Management Accounting:

A Road of Discovery
 Management Accounting:
A Road of Discovery
James T. Mackey
Michael F. Thomas

Presentations by:

Roderick S. Barclay
Texas A&M University - Commerce

James T. Mackey
California State University - Sacramento
© 2000 South-Western College Publishing
Chapter 5

How do things really work?

Accumulating product
costs
 Key Learning Objectives
1. Discuss how work traditionally
has been organized and how
cost accounting measures work
efficiently.
3. Prepare a predetermined
overhead rate and justify its
allocation base.
5. Describe how WIP is organized
in a job costing system and
calculate a job’s cost.
2. List the source documents
required for direct cost
assignment.
4. Explain the need for equivalent
units and calculate the average
department cost per equivalent
unit in a process costing
system.
6. [Appendix A] distinguish
between service and line
departments, and justify the
need for departmental PORs.
 PART I
SCIENTIFIC MANAGEMENT AND
THE ECONOMIES OF
SPECIALIZATION
Well Engineered Processes
 Identify and break down complex processes
into small sets of subtasks.
 Design each task to be easy to learn quickly
to lower the skills required.
 Create functionally specialized departments to
reduce the variety of skills required.
 Cheap, low skilled workers are easily replaced
and become a variable cost.
Each Production Subtask Uses the Same
Sequential Activities

 Move-wait-setup-run-quality inspection
 Run is the production task
 Move and wait are coordination activities
 Setup activities adjust machines for different
products
 Quality inspections occur as needed (or desired)
 Management skill is needed to coordinate
activities
 Fixed costs are need to support this system
 ‘Keeping busy’ reduces unit costs
 Multree’s Sawing Department Production
Cycle — an Illustration

 Management Activities  Operations Activities

 MOVE—Order lumber from  MOVE—Forklift truck
raw materials inventory moves lumber to Sawing
 WAIT—Have lumber available  WAIT—Lumber stacked
when saw is ready next to saw
 SETUP—Order sent to  SETUP—Specialists set up
Machining Department for machines (saws) for the
saw setup specialist specific work needed
 RUN—Schedule workers  RUN—Saw lumber
 MOVE—Order sawed lumber  MOVE—Forklift truck
to be moved to WIP storage moves lumber to stock
area yard
Management of Uncertainty
[Coordination and Control]
 Dealing with low skills, poor quality materials, and
unreliable machines
 Limits to the size of functional departments by the
‘span of management control’
 How many workers can the expert supervise?
 Example. Suppose the expert can answer 2
questions an hour. If each worker asks one
question per shift, then the expert can manage 16
workers. As variety or uncertainty increases, more
questions are asked and the effective span of
control for the supervisor decreases.
 Decreasing uncertainty and variety or increasing
worker skills increases the span of control.
 The opposite conditions result in the opposite effect
Coordination Using Slack & Buffers to
Manage Uncertainty
 Allows room for variation
 Variety is the number of different tasks required
 Increasing variety means workers are required to
know how to perform more different tasks.
 Example: Learning to do one task takes 10 minutes.
Learning 3 tasks takes 30 minutes plus another 10
minutes learning how to coordinate each pair of
tasks. 3 tasks can be combined in 3 ways for another
30 minutes. As tasks increase, learning gets more
expensive.
 Move-Wait-Setup-Run to Make Chairs—
An Illustration of Slack and Buffers
3 Tasks: Cut wood, Paint wood & Assemble the
chair
M-W-S Runs M-W-S Run M-W-S Run
30 min 2 hrs 30 min 2 hrs 30 min 2 hrs
Cut wood Paint wood Assembly

Move-wait-setup [M-W-S] takes 30 minutes on average

between each run activity.

