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Ch 4 Accumulating and Assigning Costs to Products.docx

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Wilfrid Laurier University
Susan Lade

BU247 Lecture 6-8 Chapter 4 – Accumulating and Assigning Costs to Products  How cost management systems measure the costs of products, services, and customers.  Historically, 2 cost management systems have been used: job order costing and process costing,  Since the mid-1980s, companies have been adopting activity-based costing for products, customers, and services. Cost systems differ in the way that they assign indirect costs to cost objects Cost Flows in Organizations  To compute product costs, mgmt. accounting systems should reflect actual cost flows  Manufacturing, retail, and service organizations have different patterns of cost flows  Since issues about handling production overhead costs are more complex in manufacturing, we focus on costing issues of manufacturing organizations. These concepts also apply to retail/service. Manufacturing Organizations  Manufacturing costs are classified into 3: direct materials, direct labor, manufacturing overhead  Materials are withdrawn from raw materials inventory. The cost of the raw materials entered into production is moved from the raw materials account to the work-in-process inventory account.  The costs of labor and overhead items are assigned, and (main focus) overhead costs are allocated/apportioned to production by adding them to the work-in-process inventory account.  When manufacturing is completed, work is transferred to finished goods inventory, and costs are moved from the work-in-process inventory account to the finished goods inventory account.  Finally, when goods are sold, their costs are moved to cost of goods sold.  manufacturing overhead costs often account for about half of total costs to produce goods, Retail Organizations  As goods are purchased, cost is entered into an account that accumulates the cost of merchandise inventory. Stores incur overhead costs such as labor, depreciation on the store, lighting, and heating.  Focus in retail operations is the profitability of product lines or departments. Therefore, costing attention focuses on how to allocate various overhead costs to determine, for example, the cost of purchasing and selling products, or department costs.  However, merchandise costs in retail organizations can exceed 80% of total costs to purchase and sell goods. Therefore, the potential for distorting the cost of purchasing and selling products through inappropriate allocations of overhead costs is lower in retail organizations than in manufacturing. Service Organizations  Unlike retail where major cost = merchandise, in service the major cost item = employee pay  Focus on determining the cost of a project BU247 Lecture 6-8  Salaries & wages are often 80% of total project-related costs, and these costs can be easily assigned to different projects/services  potential for cost system distortions < that of manufacturing Some Important Cost Terms  Cost object: anything for which a cost is computed (activities, products, departments)  Consumable resources: (flexible resource) consumed by the production process. The total cost of the resource is proportional to the amount used.  the cost is often called a VC  Capacity-related resources: provides capacity that is used by the production process. its cost depends on the amount of resource capacity that is acquired and not on how much is used  as size of factory/warehouse rises, associated capacity-related cost rises. (ex: depreciation on equipment, salaries)  usually a FC because cost of resource is independent of how much is used in the SR  Direct cost: cost uniquely and unequivocally attributable to a single cost object  Indirect cost: all costs that fail the test of being a direct cost  most consumable resources are direct costs, and most capacity related resources are indirect  Ex: fuel used by a truck that is carrying many products  indirect cost, even though fuel = consumable resource, since all products on board jointly consume the fuel  Ex: cost of production equipment that was acquired and used ONLY by one product = direct cost, even though it’s a capacity-related resource  Would the organization have no use for the resource of the cost object was abandoned?  if yes, then it is a direct cost. If no, it is an indirect cost.  The increased use of indirect costs (especially automation) in manufacturing has increased the need for costing systems to deal adequately with indirect costs Cost Classification and Context  Classification of a resource (and thus its cost) as direct/indirect is context-specific.  