CHAPTER 8: PRODUCT COSTING

Chapter Contents: Some Useful Definitions Overview of Product Costing Cost Objects Direct Costs Overhead Costs Cost Allocation Bases Overhead Rates ZFN Apparel Company, Example of Actual Costing

Some Useful Definitions: Cost object: A cost object is anything that we want to know the cost of. We might want to know the cost of making one unit of product, or a batch of product, or all of Tuesdays production, in which case the cost objects are one unit of product, a batch of product, or Tuesdays production, respectively. We might want to know the cost of operating a department or a factory, in which case the cost object is the department or factory. In a service sector company, we might want to know the cost of treating a patient in a hospital, or the cost of conducting an audit, in which case the cost object is the patient or the audit client. In a government setting, a cost object might be a program such as Meals on Wheels.

Product costs: A product cost is any cost that is associated with units of product for a particular purpose. Hence, the identification of product costs depends on the purpose for which it is done. For example, the factory manager is interested in manufacturing costs, whereas the merchandising manager might be interested in both manufacturing and nonmanufacturing costs, including research and development, marketing, and advertising costs.

Inventoriable costs: These are costs that are debited to inventory for either external or internal reporting purposes. For manufacturing firms, all inventoriable costs are manufacturing costs, but the reverse is not necessarily true. In other words, inventoriable costs are either the complete set or a

subset of manufacturing costs, and non-manufacturing costs are never included as inventoriable costs. For merchandising firms, inventoriable cost is usually the purchase price of inventory.

Period costs: These are costs that are expensed when incurred, usually because they are not associated with the manufacture of products. Examples include advertising costs and research and development costs. Period costs are distinguished from inventoriable costs.

Direct costs and overhead costs: In relation to a given cost object, all costs are either direct costs or overhead costs. Direct costs can be traced to the cost object in an economically feasible way. Overhead costs (also called indirect costs) are associated with the cost object, but cannot be traced to the cost object in an economically feasible way. These terms apply to companies in all sectors of the economy and to all types of organizations.

Cost driver: A cost driver is any factor that affects costs. A change in the cost driver will cause a change in the total cost of a related cost object. Any one cost object almost always has numerous cost drivers. This term applies to companies in all sectors of the economy and to all types of organizations.

Cost allocation: The assignment of overhead costs to the cost object. This term applies to companies in all sectors of the economy and to all types of organizations.

Cost allocation base: A quantitative characteristic shared by multiple cost objects that is used to allocate overhead costs among the cost objects. A cost allocation base can be a financial measure (such as the raw material cost of each unit of product) or a nonfinancial measure (such as direct labor hours incurred in the manufacture of each unit of product). The simplest cost allocation base is simply the number of cost objects (e.g., the number of units produced by the factory during a period of time).

The distinction between a cost driver and a cost allocation base can be summarized as follows. A cost driver is an economic concept; it relates to the economic reality of the business. A cost allocation base is an accounting choice that is made by accountants and managers. Usually, the best choice for a cost allocation base is a cost driver.

Conversion costs: All manufacturing costs other than direct materials.

Overview of Product Costing: Product costing follows these steps:

1. 2. 3. 4. 5.

Identify the cost object; Identify the direct costs associated with the cost object; Identify the overhead costs; Select the cost allocation base to use in assigning overhead costs to the cost object; Develop the overhead rate for allocating overhead to the cost object.

The cost accounting system builds up the cost of product (or other cost object) by recording to a job cost sheet, a work-in-process account, or some other appropriate ledger, the direct costs that can be traced to the product, and a share of the overhead costs, which are allocated to the product by multiplying the overhead rate by the amount of the allocation base identified with the cost object.

Cost Objects: Recall that a cost object is anything that we want to know the cost of, such as a product or service.

There is a common convention that can be confusing. We often talk about the cost object (the thing we want to know the cost of) as one unit of product, because factory managers and product managers speak in terms of unit costs. These managers want to know the unit cost for product pricing, product sourcing, and performance evaluation purposes. They do not want to talk about the cost of making 620 units, even if that is the batch size. However, in most batch processes, there would be very little benefit and enormous additional expense in determining the cost of each unit of product individually. Rather, the accounting system treats the batch as the cost object, and to derive a unit cost, we divide the cost of the batch by the number of units in the batch. Hence, loosely speaking, we talk as if a unit of product is the cost object, but more precisely, it is the batch (or the production run in an assembly-line process, or perhaps one days production in a continuous manufacturing process) that constitutes the cost object.

