Auerbach Enterprises
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Learning Objectives
After studying Chapter 3, you will be able to:
Differentiate among job and process cost systems.
Understand the basic characteristics of modi�ied and hybrid cost systems.
Recognize the fundamental aspects of a job cost system.
Describe the cost elements and cost �lows in a process cost system.
Compute the equivalent units of production and unit costs using FIFO.
Prepare and use cost of production reports.
Explain the impact that JIT inventory systems have on process cost accounting.
3 Process Costing
djedzure/iStock/Thinkstock
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Compute the equivalent units of production and unit costs using the weighted average method.
Where There’s a Will, There’s a Way of Costing
When Stan Stein, an attorney, founded U Will It, he envisioned an enterprise involving the mass production of routine wills with standard wording and little variation. Because he kept his fees low and had clever advertising, his �irst two years were very successful. Stein was preparing wills for clients throughout Ohio.
Periodically, Stein was approached by clients who wished to have more specialized and complex wills prepared. Stein was reluctant to accept these jobs because his practice was near full capacity. Moreover, because these specialized wills required considerable research, client conferences, and other demands made by the clients, Stein did not feel his current practice was amenable to the preparation of specialized wills. Therefore, he would routinely turn down these requests.
One day, Stein decided to invest his growing pro�its into a new venture that would be oriented to preparing specialized wills. One of Stein’s many concerns was how he would determine the costs of these customized jobs. He knew that the process costing system used for his current �irm would not be suitable for his new venture.
This chapter discusses how to determine the costs of products produced in a process cost environment as well as products produced in a job cost environment. Although we focus on manufactured products, the concepts presented are applicable in service organizations, as was just indicated in the above vignette.
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3.1 Overview of Job and Process Costing A job cost system identi�ies costs with individual jobs or products. A separate tracking of costs is associated with each job or product. The costs accumulated for a job in process can be determined at any point in time by referring to the job order cost sheet.
A process cost system identi�ies costs with individual departments for an interval of time, such as one month. Costs are not charged to speci�ic units or orders as work is performed, but unit costs are based on costs incurred during a time period and on the volume of output during the same period. The unit cost of a �inal product will be the sum of all costs allocated to the product by each department that worked on it.
Several other characteristics distinguish job costing from process costing, as discussed below. Figure 3.1 at the end of this section summarizes these differences.
Figure 3.1: Comparison of job costing and process costing
Environment
Job costing is most appropriate in environments where jobs or products are different from one another. These jobs use different types or amounts of materials, labor, and overhead. Examples include building construction, defense contracting, consulting engagements, and printing shops.
Process costing is most appropriate in an environment where products are mass produced or result from continuous processing. Each unit going through the same process is identical to other units. Examples include candy, soft drinks, clothing, chemicals, and most processed foods. In addition, individual operations can be suitable for process costing if every product passing through the operation has the same work performed on it. For instance, various models of televisions and DVD players on an assembly line may have the same operations performed during the assembly process.
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In a job cost environment, sales orders usually precede production. Production is for a speci�ic order. In a process cost environment, however, production usually precedes sales. Goods are produced for anticipated sales.
Materials, Labor, and Overhead Costs
A process cost environment will generally use materials that are standard. In a job cost setting, materials requirements are often unique to each job, and sometimes even the types of materials needed are unknown. Hence, process cost companies usually have larger inventories of materials.
Tasks in a process cost environment are generally routine. Less-skilled labor is usually needed than in a job cost environment, where workers need to perform a greater variety of tasks because of the different types of jobs. Automation is found more often in process cost settings. Therefore, the proportion of overhead cost in the total product cost will generally be higher than for job cost settings.
Focal Point for Cost Accumulation
In process cost systems, we identify materials, labor, and overhead costs with speci�ic departments or operating centers. This differs from job cost systems, which identify costs with speci�ic batches or customer orders. In this chapter, the term department will be used as a generic term and will cover the traditional concepts of department, operating or work center, operation, task, activity center, and responsibility center. As a result of charging costs to departments, few detailed records are needed with process costing.
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3.2 Modi�ied and Hybrid Systems Classifying an accounting system as a job cost or process cost system is often not easy. This is especially true when companies have a wide variety of products and processes. Modi�ications and adaptations are made to the accounting system to meet the needs of speci�ic situations. These result in systems we categorize as modi�ied cost systems and hybrid cost systems.
