costing systems: concepts and design issues
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Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
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Costing Systems:Concepts and Design Issues
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Learning Objective 1
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Product Costs
• Related to the purchase or manufacture of goods for resale.
• Assigned to inventory and cost of goods sold.
Period Costs• Related to selling and administrative operations.• Recognized as expenses in the same time period.
The Meaning of Cost
The use of valuable
resources, in order to achieve a stated purpose. In accounting, cost
is reported in monetary terms.
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Learning Objective 3
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Retailers . . . Buy finished goods.
Sell finished goods.
Manufacturers . . . Buy raw materials.
Produce and sell finished goods.
MegaLoMart
Comparing Service, Retail and Manufacturing Companies
Service firms . . . Provide a service that is
consumed when produced.
Have no inventories.
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Manufacturing Companies
The 3 major categories of manufacturing costs:
The 3 major categories of manufacturing costs:
Direct MaterialsRaw materials,
components, and other parts that
can be traced to a specific product.
Direct LaborPayments and
benefits for those employees who convert direct materials into
finished product.
Manufacturing Overhead
Indirect material
Indirect labor
Other overhead
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Manufacturing Companies
Prime Costs include:Prime Costs include:
Direct Materials Direct Labor Manufacturing Overhead
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Manufacturing Companies
Conversion Costs include:
Direct Materials Direct Labor Manufacturing Overhead
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Stages of Production and the Flow of Costs
Raw MaterialsBeg. Inventory
Add: Purchases= Raw Materials
Available for Production
Less: Raw Materials Transferred to Production
= Ending Inventory
Work-In-ProcessBeg. WIP Inventory
Add: Raw Materials Transferred InDirect LaborManufacturing Overhead
= Total Manufacturing Costs Incurred
Less: Cost of Goods Completed and Transferred to Finished Goods
= Ending WIP Inventory
Finished GoodsBeg. Inventory
Add: Cost of Goods Completed and Transferred from WIP
= Goods Available for Sale
Less: Cost of Goods Sold= Ending Inventory
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Stages of Production and the Flow of Costs - Example
Raw MaterialsBeg. Inventory
Add: Purchases= Raw Materials
Available for Production
Less: Raw Materials Transferred to Production
= Ending Inventory
What is Ending What is Ending Inventory in Inventory in February?February?
Axel Electronics makes toasters. On February 1, Axel has $15,000 of raw material on hand. Axel’s purchase and transfers to the production floor
are indicated below.
DateCost of
PurchasesCost of
TransfersFeb 3 $ 8,000 $ 5,000 Feb 10 12,000 11,000 Feb 15 14,000 7,000 Feb 20 6,000 Feb 22 9,000 Feb 27 16,000
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Axel Electronics makes toasters. On February 1, Axel has $15,000 of raw material on hand. Axel’s purchase and transfers to the production floor
are indicated below.
Stages of Production and the Flow of Costs - Example
Now let’s look at Work-in-Process.
Raw Materials$15,000
Add: 43,000= $58,000
Less: 45,000= $13,000
DateCost of
PurchasesCost of
TransfersFeb 3 $ 8,000 $ 5,000 Feb 10 12,000 11,000 Feb 15 14,000 7,000 Feb 20 6,000 Feb 22 9,000 Feb 27 16,000
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Stages of Production and the Flow of Costs - Example
What is the amount of cost transferred to
Finished Goods in February?
Work-In-ProcessBeg. WIP Inventory
Add: Raw Materials Transferred InDirect LaborManufacturing Overhead
= Total Manufacturing Costs Incurred
Less: Cost of Goods Completed and Transferred to Finished Goods
= Ending WIP Inventory
Raw Materials$15,000
Add: 43,000= $58,000
Less: 45,000= $13,000
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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Stages of Production and the Flow of Costs - Example
Work-In-Process$30,000
Add: 45,00092,000
138,000= $305,000
Less: 283,000= $22,000
Raw Materials$15,000
Add: 43,000= $58,000
Less: 45,000= $13,000
Now let’s look at
Finished Goods.
