2

Product Costing Systems

Concepts and Design Issues
 The Meaning of “Cost”?

The
Thesacrifice
sacrifice
made,
made, usually
usually
measured
measuredby bythe
the
resources
resourcesgiven
given
up,
up,to
toachieve
achieveaa
Product
ProductCosts
Costs Period
PeriodCosts
Costs
particular
particular
The
Thecost
cost purpose. Costs
Coststhat
thatare
are
purpose. identified
assigned
assignedto to identifiedwith
with
goods
goodsthatthatwere
were the
theperiod
periodin
in
either
eitherpurchased
purchased which
whichthey
theyare
are
or
ormanufactured
manufactured incurred.
incurred.
for
forresale.
resale. 2-2
 Manufacturing Companies

There
There are
are 33 major
major categories
categories of
of manufacturing
manufacturing
costs:
costs:

Direct Manufacturing
Manufacturing
Direct DirectLabor
Labor
DirectMaterials
Materials The Overhead
Overhead
resources Thecost
costofof
resourcesthat
that paying Indirect
can paying Indirectmaterial
material
canbebefeasibly
feasibly employees
observed employeeswho
who
observedbeing
being convert
Indirect
Indirectlabor
labor
used convertdirect
direct
usedtotomake
makeaa materials
specific materialsinto
into Other
Otheroverhead
overhead
specificproduct.
product. finished
finishedproduct.
product.
2-3
 Manufacturing Companies

Prime
Prime Costs
Costs include:
include:

Direct
DirectMaterials
Materials Direct
DirectLabor
Labor Manufacturing
Manufacturing
Overhead
Overhead

2-4
 Manufacturing Companies

Conversion
Conversion Costs
Costs include:
include:

Direct
DirectMaterials
Materials Direct
DirectLabor
Labor Manufacturing
Manufacturing
Overhead
Overhead