A modi�ied cost system has one or more elements of cost using job costing, while the other cost elements use process costing. For example, a manufacturer of shoes will make different sizes and styles and use different grades of leather. However, the operations of cutting and sewing the leather and attaching the heels and soles are essentially the same for each shoe. Consequently, the manufacturer can group the shoes by sizes, styles, and grades of leather, and treat the costing of materials using job costing. Then, the labor and factory overhead costs for the operations can use a process cost system.
A hybrid cost system exists where one type of cost system (job costing or process costing) is used for one phase of the production process, and another system is used for a subsequent phase. For example, in manufacturing cars, the various parts, subassemblies, engines, transmissions, and so forth may be produced where a job cost system is used. In assembly, every car, regardless of model, has the same assembly operations performed. Therefore, the labor and factory overhead costs of the assembly operations may be accounted for using a process cost system. Hybrid cost systems can involve various sequences of job and process costing, depending on the particular production process.
Operation costing is a term often used to refer to modi�ied or hybrid cost systems. Except in the simplest of cases, pure job costing or process costing does not exist. There is usually some modi�ication. Managers need to understand their own organization’s cost system in order to evaluate the cost information generated by that system. The remainder of this chapter provides detailed discussions of job cost and process cost systems.
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3.3 The Job Cost System The job cost system accumulates separately the costs of materials, labor, and overhead for each job, whether a job of one unit or a job of many units. Every job is assigned a number, which is used for accumulating the costs of that job. Daily, weekly, or monthly cost summaries for each job are generated. These summaries are referred to as job, work, or production orders. The �ile of production orders in process constitutes a subsidiary ledger in support of the work in process account in the general ledger.
Whereas a job cost system accumulates costs by jobs, a process cost system accumulates costs by departments. This, and other differences, changes the approach to determining unit costs in a process cost environment. However, as outlined in the remaining sections of this chapter, many of the product cost concepts of Chapter 2 apply as well to process costing.
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3.4 The Cost Elements in a Process Cost System The cost elements in a process cost system depend on whether the organization is a manufacturing or service organization. A manufacturer typically has more detailed costs; therefore, we focus on manufacturing �irms in the following sections. We will discuss the two major elements of manufacturing costs in a process cost system: materials and conversion costs.
Materials
Materials are requisitioned for use in a speci�ic department, and the materials costs are accumulated by the department for a speci�ic time period. Although materials can be added in any department, they are often issued from the storeroom to the �irst operating department in the process. The concept of accounting for materials costs does not depend on whether materials are added in the �irst department or in subsequent departments. Distinguishing between direct materials and indirect materials is not considered critical to obtain accurate unit costs.
Two major differences in accumulating materials costs between the job cost system and the process cost system should be noted. Materials costs are identi�ied �irst with departments and then assigned to individual units in a process cost system. Materials costs bypass departments and are charged directly to speci�ic jobs in a job cost system. In process costing, materials costs are accumulated for a period of time and averaged over all units receiving materials during the period. This averaging of costs is broader in a process cost system than in a job cost system, where costs would be averaged only over the batch of units comprising a particular job.
Conversion Costs
Labor and overhead costs are incurred to convert materials into a �inished product; hence, labor and overhead costs are called conversion costs. Because labor and overhead often enter the process at the same time, we combine them for illustrations throughout the chapter. This assumes that overhead is applied to production using direct labor hours or dollars. Where another cost driver is used, we separate the two cost elements.
Labor cost is measured monthly, by department, and without identifying speci�ic orders. Labor time tickets may be used for payroll accounting, but are not needed to measure the time to complete a single order because each unit of product in a process cost setting is presumed to take the same amount of time. Like materials, little emphasis is placed on distinguishing precisely between direct labor and indirect labor.
Overhead costs are accumulated by department. Typically, we record them in a departmental overhead control ledger by type of cost (e.g., depreciation, utilities). Overhead costs are charged to production through predetermined overhead rates for each department. In most of our illustrations, overhead appears to be actual overhead. However, the costs represent charges based on predetermined overhead rates under a normal cost system. Since normal costing was discussed in Chapter 2, we will not repeat the coverage here. We assume that overhead is accumulated and applied using departmental rates.
Cost Flows
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In a process system, a product may �low through several operations before completion. For example, production of cellular phones may start in a fabricating operation, as shown in Figure 3.2.
