Hilton Maher Selto. 2 Product Costing Systems Concepts and Design Issues McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved

Hilton • Maher • Selto

2Product Costing Systems

Concepts and Design Issues

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.

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Product Costs

The cost assigned to

goods that were either purchased or manufactured

for resale.

Product Costs

The cost assigned to

goods that were either purchased or manufactured

for resale.

Period Costs

Costs that are identified with the period in

which they are incurred.

Period Costs

Costs that are identified with the period in

which they are incurred.

The Meaning of “Cost”?

The sacrifice made, usually

measured by the resources given up, to achieve a

particular purpose.

The sacrifice made, usually

measured by the resources given up, to achieve a

particular purpose.

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Manufacturing Companies

There are 3 major categories of manufacturing costs:

There are 3 major categories of manufacturing costs:

Direct Materialsresources that can be feasibly observed being used to make a

specific product.

Direct Materialsresources that can be feasibly observed being used to make a

specific product.

Direct LaborThe cost of

paying employees who convert direct materials into

finished product.

Direct LaborThe cost of

paying employees who convert direct materials into

finished product.

Manufacturing Overhead


Indirect materialIndirect material

Indirect laborIndirect labor

Other overheadOther overhead

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Prime Costs include:Prime Costs include:

Direct MaterialsDirect Materials Direct LaborDirect Labor Manufacturing Overhead


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Conversion Costs include:Conversion Costs include:

Direct MaterialsDirect Materials Direct LaborDirect Labor Manufacturing Overhead


Nonmanufacturing Costs are all the costs not used to produce products.

Nonmanufacturing Costs are all the costs not used to produce products.

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Stages of Production and the Flow of Costs

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Stages of Production and the Flow of Costs - Example

What is Ending What is Ending Inventory in Inventory in February?February?

What is Ending What is Ending Inventory in Inventory in February?February?

Axel Electronics makes toasters. On Axel Electronics makes toasters. On February 1, Axel has $15,000 of raw February 1, Axel has $15,000 of raw material on hand. Axel’s purchase material on hand. Axel’s purchase

and transfers to the production floor and transfers to the production floor are indicated below.are indicated below.



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Now let’s look at Now let’s look at Work-in-Process.Work-in-Process.

Now let’s look at Now let’s look at Work-in-Process.Work-in-Process.

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What is the What is the amount of cost amount of cost transferred to transferred to

Finished Goods in Finished Goods in February?February?

What is the What is the amount of cost amount of cost transferred to transferred to

Finished Goods in Finished Goods in February?February?

On February 1, Axel had WIP of $30,000 on the factory floor.

During February, Axel paid $92,000 in direct labor wages. Overhead is applied

at 150% of direct labor. On 2/28,

$22,000 is still in WIP.





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Now let’s Now let’s look at look at

Finished Finished Goods.Goods.

Now let’s Now let’s look at look at

Finished Finished Goods.Goods.

Transferred Transferred to Finished to Finished

GoodsGoods

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On February 1, Axel had Finished Goods of $125,000 on hand. At the end of February, a physical inventory count revealed

$96,000 in Finished Goods still on hand.

What was Cost of Goods Sold for February?




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Production Costs in the Service Industry

A service provider cannot “inventory” services.

The costs of providing the service can be identified and accounted for just as in a manufacturing environment.

Managing and tracking the costs associated with value-chain activities can provide opportunities for improvement.

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Cost Drivers

An “Activity” is any discrete task than an organization

undertakes to make or deliver a good or

service.

An “Activity” is any discrete task than an organization

undertakes to make or deliver a good or

service.

A “cost driver” is an activity or event that causes costs to be

incurred .

A “cost driver” is an activity or event that causes costs to be

incurred .

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Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remainsproportional to the activity the same over wide ranges

level within the relevant range. of activity.

Fixed Total fixed cost remains the Fixed cost per unit goessame even when the activity down as activity level goes up.

level changes within therelevant range.

Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remainsproportional to the activity the same over wide ranges

level within the relevant range. of activity.

Fixed Total fixed cost remains the Fixed cost per unit goessame even when the activity down as activity level goes up.

level changes within therelevant range.

Cost BehaviorFixed vs. Variable

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Your total long distance telephone bill is based on how many minutes you talk.

Your total long distance telephone bill is based on how many minutes you talk.

Minutes Talked

To

tal L

on

g D

ista

nce

Tel

eph

on

e B

ill


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Minutes Talked

Per

Min

ute

Tel

eph

on

e C

har

ge

The cost per minute talked is constant. For example, 10 cents per minute.

