YOU ARE HERE!

1. Examining and recording accounting events in the conversion cycle relying on information in chapters 2,5, and 6 How the accounting system reports conversion cycle events to users YOU ARE HERE! Converting raw materials into products and role of accounting system in recording material, labor and overhead costs Completes study of the performing (recording) phase How cost of goods manufactured and cost of goods sold are determined Chapter 11 Recording and Communicating in the Conversion Cycle

2. Chapter 11: Recording and Communicating in the Conversion Cycle PART THREE:RECORDING

3. CHAPTER 11 LEARNING OBJECTIVES L.O.1: Explain why cost accumulation is important during the conversion cycle. L.O.2: Indicate how companies analyze and record materials- and labor-related events during the conversion cycle. L.O.3: Describe how companies analyze and record manufacturing overhead events during the conversion cycle.

4. CHAPTER 11 LEARNING OBJECTIVES L.O.4: Describe how companies analyze and record cost of goods manufactured and cost of goods sold during the conversion cycle. L.O.5: Explain how companies communicate conversion cycle events to users. L.O.6: (Appendix) Explain the differences between job order costing and process costing systems.

5. TYPICAL CONVERSION CYCLE ACTIVITIES • Raw materials • Labor • Other manufacturing resources Converted into Finished products

6. WHY IS COST ACCUMULATION IMPORTANT? • Determine the cost of products. • Determine if the selling price is appropriate to achieve company goals. • Determine if the product mix is appropriate to achieve company goals. • Determine cost of goods sold for the period.

7. COST ACCUMULATION ILLUSTRATED IN BUSINESS • In a manufacturing business the cost of goods sold is equal to the cost of finished goods sold. It is important that a cost accounting system track the flow of inventories from raw materials to the finished goods. Name of Inventories Reported on Company Recent Balance Sheet Anheuser-Busch $550.2 million Black & Decker $774.7 million McCormick & Company $252.0 million Proctor & Gamble $2,887.0 million

8. Financial Costs Operational Costs Strategic Costs MULTI-FACTED NEEDS FOR COST INFORMATION Assigning costs to operational activities so line managers have cost information for operational decisions. Internal monitoring and required external reporting. Assigning costs to products - determining selling price, profit margins, markets; assessing competitiveness.

9. Raw Materials Inventory Work-in-Process Inventory Finished Goods Inventory TYPES OF MANUFACTURING INVENTORIES

10. ACCOUNTING COST FLOWS Exhibit 11.2 Raw Material Inventory Work-in-Process Inventory Beginning Balance Add: Purchases Less: Indirect Materials to Manufacturing Overhead Direct Materials to Production = Ending Balance Beginning Balance Add: Direct Materials, Direct Labor, Manufacturing Overhead Less: Cost of Goods Manufactured = Ending Balance Supplier Company

11. Company Customer ACCOUNTING COST FLOWS Exhibit 11.2 Work-in-Process Inventory Finished Goods Inventory Beginning Balance Add: Direct Materials, Direct Labor, Manufacturing Overhead Less: Cost of Goods Manufactured = Ending Balance Beginning Balance Add: Cost of Goods Manufactured Less: Cost of Good Sold = Ending Balance

12. Raw Materials Storeroom Factory Production Raw materials used Direct Labor used Other Manufacturing resources used Materials stored until issued into production Finished Goods Warehouse Completed products stored PHYSICAL PRODUCT FLOWS The accounting cost flow matches the physical flow Exhibit 11.2 Product costs

13. Raw Materials Inventory Beginning balance + Purchases = Ending balance - Direct materials used - Indirect materials used RAW MATERIAL COSTS Direct materials go directly to production; indirect materials go to manufacturing overhead.

14. RECORDING RAW MATERIAL EVENTS • As indicated in Chapter 9, when companies purchase raw materials, the cost of acquiring them are recorded as inventory. If Anheuser-Busch purchases $100,000 of raw materials (barley, malt, rice and hops) on account for the production of O’Doul’s, along with freight and insurance charges of $2,500 (that are paid for in cash), the event in recorded as follows: Debit Credit 6/01/00 Raw Materials Inventory $102,500 Accounts Payable $100,000 Cash $2,500

15. Work-in-Process Inventory Beginning balance + Direct materials + Direct labor + Mfg. overhead = Ending balance - Cost of goods manufactured WORK-IN-PROCESS COSTS From Raw Materials Inventory The cost of goods manufactured is a key deliverable out of the production process.

16. RECORDING WORK-IN-PROCESS EVENTS Transfer of raw material costs • When raw materials are requisitioned from the warehouse for production, direct materials go to work-in-process and indirect materials go to manufacturing overhead to be allocated with other costs. If Anheuser Busch treats barley malt and rice as direct materials ($175,000) and treats hops as indirect materials ($5,000), the event is recorded as follows: Debit Credit 6/05/00 Work-in-Process Inventory $175,000 Manufacturing Overhead $5,000 Raw Materials Inventory $180,000

17. If raw materials purchases were incorrectly recorded as supplies expense, expenses would be overstated and net income would be understated. Assets would also be understated because the raw materials should be recorded as inventory which is a current asset. PAUSE AND REFLECT What would be the impact on the financial statements if raw materials purchases were incorrectly recorded as supplies expense?

