NINJA BOOK BUSINESS ENVIRONMENT AND CONCEPTS IV OPERATIONS MANAGEMENT

Transcription

1 NINJA BOOK BUSINESS ENVIRONMENT AND CONCEPTS IV OPERATIONS MANAGEMENT

2 I COST ACCOUNTING & MEASUREMENT 1

3 A. Cost Measurement Methods and Techniques 01 Management Accounting is the process of measuring and using information for the following purposes: a. Management planning, decision making, and control b. Reporting assets and cost of goods sold for financial statements and income taxes c. Reporting of costs under cost-based contracts Because management accounting information is used for many purposes, the accounting systems need to be sufficiently flexible to allow measuring and combining costs in different ways. 02 Assignment of costs to cost objects: Cost assignment is the process of tracing direct costs and allocating indirect/common costs to cost objects. A cost object (or cost objective) is an item or activity for which a separate and discrete measurement of costs is desired, such as a product, function, department, division, contract, or service. 03 Costs for external reporting is the financial accounting purpose of reporting the value of inventory so that the cost of goods sold and income can be determined. Costs are classified based on their attachability to inventory. a. Product costs: Direct costs can be attached to inventory based on associating cause and effect. Indirect costs are attached by systematic and rational allocation. b. Period costs: These costs are not attached to inventory, but are recognized immediately. 04 Manufacturing costs: a. Direct materials: Raw material costs that can be reasonably traced to a product on a per-unit basis. b. Direct labor: Wages relating to employees who work directly on the product (i.e., hands-on) that can be reasonably traced to a product on a per-unit basis. c. Indirect materials: These are costs incurred in the manufacturing process, but either they do not become part of the product (e.g., machine oil) or they are not reasonably traceable to the product (e.g., paint, varnish, glue). Such costs become part of factory overhead and are attached to the product through an allocation process. d. Indirect labor: This incorporates factory labor costs for personnel who do not work directly on the product and whose costs cannot be reasonably traced on a per-unit basis. This category includes salaries of peripheral production employees, notably production supervisors/managers, factory janitors, and factory security personnel. Like indirect materials, these costs become part of factory overhead and are attached to the product through an allocation process. e. Factory overhead: This is also called manufacturing overhead, factory burden, or simply overhead. It includes all costs except direct labor and direct materials that are part of making the product, but which are not directly traced to a specific product. Costs are accumulated in factory overhead accounts. They may either vary with production (variable costs) or not (fixed costs). The costs are traditionally allocated to each unit produced on some basis such as $ per direct labor hour, per direct labor cost, or per machine hour. f. Prime costs: Direct materials and direct labor together are called prime costs. g. Conversion costs: All factory costs other than direct materials are called conversion costs; they are required to convert materials into a finished product. Conversion costs include direct labor and factory overhead. 2

4 Application: Which of the following is assigned to goods that were either purchased or manufactured for resale? Relevant cost Period cost Opportunity cost Product cost D - Product costs are attached or assigned to units produced in a manufacturing process. Product costs are direct materials, direct labor, and manufacturing overhead. Relevant costs are those expected to differ among alternative future courses of action. They are also known as incremental costs or differential costs. Period costs are not associated with the manufacturing process. They are expensed in the period incurred. Period costs are selling, general, or administrative expenses. Opportunity costs are those revenues that will be lost if one action is chosen over another. 05 Manufacturing inventories: Traditional manufacturing environment a. Raw materials: This inventory includes anything tangible that becomes part of the product or its packaging. Raw materials are held in inventory until requisitioned by the production department. In the just-in-time (JIT) production system, raw materials are not stored in inventory, because they are not delivered to the factory until they are needed in production. Beginning raw materials inventory + Purchases Ending raw materials inventory = Raw materials used b. Work-in-process: Once production is begun, manufacturing costs are accumulated in the work-in-process (WIP) account until the product is finished and transferred to the finished goods inventory. Beginning WIP + Raw materials used (from a.) + Direct labor + Overhead applied Ending WIP = Cost of goods manufactured c. Finished goods: These items are ready to be sold. Beginning finished goods + Cost of goods manufactured (from b.) Ending finished goods = Cost of goods sold 3

5 Application: JacKue Co. plans to produce 200,000 pairs of roller skates during January of next year. Planned production for February is 250,000 pairs. Sales are forecasted at 180,000 pairs for January and 240,000 pairs for February. Each pair of roller skates has eight wheels. JacKue's policy is to maintain 10% of the next month's production in inventory at the end of a month. How many wheels should JacKue purchase during January? 195, ,000 1,560,000 1,640,000 D - The general inventory reconciliation formula is useful here: Beginning inventory + Purchases - Uses = Ending inventory This formula can be restated as: Purchases = Ending inventory - Beginning inventory + Uses The beginning and ending inventory will be 10% of the next month's purchases and can be calculated as follows: Beginning inventory = 10% of January's planned production = 0.10 x (200,000 pairs of skates x 8 wheels per pair) = 160,000 wheels Ending inventory = 10% of February's planned production = 0.10 x (250,000 pairs of skates x 8 wheels per pair) = 200,000 wheels Production uses for January = 200,000 pairs of skates x 8 wheels per pair = 1,600,000 wheels The necessary January purchases can then be calculated: Purchases = Ending inventory - Beginning inventory + Uses = 200,000 wheels - 160,000 wheels + 1,600,000 wheels = 1,640,000 wheels 4

