Week 4: ABC and Budgeting - Lecture

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ABC/ABM and Budgeting Concepts

Activity-Based Costing and Activity-Based Management | Why ABC? | Implementing ABC | Budgeting | The Financial Budgets

Activity-Based Costing and Activity-Based Management Normal costing approaches use averages for assigning the cost of resources uniformly to cost objects. Averaging of indirect costs can cause misleading overhead and total cost information. This can occur when average rates are applied to objects that use resources in non-uniform ways. Objects that use a minimal amount of one resource may be allocated a high level of indirect costs because the single indirect-cost rate is based on an activity in which the object uses a large amount. This would make some managers happy and others dissatisfied. For example, we have the following information for two clients of an accounting firm. Client A Partner Hours Audit Staff Hours Travel Time Direct labor hourly rate Indirect cost rate per DLH 20 100 3 $100 / DLH $120 / DLH Client B 50 70 .5 $100 / DLH $120 / DLH

In this example, Client A is further away, which requires more transportation time, and Client B is closer and thus requires less transportation time. What is the total allocated cost per client? Client A = (20+100)*$100 + (120*$120) = $26,400 Client B = (50+70)*$100 + (120*$120) = $26,400 The single direct cost-single indirect cost pool system doesn't match the costs with the resources consumed. If the auditor sets prices based on these costs, she will likely lose the overcosted Client A and keep the undercosted Client B. Why does this occur? Do you think that one partner hour is equal to one staff hour? Do you think that travel time should be billed at the same rate as times actually worked? Do you think that partner hours and staff

hours have the same relationship to indirect costs? More refined multiple direct and indirect cost pool/driver systems help alleviate this problem. If a cost system uses a single allocation base, then products that consume relatively more of that base will tend to be overcosted, since all indirect costs are loaded on that base. Products that consume proportionally less of the base will tend to be undercosted. Result: Companies that overcost their products may overprice their products and lose market share. That sentence bears repeating. Companies that overcost their product may overprice their products and lose market share. This phenomenon is called product-cost cross-subsidization, where at least one undercosted product results in at least one other product being overcosted.

More refined cost systems are cost-effective when (remember the cost/benefit ratio): 1. 2. 3. Different jobs (customers, services, etc.) consume resources differently; Competition in the output market is keen (accurate cost information helps companies to decide what jobs to emphasize and how to price them); Indirect costs are large; and Costs to implement the new cost method are not more than the benefits. Traditional Single Indirect-Cost Pool System Or Activity-Based Cost System Identify cost object. Identify direct costs for the products. (ABC will try to get more costs directly related to the products.) Select reasonable bases to use to allocate indirect costs to products. (ABC costing will use more cost-allocation bases.) Review indirect costs. Identify which cost base they will be associated with for allocation purposes. Compute the base allocation rates per unit. Allocate costs to products. Take base allocation rate times activity. (ABC will have a separate calculation for each cost-allocation base used.) Add up all direct and indirect costs for each product.

4.
Step 1 2 3 4 5 6 7 Why ABC?

Lets look at some important items. For ABC, we look at activities. Activities are actions that take place, and they include things like tasks. Its activities that consume resources (e.g., we pay workers to pack and ship finished products to customers). We change the product for each of the activities that is incurred or consumed (packing and shipping). The closer that we can come to representing the reality of the consumption of activities through cost allocation, the better information that we have for management. Activity-based costing (ABC) is a great system for allocating costs to products; however, it is not for all companies. ABC is more likely to yield benefits for a firm with:

many products that consume different amounts of resources; operations are varied and complex; a highly competitive environment in which knowledge of cost control is critical; and access to accounting and information expertise to implement and maintain the system is available.

ABCs popularity is increasing because changes in business and information technology are decreasing implementation costs while increasing the relative benefits. For one thing, companies are producing products using more complex operations in a more competitive environment. Also, with increased technology, management frequently has easy access to data that aid in developing cost relationships. Over time, the benefits of adopting ABC have been increasing, while the costs of implementation have declined, thereby increasing the popularity of ABC. The cause-effect relationships between activities and costs comprise the core of ABC costing. ABC was originally developed in the manufacturing sector, but it is now also applied to all areas of the value chain. Since ABC can be expensive to implement and maintain, companies considering ABC should first ascertain that ABC passes a cost-benefit test. The two main benefits of ABC are: 1. More accurate product/service costs; and 2. Better information for cost control. Cost Hierarchies First, lets define various cost levels. 1. Output unit-level costsCosts related to each unit (product or service). Will vary in proportion to the number of units produced. 2. Batch-level costsCosts that can be attributable to a batch. These would include things like a purchase order that is processed for a customer, setting up equipment for a new batch order, etc. 3. Product-sustaining costsCosts related to a specific product type. They would include things like the design costs for a specific product, advertising for a specific product, etc. 4. Facility-sustaining costsCosts that are not related to specific products or services but are incurred to run the entire operation. It would include things like facility rent, general and administration costs, etc. Traditional cost accounting systems treated all costs as if they were output unit-level costs. It can be difficult to identify drivers of higher-level costs, particularly facility-sustaining costs (e.g., what drives the CEO's salary?). It can be expensive to obtain data on values of higher-level cost drivers, as this information is not generally collected by the cost accounting system. (Batch-level drivers might include # setups, # purchase orders; product-sustaining drivers might include # parts, # engineering change orders.) Decreasing information processing costs makes it less expensive to obtain data on nontraditional cost drivers, and increased competition increases the benefits of accurate cost information. Hence, companies are developing more complex systems that recognize the hierarchy of costs and cost drivers. Implementing ABC

