2 Product Costing Systems Concepts and Design Issues Compatibility Mode PDF

2
Product
Costing Systems:
Concepts and
Design Issues
McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved.
2-2
Learning Objective 1
2-3
The Meaning of Cost
The use of
valuable
resources, in
order to achieve a
stated purpose. In
accounting, cost
Product Costs is reported in Period Costs
• Related to the monetary terms. • Related to selling
purchase or and administrative
manufacture of operations.
goods for resale. • Recognized as
• Assigned to expenses in the
inventory and cost same time period.
of goods sold.
2-4
2-5
Comparing Service, Retail and

Manufacturing Companies
Service firms . . . Retailers . . .
 Provide a service that is  Buy finished goods.
consumed when produced.  Sell finished goods.
 Have no inventories.
MegaLoMart
Manufacturers . . .
 Buy raw materials.
 Produce and sell finished goods.
2-6
The 3 major categories of

manufacturing costs:
Direct Labor Manufacturing

Direct Materials Overhead
Payments and
Raw materials,
benefits for those Indirect material
components, and
employees who
other parts that Indirect labor
convert direct
can be traced to a
materials into Other overhead
specific product.
finished product.
2-7
Prime Costs include:
Direct Materials Direct Labor Manufacturing

Overhead
2-8
Conversion Costs include:
Direct Materials Direct Labor Manufacturing

Overhead
2-9
Stages of Production and the Flow

of Costs
Raw Materials Work-In-Process Finished Goods
Beg. Inventory Beg. WIP Inventory Beg. Inventory
Add: Purchases Add: Raw Materials Add: Cost of Goods
= Raw Materials Completed and
Transferred In
Transferred from
Available for Direct Labor
WIP
Production Manufacturing
= Goods Available for
Less: Raw Materials Overhead Sale
Transferred to = Total Manufacturing Less: Cost of Goods Sold
Production Costs Incurred = Ending Inventory
= Ending Inventory Less: Cost of Goods
Completed and
Transferred to
Finished Goods
= Ending WIP
Inventory
2-10

of Costs - Example
Raw Materials
Axel Electronics makes toasters. On
Beg. Inventory February 1, Axel has $15,000 of raw
Add: Purchases material on hand. Axel’s purchase
= Raw Materials and transfers to the production floor
Available for
are indicated below.
Production
Less: Raw Materials
Cost of Cost of
Transferred to
Date Purchases Transfers
Production
Ending Inventory Feb 3 $ 8,000 $ 5,000
=
Feb 10 12,000 11,000
Feb 15 14,000 7,000
What is Ending
Feb 20 6,000
Inventory in Feb 22 9,000
February? Feb 27 16,000
2-11

of Costs - Example
Raw Materials
Axel Electronics makes toasters. On
$15,000 February 1, Axel has $15,000 of raw
Add: 43,000 material on hand. Axel’s purchase
= $58,000 and transfers to the production floor
Less: 45,000 are indicated below.
= $13,000
Cost of Cost of
Date Purchases Transfers
Feb 3 $ 8,000 $ 5,000
Feb 10 12,000 11,000
Feb 15 14,000 7,000
Now let’s look at
Feb 20 6,000
Work-in-Process. Feb 22 9,000
Feb 27 16,000
2-12

of Costs - Example
Raw Materials Work-In-Process On February 1, Axel

$15,000 Beg. WIP Inventory
Add: 43,000 Add: Raw Materials had WIP of $30,000
= $58,000 Transferred In on the factory floor.
Less: 45,000 Direct Labor During February,
= $13,000 Manufacturing
Axel paid $92,000 in
Overhead
= Total Manufacturing direct labor wages.
What is the Costs Incurred Overhead is applied
amount of cost Less: Cost of Goods at 150% of direct
Completed and
transferred to labor. On 2/28,
Transferred to
Finished Goods Finished Goods $22,000 is still in
in February? = Ending WIP WIP.
Inventory
2-13

of Costs - Example 150 % of $92,000
Raw Materials Work-In-Process On February 1, Axel

