ACT 600

Advanced Managerial
Accounting
CHAPTER
4
Accumulating and Assigning
Costs to Products

Learning Objectives

After studying this chapter, you

should be able to:
Describe the cost flows that
take place in manufacturing,
service, and retail organizations.
Understand the concepts of
direct and indirect costs and
appropriately classify a cost using
these concepts.
Develop indirect cost rates for
applying overhead costs to
products.

Two Cost Management Systems

Historically, two cost management
systems have been used to cost
products:
1.Job order costing and
2.Process costing.
The basic idea behind all costing
systems is to determine the cost that
products or services accumulate as
they consume organizational resources.
Cost management systems differ in
the way that they assign indirect costs
to cost objects.

Job Order System

Job order costing or job costing is a
system for assigning manufacturing
costs to an individual product or
batches of products.
Generally, the job order costing
system is used only when the
products manufactured are
sufficiently different from each other.
Since there is a significant variation in
the products manufactured, the job
order costing system will create a job
cost record for each item, job or
special order.
The job cost record will report the
direct materials and direct labor
actually used plus the manufacturing
overhead assigned to each job.

Process Costing System

Similar to Job Order Costing,

Process costing is a method for
collecting and assigning
manufacturing costs to the units
produced.
Processing cost is used when
nearly identical units are mass
produced.
(Job order costing is a method
used when the units
manufactured vary significantly

Manufacturing Organizations
Classify costs into three groups
1.direct materials, (from raw materials inventory),
2.direct labor, and
3.manufacturing overhead (machine time, factory
supplies).
These costs accumulate in work in process
inventory and are transferred to finished goods
when completed and to cost of goods sold when
the product is sold.

Retail Organizations
Retail organizations enter the cost of purchases into an
account that accumulates the cost of merchandise
inventory (approx. 80% of total cost).
Also important is the subsequent allocation of overhead
costs; (labor, depreciation, lighting, heating, etc.).
Costing attention focuses on how to allocate various
overhead costs to determine the cost of purchasing and
selling products, or department costs.

Service Organizations
Service organizations have employee pay as their
major cost item (approx. 80%). The focus here is to
determine the cost of a project.

Cost Classification

The first step in handling a cost is

to classify it as direct or indirect.
Direct costs are assigned directly
to the cost object.
The cost of the consumable
resource is a direct cost for that
cost object; e.g. the cost of
wood used to make a table in a
furniture factory is a direct cost
that would be assigned to the
table.
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Cost Classification
Indirect costs Most capacity-related
costs are indirect costs; (depreciation
on production equipment, rent of
warehouse).
Indirect costs are accumulated in an
indirect cost pool.
An appropriate portion of the indirect
cost is allocated from the cost pool to
the cost object.
In summary, the costs of consumable
resources are variable costs and almost
all variable costs are direct costs.
The costs of capacity resources are
fixed costs and almost all fixed costs
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are indirect costs.

Indirect Cost ClassificationManufacturing

A.Indirect costs can partly be fixed
manufacturing overhead: depreciation
on factory equipment, heating, lighting,
and supervisory salaries.
B.Indirect costs can also be variable
overhead cost: items such as machine
electricity use, indirect materials* and
machine supplies*.
*The latter two items can be considered
direct costs that individually are
immaterial and generally too costly
to trace to individual cost objects.
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Indirect Cost ClassificationManufacturing

Indirect costs incurred are

accumulated in one account and
those applied to work in process
are accumulated in an indirect
cost applied account.

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Cost Flows in a Manufacturing Organization

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Handling Indirect Cost in

Manufacturing Environment

Because the total indirect costs

for the year are not known until
after the year end,
organizations allocate indirect
costs to production during the
year based on predetermined
indirect cost rates
The first step is to determine
the basis, (often called the
cost driver), that will be used
to allocate the indirect cost to
production.

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Handling Indirect Cost in Manufacturing

Environment
In a labor-intensive environment the cost
driver of indirect costs in the factory might be
labor hours as factory workers use factory
space, utilities, and other overhead resources to
make products.
In a machine-intensive environment the cost
driver of indirect costs in the factory might be
machine hours, because machines consume
electricity, lubricants, and other supplies to make
products.
Once the driver is chosen, then divide the
expected indirect factory costs by the cost
driver to compute the predetermined indirect
cost rate.
predetermined indirect cost rate = Estimated Total
Factory Indirect Cost

Practical Capacity in Cost

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Handling Indirect Cost in Manufacturing

Environment
Assume
that estimated total factory indirect cost is

$14,000,000.
Consider the labor hours as the cost driver.
The factory's practical capacity expressed in labor hours
is 250,000hrs.
The predetermined indirect cost rate = $56
(14,000,000/250,000) per direct labor hour.
Therefore for every labor hour used in the factory to
produce the product, $56 of indirect cost will be
applied to the product.