6 06 Sequence of manufacturing cost flows Costs are accumulated and flow with the physical inventory from one inventory account to the next, as shown in the following T-accounts illustration: Inventory Cost Flows in Traditional Manufacturing Environment 07 Schedule of cost of goods manufactured: This schedule summarizes the costs assigned to the manufacturing process during the period. A condensed example follows: Schedule of Cost of Goods Manufactured Beginning direct materials inventory $10 + Purchases of direct materials 80 Ending direct materials inventory -30 Raw materials used 60 + Direct labor 70 + Overhead (supplies, utilities, indirect labor, etc.) 40 Total manufacturing costs for the period Beginning WIP inventory 50 Total manufacturing costs 220 Ending WIP inventory -140 Cost of goods manufactured $80 5

7 Assigning Costs to Inventory 08 Introduction: Assigning Costs to Inventory A determination of unit cost is needed for product pricing, cost control, GAAP reporting (inventory valuation, cost of goods sold), and income tax reporting. There are several methods of attaching production costs to each unit produced. Within each method, inputs can be valued using actual, normal, or standard costs. The choice of method is influenced by the production process. Production processes range from making products individually or in identifiable batches, to making a continuous stream of indistinguishable goods. Therefore, job costing can be viewed as existing at one end and process costing at the other end of a cost-tracking continuum. There are hybrid methods in between that have been known by various names, such as operation costing. Application: Companies in what type of industry may use a standard cost system for cost control? Mass production industry Service industry Both mass production and service industries Neither mass production nor service industries C - Historically, standard cost systems have been mainly used by companies involved in mass production of products. Cost categorization by materials, labor, and overhead fits in well with cost standards and variance analysis. There is no inherent reason why standard cost systems would not work equally well for service-oriented companies. In fact, the number of service companies using standard cost systems has increased rapidly in the last decade. In summary, both the mass production and service industries use standard cost systems. 09 Job costing, also called job order costing, is a tracking system used for customized products or services. a. Job cost records (or sheets): Costs are accumulated by the job, or job lot, and are recorded on job cost records as work progresses. Entries are made into the WIP ledger account for manufacturing inputs from the job cost records. The job cost records make up a subsidiary ledger that supports the control account Work in Process. b. Direct materials: Most raw materials will be traceable to the units produced through the requisition forms used to issue materials from the raw materials inventory storeroom to the production department. Indirect materials are charged to manufacturing overhead and are attached to the product through the allocation process. c. Direct labor: This cost is recorded by the employee on a detailed time record listing the job number, operation performed, hours used, etc. Indirect labor is charged to manufacturing overhead and attached to the product through the allocation process. d. Overhead: This is applied to jobs using the predetermined rate applied on the selected allocation base or cost driver. If this is a normal costing system, actual driver units experienced are used as the input quantity. If a standard costing system, the number of driver units that should have been used to complete the related activity is used. e. Job completion and sale of goods: As jobs are completed and moved to the Finished Goods warehouse, entries are made to transfer the completed cost from WIP to Finished Goods and the job cost records become a subsidiary ledger for the Finished Goods account. Ultimately, as sales occur, the job cost records become supporting documents for Cost of Goods Sold. 6

8 Application: Gram Co. develops computer programs to meet customers' special requirements. How should Gram categorize payments to employees who develop these programs? By direct costs and value-adding costs By direct costs only By value-adding costs only By neither direct costs nor value-adding costs A - Direct costs are costs that relate directly to and are traceable to products. The payments Gram makes to employee programmers can be traced to the programs so they are direct costs. Value-adding costs are those costs that are necessary to production and add value to the product. Clearly, the employee programmers' efforts are value-added costs. Some production costs such as manufacturing machine set-up or administrative work related to licensing of programs is necessary but does not add value per se to the product. 10 Process costing is used for products whose individual units are indistinguishable from other units (e.g., sugar, corn flakes, textiles, paint). Such products are continuously produced through a series of uniform production steps called processes. Costs are accumulated by process, then applied to the units processed using an average cost for input units. There is a separate Work-in-Process account for each department or process through which the units flow. At the end of each period, costs are allocated between the units completed and transferred to the next department and the unfinished units remaining in ending inventory based on equivalent finished units. Application: In computing the current period's manufacturing cost per equivalent unit, the first-in, first-out (FIFO) method of process costing considers current period costs: only. plus cost of beginning work-in-process inventory. less cost of beginning work-in-process inventory. plus cost of ending work-in-process inventory. A - 1. The FIFO method of process costing uses an equivalent unit computation that includes only work done in the current period (i.e., Equivalent units work = Work done to complete beginning work-in-process + Work on units started and completed + Work done on units left in ending work-in-process). 2. In order to be consistent with 1., only current period costs are used in calculating cost(s) per equivalent unit. Another method, the weighted-average method, averages some previous period costs with current period costs. 7

