Product Costing: Job and Process Operations: 1. Inventory Costs in Various Organizations
Product Costing: Job and Process Operations: 1. Inventory Costs in Various Organizations
Product Costing: Job and Process Operations: 1. Inventory Costs in Various Organizations
Objectives:
- Discuss flow of costs through the inventories.
- Learn about allocating indirect costs: why it is done and how it is done.
- Understand job order costing vs. process costing.
- Explain why profits under absorption and variable costing may not
always be the same.
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2. Cost Classifications
Which costs are manufacturing and which are non-manufacturing costs are
regulated by GAAP.
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Overhead (OH) All of the manufacturing costs other than direct labor and direct
materials; thus it includes indirect materials, indirect labor, and other
overhead.
Which costs are direct and which are indirect is the firm’s choice. No rigid rules that a
firm must follow.
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Direct Costs (Prime costs) Direct Labor + Direct Materials
Conversion Costs (CC) Direct Labor + Manufacturing Overhead
Non-manufacturing costs
Marketing Costs Costs incurred in getting orders from customers and providing
(or Selling Costs) customers with the finished product
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Purchase raw materials and store them in Raw or Direct Materials Inventory.
Requisition the raw materials from the inventory and move to production area.
Combine raw materials with other inputs (e.g. labor, machinery) in the production area
to manufacture the product.
The costs of all inputs used in the production are recorded in the Work In Process
(WIP) Inventory.
Take the finished products and move it to the Finished Goods (FG) Inventory.
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Direct Materials Inventory
Beginning balance
Ending balance
Ending balance
Ending balance
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3. Product Costing Systems
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Example: Job Costing vs. Process Costing
Some companies use process costing and some use job costing. A number of companies
in different industries are listed below:
1. Contract water drilling company
2. Commercial photographer
3. Tortilla manufacturer
4. Electric utility
5. Mushroom farm that produces the standard button mushroom in caves
Required:
For each company, indicate whether the company is most likely to use job costing or
process costing.
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Cost driver Some item which can be used to assign the overhead to
(= allocation base) different products. Products are assigned overhead in
proportion to the amount of the allocation base they use. A
good allocation base is easily measured and highly correlated
with the generation of overhead.
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Example: The Caterpillar
During the month of May, Caterpillar, Inc. manufactured earthmovers, medium sized
tractors, and bobcats. The direct materials and labor spent on each product is known.
Caterpillar also knows that it spent $30,000,000 in indirect costs during the month.
Caterpillar, Inc.
Costs per unit
Earthmovers Tractors Bobcats
(5 units) (10 units) (100 units)
Direct materials $10,000,000 $1,000,000 $ 100,000
Direct labor $ 5,000,000 $ 300,000 $ 20,000
Overhead ? ? ?
How should the $30,000,000 in overhead be divided among the different products?
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How much of the $30,000,000 in overhead costs is assigned to each product (earth mover,
tractor, or bobcat) made by Caterpillar?
The easiest way would be dividing the costs evenly among all products.
Each product is assigned $30,000,000/(5+10+100) = $260,870/unit.
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Caterpillar’s management knows earth movers and bobcats use different amounts of
overhead. It requires significantly more time (both labor and machine time) to
manufacture earthmovers than bobcats.
Caterpillar, Inc.
Earthmovers Tractors Bobcats
(5 units) (10 units) (100 units)
Machine hours per unit 1,620 MH/unit 90 MH/unit 10 MH/unit
a. Compute an allocation rate. What is the overhead cost per machine hour?
b. Assign costs to each product according to the product’s usage of the allocation
base.
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After much analysis, Caterpillar has divided the overhead into the following pools:
Material handling and ordering costs 480,000
Engineering costs 960,000
All other overhead costs 28,560,000
Total $ 30,000,000
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Step 2: Use an allocation base for each pool to assign the costs in the pools to
each product type.
The following allocation bases can be used for each cost pool:
Cost pool Cost driver/Allocation base
Materials handling and ordering Number of requisitions
Engineering Number of engineering hours
All other overhead Machine hours
The information about the amount of each allocation base used by each product:
Earthmovers Tractors Bobcats
Amount of base (5 units) (10 units) (100 units) Total
Number of requisitions
for the product line 5,430 530 40
Number of engineering
hours for the product line 19,650 250 100
Machine hours (per unit) 1,620 MH 90 MH 10 MH
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b. Assign costs in a pool to each product according to the product’s usage of the allocation
base for that pool. Find the overhead per unit.
Caterpillar, Inc.
Overhead costs per unit
Materials Engineering All other Total
handling and overhead
ordering
Earthmovers
Tractors
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Caterpillar Inc.
Total per unit cost (=DM+DL+OH)
Method Earthmovers Tractors Bobcats
1. Same costs for each product – DM $ 10,000,000 $ 1,000,000 $100,000
equal share
DL 5,000,000 300,000 200,000
OH 260,870 260,870 260,870
Total $15,260,870 $1,560,870 $380,870
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Question 1: Do any of the methods tell us the “actual or “true” costs for each product?
