PRODUCT COSTING

Objectives of Cost Accounting

1. For external reporting – for preparation of financial
statements

2. For internal reports for decision making by

management – planning, control, performance
measurement
Product Costs in Manufacturing Companies
1. Direct materials - the cost of materials and component
parts that are identified with finished product and may
be traced to it in an economically feasible way; usually
variable and varies in direct proportion with the volume
of production
2. Direct labor – wages and payroll costs relating to
employees who work directly on the product, which
costs can be identified directly in an economical way;
variable and increases directly with the volume of
output
3. Manufacturing overhead – “catch-all” classification;
partly variable and partly fixed
Cost Measure: Actual or Normal
Costing (Applying Overhead Costs)
Normal Costing
• method for assigning cost to products
• assigns to products actual direct material and direct labor
costs plus an amount representing ‘‘normal’’
manufacturing overhead
• a firm derives a rate for applying overhead to units
produced before the production period

Actual Costing
• assign the actual overhead costs incurred
Advantages of Normal Costing
1. Actual total manufacturing overhead costs may
fluctuate because of seasonality (the cost of utilities, for
example) or for other reasons not related directly to
activity levels.
2. If production is seasonal and total overhead costs
remain unchanged, the per-unit costs in low-volume
months will exceed the per-unit costs in high-volume
months.
Production Total Monthly Fixed Per-Unit
Units Manufacturing OH Overhead Costs
Costs
January 500 units 20,000 40
July 4,000 units 20,000 5
 Applying Overhead Costs to Production
1. Select a cost driver, or allocation base, for applying
overhead to production. Cost drivers cause an activity’s
costs. (e.g. machine hours, miles driven, etc.)

2. Estimate the dollar amount of overhead and the level of

activity for the period (for example, one year).

3. Compute the predetermined (that is, normal) overhead rate

from the following formula:
Pre-determined MOH Rate =
Applying Overhead Costs to Production
4. Apply overhead to production by multiplying the
predetermined rate, computed in Step 3, times the actual
activity (for example, the actual machine hours used to
produce a product).
Applying Overhead Costs to Production
Example: 1
Plantimum Builders manually assembles small modular
homes. In the previous year, Plantimum’s total variable
manufacturing overhead cost was $100,000 and the activity
level was 50,000 direct labor hours. The company expects
the same level of activity and costs for this year. Platimum
estimates fixed manufacturing overhead costs to be
$50,000 this year. Compute:

1. Predetermined Variable Manufacturing Overhead Rate

2. Predetermined Fixed Manufacturing Overhead Rate
Applying Overhead Costs to Production
Assume that Plantimum actually used 4,500 direct labor
hours for the month. Compute:

1. Variable Manufacturing Overhead

2. Fixed Manufacturing Overhead
Applying Overhead Costs to Production
Problem for Self Study
Pete Petezah, manager of the local Pizza Shack, has asked for your
advice about product costs. Pete wants you to compute predetermined
overhead rates for the Pizza Shack. Pete provides the following information
to you.
Late last year, Pete made the following estimates for the Pizza Shack for
this year:
(1)Estimated Variable Overhead........................... $108,000
(2)Estimated Fixed Overhead.................................. $120,000
(3)Estimated Labor Hours.......................................... 12,000 hours
(4)Estimated Labor Dollars per Hour..................... $20
(5)Estimated Output...................................................... 120,000 pizzas
Compute the predetermined overhead rate for (1) variable overhead and
(2) fixed overhead using each of the following cost drivers:
a. Labor hours b. Labor dollars c. Units of output
Choosing the Right Costing System
Type of Production Accounting Type of
System Product
Job (health care Job Costing Customized
services, custom homes,
audits by a CPA firm)
Operations (computer Operation Mostly
terminals, automobiles, Costing standardized
clothing)
Continuous Flow Process Costing Standardized
Processing (oil refinery,
soft drinks)
Types of Product Costing Systems
1. Job Order Cost System – used in manufacturing systems
that produce unique, highly distinguishable products or
small batches of custom-made products (e.g. furniture,
construction, ship building, printing, etc.)

