Chapter 18

Additional Aspects
of Product Costing
Systems

McGraw-Hill/Irwin Copyright © 2011. The McGraw-Hill Companies. All Rights Reserved.

 Classifications of
Production Processes
• Unit production.
– Physically identifiable job (e.g., shipbuilder, consulting job).
• Batch (or lot) production.
– Batch of identical items moves from one factory work
station to another (e.g., 100 fuel injectors).
• Assembly line production.
– Jobs are separately identifiable but tend to be similar (e.g.,
automobiles, computers).
• Process production.
– Outputs are not identifiable as separate units (e.g.,
petroleum, chemicals, steel).
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 Product Costing Systems

 Two basic types of costing systems:

 Job order costing.
 Process costing.
 Goal:
 Arrive at full production cost for one unit of
product.
 Requires averaging some total costs.

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 Job Order Costing
• Collects costs for each job as it moves through
production process.
• Job can be a single unit or a batch of identical
units.
 Costs are collected on a job cost record.
 Direct materials (based on material requisitions).
 Direct labor (from employee time records).
 Overhead (charged using departmental rates).

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 Job Order Costing
 Job cost records are the basis for entries into
the accounting records.
 Total of unfinished jobs = balance in WIP.
Materials
Inventory
Work in Finished
Wages Cost of
Process Goods
Payable Sales
Inventory Inventory

Overhead
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 Process Costing

• Collects costs by process (i.e. department).

• Use of equivalent units of production.
• 6 physical units halfway completed would be 3
equivalent units of production.
• Unit cost = total production costs ÷ equivalent
units of production.

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 Process Costing
• Direct materials may be accounted for
separately from conversion costs (i.e., direct
labor plus overhead).
• When? Direct materials is added at a point in
time rather than continuously.
• Total unit cost is materials equivalent unit cost
plus conversion equivalent unit cost.

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 Choice of a System
• Nature of production process usually
determines system choice.
 Variations used in practice.
 Hybrid systems.
 Backflush accounting (i.e., no work in process
inventory account, charge production costs
directly to finished goods inventory).

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 Choice of a System
• Job cost system.
– Use when requires costs traced to specific units
(e.g., repair shop).
– Easier to identify existence of and source of cost
problems.
• Process cost system.
– Use when costs cannot be traced to specific units
(e.g., ice cream production).
– Less record keeping.

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 Measurement of Direct Costs
 Direct material cost.
1. Determine quantity of material used.
 Use requisitions from stockroom.
2. Determine price per unit of material
quantity.
 Invoice cost.
 May include material-related costs (e.g.,
purchasing, moving , inspection, storing).
 Cost flow assumptions must also be
considered (i.e., LIFO, FIFO, average cost).
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 Measurement of Direct Costs
 Direct labor cost.
1. Determine quantity of labor used.
 Use time cards.
2. Determine price per unit of labor
quantity (i.e., labor rate).
 Labor rate could be actual or average labor
rate.
 May include labor-related costs (i.e., fringe
benefits such as holiday/vacation pay,
pension, health care, etc.).
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 Cost Classification Distinctions
 Direct vs. indirect:
 Refers to traceability to cost objects.
 Accounting concept.
• Variable vs. fixed:
– Refers to cost behavior.
– Economic concept.
• Summary: Direct costs can be variable or
fixed. Indirect costs can be variable or fixed.

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 Allocation of Indirect Costs
 Direct costs are preferable (i.e., directly
traceable to cost object).
 Reasons for not tracing directly:
– Impossible to do so.
– Not feasible because too costly.
– Management chooses not to do so.
 Solution: Allocate fair share of indirect
costs.
 How? Determine causation.

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 Allocation of Indirect Costs

 How indirect costs are allocated.

 Use an overhead rate (aka, absorption rate,
allocation rate, burden rate).
 First, accumulate indirect costs in cost
centers (i.e., intermediate cost object).
 Then, assign cost center costs to
product/service (i.e., final cost object).

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 Cost Center vs.
Responsibility Center
• Cost center.
 Cost object for which costs of one or
more related functions or activities are
accumulated.
 Responsibility center.
 Organization unit headed by a
manager.
 Could be one or more cost centers.
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 Types of Cost Centers
 Production cost center.
 Produces a product or a component, or
 Performs a distinct step or task of production.
 Service cost center.
 All other cost centers.
 Provides services to production cost centers,
other service centers, or for benefit of
organization as a whole.
 E.g., maintenance department, general factory
office, occupancy cost center.
 Also called indirect cost pools or overhead pools.
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 Calculating Overhead Rates

Overall Process
1. Initial Assignment. Overhead costs are
assigned to production centers or service
centers.
2. Reassignment. Service center costs are
reassigned to production centers.
3. Allocation to Products. Production
center costs are allocated to products.
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 1. Initial Assignment
 Directly assign any cost item uniquely
associated with cost center (e.g., cost center
supervisors).
 Overhead costs that benefit several centers
are jointly allocated to those centers (e.g.,
heating cost).
 Utilize different allocation bases for different
costs (e.g., square footage, headcount).

