CHAPTER 4

ACCUMULATING AND ASSIGNING COSTS TO PRODUCTS

REFFERENCE: MANAGEMENT ACCOUNTING, PEARSON

COST MANAGEMENT SYSTEMS

Many companies continue to use these two systems: cost management systems; job order costing
and process costing to cost products and services.

COST FLOW IN ORGANIZATIONS

Manufacturing Organization

Finished Goods Cost of Goods

Direct Materials Work In Process
Inventory Sold

Manufacturing
Direct Labor
Overhead Items

Retail Organization Service Organization

Cost of Employee
Store Project Project Cost
Purchases Merchandise Hours
inventory
Sold

Overhead Overhead
Items Items

SOME IMPORTANT COST TERMS

Cost Object is a anything for which a cost is computed. Examples: activities, products, products lines,
departements, or even entire organizations.

Consumable Resources or Flexible Resources is cost depends on the amount of resources that is used.
Examples: wood in a furniture factory, iron ore in a steel mill.

Capacity-Related Resources is cost depends on the amount of resource capacity that is recquired not
on capacity is used. Examples: depretiation on production equioment and salaries paid to employees.
Direct and Indirect Cost.
Direct cost is cost that uniquely and unequivocally attributable to a single cost object. Indirect cost is
any cost that fails the test of being a direct cost. Almost all variable costs are direct costs. Almost all
fixed costs are indirect costs.
Examples: the cost of production equipment or a factory supervisor that was acquired for and used
exclusively by one product is a direct cost for the product. A good test of whether the cost of a capacity
resource is indirect is whether the organization would have no use for the resource if the cost object
was abandoned.

Cost Classification and Context

Going Forward
Costing systems first classify costs as direct or indirect. Direct costs are assigned to the
appropriate cost object. Indirect costs are allocated to cost objects in a reasonable way

HANDLING INDIRECT COSTS IN A MANUFACTURING ENVIRONMENT

Costing System Structure:

Is the cost
direct indirect
direct or
indirect?

Cost Assign cost to Indirect

cost object Cost
Object
Pool(s)
Allocate a portion of the indirect cost to cost object(s)

Estimated total factory indirect cost

PRETERMINED INDIRECT COST RATE = Practical capacity in cost driver units
OVERHEAD ALLOCATION: FURTHER ISSUES

Using Planned Capacity Cost

1. The annual actual capacity-related costs are not known until the end of the accounting period
(which is usually a year), and cost analysts want to compute costs for cost objects such as
customers, products, and jobs before the year end.
2. Using planned rather than actual capacity-related costs sets a benchmark against which to
compare actual capacity-related costs at the end of the accounting period.

Reconciling Actual and Applied Capacity Costs

Option 1: Charge the difference between actual and applied indirect costs to cost of goods sold.

Option 2: Prorate the difference between actual and applied indirect coststo work in process, finished
goods, and cost of goods sold.

Option 3: Decompose the difference between actual and applied indirect costs into two parts: the
difference between actual and budgeted indirect costs and the difference between budgeted and
applied indirect costs.

Cost Driver Level

The discussion to date has assumed that the appropriate cost driver level is practical capacity. Practical
capacity is one of four commonly proposed activity levels used to compute the cost driver rate. The
other three are (1) the actual level of operations, (2) the planned level of operations, and (3) the
average level of operations.

Estimating Practical Capacity

Estimating practical capacity begins with an estimate of theoretical capacity. Suppose a machine is
nominally available for 100 hours each week. A common rule of thumb is to set practical capacity
equal to 80% of theoretical capacity. In other words, allow about 20% of theoretical capacity or, in this
case, 20 hours for activities such as maintenance, setup, and repair.

JOB ORDER AND PROCESS SYSTEMS

Job Order Costing

Job order costing is an approach to costing that estimates costs for specific customer orders because
the orders vary from customer to customer. Examples: a consulting engagement for a client, building
a nuclear reactor for a power utility, providing a meal from a restaurant menu, or treating a patient in
a hospital. In each of these cases the organization providing the product or service will typically assign
all direct material and direct labor costs to the job. The purpose of the job order costing system is to
accumulate the cost of the job because, due to job differences, costs will vary across jobs.

Process Costing

Process costing is an approach to costing that is used when all products are identical. The total cost of
all products is determined by adding up all of the direct and indirect costs used to produce the
products and then dividing by the number of products produced to get a cost per unit. Examples of
products for which process costing is appropriate are soda drinks, breakfast cereal, plastic water
bottles, and routine services such as providing influenza inoculations at a medical clinic.