Product Costing Systems

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• Product costing is a general term that refers to the process of assigning both direct and indirect costs to products or services:

– Direct costs are traced to a cost object (e.g., a job)– Indirect costs are allocated to a cost object (using one

or more cost-allocation bases/cost drivers)

• A firm’s choice of costing system depends on the firm’s industry and product or service, the firm’s strategy and management information needs, and the costs and benefits of acquiring, designing, modifying, and operating a particular system

Developing a Costing System

• When developing a product-costing system, there are three choices that must be made:– Cost accumulation method (i.e., job or process costing)– Cost measurement method (i.e., actual, normal, or

standard costing)– Overhead assignment method (i.e., volume-based or

activity-based)

• Each product-costing system will reflect these three choices– For example, an organization’s cost system may be

characterized by: job costing with normalized costs, and activity-based costing used to allocate indirect costs

Developing a Costing System (continued)

Cost accumulation: Job or Process Costing?– In a job costing system, all manufacturing

costs incurred are assigned to jobs• This type of system is appropriate when cost can be

readily identified with specific customers, jobs, or projects

• Often found in small or medium firms that produce customized products

– Process costing is often found in large firms that produce one or a few homogeneous products through continuous mass production

Developing a Costing System (continued)

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Classifications of Production Processes

• Unit production (ship builder) Pure job shop or job costing.

• Batch (or lot) production batch of identical items moves from one factory work station to another. (100 fuel injectors)

• Assembly line production jobs are separately identifiable but tend to be similar (automobiles, computers, refrigerators)

• Process production outputs are not identifiable as separate units (petroleum, chemicals, steel) Pure process costing.

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Product costing systems

Average some total costs to arrive at unit cost amounts. 2 basic types of costing systems:

Job order Process

Job Order

Costing

Construction, printing, special equipment manufacturing, shipbuilding, medical services, custom furniture manufacturers, advertising agencies, accounting firms, etc.

Process

Costing

Chemical industry, bottling companies, plastics, food products, and paper products, cement manufacturing, brick production, etc.

Cost measurement: actual, normal, or standard costing?An actual costing system uses actual costs incurred

as the measure of product costThis type of cost measurement is rarely used

because unit costs fluctuate significantly, thereby increasing the possibility of error in pricing, adding/dropping product lines, and executing performance evaluations

Under actual costing, factory overhead costs are only known at or after the end of the period (thus, cost information is not available on a timely basis)

Cost measurement: actual, normal, or standard costing?

– A normal costing system uses actual costs for direct materials and direct labor but normal costs for factory overhead:

• Normal costing involves estimating a portion of overhead to be assigned to each product as it is produced providing a timely estimate of cost

• Choice of an appropriate denominator activity level for allocating fixed overhead costs is a key consideration

– A standard costing system uses standard costs for all cost elements, direct and indirect:

• Standard costs are costs a firm should attain under relatively efficient operating conditions

• Standard costing systems provide a basis for cost control, performance evaluation, and process improvement

Cost measurement: actual, normal, or standard costing?

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Job order cost system(or job cost system)

• Collects costs for each job as it moves through production process.

Each job: separate identification number; entered on a separate job cost record. DM entered from material requisitions

releasing materials from stockroom. DL entered from employee time records. Overhead charged using departmental rates.

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Job cost system

Sum of all charges for period are debited to Work-in-process (WIP) Inventory and credited to Materials Inventory, Wages Payable, and Overhead Accounts.

Completed job: Transfer from WIP to FG (i.e. dr. FG Inventory, cr. WIP Inventory).

When billed dr. AR, cr. Sales; using job cost record amounts dr. Cost of Goods sold, cr. FG inventory.

Receive orders from customers

Schedulejobs.

Ordermaterials.

Begin production.

Events in Job Order Manufacturing

Goods in Process

Cost of GoodsSold

Labor

Materials

Ind

irec

t

FinishedGoods

FactoryOverhead

Direct

Direct

Allocate

Job Order Manufacturing Activities

Ind

irec

t

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Process cost system

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

• Determine unit costs by dividing total costs by total number of units worked on.

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Process Cost System:Inventoriable Cost

Conversion cost per unit + DM = inventory or total production cost.

Total conversion costs equivalent units of production = conversion costs per unit. Equivalent units of production = completed units

+ .5 * units in production. Just one approach. Assumes on average units in

production are half finished (hence .5). Other assumptions could be made (e.g. 0%).