Transferred to Finished
Goods
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.
150 % of $92,000
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Stages of Production and the Flow of Costs - Example
Work-In-Process$30,000
Add: 45,00092,000
138,000= $305,000
Less: 283,000= $22,000
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?
Raw Materials$15,000
Add: 43,000= $58,000
Less: 45,000= $13,000
Finished GoodsBeg. Inventory
Add: Cost of Goods Completed and Transferred from WIP
= Goods Available for Sale
Less: Cost of Goods Sold= Ending Inventory
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Stages of Production and the Flow of Costs - Example
Work-In-Process$30,000
Add: 45,00092,000
138,000= $305,000
Less: 283,000= $22,000
Raw Materials$15,000
Add: 43,000= $58,000
Less: 45,000= $13,000
Finished Goods$125,000
Add: 283,000= $408,000
Less: 312,000= $96,000
On February 1, Axel had Finished Goods of $125,000 on hand. At the end of February, a physical inventory count
revealed $96,000 in Finished Goods still on hand.What was Cost of Goods Sold for February?
Cost of goods sold
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Learning Objective 2
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Schedule of Cost of Goods Manufactured
Let’s look at aSchedule of Cost of
Goods Manufactured forCollegePak Company.
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CollegePak CompanySchedule of Cost of Goods Manufactured
Raw material used 850,000$ Direct labor 700,000 Total manufacturing overhead 1,850,000 Total manufacturing costs 3,400,000$ Add: Work-in-process inventory, January 1 350,000 Subtotal 3,750,000$ Deduct: Work-in-process inventory, December 31 400,000 Cost of goods manufactured 3,350,000$
Schedule of Cost of Goods Manufactured
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CollegePak CompanySchedule of Cost of Goods Manufactured
Raw material used 850,000$ Direct labor 700,000 Total manufacturing overhead 1,850,000 Total manufacturing costs 3,400,000$ Add: Work-in-process inventory, January 1 350,000 Subtotal 3,750,000$ Deduct: Work-in-process inventory, December 31 400,000 Cost of goods manufactured 3,350,000$
Schedule of Cost of Goods Manufactured
Computation of Cost of Raw Material Used
Raw-material inventory, January 1 200,000$ Add: Purchases of raw materials 800,000 Raw material available for use 1,000,000 Deduct: Raw material inventory, December 31 150,000 Raw material used 850,000$
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CollegePak CompanySchedule of Cost of Goods Manufactured
Raw material used 850,000$ Direct labor 700,000 Total manufacturing overhead 1,850,000 Total manufacturing costs 3,400,000$ Add: Work-in-process inventory, January 1 350,000 Subtotal 3,750,000$ Deduct: Work-in-process inventory, December 31 400,000 Cost of goods manufactured 3,350,000$
Schedule of Cost of Goods Manufactured
Include all direct labor costs incurred during the
current period.
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CollegePak CompanySchedule of Cost of Goods Manufactured
Raw material used 850,000$ Direct labor 700,000 Total manufacturing overhead 1,850,000 Total manufacturing costs 3,400,000$ Add: Work-in-process inventory, January 1 350,000 Subtotal 3,750,000$ Deduct: Work-in-process inventory, December 31 400,000 Cost of goods manufactured 3,350,000$
Schedule of Cost of Goods Manufactured
Beginning work-in-process inventory is carried over from the
prior period.
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CollegePak CompanySchedule of Cost of Goods Manufactured
Raw material used 850,000$ Direct labor 700,000 Total manufacturing overhead 1,850,000 Total manufacturing costs 3,400,000$ Add: Work-in-process inventory, January 1 350,000 Subtotal 3,750,000$ Deduct: Work-in-process inventory, December 31 400,000 Cost of goods manufactured 3,350,000$
Schedule of Cost of Goods Manufactured
Ending work-in-process inventory contains the cost of unfinished goods, and is reported in the current assets
section of the balance sheet.
