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Chapter 6
Fundamentals of Product and Service Costing
Learning Objectives
1. Explain the fundamental themes underlying the design of cost systems.
2. Explain how cost allocation is used in a cost management system.
3. Explain how a basic product costing system works.
4. Understand how overhead cost is allocated to products.
5. Explain the operation of a two-stage allocation system for product costing.
6. Describe the three basic types of product costing systems: job order, process, and operations.
Chapter Overview
I. COST MANAGEMENT SYSTEMS
II. FUNDAMENTAL THEMES UNDERLYING THE DESIGN OF COST SYSTEMS
FOR MANAGERIAL PURPOSES
III. COSTING IN A SINGLE PRODUCT, CONTINUOUS PROCESS INDUSTRY
• Basic Cost Flow Model
• Costing with no Work-in-Process Inventories
• Costing with Ending Work-in-Process Inventories
IV. COSTING IN A MULTIPLE PRODUCT, DISCRETE PROCESS INDUSTRY
• Predetermined Overhead Rates
• Product Costing of Multiple Products
• Choice of the Allocation Base for Predetermined Overhead Rate
• Choosing Among Possible Allocation Bases
V. MULTIPLE ALLOCATION BASES AND TWO-STAGE SYSTEMS
• Choice of Allocation Bases
VI. DIFFERENT COMPANIES, DIFFERENT PRODUCTION AND COSTING SYSTEMS
• Operations Costing: An Illustration
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Chapter Outline
LO 6-1 Explain the fundamental themes underlying the design of cost
systems.
COST MANAGEMENT SYSTEMS
• A cost management system is a system that provides information about the costs of
processes, products, and services used and produced by an organization.
o A well-designed cost management system accumulates and reports costs that are relevant
to the decisions that managers make.
o These costs include those associated with the processes the organization uses to meet
customer needs, to serve the customers, and to comply with regulatory and tax authorities.
• Reasons to Calculate Product or Service Costs
o The purposes of calculating individual product (and service) cost include:
▪ Computing the inventory values and cost of goods sold for the financial statements.
▪ Helping various product managers make decisions regarding pricing, production,
promotion, and so on. (See Business Application box “Importance of Distinguishing
between Production Costs and Overhead Costs.”)
LO 6-2 Explain how cost allocation is used in a cost management system.
• Cost Allocation and Product Costing
o Costs that are common to two or more cost objects are likely to be allocated to those cost
objects on a somewhat arbitrary basis; such cost allocations can result in misleading
information and poor decisions.
• Cost Flow Diagram
o A cost flow diagram provides a graphical representation of the product costing process.
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▪ Exhibit 6.1 illustrates a basic cost flow diagram.
• The cost object is the product.
• The direct materials and direct labor costs are “assigned” directly to the cost
objects; that is, we can observe the link between resources and the cost objects
that consume the resources in an unambiguous way.
• In this example, manufacturing overhead costs are allocated based on direct labor.
FUNDAMENTAL THEMES UNDERLYING THE DESIGN OF COST SYSTEMS FOR
MANAGERIAL PURPOSES
• Questions that need addressing before undertaking the design of a new cost system:
o How will managers use the information the system is designed to provide?
o What type of decisions will be made using the cost information?
o Will the benefits of improved decision making outweigh the costs of implementing the
new cost system?
• The following points relate to designing a new cost system for managerial purposes:
o Cost systems should have a decision focus.
LO 6-3 Explain how a basic product costing system works.
COSTING IN A SINGLE PRODUCT, CONTINUOUS PROCESS INDUSTRY
• Basic Cost Flow Model
o The fundamental framework for recording costs in any type of firm is the cost flow
model, which is the basic inventory equation.
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xx
xx
xx
o A third way to look at the inventory equation is the inventory T-account:
Inventory account
Beginning balance (BB)
Less: Transfers out (TO)
Plus: Transfers in (TI)
Ending balance (EB)
o The inventory equation applies to physical units and to the costs associated with the units.
• Costing with no Work-in-Process Inventories
o For a single product with a continuous production process, each individual unit of
product can be considered identical to every other one, so there is no need to trace costs
to individual units.
▪ When there are no work-in-process inventories, the cost assigned to each unit of
output produced can be calculated as:
Total manufacturing costs (materials, labor, and overhead) for the period
Total quantity of output for the period
• Example 1: In April, Baxter Paints started and completed production of 100,000
gallons of white paint. Total manufacturing costs incurred in April were
$1,000,000. There were no beginning and ending work-in-process inventories.
The following T-account shows the relations in terms of the physical units.
