BU247 Lecture 6-8 Tues. May 28 – Tues. June 4
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 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Materials are withdrawn from raw materials inventory.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,
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.
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 Tues. May 28 – Tues. June 4
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 Tues. May 28 – Tues. June 4
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 Tues. May 28 – Tues. June 4
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
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