Chapter 16 Operating Costs and Cost Allocation, Including Activity-Based Costing

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Chapter 16Chapter 16Operating Costs andOperating Costs and

Cost Allocation, Including Cost Allocation, Including Activity-Based CostingActivity-Based Costing

Belverd E. Needles, Jr.Belverd E. Needles, Jr.

Marian PowersMarian Powers

Sherry K. MillsSherry K. Mills

Henry R. AndersonHenry R. Anderson- - - - - - - - - - -- - - - - - - - - - -

Multimedia Slides by:Multimedia Slides by:

Dr. Paul J. RobertsonDr. Paul J. RobertsonNew Mexico State UniversityNew Mexico State University

Steve LeaskSteve LeaskNew Mexico State UniversityNew Mexico State University


The Management CycleThe Management Cycle

OBJECTIVE 2OBJECTIVE 2

Define and give examples of the Define and give examples of the

three elements of product cost and three elements of product cost and

compute a product’s unit cost for compute a product’s unit cost for

a manufacturing organization.a manufacturing organization.


Elements of Product CostsElements of Product Costs» There are three types of manufacturing There are three types of manufacturing

costs.costs.

1. Direct materials can be conveniently and 1. Direct materials can be conveniently and economically traced to specific units of product.economically traced to specific units of product.

2. Direct labor can be conveniently and 2. Direct labor can be conveniently and economically traced to specific units of product.economically traced to specific units of product.

3. Manufacturing overhead includes all 3. Manufacturing overhead includes all manufacturing costs that are not direct materials manufacturing costs that are not direct materials or direct labor costs.or direct labor costs.


Manufacturing OverheadManufacturing Overhead» The following are examples of The following are examples of

manufacturing overhead:manufacturing overhead:

Indirect materials.Indirect materials.

Indirect labor.Indirect labor.

Depreciation associated with Depreciation associated with manufacturing operations.manufacturing operations.

Machinery and tool maintenance.Machinery and tool maintenance.


Product Unit CostProduct Unit Cost

» A product’s unit cost equals:A product’s unit cost equals:

Total Direct Materials + Direct Labor +

Manufacturing Overhead for Units Produced

Total Units Produced


Summary of the Use of ActualSummary of the Use of Actual or Estimated Costs in or Estimated Costs in

Three Cost-Measurement MethodsThree Cost-Measurement Methods

Product CostElements

ActualCosting

NormalCosting

StandardCosting

Directmaterials

Actualcosts

Actualcosts

Estimatedcosts

Direct labor Actualcosts

Actualcosts

Manufacturingoverhead

Actualcosts

Estimatedcosts

Estimatedcosts

Estimatedcosts


Manufacturing Manufacturing Inventory AccountsInventory Accounts


Describe the flow of product-related Describe the flow of product-related

activities, documents, and costs activities, documents, and costs

through the Materials Inventory, through the Materials Inventory,

Work in Process Inventory, and Work in Process Inventory, and

Finished Goods Inventory accounts.Finished Goods Inventory accounts.


Product-Related ActivitiesProduct-Related Activities

» The flow of product-related activities The flow of product-related activities relates to:relates to:

1.1. Bringing materials into the organization.Bringing materials into the organization.

2.2. Converting raw materials into a finished Converting raw materials into a finished product.product.

3.3. Transferring completed products to Transferring completed products to finished goods storage.finished goods storage.


Manufacturing Cost Flow:Manufacturing Cost Flow:An ExampleAn Example

Direct MaterialsInventory Account

Balance 1/1/00: Used during$10,000 2000:

Total direct $25,000materialspurchasedduring 2000:

20,000

Balance12/31/00:

$ 5,000

Work in ProcessInventory Account

Balance 1/1/00: Completed $ 2,000 during 2000:

$30,000Direct materialsused during 2000:

25,000Direct labor 2000:

12,000Manufacturingoverhead 2000:

6,000

Balance 12/31/00$ 15,000



Factory PayrollAccount

Direct labor 2000:earned during $12,0002000:

$12,000

Balance12/31/00:

$ 0






6,000

Balance 12/31/00$ 15,000



Manufacturing OverheadControl Account

Total 2000:manufacturing $ 6,000overheadincurred during2000:

$ 6,000

Balance12/31/00:

$ 0






6,000

Balance 12/31/00$ 15,000








6,000

Balance 12/31/00$ 15,000

Finished GoodsInventory Account

Balance 1/1/00: Sold during 2000:$ 6,000 $24,000

Completedduring 2000:

30,000

Balance12/31/00:

$12,000



Finished GoodsInventory Account

Balance 1/1/00: Sold during 2000:$ 6,000 $24,000

Completedduring 2000:

30,000

Balance12/31/00:

$12,000

Cost of Good SoldAccount

Sold during 2000:

$24,000


Manufacturing and ReportingManufacturing and Reporting


Prepare a statement of cost of Prepare a statement of cost of

goods manufactured and an goods manufactured and an

income statement for a income statement for a

manufacturing organization.manufacturing organization.