The cost per minute talked is constant. For example, 10 cents per minute.


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Number of Local Calls

Mo

nth

ly B

asic

T

elep

ho

ne

Bill


Your monthly basic telephone bill is probably fixed and does not change when you make more local calls.

Your monthly basic telephone bill is probably fixed and does not change when you make more local calls.

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Number of Local CallsMo

nth

ly B

asic

Tel

eph

on

e B

ill p

er L

oca

l Cal

l


The fixed cost per local call decreases as more local calls are made.

The fixed cost per local call decreases as more local calls are made.

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componentscomponents

laborlabor

energyenergypartsparts

materialsmaterials

Resources that are acquired specifically for individual units of product or service


Unit-level Resources

Unit-level Resources

Directly traceable to the decision toproduce the level

of output

The Hierarchy of Costs

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Acquired as a result of the decision to make a group,or batch of similar products.

Acquired as a result of the decision to make a group,or batch of similar products.

Batch-levelBatch-level

MaterialsMaterials

Equipment Applicable to the BatchEquipment Applicable to the Batch

Specialized LaborSpecialized Labor


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Acquired as a result of the decision to produce andsell a specific product or service.

Acquired as a result of the decision to produce andsell a specific product or service.

Product-levelProduct-level

SoftwareSoftware

Personnel Applicable to that Product or ServicePersonnel Applicable to that Product or Service

Specialized EquipmentSpecialized Equipment


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Acquired as a result of the decision to serve specificcustomers.

Acquired as a result of the decision to serve specificcustomers.

Customer-levelCustomer-level

SoftwareSoftware

Personnel Dedicated to Specific CustomersPersonnel Dedicated to Specific Customers

Specialized EquipmentSpecialized Equipment


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Labor Force

Labor Force

ManagementManagementBuildingsBuildings

LandLand

Business

Support Services

Business

Support Services



Facility-level Facility-level


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Committed costs are fixed costs that are not intended to vary with production or sales volume.

Committed costs are fixed costs that are not intended to vary with production or sales volume.

If we get rid of John, we can

replace him with a new professor

making $20,000 a year less!

If we get rid of John, we can

replace him with a new professor

making $20,000 a year less!

That will certainly lower our budgeted

fixed costs.

That will certainly lower our budgeted

fixed costs.

Committed Costs, Opportunity Costs, & Sunk Costs

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Well, team, it looks like we are

gonna be working

overtime all week on this job.

Well, team, it looks like we are

gonna be working

overtime all week on this job.

Opportunity cost measures what is sacrificed when one alternative is chosen.

Opportunity cost measures what is sacrificed when one alternative is chosen.

And I passed up $95,000

with IBM for this?


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Sunk costs are past payments for resources that cannot be undone.

Sunk costs are past payments for resources that cannot be undone.

I don’t want to replace John. We just spent

$30,000 to train him on the new

equipment!

I don’t want to replace John. We just spent

$30,000 to train him on the new

equipment!

But don’t you see? That $30,000 is gone. It is

irrelevant to our decision.

But don’t you see? That $30,000 is gone. It is

irrelevant to our decision.


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Direct CostsAssigning resource costs to products and services through reliable observations and

documentation of resource use.

Direct CostsAssigning resource costs to products and services through reliable observations and

documentation of resource use.

Some products use more of a given resource than

others.

Some products use more of a given resource than

others.

Tracing is often more effective than using Average Cost, which assumes that each

product uses the same amount of each resource.

Tracing is often more effective than using Average Cost, which assumes that each

product uses the same amount of each resource.

Traceability of Resources

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Indirect CostsAttaching or assigning indirect costs to products,

services, or organizational units by some reasonable method of averaging.

Indirect CostsAttaching or assigning indirect costs to products,

services, or organizational units by some reasonable method of averaging.

Applied to costs that cannot be

efficiently traced.

Applied to costs that cannot be

efficiently traced.

Methods such as Activity-Based Costing result in more tracing and less

allocation.

Methods such as Activity-Based Costing result in more tracing and less

allocation.

Example

Traceability of Resources

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Tracing versus Allocating Costs - Example

Brickley, Inc. makes two products; bricks and play sand. The products are produced in two separate facilities, and the plant supervisors work at both plants. Allocate rent

and salaries based on revenues.

Brickley’s headquarters is downtown.

Brickley, Inc. makes two products; bricks and play sand. The products are produced in two separate facilities, and the plant supervisors work at both plants. Allocate rent

and salaries based on revenues.