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Multiple Indirect Cost Pools

The previous example uses what
is called a predetermined plantwide indirect cost rate, since a
single indirect cost rate is
used for the entire factory
Most organizations use multiple
indirect cost pools in order to
improve costing to more
accurately reflect the causeand-effect relationship
between the cost object and
the cost of the resources

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Multiple Indirect Cost Pools

The two most widely used
alternatives for designing
multiple indirect cost pools are
to base them on:
1.Organizational units, such as
departments, or
2.Activities (sometimes
processes), such as setup and
manufacturing.
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Example-Multiple Indirect Cost Pools

Consider a factory that produces 2 products
and where production involves 2 major
activities, which are organized into 2
departments: (1)manufacturing and
(2)assembly.
Machines do most of the work (called a
machine-paced operation) in the
Manufacturing Department, and workers
do most of the work in the Assembly
Department (called a labor-paced
operation).
The major difference between the two
products is that Product X458 is assembled
using fewer but much larger pieces than
Product X456. Therefore, relative to X456 it
takes longer to cut the pieces for X458 19

Example-Multiple Indirect Cost Pools

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Example-Multiple Indirect Cost Pools

(contd)
Suppose that the plant accountant advises that
$9,000,000 of the plants indirect costs are
appropriately assigned to the Machining
Department and $5,000,000 of the plants
indirect costs are appropriately assigned to
the Assembly Department.
The practical capacity of the Machining
Department expressed in machine hours (the
assumed cost driver in that department) is
30,000hrs and the practical capacity of the
Assembly Department expressed in labor
hours (the assumed cost driver in that
department) is 200,000hrs. Therefore we can
compute the predetermined indirect cost
rate for the two departments as follows:
Machining Department = 9,000,000 = $300 charged for
each mach hr.
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30,000

Example-Multiple Indirect Cost Pools (contd)

Table below summarizes the indirect cost

allocations resulting from the two
department system.

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Example-Multiple Indirect Cost Pools (contd)

Table below shows Indirect Cost

Allocations using Plant-Wide versus
Multiple Indirect Rates.

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Job Order Costing at Raul Company

Raul Company manufactures wooden doors.

The manufacturing is done in three steps.
1. In the first step workers glue pieces of
wood together to form the door and then trim
the door to the required size.
2. In the second step the door is placed on a
platform and a computer-controlled router
creates the door engraving the customer
requires.
3. In the third step the door is treated with
the finish specified by the customer and then
packed for shipment to the customer.
The work in steps 1 and 3 is labor paced and
the work in step 2 is machine paced. Each
step has its own cost driver and its own cost
driver rate.
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Job Order Costing at Raul Company

The following exhibit summarizes

the resource use and the costs
for each of the three steps and the
total product cost.

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Exercise 4-29
Mackenzie Consulting computes the cost of
each consulting engagement by adding a
portion of firm wide overhead costs to the
labor cost of the consultants on the
engagement. The overhead costs are
assigned to each consulting engagement
using a cost driver rate based on consultant
labor costs. Mackenzie Consulting overhead
costs are $7,500,000 per year, and total
consultants labor cost is estimated at
$250,000 per month.
Required
(a) What is Mackenzie Consulting cost driver
rate?
(b) If the consultant labor cost on an
engagement is $100,000, what cost will 2727

Exercise 4-30
The Brinker Company uses a job order costing system at its local
plant. The plant has a machining department and a finishing
department. The company uses machine hours to allocate
machining department overhead costs to jobs and uses direct
labor cost to allocate finishing department overhead costs to jobs.
Cost and practical capacity estimates for the current year are as
follows:

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Process Costing

Process costing is an approach to costing that is

used when all products are identical.
The total cost of all products is determined by adding
up all of the direct and indirect costs used to produce
the products. Dividing the total cost by the number of
products gives the cost per unit produced.
Examples of products for which process costing is
appropriate are soda drinks, breakfast cereal, plastic
water bottles, and routine services such as providing
influenza inoculations at a medical clinic.
In this setting cost analysts focus on the components
of total product cost.
Next slide provides an example that illustrates a
simple process costing environment

Equivalent Unit of Production

An equivalent unit of production is an indication of the
amount of work done by manufacturers who have partially
completed units on hand at the end of an accounting period.
Basically the fully completed units and the partially
completed units are expressed in terms of fully completed
units.
To illustrate, assume that a manufacturer uses direct labor
continuously in one of its production departments. During
June, the department began with no units in inventory and it
started and completed 10,000 units. It also started an
additional 1,000 units that were 30% complete at the end of
June. This department is likely to state that it manufactured
10,300 (10,000 + 300) equivalent units of product during
June.
If the department's direct labor cost was $103,000 during
the month, its June direct labor cost per equivalent unit
will be $10 ($103,000 divided by 10,300 equivalent units).
This means that $100,000 (10,000 X $10) of labor costs will
be assigned to the finished units and that $3,000 (300 X
$10) will be assigned to the partially completed units.

Reconciling Actual and

Applied Capacity Costs

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Cost Flows in a Manufacturing Organization

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Reconciling Actual and Applied

Capacity Costs

Earlier it was discussed that two

cost pools are used for each
capacity-related cost.
One pool accumulates the
actual capacity-related cost
incurred while the other pool
accumulates the capacityrelated costs applied to
production.
At the end of the year the
balances in the two accounts
must be reconciled.