Identifying activities and cost drivers is difficult but important. Operating personnel have the best understanding of the company's production process. When using ABC, accountants often question operating personnel to help identify activities and allocation bases. Many companies involve grassroots-level employees to better understand their activities and cost drivers. Johnson & Johnson asked work groups to identify their activities and the drivers of those activities. This provided more accurate information than did interviewing managers, who were further removed from the daily operations. The person eliciting the information on employees' activities must be sensitive to employees' concern for job security. Employees may overestimate time spent on valueadded activities as opposed to non-value-added activities. Insensitive questioning can hurt morale and possibly generate biased information. Companies that have successfully implemented ABC usually limit the number of activity/cost pool/allocation bases to 5-10 per department, at least in the initial implementation. More activities can be added later if additional complexity is warranted. The danger with identifying too many activities is that the company may get bogged down in a morass of detail and the implementation may fail. Always keep the cost/benefit ratio in the back of your mind. When I was in Poland, I was there for only three weeks. I had to set up an ABC model that the company could work with at the time. It had to be one that they could understand and use. I had to limit my activities, cost pools, and allocation bases. Complexity can be added at a later time. The budgeted total quantity of the allocation base used in the denominator of the indirect rate is computed by summing the estimated total quantity of the allocation base required for each product. Thus, it is the sum over all products of the (estimated quantity of the allocation base consumed per unit of product)*(estimated number of units of the product). Note that estimated numbers are used in this calculation. ABC has a direct relationship to the information necessary for good budgeting. (That will be explored next week.) An ABC approach involves more than just increasing the percentage of total costs directly traced to a cost object. The heart of an ABC approach is the analysis of activities. This analysis can also increase the percentage of costs that are directly traced. For example, a factory can trace the cost of setups to products by simply using bar codes. You trace the setup costs directly to a product. Now, how can you reduce setup time and/or produce more products per setup? ABC allows managers to focus on ways to reduce costs by identifying those costs. The more direct the relationship, the more accurate the cost allocations. A major reason why low-volume products are often undercosted is that low-volume products' batch-level and product-sustaining costs should be spread over relatively few units of low-volume products rather than spread like peanut butter over all products using output unit-level cost allocation bases. In other words, eliminating small batches can reduce costs. Have you ever purchased business cards? The first 100 cards had one price; the second 100 a lower price, and so on. ABC can help managers control costs by assisting them in reducing consumption of the allocation base. Managers control the physical activity that they can see and manage. Activities consume the resource dollars, and products consume the resources. The ABC allocation base tells the managers which activities need to be managed. ABC can help managers control costs by providing incentives to reduce the indirect cost allocation rate for each activity. A manager can be rewarded for reducing the indirect cost

rate for an activity because the accounting system visibly links the manager to this cost reduction. In a single Manufacturing Overhead (MOH) cost pool system, managers have little incentive to reduce MOH. The effects of any reduction are not linked to a particular manager if all of the MOH is aggregated in one pool. Lets look at an example: The supervisor in the cutting department requests a full 20-page report from the office every day. He seldom looks at more than the first page. With a single overhead pool, this individual has no incentive to reduce the paperwork. If, however, the department is assigned the office costs based on the number of document pages received (providing that that is an appropriate cost driver), then the manager is likely to ask only for information that he will actively use. He would probably cut down to requesting the first page every day, and only ask for the other 19 pages on an as-needed basis. ABC can lead to increased accountability that will result in decreased costs. ABC can help managers control costs by providing incentives to reduce the indirect costs allocation rate for each activity because the cost of each activity is now visible. A supervisor can be rewarded for reducing the indirect cost rate for an activity because the accounting system visibly links the supervisor to this cost reduction. In a single manufacturing overhead cost pool system, supervisors have little incentive to reduce manufacturing overhead. The effects of any reduction in this case are impossible to trace since reductions are not linked to a particular supervisor. A manager should examine the accuracy of the cost system if:

1. Managers don't believe the cost data that the system provides, and may even keep their own private set of 2. 3. 4.
off-the-book records; The company loses bids thought to be priced competitively, but wins bids it thought it priced high; The cost system hasn't changed much despite major changes in operations; and Reported costs change solely because of a new Generally Accepted Accounting Principle (GAAP) requirement.