$15,000 $30,000
Add: 43,000
had WIP of $30,000
Add: 45,000
= $58,000 92,000 on the factory floor.
Less: 45,000 138,000 During February,
= $13,000 = $305,000 Axel paid $92,000 in
Less: 283,000 direct labor wages.
= $22,000
Overhead is applied
Now let’s
at 150% of direct
look at
Transferred labor. On 2/28,
Finished
to Finished $22,000 is still in
Goods.
Goods WIP.
2-14

of Costs - Example

$15,000 Beg. Inventory
$30,000
Add: Add: Cost of Goods
43,000 Add: 45,000
Completed and
= $58,000 92,000 Transferred from
Less: 45,000 138,000 WIP
= $13,000 = $305,000 = Goods Available for
Less: 283,000 Sale
= $22,000 Less: Cost of Goods Sold
= Ending Inventory
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?
2-15

of Costs - Example Cost of goods sold

$15,000 $30,000 $125,000
Add: 43,000 Add: 45,000 Add: 283,000
= $58,000 92,000 = $408,000
Less: 45,000 138,000 Less: 312,000
= $13,000 = $305,000 = $96,000
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?
2-16
2-17
Schedule of Cost of Goods

Manufactured
Let’s look at a
Schedule of Cost of
Goods Manufactured for
CollegePak Company.
2-18

Manufactured
CollegePak Company
Schedule 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
2-19
Schedule of Cost
Computation of Costof Goods
of Raw Material Used
Manufactured
Raw-material inventory, January 1
Add: Purchases of raw materials
$ 200,000
800,000
Raw material available for use 1,000,000
Deduct: Raw material inventory, December 31 150,000
CollegePak Company
2-20

Manufactured
Include all direct labor
costs incurred during the
current period.
CollegePak Company
2-21

Manufactured
Beginning work-in-
process inventory is
carried over from the
CollegePak Company
prior period.
2-22

Manufactured
Ending work-in-process inventory
contains the cost of unfinished goods,
and is reported
CollegePak Companyin the current assets
section
Schedule of Cost of the
of Goods balance sheet.
Manufactured
2-23
Income Statement for a

Manufacturer
Now let’s look at an income

statement for CollegePak.
2-24

Manufacturer
CollegePak Company
Income Statement
For the Year Ended December 31, 20X2
Sales 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
2-25

Manufacturer
CollegePak Company
Schedule of Cost of Goods Sold
Finished-goods inventory, Jan. 1 $ 920,000
Add: Cost of goods manufactured 3,350,000
Cost of goods availableCollegePak
for sale Company 4,270,000
Deduct Finished-goods inventory, Dec. 31 1,460,000
Income Statement
Cost of goods sold $ 2,810,000
Sales 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
2-26
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.
2-27
Cost Drivers
An “activity” is any
discrete task that an Number of
organization computers made by
undertakes to make Dell in a day
or deliver a good or
service.
A “cost driver” is
some characteristic Number of
of the activity that flights by Southwest
Airlines in a given market
causes costs to be
incurred.
2-28
2-29
Cost Behavior
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.
2-30
Total Variable Cost Example
Your total long distance telephone bill

is based on how many minutes you talk.
Total Long Distance
Telephone Bill
Minutes Talked
2-31
Variable Cost Per Unit Example
The cost per long distance minute talked is

constant. For example, 5 cents per minute.
Telephone Charge
Per Minute
Minutes Talked
2-32
Total Fixed Cost Example
Your monthly basic telephone bill

probably does not change when you
make more local calls.
Monthly Basic
Telephone Bill
Number of Local Calls