9 11 Computation of unit costs and assigning costs to inventories: To compute costs relating to completed units transferred out of the department and costs of unfinished units that remain in ending inventory, both physical units and total costs must be accounted for in a five-step process. This process comprises a process costing report. The steps are listed below. Note that Steps 2 and 3 are interchangeable. Step 1: Account for all physical units. Step 2: Compute the equivalent finished units (EFU or EU) for each element of manufacturing cost that is incurred at a separate rate. Usually two computations are needed: one for materials units and one for conversion units. Step 3: Determine the total dollars to be accounted for. Step 4: Compute the per-unit cost for each separately identified manufacturing element. This will usually be materials and conversion. Step 5: Use the per-unit cost to assign the dollars to the units transferred out and to the units remaining in the ending inventory. The sum of the dollars transferred out to the next department or to finished goods and the dollars remaining in ending WIP must be equal to the total dollars identified in Step Equivalent finished units (EFU) a. Work done: There are three categories of physical units being worked on during a period: (1) Units in beginning inventory that need to be completed (2) Units received into the department during the month that are started and completed during the month (3) Units started but not finished (ending inventory units) Obviously, the same amount of work is not applied to these three different categories during the period. b. Physical units divisor: When dividing costs by a physical units denominator to arrive at a cost per unit, the denominator must be one which has evened out the inequality of work done as described above. The denominator used is the equivalent finished units. This is the number of units that would have been completed during the period if all work performed had been done only on units that were both started and finished during the period. c. Equivalent units computation methods: There are two different methods used for computing the equivalent finished units: (1) Weighted average: In this method, no attempt is made to separate the work done to complete the beginning inventory units and costs from the work performed on units started and finished. It is as though the beginning inventory data were pulled into the current period and a simplifying assumption is made that all units completed during the current period were started during the current period. Thus, all the costs incurred, including the beginning inventory costs, are averaged over all the equivalent units. This method is appropriate when costs and production remain relatively stable from period to period. It is not appropriate in a standard costing system. All costs OR Beginning inventory costs + Started costs All E.units All units completed + (EI Completion %) 8

10 (2) First In, First Out (FIFO): In this method, the beginning inventory units and costs are kept separate from the current period units and costs. The units transferred out are made up of two layers the beginning inventory units finished up during the period plus units started and finished. The ending inventory is valued using the most recent costs. This method is preferred when costs fluctuate from period to period and is required if a standard cost system is in use. Current-period costs OR Total costs Beg. inventory costs Current-period E. units Completed units + (EI %) (BI %) Application: A company uses process costing to assign product costs. Available inventory information for a period is as follows: Inventory Material Conversion (in Units) Cost Cost Beginning 0 Started during the period 15,000 $75,000 $55,500 Transferred out 13,500 End of period 1,500 The ending inventory was 25% complete as to the conversion cost. 100% of direct material was added at the beginning of the process. What was the total cost transferred out? $130,500 $126,973 $121,500 $117,450 C - Equivalent units (EU) for material were 15,000 (including 13,500 in units completed and 1,500 in ending work in process). The equivalent units of conversion cost in ending inventory equaled 1,500 units times 25%, or 375. Adding the 375 equivalent units in ending inventory to the 13,500 units completed gives 13,875 total equivalent units of conversion cost. Dividing $75,000 of material cost by 15,000 EU for material gives $5 as the unit cost for material. Dividing conversion cost of $55,500 by 13,875 EU for conversion cost gives $4 as unit cost for conversion costs. Adding the $5 to the $4 gives $9 as total cost per unit completed. Multiplying the 13,500 units completed by $9 gives total cost transferred out of $121, Materials costs: Materials are added to the manufacturing process at different points in time. For example, Material A could be added as processing begins in the department and Material B added at the 60% conversion phase. In CPA Examination problems, materials are generally added at either the beginning of the process or at the end; therefore, units will be either 0% or 100% complete as to materials costs. 9

11 14 Conversion costs: It is assumed that conversion occurs uniformly during the process; therefore, the CPA Examination question fact pattern will indicate the percentage of completion as to these costs for both the beginning and ending inventories. Note that conversion includes both labor and overhead costs. Application: If a product required a great deal of electricity to produce, and crude oil prices increased, which of the following costs most likely increased? Direct materials Direct labor Prime costs Conversion costs D - Direct material and direct labor are prime costs that would not change due to an increase in crude oil prices (unless crude oil is a material used directly in the product). Conversion cost is the cost of converting the material to finished goods, including direct labor and manufacturing overhead. Electricity used by the factory is part of overhead cost, so an increase in electricity cost would increase overhead and conversion cost. It is possible that direct material cost would increase as well if electricity is a major cost incurred by the supplier of that material or if crude oil is part of the material used in the product, but that is not indicated in the problem. This factory will certainly see an increase in overhead cost. 15 Process costing report procedure The five steps required to produce a process costing report are listed in section 11. Step 1: Account for all units. + Units in beginning inventory + Completed units transferred out + Units started during period = + Ending WIP units Total physical units to account for Total physical units accounted for Step 2: Compute equivalent finished units (EFU). The example in section 16 assumes that the department is the first processing stage. If this were for a second or subsequent department, the equivalent unit computation would need to include a third column, Transferred-in Costs. All cost elements in a Transferred-in column would be computed at 100% because units transferred in to subsequent departments come 100% complete as to costs incurred in previous departments. a. Weighted-average method: Materials Conversion Completed Units Transferred Out X X Add Ending Inventory: Materials - % added during period X Conversion - % added during period X Equivalent Finished Units, WA (EFU/WA) X X 10