ABC is a good tool and can be used equally as well on a very large scale as on a small one. With technology readily available and relatively inexpensive today, ABC is becoming more and more practical for many organizations.

Review
You may want to take the self-study quiz for Chapter 7; the link is located in the Assignments tab. Budgeting Budgeting is a process of forecasting future operating performance (income statement) and financial condition (balance sheet). Budgeting is important because it facilitates both short and long-term planning, establishes goals and objectives, and provides a basis for comparing actual results with expected, or budgeted, results. In essence, budgets serve as a roadmap. Without budgets, businesses are basically driving blindly, without any sense of direction, and they tend to be reactive instead of proactive.

The Budgeting Process The budgeting process involves estimating, or forecasting, future results. Many factors go into preparing budgets. An analysis of past performance provides a logical starting point in the budgeting process. By examining past performance, managers gain insight into the factors that impacted their company's operations. They can examine various operating factors (e.g., sales, cost of goods sold, operating expenses, etc.) and isolate the impact of sales activity and various cost components on the firm's performance. In particular, any unusual or abnormal changes in sales volume and individual cost components will be revealed. For instance, how much of the increase or decrease in revenue was due to changes in sales output (volume) and how much was attributable to changes in pricing? What caused the increase or decrease in gross profit? Was the change in gross profit largely due to a change in revenue or a change in cost of goods sold? Was any change in cost of goods sold commensurate with the change in revenue? If not, why not? What caused the increase (decrease) in operating profit? An increase (decrease) in gross profit margin, or a decrease (increase) in operating expenses? These are just some of the questions that can be answered by a thorough analysis of past results. In other words, you will be drawing on some of your previously developed skills. The budgeting process also involves assessing future economic conditions, as well as factors that are expected to affect the industry in which a company operates. An economic forecast projects the growth rate of the overall economy. Generally, the stronger the anticipated economic growth, the more optimistic the sales forecast and vice-versa. A company must also consider and adjust for any factors that will likely affect its industry. For instance, tobacco firms would have incorporated the potential impact of the prospective government mandated health and medical payments on future revenues, costs, and profitability.

The Master Budget The budgeting process involves preparing forecasted (pro-forma) financial statements. The two major components of a Master Budget are the Operating Budget and Financial Budget. The detailed budgets are pulled together to develop a plan for the company and will include input from all areas of the business. The Operating Budgets The Sales Budget is the starting point in developing the various operating budgets. Once sales are forecasted and the sales budget is prepared, the other operating budgets can be developed. The projected sales will bring into consideration past performance, global, national, and regional economic conditions, and specific industry items, as well as company-specific issues such as strength of sales force or perhaps loss of a key employee. The Production Budget is determined based on estimated sales units, which is based on the level of sales, the beginning inventory, and the desired ending inventory level. The amount of budgeted production can be determined as follows.

Budgeted Sales Units Add: Desired Ending Finished Goods Units Deduct: Beginning Finished Goods Units = Required Production Units The Direct Materials Budget is based on the units to be produced from the production budget. Basically, the same algorithm is used for this budget as was used for the production budget.

Direct Materials Units Required for Production Add: Desired Ending Direct Materials Units Less: Beginning Direct Materials Units = Required Direct Materials Purchases Units The Direct Labor Budget is also based on the production budget. Here is where various relationships and cost drivers can become important predictors of cost. If it is determined that it will take one machine hour to produce 20 units, and it takes two employees to run the machine, a relationship is now established. Using a mathematical formula, I can now determine the number of direct labor hours needed to produce the desired number of units. Be careful, however, to examine union contracts. It may state in the contract that three employees will be assigned to each machine even though only two are needed. The Manufacturing Overhead Budget is based on the total projected indirect manufacturing costs. The fixed costs within a relevant range will remain unchanged; however, be sure that the projected production rate is within that range. Higher production may mean that additional equipment must be purchased that will be supervised by additional personnel. The variable costs are estimated based on cost driver usage and established relationships. It is through the use of this budget that overhead application rates for jobs done during the year are established. This is a very important budget and probably one of the more difficult ones to prepare. Selling and Administrative Expense Budget: Again, this budget had a fixed portion and a variable portion. The fixed components, especially, may be discretionary expenses. I choose to advertise or not to advertise, but how does that fit into my projected sales? Can I increase sales volume only through aggressive advertising? The Budgeted Income Statement. After all of the operating budgets noted above have been prepared, the Budgeted Income Statement can be constructed. In addition to the information contained in the various operating budgets, the budgeted (pro forma) income statement includes projected interest expense and income taxes. These items were not reflected in the operating budgets, as they are not operating expenses. Interest expense is a financial expense, while income taxes are simply that: taxes.

The Financial Budgets The Cash Budget is part of the Financial Budget and incorporates all projected cash receipts and disbursements. It shares some similarities with the Statement of Cash Flows used in financial reporting. The Cash Budget begins with the beginning cash balance, adds projected cash receipts (e.g., cash collections from customers), deducts cash disbursements made for purchases of inventory, payment of operating expenses, and capital expenditures (e.g., purchases of plant, property, and equipment), and deducts the minimum cash balance that the business desires to maintain in order to arrive at the total cash needed before financing.