If materials are added at beginning of process, then calculations are done for materials first assuming all units in WIP are 100% complete as far as materials.

Types of Processes

• Sequential processing requires that units pass through one process before they can be worked on in the next process in the sequence.

• Parallel processing is another processing pattern that requires two or more sequential processes to produce a finished good.

Types of Processes (continued)

• Partially completed units (e.g., two subcomponents) can be worked on simultaneously in different processes and then brought together in a final process for completion.

Job-Order Vs. Process Costing

Job-Order Costing• Many jobs are worked on

during each period, with each job having different production requirements.

• Costs are accumulated by job.• The job cost sheet is the key

document for accumulating costs.

• Units costs are computed by job on a job cost sheet.

Process Costing• A homogeneous product is

produced on a continuous basis or for long periods of time.

• Costs are accumulated by department.

• The departmental production report is the key document showing the accumulation and disposition of costs.

• Unit costs are computed by department on production reports.

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Choice of a system

• Process cost: less bookkeeping. – Costs cannot be traced to specific units.– Less record keeping.

• Job cost system, costs traced to specific units. – Easier to identify existence of and source of

cost problems.

Variations used in practice.

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Backflush Accounting

• No WIP inventory accounts.

• Material charged to FG based on bill of materials.

• All conversion costs charged directly to FG inventory.

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Measurement of direct costs

Direct labor costs = quantity of labor * price per unit of labor. Time card is used to measure quantity of labor. Labor rate could be actual or average labor rate.

Some companies add labor related/fringe costs to Direct Labor (others consider fringes as overhead).

Direct material cost = quantity of material * price per unit. Quantity determined from requisitions from

stockroom. Price may be invoice or invoice plus material

related cost. Cost flow assumptions (LIFO, FIFO, avg. cost) must also

be considered.

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Direct & Indirect vs.Variable & Fixed

Some variable costs are direct costs. Some fixed costs are indirect costs. Direct Vs indirect:

Refers to traceability. Accounting concept.

• Variable vs. fixed:– Refers to cost behavior. – Economic concept.

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Allocation of Indirect Costs

Desirable to classify a cost as direct. Indirect cost assignment is more

roundabout & less accurate. Reasons for not tracing directly:

– Impossible to do so; Not feasible because too costly; Mgmt chooses not to do so.

How to determine fair share of indirect costs? Based on causal relationship.

Traditional Allocation Method

• Indirect costs allocated to cost object based on the cost object’s consumption of some measure of activity, usually labor hours

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$10,000,000 total indirect cost400,000 total labor hours

= $25 per hour rate

A product consuming 6 labor hours would be charged $150 of indirect costs

Criticisms of Traditional Overhead Allocation

• Assumes all overhead is volume-related

• Factory-wide or departmental rates– All related to single activity measure

• Departmental focus, not process focus

• Focus on costs incurred, not cause of costs

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Activity-Based Costing

• Purpose– Allocation of indirect costs based on causal

activities• Attempts to identify “direct” link between cost and

cost object

– Results in better allocation– Does not provide “true” cost

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Activity-Based Costing

• Traditional allocation method

• Activity-based allocation method

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Costs Products

Costs ProductsActivities

First stage Second stage

Overview of ABC

• Identifies activities required to produce the product or service

• Determines the cost of the activities

• Allocates costs to the cost object based on the object’s consumption of activities

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When is ABC Most Useful?

• High amounts of overhead cost• Multiple products• Complex products• Complex production system• Significant variation in volume between high and low

volume products

• Different products place different demands on resources

• Problems with current cost allocations due to changes in products or processes

• Better cost information is needed28

Operation of an ABC System

• Assign costs to activity pools– First stage allocation– Identify the costs incurred to perform various

activities

• Determine the measure of activity best related to each cost pool– Cost drivers

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Allocation of Indirect Costs

Process of assigning indirect costs to individual cost objects. Overhead rate = absorption rate = allocation

rate = burden rate = means of allocating indirect costs to products.

All costs are assigned to cost objects. Costs are assigned directly or Or indirectly, that is, allocated.

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Cost and responsibility centers

• Cost center = cost object for which costs of one or more related functions or activities are accumulated. In a product costing system, items of indirect

(overhead) cost are first accumulated in cost centers and then assigned to products.

Cost center = intermediate cost object. Product is a final cost object.

