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10/28/2015 Cost and Cost Classifications | Types | Managerial Accounting
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AccountingExplained
Cost and Cost Classifications
Cost is a sacrifice of resources to obtain a benefit or any other resource. For example in production of acar, we sacrifice material, electricity, the value of machine's life (depreciation), and labor wages etc. Thusthese are our costs.
Costs are usually classified as follows:
Product Costs Vs. Period Costs
Product costs are costs assigned to the manufacture of products and recognized for financial reportingwhen sold. They include direct materials, direct labor, factory wages, factory depreciation, etc.
Period costs are on the other hand are all costs other than product costs. They include marketing costsand administrative costs, etc.
Breakup of Product Costs
The product costs are further classified into:
Direct materials: Represents the cost of the materials that can be identified directly with theproduct at reasonable cost. For example, cost of paper in newspaper printing, cost of
Direct labor: Represents the cost of the labor time spent on that product, for example cost ofthe time spent by a petroleum engineer on an oil rig, etc.
Manufacturing overhead: Represents all production costs except those for direct labor anddirect materials, for example the cost of an accountant's time in an organization, depreciation onequipment, electricity, fuel, etc.
The product costs that can be specifically identified with each unit of a product are called direct productcosts. Whereas those which cannot be traced to a specific unit are indirect product costs. Thus directmaterial cost and direct labor cost are direct product costs whereas manufacturing overhead cost isindirect product cost.
Prime Costs Vs. Conversion Costs
Prime costs are the sum of all direct costs such as direct materials, direct labor and any other direct costs.
Conversion costs are all costs incurred to convert the raw materials to finished products and they equalthe sum of direct labor, other direct costs (other than materials) and manufacturing overheads.
Cost Classification Diagram
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Fixed Costs Vs. Variable Costs
Fixed costs are costs which remain constant within a certain level of output or sales. This certain limitwhere fixed costs remain constant regardless of the level of activity is called relevant range. For example,depreciation on fixed assets, etc.
Variable costs are costs which change with a change in the level of activity. Examples include directmaterials, direct labor, etc.
Sunk Costs Vs. Opportunity Costs
The costs discussed so far are historical costs which means they have been incurred in past and cannotbe avoided by our current decisions. Relevant in this regard is another cost classification, called sunkcosts. Sunk costs are those costs that have been irreversibly incurred or committed; they may also betermed unrecoverable costs.
In contrast to sunk costs are opportunity costs which are costs of a potential benefit foregone. Forexample the opportunity cost of going on a picnic is the money that you would have earned in that time.
Written by Obaidullah Jan, ACA, CFA
Managerial Accounting
Managerial Accounting Intro
Cost Classifications
Product and Period Costs
Direct and Indirect Costs
Prime and Conversion Costs
Relevant vs Irrelevant Costs
Cost Accounting Systems
Cost Allocation
10/28/2015 Cost and Cost Classifications | Types | Managerial Accounting
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Cost Behavior Analysis
CostVolumeProfit Analysis
Relevant Costing
Capital Budgeting
Master Budget
Inventory Management
Standard Costing
Performance Measurement
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10/28/2015 Cost Accounting Systems | Managerial Accounting
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AccountingExplained
Cost Accounting Systems
A cost accounting system (also called product costing system or costing system) is a framework used byfirms to estimate the cost of their products for profitability analysis, inventory valuation and cost control.
Estimating the accurate cost of products is critical for profitable operations. A firm must know whichproducts are profitable and which ones are not, and this can be ascertained only when it has estimatedthe correct cost of the product. Further, a product costing system helps in estimating the closing value ofmaterials inventory, workinprogress and finished goods inventory for the purpose of financial statementpreparation.
There are two main cost accounting systems: the job order costing and the process costing.
Job order costing is a cost accounting system that accumulates manufacturing costs separately foreach job. It is appropriate for firms that are engaged in production of unique products and special orders.For example, it is the costing accounting system most appropriate for an event management company, aniche furniture producer, a producer of very high cost air surveillance system, etc.
Process costing is a cost accounting system that accumulates manufacturing costs separately for eachprocess. It is appropriate for products whose production is a process involving different departments andcosts flow from one department to another. For example, it is the cost accounting system used by oilrefineries, chemical producers, etc.
There are situations when a firm uses a combination of features of both joborder costing and processcosting, in what is called hybrid cost accounting system.
In a cost accounting system, cost allocation is carried out based on either traditional costing system oractivitybased costing system.
Traditional costing system calculates a single overhead rate and applies it to each job or in eachdepartment.
Activitybased costing on the other hand, involves calculation of activity rate and application ofoverhead costs to products based on their respective activity usage.
Based on whether the fixed manufacturing overheads are charged to products or not, cost accountingsystems have two variations: variable costing and absorption costing. Variable costing allocates onlyvariable manufacturing overheads to inventories, while absorption costing allocates both variable andfixed manufacturing overheads to products. Variable costing calculates contribution margin, whileabsorption costing calculates the relevant gross profit.
Still further refinement to costing accounting systems include JITcosting, backflush costing.