Scheduling:
Perfect operations [no slack] = 7.5 hours
Practical operations [slack] = 9 hours
More Considerations— Slack and Buffers
 WIP inventory buffers allow piles of extra WIP stock
in front of each activity to assure components are
always available. Thus workers can keep busy
regardless of when components are delivered or their
quality.
 Buffers and slack allow functional departments to
operate more-or-less independently. If this is true,
then maximizing the efficiency of each separate
department should maximize the efficiency of the
company as a whole.
 The Management Problem:
Managing Uncertainties

The uncertainty Examples Solutions

 Unreliable  Missed delivery dates,
deliveries wrong materials received,
wrong amounts received
 Unreliable  Machine breakdowns,
machinery inconsistent output quality
 Product quality  Bad raw materials, bad
problems WIP, bad final products
 Labor  Poorly educated, poorly
problems motivated
 Fluctuating  Actual orders change after
product scheduled to be built and/or
demand production started
 Extra raw materials inventory
 Extra machines, extra
machine time, extra WIP,
extra finished goods
 Extra raw materials, extra
WIP inventory, extra finished
goods inventory
 Simplify tasks, allow extra
time for each task, hire extra
workers
 Extra raw materials, extra
WIP and finished goods
inventory
Management Using Cost and Profit Centers
 Role of accounting using this management
philosophy
 Costing products as they flow through the
production process—raw materials, work in
process inventories, and finished goods (this
chapter).
 Providing information to support decisions within
functional departments (Chapter 7).
 Helping management control to ‘get people to
do what you want them to do’. Accounting
accumulates and assigns costs to departments
and responsible managers.
 PART II
COSTING SYSTEMS
• TERMS DEVELOPED TO COST PRODUCTS
• MEASURING THE FLOW OF COSTS
• PROCESS COSTING SYSTEMS
• JOB COSTING SYSTEMS
Terms Developed to Cost Products
 GAAP requires that all manufacturing
costs be applied to, or absorbed into,
the products made. All
nonmanufacturing costs are applied to
the time period where they are
consumed.
Illustration of GAAP Rules
 Product Costs
 Full manufacturing costs applied to inventory accounts. All
manufacturing costs ‘absorbed’ into inventory values
 Manufacturing functions
 Direct costs—Can be physically traced to individual products
 Direct materials
 Direct labor
 Relatively accurate assignment of costs
 Period Costs
 All other costs related to being in business
 Nonmanufacturing functions
 Indirect costs—Are necessary to make products but difficult
to trace to individual products
 Indirect overhead costs
 This approach is a source of error since costs are assigned
(allocated) to products using estimates through
predetermined overhead rates
Predetermined Overhead Rates
(Volume Based)
 NOTE: This is the first of several slides
discussing and illustrating this concept.
Predetermined Overhead Rate =
Indirect Overhead Cost
Predicted Volume of Activity

 The logic: The overhead costs are incurred to support a

specified level of capacity or production ‘volume’ within
our relevant range.
 There the ‘cause and effect’ argument is to allocate
overhead costs by the ‘volume of capacity’ consumed or
used.
 Capacity is measured by many different volume related
measures in practice, I.e., direct labor hours, machine
hours, etc.
For Example:
Indirect overhead budgeted is $1,000,000 and 50,000
direct labor hours are needed to make the budgeted
production.

Predetermined overhead rate = $1,000,000

50,000 DLHs
= $20 per DLH
Thus for the chair we made earlier, the overhead
assigned is based upon the 6 runtime hours. The
overhead assigned is $120 (6 hours x $20).
Illustration: Assigning Manufacturing
Costs to Chairs
 Each chair is assigned three product costs: Direct
materials, Direct labor, and Indirect overhead costs.
Given the predetermined overhead rate is $20,
assume direct materials costs $80 and the direct
labor rate is $12 per hour.
 Costs assigned to each chair by the accounting
system is:
 Direct materials $ 80
 Direct labor (6 hrs @ $12) 72
 Manufacturing overhead (6 hrs @ $20) 120
 Unit cost $272