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Now let’s look at an income statement for CollegePak.
Income Statement for a Manufacturer
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Income Statement for a Manufacturer
CollegePak CompanyIncome Statement
For the Year Ended December 31, 20X2Sales revenue 4,500,000$ Less: Cost of goods sold 2,810,000 Gross margin 1,690,000$ Selling and administrative expenses 1,440,000 Operating profit before taxes 250,000$
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CollegePak CompanyIncome Statement
For the Year Ended December 31, 20X2Sales revenue 4,500,000$ Less: Cost of goods sold 2,810,000 Gross margin 1,690,000$ Selling and administrative expenses 1,440,000 Operating profit before taxes 250,000$
Income Statement for a Manufacturer
CollegePak CompanySchedule of Cost of Goods Sold
For the Year Ended December 31, 20X2
Finished-goods inventory, Jan. 1 920,000$ Add: Cost of goods manufactured 3,350,000 Cost of goods available for sale 4,270,000 Deduct Finished-goods inventory, Dec. 31 1,460,000 Cost of goods sold 2,810,000$
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Production Costs in the Service Sector
A service provider cannot “inventory” its services.
The costs of providing the service can be identified and measured, just as occurs in manufacturing industries.
Managing and tracking the costs associated with value-chain activities can point to opportunities for improvement.
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Cost Drivers
An “activity” is any discrete task that an
organization undertakes to make or deliver a good or
service.A “cost driver” is
incurred.
A “cost driver” is some characteristic of the activity that causes costs to be
incurred.
Number ofcomputers made by
Dell in a day
Number offlights by Southwest
Airlines in a given market
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Learning Objective 4
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Cost behavior means how a cost will react to changes in the level of business activity. Total variable costs
change when activity level changes.
Total fixed costs remain unchanged when activity level changes.
Cost Behavior
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Your total long distance telephone billis based on how many minutes you talk.
Minutes Talked
Tota
l Lon
g D
ista
nce
Tele
phon
e Bi
ll
Total Variable Cost Example
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Minutes Talked
Per M
inut
eTe
leph
one
Cha
rge
The cost per long distance minute talked isconstant. For example, 5 cents per minute.
Variable Cost Per Unit Example
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Your monthly basic telephone bill probably does not change when you
make more local calls.
Number of Local Calls
Mon
thly
Bas
ic
Tele
phon
e Bi
ll
Total Fixed Cost Example
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Number of Local Calls
Mon
thly
Bas
ic T
elep
hone
Bi
ll pe
r Loc
al C
all
The average cost per local calldecreases as more local calls are made.
Fixed Cost Per Unit Example
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Summary of Variable and Fixed Cost BehaviorCost In Total Per Unit
Variable
Fixed
Changes proportionately with changes in activity within the
relevant range.
Remains constant for each additional unit as long as activity
is in the relevant range.
Remains the same even when activity changes within the
relevant range.
The per unit amount changes each time the level of activity
changes due to the fixed nature of the related costs.
Cost Behavior Summary
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Directly traceable to the decision toproduce the level
of output
Cost Hierarchy
Includes direct material, direct labor, utilities to run equipment, other overhead directly related to
the production process.
Costs that are incurred for every unit of product manufactured or service produced.
Unit-level Costs
All unit level costs are variable, but notall variable costs are unit level costs.
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Batch-level Costs
Costs that are incurred for batch of product manufactured or service produced.
Includes setup costs, material-handling costs related to delivering raw material to the
production line, etc.
Cost Hierarchy
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Product-level Costs
Costs that are incurred for each line of product or service.
Includes design costs for product lines and marketing costs for each product line.
Cost Hierarchy
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Facility-level Costs
Costs that are incurred to maintain the organization’s overall facility and infrastructure.
Includes production manager’s salary, plant depreciation, and insurance on the facility and
equipment.