Written by Obaidullah Jan, ACA, CFA
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Managerial Accounting
Managerial Accounting Intro
Cost Classifications
Cost Accounting Systems
Job Order Costing
Job Cost Sheet
Process Costing
Process Costing – AVCO
Equivalent Units – AVCO
Process Costing – FIFO
Equivalent Units – FIFO
ActivityBased Costing
Cost Allocation
Cost Behavior Analysis
CostVolumeProfit Analysis
Relevant Costing
Capital Budgeting
Master Budget
Inventory Management
Standard Costing
Performance Measurement
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10/28/2015 Cost Allocation | Concepts | Examples
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AccountingExplained
Cost Allocation
Cost allocation (also called cost assignment) is the process of finding cost of different cost objects such asa project, a department, a branch, a customer, etc. It involves identifying the cost object, identifying andaccumulating the costs that are incurred and assigning them to the cost object on some reasonable basis.
Cost allocation is important because it the process through which costs incurred in producing a certainproduct or rendering a certain service is calculated. If costs are not accurately calculated, a businessmight never know which products are making money and which ones are losing money. If cost aremisallocated, a business may be charging wrong price to its customers and/or it might be wastingresources on products that are wrongly categorized as profitable.
Mechanism
Typical cost allocation mechanism involves:
Identifying the object to which the costs have to be assigned,
Accumulating the costs in different pools,
Identifying the most appropriate basis/method for allocating the cost
Cost object
Cost object is an item for which a business need to separately estimate cost.
Examples of cost object include a branch, a product line, a service line, a customer, a department, abrand, a project, etc.
Cost pool
Cost pool is the account head in which costs are accumulated for further assignment to cost objects.
Examples of cost pools include factory rent, insurance, machine maintenance cost, factory fuel, etc.Selection of cost pool depends on the cost allocation base used. For example if a company uses just oneallocation base say direct labor hours, it might use a broad cost pool such as fixed manufacturingoverheads. However, if it uses more specific cost allocation bases, for example labor hours, machinehours, etc. it might define narrower cost pools.
Cost driver
Cost driver is any variable that ‘drives’ some cost. If increase or decrease in a variable causes an increaseor decrease is a cost that variable is a cost driver for that cost.
Examples of cost driver include:
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Number of payments processed can be a good cost driver for salaries of Accounts Payable sectionof accounting department,
Number of purchase orders can be a good cost driver for cost of purchasing department,
Number of invoices sent can be a good cost driver for cost of billing department,
Number of units shipped can be a good cost driver for cost of distribution department, etc.
While direct costs are easily traced to cost objects, indirect costs are allocated using some systematicapproach.
Cost allocation base
Cost allocation base is the variable that is used for allocating/assigning costs in different cost pools todifferent cost objects. A good cost allocation base is something which is an appropriate cost driver for aparticular cost pool.
Example
T2F is a university café owned an operated by a student. While it has plans for expansion it currentlyoffers two products: (a) tea & coffee and (b) shakes. It employs 2 people: Mr. A, who looks after tea &coffee and Mr. B who prepares and serves shakes & desserts.
Its costs for the first quarter are as follows:
Mr. A salary 16,000Mr. B salary 12,000Rent 10,000Electricity 8,000Direct materials consumed in making tea & coffee 7,000Direct raw materials for shakes 6,000Music rentals paid 800Internet & wifi subscription 500Magazines 400
Total tea and coffee sales and shakes sales were $50,000 & $60,000 respectively. Number of customerswho ordered tea or coffee were 10,000 while those ordering shakes were 8,000.
The owner is interested in finding out which product performed better.
Solution
Salaries of Mr. A & B and direct materials consumed are direct costs which do not need any allocation.They are traced directly to the products. The rest of the costs are indirect costs and need some basis forallocation.
Cost objects in this situation are the products: hot beverages (i.e. tea & coffee) & shakes. Cost poolsinclude rent, electricity, music, internet and wifi subscription and magazines.
Appropriate cost drivers for the indirect costs are as follows:
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Rent 10,000 Number of customersElectricity 8,000 United consumed by each productMusic rentals paid 800 Number of customersInternet & wifi subscription 500 Number of customersMagazines 400 Number of customers
19,700
Since number of customers is a good cost driver for almost all the costs, the costs can be accumulatedtogether to form one cost pool called manufacturing overheads. This would simply the cost allocation.
Total manufacturing overheads for the first quarter are $19,700. Total number of customers who orderedeither product are 18,000. This gives us a cost allocation base of $1.1 per customer ($19,700/18,000).
A detailed cost assignment is as follows:
Tea & Coffee ShakesRevenue 50,000 60,000Costs: Salaries 16,000 12,000 Direct materials 7,000 6,000 Manufacturing overheads allocated 11,000 8,800Total costs 34,000 26,800Profit earned 16,000 33,200
Manufacturing overheads allocated to Tea & Cofee = $1.1×10,000
Manufacturing overheads allocated to Shakes = $1.1×8,000
Written by Irfanullah Jan
Managerial Accounting
Managerial Accounting Intro
Cost Classifications
Cost Accounting Systems
Cost Allocation
Service Dept. Cost Allocation
Repeated Distribution Method
Simultaneous Equation Method
Specific Order of Closing Method
Direct Allocation Method
Joint Cost Allocation Methods
Cost Behavior Analysis
CostVolumeProfit Analysis
Relevant Costing
Capital Budgeting
Master Budget
10/28/2015 Cost Allocation | Concepts | Examples
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Inventory Management
Standard Costing
Performance Measurement
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10/28/2015 Job Order Costing | Steps | Journal Entries | Example
http://accountingexplained.com/managerial/costsystems/jobordercosting 1/4
AccountingExplained
Job Order Costing
Job order costing is a cost accounting system in which direct costs are traced and indirect costs areallocated to unique and distinct jobs instead of departments. It is appropriate for businesses that providenonuniform customized products and services.