Beginning balance
Plus: Transfers in
Less: Transfers out
Ending balance
Beginning balance
Plus: Transfers in
1,000,000
Less: Transfers out
1,000,000
Ending balance
Less: Transfers out (TO)
xx
Ending balance (EB)
xx
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• Costing with Ending Work-in-Process Inventories
o When ending work-in-process inventory is present, the denominator of the unit-cost
calculation requires modification.
▪ Since the ending work-in–process inventory is partially completed, the “equivalent”
unit of production must be calculated for the ending work-in-process inventory and
added to the number of units completed to determine the total quantity of output for a
period.
• Example 2: (Continued from Example 1): In May, Baxter Paints incurred a total
of $990,000 manufacturing white paint. The accountant prepared the following T-
account in physical units.
Inventory account – White Paint (gallons)
Beginning balance
0
Plus: Transfers in
110,000
Less: Transfers out
90,000
Ending balance
20,000
(50% complete)
For the 20,000 gallons of paint in process at the end of May, they were on average
50 percent complete and was equivalent to 10,000 gallons of finished paint (=
20,000 gallons × 50%). Total quantity of output for May became 100,000 gallons
(= 90,000 gallons completed and transferred out + 10,000 equivalent gallons).
Each gallon of white paint was assigned a cost of $9.90 (= $990,000 ÷ 100,000
gallons). The $990,000 total manufacturing costs incurred were allocated to two
cost objects:
Inventory account – White Paint (gallons)
Beginning balance
0
Plus: Transfers in
990,000
Less: Transfers out
Ending balance
99,000
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See Demonstration Problem 1
COSTING IN A MULTIPLE PRODUCT, DISCRETE PROCESS INDUSTRY
• When a firm manufactures multiple-products using a manufacturing process that takes place
in a series of discrete steps that differ in detail depending on the product, the benefits of more
detailed costing often outweigh the costs.
o The cost flow diagram in Exhibit 6.3 describes the problem of taking costs from the three
basic cost pools (direct materials, direct labor, and manufacturing overhead) and
allocating them to the cost objects (various products).
▪ Direct costs (direct materials and direct labor) can be directly traced or assigned to the
products at relatively low cost. Work orders, inventory requisitions, and skilled
workers’ time spent are specific to the individual products.
▪ A problem arises, however, with manufacturing overhead. By definition, these costs
cannot be identified directly (for a reasonable cost) with individual units of product. If
they could be, they would be included in either direct materials or direct labor.
Therefore: we need to identify one or more allocation bases to use to allocate the
manufacturing overhead to the various products.
LO 6-4 Understand how overhead cost is allocated to products.
• Predetermined Overhead Rates
o A predetermined overhead rate represents the cost per unit of the allocation base used
to charge manufacturing overhead to products.
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▪ Example 3: Grange Boats makes two products, C-20 and C-27 sailboats, and uses
direct labor hours to allocate manufacturing overhead to products. For next January,
the budget data indicate that 10 C-27s and 30 C-20s will be produced using 2,000 and
3,000 direct labor hours, respectively. The total manufacturing overhead is expected
to be $180,000. The predetermined overhead rate can be calculated as:
Predetermined overhead rate =
$180,000
(2,000 + 3,000) direct labor hours
• Product Costing of Multiple Products
o The cost assigned to each unit of output produced in a multiple-product, discrete process
firm can be calculated as:
Total manufacturing costs (materials, labor, and overhead) for a product
Total quantity of output for a product
o The product costs are estimates, not actual results.
▪ They are useful for decisions about future pricing and whether to continue making a
particular product.
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• Choice of the Allocation Base for Predetermined Overhead Rate
o There are at least two reasons why a particular allocation base is chosen:
o Using direct labor dollars instead of direct labor hours as the allocation base changes the
unit cost (as illustrated below).
▪ Example 5 (Continued from Examples 3 and 4): If Grange Boats selects instead direct
labor cost as the allocation base, then the predetermined overhead rate can be
calculated as:
See Demonstration Problem 2
• Choosing Among Possible Allocation Bases
o The choice of possible allocation bases, though arbitrary, could have important
implications for decision making.
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▪ Cost estimation methods can be applied to aid in making the choice.
• The overhead accounts can be analyzed to determine which allocation base seems
to be more highly related to overhead.
LO 6-5 Explain the operation of a two-stage allocation system for product
costing.
MULTIPLE ALLOCATION BASES AND TWO-STAGE SYSTEMS
• Exhibit 6.7 provides more detail on the components of manufacturing overhead at Grange
Boats.
