Chapter Summary
LO.1 Accounting Information, Types
• Accounting
- provides information to external parties
(stockhold- ers, creditors, and various regulatory
bodies) for investment and credit decisions.
- helps an organization estimate the cost of its prod-
ucts and services.
- provides information useful to internal managers
who are responsible for planning, controlling, deci-
sion making, and evaluating performance.
• The purposes of financial, management, and cost
account- ing are as follows:
- financial accounting is designed to meet external
information needs and to comply with generally
accepted accounting principles;
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- management accounting is designed to satisfy
inter- nal users’ information needs; and
- cost accounting overlaps financial accounting and
management accounting by providing product
cost- ing information for financial statements and
quan- titative, disaggregated, cost-based
information that managers need to perform their
responsibilities.
LO.2 Cost Accounting Standards
• Generally accepted cost accounting standards
- do not exist for companies that are not engaged in
contracts with the federal government; however,
the Statements on Management Accounting and
Management Accounting Guidelines are well-
researched suggestions related to high-quality man-
agement accounting practices.
 Chapter 1 Introduction to Cost Accounting 17

- are prepared by the Cost Accounting Standards departments as well as the level of each manager’s
Board for companies engaged in federal government authority and responsibility.
cost/bidding contracts. - has line personnel who seek to achieve the organiza-
LO.3 Ethical Standards tional mission and strategy through balanced
• Ethical behavior in organizations is addressed in part score- card targets.
in the following items: - has staff personnel, such as cost accountants, who
- IMA’s Statement of Ethical Professional Practice, advise and assist line personnel.
which refers to issues of competence, confidentiality, - is influenced by management style and organiza-
integrity, and credibility. tional culture.
- Sarbanes-Oxley Act, which requires corporate CEOs LO.6 Value Chain
and CFOs to sign off on the accuracy of financial • The value chain is a set of value-adding functions or
reports. processes that convert inputs into products and services
- False Claims Act, which provides for whistle-blow- for company customers.
ing protection related to frauds against the U.S. • Value chain functions include
government.
- research and development,
LO.4 Mission Statements, Organizational Strategy
- product design,
• The organizational mission and strategy are
important to cost accountants because such - supply,
statements help to - production,
- indicate appropriate measures of accomplishment. - marketing,
- define the development, implementation, and moni- - distribution, and
toring processes for the organizational information - customer service.
systems.
LO.7 Balanced Scorecard
• Two common corporate strategies are • A balanced scorecard
- cost leadership, which refers to maintaining a com-
petitive edge by undercutting competitor prices, and - indicates critical goals and targets needed to
- product differentiation, which refers to offering (gen- opera- tionalize strategy.
erally at a premium price) superior quality - measures success factors for learning and growth,
products, more unique services, or a greater number internal business, customer satisfaction, and financial
of features than competitors. value.
• Organizational strategy may be constrained by - includes financial and nonfinancial, internal and
- monetary capital, intellectual capital, and/or external, long-term and short-term, and lead and lag
technology. indicators.
- external cultural, fiscal, legal/regulatory, or political LO.8 Ethical Behavior
situations. • Accountants need to be aware of ethical conduct and
- competitive market structures. laws globally, not just in the United States.
LO.5 Organizational Structure • Ethical behavior has been addressed internationally:
• The organizational structure - The Foreign Corrupt Practices Act and the OECD’s
- is composed of people, resources other than people, and commitments that are acquired and arranged relative to authority and
responsibility to achieve the organizational mission, strategy, and goals.
- is used by cost accountants to understand how infor- mation is communicated between managers and
Chapter Summary
LO.1 Cost Classification
• Direct or indirect, depending on their relationship to a
cost object.
• Variable, fixed, or mixed depending on their reaction to
a change in a related activity level.
• Unexpired (assets) or expired (expenses or losses)
depending on whether they have future value to the
company.
• Product (inventoriable) or period (selling, adminis-
trative, and financing) depending on their associa-
tion with the revenue-generating items sold by the
company.
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LO.2 Assumptions Used to Estimate Product Cost within
Relevant Range of Activity
• Variable costs are constant per unit and will change in
total in direct proportion to changes in activity.
• Fixed costs are constant in total and will vary inversely
on a per-unit basis with changes in activity.
• Mixed costs fluctuate in total with changes in activ-
ity and can be separated into their variable and fixed
components.
• Step costs are either variable or fixed, depending on
the size of the changes (width of the steps) in cost
that occur with changes in activity.
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44 Chapter 2 Cost Terminology and Cost Behaviors