Next, the projected cash flows from financing activities (debt issuance and repayment, stock issuance, and repurchases and interest expense) are added (if positive) or subtracted (if negative) to arrive at the projected ending cash balance. Most organizations break this budget down into a minimum of at least monthly segments. It is not unusual to break this budget down into 52 weekly budgets. In actuality, an annual cash budget does not account for the ups and downs of the annual business cycle. It is through this budget that a

company can predetermine when short-term financing will be necessary. Bankers love organizations that come in six months before the fact to request a loan, possibly in the form of a line of credit. After all of the budgets have been prepared, the Budgeted Balance Sheet can be constructed.

No matter who you are and where you work, you will almost certainly be involved in the budgeting process at some point in time. This is an extremely important topic.

Tutorial
Master Budget

This presentation reviews the master budget process. It uses the metaphor of a jigsaw puzzle to represent the master budget process in managerial accounting. As you put the pieces of the puzzle together, you will learn about each piece and how it contributes to the overall process. Once you are finished putting the puzzle together, you should have a better understanding of the master budget process.

Review
You may want to take the self-study quiz for Chapter 8; the link is located in the Assignments tab.

Week 3: Cost-Volume-Profit Analysis and Variable Costing - Lecture

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CVP Analysis/Variable Costing

Cost-Volume-Profit (CVP) Analysis | Break-Even Point | CVP Analysis and Targeted Income | Absorption vs. Variable Costing Methods

Cost-Volume-Profit (CVP) Analysis Cost-Volume-Profit (CVP) Analysis considers the impact that changes in output have on revenue, costs, and net income. In applying CVP Analysis, costs are separated into variable and fixed costs. This distinction is important because, as mentioned previously, variable costs change with changes in output, whereas fixed costs remain constant throughout what is referred to as a relevant range. CVP analysis is based on the following equation: Profit = Total Revenues Total variable costs Total fixed costs The Contribution Margin Income Statement format is very useful in CVP analysis. Recall that the contribution margin income statement format is as follows. Total Revenue` Less all variable costs = Contribution margin Less fixed costs = Operating income The contribution margin ratio is an important ratio that is reviewed by management and is calculated as follows: Contribution Margin Ratio = Contribution Margin per Unit/Unit Selling Price

The contribution margin ratio tells us the percentage of revenue that will be available to cover fixed costs. Note that the information needed to calculate this ratio is generally not available in published financial statements since costs are not classified by their behavior. A word of caution: Be sure that you understand the difference between gross profit and contribution margin. Gross profit is Net Sales less Cost of Goods Sold. Contribution Margin is Total Revenues less Total Variable Costs. This week, we will also be looking at the breakeven point. The breakeven point is where total revenues equal total costs (net operating income will be zero).

CVP Chart

Underlying Assumptions of CVP Analysis CVP analysis is based on a model that is a simplification of reality; therefore, it is not a perfect model. The assumptions are as follows. Revenues and variable costs per unit do not change within the relevant range. This means that the contribution margin will also be the same per unit within the relevant range. Total fixed costs do not change within the relevant range. The variable and fixed cost components of mixed costs have been separated. Accuracy of this separation is particularly unrealistic, but reliable estimates can be developed. Sales and production are equal; thus, there is no material fluctuation in inventory levels. This assumption is necessary because of the allocation of fixed costs to inventory at potentially different rates each year. This assumption is more realistic as companies begin to use just-in-time inventory systems. There will be no capacity additions during the period under consideration. If such additions were made, fixed (and, probably, variable) costs would change. In companies with more than one product, we assume that the sales mix will remain the same. If this assumption was not made, no useful weighted average contribution margin could be computed for the company for purposes of CVP analysis. There is either no inflation, inflation affects all cost factors equally, or if factors are affected unequally, the appropriate effects are incorporated into the CVP figures. Efficiency and productivity remain unchanged as the volume of production changes. We assume that there will be no changes in technology that will affect productivity or labor costs. We also assume that there will be no changes in the market.

Break-Even Point A common application of CVP Analysis is determining the break-even point (BEP). The following steps illustrate the derivation of the break-even formula in terms of both quantity and total revenue dollars. Break-Even Quantity The break-even point occurs when: Revenues (Sales) = Total Cost, i.e., Net Income = 0 Since: Total Cost = Variable Cost + Fixed Cost Break-even occurs when: Revenues (Sales) = Variable Cost + Fixed Cost The above is a foundation formula! Since: Revenues = Quantity (Q) x Sales Price per Unit (P) and Variable Cost = Quantity (Q) x Cost per Unit (C) Break-even in dollars occurs when:

(Q x P) = (Q x C) + Fixed Cost or, (Q x P) - (Q x C) = Fixed Cost Q(P - C) = Fixed Cost Break-Even Quantity (Q) = Fixed Cost (P - C) where (P - C) is the contribution margin per unit Break-Even Revenue The break-even point can also be calculated in terms of total revenue dollars, as follows: Recall that: Revenues (Sales) - Variable Cost = Contribution Margin so, break-even occurs when: Contribution Margin = Fixed Cost Since: Contribution Margin = Revenue Dollars x Contribution Margin Ratio Break-even occurs when: Revenue x Contribution Margin Ratio = Fixed Cost or Break-Even Revenue = Fixed Cost Contribution Margin Ratio, where Contribution Margin Ratio = [Price per Unit (P) - Variable Cost per Unit (C)] Price Per Unit The Break-Even Revenue can also be calculated by multiplying the Break-Even Quantity (Q) by the Sales Price per Unit.