Statement of Statement of Cost of Goods Manufactured: Step 1Cost of Goods Manufactured: Step 1

Angelo’s Rolling Suitcases, Inc. Statement of Cost of Goods ManufacturedFor the Year Ended December 31, 20xx

Direct Materials Used:

Direct Materials Inventory, 1/1/xx $10,000

Direct Materials Purchased 20,000

Cost of Direct Materials Available for Use $30,000

Less Direct Materials Inventory, 12/31/xx 5,000

Cost of Direct Materials Used $25,000




Cost of Direct Materials Used $25,000

Direct Labor 12,000

Manufacturing Overhead 6,000

Total Manufacturing Costs $43,000




Total Manufacturing Costs $43,000

Add Work in Process Inventory, 1/1/xx 2,000

Total Cost of Work in Process During the Year $45,000

Less Work in Process Inventory, 12/31/xx 15,000

Cost of Goods Manufactured $30,000


Income StatementIncome StatementAngelo’s Rolling Suitcases, Inc.

Income StatementFor the Year Ended December 31, 20xx

Sales $50,000

Cost of Goods Sold: Finished Goods Inventory, 1/1/xx $ 6,000 Cost of Goods Manufactured 30,000 Total Cost of Finished Goods Available for Sale $36,000 Less Finished Goods Inventory, 12/31/ xx 12,000 Cost of Goods Sold 24,000Gross Margin $26,000Selling & Administrative Expenses 16,000Net Income $10,000


Cost AllocationCost Allocation


Define Define cost allocationcost allocation and explain and explain

the process of manufacturing the process of manufacturing

overhead allocation using cost overhead allocation using cost

objects, cost pools, and cost objects, cost pools, and cost

drivers.drivers.



» A cost object is a: A cost object is a:

productproduct

processprocess

departmentdepartment

activityactivity

that the organization wishes to cost.that the organization wishes to cost.



» Cost allocation is the process of Cost allocation is the process of

assigning pooled indirect costs to assigning pooled indirect costs to

specific cost objects using an specific cost objects using an

allocation base that represents a allocation base that represents a

major function of a business.major function of a business.


Allocation of Allocation of Manufacturing OverheadManufacturing Overhead

The pooling of manufacturing The pooling of manufacturing

overhead costs that are affected by a overhead costs that are affected by a

common activity.common activity.

The selection of a cost driver whose The selection of a cost driver whose

activity level causes a change in the activity level causes a change in the

cost pool.cost pool.

» The allocation of manufacturing The allocation of manufacturing overhead requires the following:overhead requires the following:



» A cost pool is a pool of overhead A cost pool is a pool of overhead costs related to a cost object.costs related to a cost object.

» A cost driver is an activity that A cost driver is an activity that causes the cost pool to increase in causes the cost pool to increase in amount as the cost driver increases.amount as the cost driver increases.


Manufacturing Overhead Manufacturing Overhead Allocation Using the Allocation Using the Traditional ApproachTraditional Approach


Calculate product unit cost using Calculate product unit cost using

the traditional allocation of the traditional allocation of

manufacturing overhead costs.manufacturing overhead costs.


Predetermined Overhead RatePredetermined Overhead Rate» The use of one predetermined The use of one predetermined

overhead rate to apply manufacturing overhead rate to apply manufacturing overhead to a product is appropriate overhead to a product is appropriate if organizations:if organizations:

1.1. Manufacture only one product, orManufacture only one product, or

2.2. Manufacture a few very similar products Manufacture a few very similar products that require the same production that require the same production processes and production-related processes and production-related activities.activities.


Traditional Activity BasesTraditional Activity Bases

» Traditional activity bases are Traditional activity bases are volume-related bases such as:volume-related bases such as:

Direct labor hours.Direct labor hours.

Direct labor costs.Direct labor costs.

Machine hours.Machine hours.

Units of production.Units of production.


Assignment of Manufacturing Assignment of Manufacturing Overhead Costs:Overhead Costs:

Traditional ApproachTraditional Approach

= $5 per Direct Labor Hour

Predetermined Overhead Rate =

$200,000

40,000 DirectLabor Hours

Step 1: Calculate the predetermined overhead rate.



Traditional ApproachTraditional ApproachStep 2: Apply manufacturing overhead costs to production.

Regular

Cost Driver Level Cost Applied

Overhead costs applied:

Manufacturing overhead:$5 per DLH

X 25,000 DLH $125,000

10,000Number of units

$ 12.50Manufacturing overheadcost per unit



Traditional ApproachTraditional ApproachStep 2: Apply manufacturing overhead costs to production.

