Cost Flows in Organizations In order to compute product costs, management accounting systems should reflect the actual cost flows in an organization Manufacturing, retail, and service organizations have different patterns of cost flows resulting in different management accounting priorities Exhibits 4-1 to 4-3
Review of Important Cost Terms Cost Object Consumable resources vs Capacity-related resources Direct vs Indirect costs
Handling Indirect Costs in a Manufacturing Environment Direct costs: assign costs to the cost object directly; Indirect costs: allocate a portion of the cost to the cost object
Indirect Manufacturing Costs (Overhead) Allocation Allocation steps: • Choose an allocation base: • e.g. direct labor hours, direct labor cost, or machine hours • Calculate allocation rate: • Total Indirect Cost /Total Allocation base • Applied indirect costs =allocation rate * actual quantity of base used
Lollah Mfg Company expects annual mfg. overhead to be $800,000, 50,000 direct labor hours costing $1,600,000 and machine run time of 25,000 hours. Calculate overhead allocation rates based on direct labor hours, direct labor cost, and machine time.Product A: DL 10,000 hrs; DL cost $300,000; MH: 7,000 hrs OH allocation (Direct labor hours): OH allocation (Direct labor cost): OH allocation (MH): Practice exercise
Indirect Manufacturing Costs (Overhead) Allocation A lot of firms use a single overhead rate Which allocation base is better? Labor intensive? Highly mechanized? Activity Based Costing (ABC) assigns overhead costs to products using a numberof allocation bases (discussed in ch5; save pg130-134 for ch5).
Indirect Manufacturing Costs (Overhead) Allocation Predetermined Indirect Cost (OH) Rate Utilize estimates rather than actual costs and quantities Why not use actual amounts? Because total actual overhead cost and total actual level of the allocation base are not known until the end of the accounting period, making it impossible to determine the actual overhead rate until that time. Allows decisions to be made based on budgeted amounts. Thus, we can have an immediate cost figure to determine the price to charge for a job (customer).
Overapplied Overhead If applied OH is greater than actual, OH is overapplied Overapplied OH eliminated at end of period as follows: -If small amount, Dr. Mfg. OH and Cr. COGS -If relatively large amount, apportion and close to Work in Process, Finished Goods and COGS
Underapplied Overhead If actual OH is greater than applied, OH is underapplied Underapplied OH eliminated at end of period as follows: -If small amount, Dr. COGS and Cr. Mfg. OH -If relatively large amount, apportion and close to Work in Process, Finished Goods and COGS
Review Actual overhead was $1,500,000. The predetermined overhead rate was $17 per direct labor hour, and there were 100,000 direct labor hours. Overhead was: • Underapplied by $200,000 • Overapplied by $200,000 • Underapplied by $20,000 • Overapplied by $20,000
Job-Order versus Process Costing Job Order Costing Product: custom e.g. construction Document: job cost sheet WIP-job Job costs =DM+DL+OH allocated Process Costing • Product: identical • e.g. producers of paints and plastics • Document: production cost report • WIP-department • Cost accumulated by each operation. • Unit cost =total costs of production/ total number of units produced
Practice Excercises Handout Q1: Job order vs Process costing E4-27
Process Costing:Costs and Units Process costing is essentially a system of averaging. Manufacturing costs are divided by equivalent units to calculate an average unit cost. A company that uses process costing system needs to keep records for both product costs and units. Costs: Beg WIP + Cost Incurred during the period=Cost Transferred out +End WIP Units: Units in Beg WIP+ Units started=Units Completed + Units in End WIP Handout Q2
Calculating Unit Cost Cost Per Equivalent Unit The average unit cost is referred to as cost per equivalent unit
Calculating Unit Cost Equivalent Units Partially completed units are converted to a comparable number of completed units, called equivalent units e.g. 100 units that are 50% complete are equivalent to 50 complete units (100 x 50%) Equivalent units may be different for material and conversion costs (labor and OH) if they enter production at different times. Easy to identify when materials are added Materials are often added at the beginning of the process. Sometimes they are added evenly or at the end of the process. Harder to identify when labor and overhead are added Often grouped together as conversion costs Assumed to be added evenly
Process Costing:Kent Chemicals Example Mixing Department Beginning Work in Process: 10,000 gallon (% complete: 100% materials, 80% conversion costs) -Direct material costs = $18,000 -Direct labor =$7,800 -Overhead = $23,400 70,000 gallons started -Direct material costs = $142,000 -Direct labor cost = $62,200 Overhead cost = $186,600 60,000 gallons completed. Ending WIP 100% completed for materials and 50% completed for conversion costs. Required: Finish the product cost report for the mixing department of Kent (Handout Q3)
Dealing with Transferred-In Cost Process Costing Systems generally use multiple processes Items completed in one processing department, costs are transferred to the next department Transferred-in costs are treated as direct materials in the next processing departing. When units are completed in the final process, the costs are transferred to finished goods.
Drop a Product Line Analysis involves calculating the change in income that will result from dropping the product line: If income increases, the product line should be dropped If income decreases, the product line should not be dropped Note: Allocated costs are not relevant
Dropping a Product Line – Mercer Hardware Example Profit calculation with three product lines
Dropping a Product Line – Mercer Hardware Example Profit calculation with two product lines
Beware of the Cost Allocation Death Spiral When dropping a product line - Common fixed costs are not incremental Common fixed cost allocation is spread among remaining product lines Management must understand and remember this impact when making decisions
Practice Group Case 4-51