Job order costing is one of the two main cost accounting systems, the other being the process costing inwhich costs are traced and allocated first to different processes carried out in different departments andthen to products and services. Many companies use costing systems that are a blend of features of bothjoborder costing and process costing systems.
Companies that use joborder costing
Some of the companies that use joborder costing include:
Accounting, consulting and legal firms
Architects
Manufacturers of ships and airplanes
Book publishers
Movie producers
The nature of their work is such that they are interested in finding profitability of different jobs and hencethey accumulate costs with reference to different jobs like audit engagement, consulting projects, books,movies, etc.
Steps in joborder costing process
In a joborder costing system, jobs are accounted for using the joborder cost sheet. The process involvesthe following steps:
1. Identification of the job
2. Tracing direct costs to the job
3. Identifying the indirect costs i.e. manufacturing overheads and finding the cost allocation base foreach cost.
4. Applying the indirect costs to the job using the predetermined allocation rate.
5. Finding total cost by summing up all the cost components.
6. Closing the under/overapplied manufacturing overheads to cost of goods sold/income statement.
7. Calculating revenue and profit.
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Journal entries: example
Dynamic Systems Inc. (DS) received an order to manufacture a customized airplane for the official use ofthe president of Pakistan. DS will charge an amount equal to the cost of the airplane plus a 30% profitmargin on cost to the government of Pakistan. The job code is PK03.
Since the manufacture of the airplane is a oneoff project, joborder costing is the most appropriate costaccumulation system. Let us post the required journal entries in the DS costing system.
1. DS purchased raw materials (such as aluminum, fiber, etc.) at a cost of $4 million.
Material inventory $4,000,000
Accounts payable $4,000,000
2. $2.8 million worth of raw materials were used in the project as direct materials.
Work in process—PK03 $2,800,000
Inventories $2,800,000
3. $0.4 million worth of raw materials were used as indirect materials.
Manufacturing overheads $400,000
Inventories $400,000
4. Total direct labor hours consumed on the job cost $3 million. The amount is already paid.
Work in process—PK03 $3,000,000
Cash $3,000,000
5. Indirect labor hours relevant to the project cost $1 million.
Manufacturing overheads $1,000,000
Cash $1,000,000
6. Other indirect costs yet to be paid were $2.5 million.
Manufacturing overheads $2,500,000
Accounts payable $2,500,000
7. Manufacturing overheads are charged to jobs at 100% of direct labor cost i.e. $3,000,000.
Work in process—PK03 $3,000,000
Manufacturing overheads $3,000,000
8. The cost of PK03 is transferred from work in progress to finished goods on its completion at total cost of$8,800,000 (=direct materials cost of $2,800,000 plus direct labor cost of $3,000,000 and appliedmanufacturing overheads of $3,000,000).
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Finished goods $8,800,000
Work in process—PK03 $8,800,000
9. Revenue is recorded at $11,440,000 [= $8,800,000 × 1.3].
Accounts receivable $11,440,000
Revenue $11,440,000
10. Actual manufacturing overheads are $3,900,000 (=indirect materials of $400,000 plus indirect laborof $1,000,000 and other overheads of $2,500,000). Applied manufacturing overheads are $3,000,000.The $900,000 worth of manufacturing overheads underapplied is taken to the cost of goods sold orincome statement.
Cost of goods sold $900,000
Manufacturing overheads $900,000
Profit on PK03 is $1,700,000 (=revenue of $11,440,000 minus finished goods of $8,800,000 and underapplied overheads adjustment of $900,000).
Written by Obaidullah Jan, ACA, CFA
Managerial Accounting
Managerial Accounting Intro
Cost Classifications
Cost Accounting Systems
Job Order Costing
Job Cost Sheet
Process Costing
Process Costing – AVCO
Equivalent Units – AVCO
Process Costing – FIFO
Equivalent Units – FIFO
ActivityBased Costing
Cost Allocation
Cost Behavior Analysis
CostVolumeProfit Analysis
Relevant Costing
Capital Budgeting
Master Budget
Inventory Management
Standard Costing
Performance Measurement
Accounting Explained
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10/28/2015 Process Costing | Steps | Journal Entries | Example
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AccountingExplained
Process Costing
Process costing is a cost accounting system in which direct costs are traced and indirect costs areallocated to processes carried out in different departments. The cost of finished goods is then computedbased on average cost accumulated at the end of the last department.
Unlike joborder costing, which is another widelyused costing system, process costing averages out costsover all departments and values the finished products and closing work in process, if any, using either thefirstinfirstout (FIFO) or weightedaverage convention.
Companies that use process costing
Process costing is appropriate for companies that produce standardized products in large quantities. Sincethe products are very similar in nature, different departments specialize in different processes. In suchsituation, it is more efficient to accumulate costs at the process/department level and hence the name.Examples include oil refineries, paint and chemical manufacturers, fast moving consumer goods (FMCG)producers, etc.
