18/03/2014

Last week....
Lecture 3: Product Costing Systems
• Some concepts that we discussed  (and we need for 
this week):
• Cost behaviour: Fixed & Variable cost
Dr. Vijaya Murthy • Cost object: anything of interest for which a cost is 
desired.
• For more, please visit:
F l i it
http://www.learnmanagerialaccounting.com/FreeMateria
l/costbehavior/index.html
• Unit cost & Total cost; Unit selling price & Total selling 
price
• Variable cost statements

LEARNING OBJECTIVES (Session 1) Types of Manufacturing Inventories
• Difference between absorption costing and  • Direct materials – resources in‐stock and 
variable costing and treatment of Fixed 
manufacturing overhead. available for use
• Compute income under absorption costing and  • Work‐in‐process (or progress) – products 
variable costing and explain the difference in
variable costing and explain the difference in  started but not yet completed Often
started but not yet completed. Often 
income
abbreviated as WIP
• Describe the undesirable incentives for managers 
to build up inventory when a company uses  • Finished goods – products completed and 
absorption costing ready for sale
• Explain why product costs are computed in 
different ways for different purposes

Types of Inventoriable Costs Other Cost Classifications
• Also known as product costs • Prime cost is a term referring to all direct 
– Direct materials
manufacturing costs (labour and materials)
– Direct labour • Conversion cost is a term referring to direct 
– Indirect Manufacturing 
Indirect Manufacturing – factory costs that are not 
factory costs that are not labour and factory overhead costs collectively
traceable to the product. Other common names for this  • Inventoriable costs – product manufacturing 
type of cost include manufacturing overhead costs or  costs. These costs are capitalised as assets 
factory overhead costs (inventory) until they are sold and transferred to 
cost of goods sold
• Period costs – have no future value and are 
expensed as incurred

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Inventory Costing Choices: Overview Costing Comparison
• Absorption costing – product costs are  • Variable costing is a method of inventory 
capitalised; period costs are expensed costing in which only variable manufacturing 
• Variable costing – variable product and period  costs are included as Inventoriable costs
p ; p p
costs are capitalised; fixed product and period  • Absorption costing is a method of inventory 
Absorption costing is a method of inventory
costs are expensed
costing in which all variable manufacturing 
costs and all fixed manufacturing costs are 
included as Inventoriable costs

Absorption and Variable Costing
Variable Versus Absorption Costing
Absorption Costing Variable Costing
Direct material
The differences between variable-costing and
Direct labour
absorption-costing methods are based on the PRODUCT COST
treatment of fixed manufacturing overhead
fixed manufacturing overhead PRODUCT COST
overheads
g
Variable mfg 

Fixed mfg. 
Overheads
Selling &  PERIOD COST
PERIOD COST Administrative 
overheads
The difference between absorption and variable costing is
the treatment of fixed manufacturing overhead.

What is the format of Income Statement under  What Is the Format For a 
absorption costing? Variable‐Costing Income Statement?

Sales Sales Revenue
Less: Cost of Goods Sold Less: Variable Manufacturing Costs
(includes Direct Materials, Direct Labour, Variable 
Less: Variable Selling & Administrative 
Overhead, Fixed Overhead for Units Sold)
= Gross Margin
Gross Margin = Contribution Margin
Contribution Margin
Less: Selling & Administrative Expenses Less: Fixed Manufacturing Overhead
= Net Income Less: Fixed Selling & Administrative
= Net Income

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Unit Cost Computations Unit Cost Computations

Unit product cost is determined as follows:
Harvey Company produces a single product
with the following information available:

Under absorption costing, all production costs, variable

and fixed, are included when determining unit product
cost. Under variable costing, only the variable
production costs are included in product costs.

Income Comparison of Absorption Costing

Absorption and Variable Costing
Let’s assume the following additional information
for Harvey Company.
– 20,000 units were sold during the year at a price
of $30 each
each.
– There is no beginning inventory.

Now, let’s compute net operating income using both

absorption and variable costing.
Fixed manufacturing overhead deferred in
inventory is _______ units × $6 = ________.