Review
Click here to open the Break-Even Point Tutorial CVP Analysis and Targeted Income The Break-Even formula can be modified to determine: (1) a Targeted Sales Volume in Units (Quantity), or (2) a Targeted Sales Volume in Total Dollars needed to achieve a targeted income. Target Sales Volume in Units = (Fixed Cost + Target Income) Contribution Margin per Unit Target Sales Volume in Dollars = (Fixed Cost + Target Income) Contribution Margin Ratio NOTE: These formulas are the same as the Break-Even Quantity and Break-Even Revenue formulas, with the addition of the Target Income in the numerator.

Another variation on the theme is Margin of Safety. This indicates the quantity that sales can decrease from the targeted level (or current level) before the company will incur losses. This criterion is often used to evaluate the adequacy of planned sales. The margin of safety is expressed in terms of dollars or in terms of a percent.

Review
Click here to open the Cost Value Profit Tutorial You may also want to take the self-study quiz for Chapter 5; the link is located in the Assignments tab.

Absorption vs. Variable Costing Methods Absorption costing is a costing method that is used for financial and tax reporting purposes (there are some slight variations, though). For financial and tax reporting purposes, this method does a better job of matching revenues with costs (matching principle). Costs of products will include direct materials, direct labor, and manufacturing overhead costs (both fixed and variable costs). Manufacturing overhead costs once again include indirect labor, indirect materials, factory costs (e.g., factory rent, factory building and equipment depreciation, factory real estate taxes, factory utilities, and other costs of production), and others. Manufacturing overhead will include costs that are variable and fixed. We use the traditional income statement format when we use the absorption method. Under the variable costing method, it is argued that fixed manufacturing overhead costs are capacity costs and will be incurred even if nothing is produced. Under the variable costing method, fixed manufacturing overhead costs are treated as period costs instead of product costs. For the variable costing method, we use the contribution format income statement. The only difference between the absorption costing and variable costing methods is how the fixed manufacturing overhead expenses are treated. For absorption costing, they are treated as product costs; for variable costing, they are treated as period costs. One of the negative features for the absorption costing method is that if inventory levels increase, net income will increase. The reason why this happens is because more fixed manufacturing overhead costs are deferred in inventory. This can be a problem if users of financial information dont understand the impact of increased inventory levels. They actually see a phantom profit. In some cases, managers may increase inventory levels just to increase profits. If units produced and sold stay the same, inventory levels will stay the same and the net operating income will be the same under both methods. If units produced are greater than units sold, inventory will increase and net operating income will be greater under the absorption method. If units produced are less than units sold, inventory will decrease and net operating income will be less under the absorption method. Today, we find that companies are working very hard to keep their inventory levels as low as possible. Many companies use JIT (just in time inventory production), which means that they only begin production when they have orders for goods. Because of this factor, inventory levels are lower. This means that the difference in net operating income between these methods is smaller than it might have been in the past. It is, however, important for managers to understand the impact of changes in inventory levels on net operating income under the two methods.

Week 2: Job Order and Process Costing Systems - Lecture

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Job Order and Process Costing Systems

Introduction | Job Order Costing | Over- and Under-Applied Overhead | Process Costing | Weighted Average Method | First in, First Out Method Introduction All companies need to have a good understanding of the cost of the products and services that they provide to their customers. The two most common systems for allocating costs to products and services would be process costing and job-order costing systems. We will be looking at these two systems, how costs are allocated, and the types of companies that will use each system. Process costing systems are used when a company produces many units of a single product and each unit of product is the same as the next. Due to the fact that each unit is identical, it is reasonable to assign the same cost to each unit. Examples of companies that would use process costing include: PepsiCo (soft drink manufacturer); Ford Motor Company (automaker); and Sara Lee (consumer goods).

Costing systems are used when a company produces many different products during the period. Generally, the product or service is unique for that specific customer. In this type of situation, costs will be accumulated for each job. Costs directly related to the job will be recorded to the job, and indirect costs will be allocated to the job. Examples of companies that would use job-order costing include: Poblocki & Sons (large scale construction); Lockheed-Martin (aircraft manufacturing); and Sony Pictures (movie production).

Comparing process costing and job-order costing is depicted below.

