Chapter 6

Fundamentals of Product
and Service Costing

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
 Cost Management Systems
L.O. 1 Explain the fundamental themes underlying
the design of cost systems.

• The objective of the cost management system

is to provide information about costs relevant
for decision making.

• The cost system accumulates and reports costs

about processes, products, and services.

6-2
LO1
Reasons to Calculate Product
or Service Costs

• For decision making

• For deciding what to sell

• For setting prices

• For knowing the cost of goods sold

• For knowing the cost of inventory

6-3
 Cost Allocation and Product Costing
L.O. 2 Explain how cost allocation is used
in a cost management system.

Basic Cost Flow Diagram

Cost Direct Direct Manufacturing

pools materials labor overhead
Indirect
Cost
allocation (allocated
rule by direct
Direct labor cost)

Cost
Alpha Beta
objects

6-4
 Basic Cost Flow Model
L.O. 3 Explain how a basic product costing system works.

• How costs and units move through inventories:

Beginning Transfers Transfers Ending

+ – =
balance in out balance
BB + TI – TO = EB

• This is true for the following accounts:

– Raw Materials (RM)
– Work-in-Process (WIP)
– Finished Goods (FG)

6-5
LO3
Costing with No Work-in-Process
Inventories
• Baxter Paint begins production on April 1.
• It starts and completes production of 100,000
gallons of paint in April and has no ending
work-in-process inventory.

Cost of resources used in April:

Materials $ 400,000
Labor 100,000
Manufacturing overhead 500,000
Total $1,000,000

6-6
LO3
Costing with No Work-in-Process
Inventories
• What are the costs at the end of the period?

• $1,000,000 was added to work-in-process

and then transferred out to finished goods.
• Since Baxter produced 100,000 gallons of
paint, then the cost per gallon of paint is $10.

6-7
LO3
Costing with Work-in-Process
Inventories
Production for Baxter Paint for May follows (gallons):
Beginning inventory -0-
Started in May 110,000
Total 110,000
Ending WIP (50% complete) 20,000
Transferred out 90,000

6-8
LO3
Costing with Work-in-Process
Inventories

BB + TI – TO = EB
110,000 90,000 20,000 gallons
0 + – =
gallons gallons (50% complete)

FG

6-9
LO3
Costing with Work-in-Process
Inventories
• How do we cost Baxter’s 20,000 gallons of paint that
are only half finished?
• 20,000 gallons half finished is equivalent to 10,000
gallons finished.
• 90,000 gallons transferred out plus 10,000 equivalent gallons
of finished paint equals 100,000 equivalent gallons of paint.

Gallons of paint transferred out 90,000

Equivalent gallons of finished paint 10,000
Total equivalent gallons of paint 100,000

6 - 10
LO3
Costing with Work-in-Process
Inventories

Direct material + Direct labor + Overhead

($990,000)

90,000 10,000
gallons Equivalent gallons gallons
(90%) (10%)
Finished goods Work-in-process
inventory inventory
$891,000 $99,000

6 - 11
 Predetermined Overhead Rates
L.O. 4 Understand how overhead cost is allocated to products.

• Indirect costs are allocated using a predetermined

overhead rate (POHR).
• POHR is the cost per unit of the allocation base used
to charge overhead to products.

POHR = $ ÷ Base

6 - 12
 Multiple Allocation Bases
and Two-Stage Systems
L.O. 5 Explain the operation of a two-stage allocation
system for product costing.

• We can use two or more allocation bases to allocate

manufacturing overhead to products.

6 - 13
 LO5
Multiple Allocation Bases
and Two-Stage Systems
Cost
pool Manufacturing overhead
First stage

Machine-related Direct labor-related

costs costs

Cost Indirect costs Indirect costs

Second
allocation (allocated in proportion (allocated in proportion
stage
rules to machine hours) to direct labor costs)

Cost
objects C-27s C-20s

6 - 14
 LO5
Multiple Allocation Bases
and Two-Stage Systems

Cost Overhead
pool $180,000

Intermediate Labor-related Machine-related

cost pools $108,000 $72,000

Cost allocation Direct labor Machine

rule costs hours

6 - 15
 Product Costing Systems
L.O. 6 Describe the three basic types of product costing
systems: job order, process, and operations.

• Job costing:
– An accounting system that traces costs to individual units
or to specific jobs, contracts, or batches of goods.
(custom homes, movies, services)
• Process costing:
– An accounting system used when identical units are
produced through a series of uniform production steps.
(cornflakes, facial tissues, paint)

6 - 16
 End of Chapter 6

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.