Cost Hierarchy
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Learning Objective 5
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DiscretionaryEasier to alter in the
short term by current managerial decisions.
CommittedLong-term obligations, difficult to change in
the short term.
Rental and/or Lease Financing of Buildings and
equipment
Advertising and Research and Development
Committed and Discretionary Costs
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The potential benefit that is given up whenone alternative is selected over another.
If you were not attendingcollege, you could beearning $20,000 per year.Your opportunity cost ofattending college forone year is $20,000.
Opportunity Costs
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Past payments for resources that cannot be changed by any current or future decision.
Sunk costs should not be considered in decisions.
Example: You bought an automobile for $12,000 two years ago. Whatever you do with the automobile in the future, you cannot nullify the original transaction. If it has a trade-in value, that value would become an opportunity cost in your future decisions.
Sunk Costs
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Direct Costs Costs that can be
traced easily and conveniently to a product or department.
Example: Cost of paint in the paint department of an automobile assembly plant.
Indirect Costs Costs that need to be
allocated, before they can be assigned to a product or department.
Example: Cost of national advertising for an airline is indirect to a given flight or route.
Traceability of Resources
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Learning Objective 6
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A system of accounting for costs in which both fixed and variable production costs
are included in product costs.
FixedCosts
VariableCosts
Product
Absorption (Full) Costing
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A system of cost accounting that assigns only the variable cost of production to products.
FixedCosts
VariableCosts
Product
Variable Costing
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Learning Objective 7
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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 vs. Variable Costing
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Let’s see what we can learn about the differences between absorption and variable costing by looking at a numerical example.
Absorption and Variable Costing
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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:
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Unit product cost is determined as follows:
Selling and administrative expenses arealways treated as period expenses and deducted from
revenue as they are incurred.
Absorption Costing vs. Variable Costing - Example
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Absorption CostingSales (28,000 × $40) 1,120,000$ Less cost of goods sold: Beginning inventory -$ Add COGM (30,000 × $19) 570,000 Goods available for sale 570,000 Ending inventory (2,000 × $19) 38,000 532,000 Gross margin 588,000 Less selling & admin. exp. Variable (28,000 x $4) 112,000$ Fixed 250,000 362,000 Net income 226,000$
Absorption Costing vs. Variable Costing - Example
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$
Variablecostsonly.
All fixedmanufacturing
overhead isexpensed.
Absorption Costing vs. Variable Costing - Example
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Cost of Goods Sold
Ending Inventory
Period Expense Total
Absorption costing Variable mfg. costs 336,000$ 24,000$ -$ 360,000$ Fixed mfg. costs 196,000 14,000 - 210,000
532,000$ 38,000$ -$ 570,000$
Variable costing Variable mfg. costs 336,000$ 24,000$ -$ 360,000$ Fixed mfg. costs - - 210,000 210,000
336,000$ 24,000$ 210,000$ 570,000$
Comparing Absorption andVariable Costing
Let’s compare the methods.
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We can reconcile the difference between absorption and variable net income as follows:
Variable costing net income 212,000$ Add: Fixed mfg. overhead costs deferred in inventory (2,000 units × $7 per unit) 14,000 Absorption costing net income 226,000$
Fixed mfg. overhead $210,000Units produced 30,000 = $7.00 per unit=
Reconciling Income
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Let’s look at the second
year ofoperations
for Howell, Inc.
Extending the Example
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In its second year of operations, Howell started with an inventory of 2,000 units, produced 30,000 units and sold
32,000 units at $40 each.
Howell Inc., Year 2
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Unit product cost is determined as follows:
There has been nochange in Howell’s
cost structure.
Howell Inc., Year 2
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Absorption CostingSales (32,000 × $40) 1,280,000$ Less cost of goods sold: Beg. inventory (2,000 x $19) 38,000$ Add COGM (30,000 × $19) 570,000 Goods available for sale 608,000$ Ending inventory - 608,000 Gross margin 672,000$ Less selling & admin. exp. Variable (32,000 × $4) 128,000$ Fixed 250,000 378,000 Net income 294,000$
Units in ending inventory from the previous period.