Job-Order Costing 1. Many different jobs are worked on during each period, with each job having different production requirements. 2. Costs are accumulated by individual job. 3. Unit costs are computed by job on the job cost sheet.

Process Costing 1. A single product is produced either on a continuous basis or for long periods of time. All units of product are identical. 2. Costs are accumulated by department. 3. Unit costs are computed by department.

In general, make a note of these differences. We use job-order costing when we are working on various jobs or products during a period; we use process costing when we are producing one product during the period. With job-order costing, we accumulate and keep track of costs for each job or product; for process costing, costs are recorded to specific departments. With job-order costing, average unit costs are computed by job; with process costing, average unit costs are computed for a particular operation or by department.

Job Order Costing The types of manufacturing costs that are assigned to products using a job-order costing system include two below. Direct costs: Direct labor and direct materials; these items can be traced directly to the job or product. Indirect costs: Manufacturing overhead costs; these are costs that cant be directly traced to jobs or products. Indirect costs are allocated to jobs or products.

The Accounting Department will use a job cost sheet that keeps track of the direct and indirect costs related to a specific job. Lets look at an example, using the Pearly Corporation. Each job will be assigned a unique job number. Direct materials, direct labor, and manufacturing overhead costs will then be recorded to the specific job as follows: Direct materials cost When production begins on a job, a Materials Requisition Form will be completed. The form will identify the type, quantity, and total cost of materials to be taken out of inventory. In addition, the job number e.g., Job-143) that the materials are for will be identified and these costs will be recorded on the job cost sheet (e.g., Job-143) by the Accounting Department. Direct labor costs Time tickets will be used to keep track of the time that each laborer spent on each job, and the costs will be recorded on the job cost sheets by the Accounting Department. (e.g., Job-143). Manufacturing overhead First, we need to select an allocation base to use to allocate the overhead costs. Some examples of allocation bases would be direct labor hours, direct labor dollars, and machine hours. Allocation bases are used because: It may not be possible or is difficult to trace these costs to particular jobs; Manufacturing overhead consists of many different items, ranging from the grease used in machines to the production managers salary; and Many types of manufacturing overhead costs are fixed even though output may fluctuate during the year.

Second, we would calculate the predetermined overhead rate. This rate is calculated by dividing the estimated amount of manufacturing overhead for the coming period by the estimated quantity of the allocation base for the coming period. When we select an allocation base, we are looking for one that relates to the base and drives the costs.

Predetermined Overhead Rate = Estimated Manufacturing Overhead Costs / Allocation Base

Predetermined overhead rates that rely upon estimated data are often used because actual overhead costs for the period are not known until the end of the period. In addition, actual overhead costs can fluctuate seasonally, thus misleading decision makers. Third, the manufacturing overhead is allocated to the jobs and products by taking the predetermined overhead rate times the allocation base amount (this is called a normal costing system).

Manufacturing Overhead Application = Actual Amount of the Allocation Base x Predetermined Overhead Rate
For example, assume that the Pearly Corporation applies overhead to jobs based on direct labor hours. For the year, it is estimated that its total overhead costs will be $640,000. The company estimates its total direct labor hours for the year to be 160,000. Job 143 required eight hours of direct labor at $10.50 per hour and $75 of direct materials. Calculating the predetermined overhead rate = $640,000 / 160,000 = $4 per direct labor hour. The overhead that will be shown on the job cost sheet for Job 143 will be $32 (eight hours x $4 per hour)

The job cost sheet will show the direct materials, direct labor, and manufacturing overhead for Job 143. Note: Companies that use job-order cost systems to assign manufacturing costs to products also incur nonmanufacturing costs. Nonmanufacturing costs are considered period costs. Period costs will be expensed in the period in which they were incurred. For example, the costs of sales or administrative expenses are not part of the product cost. These costs, however, should be taken into account when pricing the product to ensure that they are covered! Over- and Under-Applied Overhead Generally, actual manufacturing overhead costs will not match the amount of overhead that has been applied to jobs (Work in Process) for the period. This difference is called underapplied overhead or overapplied overhead. Underapplied overhead occurs when the amount of overhead applied to jobs is less than the overhead actually incurred. Overapplied overhead occurs when the amount of overhead applied to jobs is greater than the overhead actually incurred.

Let's compute underapplied or overapplied overhead for our Pearly Company example. Recall the following information related to this example.