Nonmanufacturing
Nonmanufacturing Costs
Costs are
are all
all the
the costs
costs not
not
used
used to
to produce
produce products.
products.
2-5
 Stages of Production and the
Flow of Costs
Raw Materials Work-In-Process Finished Goods
Beg. Inventory Beg. WIP Inventory Beg. Inventory
Add: Purchases Add: Raw Materials Add: Goods Completed
= Raw Materials Transferred In and Transferred from
Available for Direct Labor WIP
Production Allocated = Goods Available for
Less: Raw Materials Manufacturing Sale
Transferred to Overhead Less: Cost of Goods Sold
Production = Manufacturing = Ending Inventory
= Ending Inventory Costs for the Period
Less: Goods Completed
and Transferred to
Finished Goods
= Ending WIP
Inventory 2-6
 Stages of Production and the
Flow of Costs - Example
Raw Materials Axel
AxelElectronics
Electronicsmakes
makestoasters.
toasters. On
On
Beg. Inventory February
February1,1,Axel
Axelhas
has$15,000
$15,000of
ofraw
raw
Add: Purchases material
materialon
onhand.
hand. Axel’s
Axel’spurchase
purchase
= Raw Materials
and
andtransfers
transfersto
tothe
theproduction
productionfloor
floor
Available for
Production are
areindicated
indicatedbelow.
below.
Less: Raw Materials
Cost of Cost of
Transferred to
Date Purchases Transfers
Production
= Ending Inventory 3-Feb $8,000 $5,000
10-Feb $12,000 $11,000
15-Feb $14,000 $7,000
What
WhatisisEnding
Ending 20-Feb $6,000
Inventory
Inventoryin
in 22-Feb $9,000
February?
February? 27-Feb $16,000
2-7
 Stages of Production and the
Flow of Costs - Example
Raw Materials Axel
AxelElectronics
Electronicsmakes
makestoasters.
toasters. On
On
$15,000 February
February1,1,Axel
Axelhas
has$15,000
$15,000of
ofraw
raw
Add: 43,000 material
materialon
onhand.
hand. Axel’s
Axel’spurchase
purchase
= $58,000 and
Less: 45,000
andtransfers
transfersto
tothe
theproduction
productionfloor
floor
= $13,000
are
areindicated
indicatedbelow.
below.
Cost of Cost of
Date Purchases Transfers
3-Feb $8,000 $5,000
10-Feb $12,000 $11,000
15-Feb $14,000 $7,000
Now
Nowlet’s
let’slook
lookat
at 20-Feb $6,000
Work-in-Process.
Work-in-Process. 22-Feb $9,000
27-Feb $16,000
2-8
 Stages of Production and the
Flow of Costs - Example
Raw Materials Work-In-Process
On
OnFebruary
February1, 1,Axel
Axel
$15,000 Beg. WIP Inventory
Add: 43,000 Add: Raw Materials had
hadWIP WIPofof$30,000
$30,000
= $58,000 Transferred In on
onthe
thefactory
factoryfloor.
floor.
Less: 45,000 Direct Labor During
DuringFebruary,
February,
= $13,000 Allocated
Axel
Axelpaidpaid$92,000
$92,000in in
Manufacturing
Overhead direct
directlabor
laborwages.
wages.
What = Manufacturing Overhead
Overheadisisapplied
applied
Whatisisthe
the
amount Costs for the Period at
at150%
150%of ofdirect
direct
amountof ofcost
cost Less: Goods Completed
transferred labor.
labor.On
On2/28,
2/28,
transferredto
to and Transferred to
Finished $22,000
$22,000isisstill
stillin
in
FinishedGoods
Goodsin in Finished Goods
February? = Ending WIP WIP.
WIP.
February? Inventory 2-9
 Stages of Production and the
Flow of Costs - Example
Raw Materials Work-In-Process On
OnFebruary
February1, 1,Axel
Axel
$15,000 $30,000
Add: 43,000 Add: 45,000
had
hadWIP WIPofof$30,000
$30,000
= $58,000 92,000 on
onthe
thefactory
factoryfloor.
floor.
Less: 45,000 138,000 During
DuringFebruary,
February,
= $13,000 Axel
= $305,000 Axelpaidpaid$92,000
$92,000in in
Less: 283,000 direct
= $22,000
directlabor
laborwages.
wages.
Overhead
Overheadisisapplied
applied
Now
Nowlet’s
let’s at
at150%
150%of ofdirect
direct
look
lookat
at
Transferred labor.
labor.On
On2/28,
2/28,
Finished
Finished
to Finished $22,000
$22,000isisstill
stillin
in
Goods.
Goods.
Goods WIP.
WIP.
2-10
 Stages of Production and the
Flow of Costs - Example
Raw Materials Work-In-Process Finished Goods
$15,000 $30,000 Beg. Inventory
Add: 43,000 Add: 45,000 Add: Goods Completed
= $58,000 92,000 and Transferred from
Less: 45,000 138,000 WIP
= $13,000 = $305,000 = Goods Available for
Less: 283,000 Sale
$22,000 Less: Cost of Goods Sold
=
= Ending Inventory

On
OnFebruary
February1,1,Axel
Axelhad
hadFinished
FinishedGoods
Goodsof of$125,000
$125,000on
onhand.
hand.
At
Atthe
theend
endof
ofFebruary,
February,aaphysical
physicalinventory
inventorycount
countrevealed
revealed
$96,000
$96,000in
inFinished
FinishedGoods
Goodsstill
stillon
onhand.
hand.
What
Whatwas
wasCost
Costof
ofGoods
GoodsSold
Soldfor
forFebruary?
February? 2-11
 Stages of Production and the
Flow of Costs - Example
Raw Materials Work-In-Process Finished Goods
$15,000 $30,000 $125,000
Add: 43,000 Add: 45,000 Add: 283,000
= $58,000 92,000 = $408,000
Less: 45,000 138,000 Less: 312,000
= $13,000 = $305,000 = $96,000
Less: 283,000
= $22,000