Direct Costs:

Management accounting classifies product costs as either direct costs or overhead costs (indirect costs). This distinction is important because costing systems handle these two types of costs very differently. The distinction is sometimes subtle, because whether a cost is direct or overhead is a function of the cost object, and also partly a matter of choice on the part of managers and accountants.

Following are three definitions of direct costs from different accounting textbooks:

Direct costs of a cost object are costs that are related to the cost object and can be traced to it in an economically feasible way.

Direct costs are costs that can be directly attached to the unit under consideration.

Direct costs are costs that can be traced easily to specific products.

Direct costs are also called prime costs. For manufacturing companies, direct costs usually can be categorized as either materials or labor.

Direct materials: materials that become part of the finished product and that can be conveniently and economically traced to specific units (or batches) or product.

Example of direct materials for an apparel manufacturer: fabric. All other materials, such as thread and zippers, are probably indirect.

Direct labor: costs for labor that can be conveniently and economically traced to a unit (or batch) of product. The following examples show how the determination of whether a cost is direct or overhead depends on the identification of the cost object: Examples of direct labor for an apparel manufacturer:

1)

If the cost object is a single pair of pants, in a batch of several dozen pairs:

Probably no labor is direct.

2)

If the cost object is a batch of several dozen pairs of pants:

Probably, sewing operators wages are direct.

3)

If the cost object is a production line in the factory, add:

The line managers salary, and possibly wages incurred in the cutting room (where rolls of fabric are cut into panels and pieces that are then sewn together).

4)

If the cost object is the entire factory, add:

The factory managers salary, wages of maintenance and janitorial workers, and salaries of front office personnel.

Even though probably no labor is direct with respect to a single pair of pants, if labor is direct with respect to a batch of 50 or 100 units, cost accountants would usually (and loosely) call labor a direct cost with respect to units of product, and divide the direct labor cost for the batch by the number of units per batch to derive the direct labor cost per unit.

Overhead Costs: Overhead costs are costs that are related to the cost object, but cannot be traced to the cost object in an economically feasible way. Overhead costs are not directly traceable to specific units of production. Examples of overhead costs incurred at an apparel manufacturer, when the cost object is a batch of product, probably include the following:

Electricity Factory office salaries Building and machine maintenance Factory depreciation

The distinction between direct costs and overhead costs relate, in some measure, to the way the accounting system treats the cost. For example, one apparel manufacturer might track thread using the same methods that are used to track fabric, thus treating thread as a direct material. Another apparel manufacturer might decide that the cost of thread is immaterial, and does not warrant the cost and effort to track it as a direct cost. For this company, thread is an overhead cost. Therefore, whether some costs are direct or overhead depend on a choice made by the manager and the cost accountant.

There are three ways overhead costs can be treated in any decision-making context: (1) they can be ignored, (2) they can be treated as a lump-sum, or (3) they can be allocated to the products and services (i.e., to the cost objects) to which they relate. Each of these three alternatives is appropriate, depending on the circumstances and the purpose for which the accounting is done. However, in this chapter and throughout much of this book, we are concerned with the third alternative: how to allocate overhead costs to products and services.

Cost Allocation Bases The allocation base is the link that is used to attach overhead costs to the cost object. In a manufacturing setting, the simplest allocation base is the number of units produced. For example, if the factory makes 15,000 units, the accounting system can simply spread the overhead costs evenly over all 15,000 units. The problem with using units as an allocation base, however, is that if the factory makes a range of different products, those products might differ significantly in their resource utilization. A deluxe widget might require twice as much labor and 20% more materials than a standard widget, and one might infer that the deluxe widget also requires more resources that are represented by overhead costs.

Whatever cost allocation base is chosen, it must be a common denominator across all cost objects. For example, a furniture factory could allocate overhead costs across all products using direct labor hours, because direct labor is incurred by all products made at the factory. However, it would not seem appropriate to allocate factory overhead based on the quantity of wood used in each unit, if the factory makes both wood furniture and a line of plastic-molded, because no overhead would be allocated to the plastic chairs.

Overhead Rates: The overhead rate is the ratio of cost pool overhead dollars in the numerator, and the total quantity of the allocation base in the denominator: Overhead rate

Overhead costs in the cost pool = Total quantity of the allocation base

The result represents dollars of overhead per unit of the allocation base. For example, if an apparel factory allocates overhead based on direct labor hours, the overhead rate represents dollars of overhead per direct labor hour. Assume the overhead rate is $20 per direct labor hour. Then for every hour that a sewing operator spends working on product, $20 will be allocated to the products that the sewing operator assembles during that hour.