LO.3 Conversion Process Differences
• Manufacturers require extensive activity to convert raw
material into finished goods; the primary costs in
these companies are direct material, direct labor, and
over- head; manufacturers use three inventory accounts
(Raw Material, Work in Process, and Finished Goods).
• Service companies often require extensive activity to
perform a service; the primary costs in these companies
are direct labor and overhead; service companies may
use Supplies Inventory and Work in Process Inventory
accounts but typically have no Finished Goods
Inventory.
• Retailers require little, if any, activity to make purchased
goods ready of sale; the primary costs in these com-
panies are purchase prices of goods and labor wages;
retailers use a Merchandise Inventory account.
LO.4 Product Cost Categories
• Direct material, which is the cost of any item that is
physi- cally and conveniently traceable to the product or
service.
• Direct labor, which is the wages or salaries of the people
whose work is physically and conveniently traceable
to the product or service.
• Overhead, which is any cost incurred in the conversion
(or production) area that is not direct material or
direct labor; overhead includes indirect material and
indirect labor costs.
LO.5 Cost of Goods Manufactured
• CGM equals the costs that were in the conversion
area at the beginning of the period plus production
costs (direct material, direct labor, and overhead)
incurred during the period minus the cost of
incomplete goods that remain in the conversion area
at the end of the period.
• CGM is shown on an internal management report
called the schedule of cost of goods manufactured; it
is equivalent to the cost of goods purchased in a retail
company.
• CGM is added to beginning Finished Goods Inventory
to determine the cost of goods available (CGA) for
sale for the period; CGA is reduced by ending
Finished Goods Inventory to determine cost of goods
sold on the income statement.

Solution Strategies

Product Cost, p. 30
Direct Material
+ Direct Labor
+ Overhead
= Total Product Cost

Schedule of Cost of Goods Manufactured, p. 41

Beginning balance of Work in Process Inventory $XXX
Manufacturing costs for the period:
Raw material (all direct):
Beginning balance $ XXX
Purchases of material XXX
Raw material available for use $ XXX
Ending balance (XXX)
Direct material used $XXX
Direct labor XXX
Variable overhead XXX
Fixed overhead XXX
Total current period manufacturing costs XXX
Total cost to account for $XXX
Ending balance of Work in Process Inventory (XXX)
Cost of goods manufactured $XXX
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 Chapter 2 Cost Terminology and Cost Behaviors 45

Cost of Goods Sold, p. 41

Beginning balance of Finished Goods Inventory $XXX
Cost of goods manufactured XXX
Cost of goods available for sale $XXX
Ending balance of Finished Goods Inventory (XXX)
Cost of goods sold $XXX

Demonstration Problem

Latourneau Company had the following account balances as of August 1, 2010:

Raw Material (direct and indirect) Inventory $20,300

Work in Process Inventory 7,000
Finished Goods Inventory 18,000

During August, the company incurred the following factory costs:

1. Purchased $164,000 of raw material on account.
2. Issued $180,000 of raw material to production, of which $134,000 was for direct materials.
3. Accrued $88,000 in factory payroll costs; $62,000 was for direct labor and the rest was
for supervisors’ salaries.
4. Accrued $7,000 of utility costs; of this amount, $1,600 was fixed.
5. Accrued $2,000 of property taxes on the factory.
6. Recorded the expiration of $1,600 of prepaid insurance on factory equipment.
7. Recorded $40,000 of straight-line depreciation on factory equipment.
8. Applied actual overhead to Work in Process Inventory.
9. Transferred goods costing $320,000 to Finished Goods Inventory.
10. Recorded total sales of $700,000; of these, $550,000 were on account.
11. Recorded cost of goods sold of $330,000.
12. Recorded selling and administrative costs of $280,000 (credit “Various accounts”).