On
OnFebruary
February1,1,Axel
Axelhad
hadFinished
FinishedGoods
Goodsof of$125,000
$125,000on
onhand.
hand.
At
Atthe
theend
endof
ofFebruary,
February,aaphysical
physicalinventory
inventorycount
countrevealed
revealed
$96,000
$96,000in
inFinished
FinishedGoods
Goodsstill
stillon
onhand.
hand.
What
Whatwas
wasCost
Costof
ofGoods
GoodsSold
Soldfor
forFebruary?
February? 2-12
Production Costs in the Service
Industry
• A service provider cannot
“inventory” services.
• The costs of providing the
service can be identified and
accounted for just as in a
manufacturing environment.
• Managing and tracking the costs
associated with value-chain
activities can provide
opportunities for improvement.

2-13
 Cost Drivers
An
An “Activity”
“Activity” is
is any
any
discrete
discrete task
task than
than # of computers
an
an organization
organization
undertakes
made by Dell in
undertakes to to make
make
or
or deliver
deliver aa good
good oror a day
service.
service.
AA“cost
“cost driver”
driver” is
is an
an # of Miles
activity
activity or
or event
event that
that
causes
flown by Southwest
causes costs
costs toto be
be
incurred
incurred .. each day
2-14
 Cost Behavior
Fixed vs. Variable

Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Fixed Total fixed cost remains the Fixed cost per unit goes
same even when the activity down as activity level goes up.
level changes within the
relevant range.

2-15
 Cost Behavior
Fixed vs. Variable

Your
Your total
total long
long distance
distance telephone
telephone bill
bill is
is
based
based onon how
how many
many minutes
minutes you
you talk.
talk.
Total Long Distance
Telephone Bill

Minutes Talked
2-16
 Cost Behavior
Fixed vs. Variable
The
The cost
cost per
per minute
minute talked
talked is
is constant.
constant. For
For
example,
example, 10
10 cents
cents per
per minute.
minute.

Telephone Charge
Per Minute

Minutes Talked
2-17
 Cost Behavior
Fixed vs. Variable
Your
Yourmonthly
monthlybasic
basic telephone
telephonebill
bill is
isprobably
probablyfixed
fixed and
and
does
doesnot
notchange
changewhen
when you
you make
makemoremorelocal
local calls.
calls.
Monthly Basic
Telephone Bill

Number of Local Calls 2-18

 Cost Behavior
Fixed vs. Variable
The
Thefixed
fixed cost
cost per
per local
localcall
call decreases
decreases as
asmore
morelocal
local
calls
calls are
are made.
made.

Monthly Basic Telephone

Bill per Local Call

Number of Local Calls 2-19

 The Hierarchy of Costs
Directly traceable
Unit-level
Unit-level to the decision to
produce the level
Resources
Resources of output

Resources
Resourcesthat
that are
areacquired
acquired specifically
specifically for
for
individual
individual units
units of
of product
productor
or service
service

materials
materials components
components

parts
parts labor
labor
energy
energy 2-20
 The Hierarchy of Costs

Batch-level
Batch-level

Acquired as
Acquired as aa result
result of
of the
the decision
decision to
to make
make aa group,
group,
orbatch
or batch of
of similar
similarproducts.
products.

Materials
Materials Specialized Labor
Specialized Labor

EquipmentApplicable
Equipment Applicable to
to the
the Batch
Batch
2-21
 The Hierarchy of Costs

Product-level
Product-level

Acquired as
Acquired as aa result
result of
of the
the decision
decision to
to produce
produce and
and
sell aa specific
sell specific product
product or
orservice.
service.

Software
Software Specialized Equipment
Specialized Equipment

PersonnelApplicable
Personnel Applicable to
to that
that Product
Product or
orService
Service
2-22
 The Hierarchy of Costs

Customer-level
Customer-level

Acquired as
Acquired as aa result
result of
of the
the decision
decision to
to serve
serve specific
specific
customers.
customers.