Steps in process costing
Process costing involves preparing a process cost sheet using the following steps:
1. Preparing the quantity schedule to account for the number of units.
2. Finding the percentage of completion of units in closing work in process and calculating equivalentunits using FIFO or weighted average convention, whichever is relevant.
3. Accumulating costs brought forward from previous department, if any, and costs incurred in currentdepartment, including manufacturing overheads.
4. Finding cost per equivalent unit.
5. Valuing units transferred to finished goods and units in closing work in process at the cost perequivalent unit and their relevant percentage of completion.
Journal entries
International Chemicals (IC) is engaged in preparation of affordable quality paints by exploiting economiesof scale. It has four departments: pigment dispersing, letdown, testing and canning. Let us post somehypothetical journal entries for IC's process costing.
1. Assume $10,000 worth of pigments and resins are introduced in pigment dispersing department asdirect materials.
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Work in Process—pigment dispersing $10,000
Raw materials $10,000
2. 50 hours of direct labor @ $25 per hour are used.
Work in Process—pigment dispersing $1,250
Payroll/wagespayable $1,250
3. Manufacturing overheads are allocated to each department at $500 per direct labor hour worked.
Work in Process—pigment dispersing $25,000
Manufacturing Overheads $25,000
4. Actual manufacturing overheads are $24,250.
Manufacturing Overheads $24,250
Payables/Cash $24,250
5. Total cost of pigment dispersing department which comes to be $36,250 ($10,000 + $1,250 +$25,000), is transferred to let down department.
Work in Process—let down $36,250
WIP—pigment dispersing $36,250
6. Total cost of pigment dispersing department are debited to work in process account for letdowndepartment using scheme of journal entries given from 14 and the accumulated cost is then transferredto testing department and so on till the finished goods are transferred out from canning department tofinished goods account.
Written by Obaidullah Jan, ACA, CFA
Managerial Accounting
Managerial Accounting Intro
Cost Classifications
Cost Accounting Systems
Job Order Costing
Job Cost Sheet
Process Costing
Process Costing – AVCO
Equivalent Units – AVCO
Process Costing – FIFO
Equivalent Units – FIFO
ActivityBased Costing
Cost Allocation
10/28/2015 Process Costing | Steps | Journal Entries | Example
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Cost Behavior Analysis
CostVolumeProfit Analysis
Relevant Costing
Capital Budgeting
Master Budget
Inventory Management
Standard Costing
Performance Measurement
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10/28/2015 Process Costing – FIFO Method | Steps | Example
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AccountingExplained
Process Costing – FIFO Method
Under the FIFO method of process costing, costs are transferred to next department and ultimately tofinished goods in the order in which they entered the current department i.e. costs entering first aretransferred first and hence the name FIFO–firstinfirstout.
Unlike the weighted average method, the FIFO method does not involve any averaging out of the totalcosts incurred during a period. It moves the cost of beginning work in process (including the costsincurred in current period) straight to cost of units transferred out and distributes the costs added duringthe period first to the cost of units transferred out and the rest to the cost of units in the ending work inprocess.
FIFO method involves following steps, majority of which are the same as in weighted average method:
Preparing the quantity schedule: i.e. reconciling units in the beginning work in process, unitsadded/started during the period, units transferred out and units in ending WIP.
Bringing forward the cost of ending WIP of last period as cost of beginning work in process of thecurrent period.
Bringing forward the percentage of completion of the ending WIP of last period.
Finding the costs brought forward from previous department and cost added in the currentdepartment under different heads: direct materials and conversion costs.
Finding units started/added and completed during the current period.
Finding total equivalent units.
Finding cost per equivalent unit for each cost component.
Allocating the cost between units transferred out and ending WIP.
Example
Let us use the same example as in the article on process costing under weighted average method.
Prepare a cost of production report for the packaging department of Company ABC for the month ofDecember 2013 under FIFO method of process costing. Important information is reproduced here.
20,000 units in work in process as at 1 December: $20,000 of direct materials and $40,000 ofconversion costs (i.e. $10,000 direct labor and $30,000 manufacturing overheads). 100% of thedirect materials cost and 40% of the conversion cost have been incurred in last period on theseunits.
200,000 units transferred in from production department during the month: at a total cost of$555,000.
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Costs added included: direct materials of $22,000 and conversion costs of $20,000.
180,000 units transferred to finished goods.
40,000 units in work in process as at 31 December: 100% complete as to costs transferredin,80% complete as to materials and 50% complete as to conversion costs.
Solution
The first step is the preparation of quantity schedule.
As at 1 December 20,000Transferred in 200,000Units to be accounted for 220,000Transferred out from units from 1 December 20,000Units both started and completed during the current period 160,000Units transferred out 180,000As at 31 December 40,000Units accounted for 220,000
Now, calculate the equivalent units:
Transferredin
DirectMaterials
ConversionCosts
Units in beginning WIP (A) 0 20,000 20,000% of completion of beginning WIP in previous period (B) 0% 100% 40%% of beginning WIP completed this period [C=100%B] 100% 0% 60%Equivalent units in beginning WIP [D=A×C] 12,000Units both started and completed in current period (E) 160,000 160,000 160,000Units of ending WIP (F) 40,000 40,000 40,000Percentage of completion of ending WIP (G) 100% 80% 50%Equivalent units in ending WIP (H=F×G) 40,000 32,000 20,000Total equivalent units (D+E+H) 200,000 192,000 192,000
Next, find cost per equivalent unit.