Variable Costing
Comparing the Two Methods
Variable Costing
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
Add COGM (25,000 × $10)
Goods available for sale -
Less ending inventory (5,000 × $10) 50,000
Variable cost of goods sold
Variable selling & administrative
expenses (20,000 × $3) 60,000
Contribution margin
Less fixed expenses:
Manufacturing overhead
Selling & administrative expenses 100,000 100,000
Net operating income

7-18

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Comparative Income Effects
Comparing the Two Methods
We can reconcile the difference between Absorption
Variable costing
costing
absorption and variable income as follows:
Are fixed product
costs
Variable costing net operating income $ 90,000 inventoried? No Yes
Add: Fixed mfg.
mfg overhead costs
Are
deferred in inventory classifications
(5,000 units × $6 per unit) 30,000 between variable
Absorption costing net operating income $ 120,000 & fixed costs Yes Infrequently
routinely made?

Fixed mfg. overhead $150,000

= = $___ per unit
Units produced 25,000 units

Comparative Income Effects
How do changes in unit inventory cost  • Managers may seek to manipulate income
affect operating income if…?
Variable costing
Production = sales Equal
Production > sales Lower
Production < sales Higher
Performance Issues and Absorption 
Costing
 
by producing too many units
• Production beyond demand will increase the 
amount of inventory on hand
Absorption • This will result in more fixed costs being 
This will result in more fixed costs being
costing
capitalised as inventory
Equal • That will leave a smaller amount of fixed 
Higher costs to be expensed during the period
Lower • Profit increases and potentially so does a 
manager’s bonus

Other Manipulation Schemes Beyond 
Inventories and Costing Methods
Simple Overproduction
• One way to prevent the unnecessary buildup 
of inventory for bonus purposes is to base  • Deciding to manufacture products the 
manager’s bonuses on profit calculated using  absorb the highest amount of fixed costs, 
variable costing
variable costing regardless of demand (‘cherry‐picking’)
dl fd d (‘ h i ki ’)
• Drawback: complicated system of producing  • Accepting an order to increase production 
two inventory figures – one for external  even though another plant in the same 
reporting and the other for bonus calculations firm is better suited to handle that order
• Deferring maintenance

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Management Countermeasures for Fixed  Management Countermeasures for Fixed 
Cost Manipulation Schemes Cost Manipulation Schemes

• Careful budgeting and inventory planning • Careful budgeting and inventory planning
• Incorporate an internal carrying charge for  • Incorporate an internal carrying charge for 
inventory inventory
• Change (lengthen) the period used to  • Change (lengthen) the period used to 
evaluate performance evaluate performance
• Include non‐financial as well as financial  • Include non‐financial as well as financial 
variables in the measures to evaluate  variables in the measures to evaluate 
performance performance

Learning Objectives (Session 2) Product and Service Costing

1. Distinguish job‐costing from process‐costing
2. Outline the seven‐step approach to job costing
3. Distinguish actual costing from normal costing
4. Describe the five steps in process‐costing
5. Calculate equivalent units and understand how  Managerial 
Financial Accounting
to use them Accounting and Cost 
Product costs are used  Management
6. Use the weighted‐average method of process  to value inventory and to 
costing compute cost of Product costs are used 
goods sold.  for planning, control, 
directing, and 
management decision 
making.
27

Product costing systems Flow of costs in manufacturing
businesses
• accumulate product‐related costs and uses 
systematic procedures to assign them to the  Several manufacturing ledger accounts:
final products • Raw materials inventory,
• In some businesses upstream and 
In some businesses upstream and • W ki
Work in process inventory,
i
downstream costs are regarded as product  • Finished goods inventory,
related.
• Cost of goods sold expense, and
• Product costs are the inputs into the product 
• Profit and loss account
costing system
• How are these ledger accounts interrelated?

