CHAPTER 8: Product Costing

 
 
Chapter Contents:
-                      Some useful definitions
-                      Overview of product costing
-                      Cost objects
-                      Direct costs
-                      Overhead costs
-                      Cost allocation bases
-                      Overhead rates
-                      ZFN Apparel Company, example of Actual Costing
-                      Exercises and problems
 
 
Some Useful Definitions:
Cost object: A cost object is anything that we want to know the cost
of. We might want to know the cost of making one unit of product,
or a batch of product, or all of Tuesday’s production, in which case
the cost objects are one unit of product, a batch of product, or
Tuesday’s production, respectively. We might want to know the cost
of operating a department or a factory, in which case the cost object
is the department or factory. In a service sector company, we might
want to know the cost of treating a patient in a hospital, or the cost
of conducting an audit, in which case the cost object is the patient or
the audit client. In a government setting, a cost object might be a
program such as “Meals on Wheels.”
 
Product costs: A product cost is any cost that is associated with
units of product for a particular purpose. Hence, the identification of
product costs depends on the purpose for which it is done. For
example, the factory manager is interested in manufacturing costs,
whereas the merchandising manager might be interested in both
manufacturing and nonmanufacturing costs, including research and
development, marketing, and advertising costs.
 
Inventoriable costs: These are costs that are debited to inventory
for either external or internal reporting purposes. For manufacturing
firms, all inventoriable costs are manufacturing costs, but the
reverse is not necessarily true. In other words, inventoriable costs
are either the complete set or a subset of manufacturing costs, and
non-manufacturing costs are never included as inventoriable costs.
For merchandising firms, inventoriable cost is usually the purchase
price of inventory.
 
Period costs: These are costs that are expensed when incurred,
usually because they are not associated with the manufacture of
products. Examples include advertising costs and research and
development costs. Period costs are distinguished from inventoriable
costs.
 
Direct costs and overhead costs: In relation to a given cost object,
all costs are either direct costs or overhead costs. Direct costs can be
traced to the cost object in an economically feasible way. Overhead
costs (also called indirect costs) are associated with the cost object,
but cannot be traced to the cost object in an economically feasible
way. These terms apply to companies in all sectors of the economy
and to all types of organizations.
 
Cost driver: A cost driver is any factor that affects costs. A change
in the cost driver will cause a change in the total cost of a related
cost object. Any one cost object almost always has numerous cost
drivers. This term applies to companies in all sectors of the economy
and to all types of organizations.
 
Cost allocation: The assignment of overhead costs to the cost
object. This term applies to companies in all sectors of the economy
and to all types of organizations.
 
Cost allocation base: A quantitative characteristic shared by
multiple cost objects that is used to allocate overhead costs among
the cost objects. A cost allocation base can be a financial measure
(such as the raw material cost of each unit of product) or a
nonfinancial measure (such as direct labor hours incurred in the
manufacture of each unit of product). The simplest cost allocation
base is simply the number of cost objects (e.g., the number of units
produced by the factory during a period of time).
 
The distinction between a cost driver and a cost allocation base can
be summarized as follows. A cost driver is an economic concept; it
relates to the economic reality of the business. A cost allocation base
is an accounting choice that is made by accountants and managers.
Usually, the best choice for a cost allocation base is a cost driver.
 
Conversion costs: All manufacturing costs other than direct
materials.
 
 
Overview of Product Costing:
Product costing follows these steps:
 
1.                  Identify the cost object;
2.                  Identify the direct costs associated with the cost object;
3.                  Identify the overhead costs;
4.                  Select the cost allocation base to use in assigning overhead
costs to the cost object;
5.                  Develop the overhead rate for allocating overhead to the
cost object.
 
The cost accounting system “builds up” the cost of product (or other
cost object) by recording to a job cost sheet, a work-in-process
account, or some other appropriate ledger, the direct costs that can
be traced to the product, and a share of the overhead costs, which
are allocated to the product by multiplying the overhead rate by the
amount of the allocation base identified with the cost object.
 
 
Cost Objects:
Recall that a cost object is anything that we want to know the cost
of, such as a product or service.
 
There is a common convention that can be confusing. We often talk
about the cost object (the thing we want to know the cost of) as one
unit of product, because factory managers and product managers
speak in terms of unit costs. These managers want to know the unit
cost for product pricing, product sourcing, and performance
evaluation purposes. They do not want to talk about the cost of
making 620 units, even if that is the batch size. However, in most
batch processes, there would be very little benefit and enormous
additional expense in determining the cost of each unit of product
individually. Rather, the accounting system treats the batch as the
cost object, and to derive a unit cost, we divide the cost of the batch
by the number of units in the batch. Hence, loosely speaking, we
talk as if a unit of product is the cost object, but more precisely, it is
the batch (or the production run in an assembly-line process, or
perhaps one day’s production in a continuous manufacturing
process) that constitutes the cost object.
 