Transferredin
DirectMaterials
ConversionCosts
Total
Costs (I) $555,000 $22,000 $20,000 $597,000Total equivalent units (J) 200,000 192,000 192,000Cost per equivalent unit (I/J) $2.775 $0.1146 $0.1042 $2.993
We need to find the cost of units transferred out. Since we are using FIFO method, we first include theentire beginning WIP in the cost of units transferred out and then include units started/added during theperiod.
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Cost of beginning WIP brought forward from last period (K) $60,000Transferredin costs [(100%100%)*20,000*2.775] (L) $Direct materials [(100%100%)*20,000*0.1146] (M) $Conversion costs [(100%40%)*20,000*0.1042] (N) $1,250Cost incurred on beginning WIP in current period (O=L+M+N) $1,250Beginning WIP (P=K+O) $61,250Cost of units started and completed in current period (2.993*160,000) (Q) $479,000Cost of units transferred out (P+Q) $540,250
Cost of units in ending work in process comes from units added during the period:
Transferredin
DirectMaterials
ConversionCosts
Total
Units as at 31 December (R) 40,000 40,000 40,000 40,000Cost per equivalent unit (S) $2.775 $0.1146 $0.1042 $2.993Percentage of completion (T) 100% 80% 50%Total cost (R×S×T) $111,000 $3,667 $2,083 $116,750
It can also be calculated using the shortcut formula given below
Cost of ending WIP =Cost of Beginning WIP + Costs Transferredin + Costs Added in Current Department − Costs Transferredout
Value of ending WIP based on this formula is:
Cost of ending WIP = $60,000 + $555,0000 + $42,000 − $540, 250 = 116,750
We can summarize the cost movement using the cost schedule given below:
Cost to be accounted for Accounted for asBeginning WIP 60000 Transferred out 540,250Cost transferred in 555000 Closing WIP 116,750Cost addedMaterials 22000Conversion 20000
42000Total 657000 Total 657,000
Written by Obaidullah Jan, ACA, CFA
Managerial Accounting
Managerial Accounting Intro
Cost Classifications
Cost Accounting Systems
Job Order Costing
10/28/2015 Process Costing – FIFO Method | Steps | Example
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Job Cost Sheet
Process Costing
Process Costing – AVCO
Equivalent Units – AVCO
Process Costing – FIFO
Equivalent Units – FIFO
ActivityBased Costing
Cost Allocation
Cost Behavior Analysis
CostVolumeProfit Analysis
Relevant Costing
Capital Budgeting
Master Budget
Inventory Management
Standard Costing
Performance Measurement
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10/28/2015 Process Costing – Weighted Average Method | Steps | Example
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AccountingExplained
Process Costing – Weighted Average Method
Process costing system is used for standardized production processes. Whenever a process cost sheet isprepared for a department, the department most likely has some unfinished units either in its beginningwork in process, closing work in process or both. In such a situation, it is important to determine a costflow assumption, i.e. to agree on the order in which costs are transferred out to the next department.There are two costflow assumptions: firstinfirstout (FIFO) and weighted average.
In the weighted average method of process costing, the costs are averaged out and evenly applied to bothunits transferred out and units in closing work in process. Unlike FIFO method, which assumes costsintroduced first into a department are transferred out first, weighted average method does not assumeany specific order.
Process costing under weightedaverage method involves the following steps:
1. Preparing the quantity schedule: i.e. finding units in the beginning work in process for the period,units started or units transferredin from prior departments, units transferred out to nextdepartment or units of finished goods, and units in closing work in process.
2. Bringing forward the cost of units in the beginning work in process from last period. The cost shouldbe broken up into all its components: direct materials and conversion costs (=direct labor andmanufacturing overheads).
3. Finding the costs added in the current department under different heads: direct materials, directlabor and manufacturing overheads.
4. Finding total cost to be accounted for under each head i.e. direct materials, direct labor andmanufacturing overheads. This would involve adding the cost included in the opening work inprocess on account of direct materials, direct labor and manufacturing overheads to thecorresponding amounts added during the period on account of the relevant cost component.
5. Finding total equivalent units.
6. Finding cost per equivalent unit for each cost component by dividing the total cost for the costcomponent by total equivalent units for the relevant cost component.
7. Allocating the cost between the units transferred out and units included in the closing work inprocess.
Example
Let us prepare a process cost sheet under weighted average method using the following data forCompany ABC's packaging department for the month of December 2013.
20,000 units in work in process as at 1 December: $20,000 direct materials and $40,000 forconversion costs (i.e. $10,000 direct labor and $30,000 manufacturing overheads)
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200,000 units transferred in from production department during the month: at a total cost of$555,000.
Costs added included: direct materials of $22,000 and conversion costs of $20,000.
180,000 units transferred to finished goods
40,000 units in work in process as at 31 December: 100% complete as to costs transferredin,80% complete as to materials and 50% complete as to conversion costs.