2. Operations Cost System - a hybrid of job and process

costing; operations are a standardized method of making a
product that is performed repeatedly in production

3. Process Cost System – used for mass production of like

units (e.g. flour milling, cement manufacturing, food
processing, and other products which are indistinguishable
from each other)
Job Costing
Example 2:
An April, Plantimum Builders started and completed three
custom mobile home jobs (no beginning inventories). The
data and costs are:
Direct Labor Direct Direct Labors
Materials Hours
Job 1001 $ 8,000 $ 20,800 400
Job 1002 6,000 18,100 300
Job 1003 5,000 11,250 250
Total
Compute: $ 19,000 $ 50,150
(1) Total Overhead Cost per Job (2) Total Cost per Job
Process Costing
Firms accumulate costs in a department or production
process during an accounting period (for example, one
month), then spread those costs evenly over the units
produced that month, computing an average unit cost. The
formula follows:

Unit Cost =
Process Costing
Assume Plantimum Builders had used process costing for
the three jobs started and completed in April. The average
cost per job would be computed as follows:

$24,000 per Job

Job and Process Costing
Problem for Self-Study
Classifying Production as Jobs or Processes. Classify each of
the following as the product of either a job or a continuous
process:
1. Work for a client on a lawsuit by lawyers in a law firm
2. Diet cola
3. Patient care in an emergency room for a college
basketball player
4. House painting by a company called Student Painters
5. Paint
PLANNING AND CONTROL OF DIRECT
MATERIALS
Materials planning – providing required quantity and
quality of materials at the required time and place in the
manufacturing process

The planning of direct materials includes the planning of

the following:
1. Master Usage Budget – materials budget for
production; volume of finished products to be produced
times the number of individual components needed
2. Material Purchases Budget – determined from the
material usage budget and the required inventory level
PLANNING AND CONTROL OF DIRECT
MATERIALS
3. Finished Production Budget – used in determining
additions to the finished goods inventory

4. Inventories Budget – includes raw materials, work-in-

process, and finished goods; determined for the planning
period
Control of Materials
Control of materials involves the comparison of actual
performance with standard performance and instituting the
corrective action.

Check points:
1. Purchasing and receiving – the controller must have
assurance that the materials paid for are received and
used as intended
2. Usage – a comparison must be made of the actual and
budgeted or standard quantities used in production
Reasons for the variances in planned purchases and usage
must be investigated.
 STANDARD COSTS AND
VARIANCE ANALYSIS
Planning and Control of Direct Materials, Labor and
Overhead Costs
Our objectives:
1. Explain how standard costs are developed.
2. Calculate and interpret variances for direct
material.
3. Calculate and interpret variances for direct labor.
4. Calculate and interpret variances for
manufacturing overhead.
5. Explain why a “favorable” variance may be
unfavorable, how process improvements may lead
to “unfavorable” variances, and why evaluation in
terms of variances may lead to overproduction.
Standard Costs

1. Standard cost refers to expected costs under

anticipated conditions.
2. Standard cost systems allow for comparison of
standard versus actual costs.
3. Differences are referred to as standard cost
variances.
4. Variances should be investigated if significant.
Standard Costs and Budget
1. Standard cost is the standard cost of a single
unit.
2. Budgeted cost is the cost, at standard, of the
total number of budgeted units.
What is variance?
Variance is the difference between the actual and
budgeted/standard cost.
1. Materials variance
2. Labor variance
3. Overhead variance

Favorable Variance – actual cost/usage is lower

than standard at same output level

Unfavorable Variance – actual cost/usage is

higher than standard at same output level
A General Approach to Variance Analysis

1. Direct material
a. Quantity (efficiency) variance
b. Price variance
2. Direct labor
a. Labor rate (price) variance
b. Labor efficiency (quantity) variance
3. Overhead
a. Overhead volume variance
b. Controllable overhead variance
Material Variances