12 b. FIFO method: Materials Conversion Completed Units Transferred Out X X Add Ending Inventory: Materials - % added during period X Conversion - % added during period X Less Beginning Inventory: Materials - % completed at beginning of period (X) X Conversion - % completed at beginning of period (X) Equivalent Finished Units, FIFO (EFU/FIFO) X X Step 3: Determine total costs to account for: Beginning costs $ Add period costs: Transferred in $ Direct materials $ Direct labor $ Overhead $ Total costs to account for $ Step 4: Compute per-unit cost for materials and conversion. (Where EFU is the same for both materials and conversion, only one computation needs to be done.) a. Weighted-average method: Total materials costs EFU/WA - Materials b. FIFO method: Current-period materials costs EFU/FIFO - Materials Total conversion costs EFU/WA - Conversion Current-period conversion costs EFU/FIFO - Conversion Step 5: Total costs accounted for: Transferred-out costs + Ending WIP costs Total costs accounted for (must equal total costs to account for in Step 3) 11

13 Application: Weighted-average and first-in, first-out (FIFO) equivalent units would be the same in a period when which of the following occurs? No beginning inventory exists. No ending inventory exists. Beginning inventory units equal ending inventory units. Both a beginning and an ending inventory exist but are not necessarily equal. A - The basic difference between the weighted-average and the first-in, first-out (FIFO) method equivalent unit methods is the handling of the prior-period costs. The FIFO method separates product units and costs into two groups: 1. Costs related to the prior period 2. Costs related to the current period In contrast, the weighted-average method blends the units and costs from both periods as if they were all part of the current period. The following chart compares the two methods: Weighted-Average Method Units in the beginning are treated as if they were started FIFO Method Only the work needed to complete the units in the beginning inventory is and completed in the current included in the calculation of period. equivalent units for the period. Costs related to the beginning Only costs related to the current inventory are added to the costs period are included in the computations added during the current period when determining the costs per equivalent unit for the period. All units transferred out are of the costs per equivalent unit for the period. The units transferred out are divided treated in a like fashion whether into two groups: (1) units in the they were part of the beginning beginning inventory and (2) units started inventory or were started and and completed during the current period. completed during the current period. The costs to be accounted for are The costs to be accounted for are the same using both methods. the same using both methods. Since the differences related to the cost assignment of the costs to be accounted for relate to the handling of the beginning inventory, the weighted-average and FIFO equivalent units would be the same under a condition when the difference is nonexistent in other words, when there is no beginning inventory. 12

14 16 Process costing report example: Levittown Company employs a process cost system for its manufacturing operations. All direct materials are added at the beginning of the process and conversion costs are added uniformly. Levittown s production quantity schedule and costs for November are reproduced below for the first stage of processing: Beginning WIP (60% complete as to conversion costs) 1,000 Units started during period 5,000 Ending WIP (20% complete as to conversion costs) 2,000 Materials Conversion Total Beginning inventory costs $2,000 $6,000 $8,000 Current-period costs 5,500 38,000 43,500 $7,500 $44,000 $51,500 A process cost report for Levittown Company for this process stage would require the following steps (sections 17 and 18). 17 Process costing report example: Weighted-average method Step 1: Determine physical units to account for. Units in beginning inventory 1,000 Completed units transferred out 4,000 + Units started during period 5,000 + Ending inventory units 2,000 Physical units 6,000 6,000 Step 2: Compute equivalent finished units. Materials Conversion Completed Units Transferred Out 4,000 4,000 + Ending Inventory, Materials (2, %) 2,000 Conversion (2,000 20%) 400 EFU (Weighted Average) 6,000 4,400 Step 3: Determine total costs to be accounted for. Materials Conversion Total Beginning inventory costs $2,000 $6,000 $8,000 Period costs 5,500 38,000 43,500 Total costs to account for $7,500 $44,000 $51,500 Step 4: Compute unit costs based on EFU denominators computed in Step 3. (Use total costs.) Materials $7,500 6,000 units = $1.25 per unit Conversion $44,000 4,400 units = per unit Total unit cost (weighted average) $

15 Step 5: Use unit costs computed in Step 4 to allocate costs between units completed and transferred out and units in ending inventory. Units Transferred Out: (4,000 $11.25) $45,000 Ending WIP Inventory Materials (2,000 $1.25) $2,500 Conversion (2,000 20% $10.00) 4,000 Total Costs in Ending WIP 6,500 Total Costs Accounted For $51, Process costing report example: FIFO method Step 1: Determine physical units to be accounted for. (Note that this is the same under both weighted-average and FIFO methods.) Units in beginning inventory 1,000 Completed units transferred out 4,000 + Units started during period 5,000 + Ending inventory units 2,000 Physical units 6,000 6,000 Step 2: Compute equivalent finished units. Materials Conversion Completed Units Transferred Out 4,000 4,000 + Ending Inventory, Materials (2, %) 2,000 Conversion (2,000 20%) 400 Less Beginning Inventory, Materials (100%) -1, Conversion (60%) -600 EFU (FIFO) 5,000 3,800 Step 3: Determine total costs to be accounted for. (Note that this also is the same under both weighted-average and FIFO methods.) Materials Conversion Total Beginning inventory costs $2,000 $6,000 $8,000 Period costs 5,500 38,000 43,500 Total costs to account for $7,500 $44,000 $51,500 Step 4: Compute unit costs based on EFU denominators computed in Step 3. (Use current-period costs.) Materials $5,500 5,000 units = $1.10 per unit Conversion $38,000 3,800 units = per unit Total unit cost (FIFO) $