Required:
a. Journalize the transactions for August.
b. Post transactions to T-accounts for Raw Material Inventory, Work in Process Inven-
tory, Finished Goods Inventory, and Cost of Goods Sold.
c. Prepare a schedule of cost of goods manufactured for August using actual costing.
d. Prepare an income statement, including a detailed schedule of cost of goods sold.

Solution to Demonstration Problem

a. (1) Raw Material Inventory 164,000
Accounts Payable 164,000
To record raw material purchased on account
(2) Work in Process Inventory 134,000
Variable Overhead Control 46,000
Raw Material Inventory 180,000
To transfer direct and indirect materials to production

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 46 Chapter 2 Cost Terminology and Cost Behaviors

(3) Work in Process Inventory 62,000

Fixed Overhead Control 26,000
Salaries and Wages Payable 88,000
To accrue factory wages and salaries
(4) Variable Overhead Control 5,400
Fixed Overhead Control 1,600
Utilities Payable 7,000
To accrue factory utility expenses
(5) Fixed Overhead Control 2,000
Property Taxes Payable 2,000
To accrue property tax
(6) Fixed Overhead Control 1,600
Prepaid Insurance 1,600
To record expired insurance on factory equipment
(7) Fixed Overhead Control 40,000
Accumulated Depreciation—Factory Equipment 40,000
To record depreciation on factory equipment
(8) Work in Process Inventory 122,600
Variable Overhead Control 51,400
Fixed Overhead Control 71,200
To assign actual overhead to WIP Inventory
(9) Finished Goods Inventory 320,000
Work in Process Inventory 320,000
To record cost of goods manufactured
(10) Accounts Receivable 550,000
Cash 150,000
Sales 700,000
To record sales on account and for cash
(11) Cost of Goods Sold 330,000
Finished Goods Inventory 330,000
To record cost of goods sold for the period
(12) Selling & Administrative Expenses 280,000
Various accounts 280,000
To record selling and administrative expenses

b. Raw Material Inventory Work in Process Inventory

BB 20,300 (2) 180,000 BB 7,000 (9) 320,000

(1) 164,000 (2) 134,000
(3) 62,000
(8) 122,600
EB 5,600
EB 4,300

Finished Goods Inventory Cost of Goods Sold

(11)330,000
BB 18,000 (11) 330,000
(9) 320,000
EB 8,000

where BB = beginning balance

EB = ending balance

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 Chapter 2 Cost Terminology and Cost Behaviors 47

c. LATOURNEAU COMPANY
Schedule of Cost of Goods Manufactured
For Month Ended August 31, 2010

Balance of Work in Process Inventory, 8/1/10 $ 7,000

Manufacturing costs for the period
Raw material
Beginning balance $ 20,300
Purchases of material 164,000
Raw material available $184,300
Indirect material used $46,000
Ending balance 4,300 (50,300)
Total direct material used $134,000
Direct labor 62,000
Variable overhead 51,400
Fixed overhead 71,200
Total current period manufacturing costs 318,600
Total cost to account for $325,600
Balance of Work in Process Inventory, 8/31/10 (5,600)
Cost of goods manufactureda $320,000

a
Note the similarity between the schedule of CGM and the WIP Inventory T-account.

d. LATOURNEAU COMPANY
Income Statement
For the Month Ended August 31, 2010

Sales $700,000
Cost of goods sold
Finished goods, 8/1/10 $ 18,000
Cost of goods manufactured 320,000
Cost of goods available $338,000
Finished goods, 8/31/10 (8,000)
Cost of goods sold (330,000)
Gross margin $370,000
Selling and administrative expenses (280,000)
Income from operations $ 90,000