Solution
Let us prepare the quantity schedule.
As at 1 December 20,000Transferred in 200,000Units to be accounted for 220,000Transferred out 180,000As at 31 December 40,000Units accounted for 220,000
Next, calculate the equivalent units.
Transferredin
DirectMaterials
ConversionCosts
Transferred out (A) 180,000 180,000 180,000Units as at 31 December (B) 40,000 40,000 40,000Percentage of completion (C) 100% 80% 50%Equivalent units as at 31 Dec (D=B×C) 40,000 32,000 20,000Total equivalent units (A+D) 220,000 212,000 200,000
Next, calculate the cost per equivalent unit.
Transferredin
DirectMaterials
ConversionCosts
Total
As at 1 December $0 $20,000 $40,000 $60,000Added during the month $555,000 $22,000 $20,000 $597,000Costs to be accounted for $555,000 $42,000 $60,000 $657,000Total equivalent units 220,000 212,000 200,000Cost per equivalent unit $2.52 $0.20 $0.30 $3.02
Now, we need to find the cost of units transferred out. It equals $543,600 [= $3.02 × 180,000].
We also need the figure for cost of work in process as at 31 December. It can be calculated as shown inthe table below.
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Transferredin
DirectMaterials
ConversionCosts
Total
Units as at 31 December (A) 40,000 40,000 40,000 40,000Cost per equivalent unit (B) $2.52 $0.20 $0.30 $3.02Percentage of completion (C) 100% 80% 50%Total cost (A×B×C) 100,909 6,340 6,000 113,249
Since cost of opening WIP plus cost added must equal cost transferred out and cost in closing WIP, thecost of closing WIP can be calculated using as shortcut formula given below:
Cost of closing WIP = Costs to be Accounted for − Costs Transferred Out
In this example, it turns out a figure of $113,400 (total cost to be accounted for of $657,000 minuscosts transferred out of $543,600). The minor difference is due to rounding off.
The final process cost sheet should look like as follows:
Company ABCPackaging DepartmentCost of Production Report
Dec13QUANTITY SCHEDULEAs at 1 December 20,000Transferred in 200,000Units to be accounted for 220,000Transferred out 180,000As at 31 December 40,000Units accounted for 220,000
COST SCHEDULEDirect materials 20,000Conversion costs 40,000As at 1 December (A) 60,000Coststransferred in (B) 555,000Direct materials 22,000Conversion costs 20,000Costs added (C) 42,000Total costs to be accounted for (A+B+C) 657,000Transferred to finished goods (D) 543,751Costs transferredin 100,909Direct materials 6,340Conversion costs 6,000As at 31 December (E) 113,249Total costs accounted for (D+E) 657,000
Written by Obaidullah Jan, ACA, CFA
Managerial Accounting
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Managerial Accounting Intro
Cost Classifications
Cost Accounting Systems
Job Order Costing
Job Cost Sheet
Process Costing
Process Costing – AVCO
Equivalent Units – AVCO
Process Costing – FIFO
Equivalent Units – FIFO
ActivityBased Costing
Cost Allocation
Cost Behavior Analysis
CostVolumeProfit Analysis
Relevant Costing
Capital Budgeting
Master Budget
Inventory Management
Standard Costing
Performance Measurement
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AccountingExplained
Equivalent Units – FIFO Method
Equivalent units under FIFO method are the number of finished units that could have been prepared in aprocess during a period had there been no unfinished units, either in opening WIP or closing WIP.
Under the FIFO cost flow assumption, it is assumed that the costs that enter first in the department exitfirst. The consequence of this assumption is that the cost of units transferred out first includes the cost ofopening WIP and then the cost of units added during the period. The cost of opening WIP is carrieddirectly to the units transferred out. Equivalent units are relevant only for costs incurred during theperiod: which includes costs incurred on completing the opening WIP (i.e. the unfinished part), costincurred on units started/added and transferred out and cost incurred on units in closing work in process.
Formula
Equivalent units under FIFO method are calculated using the following formula:
Equivalent units for each cost component = (100% − A) × B + C + D × E
Where,A = percentage of completion at the end of last periodB = units in opening work in processC = units added/started and transferred outD = percentage of completion of units in closing work in processE = units in closing work in process
Example
Calculate equivalent units under FIFO method using the data given below:
Units in opening work in process 10,000Units added 190,000Units transferred out 195,000Units in closing work in process 5,000Percentage of completion of opening WIP–direct materials 80%Percentage of completion of opening WIP–conversion costs 40%Percentage of completion of closing WIP–direct materials 100%Percentage of completion of closing WIP–conversion costs 60%
Solution
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Direct Materials Conversion CostsUnits in beginning WIP (A) 10,000 10,000% of completion of beginning WIP in previous period (B) 80% 40%% of beginning WIP completed this period [C=100%B] 20% 60%Equivalent units in beginning WIP [D=A×C] 2,000 6,000Units started and completed in current period 185,000 185,000Units closing WIP (E) 5,000 5,000% of completion of closing WIP (F) 100% 60%Equivalent units in closing WIP (G=E×F) 5,000 3,000Total equivalent units 192,000 194,000
Written by Obaidullah Jan, ACA, CFA
Managerial Accounting
Managerial Accounting Intro
Cost Classifications
Cost Accounting Systems
Job Order Costing
Job Cost Sheet
Process Costing
Process Costing – AVCO
Equivalent Units – AVCO
Process Costing – FIFO
Equivalent Units – FIFO
ActivityBased Costing
Cost Allocation
Cost Behavior Analysis
CostVolumeProfit Analysis
Relevant Costing
Capital Budgeting
Master Budget
Inventory Management
Standard Costing
Performance Measurement
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AccountingExplained
Equivalent Units – Weighted Average Method
Equivalent units are the number of finished units that would have been prepared had there been nopartially completed units in a process.