16 Step 5: Use unit costs computed in Step 4 to allocate costs between units completed and transferred out and units in ending inventory. Units Transferred Out: 1. From Beginning Inventory Beginning Costs $8,000 Costs to Complete Beginning Inventory Materials added during period -0- Conversion added to complete during period (1,000 units 40%* added $10.00) 4, Started and Completed (3,000 $11.10) 33,300 Total Costs Transferred Out (4,000 units) $45,300 Ending WIP Materials (2,000 $1.10) $2,200 Conversion (2,000 20% $10.00) 4,000 Total Costs of 2,000 units in WIP 6,200 Total Costs Accounted For $51,500 * Beginning inventory was 60% complete as of the beginning of the month and all materials had been added in the previous period at the beginning of the process. Therefore, 40% conversion costs were added during the period and no additional materials costs were incurred for these units. 19 Spoilage consists of units that are lost, broken or otherwise defective and cannot be sold with regular good units. a. Normal spoilage: A certain amount of spoilage is expected as part of the manufacturing process. The amount expected spoilage is often expressed as a percent relative to the good units produced. It is considered to be a cost of producing the good units and is classified as a product cost. b. Abnormal spoilage: This is spoilage in excess of the expected level. It is treated as a period cost. Cost relating to abnormal spoilage units is transferred out of the WIP account into a loss account. c. Treatment in EFU calculation: Abnormal spoilage units are generally always included in the computation of equivalent units, because their cost must be calculated and recorded as a separate loss. However, the inclusion of normal spoiled units depends on whether a company wishes to separately identify and report the extent to which normal spoilage costs impact the cost of good units. There are, therefore, two treatments for normal spoilage: (1) Include the units and add their cost to only the cost of good units passing the inspection point (separate identification of costs), or (2) Exclude the units, thereby increasing the manufacturing cost per equivalent unit, and spreading normal spoilage cost over not only good units completed, but also over abnormal spoilage units and equivalent units in ending inventory (hidden cost method). 15

17 Application: Which of the following choices shows the proper treatment of sales commissions and abnormal spoilage charges when calculating a manufactured good's inventoriable cost? Include both sales commissions and abnormal spoilage Include sales commissions and exclude abnormal spoilage Exclude sales commissions and include abnormal spoilage Exclude both sales commissions and abnormal spoilage D - Abnormal spoilage is spoilage in excess of the expected level. It is a period cost (a loss recognized in the income statement of the period incurred) rather than being included in the inventory asset account. Sales commissions are a selling cost, not a manufacturing cost. Selling costs are expensed in the period incurred, not included in the inventory asset account. 20 Separately reported normal spoilage costs: Spoiled units are identified at an inspection point. The inspection point usually occurs upon completion of departmental processing. Therefore, normal spoilage costs should be identified and added to the costs of good units completed. No normal spoilage costs should be attached to the incomplete units in ending inventory. To accomplish this, all spoilage units are included in the equivalent unit computation to arrive at a manufacturing cost per equivalent unit. The cost of normal spoilage is added to the cost of good units produced. The cost of abnormal spoilage is removed from work in process and is charged as an expense of the period. 21 Example of separately reported normal spoilage costs: For cost control purposes, Hamilton Company requires separate identification of all spoilage costs. Normal spoilage costs are added to the cost of good units produced up to the point of inspection. The cost of abnormal spoilage is written off as a period loss. Inspection occurs upon completion of departmental processing, before units are transferred to the next department. The extracting department processed 14,000 units during the month of January. Of these, 10,000 were completed and 4,000 units remained 60% converted in the ending inventory on January 31. Of the 10,000 units completed, 1,000 were spoiled. Spoilage of 10% of good units is considered normal. No materials are added in the department. Conversion costs to account for are $59,520. The weighted-average method is used for EFU computation. Identify (1) the loss due to abnormal spoilage, and (2) the cost of good units transferred out, including that portion of cost attributable to normal spoilage. 1. Identify normal and abnormal spoilage. Total units completed 10,000 Less total spoilage <1,000> Good units completed 9,000 16

18 2. Compute the equivalent units of production using the weighted-average method (only conversion element involved). Good units completed 9,000 Abnormal spoilage units 100 Normal spoilage units 900 Ending inventory (4,000 60% converted) 2,400 Equivalent finished units 12, Compute unit conversion cost. $59,520 / 12,400 equivalent units = $4.80 per equivalent unit 4. Assign costs to abnormal spoilage and inventories. Abnormal spoilage, 100 units at $4.80 (to loss account) $480 Good units transferred out: Good units, 9,000 at $4.80 $43,200 Normal spoilage units, 900 at $4.80 4,320 Total cost of good units transferred out 47,520 Ending inventory, 2,400 equivalent units at $ ,520 Total product costs 59,040 Total costs accounted for $59,520 Note: (1) The normal spoilage costs are separately identified so that (2) the impact of those costs is seen on the unit cost of good units transferred out ($47,520 total costs 9,000 good units transferred = $5.28, as opposed to $4.80/unit overall manufacturing cost), and (3) no normal spoilage cost is included in ending inventory. Any spoilage in those 4,000 units will be identified upon their completion and allocated to those units at that time. 17