2-33
Fixed Cost Per Unit Example
The average cost per local call

decreases as more local calls are made.
Monthly Basic Telephone

Bill per Local Call
Number of Local Calls

2-34
Cost Behavior Summary
Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit
Variable Changes proportionately with Remains constant for each

changes in activity within the additional unit as long as activity
relevant range. is in the relevant range.
Fixed Remains the same even when The per unit amount changes
activity changes within the each time the level of activity
relevant range. changes due to the fixed nature
of the related costs.
2-35
Cost Hierarchy
Directly traceable
Unit-level to the decision to
produce the level
Costs of output
Costs that are incurred for every unit of product

manufactured or service produced.
Includes direct material, direct labor, utilities to

run equipment, other overhead directly related to
the production process.
All unit level costs are variable, but not

all variable costs are unit level costs.
2-36
Cost Hierarchy
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.
2-37
Cost Hierarchy
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.
2-38
Cost Hierarchy
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.
2-39
2-40
Committed and Discretionary Costs
Committed Discretionary
Long-term obligations, Easier to alter in the
difficult to change in short term by current
the short term. managerial decisions.
Rental and/or Advertising and

Lease Financing Research and
of Buildings and Development
equipment
2-41
Opportunity Costs
The potential benefit that is given up when

one alternative is selected over another.
If you were not attending

college, you could be
earning $20,000 per year.
Your opportunity cost of
attending college for
one year is $20,000.
2-42
Sunk Costs
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.
2-43
Traceability of Resources
Direct Costs Indirect Costs

 Costs that can be  Costs that need to be
traced easily and allocated, before they
conveniently to a can be assigned to a
product or department. product or department.
 Example: Cost of paint in  Example: Cost of
the paint department of national advertising for
an automobile assembly an airline is indirect to a
plant. given flight or route.
2-44
2-45
Absorption (Full) Costing
A system of accounting for costs in which

both fixed and variable production costs
are included in product costs.
Fixed
Costs
Product
Variable
Costs
2-46
Variable Costing
A system of cost accounting that assigns only the

variable cost of production to products.
Fixed
Costs
Product
Variable
Costs
2-47
2-48
Absorption Costing vs. Variable

Costing
Absorption Variable
Costing Costing
Direct materials
Direct labor Product costs
Product costs Variable mfg. overhead
Fixed mfg. overhead

Period costs
Period costs Selling & admin. exp.
2-49
Absorption and Variable Costing
Let’s see what we can learn about the

differences between absorption and variable
costing by looking at a numerical example.
2-50

Costing - Example
Howell, Inc. produces a single product with a sales price

of $40 and the following cost information:
2-51

Costing - Example
Unit product cost is determined as follows:
Selling and administrative expenses are

always treated as period expenses and deducted from
revenue as they are incurred.
2-52

Costing - Example
Howell, Inc. had no beginning inventory, produced
30,000 units and sold 28,000 units this year.
Absorption Costing
Sales (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
2-53

Costing - Example
Variable
Variable Costing
costs
Sales (28,000 × $40) $ 1,120,000
Less variable expenses: only.
Beginning inventory $ - All fixed
Add COGM (30,000 × $12) 360,000 manufacturing
Goods available for sale 360,000
Ending inventory (2,000 × $12) 24,000
overhead is
Variable cost of goods sold 336,000 expensed.
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
2-54
Comparing Absorption and

Variable Costing
Let’s compare the methods.
Cost of
Goods Ending Period
Sold Inventory 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
2-55
Reconciling Income
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 $210,000

= = $7.00 per unit
Units produced 30,000
2-56
Extending the Example
Let’s look at
the second
year of
operations
for Howell, Inc.
2-57
Howell Inc., Year 2
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.
2-58
Howell Inc., Year 2

Unit product cost is determined as follows:
There has been no

change in Howell’s
cost structure.
2-59
Howell Inc., Year 2

Units in ending inventory from the previous period.
Absorption Costing
Sales (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
30,000 units produced in the current period.