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Reconciling Actual and Applied Capacity

Costs
Any under, or over allocated costs must
be charged to something. The choices
include:
1. Charge the difference between actual
and applied indirect costs to cost of
goods sold.
2. Prorate the difference between actual
and applied to work in process, finished
goods, and cost of goods sold
3. Decompose the difference between
actual and applied into two parts:
i. The difference between actual and
budgeted indirect costs.
ii. The difference between budgeted and
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applied indirect costs.

Reconciling Actual and Applied Capacity

Costs
Suppose that Watts Company uses a single indirect cost
pool and has estimated capacity-related costs to be
$10,000,000 for the year. Watts Company uses the
practical capacity of the capacity resource, which is 50,000
machine hours, to compute the cost driver rate of $200
($10,000,000/50,000) per machine hour.
During the year actual capacity-related costs were
$9,500,000, which is the balance in the indirect cost pool
that accumulates the actual costs. Production required
45,000 machine hours. The balance in the indirect cost
applied cost pool will be $9,000,000 (45,000 $200).
The two accounts must be reconciled, which raises the
question of what the cost analyst should do with the
$500,000 difference. Note that the actual cost is
$500,000 greater than the cost that has been applied to
production.
The cost analyst has to charge this unallocated actual cost
of $500,000 to something.

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Reconciling Actual and Applied

Capacity Costs
Option 1: Charge the difference between
actual and applied indirect costs to cost
of goods sold.
The simplest option is simply to charge the
$500,000 to the cost of goods sold in the
current period. That is, cost of goods sold is
increased by $500,000.
Option 2: Prorate the difference between
actual and applied indirect costs to work
in process, finished goods, and cost of
goods sold.
The second approach is to prorate the
$500,000 difference proportionately to the
ending balances of work in process,
finished goods inventory, and cost of
goods sold.

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Reconciling Actual and Applied

Capacity Costs
Option 3: Decompose the
difference between actual and
applied indirect costs into two
parts: (1) the difference between
actual and budgeted indirect costs
and (2) the difference between
budgeted and applied indirect
costs.
1. The difference between actual
and budgeted indirect costs is (-)
$500,000 ($9,500,000 - $10,000,000),
which reflects a favorable indirect
cost spending variance. The lower
actual cost creates a favorable effect
on income, relative to the budgeted

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2.

Reconciling Actual and Applied

Capacity Costs

The difference between budgeted and

applied indirect costs is $1,000,000
($10,000,000 - $9,000,000).
This difference results from idle capacity.
The machine hours practical capacity was
50,000, whereas the actual machine hours
used totaled 45,000. This means that idle
capacity was 5,000 (50,000 - 45,000) machine
hours with an associated cost of $1,000,000
(5,000 $200). This idle capacity cost would
be charged directly to cost of goods sold.
The net effect of these two steps would be to
increase the balance of cost of goods
sold by $500,000 ($1,000,000 - $500,000).
Although the net effect is the same as in
Option 1, in Option 3 management receives
more detailed information on reasons for the
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difference.

-EXERCISES-

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Exercise 4-31
Eastern Wood Products has two production departments:
cutting and assembly. The company has been using a
plantwide cost driver rate computed by dividing plantwide
overhead costs by total plantwide direct labor hours. The
estimates for overhead costs and practical capacity
quantities of cost drivers for the current year follow:
Cuttin
g
Manufacturing
overhead

Assem
bly

$40,00 $60,000
0

Total
$100,0
00

Direct labor hours

2,000

6,000

8,000

Machine hours

4,000

3,000

7,000

Required
(a) Compute the plantwide cost driver rate.
(b)Determine departmental cost driver rates based on
direct labor hours for assembly and machine hours for
cutting.
(c) Provide reasons why Eastern Wood might use the
method in part a or the one in part b.
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Exercise 4-40 Page 180

The Hilton Company sells and services lawn mowers, snow
blowers, and other equipment. The service department uses a
job order cost system to determine the cost of each job, such
as oil changes, tune-ups, and repairs. The department assigns
conversion costs through a cost driver rate on the basis of
direct labor hours. The cost driver rate additionally includes a
markup of 30% on the jobs conversion costs in order to provide
a reasonable profit for Hilton. The customers invoice itemizes
prices for parts and labor, where the stated labor rate is the
departments cost driver rate, which includes direct labor costs,
assigned overhead costs, and the 30% markup on conversion
costs. Hilton Companys service department estimated the
following information for the current year:
Salaries of mechanics
$225,000
Fringe benefits
65,000
General and administrative
16,000
Depreciation
54,000
Billable direct labor hours
6,000
Required
(a) Determine Hilton Companys service departments cost
driver rate for assigning conversion costs on the basis of
billable direct labor hours.
(b) Job 123 required $52.50 of materials and 0.8 direct labor
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hour. Determine the price charged for job 123.
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-END-

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