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 2. Reassignment

 Step down method.

 Allocate service costs in a prescribed order.
 E.g., first allocating costs of service centers that
provides the most services to others.
 E.g., first allocating costs of service centers that
receives the fewest services from others.
 Direct method.
• Service centers costs are only allocated to
production centers (ignoring services provided
to other service centers).
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 3. Allocation to Products
 In a process cost system:
 Total overhead ÷ Equivalent units of production =
Overhead cost per unit.
 In a job cost system:
 More complex; may use multiple overhead rates.
 Overhead is assigned to product using some activity
measure (e.g., direct labor hours, machine hours).
 Overhead rate: Total overhead costs ÷ Total units of
activity measure.
 For each job: Overhead costs allocated (applied) =
Overhead rate x Units of activity measure used by
job.

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 Cost Drivers (Allocation Bases)
 Should reflect a causal relationship between
cost and cost object.
 Cost driver categories:
1. Payroll related (e.g., social security taxes, fringe
benefits).
2. Headcount related (e.g., human resource cost
related to number of employees, not what they
are paid).
3. Material related (e.g., costs related to purchasing,
receiving, inspecting, weighing, counting).
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 Cost Drivers (Allocation Bases)
 Cost driver categories (continued):
4. Space related (e.g., floor area occupied).
5. Transaction or activity related (e.g., costs related
a batch such as scheduling, set up costs).
6. Product related (e.g., tools and dies, engineering
change orders).
7. Customer related (e.g., sales calls, customer
service, advertising).
8. Business related (e.g., costs of CEO, CFO, HR
manager).
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 Using Predetermined
Overhead Rates
 An estimated, annual overhead rate (instead
of a monthly actual overhead rate).
 Why?
• Actual monthly rates affected by conditions
peculiar to month.
• Permits more prompt calculation of product costs.
• Calculating once a year is less effort than going
through the calculation every month.

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 Establishing Predetermined
Overhead Rates
• Prepare overhead budgets for each production
cost center at various levels of activity.
 Identify costs as variable, fixed, semi-variable.
 Estimate average level of activity expected in
each production cost center for coming year
(i.e., standard volume).
 Calculate an overhead rate for each production
center (i.e., Budgeted overhead cost at standard
volume ÷ Standard volume).
 Some companies use a plantwide overhead rate
instead of by individual production cost center.
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 Overhead (Clearing Account)
• Debit for actual overhead costs incurred.
• Credit for overhead amounts absorbed (applied)
to products.
• Predetermined overhead rate X Activity incurred (for
each job).
• If absorbed costs are greater (less) than actual
costs, overhead is overabsorbed (underabsorbed).
• Balance is transferred to Overhead Variance
account.

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 Plantwide Overhead Rate
• GAAP only requires aggregate inventory
and cost of goods sold to be materially
accurate -- not by individual product.
 Can create some products to be
undercosted, others overcosted.
 Can create cross-subsidies when used in
pricing and other decisions based on
individual product cost.
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 Activity-Based Costing
 Minimizes cross-subsidization among
products.
 Recognizes that complexity is the single
largest driver of cost.
 Utilizes more service center cost pools (called
activities or activity centers).
 Utilizes more cost drivers (i.e., unit-level,
batch-level and product-level).

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 Activity-Based Costing
 Examples of cost drivers used:
– Unit level drivers.
• E.g., number of units, direct labor hours, direct labor dollars,
machine hours.
• Costs per unit stay the same regardless of number of units.
– Batch level drivers.
• E.g., number of orders processed, number of production
batches run.
• The larger the production run or order, the lower the costs
per unit.
– Product level drivers
• Costs required to design or maintain products.
• Are assigned based on number of products.

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 Activity-Based Costing
 Each activity is allocated based on the cost
driver determined to be most appropriate
for that pool of costs.
 Activity’s costs may be assigned directly to
product (rather than through a production
cost center).
 Pitfall? Increased recordkeeping.
 Time-based activity-based costing.
 Focuses on amount of time spent in performing
activities.

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 Activity-Based Management
 Supported by activity-based costing.
 Purpose is to focus company on finding more
profitable businesses or finding ways to
perform tasks better, faster, and cheaper.
 May involve:
– Total quality management.
– Quality function deployment.
– Process improvement.
– Reengineering.
– Elimination of non-value-added activities.

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