• A close inspection of the components of manufacturing overhead may reveal that more than
one factor is driving the resource consumption during production. If this is the case, we can
use two or more allocation bases to allocate manufacturing overhead to the products.
o The approach is referred to as a two-stage cost allocation. The process has two-steps:
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o An alternative view is shown below.
Direct costs:
Direct materials
Direct labor
Assigned to
Cost
objects:
o Example 6 (Continued from Examples 3 and 4): An analysis of Grange Boats’ January
budget data shows that the total machine-related overhead is $72,000 and there are 4,000
machine hours (1,000 machine hours for C-27s and 3,000 machine hours for C-20s), so
the machine-related overhead rate is $18 per machine hour (= $72,000 ÷ 4,000 machine
hours).
The total labor-related overhead is $108,000 and the direct labor costs are $150,000
($72,000 for C-27s and $78,000 for C-20s), so the labor-related overhead rate is 72% of
direct labor cost (= $108,000 ÷ $150,000 direct labor cost).
Manufacturing
overhead
First stage
allocation
Cost pools
Second stage
allocation
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• Choice of Allocation Bases
o In a two-stage allocation system:
▪ Allocation bases still have to be chosen that best reflect the relation between overhead
incurred and activity.
LO 6-6 Describe the three basic types of product costing systems: job order,
process, and operations.
DIFFERENT COMPANIES, DIFFERENT PRODUCTION AND COSTING SYSTEMS
• Different companies have different production and costing systems.
o The two production processes that sit at the opposite end of the production spectrum can
be described as discrete (such as boat building) and continuous (such as paint
manufacturing), respectively.
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▪ Process costing is an accounting system used when identical units are produced
through a series of uniform production steps.
▪ Continuous flow processing is a system that generally mass-produces a single,
homogeneous output in a continuing process.
• Process systems are used in manufacturing chemicals, grinding flour, and refining
oil.
• Operations Costing: An Illustration
o The design of the cost system is fundamentally the same.
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Matching
A.
Continuous flow processing
F.
Operation costing
B.
Cost management system
G.
Predetermined overhead rate
C.
Job
H.
Process costing
D.
Job costing
I.
Two-stage cost allocation
E.
Operation
_____ 1. A system that provides information about the costs of processes, products, and
services used and produced by an organization.
_____ 2. Represents the cost per unit of the allocation base used to charge manufacturing
overhead to products and is calculated from the budgeted data.
_____ 3. The process of first allocating costs to intermediate cost pools and then to the
individual cost objects using different allocation bases.
_____ 4. Units of a product that are easily distinguishable from other units.
_____ 5. A system that generally mass-produces a single, homogeneous output in a continuing
process.
_____ 6. A standardized method or technique of making a product that is repetitively
performed.
_____ 7. An accounting system used when identical units are produced through a series of
uniform production steps.
_____ 8. A hybrid costing system often used in manufacturing goods that have some common
characteristics plus some individual characteristics.
_____ 9. An accounting system that traces costs to individual units or to specific jobs, contracts,
or batches of goods.
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Matching Answers
1. B
Multiple Choice
1. Which of the following statements is correct?
a. A cost flow diagram is helpful by providing a graphical representation of the product
costing process.
b. Manufacturing overhead can be directly traced to products.
c. The cost system should be tailored to the needs of accountants.
d. The benefits of accurate cost information always outweigh the costs of the information
system.
2. Which of the following statements about the design of the cost systems is correct?
a. Cost systems should have a decision focus.
b. Different cost information is used for different purposes.
c. Cost information for managerial purposes must meet the cost-benefit test.
d. All of the above.
3. In June, 30,000 bushels of corn are 70% completed in the ending work-in-process inventory.
What are the equivalent units of production?
a. 18,000 bushels
b. 19,500 bushels
c. 21,000 bushels
d. 24,000 bushels
Use the following information to answers questions 4 through 7:
Company B produces two products, P1 and P2, at its two departments: Machining and Assembly.
The accountant tries to allocate overhead costs to the two products.
Overhead
P1
P2
Total
Machining
$300,000
1,200 machine hours
800 machine hours
2,000 machine hours
Assembly
150,000
600 labor hours
900 labor hours
1,500 labor hours
Total
$450,000
4. If the accountant decides to allocate overhead based on machine hours, what is P2’s share of
the total overhead costs?
a. $180,000
b. $200,000
c. $220,000
d. $240,000
5. If the accountant decides to allocate overhead based on labor hours, what is P1’s share of the
total overhead costs?
a. $180,000
b. $200,000
c. $220,000
d. $240,000
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6. If the accountant chooses machine hours for Machining and labor hours for Assembly as
allocation bases, what is the overhead rate at Machining?
a. $100 per labor hour
b. $140 per labor hour
c. $120 per machine hour
d. $150 per machine hour
7. If the accountant chooses machine hours for Machining and labor hours for Assembly as
allocation bases, what is P1’s share of the total overhead costs?
a. $180,000
b. $240,000
c. $270,000
d. $300,000
8. For a two-stage allocation system:
a. The first stage is the most difficult to accomplish.
b. Cost pools ideally consist of homogeneous cost items.
c. Exactly two overhead rates are required.
d. The allocation bases bear no relationship with the overhead costs.