Chapter Summary
LO.2 Underapplied and Overapplied Overhead
LO.1 Overhead Cost Allocation • Underapplied (actual is more than applied) or overap- plied (actual
• Manufacturing overhead costs are allocated to products is less than applied) overhead is
to - caused by a difference between actual and budgeted OH costs
- eliminate the problems caused by delays in obtaining and/or a difference between the actual and budgeted level of
actual cost data. activity chosen to compute the pre- determined OH rate.
- make the overhead allocation process more effective.
- allocate a uniform amount of overhead to goods or
services based on related production efforts.
- allow managers to be more aware of individual prod-
uct or product line profitability as well as the profit-
ability of doing business with a particular customer
or vendor.

- closed at the end of each period (unless
normal capac- ity is used for the
denominator level of activity) to
➢ Cost of Goods Sold (CGS) if the
amount of underapplied or
overapplied overhead is imma-
terial (underapplied will cause
CGS to increase, and overapplied
will cause CGS to decrease)
or
➢ Work in Process Inventory,
Finished Goods Inventory, and Cost of Goods
Sold (based on their proportional balances), if the
amount of underap- plied or overapplied
overhead is material.
LO.3 Predetermined Overhead Rates and Capacity
• Capacity measures affect the setting of predetermined
OH rates because the use of
- expected capacity (the budgeted capacity for the
upcoming year) will result in a predetermined OH
rate that would probably be most closely related to an
actual OH rate.

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Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing
- practical capacity (the capacity that allows for normal
operating interruptions) will generally result in a pre-
determined OH rate that is substantially lower than
an actual OH rate would be.
- normal capacity (the capacity that reflects a long-
run average) can result in an OH rate that is higher
or lower than an actual OH rate, depending on
whether capacity has been over- or underutilized
during the years under consideration.
- theoretical capacity (the estimated maximum poten-
tial capacity) will result in a predetermined OH rate
that is exceptionally lower than an actual OH rate;
however, this rate reflects a company’s utopian use of
its capacity.
LO.4 High–Low Method and Least Squares Regression
• Mixed costs are separated into their variable and fixed
components by
- the high–low method, which considers the change
in cost between the highest and lowest activity levels
in the data set (excluding outliers) and determines
a variable cost per unit based on that change; fixed
cost is then determined by subtracting total variable
cost at either the highest or the lowest activity level
from total cost at that level.
- regression analysis, which uses the costs and activ-
ity levels in the entire data set (excluding outliers)
as input to mathematical formulas that allow the
deter- mination first of variable cost and,
subsequently, of fixed cost.
LO.5 Predetermined Overhead Rates and Flexible Budgets
• Flexible budgets are used by managers to help set
pre- determined OH rates by
- allowing managers to understand what manufactur-
ing OH costs are incurred and what the behaviors
(variable, fixed, or mixed) of those costs are.
- allowing managers to separate mixed costs into
their variable and fixed elements.
- providing information on the budgeted costs to be
incurred at various levels of activity.
- providing the impacts on the predetermined fixed
OH rate (or on a plantwide rate) from changing the
denominator level of activity.
Solution Strategies
Predetermined Overhead Rate, p. 68
Total Budgeted OH Cost at a Specified Activity Level
Predetermined OH Rate =
Volume of Specified Activity Level
(Can be separate variable and fixed rates or a combined rate)
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89
LO.6 Absorption and Variable Costing
• Absorption and variable costing differ in that
- absorption costing
➢ includes all manufacturing costs, both variable
and fixed, as product costs.
➢ presents nonmanufacturing costs on the income
statement according to functional areas.
- variable costing
➢ includes only the variable costs of production
(direct material, direct labor, and variable manu-
facturing overhead) as product costs.
➢ presents both nonmanufacturing and manufac-
turing costs on the income statement according
to cost behavior.
LO.7 Changing Sales or Production Levels in Absorption and
Variable Costing
• Differences between sales and production volume result
in differences in income between absorption and vari-
able costing because
- absorption costing requires fixed costs to be written
off as a function of the number of units sold;
➢ thus, if production volume is higher than sales
volume, some fixed costs will be deferred in
inventory at year-end, making net income higher
than under variable costing.
➢ conversely, if sales volume is higher than produc-
tion volume, the deferred fixed costs from pre-
vious periods will be written off as part of Cost
of Goods Sold, making net income lower than
under variable costing.
- variable costing requires all fixed costs to be writ-
ten off in the period incurred, regardless of when the
related inventory is sold;
➢ thus, if production volume is higher than sales
volume, all fixed manufacturing costs are
expensed in the current period and are not
deferred until the inventory is sold, making net
income lower than under absorption costing.
➢ conversely, if sales volume is higher than
production volume, only current period fixed
manufacturing costs are expensed in the current
period, making net income higher than under
absorption costing.
90 Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing

High–Low Method, p. 74
(Using assumed amounts)
(Independent (Dependent Variable) Total Variable
Variable) Associated Cost (Rate × Total Fixed
Activity Total Cost − Activity) = Cost
“High” level 14,000 $18,000 − $11,200 = $6,800
“Low” level 9,000 14,000 − 7,200 = 6,800
Differences 5,000 $ 4,000

$0.80
variable cost per unit of activity

Least Squares Regression Analysis, p. 75

The equations necessary to compute b and a values using the method of least squares are
as follows:
_ _
∑xy — n( x)( y)
b= _

_
∑ x — n( x)
_
2 2

a = y — bx
_
where x = mean of the independent variable
_
y = mean of the dependent variable
n = number of observations

Underapplied and Overapplied Overhead, p. 70

Manufacturing Overhead Control XXX
Various accounts XXX
To record actual overhead costs
Work in Process Inventory YYY
Manufacturing Overhead Control YYY
To apply overhead to WIP

A debit balance in Manufacturing Overhead at the end of the period is underapplied

overhead; a credit balance is overapplied overhead. The debit or credit balance in the over-
head account is closed at the end of the period to Cost of Goods Sold or prorated to
Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold.

Flexible Budget, p. 78
To prepare a flexible budget,
1. separate mixed costs into variable and fixed elements;
2. determine the a + bX cost formula for each item of the budget category (for example,
all items creating manufacturing overhead);
3. select several potential levels of activity within the relevant range; and
4. use the cost formulas to determine the total cost expected at each of the selected levels
of activity.

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Chapter 3 Predetermined Overhead Rates, Flexible Budgets, and Absorption/Variable Costing

Absorption and Variable Costing, p. 81

1. Determine which method is being used
(absorption or variable). The following
abbre- viations are used: VOH, variable
manufacturing overhead; FOH, fixed
manufacturing overhead; DM, direct
material; DL, direct labor.
a. If absorption:
- Determine the FOH application rate.
- Determine the denominator
capacity used in determining
manufacturing FOH.
- Determine whether production
was equal to the denominator
capacity. If not, a FOH volume
variance must be properly
assigned to CGS and, possibly,
inventories.
- Determine the cost per unit of product, which consists of (DM + DL +
VOH + FOH).
b. If variable:
- Determine the cost per unit of product, which consists of (DM + DL +
VOH).
- Determine the total fixed
manufacturing OH and assign
that amount to the income
statement as a period expense.
2. Determine the relationship of production to sales.
a. If production = sales, then absorption costing income = variable costing income.
b. If production > sales, then absorption costing income > variable costing income.
c. If production < sales, then absorption costing income < variable costing income.
3. The dollar difference between
absorption costing income and variable
costing income equals fixed
predetermined OH rate × change in
inventory units.