Estimated total overhead costs $640,000 Estimated total direct labor hours 160,000 Predetermined overhead rate $4 per direct labor hour Lets assume the following. Actual overhead $650,000 Actual direct labor hours 170,000 In this case, the overapplied overhead will be $30,000 and it is calculated as follows. Step 1 Calculate the overhead that was applied by taking the actual direct labor hours incurred times the predetermined overhead rate. 170,000 x $4 = $680,000 Step 2 Compare actual manufacturing costs to the applied overhead for the accounting period = $650,000 - $680,000 = $30,000 OVERapplied

Transcript

Disposition of underapplied or overapplied overhead balances Any remaining balance in the Manufacturing Overhead account, such as Pearly Company's $30,000 of overapplied overhead, is adjusted in one of the following manners. The Cost of Goods Sold is adjusted for the amount that is overapplied or underapplied. Manufacturing Overhead: 30,000 Cost of Goods Sold: 30,000 To adjust cost of goods sold for overapplied overhead. The amount that is overapplied or underapplied can be allocated pro-rata to the Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold. Let's look at an example. Overhead applied to Ending Work in Process = $68,000 Overhead applied to Ending Finished Goods Inventory = $204,000 Overhead applied to Cost of Goods Sold = $408,000 Total = $680,000 The allocation percentages would then be as they are below.

Work in Process = $68,000 / $680,000 = 10% Finished Goods = $204,000 / $680,000 = 30% Cost of Goods Sold = $408,000 / $680,000 = 60% The overapplied overhead would then be allocated by taking the allocation percentage times the amount of the overapplied or underapplied overhead as follows:

Work in Process = $30,000 x 10% = $3,000 Finished Goods Inventory = $30,000 x 30% = $9,000 Cost of Goods Sold = $30,000 x 60% = $18,000 In the above example, we are assuming that there was only one predetermined overhead rate. In larger companies, it is common to have more than one overhead pool of costs, so they will have multiple predetermined overhead rates that need to be applied. While using multiple predetermined overhead rates is more complex, the process still works the same way. Note: Job-order costing can also be used by service industries. For example, in a public accounting firm, each client represents a job." Each accountant and support staff for the company will record the amount of time spent on each client (job), which will be recorded as a cost for the job. Any other costs that can be directly charged to the client will be recorded to the job (e.g., photocopies, travel, meals, etc.). Overhead costs will be allocated in the same way that was utilized for manufacturing companies. Review Click here to open the Job Order Costing Tutorial. You may also want to take the self-study quiz for Chapter 3; the link is located in the Assignments tab.

Process Costing

In a process costing environment, products typically flow in a sequence from one department to another. Costs for process and job-order costing flow in the same manner. DM, DL, MFG OH -----> WIP -----> FG -----> CGS Nonetheless, there is a key fundamental difference between process and job-order costing systems: process costing systems trace and apply manufacturing costs to departments. Each department will have its own Work in Process account. When the work is completed in one department and moved to the next department, the product costs (direct material, direct labor, and manufacturing overhead) will be taken out of the first departments Work

in Process account and put into the next departments Work in Process account. These costs would be called transferred-in costs.

Transcript

Generally, in any production process, there are always units that have been started but not completed. These partially completed units complicate the determination of a departments output for a given period and the unit cost that should be assigned to that output. For this reason, we convert these partially completed units into whole units called equivalent units. We compute equivalent units by taking the number of units that are partially completed times the percentage that these units are completed. The basic idea behind this concept is easily explained by saying that if we have two units that are halfway completed, we have one complete unit. For example, if we have 100,000 units and these units are 45% complete, we can say we have 45,000 equivalent units. There are two methods that can be used to calculate equivalent units. The methods are the weighted-average and the FIFO method. Let's review each method. Weighted Average Method For the weighted average method, we treat all units the same way. We combine the units and costs from the prior period and the current period. To compute the equivalent units of production, we take the units completed during the period plus the equivalent units that are in the departments ending Work In Process inventory. Today, because of the high degree of automation in most factories, direct labor costs are small. For this reason, the conversion costs (direct labor and manufacturing overhead) are combined to simplify the computations. Let's work through an example of the weighted-average method. Assume that the Walnut Milling Department reported activity for May as follows. Units Beginning Work in Process Units Started and Completed Ending Work in Process * Total Cost * 50% completed for materials, 25% completed for conversion 500 300 $28,250 $44,600 Cost for Materials $2,250 Costs for Conversion $14,600 $30,000

5,000 $26,000

Computing equivalent unitsweighted average method o Step 1: Determine the number of units that were completed during the period and transferred out in May (would be 500 units from beginning inventory plus the units started and completed during the period of 5,000 for a total of 5,500 units).

Step 2: Determine the equivalent units of production related to materials that are in the ending Work In Process inventory (150 units = 300 units in ending inventory x 50% completed). This will be added to the units completed that were determined in Step 1 (5,500 units). The total equivalent units for materials = 5,650 (5,500 units completed and transferred from Step 1 plus 150 units that are in ending inventory). Step 3: Determine the equivalent units of production related to conversion costs that are in the ending Work In Process inventory. (75 units = 300 units in ending inventory x 25% completed). This will be added to the units completed that were computed in Step 1 (5,500 units). The total equivalent units for conversion = 5,575 (5,500 units completed and transferred from Step 1 plus 75 units that are in ending inventory).