18. RECORDING WORK-IN-PROCESS EVENTS Transfer of labor costs • Once raw materials are issued into production, the company uses direct labor and manufacturing overhead to convert the materials into finished goods. Assume that on, Friday, January 25, ‘00, employees of Anheuser-Busch submit timecards. One group, direct labor, worked 6,000 hours at $12. The other group, indirect labor, earned $3,000 for the week. Ignoring withholdings, the event would be recorded as follows: Debit Credit 6/05/00 Work-in-Process Inventory $72,000 Manufacturing Overhead $3,000 Wages Payable $75,000

19. Most companies consider payroll taxes( i.e., the taxes imposed on the employer) on manufacturing employees to be a product cost. Payroll taxes would be part of manufacturing overhead and would be applied to production. PAUSE AND REFLECT What is the impact of payroll taxes on manufacturing inventories?

20. Indirect materials • Indirect labor • Miscellaneous other indirect costs • Production utilities • Depreciation on production equipment • Insurance on production facilities • Rent on production facilities • Maintenance on production equipment COMPONENTS OF MANUFACTURING OVERHEAD

21. Estimated manufacturing overhead • Applied manufacturing overhead • Actual manufacturing overhead COMPONENTS OF MANUFACTURING OVERHEAD • To understand how companies analyze and record manufacturing overhead, it is important to understand the meaning of the following terms.

22. Applied manufacturing overhead • Estimated manufacturing overhead • Actual manufacturing overhead COMPONENTS OF MANUFACTURING OVERHEAD • The total estimated amount of manufacturing overhead costs estimated at the beginning of the accounting period. • The total amount of manufacturing overhead costs charged to production during the accounting period. • The total actual costs incurred during the accounting period. This is not known until the end of the accounting period.

23. APPLIED MANUFACTURING OVERHEAD • Actual overhead occurs sporadically during the accounting period and production is more continuous throughout the period. Overhead must be allocated to on-going production. • To provide an accounting tool to allocate overhead costs during the year, a business will estimate the overhead by calculating predetermined overhead application rates. • The predetermined rate can then be applied to production even though actual overhead is not yet known.

24. PREDETERMINED OVERHEAD APPLICATION RATE Estimated amount of overhead = Estimated amount of cost driver Applied overhead per actual unit of cost driver used in production

25. ACTIVITY-BASED COSTING Exhibit 11.4 illustrates how activities are grouped into cost pools under ABC • In an activity-based cost system (ABC), a business looks at every activity that is necessary to produce the goods and allocates costs to each of those processes (or activities) based on the consumption of cost drivers. • Consider some of the operational costs of a typical production facility: testing, blending, mixing and bottling. Each of these activities has different costs associated with it for each line of product and each may have its own overhead application rate in an ABC system.

26. STEPS IN APPLYING ACTIVITY-BASED COSTING Step 1: Identify Levels and Activities Step 2:Choose Cost Drivers Step 3:Estimate the Overhead Costs Step 4:Estimate Cost Drive Usage Step 5:Calculate Predetermined Overhead Rate Step 6:Apply the Overhead to Production The difference between the traditional overhead allocation and ABC is the level of detail, number of activities examined, and cost drivers assigned.

27. Narrow Focus Broad Focus PRODUCTION LEVELS FOR ABC COST REVIEW • Unit-related Level • Batch-related Level • Product-sustaining Level • Facility-sustaining Level

28. COST POOLS A group of costs that change in response to the same cost driver. • Number of square feet • Depreciation • Property taxes • Utilities

29. APPLYING PREDETERMINED OVERHEAD APPLICATION RATE Estimated manufacturing $5 per actual overhead for the year $100,000 = machine hour Estimated machine hours used in per year 20,000 production The Overhead Application Rate (OAR) is $5. Thus, if 50,000 machine hours are used in production during the year, then overhead is applied to production as follows: 50,000 x $5 = $250,000 As an example in an ABC system, this rate might only apply to blending.