ZFN Apparel Company, Example of Actual Costing: The ZFN apparel company in Albuquerque, New Mexico makes jeans and premium chinos. Each product line has its own assembly line on the factory floor. Overhead costs for the factory for 2005 were $3,300,000. 500,000 jeans and 400,000 chinos were produced during the year. 500,000 direct labor hours were used: 200,000 for jeans, and 300,000 for chinos. The average direct labor wage rate was the same on both assembly lines, and was $14 per hour. Denim fabric is used to make jeans, and chinos are made from a cotton twill fabric. Overhead is allocated using direct labor hours.

The following journal entries and T-accounts illustrate how the accounting system records the manufacturing activities of the factory in order to derive product cost information for jeans and chinos. Journal entry (6) to debit overhead to work-in-process is based on an overhead rate calculated as follows.

$3,300,000 500,000 direct labor hours = $6.60 per direct labor hour.

In practice, the factory would track costs by batch, or perhaps weekly, but to simplify our example, we record only one journal entry for each type of transaction. We also make the unrealistic assumption that there is no work-in-process at the end of the period. To focus the presentation on inventory-related accounts, T-accounts for some non-inventory accounts, and the entry to debit accounts receivable and credit revenue, are omitted. (1) Raw Materials: denim fabric Raw Materials: cotton twill Accounts Payable $3,000,000 2,250,000 $5,250,000

(To record the purchase of 600,000 yards of denim fabric at $5.00 per yard, and 500,000 yards of cotton twill fabric at $4.50 per yard.)

(2)

Work-in-process: Jeans Raw Materials: denim fabric

$2,500,000 $2,500,000

(To record materials requisitions for 500,000 yards, for the movement of denim from the receiving department to the cutting room.)

(3)

Work-in-process: Chinos Raw Materials: cotton twill

$2,160,000 $2,160,000

(To record materials requisitions for 480,000 yards, for the movement of cotton twill from the receiving department to the cutting room.)

(4)

Work-in-process: Jeans Work-in-process: Chinos Accrued Sewing Operator Wages

$2,800,000 4,200,000 $7,000,000

(To record sewing operator wages for the year: 200,000 hours for jeans, and 300,000 hours for chinos, at $14 per hour.)

(5)

Factory Overhead Accounts Payable Accrued Wages for Indirect Labor Accumulated Depreciation

$3,300,000 $1,800,000 900,000 600,000

(To record overhead costs incurred during the year, including utilities, depreciation, repairs and maintenance, and indirect wages and salaries.)

(6)

Work-in-process: Jeans Work-in-process: Chinos Factory Overhead

$1,320,000 1,980,000 $3,300,000

(To allocate factory overhead to production, using an overhead rate of $6.60 per direct labor hour.)

(7)

Finished Goods: Jeans Work-in-process: Jeans

$6,620,000 $6,620,000

(To record the completion of all 500,000 jeans, at $13.24 per pair.)

(8)

Finished Goods: Chinos Work-in-process: Chinos

$8,340,000 $8,340,000

(To record the completion of all 400,000 chinos, at $20.85 per pair.)

(9)

Cost of Goods Sold: Jeans Cost of Goods Sold: Chinos Finished Goods: Jeans

$5,296,000 $7,297,500 $5,296,000 $7,297,500

Finished Goods: Chinos

(To record the sale of 400,000 jeans and 350,000 chinos.)

Raw Materials: Denim Fabric

Raw Materials: Cotton Twill (1) $3,000,000

$ 500,000

$2,500,000

(2) (1) $2,250,000

$ 90,000 $2,160,000 (3)

Accrued Sewing Operator Wages

Factory Overhead

$7,000,000

(4) (5) $3,300,000

$0 $3,300,000 (6)

Work-in-Process: Jeans Work-in-Process: Chinos (2) (4) (6) $2,500,000 2,800,000 1,320,000 $0 $6,620,000

(7) (3) (4)

(6) $2,160,000 4,200,000 1,980,000 $0 $8,340,000 (8)

Finished Goods: Jeans Finished Goods: Chinos (7) $6,620,000

$1,324,000 $5,296,000

(9) (8) $8,340,000

$1,042,500 $7,297,500 (9)

Cost of Goods Sold: Jeans Cost of Goods Sold: Chinos (9) $5,296,000

(9) $7,297,500

Accounts Payable

$5,250,000 1,800,000 (1) (5)

The per-unit inventory cost is calculated as follows:

Jeans: Chinos:

$6,620,000 500,000 pairs = $13.24 per pair $8,340,000 400,000 pairs = $20.85 per pair