 For finished goods, each chair is costed at $272

Illustration Continued
 Go back to the Move-Wait-Setup-Run flow illustration for
chairs shown earlier.
 What do you think the work in process Inventory cost
should be for a semi-finished chair that has been cut and
painted buy not yet assembled?
 There is a lot of variation in how these costs are applied
to inventories in practice. However, for GAAP purposes,
any ‘full or absorption’ costing systems that apply all the
manufacturing costs in a consistent logical manner is
acceptable. We will examine two approaches — Process
and Job Costing.
 Costing procedures in practice vary dramatically from
company to company. Overhead can be applied based on
departmental and company wide rates. The discussion
here is simplified. Our presentation is designed to give
you insight into the underlying concepts.
 PART 2
MEASURING THE FLOW OF COSTS
THROUGH THE COMPANY
Measuring Cost Flows
 As work is completed, Costs are absorbed in
the cost objects (WIP inventories). The
products are like a wave absorbing the costs
that are transforming the product as it flows
through the company.
The Accounting System
 Is designed to assign manufacturing costs to
WIP.
 Includes documentation and a set of
accounts.
 Usually each functional department is a cost
center.
 For each function, like sawing, painting, and
assembly summary sets of accounts are used
to accumulate coast and assign them to
products.
Some Commonly Used Documents
 Purchase orders to authorize the purchase and
receipt of materials.
 Receiving reports to document that we have received
the materials and authorize payment.
 Material requisitions to track the movement of
materials within the company and trace materials to
products.
 Time cards to directly trace labor costs to products.

Note: Refer to Exhibit 5-8, p.153 of your text to

view a flow diagram of Multree’s
manufacturing process.
 PART 3
PROCESS COSTING SYSTEMS
Process Costing Systems
— Basic Concepts
 When each product is manufactured in the same
manner, we can use process costing (homogeneity).
 A key concept is an equivalent unit. This means the
work in two units half finished is equal to the work in
one finished unit.
 Another concept is that the resources needed to
make a product are not consumed uniformly. That is,
all the materials may be added at the beginning of
the work, while direct labor and overhead are applied
uniformly to convert the materials to a finished
product Conversion costs).
 Pattern of Resource Use
Equivalent Units vs. Percentage of Completion

Direct Labor Direct Material Overhead

Applied Applied at the Applied using

uniformly beginning of the Direct Labor
process hours
 Diagram Analysis and Discussion
 From these drawings, when a product is half
done it has consumed.
 Equivalent units of direct labor = .5 E.U.’s
 Equivalent units of direct materials = 1.0 E.U.’s
 Equivalent units of overhead = .5 E.U.’s
 A WIP unit that is half done has the same
materials as one finished unit and half the
direct labor and overhead as a finished unit.
Steps in Process Costing
 Determine the number of input factors needed.
 Determine the equivalent units of each input used.
 Calculate the costs of each input consumed in
production.
 Calculate the cost per equivalent unit of each input.
Cost per E.U. of direct labor = Direct labor costs
E.U.s of direct labor
 Using equivalent unit costs, assign the appropriate
costs to the goods finished and the WIP
Illustration
 Background
 Let’s develop the assignment of the costs for work
done in the painting department. During the
month costs are accumulated for each
department. For accounting purposes we need to
allocate these costs to products worked on each
month. How can we use process costing to assign
costs to inventories? Transferred out WIP
inventories are sent to the assembly department
to be finished. WIP inventories remain in the
department at the end of the accounting period.
Step One:
 Determine the number of input factors
needed.
 The components for each chair are painted at the
same time. The paint is requisitioned at the
beginning of the run activity.
 Painting is applied at the beginning of the process
by direct labor workers.
 Overhead costs are accumulated for the painting
department and assigned to products based upon
direct labor hours.
Step Two:
 Determine the equivalent units of each input.
 Information must be gathered about the status of
current WIP and the number of painted chair
component packages (units) transferred to the
assembly department during the period examined
 The records show 65 units were transferred this
month. After examining the WIP, workers
estimated that the 10 component packages in
process wee 60% done.
 (Calculations follow on the next slide.)
Step Two: (Continued)