The concept of equivalent units is applicable to process costing. Since processes are continuous, when acost of production report is prepared, the unfinished units in the opening work in process or closing workin process are assigned an estimated percentage of completion. Based on this percentage of completion,number of equivalents units is calculated in order to find cost per completed unit.
Formula
The calculation of equivalent units depends on the cost flow assumption used i.e. the calculation isdifferent for firstinfirstout and weighted average. In the weighted average method, total equivalentunits for the process for a period are calculated using the following formula.
Total equivalent units for a cost component = A + B × C
WhereA = units transferred out to the next department/finished goodsB = units in closing work in processC = percentage of completion with respect to the relevant cost component
Example
Calculate total equivalents units using the following information.
Units in opening work in process 10,000Units added 190,000Units transferred out 195,000Units in closing work in process 5,000% of completion of closing WIP–direct materials 100%% of completion of closing WIP–conversion costs 60%
Solution
Total equivalent units–direct materials = 190,000 + 5,000 × 100% = 195,000
Total equivalent units–conversion costs = 190,000 + 5,000 × 60% = 193,000
Written by Obaidullah Jan, ACA, CFA
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Managerial Accounting
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Managerial Accounting Intro
Cost Classifications
Cost Accounting Systems
Job Order Costing
Job Cost Sheet
Process Costing
Process Costing – AVCO
Equivalent Units – AVCO
Process Costing – FIFO
Equivalent Units – FIFO
ActivityBased Costing
Cost Allocation
Cost Behavior Analysis
CostVolumeProfit Analysis
Relevant Costing
Capital Budgeting
Master Budget
Inventory Management
Standard Costing
Performance Measurement
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AccountingExplained
ActivityBased Costing
Activitybased costing is a method of assigning indirect costs to products and services which involvesfinding cost of each activity involved in the production process and assigning costs to each product basedon its consumption of each activity.
Activitybased costing is more refined approach to costing products and services than the traditionalcosting method. It involves the following steps:
Identification of activities involved in the production process;
Classification of each activity according to the cost hierarchy (i.e. into unitlevel, batchlevel,product level and facility level);
Identification and accumulation of total costs of each activity;
Identification of the most appropriate cost driver for each activity;
Calculation of total units of the cost driver relevant to each activity;
Calculation of the activity rate i.e. the cost of each activity per unit of its relevant cost driver;
Application of the cost of each activity to products based on its activity usage by the product.
Cost Hierarchy
The first step in activitybased costing involves identifying activities and classifying them according to thecost hierarchy. Cost hierarchy is a framework that classifies activities based the ease at which they aretraceable to a product. The levels are (a) unit level, (b) batch level, (c) product level, and (d) facility level.
Unit level activities are activities that are performed on each unit of product. Batch level activities areactivities that are performed whenever a batch of the product is produced. Product level activities areactivities that are carried out separately for each product. Facility level activities are activities that arecarried out at the plant level. The unitlevel activities are most easily traceable to products while facilitylevel activities are least traceable.
Example
Alex Erwin started Interwood, a niche furniture brand, 10 years ago. He ran the business as a soleproprietorship. While he has 50 skilled carpenters and 5 salesmen on his payroll, he has been taking careof the accounting by himself. Now, he intends to offer 40% of the ownership to public in next coupleyears, and is willing to make changes and has hired you as the management accountant to organize andimprove the accounting systems.
Interwood's total budgeted manufacturing overheads cost for the current year is $5,404,639 andbudgeted total labor hours are 20,000. Alex applied traditional costing method during all of the 10 years
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period, and based the predetermined overhead rate on total labor hours.
Interwood's sofa range includes the 2set, 3set and 6set options. Platinum Interiors recently placed anorder for 150 units of the 6set type. The order is expected to be delivered in 1 month time. Since it is acustomized order, Platinum will be billed at cost plus 25%.
You are not a fan of traditional product costing system. You believe that the benefits of activitybasedcosting system exceeds its costs, so you sat down with Aaron Mason, the chief engineer, to identify theactivities which the firm undertakes in its sofa division. Next, you calculated the total cost that goes intoeach activity, identified the cost driver that is most relevant to each activity and calculated the activityrate. The results are summarized below:
Activity A (in $) Relevant Cost Driver B C=A/B (in $)Production of components 2,313,132 Machine hours 25,000 93Assembly of components 1,231,312 Number of labor hours 20,000 62Packaging 213,123 Units 5,000 43Shipping 231,230 Units 5,000 46Setup costs 34,243 Number of setups 240 143Designing 123,132 Designer hours 1,000 123Product testing 24,234 Testing hours 500 48Rent 1,234,233 Labor cost $1,645,644 75%
Once the order was ready for packaging, Aaron gave you a summary of total cost incurred and astatement of activities performed (also called the bill of activities) as shown below:
Order No: 15X2013Customer: Platinum Interiors
Units: 150Type: 6 unitAmounts in $
Cost of direct materials 25,000Cost of purchased components 35,000Labor cost 15,600 Activity Relevant Cost Driver Activity UsageProduction of components Machine hours 320Assembly of components Number of labor hours 250Packaging Units 150Shipping Units 150Setup costs Number of setups 15Designing Designer hours 70Testing Testing hours 22Rent Labor cost 4500
Part A
Calculate the total cost of the order and the invoice value of the order based on traditional costingsystem.