These amounts, which are used in journal entry (9), can be detailed as follows:

Input Jeans Chinos Fabric Direct labor Overhead Total 1 yard per jean x $5 per yard = $5.00 0.4 hours per jean x $14 per hour = $5.60 0.4 hours per jean x $6.60 per hour = $2.64 $13.24 1.2 yards per chino x $4.50 per yard = $5.40 0.75 hours per chino x $14 per hour = $10.50 0.75 hours per chino x $6.60 per hour = $4.95 $20.85

In the above table, the direct labor hours per jean and per chino appear in the lines for both the perunit direct labor cost and the per-unit overhead cost, because overhead is allocated based on direct labor hours. If the allocation base had been something else, such as machine hours, the hours per unit would only appear in the calculation of the direct labor cost.

More overhead is allocated to each pair of chinos than to each pair of pants ($4.95 versus $2.64) because direct labor hours has been chosen as the allocation base, and each chino requires more direct labor time than each pair of jeans (0.75 hours versus 0.40 hours). Changing the allocation base cannot change the total amount of overhead incurred, but it will usually shift costs from some products to others. For example, if the allocation base were units of production instead of direct labor hours, the overhead rate would be:

$3,300,000 900,000 units = $3.67 per unit.

In this case, the total cost per pair of jeans would increase from $13.24 to $14.27, and the total cost

per pair of chinos would decrease from $20.85 to $19.57.

Because the choice of allocation base determines how overhead is allocated across products, product managers usually have preferences over this choice (because a lower reported product cost results in higher reported product profitability). However, the companys choice of allocation base should be guided, if possible, by the cause-and-effect relationship between activity on the factory floor and the incurrence of overhead resources. For example, direct labor hours is a sensible allocation base if the significant components of overhead increase as direct labor hours increase. More direct labor implies more indirect labor by human resources and accounting personnel, janitorial staff and other support staff. Also, more direct labor implies more machine time, which implies more electricity usage, and more repairs and maintenance expense. For these reasons, direct labor hours is probably a better choice of allocation base than units of product.

MANAGEMENT ACCOUNTING: CONCEPTS AND TECHNIQUES

By Dennis Caplan

PART 2: MICROECONOMIC FOUNDATIONS OF MANAGEMENT ACCOUNTING

CHAPTER 7: COST-VOLUME-PROFIT

Chapter Contents: The Basic Profit Equation Assumptions in CVP Analysis

Target Costing Leverage Examples

The Basic Profit Equation: Cost-Volume-Profit analysis (CVP) relates the firms cost structure to sales volume and profitability. A formula that facilitates CVP analysis can be easily derived as follows:

Profit

Sales Costs

Profit

Sales (Variable Costs + Fixed Costs)

Profit + Fixed Costs

Sales Variable Costs

Profit + Fixed Costs

Units Sold x (Unit Sales Price Unit Variable Cost)

This formula is henceforth called the Basic Profit Equation and is abbreviated:

P + FC = Q x (SP VC)

Contribution margin is defined as

Sales Variable Costs

The unit contribution margin is defined as

Unit Sales Price Unit Variable Cost

Typically, the Basic Profit Equation is used to solve one equation in one unknown, where the unknown can be any of the elements of the equation. For example, given an understanding of the firms cost structure and an estimate of sales volume for the coming period, the equation predicts profits for the period. As another example, given the firms cost structure, the equation indicates the required sales volume Q to achieve a targeted level of profits P. If targeted profits are zero, the equation simplifies to

Q = FC Unit Contribution Margin

In this case, Q indicates the required sales volume to break even, and the exercise is called breakeven analysis.

CPV analysis can be depicted graphically. The graph below shows total revenue (SP x Q) as a function of sales volume (Q), when the unit sales price (SP) is $12.

The following graph shows the total cost function when fixed costs (FC) are $4,000 and the variable cost per unit (VC) is $5.

The following graph combines the revenue and cost functions depicted in the previous two graphs into a single graph.

The intersection of the revenue line and the total cost line indicates the breakeven volume, which in this example, occurs between 571 and 572 units. To the left of this point, the company incurs a loss. To the right of this point, the company generates profits. The amount of profit or loss can be

measured as the vertical distance between the revenue line and the total cost line.