Software
Software Specialized Equipment
Specialized Equipment

Personnel Dedicated
Personnel Dedicated to
to Specific
Specific Customers
Customers
2-23
 The Hierarchy of Costs
Facility-level
Facility-level

Resources
Resourcesthat
that are
areacquired
acquired specifically
specifically for
for
individual
individual units
units of
of product
productor
or service
service
Busines
Busines
ss Labor
Labor
Support
Support Force
Force
Services
Services
Land
Land Management
Management
Buildings
Buildings 2-24
 Committed Costs,
Opportunity Costs, & Sunk
Costs
Committed
Committedcosts
costsare
arefixed
fixedcosts
coststhat
thatare
arenot
notintended
intended
to
tovary
varywith
with production
productionoror sales
salesvolume.
volume.

IfIf we
weget
getrid
rid of
of That
Thatwill
will
John,
John, wewe can
can certainly
certainly
replace
replace him him with
with aa lower
lower our
our
new
new professor
professor budgeted
budgeted
making
making$20,000
$20,000aa fixed
fixed costs.
costs.
year
yearless!
less!

2-25
 Committed Costs,
Opportunity Costs, & Sunk
Costs
Opportunity
Opportunitycost
costmeasures
measureswhat
what is
issacrificed
sacrificedwhen
when
one
onealternative
alternativeis
ischosen.
chosen.
And I passed
Well, up $95,000
Well, team,
team, itit
looks with IBM for
lookslike
likewe
weareare
gonna this?
gonnabe beworking
working
overtime
overtimeallallweek
week
on
onthis
thisjob.
job.

2-26
 Committed Costs,
Opportunity Costs, & Sunk
Costs
Sunk
Sunkcosts
costsare
arepast
past payments
payments for
for resources
resourcesthat
that
cannot
cannot be
be undone.
undone.

II don’t But
But don’t
don’t you
you
don’twant
want to
to
replace see?
see? That
That
replaceJohn.
John. WeWe
just $30,000
$30,000 isis
justspent
spent$30,000
$30,000
to gone.
gone. ItIt is
is
to train
train him
him on
on the
the
new irrelevant
irrelevant to to
newequipment!
equipment!
our
our decision.
decision.

2-27
 Traceability of Resources
Direct
Direct Costs
Costs
Assigning
Assigningresource
resourcecosts
coststo to products
productsand
and
services
servicesthrough
through reliable
reliable observations
observationsand
and
documentation
documentationof of resource
resource use.
use.

Tracing
Tracing is
isoften
often more
more
Some
Someproducts
productsuse
use effective
effective than
thanusing
using
more
moreofofaagiven
given Average
AverageCost,
Cost,which
which
resource
resourcethan
than assumes
assumes that
thateach
each
others.
others. product
product uses
uses the
the same
same
amount
amount ofofeach
each resource.
resource.
2-28
 Traceability of Resources
Indirect
Indirect Costs
Costs
Attaching
Attachingororassigning
assigningindirect
indirect costs
coststo
toproducts,
products,
services,
services, or
ororganizational
organizational units
units by
by some
some
reasonable
reasonable method
method of
ofaveraging.
averaging.

Methods
Methods such
suchasasActivity-
Activity-
Applied
Appliedto tocosts
costs Based
Based Costing
Costing result
result in
in
that
that cannot
cannot bebe more
moretracing
tracingand
andless
less
efficiently
efficiently traced.
traced. allocation.
allocation.
Example 2-29
Tracing versus Allocating Costs
- Example
Brickley,
Brickley, Inc.
Inc.makes
makes two
twoproducts;
products; bricks
bricksand
and play
play sand.
sand.
The
Theproducts
productsare areproduced
producedinintwo
twoseparate
separatefacilities,
facilities,and
and
the
theplant
plant supervisors
supervisors work
workat
at both
bothplants.
plants. Allocate
Allocaterentrent
and
andsalaries
salariesbased
basedon on revenues.
revenues.