9. Which of the following statements is not correct?
a. Jobs are indistinguishable from each other.
b. Companies that produce customized products use job costing methods.
c. Companies that generally mass-produce a single, homogeneous output in a continuing
process adopt the continuous flow processing.
d. Operation is a standardized method of making a product.
10. Operations costing:
a. Is a hybrid costing system.
b. Is suitable when different products use the same production process and different
materials for input.
c. Combines features from both job and process costing.
d. All of the above.
11. Job order system and process system are similar in the sense that:
a. Both use the same inventory costing method.
b. Both keep track of prime costs, but not overhead items.
c. Both use the same manufacturing technique.
d. Both require inputs of direct materials, direct labor, and overhead.
12. The basic inventory equation can be represented by:
a. BB + TI = TO + EB.
b. BB – TI = TO + EB.
c. BB + EB = TI + TO.
d. BB + TO – TI = EB.
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Multiple Choice Answers
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Demonstration Problem 1
In the first quarter of operation, the Blending Department of ChemUSA produced 50,000 barrels
of Compound X and left 20,000 barrels in ending work-in-process inventory which was, on
average, 55 percent completed. A total of $231,800 was incurred in that period. There was no
beginning work-in-process inventory.
Required:
1. Determine the amount of Compound X started in the first quarter.
2. Compute the cost of Compound X transferred to finished goods and the amount of work-in–
process inventory as of the end of the first quarter.
Demonstration Problem 1 – Solution
Part 1
Compound X (barrels)
0
0
Part 2
For the 20,000 barrels of Compound X in process at the end of the first quarter, they were on
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Demonstration Problem 2
Capable Golf Cart, Inc. (CGC) manufactures two models of golf cart: LX and EX. The budget
data for next month is available.
LX
EX
Total
Units produced
50
30
80
Direct labor hours
2,000
3,000
5,000
Machine hours
1,500
1,200
2,700
Direct materials
$125,000
$90,000
$215,000
Direct labor
90,000
60,000
150,000
Manufacturing overhead
202,500
Total
$567,500
Required:
1. Compute the reported unit cost for each product if direct labor hours are used as the
allocation base.
2. Compute the reported unit cost for each product if direct labor costs are used as the allocation
base.
3. Compute the reported unit cost for each product if machine hours are used as the allocation
base.
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Demonstration Problem 2 – Solution
Part 1
LX
EX
Total
Units produced (a)
50
30
80
Direct labor hours
2,000
3,000
5,000
Direct materials
$90,000
Direct labor
150,000
(@$40.50 per direct labor hour)
Total costs (b)
Unit cost (b) ÷ (a)
Part 2
Predetermined overhead rate =
LX
EX
Total
Units produced (a)
80
Direct materials
Direct labor
150,000
(@135% of direct labor cost)
Total costs (b)
Unit cost (b) ÷ (a)
$202,500
= 135% of direct labor cost.
Demonstration Problem 2 – Solution, continued
Part 3
Predetermined overhead rate =
$202,500
2,700 machine hours
= $75 per machine hour.
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Demonstration Problem 3
Jim is a florist who runs Bountiful Flower Shop as a sole owner. During the third week of June,
he received two orders for flower bouquets that required same operations but different
flower/basket combinations. Orders 471 and 472 were for a wedding hall and a business
conference, respectively. The following information was available.
Order 471
Order 472
Total
Number of bouquets
120
90
210
Flowers
$1,800
$1,080
$2,880
Baskets
600
360
960
Supplies
240
90
330
Total costs of materials
$2,640
$1,530
$4,170
Direct labor in operation
$ 630
Overhead in operation
1,155
Total costs in operation
$1,785
Required:
Determine the total cost and unit cost for Orders 471 and 472.
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Demonstration Problem 3 – Solution
The costs of materials can be assigned directly to the two orders. Because the time and the effort
required to put together each bouquet is essentially the same, Jim could allocate the operation
costs based on the number of units (bouquets) assembled. That is,