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Time line:
Beginning End of
of period Throughout the period period
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Example:
In the 3rd quarter, the Meadowcraft Furniture Company made 20,100 tables of different
sizes and shapes, 68,400 various chairs, and 5,430 other metal furniture products, for a
total of 93,930 units. We are not going to find the cost of all different products; we want
to find the cost of two special orders:
Order #23 consists of 10 chairs with cushions.
Order #57 consists of 7 tables.
Since direct materials and direct labor are traced to the product or job, we know the
direct materials and labor costs for each special order:
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Meadowcraft uses normal costing. At the beginning of the year, Meadowcraft formed
the following estimates:
MEADOWCRAFT
Estimates of overhead for the quarter
Fabrication Department:
Depreciation of robotic welder, salaries for levelers and quality
control personnel, depreciation on facilities for Fabrication
Department, etc.
$ 501,000
Painting Department:
Depreciation of primer tank, paint cleaners, depreciation on
facilities for Painting Department, etc.
1,200,000
Sewing Department:
Sewing supplies, depreciation on sewing machines, etc. 243,000
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At the end of the quarter, Meadowcraft noted the following actual results:
MEADOWCRAFT
Actual overhead costs for the Quarter
Fabrication department $ 490,000
Painting department 1,300,000
Sewing department 260,000
Total actual overhead costs $2,050,000
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Entire plant – Actual total usage of resources
Fabrication Painting Sewing Total
Direct labor 9,000 DLH 2,500 DLH 2,100 DLH 13,600 DLH
Machine time 13,000 MH 38,000 MH 1,200 MH 52,200 MH
Order 23 (10 chairs with cushions) – Actual usage of resources per unit
Fabrication Painting Sewing Total
Direct labor 0.2 DLH 0.7 DLH 0.5 DLH 1.2 DLH
Machine time 0.5 MH 0.4 MH 0.1 MH 1.0 MH
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Suppose management has decided it needs more accurate product information to make
its pricing and production choices.
The Fabrication Department is labor intensive, and overhead costs are largely related to
labor time used in the manufacture of the product.
The Painting Department is highly automated, and overhead costs are driven by
machine time.
The Sewing Department is very labor intensive, and overhead costs are related to labor
time.
If Meadowcraft were to use department rates, what is the cost of each order?
Step 1: form pools.
Step 2: calculated predetermined OH rate and assign OH costs to each job.
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Order 23 (chairs) Order 57 (tables)
Direct costs
Fab. OH
Paint OH
Sewing OH
Total
* units in Job
Under-applied by $ 289,000
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Can we understand why we got different costs for the products with different methods?
(1) Allocate a portion of the over- or underapplied overhead to work in process inventory,
finished goods inventory, and cost of goods sold. The allocation would be based on
the relative dollar value in each of the three accounts involved.
(2) Adjust to adjust cost of goods sold for the entire amount of the over- or under-
applied overhead. An easier way to deal with the problem
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3.2 Process costing
- Collects costs by process (i.e., department).
- Determine unit costs by dividing total costs by total number of units worked on.
- Inventory cost = Conversion cost per unit + DM
- Why is a different accounting method needed for process costing?
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Example 1:
Suppose your cousin Sue was hired to assemble 10 bicycles. At the end of the month Sue is
paid $1,600 for her labor. One would like to know the labor cost of each bike.
Four of the bikes are complete; it took Sue 25 hours to assemble each. The other six bikes
are as yet unfinished and still in process; Sue has spent only 10 hours on each of the
unfinished bikes.
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4 complete bikes equivalent to 4 complete bikes
6 bikes partially complete equivalent to
Labor cost for each finished bike (=labor cost per equivalent unit):
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Example 2:
John Boos & Company (www.johnboos.com) has been in business making stainless steel
and wood products since 1887. Suppose John Boos manufactures several types of serving
trays. The deluxe model has a stainless bottom with wooden handles. At the end of the
period, John Boos finds that it has 100 trays partially done in its ending WIP Inventory.
Labor and overhead are added continuously throughout the manufacturing process. All of
the steel is added at the beginning of the production process; the wooden handles are
attached when the manufacturing process is 60% finished. John Boos estimated that these
100 trays are 35% finished.
What are the equivalents units for the trays in terms of the steel? in terms of the wood? in
terms of conversion costs? Time line indicating the manufacturing process or the percent
of the required CC that has been applied to the product:
WIP Inventory
Costs in beginning inventory Units completed and transferred
Costs added during period to Finished Goods Inventory or to
the next department
Note these units are unfinished. So one must use equivalent units here.
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Example:
The beginning work in process inventory showed a balance of $48,240. Of this amount,
$16,440 is the cost of direct materials, and $31,800 are conversion costs. There were 8,000
units in the beginning inventory that were 30% complete with respect to both direct
materials and conversion costs.
During the period, 14,000 units were started; 5,000 remained in the ending inventory at the
end of the period. The units in ending inventory were 80% complete with respect to direct
materials and 40% complete with respect to conversion costs.