Units Produced Sales Price

Product & Sold per Unit
Bricks 2,000,000 $ 0.75
Sand Brickley’s
Brickley’s headquarters
tonsisis$
headquarters
30,000 downtown.
downtown.
90.00

2-30
Tracing versus Allocating Costs
- Example
The
Thebrick
brick operation
operationconsumes
consumes70% 70% of of the
thematerial
material
purchased.
purchased. TheTheplay
play sand
sanduses
usesthe
the remaining
remaining30%.
30%.
Labor
Labor has
hasananaverage
averagecostcost of of $10
$10per
perhour.
hour. The
Thebrick
brick
operation
operationuses
uses 21,000
21,000labor labor hours.
hours. TheTheplay
playsand
sand
operation
operationusesuses14,000
14,000labor
labor hours.
hours.
The
Thecompany
company pays
pays all
all utilities
utilities on
on one
one bill
billthat
that goes
goes to
to the
the
headquarters.
headquarters. Headquarters
Headquarters allocates
allocates 50%
50% ofofthe
theutilities
utilities
cost
cost totoeach
eachproduct.
product.

2-31
 Tracing versus Allocating Costs
- Example
How
Cost Type Total Cost Bricks Sand Assigned
Sales Revenue $ 4,200,000 ? ? ?
Materials 800,000 ? ? ?
Labor 350,000 ? ? ?
Supervisors 140,000 ? ? ?
Plant Rent 700,000 ? ? ?
Total Utilities 160,000 ? ? ?

Compute
Compute the
the missing
missing values
values and
and
information.
information.
2-32
 Tracing versus Allocating Costs
- Example
How
Cost Type Total Cost Bricks Sand Assigned
Sales Revenue $ 4,200,000 $ 1,500,000 $ 2,700,000 Direct
Materials 800,000 ? ? ?
Labor 350,000 ? ? ?
Supervisors 140,000 ? ? ?
Plant Rent 700,000 ? ? ?
Total Utilities 160,000 ? ? ?

Sales
SalesRevenue
Revenueis isTRACED
TRACED to
to each
each product
product based
basedon on
the
theactual
actual revenue
revenueeach
eachproduct
product generates.
generates.
Example:
Example: Sand
SandRevenue
Revenue== 30,000
30,000tons
tons ×× $90
$90 per
per ton
ton
2-33
 Tracing versus Allocating Costs
- Example
How
Cost Type Total Cost Bricks Sand Assigned
Sales Revenue $ 4,200,000 $ 1,500,000 $ 2,700,000 Direct
Materials 800,000 $ 560,000 $ 240,000 Direct
Labor 350,000 $ 210,000 $ 140,000 Direct
Supervisors 140,000 ? ? ?
Plant Rent 700,000 ? ? ?
Total Utilities 160,000 ? ? ?

Material
Materialand
andLabor
Laborare
aretraced
tracedtotoeach
eachproduct
productbased
based
on
onhow
howmuch
muchofof each
eachresource
resourceeach
eachproduct
productuses.
uses.
Example;
Example; Bricks
Brickslabor
labor == 21,000
21,000 hours
hours ××$10
$10per
perhour
hour
2-34
 Tracing versus Allocating Costs
- Example
How
Cost Type Total Cost Bricks Sand Assigned
Sales Revenue $ 4,200,000 $ 1,500,000 $ 2,700,000 Direct
Materials 800,000 $ 560,000 $ 240,000 Direct
Labor 350,000 $ 210,000 $ 140,000 Direct
Supervisors 140,000 $ 50,000 $ 90,000 Indirect
Plant Rent 700,000 $ 250,000 $ 450,000 Indirect
Total Utilities 160,000 ? ? ?