19 Application: During the current year, the following manufacturing activity took place for a company's products: Beginning work-in-process, 70% complete Units started into production during the year 10,000 units 150,000 units Units completed during the year 140,000 units Ending work-in-process, 25% complete 20,000 units What was the number of equivalent units produced using the first-in, first-out method? 138, , , ,000 A - Equivalent units is the number of units that would have been completed had the same production effort been devoted to starting and finishing a smaller number of units (the number of complete units). On a FIFO (first-in, first-out) method, the equivalent units are calculated as follows: Units completed during the period Plus equivalent units in-process at end of period XX XX Less equivalent units in-process at beginning of period XX --- Total equivalent units for FIFO method XXX Units completed during the year = 140,000 units Equivalent units in-process at end of period = 25% of 20,000 = 5,000 units Equivalent units in-process at end of period = 70% of 10,000 = 7,000 units 140, ,000-7,000 = 138,000 equivalent units 22 Hidden normal spoilage costs: (Use this method when no information is given about spoilage inspection point or when not told to attach cost to only good units produced.) Some companies choose not to separately identify normal spoilage costs. This is appropriate when such costs are relatively small. In this procedure, abnormal spoilage is included in the equivalent unit computation, but normal spoilage is excluded. Thus, the per-unit manufacturing cost is proportionately higher. The normal spoilage cost is absorbed into the cost of all remaining equivalent units (including abnormal spoilage and ending inventory). 18

20 23 Example of hidden normal spoilage costs: Assume the same facts for Hamilton Company as described in section 21, but that normal spoilage costs are not separately identified. 1. Computation of spoilage units would be the same as with separately reported normal spoilage costs. Total units completed 10,000 Less total spoilage 1,000 Good units completed 9,000 Total spoilage 1,000 Less normal spoilage (9,000 good 10%) 900 Abnormal spoilage Compute equivalent units. Good units completed 9,000 Abnormal spoilage units 100 Ending inventory (4,000 60%) 2,400 Equivalent finished units 11, Compute unit conversion cost. $59,520 / 11,500 equivalent units = $5.18 (rounded) 4. Assign costs to abnormal spoilage and inventories. Abnormal spoilage, 100 units at $5.18 (to loss account) $518 Good units transferred out, 9,000 at $ ,620 Ending inventory, 2,400 equivalent units at $ ,432 Total product costs 59,052 Total costs accounted for ($50 difference due to rounding) $59,520 Note: (1) The normal spoilage costs are not separately identified; rather, (2) they are hidden in the unit manufacturing cost of $5.18, and (3) both the abnormal spoilage units and ending inventory include some normal spoilage costs. For this reason, some authorities believe this method is not theoretically correct and do not advocate its use. 24 Spoilage in job costing: The net cost (cost less any disposal value) related to normal spoilage that is not attributable to a particular job is charged to factory overhead. It is thus allocated to all jobs worked on through the normal overhead application procedure. The net cost of spoilage attributable to the characteristics of a particular job or job lot is charged to that particular job. The cost of abnormal spoilage not attributable to a particular job is treated as a period cost and charged to a special loss account. 25 Scrap: Normally, no cost is assigned to scrap. Its disposal value is most commonly credited to factory overhead. Where feasible, it may be used to reduce the cost of a particular job or type of job. 26 Rework costs: Costs of reworking defective units are generally charged to factory overhead and are spread among all units produced through the overhead application process. Special circumstances may cause such costs to be charged to a particular job. 19

21 27 Costing methods: Inputs into the production process can be accounted for by three different costing methods: actual, normal, and standard costing. Input Actual Costing Normal Costing Standard Costing Direct Materials Actual Actual Standard Input at Budgeted Rate Direct Labor Actual Actual Standard Input at Budgeted Rate Factory Overhead Actual Actual Input at Budgeted Rate Standard Input at Budgeted Rate 28 Actual costing: The inputs to production are valued at their actual cost, the actual number of dollars paid for direct materials, direct labor, and overhead. All factory overhead costs incurred (debit to Factory Overhead Control) would be applied to Work-in-Process (credit Factory Overhead Control). The problem is that the total actual costs of overhead are not known until the end of the period. It may not be practical to wait until the end of the year to cost products, particularly if cost is a factor in setting prices. If monthly overhead costs are used, unit costs could vary widely. 29 Normal costing: The inputs of direct materials and direct labor are valued at their actual cost, but overhead is applied on a budgeted or normalized basis. Estimated overhead costs are divided by estimated production for the year to determine an application rate. If overhead is applied on a direct labor hour basis, then the overhead rate would be applied to actual direct labor hours. 20