Step 1: Take total costs for materials and divide by the total equivalent units for materials: $28,250 / 5,650 = $5 per equivalent unit for materials Step 2: Take total costs for conversion and divide by the total equivalent units for conversion: $44,600 / 5,575 = $8 per equivalent unit for conversion costs

Applying costsweighted average method o Step 1: Calculate the total costs of the units transferred out. Since all units transferred out are 100% completed, we can add the per unit cost for materials of $5 and the conversion costs of $8. We then multiply the $13 ($5 + $8) cost per unit by the number of units transferred out of 5,500 to get $71,500 total costs of units completed and transferred out. Step 2: Calculate the costs in ending Work in Process: First, calculate the ending inventory costs for materials by taking the equivalent units for materials in ending inventory and multiplying by the cost per equivalent unit for materials = 150 units x $5 = $750. Second, calculate the ending inventory costs per conversion costs by taking the equivalent units for conversion in ending inventory and multiplying by the cost per equivalent unit for conversion = 75 units x $8 = $600. Third, add the results from Step 1 and Step 2 above = $750 + $600 = $1,350 total cost of ending Work In Process inventory.

Reconciling Costs o We first compute the total costs to account for: Take the total costs for materials and for conversion in the chart above = $28,250 + $44,600 = $72,850 Costs for which to account. We then compute the total costs accounted for as follows. + Costs of the units completed and transferred out: $71,500 + Total cost of ending Work In Process inventory: 1,350 = Costs accounted for: $72,850 ***Notice that the two totals agree, indicating that all costs have been accounted for!

First In, First Out Method

The difference between the FIFO method and the weighted average method is how the equivalent units in beginning Work In Process inventory are computed. Let's revisit the Walnut Milling Department example. Recall that the department reported activity for May as follows. Units Beginning Work in Process (50% completed) Units started and completed Ending Work in Process * Total Cost * 50% completed for materials, 25% completed for conversion Computing equivalent unitsFIFO method o Step 1: Compute the equivalent units needed to complete beginning inventory. In our example, we had 500 units in beginning Work In Process, and they were 50% completed. Therefore, to complete the units, we need to complete the remaining 50% of the units (100% - 50% previously competed = 50% to complete) = 500 units x 50% to complete = 250 units needed to complete beginning inventory for materials, and 250 units needed to complete beginning inventory for conversion. Step 2: Compute the equivalent units of production for materials in ending Work In Process inventory. Three hundred units in ending inventory x 50% completed = 150 equivalent units for materials, ending inventory. Step 3: Compute the equivalent units of production for conversion costs in ending Work In Process inventory. Three hundred units in ending inventory x 25% complete = 75 equivalent units for conversion, ending inventory. Step 4: Compute equivalent units for materials. Add the following: + Equivalent units to complete beginning inventory: 250; + Units started and completed: 5,000; + Equivalent units in ending inventory: 150; and = Equivalent units for materials: 5,400. o Step 5: Compute equivalent units for conversion costs. Add the following: + Equivalent units to complete beginning inventory: 250; + Units started and completed: 5,000; 500 300 $28,250 $44,600 Cost for Materials $2,250 Costs for Conversion $14,600 $30,000

5,000 $26,000

+ Equivalent units in ending inventory: 75; and = Equivalent units for conversion: 5,325.

Step 1: Compute the cost per equivalent unit for materials. Cost of materials for units started and completed / total equivalent units for materials $26,000 / 5,400 = 4.8148 per equivalent unit for materials Step 2: Compute the cost per equivalent unit for conversion costs. Costs for conversion on units started and completed / total equivalent units for conversion $30,000 / 5,325 = 5.6338 per equivalent unit for conversion costs

Step 1: Calculate the total costs of the units transferred out. Since all units transferred out are 100% completed, we can add the per unit cost for materials and conversion costs: $4.8148 + $5.6338 = $10.4486 and multiply the result by the number of units completed and transferred out: 5,250 x $10.4486 = $54,855 (rounded), and we ADD the costs of materials and conversion in the beginning inventory: $54,855 + $2,250 + $14,600 = $71,705 total costs of units completed and transferred out Step 2: Calculate the costs in ending Work In Process: First, calculate the ending inventory costs per materials by taking the equivalent units for materials in ending inventory and multiplying by the cost per equivalent unit per materials = 150 units x $4.8148 = $722 (rounded). Second, calculate the ending inventory costs per conversion costs by taking the equivalent units for conversion in ending inventory and multiplying by the cost per equivalent unit per conversion = 75 units x $5.6338 = $423 (rounded). Third, add the results from Step 1 and Step 2 above = $722 + $423 = $1,145 total cost of ending Work In Process inventory.

Reconciling Costs o We first compute the total costs to account for: Take the total costs for materials and for conversion in the chart above = $28,250 + $44,600 = $72,850 Costs to account for. We then compute the total costs accounted for. + Costs of the units completed and transferred out: $71,705 + Total cost of ending Work-In-Process inventory: 1,145 = Costs account for: $72,850 ***Notice that the two totals agree, indicating that all costs have been accounted for! Review Click here to open the Process Costing tutorial. You may also want to take the self-study quiz for Chapter 4; the link is located in the Assignments tab.