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Solution
In the traditional costing system, cost equals materials cost plus labor cost plus manufacturing overheadscharged at the predetermined overhead rate.
The predetermined overhead rate based on direct labor hours = $5,404,639/20,000 = $270 per laborhour
The actual number of labor hours spent on the order is 250. Once we have this data, we can estimate themanufacturing overheads and the total cost as follows:
Direct materials 25,000Purchased components 35,000Labor cost 15,600Manufacturing overheads ($270 × 250) 67,500Total cost under traditional product costing system 143,100
Platinum is billed at cost plus 25%, so the amount of sales to be booked would amount to $178,875 (=$143,100 × 1.25).
Part B
You know activitybased costing is a more refined approach. Now, since you have all the data needed,calculate the order cost using activity based costing.
Solution
In activitybased costing, direct materials cost, cost of purchased components and labor cost remains thesame as in traditional product costing. However, the value of manufacturing overheads assigned is moreaccurately estimated. The following worksheet estimates the manufacturing overheads that should beassigned to the order of Platinum Interiors:
(A) (B) (A × B)Activity Activity Rate Activity Usage Activity Cost AssignedProduction of components 93 320 29,760Assembly of components 62 250 15,500Packaging 43 150 6,450Shipping 46 150 6,900Setup costs 143 15 2,145Designing 123 70 8,610Product testing 48 22 1,056Rent 75% 15,600 11,700
82,121
Total cost of the order is hence:
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US$Direct materials 25,000Purchased components 35,000Labor cost 15,600Manufacturing overheads 82,121Total cost under activitybased costing 157,721
Based on the more accurate estimation of the order cost, the invoice should be raised at $197,150(=$157,721 × 1.25) instead of $178,875 calculated under traditional product costing system.
The example highlights the importance of correct estimation of the product cost and the usefulness ofactivitybased costing in achieving that goal.
Written by Obaidullah Jan, ACA, CFA
Managerial Accounting
Managerial Accounting Intro
Cost Classifications
Cost Accounting Systems
Job Order Costing
Job Cost Sheet
Process Costing
Process Costing – AVCO
Equivalent Units – AVCO
Process Costing – FIFO
Equivalent Units – FIFO
ActivityBased Costing
Cost Allocation
Cost Behavior Analysis
CostVolumeProfit Analysis
Relevant Costing
Capital Budgeting
Master Budget
Inventory Management
Standard Costing
Performance Measurement
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AccountingExplained
Cost Volume Profit Analysis
CostVolumeProfit (CVP) analysis is a managerial accounting technique that is concerned with the effectof sales volume and product costs on operating profit of a business. It deals with how operating profit isaffected by changes in variable costs, fixed costs, selling price per unit and the sales mix of two or moredifferent products.
CVP analysis has following assumptions:
1. All cost can be categorized as variable or fixed.
2. Sales price per unit, variable cost per unit and total fixed cost are constant.
3. All units produced are sold.
Where the problem involves mixed costs, they must be split into their fixed and variable component byHighLow Method, Scatter Plot Method or Regression Method.
CVP Analysis Formula
The basic formula used in CVP Analysis is derived from profit equation:
px = vx + FC + Profit
In the above formula, p is price per unit; v is variable cost per unit; x are total number of units produced and sold; and FC is total fixed cost
Besides the above formula, CVP analysis also makes use of following concepts:
Contribution Margin (CM)
Contribution Margin (CM) is equal to the difference between total sales (S) and total variable cost or, inother words, it is the amount by which sales exceed total variable costs (VC). In order to make profit thecontribution margin of a business must exceed its total fixed costs. In short:
CM = S − VC
Unit Contribution Margin (Unit CM)
Contribution Margin can also be calculated per unit which is called Unit Contribution Margin. It is theexcess of sales price per unit (p) over variable cost per unit (v). Thus:
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Unit CM = p − v
Contribution Margin Ratio (CM Ratio)
Contribution Margin Ratio is calculated by dividing contribution margin by total sales or unit CM by priceper unit.
Written by Irfanullah Jan
Managerial Accounting
Managerial Accounting Intro
Cost Classifications
Cost Accounting Systems
Cost Allocation
Cost Behavior Analysis
CostVolumeProfit Analysis
BEP Equation Method
BEP Contribution Method
Sales Mix Breakeven Point
Contribution Margin
Target Income Sales
Margin of Safety
Degree of Operating Leverage
Absorption Costing
Target Costing
Costplus Pricing
Variable Costing
Relevant Costing
Capital Budgeting
Master Budget
Inventory Management
Standard Costing
Performance Measurement
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