22 Application: Merry Co. has two major categories of factory overhead: material handling and quality control. The costs expected for these categories for the coming year are as follows: Material handling $120,000 Quality inspection 200,000 The plant currently applies overhead based on direct labor hours. The estimated direct labor hours are 80,000 per year. The plant manager is asked to submit a bid and assembles the following data on a proposed job: Direct materials $4,000 Direct labor (2,000 hours) 6,000 What amount is the estimated product cost on the proposed job? $8,000 $10,000 $14,000 $18,000 D - The first step in this problem is to calculate the two factory overhead rates: 1. Material handling 2. Quality control This is accomplished by dividing the expected annual costs by the estimated direct labor hours (DLH) for the coming year. Material handling overhead rate = $120,000 80,000 DLH hours = $1.50 per DLH Quality control overhead rate = $200,000 80,000 DLH hours = $2.50 per DLH The estimated cost of the proposed job can then be determined assuming that 2,000 hours of direct labor will be needed to complete the job. Direct materials $ 4,000 Direct labor 6,000 Applied material handling (2,000 hours x $1.50 per DLH) 3,000 Applied quality inspection (2,000 hours x $2.50 per DLH) 5,000 Estimated product cost for proposed job $18, Standard costing: In a standard costing system, standard costs are developed for all inputs per unit of production. For example, if overhead is applied on direct labor hours, it would be applied according to the number of hours that should have been used to make that unit, not the actual number of direct labor hours used. Standard costs are designed to control the two components of the cost of producing something: the price paid and the quantity used. Price and quantity standards are set for materials, labor and overhead. Standard cost is a unit concept. It represents the budget to produce one unit. Standard costs are often used to develop a master budget and flexible budget, and variances from standard costs are then analyzed. a. Ideal standards: These are standards that can be attained only under perfect conditions. There is no allowance for machinery to break down, or to wait for materials, or for other delays that can be expected in a normal world. Ideal standards require at all times a level of effort and skill that would be expected from the very best employees at their peak performance. Ideal standards are generally not used in practice, because they discourage the efforts of ordinary 21

23 employees who know they can t make the standard, so why bother? Variances are often viewed as useless because part of the variance is normal. Expected differences from the standard obscure the actual variances that need to be investigated. However, advocates of TQM (total quality management) and continuous improvement are often in favor of the use of ideal standards because such standards can encourage greater efficiency over time. b. Attainable standards: Practical standards are tight, but attainable. They can be achieved by normal workers working with reasonable, efficient effort, with a reasonable allowance for breakdowns, etc. Variances provide useful information because they represent abnormal conditions that need to be investigated. Attainable standards are also useful in the planning and budget process when calculating the production budget, etc. Applying Overhead 31 Applying overhead: In both normal and standard costing systems, a process must be developed for calculating and applying a budgeted overhead allocation rate. 32 Overhead application/allocation rate: Overhead is allocated to cost objects (e.g., units or jobs) using an application rate (also called an allocation rate), which may be calculated in several different ways: a. Actual overhead application rate: This rate is calculated by dividing the overhead costs by the actual volume of the allocation base. An actual rate is useful when the goal is to measure actual costs; however, actual data may not be available on a timely basis. b. Budgeted (or predetermined) overhead application rate: This rate is calculated by dividing estimated (or budgeted) overhead cost by the estimated (or budgeted) volume of the allocation base. A standard overhead application rate is an example of a predetermined rate. Application: The accountant for Champion Brake, Inc., applies overhead based on machine hours. The budgeted overhead and machine hours for the year are $260,000 and 16,000, respectively. The actual overhead and machine hours incurred were $275,000 and 20,000. The cost of goods sold (COGS) and inventory data compiled for the year is as follows: Direct materials $50,000 COGS 450,000 Work-in-process (WIP) (units) 100,000 Finished goods (units) 150,000 What is the amount of over/underapplied overhead for the year? $15,000 $50,000 $65,000 $67,000 B - The overhead application rate is $16.25 per machine hour (budgeted overhead of $260,000 divided by budgeted machine hours of 16,000). Multiplying that rate by actual hours of 20,000 gives $325,000 for overhead applied. Subtracting that from the $275,000 actual overhead gives a variance of $50,000. The overhead is over-applied since more overhead was applied to work-in-process than the actual overhead. 22

24 33 Example of overhead application/allocation rate: XYZ Company is a highly automated machinery manufacturer. The company estimated its manufacturing overhead expenses as follows. All of these costs are classified as fixed. Depreciation $100,000 Rent 50,000 Utilities 35,000 Supervision 10,000 $195,000 Expected Material Cost $390,000 Expected Machine Hours (normal capacity) 19, Calculate the overhead application rate using (a) material cost and (b) machine hours as the allocation base. 2. Calculate the overhead charged to Job A if 900 hours of machine time and $20,000 of materials were used, assuming that the allocation base is (a) material cost and (b) machine hours. Solutions: 1. Calculation of application rate: a. Overhead application rate based on material cost (overhead cost divided by material cost): $195,000 = $0.50 per dollar of material cost (or 50% of material cost) $390,000 b. Overhead rate based on machine hours (overhead cost divided by machine hours): $195,000 = $10 per machine hour 19,500 hours 2. Allocation of overhead to Job A: a. Assuming that overhead is based on material costs: $20,000 $0.50 = $10,000 b. Assuming that overhead is based on machine hours: 900 hours $10 = $9, Under/over-applied overhead: In a normal costing system, overhead is allocated using a predetermined application rate and actual volume of the allocation base. In a standard costing system, overhead is allocated using a standard overhead rate per unit of output. In these costing systems, there will always be some amount of underapplied or over-applied overhead caused by deviations from budgeted or standard amounts in either the numerator or the denominator of the application rate: 23