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Allocating Overhead
Flow of Costs in Manufacturing Firm Direct/Indirect Costs to Products

Work-in-Process Inventory Finished Goods Inventory

Direct material cost Product cost transferred
Direct labor cost
Manufacturing overhead when product is finished
Cost of Goods Sold
Expense closed into
Income Summary at end
of accounting period
To estimate the cost of a product we need to identify 
the cost of resources used
Some resources are consumed directly and are traced
Some resources are consumed directly, and are traced 
Income Summary directly to each product
Overhead costs are essential to production, but have 
no observable relationships to the product  
need to be allocated
Let’s investigate using the 
AFB Company

3 32

Types of Product‐
Types of Product‐Costing Systems Types of Product
Types of Product‐‐Costing Systems

Process Job‐Order Process Job‐Order

Costing Costing Costing Costing

 Used for production of large, unique, high‐cost items.  Production costs traced to process/department, and averaged across all units 
produced
 Built to order rather than mass produced.
Mass production or repetitive environment ‐automated continuous production 
 Many costs can be directly traced to each job. Petrol production, processed food, chemical and plastics manufacturers
TWO TYPES: Repetitive services – routine processing of cheques by banks, handling of 
Job‐shop operations license applications by government departments
Products manufactured in very low volumes or one at a time. 
 Batch‐production operations
Multiple products in batches of relatively small quantity.
Printers, furniture manufacturers, machinery manufacturers
Many service firms—lawyers, accountants, consulting engineers, IT firms

Comparing Process and Job‐Order  Some Comparisons of Job‐Order
Costing Costing and Process Costing
Job-Order Process
Number of jobs worked Many Single Product Process costing
Cost accumulated by Job Department
Job‐order costing Costs accumulated by 
Costs accumulated by  department or process.
Average cost computed by Job Department
the job. Work in process has a
Work in process has a
Work in process has a  production report for
job‐cost sheet for each each batch of products.
job. A few identical, low cost 
Many unique, high cost  products.
jobs. Units continuously
Jobs built to customer  produced for inventory
order. in automated process.

3‐35

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Costing Approaches Costing Approaches Summarised
• Actual costing allocates:
– Indirect costs based on the actual indirect cost 
rates times the actual activity consumption
• Normal costing allocates: 
– Indirect costs based on the budgeted indirect cost 
rates times the actual activity consumption
• Both methods allocate direct costs to a cost object the 
same way: by using actual direct‐cost rates times 
actual consumption

Sample Job Cost Document
Seven‐step Job Costing
1. Identify the job that is the chosen cost object
2. Identify the direct costs of the job
3. Select the cost‐allocation base(s) to use for allocating  Exhibit 5‐2
indirect costs to the job
4. Match indirect costs to their respective cost‐allocation 
base(s)
5. Calculate an overhead allocation rate:
• Actual OH costs ÷ actual OH allocation base
6. Allocate overhead costs to the job:
• OH allocation rate x actual base activity for the job
7. Compute total job costs by adding all direct and indirect 
costs together

Sample Job Cost Source 
Documents Job Costing Overview

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Process Cost Flows
Process‐Costing
One Production Department
• Process‐costing is a system where the unit cost of a  Work-in-Process Finished Goods
Inventory Inventory Cost of Goods Sold
product or service is obtained by assigning total costs  Direct material
Cost of goods completed Cost of goods sold
to many identical or similar units Direct labour
Applied manufacturing and transferred to during current
• Each unit receives the same or similar amounts of  overhead finished goods period

direct materials costs, direct labour costs and 
manufacturing overhead
• Unit costs are computed by dividing total costs 
incurred by the number of units of output from the 
production process

Process Cost Flows
Equivalent Units:  A Key Concept
Two Sequential Production Departments
Work-in-Process Inventory Work-in-Process Inventory
Production Department A Production Department B
Direct material Cost of goods completed
Direct labour in department A and Cost of goods completed • Costs are accumulated for a period of time for 
Applied manufacturing transferred to and transferred to
overhead department B finished goods
products in work‐in‐process inventory. 
Direct material • Products in work‐in‐process inventory at the 
Direct labour beginning and end of the period are only partially 
Applied manufacturing
overhead complete. 
• Equivalent units is a concept expressing these 
Finished Goods Inventory Cost of Goods Sold partially completed products as a smaller number of 
Cost of goods sold fully completed products.
during current period

4‐45

Equivalent Units Example Equivalent Units Question 1

Two one‐half completed products are For the current period, Jones started 15,000 units 
equivalent to one completed product. and completed 10,000 units, leaving 5,000 units in 
process 30 percent complete.  How many 
equivalent units of production did Jones have for 
the period?
+ = l
a.  10,000
b.  11,500
c.  13,500
So, 10,000 units 70 percent complete
are equivalent to 7,000 complete units. d.  15,000
4‐47 4‐48