Costs incurred during the period amounted to $126,852 for direct materials and $219,120
for conversion.
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Direct materials (DM) Conversion costs (CC)
Costs of units completed and transferred out and units in ending WIP
Units completed and transferred out
(17,000 units):
Unfinished units in ending WIP
(5,000 units)
DM cost: 80%*5,000 = 4,000EU
CC cost: 40%*5,000 = 2,000EU
Total costs:
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WIP Inventory
Beginning Inventory:
DM $16,440
CC 31,800
Total 48,240
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4. Absorption and Variable Costing
When designing a product costing system we have identified 4 choices a manager must
make:
(1) How many overhead rates or drivers or cost pools should be used?
∙ Single overhead rate
∙ Overhead rate for each department
∙ Many overhead rates or Activity based Costing (ABC)
(2) Can the accounting be dome for batches or is production continuous and
equivalent units must be considered?
∙ Job order costing
∙ Process costing
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∙ Assign all manufacturing costs and some variable selling and administration
costs to the units produced.
New choice:
∙ Variable costing, direct costing – assign only variable manufacturing costs
(direct materials, direct labor, variable manufacturing overhead) to the
product; treat fixed manufacturing costs as an expense of the period.
Which manufacturing costs are product costs and which are period costs?
Absorption costing Variable costing
Product costs
Period costs
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Overview of Variable and Absorption Costing
Variable Absorption
Costing Costing
Direct Materials
Product
Direct Labor Product
Costs
Variable Manufacturing Overhead Costs
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4.2 Absorption Net Income vs. Variable Net Income
Absorption net income and variable net income may be quite different. In this
section, we want to understand what causes the difference.
When FOH is assigned to products, each crate is allocated the same amount of FOH.
What is the FOH rate?
$100/5 = $20/crate
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Second period: Produced 5 crates, but sold 6 crates at $50/crate.
FG Inventory – Absorption Costing FG Inventory – Variable Costing
This period’s production: This period’s production:
$25 $25 $25 $25 $25
($20 ($20 ($20 ($20 ($20 $5 $5 $5 $5 $5
in FOH) in FOH) in FOH) in FOH) in FOH)
Last period’s production: Last period’s production:
$25 $25
($20 ($20 $5 $5
in FOH) in FOH)
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Example 2: The difference between absorption income and variable income
Conair (www.conair.com) is a well-known manufacturer of hairdryers. Suppose
Conair use normal costing and has estimated overhead for the period as follows:
Estimated production 16,000 units
VOH/unit $2.00/unit
Total FOH* $40,000
*The same FOH is allocated to each unit.
Actual results for the period, are as follows:
Actual production 16,000 units
Direct materials/unit $10.00/unit
Direct labor/unit $8.00/unit
VOH/unit $2.00/unit
Total FOH* $40,000
Variable S&A/unit $6.00/unit
Total Fixed S&A $60,000
Selling price $40.00/unit
*The same FOH is allocated to each unit.
There is no beginning or ending WIP balances; all units started were completed.
Absorption cost per unit: Variable cost per unit:
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No FOH costs being deferred to inventory or extra FOH costs coming out of the inventory.
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Case: Managerial Incentives with Absorption Costing
Company Q produced and sold 10,000,000 units at 43.00 per unit in Year 0.
Variable manufacturing cost per unit was $1.00. Total fixed manufacturing costs
were $24,000,000, and total fixed selling and administration costs were
$5,000,000. The company uses absorption costing, incompliance with GAAP.
The same amount of overhead is assigned to each unit.
Company Q – Income Statement (Absorption Costing),
For Year Ending December 31, Year 0
Absorption cost per unit:
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A new president was hired the following year. He was paid no salary but was
promised 10% of operating profit (before considering the bonus). The new
president stepped up production to an annual rate of 30,000,000 units. Sales
remained constant at 10,000,000. Total fixed costs, selling and administration
costs, and variable cost per unit were unchanged.
Company Q – Income Statement (Absorption Costing),
For Year Ending December 31, Year 1
Absorption cost per unit:
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What is going on?
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Example 3: The difference between absorption income and variable income
when production changes annually.
In the first two examples, production and costs were the same each year; hence
the production cost of each unit was the same each year. In this example, the
cost of making a unit of production is different in the two years.
Bell ports uses actual costing, assigning the same fixed costs to each unit. In
Year 2, Bell sports had the same costs as above made 15,000 while selling
15,500 pairs. The price per helmet was $60. Bell Sports uses LIFO inventory
method.
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a. What is the variable cost per unit in each year? Absorption cost per unit in each
year?
Year 1 Year 2
Variable cost / unit
Absorption cost / unit
b. What was the value of Bell Sports’ finished good inventory at the end of Year 1
using variable costing? Using absorption costing?
Variable costing Absorption costing
FG inventory end of
Year 1
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d. Using absorption costing, what was income in Year 2?
Using variable costing, what was income in Year 2?
How is the difference explained?
Absorption Costing Variable Costing
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