25 a. Inaccurate cost budget: Even if actual production is equal to the anticipated levels at which the application rate is set, actual costs are likely to differ from budgeted. This affects the numerator of the ratio, resulting in an inappropriate application rate. b. Inaccurate allocation base budget: If actual volume of the allocation base (labor hours, materials dollars, etc.) is different than the budgeted volume, the denominator in the application rate is incorrect relative to actual activities. This difference can be caused by a difference between budgeted and actual production volumes or deviations from budgeted efficiency. 35 Disposition of under/overapplied overhead: The amount of underapplied or overapplied overhead must be periodically closed. a. Fixed overhead allocated based on normal capacity: In the past, any material over/underapplied overhead was prorated among work in process, finished goods, and cost of goods sold. Now, however, FASB ASC requires fixed factory overhead to be allocated to inventory using normal capacity, or the typical volume of production. The new accounting standard prevents the overstatement of inventory values when production volumes fall below normal. Assuming that normal capacity is used to establish the predetermined overhead rate, any over/underapplied overhead caused by differences between actual and normal capacity should be recorded in cost of goods sold. The new accounting standard is likely to increase the number of companies that account for fixed and variable overhead separately. In addition, more companies are likely to use normal capacity as the budgeted volume when establishing predetermined overhead rates. b. Adjustment for fixed overhead: In general, over/underapplied fixed overhead should be assigned to cost of goods sold. However, any material amounts of over/underapplied fixed overhead caused by an inaccurate cost budget should be prorated among ending units in work in process, finished goods, and cost of goods sold. c. Adjustment for variable overhead: By definition, variable overhead is expected to vary with the volume of production. This means that over/underapplied variable overhead is caused by error in the budgeting process. Accordingly, any material amounts of over/underapplied variable overhead should be prorated among ending units in work in process, finished goods, and cost of goods sold. If the over/underapplied amount is not material, it may be adjusted to cost of goods sold alone. 36 Example of disposition of under/overapplied overhead: Continue with the information from section 33. Assume that XYZ Company incurred $180,000 of manufacturing expenses and that actual machine hours were 17,000. Before any adjustment is made, the amounts of fixed overhead applied units in work-in-process, finished goods, and cost of goods sold are $17,000, $34,000, and $119,000, respectively. 1. Calculate the actual fixed overhead rate based on (a) actual machine hours and (b) normal capacity. 2. Calculate the amount of over/underapplied fixed overhead, then calculate the amount attributable to (a) inaccurate cost budget and (b) difference between actual and normal capacity. 3. What adjustments should be made if the fixed overhead spending variance is considered immaterial? 4. What adjustments should be made if the fixed overhead spending variance is considered material? 24

26 Solutions: 1a. Actual fixed overhead rate based on actual machine hours: $180,000 = $10.59 per machine hour 17,000 1b. Actual fixed overhead rate based on normal capacity: $180,000 = $ per machine hour 19,500 Note: The rate of $ should be used to assign fixed overhead to inventory. 2. Over/underapplied fixed overhead: Actual fixed overhead $180,000 Fixed overhead applied (17,000 hours $10 per hour) <170,000> $10,000 a. Amount attributable to inaccurate cost budget: Actual volume (Predetermined rate Actual rate based on normal capacity) = 17,000 hours ($ $9.2308) = $13,077 Overapplied b. Amount attributable to difference between actual and normal capacity: Actual rate based on normal capacity (Normal capacity Actual volume) = $ (19,500 17,000) = $23,077 Underapplied Math check: $13,077 + $(23,077) = $(10,000) Underapplied overhead 25

27 3. If the $13,077 amount is considered material, then it should be prorated among WIP, finished goods, and COGS. However, the $23,077 amount should be assigned only to COGS. Overhead in WIP account ending balance $17,000 10% of total Overhead in Finished Goods ending balance 34,000 20% of total Overhead in Cost of Goods Sold 119,000 70% of total Total Actual Fixed Overhead $170, % Adjustment: Dr. (Cr.) Allocation of over/underapplied overhead: WIP Fin. Goods COGS Inaccurate cost budget: $13,077 overapplied 10% -$1,308 $13,077 overapplied 20% -$2,615 $13,077 overapplied 70% -$9,154 Diff. between actual and normal capacity: $23,077 underapplied 23,077 Total adjustment -$1,308 -$2,615 $13,923 Journal Entry: Cost of goods sold 13,923 Work in process 1,308 Finished goods 2,615 Overhead control 10, If the $13,077 amount is considered immaterial, then it may be netted against the $23,077 amount and assigned directly to COGS: Journal Entry: COGS (23,077 13,077) 10,000 Overhead control 10, Cost allocation is the process of assigning indirect costs (also called overhead, common costs, or joint costs) to cost objects. The focus in financial accounting is primarily on the allocation of factory overhead to inventories and cost of goods sold. However, indirect costs may also be allocated to help management plan and control operations. It is a controversial topic because, by its very nature, allocation is an arbitrary process. 38 Cost allocation terms a. Cost pool: Because indirect costs cannot be traced to the cost object, it is efficient to accumulate indirect costs in one or more cost pools. The dollars in the cost pool are then allocated to cost objects. b. Allocation base versus cost driver: The allocation base is an activity measure used to allocate cost pool dollars to cost objects. Any logical allocation base may be used; however, the allocation base should ideally have a cause-and- 26