Brickley’s headquarters is downtown.

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The brick operation consumes 70% of the material purchased. The play sand uses the remaining 30%.

Labor has an average cost of $10 per hour. The brick operation uses 21,000 labor hours. The play sand

operation uses 14,000 labor hours.

The company pays all utilities on one bill that goes to the headquarters. Headquarters allocates 50% of the utilities

cost to each product.

The brick operation consumes 70% of the material purchased. The play sand uses the remaining 30%.

Labor has an average cost of $10 per hour. The brick operation uses 21,000 labor hours. The play sand

operation uses 14,000 labor hours.

The company pays all utilities on one bill that goes to the headquarters. Headquarters allocates 50% of the utilities

cost to each product.


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Compute the missing values and information.

Compute the missing values and information.


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Sales Revenue is TRACED to each product based on the actual revenue each product generates.

Example: Sand Revenue = 30,000 tons × $90 per ton

Sales Revenue is TRACED to each product based on the actual revenue each product generates.

Example: Sand Revenue = 30,000 tons × $90 per ton


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Material and Labor are traced to each product based on how much of each resource each product uses.

Example; Bricks labor = 21,000 hours × $10 per hour

Material and Labor are traced to each product based on how much of each resource each product uses.

Example; Bricks labor = 21,000 hours × $10 per hour

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Supervisor salaries and rent are allocated on the basis of relative revenues. Approximately 35.7% goes to

Bricks. Approximately 64.3% goes to Sand.

Supervisor salaries and rent are allocated on the basis of relative revenues. Approximately 35.7% goes to

Bricks. Approximately 64.3% goes to Sand.

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The utilities are allocated from the home office with 50% of the utilities being charged to each product.

The utilities are allocated from the home office with 50% of the utilities being charged to each product.


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Variable Costing measures product cost by the unit-level resources

used.

Variable Costing measures product cost by the unit-level resources

used.

Absorption Costing allocates indirect costs to products

along with unit-level and variable costs.

Absorption Costing allocates indirect costs to products

along with unit-level and variable costs.

Income-Reporting Effects of Alternative Product-Costing Methods

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Absorption Costing

Variable Costing

Direct materialsDirect labor Product costs

Product costs Variable mfg. overhead

Fixed mfg. overheadPeriod costs

Period costs Selling & admin. exp.

Absorption Costing

Variable Costing

Direct materialsDirect labor Product costs

Product costs Variable mfg. overhead

Fixed mfg. overheadPeriod costs

Period costs Selling & admin. exp.

Income-Reporting Effects of Alternative Product-Costing Methods

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Absorption Costing vs. Variable Costing - Example

Howell, Inc. produces a single product with a sales price of $40 and the following cost information:

Howell, Inc. produces a single product with a sales price of $40 and the following cost information:

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Unit product cost is determined as follows:

Selling and administrative expenses arealways treated as period expenses and deducted from

revenue.

Selling and administrative expenses arealways treated as period expenses and deducted from

revenue.


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Howell, Inc. had no beginning inventory, produced 30,000 units and sold 28,000 units this year.

Howell, Inc. had no beginning inventory, produced 30,000 units and sold 28,000 units this year.

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Variable CostingSales (28,000 × $40) 1,120,000$ Less variable expenses: Beginning inventory -$ Add COGM (30,000 × $12) 360,000 Goods available for sale 360,000 Ending inventory (2,000 × $12) 24,000 Variable cost of goods sold 336,000 Variable selling & administrative expenses (28,000 × $4) 112,000 448,000 Contribution margin 672,000 Less fixed expenses: Manufacturing overhead 210,000$ Selling & administrative expenses 250,000 460,000 Net income 212,000$

Variable CostingSales (28,000 × $40) 1,120,000$ Less variable expenses: Beginning inventory -$ Add COGM (30,000 × $12) 360,000 Goods available for sale 360,000 Ending inventory (2,000 × $12) 24,000 Variable cost of goods sold 336,000 Variable selling & administrative expenses (28,000 × $4) 112,000 448,000 Contribution margin 672,000 Less fixed expenses: Manufacturing overhead 210,000$ Selling & administrative expenses 250,000 460,000 Net income 212,000$


Variablecostsonly.

Variablecostsonly.

All fixedmanufacturing

overhead isexpensed.

All fixedmanufacturing

overhead isexpensed.

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End of Chapter

Hu-man!

I will absorb

you!

Documents

Hilton Maher Selto. 2 Product Costing Systems Concepts and Design Issues McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved