Systems (Continued) • JIT systems can reduce inventory levels by: • Purchasing direct materials in smaller quantities • Maintaining favorable relationships with suppliers and vendors • Using “pull” method of manufacturing -- inventory ion a given stage is only produced when required by the next stage • Establishing high quality standards for finished goods inventory (have to have little or no margin for error) • Producing finished goods inventory in smaller quantities and only as required for sale

45. Features of JIT Production Systems • Simplified and improved production processes • Zero production defects • This is an important limitation! • Flexible workforce • Overall costs for the firm are minimized • Vendors are certified suppliers: • Fewer, ultra-reliable suppliers • Defect-free supplier deliveries • Frequent deliveries of small quantities of inventory

46. Benefits of JIT • Lower inventory costs - lower investment in inventory, lower carrying/handling costs, lower investment in storage capacity, lower risk of obsolescence/spoilage • Lower labor costs • Lower scrap/rework costs • Reductions in paperwork • Lower overall material costs from improved quality of materials and potential price reductions by vendors negotiating long-term supply contracts