Both the physical units and costs will be identi�ied for the fabricating operation over a period of time, such as a month. When the inner components of the phones are completed in the fabricating operation, the units with their costs are transferred by automated guided vehicles to the next operation—in this case, the molding operation where the casings are formed. Additional costs will be incurred and accounted for in the molding operation. At the completion of the molding operation, the units and accumulated costs of preceding operations will be transferred to the last operation in this example, the �inishing operation.
Figure 3.2: Flow of units and costs in a process manufacturing system
Because costs need to be identi�ied with departments, a process cost system normally involves accounting transfers between departmental work in process inventory accounts. Each department has its own work in process account; when goods are completed in one department, their costs are transferred to the work in process account of the next department.
In some types of operations, a subassembly may be produced on a separate production line for addition to the product at a later stage. For example, assume that the main production line for computer keyboards extends from Department A (Fabricating) to Department C (Finishing). A subassembly line, consisting of Departments W (Forming) and X (Soldering), uses numerically controlled machines to produce a component that converts physical measures like velocity and pressure into digital form. These
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components are brought into the main line in Department C. A diagram showing the �low of units and costs for this example appears in Figure 3.3.
Figure 3.3: Flow of units and costs for subassembly components
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3.5 The Equivalent Unit Concept A primary goal of any cost accounting system is to identify product costs for determining ending inventories of work in process and �inished goods and for establishing the cost of goods sold amount. Costs are attached to units in inventories whether the units are wholly or partially completed. The mechanism for tracing costs to units is a unit cost.
Unit Costs
When calculating unit costs, we typically think of a formula similar to the following:
Applying this formula to the typical process cost situation is complicated by two major factors: (1) the stage of completion of units in work in process inventories, and (2) the different points in time that materials and conversion costs enter a departmental process. We will discuss point (2) in more detail later in the chapter.
The number of units completed is not a good measure for determining an appropriate unit cost when there are partially completed units in beginning or ending inventories. Consequently, an equivalent unit must be identi�ied. Equivalent units represent the theoretical number of units that could have been produced had the resources been applied to units that were started and completed during the period. We can also think of equivalent units as representing the actual work done on the physical units. For instance, two physical units 50% complete represent the equivalent of one unit 100% complete.
Flow of Physical Units
For each department, the �low of physical units can be viewed as follows:
Units in beginning work in process inventory + Units of product started during the period =
Units completed and transferred out + Units in ending work in process inventory
This relationship among physical units is also shown in Figure 3.4. As diagrammed, the number of units started and completed during the period can be computed two ways:
Units completed and transferred out – Units in beginning work in process inventory =
Units started and completed
or
Units of product started during the period – Units in ending work in process inventory =
Units started and completed
Knowing where all units are in a production process is an important starting point for calculating unit costs. Figure 3.4 represents the location and �low of physical units through a production process for a
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given time period.
Figure 3.4: Relationship among physical units within a department
Stage of Completion
In a process cost system, the units in the beginning and ending inventories are usually at different stages of completion. The stage of completion is the average percentage of work completed on a unit of product at any point in time. For a department, it is useful to identify three distinct groupings of products when computing equivalent units:
1. Partially completed units in the beginning inventory that are completed during the current period. The work to complete these units is represented by 100% less the stage of completion when the period started. We generally assume a �irst-in, �irst-out �low, which will be explained in more detail later in this chapter.
2. Units started and completed during the period. The work completed is represented by 100%. 3. Partially completed units at the end of the period. The work completed is represented by the
percentage of completion at the end of the period.
When all three of these groups are summed, the result is equivalent units of output for this time period— the work done by the workers in this department. This is the number of units that could have been produced if all production were started and completed during the period, assuming no beginning or ending work in process inventories.