Responsibility center = an 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,

to other cost service centers, or for benefit of the 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

• Series of steps

• Direct materials and direct labor costs are assigned directly to product costs.

• Allocation of overhead costs to product cost objects involves 3 steps:– All overhead costs are assigned to

production (PC) or service centers (SC).– SC costs are reassigned to PCs.– Costs allocated to products from PCs.

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First Allocation Step

All overhead costs for an accounting period are assigned to service and production cost centers. Some costs are directly charged to center. Overhead costs that benefit several centers

are jointly allocated to those centers. Examples of allocation bases: Square footage, headcount.

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Second Allocation Step

Cost accumulated in each service cost center is reassigned to production cost centers. Step down order:

Allocating service costs in a prescribed order (following assumes 2 service cost centers).

First allocate either costs of service center that provides the most services to other cost centers or costs of the service center that receives fewest services from other service centers.

Then allocate costs of remaining service cost center

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Final Allocation Step

Allocate from production cost centers to products that pass through. In a process cost system: Overhead per unit

= total overhead divided by number of equivalent units.

In a job cost system: overhead is assigned to product by using some activity measure (e.g. direct labor hours, machine hours). Rate is determined by dividing total overhead costs

by activity measure. For each job, overhead costs are allocated to it or

applied to it or absorbed by it by multiplying activity measure by rate.

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Cost drivers (allocation bases)

Causal relationship between cost & object. • Payroll related (social security taxes, fringe benefits).• Headcount related (human resource related).• Material related (purchasing receiving, counting).• Space related (facility related).• Transaction or activity related (scheduling, set up costs).

Also called a batch-level driver.• Product related (tools and dies, engineering change

orders)• Overall drivers - covers a mixture of activities. (direct

labor hours or costs)- default drivers.• Customer related (sales calls, customer service,

advertising).• Business related (CEO, CFO).

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Establishing predetermined rates

• Prepare overhead budgets for various levels of activity. Identify costs as variable, fixed, semi-variable.

Estimate average level of activity expected in each cost center for coming year.

Calculate each production center’s overhead rate by dividing budgeted overhead cost at standard volume by standard volume.

Some companies use a plant wide overhead rate instead of by production cost center.

The ABC Model

Indirect Cost

Pool

Activity

Centre C

Activity

Centre D

Product 1 Product 2 Product 3

1st Stage Allocation

2nd Stage

Allocation

Resource Drivers

Activity

Drivers

$

Activity

Centre B

Activity

Centre B

Activity

Centre A

Activity

Centre A

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Why use predetermined overhead rates?

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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Under-absorbed and over-absorbed overhead

• Actual overhead costs are charged to cost center overhead clearing account.

Overhead clearing account is credited for the amounts determined from predetermined overhead rate. Amount absorbed by product > actual costs,

overhead: over-absorbed (under-absorbed). If over-absorbed (under-absorbed): credit (debit)

balance in overhead clearing account. Balance is transferred to Overhead variance

account. Adjusts COGS or Inv.

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Accuracy of Costing

• GAAP requires aggregate inventory and COGS (not by product), to be materially accurate.

For better decision making: Some companies use activity based costing

primarily to estimate costs for profitability analysis.

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Cross Subsidies

• If actual cost structure is complex and a simple overhead allocation approach is used, some products costs will be understated and some overstated.

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Steps of Activity Based Costing

Many more service center cost pools (called activities or activity centers).

Activity’s costs can be assigned directly to product rather than through a production cost center.

ABC uses unit-level, batch-level and product-level cost drivers.

Each activity is allocated based on the cost driver determined to be most appropriate for that pool of costs.

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Examples of Drivers

• Unit level drivers (number of units, direct labor hours, direct labor dollars, machine hours) the more units the more costs assigned to the product. Costs per unit stay the same regardless of number of units.

• Batch level drivers (number of orders processed, number of production batches run) used to allocate costs associated with setting up production or processing orders. The larger the production run or order, the lower the costs per unit.

• Product level drivers (number of products) costs required to design or maintain products are assigned based on number of products.

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Steps in an ABC Costing Approach

• Cost drivers are identified for each activity.• All costs for period are assigned either directly to

product (e.g. direct material) or to a cost pool associated with each activity and cost driver.

• Costs assigned to product based on cost driver.• Cost per unit determined by dividing total costs

assigned to product by number of units of product.