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Calculating and Using Equivalent Units of 
Equivalent Units Question 2 Production

If Jones incurred $27,600 in production costs 
To calculate the direct materials and conversion costs 
for the 11,500 equivalent units.  What was  per equivalent unit for the period:
Jones’s cost per equivalent unit for the 
period? Materials 
cost per Materials cost for the period
i l f h i d
a. $1.84 = Materials equivalent units for the 
equivalent    
b. $2.40 unit period

c. $2.76 Conversion 
cost per Conversion cost for the period
d. $2.90 equivalent     = Conversion equivalent units for the 
unit period
4‐49

Equivalent Units of Production –
Equivalent Units of Production –
Departmental Production Report
Weighted‐‐Average Method
Weighted
 Analysis of
physical flow The weighted‐average method . . .
of units.
 Calculation – Makes no distinction between work done in the 
of equivalent prior period and work done in the current period.
units.
– Blends together units and costs from the prior 
Blends together units and costs from the prior
 Computation
of unit costs. period and the current period.

 Analysis of
total costs. The FIFO method is a more
complex method and is
rarely used in practice.

4‐51

Production Report Example Production Report Example
Work in process, March 1:   20,000 units Cost 
Materials: 100% complete. $  50,000
• MVP Sports Equipment Company makes baseball gloves in two  Conversion: 10% complete. 7,200
departments, Cutting and Stitching.  Units started into production in March: 30,000 units
Units completed and transferred out in March: 40,000 units
• MVP uses the weighted‐average cost procedure. Work in process, March 31:   10,000 units
Materials 100% complete.
• Material
Material is added at the beginning of the Cutting Department, 
is added at the beginning of the Cutting Department Conversion p
50% complete.
and conversion is incurred uniformly throughout the process. Costs incurred during March
Materials cost 90,000
• Using the following information for the month of March, let’s  Conversion costs:
Direct labor $  86,000
prepare a production report for the Cutting Department.  Applied manufacturing overhead  107,500
Total conversion costs 193,500
Total costs to account for $  340,700

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Production Report Example Production Report Example
 Analysis of Physical Flow of Units  Calculation of Equivalent Units
Conversion Equivalent Units
Physical Physical Percentage Direct
Units Units Complete Material Conversion
Work in process,
process March 1 20 000
20,000
Units started during March Work in process, March 1 20,000 10%
Units started during March 30,000
Total units to account for 50,000 50% of ________ units
Total units to account for 50,000

Units completed and transferred out during March 40,000 Units completed and transferred 40,000 100% 40,000 40,000
Work in process, March 31 Work in process, March 31 10,000 50%
Total units accounted for 50,000 Total units accounted for 50,000
Total equivalent units 50,000

Beginning inventory % is not used in weighted‐average method.

Production Report Example Production Report Example
 Computation of unit costs  Analysis of total costs
Direct Cost of goods completed and transferred during March
40,000 units x $7.26 per equivalent unit $ 290,400
Material Conversion Total
Work in Process, March 1 $ 50,000 $ 7,200 $ 57,200 Costs remaining in work-in-process on March 31
Costs incurred during March 90,000 193,500 283,500 Di
Direct
t Material:
M t i l
10,000 equivalent units x $2.80 per equivalent unit
Total costs to account for $ 140,000 $ 200,700 $ 340,700
Convserion:
Equivalent units 50,000 45,000
5,000 equivalent units x $4.46 per equivalent unit
Cost per equivalent unit
Total cost of March 31 work-in-process 50,300
Total costs accounted for All costs 
accounted for
$140,000 ÷ 50,000 equivalent units
$____ + $_____
$200,700 ÷ 45,000 equivalent units

Tutorial Preparation 
• Read Horngren et al., (2nd ed) chapters 
2 and 5
• Homework Questions: 2.33, 2.35, 5.16, 
Homework Questions: 2 33 2 35 5 16
5.28, 5.40
• UNSEEN TUTORIAL QUESTION
• Computer Assignment.

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