For example, the Norwich Post Of�ice has a sorting department. On March 1, 15,000 units were in process and were 60% completed. During March, the department started work on 200,000 units. On March 31, 20,000 units were in process and were 30% completed. From our �low of physical units formula, we calculate the number of units completed as follows:
Units in beginning inventory 15,000
+ Units started during period 200,000
− Units in ending inventory (20,000)
Units completed and transferred 195,000
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Next, we compute the units started and completed using both methods described previously:
Units completed and transferred 195,000
− Units in beginning inventory (15,000)
Units started and completed 180,000
or
Units started during period 200,000
– Units in ending inventory (20,000)
Units started and completed 180,000
We now have the three groups of units and their stages of completion, which are necessary to �ind the number of equivalent units. The calculation for the equivalent units of output for the period is as follows:
Current period work to complete beginning inventory [15,000 × (100% − 60%)] 6,000
+ Units started and completed (180,000 units × 100%) 180,000
+ Current period work in ending inventory (20,000 units × 30%) 6,000
Equivalent units of output (work done during the period) 192,000
Timing of Inputs
Materials, labor, and overhead are the inputs to the production process. These inputs may enter at different points during the process. The most common situation is for materials to enter at the beginning of a departmental process and for labor and overhead to be added continuously throughout the process. Consequently, it is possible for some units in process to have all of their materials added but only part of the labor and overhead. In other processes, the materials may be added continuously or at the end of the process. For our purposes, unless otherwise stated, presume that materials are added at the beginning of the process, and labor and overhead enter the process together and are added continuously or evenly throughout the process.
To calculate unit costs when inputs have different timing for entering a process, we need to calculate the equivalent units for each cost input. Therefore, one equivalent unit computation is for materials; another computation is for conversion costs. The computational steps developed in the next section will show how separate equivalent units quantities are used to establish unit costs.
Computational Steps
Tracing physical units to a department and accounting for those units are generally clerical functions. Likewise, the identi�ication of the costs charged to a department is a relatively simple function. However, distributing the costs to work completed and ending inventories requires an understanding of several steps. These steps are:
1. Determine �low of physical units. 2. Calculate equivalent units.
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3. Compute unit costs. 4. Distribute total costs to units. 5. Reconcile the costs.
The last step checks whether the four previous steps were completed accurately. This step veri�ies that the total costs distributed to the units equal the total costs charged to the department. Each of these steps will be presented in detail as part of developing a cost of production report.
We assume a �irst-in, �irst-out (FIFO) cost method in progressing through the �ive computational steps. The beginning inventory is completed before new units are completed. Costs incurred �low in the same manner. Most companies using process costing use the FIFO cost method. Another frequently used method, the weighted average cost method, is discussed later in this chapter.
Under FIFO, the older units and costs are transferred out �irst, and the more current units and costs are transferred out next. Only the most recent costs are held as ending inventory. With the FIFO cost method, the equivalent units of output are literally the units that could have been completed if all efforts during the period were devoted to starting and completing units, allowing no partially completed units. Usually, however, some units will be in a stage of partial completion at both the beginning and at the end of the month. The beginning work in process units are completed during the month, and a start has been made on the units in ending work in process.
To illustrate the computational steps, consider the current plant of Shirts Unlimited. Sweatshirts are produced in three departments: Cutting, Sewing, and Finishing. Our illustration will focus on the Cutting Department. All cloth material enters production at the beginning of the Cutting Department operations. The cloth is cut there. Both materials and conversion costs are incurred in the Cutting Department. Its activity for May is summarized as follows:
Work in process, May 1:
Units 4,000
Stage of completion:
Materials 100%
Conversion costs 40%
Costs:
Materials $400,000
Conversion costs 80,000
Beginning inventory total cost $480,000
Units started 12,000
Units completed and transferred 14,000
Current period costs:
Materials $1,200,000
Conversion costs 650,000
Total costs added $1,850,000
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Work in process, May 31:
Units 2,000
Stage of completion:
Materials 100%
Conversion costs 30%
Step 1: Determine Flow of Physical Units. Determining the �low of physical units for a department involves identifying the units in the beginning inventory, the units started and completed during the period, and the units in the ending inventory. These are whole units; stage of completion is not an issue here. For the Cutting Department of Shirts Unlimited, we have:
Units in beginning work in process 4,000
Units started and completed: (12,000 – 2,000 or 14,000 – 4,000) 10,000
Units in ending work in process 2,000
Total units 16,000
Step 2: Calculate Equivalent Units. Equivalent units are computed by multiplying physical units by the percentage of work completed on them. For our example, using the units started and completed method, we have the following calculations:
Materials Conversion
Current period work to complete beginning inventory:
4,000 × (100% − 100%) 0
4,000 × (100% − 40%) 2,400
Units started and completed in May:
10,000 × 100% 10,000 10,000
May’s work in ending inventory:
2,000 × 100% 2,000
2,000 × 30% 600
Equivalent units (work done during May) 12,000 13,000
Note that in deriving the 2,400 equivalent units to complete the beginning inventory for conversion costs, we multiply the 4,000 physical units by 60% (100% – 40%) because the units were already 40% complete and another 60% of work is needed in the current period to complete those units.