30. APPLYING PREDETERMINED OVERHEAD APPLICATION RATE Manufacturing Overhead Expense Increase for actual manufacturing overhead costs Decrease for overhead applied to production based on OAR, or $250,000 Work-In-Process Inventory Increase for overhead applied to production based on OAR, or $250,000

31. RECORDING WORK-IN-PROCESS EVENTS Transfer of applied manufacturing overhead • When the overhead application rate is applied to production during the year, the total amount of applied overhead is charged to the work-in-process inventory as illustrated in the T-accounts on the previous slide. Thus, this event is recorded as follows: Debit Credit 6/05/00 Work-in-Process Inventory $250,000 Manufacturing Overhead $250,000

32. OVER OR UNDERAPPLIED MANUFACTURING OVERHEAD • Because an overhead application rate is used to apply overhead to production, the amount applied does not equal the actual overhead incurred during the same period. This results in under or overapplied manufacturing overhead: Actual Overhead Incurred less: Overhead Applied = Under or Overapplied Overhead

33. Since manufacturing overhead represents a product cost, the cost of the products will be understated or overstated during the period. Product cost will be understated if applied overhead is less than actual; product cost will be overstated if applied overhead is more than actual. Since cost is a major factor in determining selling price, a company might make erroneous judgements about the selling price and profit margins. PAUSE AND REFLECT What is the impact of under- or overapplied manufacturing overhead and why is it important to adjust to actual cost?

34. Manufacturing Overhead Expense Debits + Credits - increase for actual manufacturing overhead costs decrease for overhead applied to production based on OAR OVER-OR UNDERAPPLIED MANUFACTURING OVERHEAD A net credit balance means manufacturing overhead is over-applied to production; product cost is overstated. A net debit balance means manufacturing overhead is underapplied to production; product costs are understated.

35. DISPOSITION: OVER-OR UNDERAPPLIED MANUFACTURING OVERHEAD • Amount not material • Write off against cost of goods sold • Amount is material • Write off against • Ending work-in-process inventory • Ending finished goods inventory • Cost of goods sold

36. RECORDING WORK-IN-PROCESS EVENTS Disposition of under- or overapplied manufacturing overhead • Assume that actual overhead during the period is $500,000 but $450,000 was applied to production. There is a $50,000 debit balance in manufacturing overhead because more overhead was incurred than applied. Product costs are therefore understated until an adjustment is made. Assuming this amount is not material, the event would be recorded as follows: Debit Credit 12/31/00 Cost of Goods Sold $50,000 Manufacturing Overhead $50,000

37. It should be pro-rated among work-in-process inventory, finished goods inventory and cost of goods sold on a pro-rata basis. This allocates a proportion of the underapplied overhead to the three accounts used during the current period in which overhead allocations lie. If work-in-process, finished goods and cost of goods sold are $100,000, $200,000 and $300,000, respectively, then each would be debited as follows: work-in-process (1/6), $25,000; finished goods (1/3), $50,000; and cost of goods sold (1/2), or $100,000. Manufacturing overhead would be credited for $150,000. PAUSE AND REFLECT If manufacturing overhead were $150,000 underapplied and this amount was considered material, how would you determine the adjustment needed?

38. Finished Goods Inventory Beginning balance + Cost of goods manufactured = Ending balance - Cost of goods sold FINISHED GOODS COSTS From WIP Inventory Cost of goods sold is charged to expense and matched against revenues earned during the same period.

39. RECORDING FINISHED GOODS EVENTS Transferring the cost of goods manufactured • If the cost of O’Doul’s manufactured during the period is $842,000, this represents the cost of goods manufactured (i.e., direct material, direct labor and manufacturing overhead applied). Once products are complete, they are transferred to finished goods inventory to await sale to customers. This event would be recorded as follows: Debit Credit 9/15/00 Finished Goods Inventory $842,000 Work-in-Process Inventory $842,000

40. RECORDING FINISHED GOODS EVENTS Recording the cost of goods sold • If Anheuser Busch sold O’Doul’s beer costing $1,233,000 to distributors for $2,152,500 during the period, the event would be recorded as follows: Debit Credit 12/15/00 Cost of Goods Sold $1,233,000 Finished Goods Inventory $1,233,000 Accounts Receivable $2,152,500 Sales $2,152,500

41. REPORTING RESULTS: THE COST OF GOODS MANUFACTURED Exhibit 11.6 O’Douls Cost of Goods Manufactured • Summarizes the total raw materials, labor and manufacturing overhead consumed in a production process. • It allows comparison with budgeted production and evaluation of the efficiency of the production process. Beg. Bal. Raw Materials $146,650 Add: raw materials purchased 662,600 Raw materials available 811,250 Less: indirect materials used 25,300 End. Bal. Raw Materials Direct materials issued to production $666,670 Beg. Bal. WIP 106,440 Add: Direct materials used 666,670 Direct labor used 102,350 M.O. Applied 800,410 Total work-in-process costs $1,675,870 Less: End.Bal. WIP Inventory 50,820 Cost of goods manufactured $1,625,050

42. REPORTING RESULTS: THE COST OF GOODS SOLD • The cost of goods sold for a manufacturing company is the cost of finished goods sold. • The computation is the same except the finished goods inventory account is used and cost of goods sold is adjusted for under- or overapplied overhead. O’Douls Cost of Finished Goods Sold Beginning Inventory, finished goods $115,400 Add: cost of goods manufactured 1,625,050 Cost of goods available for sale $1,740,450 Less: Ending inventory, finished goods 114,700 Unadjusted cost of goods sold $1,625,750 Less: overapplied overhead 23,500 Cost of goods sold $1,602,250