 
Direct Costs:
Management accounting classifies product costs as either direct
costs or overhead costs (indirect costs). This distinction is important
because costing systems handle these two types of costs very
differently. The distinction is sometimes subtle, because whether a
cost is direct or overhead is a function of the cost object, and also
partly a matter of choice on the part of managers and accountants.
 
Following are three definitions of direct costs from different
accounting textbooks:
 
Direct costs of a cost object are costs that are related to the cost
object and can be traced to it in an economically feasible way.
 
Direct costs are costs that can be directly attached to the unit
under consideration.
 
Direct costs are costs that can be traced easily to specific
products.
 
Direct costs are also called prime costs. For manufacturing
companies, direct costs usually can be categorized as either
materials or labor.
 
Direct materials: materials that become part of the finished product
and that can be conveniently and economically traced to specific
units (or batches) or product.
 
An example of direct materials for an apparel manufacturer is fabric.
All other materials, such as thread and zippers, are probably
indirect.
 
Direct labor: costs for labor that can be conveniently and
economically traced to a unit (or batch) of product. The following
examples show how the determination of whether a cost is direct or
overhead depends on the identification of the cost object:
 
Examples of direct labor for an apparel manufacturer:
 
1)                  If the cost object is a single pair of pants, in a batch of
several dozen pairs:
 
Most likely no labor is direct.
 
2)                  If the cost object is a batch of several dozen pairs of pants:
 
Most likely sewing operators’ wages are direct.
 
3)                  If the cost object is a production line in the factory:
 
Add the line manager’s salary, and possibly wages incurred in the
cutting room (where rolls of fabric are cut into panels and pieces
that are then sewn together).
 
4)                  If the cost object is the entire factory:
 
Add the factory manager’s salary, wages of maintenance and
janitorial workers, and salaries of front office personnel.
 
Even though it is likely that no labor is direct with respect to a single
pair of pants, if labor is direct with respect to a batch of 50 or 100
units, cost accountants would usually (and loosely) call labor a
direct cost with respect to units of product, and divide the direct
labor cost for the batch by the number of units per batch to derive
the direct labor cost per unit.
 
 
Overhead Costs:
Overhead costs are costs that are related to the cost object, but
cannot be traced to the cost object in an economically feasible way.
Overhead costs are not directly traceable to specific units of
production. Examples of overhead costs incurred at an apparel
manufacturer, when the cost object is a batch of product, would
usually include the following:
 
-                      Electricity
-                      Factory office salaries
-                      Building and machine maintenance
-                      Factory depreciation
 
The distinction between direct costs and overhead costs relate, in
some measure, to the way the accounting system treats the cost. For
example, one apparel manufacturer might track thread using the
same methods that are used to track fabric, thus treating thread as a
direct material. Another apparel manufacturer might decide that the
cost of thread is immaterial, and does not warrant the cost and effort
to track it as a direct cost. For this company, thread is an overhead
cost. Therefore, whether some costs are direct or overhead depend
on a choice made by the manager and the cost accountant.
 
There are three ways overhead costs can be treated in any decision-
making context: (1) they can be ignored, (2) they can be treated as a
lump-sum, or (3) they can be allocated to the products and services
(i.e., to the cost objects) to which they relate. Each of these three
alternatives is appropriate, depending on the circumstances and the
purpose for which the accounting is done. However, in this chapter
and throughout much of this book, we are concerned with the third
alternative: how to allocate overhead costs to products and services.
 
 
Cost Allocation Bases
The allocation base is the “link” that is used to attach overhead costs
to the cost object. In a manufacturing setting, the simplest allocation
base is the number of units produced. For example, if the factory
makes 15,000 units, the accounting system can simply “spread” the
overhead costs evenly over all 15,000 units. The problem with using
units as an allocation base, however, is that if the factory makes a
range of different products, those products might differ significantly
in their resource utilization. A deluxe widget might require twice as
much labor and 20% more materials than a standard widget, and one
might infer that the deluxe widget also requires more resources that
are represented by overhead costs.
 
Whatever cost allocation base is chosen, it must be a “common
denominator” across all cost objects. For example, a furniture
factory could allocate overhead costs across all products using direct
labor hours, because direct labor is incurred by all products made at
the factory. However, it would not seem appropriate to allocate
factory overhead based on the quantity of wood used in each unit, if
the factory makes both wood furniture and a line of plastic-molded,
because no overhead would be allocated to the plastic chairs.
 
 
Overhead Rates:
The overhead rate is the ratio of cost pool overhead dollars in the
numerator, and the total quantity of the allocation base in the
denominator:
       
 =
Overhead rate Overhead costs in the cost pool
Total quantity of the allocation base
   
The result represents dollars of overhead per unit of the allocation
base. For example, if an apparel factory allocates overhead based on
direct labor hours, the overhead rate represents dollars of overhead
per direct labor hour. Assume the overhead rate is $20 per direct
labor hour. Then for every hour that a sewing operator spends
working on product, $20 will be allocated to the products that the
sewing operator assembles during that hour.
 