For a university with a prof that teaches 6 courses 1) If the cost object is the entire university, your prof’s salary is a direct cost 2) If the cost object is the course you’re taking, the salary is an indirect cost because your course is sharing a capacity related resource (your prof) with other courses Handling Indirect Costs in a Manufacturing Environment 1) The first step is to classify the cost as direct or indirect. A) Assumption: direct costs can be reasonably identified& assigned to the appropriate cost object B) If the cost is indirect, it is assigned to an indirect cost pool (there can be one or many). 2) An appropriate portion of the indirect cost is allocated from the cost pool(s) to the cost object(s) allocation ideally reflects cause-effect relationship between: LR use of capacity resource by cost object, and associated cost of that LR use  Tis allocation process involves judgment and subjectivity BU247 Lecture 6-8  Fixed Manufacturing Overhead (MOH) costs cannot be traced direct to specific units produced. They’re the most important indirect costs for manufacturing companies  heating, lighting, depreciation, factory taxes, indirect materials, and supervisory salaries.  In the simple costing system, indirect costs are accumulated in a single indirect cost pool.  Some organizations create another category called variable overhead, which includes costs for machine electricity usage, indirect materials (thread, glue, etc.), and machine supplies.  Variable overhead costs are actually direct costs that are too costly and immaterial (in relation to total product cost) to trace to individual cost objects accumulated in a VC account. Variable overhead costs may be assigned as direct costs. Alternatively, for simplicity, variable overhead costs may be grouped with fixed overhead in developing methods for allocating overhead to cost objects.  “Indirect cost” for overhead emphasizes the challenges in allocating fixed overhead to cost objects.  Organizations use a separate account (such as “Indirect Cost Applied”) to record applied indirect costs: indirect costs allocated as production occurs during the year.  The resulting situation is shown below, which shows one indirect cost account that accumulates the indirect costs incurred, and a second that accumulates the indirect costs applied to production.  Total indirect costs for the year are not known until year end  so when all the costs have been accumulated, organizations allocate indirect costs to production during the year using a predetermined indirect cost rate. To develop this rate: 1) Determine the basis (cost driver), which will be used to allocate the indirect cost to production. Choose a cost driver that best explains the long-run behavior of the indirect cost.  In a labour- intensive environment, the cost driver of indirect costs might be labor hours, as workers use factory space, utilities, and other overhead resources. In a machine-intensive environment the cost driver might be machine hours because machines consume electricity, lubricants, etc. 2) Cost analysts compute the predetermined indirect cost rate (POHR predetermined overhead rate, or cost driver rate)  divide expected indirect factory costs by # of cost driver units o The choice of # of cost driver units is a source of debate. We assume that the cost driver unit chosen is the factory’s practical capacity. o POHR is often used to allocate/apply overhead to cost objects; determined before period  Example: if total factory indirect cost = 14000k, and labour hours is chosen to be the cost driver, and the factory practical capacity expressed in labour hours = 250k  14000k/250k = $56  for every labour hour used in the factory to produce that product, $56 of indirect cost is applied to product.  Predetermined plant-wide indirect cost rate: a single indirect cost rate is used for entire factory  Overhead applied = POHR x actual cost driver activity  POHR is an estimate!!! BU247 Lecture 6-8 Multiple Indirect Cost Pools  Most organizations use this to improve costing: more accurate reflect the cause-effect relationship between the cost object and the cost of resources used by the cost object  Two most widely used alternatives for designing multiple indirect cost pools are to base them on 1) Organizational units: departments 2) Activities (processes): setup and manufacturing  Costing system distortions relate to handling indirect costs.  If there are two main departments, manufacturing and assembly department, then two predetermined indirect cost rates are calculated  one for each department o (Indirect costs for machining dep.) / (practical capacity of Machining dep., in machine hours) o (Indirect costs for assembly dep.) / (practical capacity of assembly dep. expressed in labour hours)  Example: let’s say the predetermined indirect cost rate for Machining Dep. = 300, and for the Assembly Dep. = 25. Let’s also say there are two products, A and B. Given the following data: o The indirect cost allocations resulting from the 2-department system are:  Note that if the example above used plant-wide rate system, the numbers for each product would differ from above. Using predetermined rate of $56 from the first costing example: o Product A  (0.25 + 1.75) x 56 = 112
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