2-60
Howell Inc., Year 2

Variable Costing
Sales (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
2-61
Summary
Income Comparison
Costing Method 1st Period 2nd Period Total

Absorption $ 226,000 $ 294,000 $ 520,000
Variable 212,000 308,000 520,000
In the first period, production (30,000 units)

was greater than sales (28,000).
In the second period, production (30,000 units)
was less than sales (32,000).
For the two-year period, total absorption
income and total variable income are the same.
2-62
Summary
2-63
2-64
Variable versus Absorption Costing
All manufacturing Fixed costs are

costs must be assigned
not really the costs
to products to properly
match revenues and of any particular
costs. product.
Absorption Variable
Costing Costing
2-65
Depreciation,
taxes, insurance and These are capacity
salaries are just as costs and will be
essential to products incurred even if nothing
as variable costs. is produced.
Absorption Variable
Costing Costing
2-66
They are the

Absorption
numbers that
costing product costs appear on our
are misleading for external
decision making. reports.
Variable Absorption
Costing Costing
2-67
Variable versus Absorption

Absorption CostingCosting
Cost of goods sold decreases because production
exceeds sales, leaving a portion of fixed
manufacturing costs in inventory.
Variable cost $10
Fixed manufacturing overhead $100,000
Units sold 10,000
Fixed Total Average

Units Total Variable Manufacturing Manufacturing Manufacturing Cost of
Produced Cost Overhead Cost Cost Goods Sold
10,000 $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
2-68 Absorption Costing
Cost of goods sold decreases because production
exceeds sales, leaving a portion of fixed
manufacturing costs in inventory.
COGS for 10,000 units
COGS $200,000
$150,000
$100,000
0
0
0
0
0
,0
,0
,0
,0
,0
,0
,0
34
10
14
18
22
26
30
Number of units produced
2-69
Throughput Costing
Unit-level
spending for
direct costs Product
cost
Indirect, past
or committed
costs
Unit-level costs are incurred every time a unit of

product is manufactured and will not be incurred
again until the next unit is manufactured.
2-70
Throughput Costing
Example
In an automated process direct material may be

the only unit-level cost and so is the only product cost.
All other manufacturing costs are expensed as period costs.
Incentive to Average unit cost does

overproduce not vary with changes
is reduced in production levels.
Advantages
2-71
2-72
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.
2-73
End of Chapter 2

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2

The Meaning of Cost

Comparing Service, Retail and

The 3 major categories of

Direct Labor Manufacturing

Prime Costs include:

Direct Materials Direct Labor Manufacturing

Conversion Costs include:

Direct Materials Direct Labor Manufacturing

Stages of Production and the Flow

Stages of Production and the Flow

Stages of Production and the Flow

Stages of Production and the Flow

Raw Materials Work-In-Process On February 1, Axel

Stages of Production and the Flow

Raw Materials Work-In-Process On February 1, Axel

Stages of Production and the Flow

Raw Materials Work-In-Process Finished Goods

On February 1, Axel had Finished Goods of $125,000 on

Stages of Production and the Flow

Raw Materials Work-In-Process Finished Goods

On February 1, Axel had Finished Goods of $125,000 on

Schedule of Cost of Goods

Schedule of Cost of Goods

Schedule of Cost of Goods

Schedule of Cost of Goods

Schedule of Cost of Goods

Income Statement for a

Now let’s look at an income

Income Statement for a

Income Statement for a

Production Costs in the Service

Cost behavior means how

Total Variable Cost Example

Your total long distance telephone bill

Variable Cost Per Unit Example

The cost per long distance minute talked is

Total Fixed Cost Example

Your monthly basic telephone bill

Number of Local Calls

Fixed Cost Per Unit Example

The average cost per local call

Monthly Basic Telephone

Number of Local Calls

Cost Behavior Summary

Summary of Variable and Fixed Cost Behavior

Variable Changes proportionately with Remains constant for each

Costs that are incurred for every unit of product

Includes direct material, direct labor, utilities to

All unit level costs are variable, but not

Costs that are incurred for batch of product

Includes setup costs, material-handling costs

Costs that are incurred for each line of product

Includes design costs for product lines and

Costs that are incurred to maintain the

Includes production manager’s salary, plant

Committed and Discretionary Costs

Rental and/or Advertising and

The potential benefit that is given up when

If you were not attending

Sunk costs should not be considered in decisions.

Direct Costs Indirect Costs

Absorption (Full) Costing