ZFN Apparel Company, Example of Actual Costing:
The ZFN apparel company in Albuquerque, New Mexico makes
jeans and premium chinos. Each product line has its own assembly
line on the factory floor. Overhead costs for the factory for 2005
were $3,300,000. 500,000 jeans and 400,000 chinos were produced
during the year. 500,000 direct labor hours were used: 200,000 for
jeans, and 300,000 for chinos. The average direct labor wage rate
was the same on both assembly lines, and was $14 per hour. Denim
fabric is used to make jeans, and chinos are made from a cotton twill
fabric. Overhead is allocated using direct labor hours.
 
The following journal entries and T-accounts illustrate how the
accounting system records the manufacturing activities of the
factory in order to derive product cost information for jeans and
chinos. Journal entry (6) to debit overhead to work-in-process is
based on an overhead rate calculated as follows.
 
$3,300,000 ÷ 500,000 direct labor hours = $6.60 per direct
labor hour.
 
In practice, the factory would track costs by batch, or perhaps
weekly, but to simplify our example, we record only one journal
entry for each type of transaction. We also make the unrealistic
assumption that there is no work-in-process at the end of the period.
To focus the presentation on inventory-related accounts, T-accounts
for some non-inventory accounts, and the entry to debit accounts
receivable and credit revenue, are omitted.

 
(1) Raw Materials: denim fabric $3,000,000
Raw Materials: cotton twill 2,250,000
Accounts Payable
$5,250,000
 
(To record the purchase of 600,000 yards of denim fabric at $5.00
per yard, and 500,000 yards of cotton twill fabric at $4.50 per yard.)
 
 
(2) Work-in-process: Jeans $2,500,000
Raw Materials: denim fabric
$2,500,000
 
(To record materials requisitions for 500,000 yards, for the
movement of denim from the receiving department to the cutting
room.)
 
 
(3) Work-in-process: Chinos $2,160,000
Raw Materials: cotton twill
$2,160,000
 
(To record materials requisitions for 480,000 yards, for the
movement of cotton twill from the receiving department to the
cutting room.)
 
 
(4) Work-in-process: Jeans $2,800,000
Work-in-process: Chinos 4,200,000
Accrued Sewing Operator Wages
$7,000,000
 
(To record sewing operator wages for the year: 200,000 hours for
jeans, and 300,000 hours for chinos, at $14 per hour.)
 
 
(5) Factory Overhead $3,300,000
Accounts Payable
$1,800,000
Accrued Wages for Indirect Labor
900,000
Accumulated Depreciation
600,000
 
(To record overhead costs incurred during the year, including
utilities, depreciation, repairs and maintenance, and indirect wages
and salaries.)
 
 
(6) Work-in-process: Jeans $1,320,000
Work-in-process: Chinos 1,980,000
Factory Overhead
$3,300,000

(To allocate factory overhead to production, using an overhead rate

of $6.60 per direct labor hour.)
 
 
(7) Finished Goods: Jeans
$6,620,000
Work-in-process: Jeans
$6,620,000

(To record the completion of all 500,000 jeans, at $13.24 per pair.)
 
 
(8) Finished Goods: Chinos $8,340,000
Work-in-process: Chinos
$8,340,000

(To record the completion of all 400,000 chinos, at $20.85 per pair.)

 
(9) Cost of Goods Sold: Jeans $5,296,000
Cost of Goods Sold: Chinos 7,297,500
Finished Goods: Jeans
$5,296,000
Finished Goods: Chinos
7,297,500

(To record the sale of 400,000 jeans and 350,000 chinos.)

     

Raw Materials: Raw Materials:

Denim Fabric Cotton Twill

(1) $3,000,000 $2,500,000 (2)   (1) $2,250,000 $2,160,000 (3)

     

$ 500,000   $ 90,000

 
                 
Accrued Sewing    

Operator Wages Factory Overhead

    $7,000,000 (4)   (5) $3,300,000 $3,300,000 (6)

   

   

  $0
                 
Work-in-Process: Jeans   Work-in-Process: Chinos
(2) $2,500,000 $6,620,000 (7)   (3) $2,160,000 $8,340,000 (8)

(4) 2,800,000   (4) 4,200,000

(6) 1,320,000   (6) 1,980,000

$0   $0

 
                 
Finished Goods: Jeans   Finished Goods: Chinos
(7) $6,620,000 $5,296,000 (9)   (8) $8,340,000 $7,297,500 (9)
      

     

$1,324,000   $1,042,500

 
                 
Cost of Goods Sold: Jeans   Cost of Goods Sold: Chinos
(9) $5,296,000       (9) $7,297,500    

 
                 
             
Accounts Payable    
    $5,250,000 (1)  

1,800,000 (5)