Step 3: Compute Unit Costs. We begin this step by itemizing the costs for which the Cutting Department will be held accountable.
Materials Conversion Total
Beginning inventory $400,000 $80,000 $480,000
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Materials Conversion Total
May’s costs 1,200,000 650,000 1,850,000
Total costs $1,600,000 $730,000 $2,330,000
The unit costs for materials and conversion costs are calculated from the current month’s costs and equivalent units. Last month’s costs and equivalent units of work are included in the beginning inventory amount and will be treated separately. Using May’s costs and the equivalent units from above, the costs for May are divided by the equivalent units for May to obtain unit costs:
Unit Costs for May:
Unit cost for materials = $1,200,000 / 12,000 = $100
Unit cost for conversion = $650,000 / 13,000 = $50
The beginning work in process cost provides useful information for managers. These dollars represent costs from the prior period—in this case, the previous month. Thus, unit cost information about the beginning inventory is obtained by dividing the beginning inventory costs by the prior period work (i.e., equivalent units) in the beginning inventory:
April’s Unit Costs in May’s Beginning Inventory:
Unit cost for materials = $400,000 / 4,000 = $100
Unit cost for conversion = $80,000 / 1,600 = $50
These unit costs are identical to those for the current period, although such a case will not occur very often.
Step 4: Distribute Total Costs to Units. We next show the distribution of costs to units using the unit costs and equivalent units derived earlier.
Costs Accounted for: Materials Conversion Total
Completed and transferred to Sewing:
Work in Process, May 1:
Prior period costs $400,000 $80,000 $480,000
May:
Equivalent units 0 2,400
Times costs per unit $100 $50
Costs $0 $120,000 $120,000
Completed cost of beginning inventory $400,000 $200,000 $600,000
Started and Completed:
Units 10,000 10,000
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Costs Accounted for: Materials Conversion Total
Times cost per unit $100 $50
Costs $1,000,000 $500,000 $1,500,000
Total cost of completed and transferred units $1,400,000 $700,000 $2,100,000
Work in Process, May 31:
Equivalent units 2,000 600
Times cost per unit $100 $50
Costs $200,000 $30,000 $230,000
Total costs accounted for $1,600,000 $730,000 $2,330,000
Note the sequence of computations. First, the old costs in the beginning work in process are listed. Then, we compute the cost to complete the beginning work in process in the current period. Next, we calculate the costs associated with units started and completed. The sum of all of these costs is the cost of goods completed and transferred out. This is also called the cost of goods manufactured. Finally, we determine the costs of the work done on the units still in process on May 31.
Often the unit cost calculations result in the need to round to some decimal place. The more decimal places used, the less the rounding error in total dollars assigned to units completed and units in ending inventory. If rounding errors occur, it is customary to adjust the costs assigned to units completed to compensate for the rounding error.
Step 5: Reconcile the Costs. This �inal step in the computational process is really a check to ensure that all department costs are charged to units completed and units in the ending inventory. As shown in Step 3, the total costs charged to the Cutting Department are $2,330,000. After distributing the costs to the units completed and units in the ending inventory, the sum should also equal $2,330,000. This is con�irmed by the total costs accounted for in Step 4. This check shows that materials and conversion costs charged to the department have indeed been distributed to all units.
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3.6 Cost of Production Report The �ive computational steps provide all of the calculations needed to prepare a cost of production report for May. This report, which presents information about units, costs charged to the department, and how the costs are accounted for, is shown in Figure 3.5.
Figure 3.5: Cost of production report for Cutting Department (FIFO method)
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In T-account form, the transactions re�lected in the cost of production report would be summarized as shown in Figure 3.6.
Figure 3.6: Flow of cost from Cutting Department to Sewing Department
We use the same procedures to determine costs for subsequent departments in the processing operation. In departments after the �irst, however, unit costs must be combined with the accumulated costs of work done in earlier departments. For example, if operations cover 10 departments, Department 10 would obtain a unit cost for the total work done in all preceding nine departments and calculate a unit cost for its own work.