Differences between standard and actual material

costs may be due to:
a. Material price variance (purchase cost)
b. Material quantity variance (usage)
Material Price Variance
(AP – SP) x AQp
Where:
AP = actual price per unit of material
SP = standard price per unit of direct material
AQp = actual quantity of material purchased
If:
Actual price > standard price: Unfavorable
Actual price < standard price: Favorable
Material Quantity Variance
(AQu – SQ) x SP
Where:
AQu = actual quantity of material used
SQ = standard quantity of material allowed
SP = standard price of material
If:
Actual quantity > standard quantity: Unfavorable
Actual quantity < standard quantity: Favorable
Direct Labor Variance
Differences between standard and actual direct
labor costs can be due to:
a. Labor rate (price) variance
b. Material efficiency (quantity) variance
Labor Rate Variance
(AR – SR) x AH
Where:
AR = actual wage rate (price)
SR = standard wage rate (price)
AH = actual number(quantity) labor hours
If:
Actual rate > standard rate: Unfavorable
Actual rate < standard rate: Favorable
Labor Efficiency Variance
(AH – SH) x SR
Where:
AH = actual number of hours worked
SH = standard number of hours worked
SR = standard labor wage rate
If:
Actual hours > standard hours: Unfavorable
Actual hours < standard hours: Favorable
Overhead Variances
Differences between overhead applied to
inventory at actual overhead costs:
a. Controllable overhead variance
b. Overhead volume variance
Controllable Overhead Variance
• Actual overhead ($): flexible budget level of
overhead ($) for actual volume of production
• Referred to as controllable because managers are
expected to control costs

Actual > budget: unfavorable

Actual < budget, then the variance is favorable
Overhead Volume Variance
Overhead volume variance =
Flexible budget level of overhead for actual level of
production minus Overhead applied to production
using standard overhead rate.

• This variance is solely the result of a different

number of units being produced than planned in
the static budget.
• Usefulness is limited
Example: Darrington Ice Cream
Example: Darrington Ice Cream

Standard Costs Per Unit

Item Qty. x Price =
Total
Direct Materials: 0.8 gal. 2.50 =
$2.00
Direct Labor: 0.125 hrs. 12.00 =
$1.50
Mfg. Overhead:
$0.75
Total Cost Per Unit (Standard)
Materials Variance
Material price variance:
(AP – SP) x AQp
($2.72 - $2.50) x 810,000 = $178,200 Unfavorable

Material quantity variance:

(AQu – SQ) x SP
(809,000 – 800,000) x $2.50 = $22,500 Unfavorable
Labor Variance
Labor rate (price) variance:
(AR – SR) x AH
($12.10 - $12.00) x 130,000 = $13,000 Unfavorable

Labor efficiency (quantity) variance:

(AH – SH) x SR
(130,000 – 125,000) x $12 = $60,000 Unfavorable
Overhead Variances
Controllable overhead variance:
Actual overhead ($) – Flexible budget level of
overhead ($) for actual volume of production:
$680,000 - $700,000 = $20,000 Unfavorable

Overhead volume variance:

Flexible budget level of overhead for actual level of
production – Overhead applied to production using
standard overhead rate:
$700,000 - $750,000 = $50,000 Favorable
Investigation of Standard Costs Variances

1. Standard cost variances are not a definitive sign

of good or bad performance.
2. Variances are merely indicators of potential
problems which must be investigated.
3. There are many plausible explanations for them.
“Favorable” Variances may be Unfavorable

1. A “favorable” variance does not mean that it

should not be investigated.
2. Raw materials are good examples of this
phenomenon.
3. Consider inferior, low-priced materials.
4. A favorable price variance may result, but there
may also be substantially more scrap and
rework, and thus a higher quantity variance.
Can Process Improvements Lead to “Unfavorable”
Variances?

1. Process improvements frequently lead to

unfavorable variances.
2. Process improvements often lead to increased
productivity.
3. Therefore fewer hours may be required to
produce a unit of output.
4. But actual hours will remain unchanged unless
the firm terminates the workers to became
“more productive.”
Responsibility Accounting and Variances

1. Managers should be held responsible only for

costs they can control.
2. This is also true in the area of variance analysis.
3. A purchasing agent may be held responsible
for direct material price variances, but certainly
not direct material quantity (usage) variances.