Equivalent units for materials =

=
= 75 Equivalent units of materials

Equivalent units for direct labor & overhead

(conversion costs) =
=
=
= 71 equivalent units
Step Three:
 Calculate the costs of each input consumed in
production.
 All the overhead costs gathered for the month
plus all the direct labor costs add up to 44,544.
The costs transferred in from the sawing
department plus the paint requisitioned for the
month adds up to $12,600.
Step Four:
 Calculate the cost per equivalent unit for each
input.

 Cost per E.U. of materials =

 Cost per E.U. of conversion costs =

Step Five:
 Using equivalent unit costs, assign the appropriate
cost to the goods finished and WIP
Costs assigned to the 10 component packages in WIP
=
=
= $2,064

Costs assigned to the 65 packages (units) transferred

out to assembly
=
=
= $15,080
Process Costing Can Be Almost Infinitely
Complex
 What would happen to our calculations if we
started with WIP?
 How would we calculate the costs of spoilage
and waste if we want to record it separately?
 How would you track costs if you use LIFO,
FIFO, or Weighted Average?
 How difficult would this be if the costs varied
due to variation in the quality of materials,
labor, and breakdowns occurred?
 PART 4
JOB COSTING SYSTEMS
Job Costing—General
 Process costing systems are good enough for
products that consume the same resources
but when products consume resources
differently, job costing systems are needed.
 Job costs systems have documents that track
costs to individual jobs not departments. Each
job can be assigned a unique combination of
costs.
 WIP Subsidiary Ledger Accounts in
Job Costing Systems
WIP Job 101 WIP Job 245 WIP Job 347
Direct materials
Lumber $ 8,000 $7,500 $10,500
Sheetrock 1,500 900 2,100
Cabinets 5,000 3,500
Appliances 3,250
Other costs 8,500
Direct Labor
Sawing 1,250 1,000 1,125
Framing 1,725 1,400 2,175
Wiring 1,475 1,200 1,750
Plumbing 1,350 2,500 3,000
Other costs 19,200
Applied O/H @$4.74 11,850 2,891 3,816
Total job cost $63,100
Ending balance $0 $20,891 $24,466
An Illustration
 Suppose each chair (or job lot of chairs)
is custom designed. Materials, painting,
and assembly costs are influenced by
the product design.
 The painting department uses job
costing.
 Direct labor rates are still $12 per hour
and the POR rate is still $20 per direct
labor hour.
Three Jobs were Worked on During the
Period:
 Job 111 (20 units) =  Beginning WIP cost is $4,000.
40 direct labor hours are used
to finish the job.
 Job 122 (3 units) =  This job was started and
finished this period. The
transferred in costs from
sawing were $2,200 each. No
additional materials were
added, but it took 120 labor
hours to finish the job.
 Job 122 (10 units) =  This job took 10 units from
sawing costed at $200 each. It
was not finished and only 10
hours of work had been
applied this month.
Calculation of Costs Assigned to Each Job
Job 111 (20 units)
Beginning work in process $4,000
+ Direct labor costs (40 x $12) 480
+ Overhead applies (40 x $20) 800
Total Costs $5,280

Cost per unit = ($5,280/20) = $264

Job 121 (3 units)

Transferred in direct materials ($2,200 x 3) $ 6,600
+ Direct labor (120 x $12) 1,440
+ Overhead (120 x $20) 2,400
Total Costs $10,440

Cost per unit = $10,440/3 = $3,480

Calculations: (Continued)

Job 122 (10 units) — Ending WIP

Transferred in direct materials
+ Direct labor
+ Overhead
Total costs

Ending Work in Process inventory = $2,820