30,000 units produced in the current period.
Howell Inc., Year 2
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Variable CostingSales (32,000 × $40) 1,280,000$ Less variable expenses: Beg. inventory (2,000 × $12) 24,000$ Add COGM (30,000 × $12) 360,000 Goods available for sale 384,000$ Ending inventory - Variable cost of goods sold 384,000$ Variable selling & administrative expenses (32,000 × $4) 128,000 512,000 Contribution margin 768,000$ Less fixed expenses: Manufacturing overhead 210,000$ Selling & administrative expenses 250,000 460,000 Net income 308,000$
Howell Inc., Year 2
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In the first period, production (30,000 units)was greater than sales (28,000).
Income Comparison
Costing Method 1st Period 2nd Period TotalAbsorption 226,000$ 294,000$ 520,000$ Variable 212,000 308,000 520,000
In the second period, production (30,000 units)was less than sales (32,000).
For the two-year period, total absorptionincome and total variable income are the same.
Summary
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Learning Objective 8
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Fixed costs arenot really the costs
of any particularproduct.
VariableCosting
Variable versus Absorption Costing
AbsorptionCosting
All manufacturingAll manufacturingcosts must be assignedcosts must be assignedto products to properlyto products to properlymatch revenues andmatch revenues and
costs.costs.
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AbsorptionCosting
These are capacitycosts and will be
incurred even if nothingis produced.
VariableCosting
Depreciation,taxes, insurance andsalaries are just as
essential to productsas variable costs.
Variable versus Absorption Costing
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VariableCosting
Absorptioncosting product costs
are misleading fordecision making.
They are the numbers that appear on our
external reports.
AbsorptionCosting
Variable versus Absorption Costing
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Variable versus Absorption Costing
Variable cost $10Fixed manufacturing overhead $100,000Units sold 10,000
Units Produced
Total Variable Cost
Fixed Manufacturing
Overhead
Total Manufacturing
Cost
Average Manufacturing
CostCost of
Goods Sold10,000 $100,000 $100,000 $200,000 20.00$ 200,000$ 12,000 $120,000 $100,000 $220,000 18.33$ 183,333$ 14,000 $140,000 $100,000 $240,000 17.14$ 171,429$ 16,000 $160,000 $100,000 $260,000 16.25$ 162,500$ 18,000 $180,000 $100,000 $280,000 15.56$ 155,556$ 20,000 $200,000 $100,000 $300,000 15.00$ 150,000$
Absorption CostingCost of goods sold decreases because production
exceeds sales, leaving a portion of fixedmanufacturing costs in inventory.
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Variable versus Absorption Costing
COGS for 10,000 units
$100,000
$150,000
$200,000
10,00
014
,000
18,00
022
,000
26,00
030
,000
34,00
0
Number of units produced
CO
GS
Absorption CostingCost of goods sold decreases because production
exceeds sales, leaving a portion of fixedmanufacturing costs in inventory.
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Throughput Costing
Productcost
Unit-levelspending fordirect costs
Unit-level costs are incurred every time a unit ofproduct is manufactured and will not be incurred
again until the next unit is manufactured.
Indirect, past or committed
costs
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Example
In an automated process direct material may bethe only unit-level cost and so is the only product cost.
All other manufacturing costs are expensed as period costs.
Incentive tooverproduceis reduced
Average unit cost doesnot vary with changesin production levels.
Advantages
Throughput Costing
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Learning Objective 9
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Intentional Overproduction of Inventory
Absorption costing: Excess inventory would include more fixed production costs, so that gross income for the period would be artificially higher.
An unethical manager would have an incentive to “produce for inventory” at the end of a period, in order to obtain a better looking bottom line.
Throughput costing: No such incentive would exist, since fixed production costs would be charged against operating income for the period.
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