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- Costing Systems - Process Costing - Service Department Cost Allocation

Chapter 3. Traditional Cost Management System. - Costing Systems - Process Costing - Service Department Cost Allocation. After reading this chapter, you will be able to: understand job order costing systems

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- Costing Systems - Process Costing - Service Department Cost Allocation

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  1. Chapter 3 Traditional Cost Management System - Costing Systems - Process Costing- Service Department Cost Allocation

  2. After reading this chapter, you will be able to: • understand job order costing systems • understand how using job bid sheets is effective for estimating product costs in a job order costing system • use cost driver rates to apply support activity costs to products • discuss why cost systems with multiple cost driver rates give different cost estimates than cost systems with a single rate • evaluate a cost system to understand whether it is likely to distort product costs, explain the importance of recording actual costs, and compare them with estimated costs • appreciate the importance of conversion costs and the measurement of costs in multistage continuous-processing industries • understand the significance of differences between job order costing and multistage-process costing systems • understand the two-stage allocation process and service department allocation methods

  3. Cost Management Systems (1of2) • Two cost management systems have been used traditionally to cost products and services - Job order costing - Process costing • Many companies continue to use these two systems . • Companies have been adopting activity­ based costing (ABC) for product and customer costing.

  4. Cost Management Systems(2of2) • Allcostsystems work in essentially the same way: - Expense categories are developed and then expenses are mapped to service departments, production centers, or activities - Expenses are then attached to cost objects • Theway these links are made and the activities defined is what differentiates these systems

  5. Job Order v. Process Costing Systems • A job order costing system estimates the costs of manufacturing products for different jobs required for specific customer orders - Applicable in organizations that treat each individual job as a single unit of output • A process costing system is applicable when all units produced during a specified time frame are treated as one unit of output - Every unit made during the time period is essentially identical

  6. Need for Job Order Costing • Products may differ - Materials content - Hours of labor required - Machine time required - Demand placed on support activity resources (i.e., manufacturing overhead) - Special customer needs that require customized production • With such variety, managers need to understand the costs of individual products so that they can assess product and customer profitability

  7. The Cost Flow Model • The cost flow model essentially uses an inventory concept to track costs - Raw materials inventory - Work-in-process (WlP) inventory • Raw materials are transformed by labor and support resources • Costs of the resources for each job not yet completed - Finished goods inventory • When the goods are sold, they are accounted for in the expense category Cost of Goods Sold

  8. Bidding Using Job Order Costing • Firms are sometimes required to bid on jobs before customers decide to place an order with them • Costs need to be estimated for each job in order to prepare a bid • Job order costing systems provide the means to estimate these costs • A job bid sheet provides a format for recording the estimated costs

  9. Bid Number: J4369 Date: July 6, 2004 Customer: Michigan Motors Product: Automobile engine valves (Valve # L181) Engineering Design Number: JDR-I03 Number of Units: 1,500 Job Bid Sheet (1of6) • Panel1 identifies the customer, the product, and the number of units required

  10. Materials QuantityPriceAmountBar steel stock 3“ 3,600 Ibs $11.30 $40,680Subassembly 1,500 Ibs $39.00 $58,500Total direct materials $99,180 Job Bid Sheet (2of6) • Panel2 lists all the materials required to complete the job

  11. Labor HoursRateAmountLathe operators 480 $26.00 $12,480Assembly workers 900 $18.00 $16,200Total direct labor 1,380 $26,680 Job Bid Sheet (3of6) • Panel 3 lists the amount of direct labor required for the job

  12. Support Costs Amount600 machine-hours @ $40/hour $24,000 1,380 direct labor hours @$36/hour $49,680Total support costs $73,680 Job Bid Sheet (4of6) • Panel 4 contains estimates for cost driver costs

  13. Direct material $99,180 Direct labor $28,680 Support costs $73,680 Total costs $201,540 Job Bid Sheet (5of6) • Panel 5 summarizes the total costs estimated for the job

  14. Total costs $201,540 Add 25% markup $50,385 Bid price $251,925Unit cost $134.36 Unit price $167.95 Job Bid Sheet (6of6) • A markup rate is applied to translate the estimated cost into a bid price • A 25% markup rate is assumed in this example

  15. Job Costs And Markup • The total job costs plus the margin equals the bid price • The markup rate depends on a variety of factors: - The amount of support costs excluded from the cost driver rate - The target rate of return desired by the corporation - Competitive intensity - Past bidding strategies adopted by key competitors - Demand conditions - Overall product-market strategies

  16. Determination Of Cost Driver Rates • Many firms now recognize that several different factors may be driving support costs rather than one or even two factors, such as direct labor or machine hours - Firms are now taking greater care in identifying which support costs should relate to what cost driver

  17. Cost Driver Rates • All costs associated with a cost driver, such as setup hours, are accumulated separately - Each subset of total support costs that can be associated with a distinct cost driver is referred to as a cost pool • Each cost pool has a separate cost driver rate • Activity cost driver rate = Cost of support activity I Level of cost driver

  18. Stable Cost Driver Rates (1of2) • The cost of the support activity is the cost of the resources committed to the particular activity - The cost of a support activity excludes fluctuations in costs caused by short-term adjustments such as overtime payments - The level of the support activity cost driver also excludes short-term variations in demand as reflected in overtime or idle time

  19. Stable Cost Driver Rates (2of2) • The ratio shown in the previous equation is based on costs and cost driver levels, the rate remains stable over time: - It does not fluctuate as activity levels change in the short run - It does not change simply because of short-run changes in external factors that do not affect the efficiency or price of the activity resources

  20. Fluctuating Rates • For example, if the rate for machine costs is based on quarterly cost driver levels instead of the normal levels: - The rate increases as the demand for the machine activity falls - The rate decreases as the demand increases • In contrast, the cost driver rate based on costs and activity levels remains fixed throughout the year - Costs depend on the machine capacity made available and not on the season

  21. Number of Cost Pools • The number of cost pools can vary - Some German firms use over 1,000 • The general principle is to use separate cost pools if the cost or productivity of resources is different and if the pattern of demand varies across resources • The increase in measurement costs required by a more detailed cost system must be traded off against the benefit of increased accuracy in estimating product costs - If cost and productivity differences between resources are small, having more cost pools will make little difference in the accuracy of product cost estimates

  22. Recording Actual Job Costs • Job order cost accounting systems record costs actually incurred on individual jobs as they are produced - This process allows comparison of actual costs with the estimated costs • Copies of all materials requisition notes and worker time cards are forwarded to the accounting department, which then posts them on a job cost sheet • The system calculates total costs for the portion of the job completed • The structure of the job cost sheet is similar to that of the job bid sheet - The direct materials and direct labor costs on the job cost sheet represent the job's actual costs incurred

  23. (Multistage) Process Costing • For many plants engaged in continuous processing production flows continuously, semi-continuously, or in large batches from one process stage to the next • At each successive process stage, there is further progress toward converting the raw materials into the finished product • In continuous processing it is necessary first to determine costs for each stage of the process and then to assign their costs to individual products

  24. Multistage Process Costing Systems • Product costing systems in process-oriented plants allows measurement of the costs of converting the raw materials during a time period to be made separately for each process stage • The conversion costs are applied to products as they pass through successive process stages • This system for determining product costs, known as a multistage process costing system, is common in process-oriented industries

  25. Comparison With Job Order Costing • Both systems have the same objective: - Assign material, labor, and manufacturing support activity costs to product • Process costing systems differ in that they: - Do not maintain separate cost records for individual jobs - Measure costs only for process stages - Determine cost variances only at the level of the process stages instead of at the level of individual jobs

  26. Job Order and Multistage Process Costing (1of3) • In job order costing production is carried out in different jobs • In multistage process costing, production is carried out continuously, semi­ continuously, or in large batches

  27. Job Order and Multistage Process Costing (2of3) • In job order costing, production requirements are different for each individual job • In multistage process costing, production requirements are homogeneous across products or jobs

  28. Job Order and Multistage Process Costing (3of3) • In job order costing, variances between actual and estimated direct material and direct labor costs are determined for each individual jobs • In multistage process costing, variances between actual and estimated costs are determined for individual process stages

  29. Service Department Cost Allocations Appendix 3-1

  30. Operating Expense Allocations • Traditional cost accounting systems assign operating expenses to products with a two-stage procedure: • Expenses are assigned to production departments • Production department expenses are assigned to the products • Departmental structure influences the first-stage allocation process

  31. Effect Of Departmental Structure • production departments- departments that have direct responsibility for converting raw materials into finished products are called • Service departments perform activities that support production, such as: • Machine maintenance • Production engineering • Machine setup • Production scheduling - All service department costs are indirect support activity costs because they do not arise from direct production activities

  32. Two-Stage Cost Allocation (1of2) • Conventional product costing systems assign indirect costs to jobs or products in two stages 1. In the first stage: - System identifies indirect costs with various production and service departments - Service department costs are then allocated to Production departments 2. The system assigns the accumulated indirect costs for the production departments to individual jobs or products based on Predetermined departmental cost driver rates