Supervisor
Supervisorsalaries
salariesand
andrent
rent are
areallocated
allocatedononthe
thebasis
basis
of
of relative
relativerevenues.
revenues. Approximately
Approximately35.7%
35.7%goes
goesto
to
Bricks.
Bricks. Approximately
Approximately 64.3%
64.3% goes
goes to
to Sand.
Sand.
2-35
 Tracing versus Allocating Costs
- Example
How
Cost Type Total Cost Bricks Sand Assigned
Sales Revenue $ 4,200,000 $ 1,500,000 $ 2,700,000 Direct
Materials 800,000 $ 560,000 $ 240,000 Direct
Labor 350,000 $ 210,000 $ 140,000 Direct
Supervisors 140,000 $ 50,000 $ 90,000 Indirect
Plant Rent 700,000 $ 250,000 $ 450,000 Indirect
Total Utilities 160,000 $ 80,000 $ 80,000 Indirect

The
Theutilities
utilities are
are allocated
allocatedfrom
from the
the home
home office
officewith
with
50%
50%of
of the
theutilities
utilitiesbeing
beingcharged
chargedto toeach
eachproduct.
product.

2-36
Income-Reporting Effects of Alternative
Product-Costing Methods

Variable
VariableCosting
Costing
measures
measuresproduct
product
cost
costbybythe
theunit-
unit-
level
levelresources
resources
used.
used.

Absorption
AbsorptionCosting
Costing
allocates
allocatesindirect
indirect
costs
coststotoproducts
products
along
alongwith
withunit-level
unit-level
and
andvariable
variablecosts.
costs.
2-37
 Income-Reporting Effects of Alternative
Product-Costing Methods

Absorption Variable
Costing Costing

Direct materials
Direct labor Product costs
Product costs Variable mfg. overhead

Fixed mfg. overhead

Period costs
Period costs Selling & admin. exp.

2-38
Absorption Costing vs. Variable
Costing - Example
Howell,
Howell, Inc.
Inc. produces
produces aa single
single product
product with
with aa sales
sales price
price
of
of $40
$40 and
and the
the following
following cost
cost information:
information:

Number of units produced annually 30,000

Variable costs per unit:
Direct materials, direct labor,
and variable mfg. overhead $ 12
Selling & administrative expenses $ 4

Fixed costs per year:

Manufacturing overhead $ 210,000
Selling & administrative expenses $ 250,000
2-39
Absorption Costing vs. Variable
Costing - Example
Unit product cost is determined as follows:

Absorption Variable
Costing Costing
Direct materials, direct labor,
and variable mfg. overhead $ 12 $ 12
Fixed mfg. overhead
($210,000 ÷ 30,000 units) 7 -
Unit product cost $ 19 $ 12

Selling
Sellingand
andadministrative
administrativeexpenses
expensesare
are
always
alwaystreated
treatedas
asperiod
periodexpenses
expensesand
anddeducted
deductedfrom
from
revenue.
revenue. 2-40
Absorption Costing vs. Variable
Costing - Example
Howell,
Howell,Inc.
Inc.had
had no
no beginning
beginning inventory,
inventory, produced
produced
30,000
30,000 units
unitsand
and sold
sold 28,000
28,000 units
unitsthis
thisyear.
year.
Absorption Costing
Sales (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
2-41
Absorption Costing vs. Variable
Costing - Example
Variable
Variable Variable Costing
Sales (28,000 × $40)
costs
costs $ 1,120,000
Less variable expenses: only.
only.
Beginning inventory $ - All
Allfixed
fixed
Add COGM (30,000 × $12) 360,000 manufacturing
Goods available for sale 360,000 manufacturing
Ending inventory (2,000 × $12) 24,000
overhead
overheadis is
Variable cost of goods sold 336,000 expensed.
expensed.
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
2-42
End of Chapter

Hu-man!
I will
absorb
you!

2-43