Assumptions in CVP Analysis: The Basic Profit Equation relies on a number of simplifying assumptions. Only one product is sold. However, multiple products can be accommodated by using an average sales mix and restating Q, SP and VC in terms of a representative bundle of products. For example, a hot dog vendor might calculate that the average customer buys two hot dogs, one bag of chips, and two-thirds of a beverage. Q is the number of customers, and SP and VC refer to the sales price and variable cost for this average customer order. If the equation is applied to a manufacturer, beginning inventory is assumed equal to zero, and production is assumed equal to sales. Relaxing these assumptions requires additional structure on the equation, including specifying an inventory flow assumption (e.g., FIFO or LIFO) and the extent to which the matching principle is honored for manufacturing costs. The analysis is confined to the relevant range. In other words, fixed costs remain unchanged in total, and variable costs remain unchanged per unit, over the range of Q under consideration.

Target Costing: A relatively recent innovation in product planning and design is called target costing. In the context of the Basic Profit Equation, target costing sets a goal for profits, and solves for the unit variable cost required to achieve those profits. The design and manufacturing engineers are then assigned the task of building the product for a unit cost not to exceed the target. This approach differs from a more traditional product design approach, in which design engineers (possibly with input from merchandisers) design innovative products, manufacturing engineers then determine how to make the products, cost accountants then determine the manufacturing costs, and finally, merchandisers and sales personnel set sales prices. Hence, setting the sales price comes last in the traditional approach, but it comes first in target costing.

Target costing is appropriate when SP and Q are predictable, but are not choice variables, such as might occur in well-established competitive markets. In such a setting, merchandisers might know the price that they want to charge for the product, and can probably estimate the sales volume that will be achieved at that price. Target costing has been used successfully by a number of companies including Toyota, which redesigned the Camry around the turn of the century as part of a target costing strategy.

Leverage:

There is often a trade-off between fixed cost inputs and variable cost inputs. For example, in the manufacturing sector, a company can build its own factory (thereby operating with relatively high fixed costs but relatively low variable costs) or outsource production (operating with relatively low fixed costs but relatively high variable costs). A merchandising company can pay its sales force a flat salary (relatively higher fixed costs) or rely to some extent on sales commissions (relatively higher variable costs). A restaurant can purchase the equipment to launder table cloths and towels, or it can hire a laundry service.

A company that has relatively high fixed costs is more highly leveraged than a company with relatively high variable costs. Higher fixed costs result in greater downside risk: as Q falls below the breakeven point, the company loses money more quickly than a company with less leverage. On the other hand, the companys lower variable costs result in a higher unit contribution margin, which means that as Q rises above the breakeven point, the more highly-leveraged company is more profitable.

There is an ongoing trend for companies to outsource support functions and other non-core activities to third party suppliers and providers. Usually, outsourcing reduces the leverage of the company by eliminating the fixed costs associated with conducting those activities inside the firm. When the activities are outsourced, the contractual payments to the outsource providers usually contain a large variable cost component and a relatively small or no fixed cost component.

Examples: Breakeven: Steve Poplack owns a service station in Walnut Creek. Steve is considering leasing a machine that will allow him to offer customers the mandatory California emissions test. Every car in the state must be tested every two years. The machine costs $6,000 per month to lease. The variable cost per test (i.e., per car inspected) is $10. The amount that Steve can charge each customer is set by state law, and is currently $40.

How many inspections would Steve have to perform monthly to break even from this part of his business?

Q = FC Unit Contribution Margin Q = $6,000 ($40 - $10) = 200 inspections

Targeted profits, solving for volume: Refer to the information in the previous question. How many inspections would Steve have to perform monthly to generate a profit of $3,000 from this part of his business?

P + FC = Q x (SP VC) $3,000 + $6,000 = Q x ($40 - $10) Q = 300 inspections

Targeted profits, solving for sales price: Alice Waters (age 9) runs a lemonade stand in the summer in Palo Alto, California. Her daily fixed costs are $20. Her variable costs are $2 per glass of icecold, refreshing, lemonade. Alice sells an average of 100 glasses per day. What price would Alice have to charge per glass, in order to generate profits of $200 per day?

P + FC = Q x (SP VC) $200 + $20 = 100 x (SP - $2) SP = $4.20 per glass

Contribution margin: Refer to the previous question. What price would Alice have to charge per glass, in order to generate a total contribution margin of $200 per day?

Total CM = Q x (SP VC) $200 = 100 x (SP - $2.00) SP = $4.00 per glass

Target costing: Refer to the information about Alice, but now assume that Alice wants to charge $3 per glass of lemonade, and at this price, Alice can sell 110 glasses of lemonade daily. Applying target costing, what would the variable cost per glass have to be, in order to generate profits of $200 per day?

P + FC = Q x (SP VC) $200 + $20 = 110 x ($3 VC) VC = $1