  33. Two-Stage Cost Allocation (2of2) Support Costs Service Department S1 Service Department S2 Stage 1 Allocation Production Department P1 Production Department P2 Stage 2 Allocation Individual Products/Jobs

  34. Allocating Service Department Costs To Production Departments • There are three ways - Direct allocation • Sequential allocation • Reciprocal allocation • The last two are used when service departments consume services provided by other departments

  35. Total Manufacturing Support Costs $1,127,800 Maintenance $160,000 Setup $300,000 Scheduling $120,000 Engineering $180,000 General and Administrative $90,000 Service Department Casting $65,600 Machining $131,600 Assembly $51,000 Packing $29,600 Production Department PATIENTAID EXAMPLE Step 1 of Stage 1 cost allocations (given)

  36. Direct Allocation Method • Allocates the service department costs directly to the production departments - Allocations to production departments are based on each production department's relative use of the applicable cost driver - It ignores the possibility that some of the activities of a service department may benefit other service departments as well as production departments

  37. Allocation Bases Values

  38. Allocation Ratios Based on relative allocation basis value 300,000 / 1,200,000 = 0.250

  39. Allocation of Service Department Costs • Multiply service department cost by the allocation ratios $160,000 x 0.250 = $40,000

  40. Stage 2Cost Allocations • Stage 2 allocations - Require the identification of appropriate cost drivers for each production department - Assign production department costs to jobs and products while they are worked on in the departments • Conventional cost accounting systems use unit- related cost drivers, such as the number of units made, the number of direct labor hours (or cost), and the number of machine hours • Dividing the indirect costs accumulated in each production department by the total number of units of the corresponding cost driver results in cost driver rates for each department

  41. PATIENTAID Stage 2 (1ot2) • The Casting Department allocates its indirect costs to jobs based on machine hours, with total capacity for Casting equaling 6,000 machine hours • Total indirect costs for Casting, after the allocation from service departments in Step 2 of Stage 1 was $216,000 • As a result, Casting allocates indirect costs to jobs at a rate of $36.00 per machine hour = $216,00016,000 hours • Each department will make a similar calculation

  42. PATIENTAID Stage 2 (2of2) • If Job J189-4 uses 40 machine hours while in the Casting Department, Casting will allocate $1,440 of its indirect costs to Job J189-4 = 40 hours x $36.00 per hour • Each department will allocate indirect costs to Job J189-4 in a similar manner, and Casting will allocate some costs to all jobs in a similar manner • To determine the total cost of Job J198-4, add the Direct Material and Direct Labor cost assigned in each department and the indirect cost allocated from each department • To determine the cost per unit, divide the total cost by the number of units in Job J189-4

  43. Sequential and Reciprocal Allocation Methods • The sequential allocation method allocates service department costs to one service department at a time in sequential order • The reciprocal allocation method determines service department cost allocations simultaneously

  44. Sequential Allocation Method (1of3) • Service departments first be arranged in order - A service department can receive costs allocated from another service department only before its own costs have been allocated to other departments • Once a service department's costs have been allocated, no costs can be allocated back to it from other departments

  45. Sequential Allocation Method (2of3) 480,000 / 800,000 = 0.600 2,000 / 4,000 = 0.500

  46. Sequential Allocation Method(3of3) $320,000 * 0.600 = $192,000 ($180,000 + 40,000) * 0.500 = $110,000

  47. Reciprocal Allocation Method (1of5) • If both service departments consume each other's services, the reciprocal allocation method is appropriate • The reciprocal allocation method recognizes reciprocal interactions between different service departments • The example changes only to recognize Power's use of Engineering's services

  48. Reciprocal Allocation Method (2 of 5) 480,000 / 800,000 = 0.600 2,000 / 5,000 = 0.400

  49. Reciprocal Allocation Method (3of5) • Before allocating any costs to the production departments, determine the reciprocal allocation between service departments: - Power's total cost is $320,000 + 20% of the total cost of Engineering (P=320,000+0.20E) - Engineering's total cost is $1800000 + 12.5% of the total cost of Power (E=180,000+ 0.125P) • Solve the simultaneous equations by substitution

  50. Reciprocal Allocation Method(4of5) • P=320,000+.20E, with E=180,000+.125P • P=320,000+.20 (180,000+.125P) • P=320,000 + 36,000 + .025P • .975P=320,000 + 36,000 • P= $365,128 • E=180,000+.125P • E=180,000+ .125(365,128) • E=180,000+45,641 • E= $225,641 These costs will be allocated to the production departments usingthe allocation ratios shown previously

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