Deluxe

Cost Driver Level Cost Applied

Overhead costs applied:

Manufacturing overhead:$5 per DLH

X 15,000 DLH $ 75,000

5,000Number of units

$ 15.00Manufacturing overheadcost per unit


Product Unit Cost:Product Unit Cost: Traditional Approach Traditional Approach

Step 3: Product Unit Cost

RegularRolling Suitcase

DeluxeRolling Suitcase

Product costs per unit:

Direct materials $40.00 $42.00

Direct labor 37.50 45.00

Manufacturing overhead 12.50 15.00

Product unit cost $90.00 $102.00


Activity-Based CostingActivity-Based Costing


Define and explain Define and explain

activity-based costing.activity-based costing.


Product Costing SystemsProduct Costing Systems» Increased competition from foreign Increased competition from foreign

companies identified a weakness in companies identified a weakness in the product costing systems of many the product costing systems of many U.S. organizations.U.S. organizations.

Product costing systems did not Product costing systems did not accurately assign manufacturing accurately assign manufacturing overhead costs to product lines.overhead costs to product lines.

These inaccurate product unit costs led These inaccurate product unit costs led to poor decisions and lost market share.to poor decisions and lost market share.


Activity-Based Costing Activity-Based Costing (ABC)(ABC)

» In the search for more accurate In the search for more accurate

product costing, many organizations product costing, many organizations

embraced activity-based costing.embraced activity-based costing.


ABC Cost AssignmentABC Cost Assignment» ABC is an approach to cost ABC is an approach to cost

assignment that:assignment that:

Categorizes all indirect costs by Categorizes all indirect costs by identifying activity cost pools.identifying activity cost pools.

Traces costs to those activity pools.Traces costs to those activity pools.

Assigns activity costs to products Assigns activity costs to products using a cost driver that is related to the using a cost driver that is related to the cause of the cost.cause of the cost.


Activity-Based CostingActivity-Based Costing» ABC is particularly useful for ABC is particularly useful for

organizations that have:organizations that have:

Product diversity.Product diversity.

Products that vary in the amounts of Products that vary in the amounts of

production-related activities or production-related activities or

complexity required in their complexity required in their

manufacture, store, move, package, or manufacture, store, move, package, or

ship.ship.


Manufacturing Overhead Manufacturing Overhead Allocation Using ABCAllocation Using ABC


Calculate product unit cost using Calculate product unit cost using

activity-based costing to assign activity-based costing to assign

manufacturing overhead costs.manufacturing overhead costs.


ABC ApproachABC Approach

» When ABC is used, manufacturing When ABC is used, manufacturing

costs are grouped into smaller costs are grouped into smaller

activity cost pools.activity cost pools.


ABC ApproachABC Approach» Costs from activity cost pools are assigned Costs from activity cost pools are assigned

to cost objects using cost drivers.to cost objects using cost drivers.

Cost drivers are identified and cost driver Cost drivers are identified and cost driver levels are estimated for each cost pool.levels are estimated for each cost pool.

Each cost pool rate is calculated by Each cost pool rate is calculated by dividing the estimated cost amount by the dividing the estimated cost amount by the cost driver level.cost driver level.

Manufacturing overhead is applied to the Manufacturing overhead is applied to the product’s cost by multiplying the cost pool product’s cost by multiplying the cost pool rate by the actual cost driver amount.rate by the actual cost driver amount.


ABC SystemsABC Systems» ABC systems assign costs to cost ABC systems assign costs to cost

objects based on each cost object’s objects based on each cost object’s consumption of activities.consumption of activities.

» The total applied manufacturing The total applied manufacturing overhead cost is added to the cost of overhead cost is added to the cost of direct materials and direct labor to direct materials and direct labor to determine the total product cost.determine the total product cost.

» The product unit cost is the total The product unit cost is the total product cost divided by the total units product cost divided by the total units produced.produced.


ABC Costing SystemsABC Costing Systems» Problems with product costs Problems with product costs

produced by traditional volume-produced by traditional volume-based costing systems include:based costing systems include:

Traditional volume-based system, low-Traditional volume-based system, low-volume products are undercosted and volume products are undercosted and high-volume products are overcosted.high-volume products are overcosted.

Organizations face greater risk of Organizations face greater risk of making poor decisions when significant making poor decisions when significant product cost distortions exist.product cost distortions exist.


Cost Driver LevelCost Driver Level

Estimated Cost Driver Level

Cost Driver Regular Deluxe Total

Number of setups 300 400 700

Number of inspections 150 350 500

Packaging hours 600 1,400 2,000

Machine hours 4,000 6,000 10,000


Using ABC to Allocate Using ABC to Allocate Manufacturing Overhead Cost to Manufacturing Overhead Cost to

ProductionProduction

Setup$70,000

Inspection$60,000

Packaging$50,000

Building$20,000

Regular Deluxe

Chapter 16 Operating Costs and Cost Allocation, Including Activity-Based Costing

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