Management’s Use of Cost of Production Reports
Internal accounting reports often serve only to attach dollars to the events about which managers already know. For example, managers know about volumes, inef�iciencies, and scrap, but they do not know the costs related to them. However, the information provided by a cost of production report can be used by managers in several different ways.
When unit costs for materials and conversion costs change from one period to the next, a manager should ask why. Why is a materials price higher or lower? What causes conversion costs to change? The manager has to �ind the answers to ensure that the numbers reported represent reality and are accurate. Sometimes managers intuitively know the numbers are either correct or incorrect because of their experiences.
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Cost of production reports for several periods in succession can show trends. Here certain questions arise. Are inventories bouncing around, or are they stable? Why? Why are unit costs steadily moving up, or why are they erratic? Are we changing the mix of workers as re�lected in labor cost changes? These and many other questions help managers understand their working environment and the company’s focus much better.
Ethical Considerations
As with all �inancial reports, production reports can easily be manipulated. Estimating the stage of completion of the work in process is an area particularly susceptible to manipulation by production managers. These estimates are very subjective. Two reasons explain why managers might be motivated to overestimate the stage of completion. First is pressure to meet production quotas of units or equivalent units produced. A second reason relates to minimizing unit costs. A higher estimate for the degree of completion of the work in process inventory results in a greater number of equivalent units of output for the period. This, in turn, generates a lower cost per equivalent unit. Notice, however, that any overestimate in one period results in an opposite impact in the following period. Management accountants, nevertheless, need to be aware that temptations to overestimate the stage of completion may exist.
Contemporary Practice 3.1: Process Costing at a Consumer Packaged Goods Company
A journal article describes process costing at a consumer packaged goods company as follows: “Production volume that’s in process at the end of the reporting period is estimated based on the standard cost per unit multiplied by a percentage-complete standard. A study is conducted periodically that analyzes the level of work-in-process over time. Results indicate that work-in- process tends to be, on average, 75% complete. The company uses this percentage (75%) of the inputs placed into production for the period as the volume standard to apply to work-in-process inventory for reporting purposes.”
Source: Dosch, J., & Wilson, J. (2010, August). Process costing and management accounting in today’s business environment. Strategic Finance, 37–43.
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3.7 Simpli�ications of JIT and Automation For companies adopting a just-in-time (JIT) philosophy, the expectation is to reduce or eliminate inventories. If a company implements JIT throughout its operations, the �inal departments in the process �inish the products just in time to be shipped; parts, components, and subassemblies are manufactured just in time to meet the �inal department’s needs; and so on, back through the process. Even in the beginning, materials are received just in time to enter the appropriate department.
JIT can signi�icantly simplify accounting for a process cost system. Partially completed units within each department will be kept as low as possible. Thus, little difference exists between units completed and work done during the period. Consequently, the costs incurred during the period are largely tied to goods completed. As a result, unit costs are more accurate in a JIT environment because they are less in�luenced by stage of completion estimates. This is true of automated factories as a whole, since they tend to have fairly uniform amounts of beginning and ending work in process inventories. Thus, work done during the period will be approximately equal to the number of units completed during the period.
In addition, little need exists to transfer costs from one department to the next. The costs of the period can be recorded directly to the cost of goods sold account. Process costs per unit can still be computed, but on a daily or weekly basis. The unit costs will be calculated using units produced, rather than equivalent units. Further aspects of JIT product costing are discussed in Chapter 4.
In JIT factories, certain departments remain idle until their outputs are needed by the next department. This may cause a particular department to appear inef�icient in one period and very ef�icient in another. Therefore, evaluations of managers and costs in JIT plants need to consider the �low of production and who controls decisions of what and when to produce.
Many managers believe that a system truly operating under JIT will have no inventories and, therefore, no need for a process cost system. Because the process �low time is not zero, some items are always in production in a partially completed stage. Process costing becomes greatly simpli�ied in such a setting, but it is not eliminated.
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3.8 Weighted Average Cost Method An alternative to the �irst-in, �irst-out cost method for calculating equivalent units is the weighted average cost method. This method averages the beginning work in process inventory (last period’s costs) and the current production (this period’s costs). The method assumes that the started and completed units for the period are the units completed and transferred out (regardless of when the units were started). In computing unit costs, equivalent units are calculated as the sum of (1) the units completed during the period, and (2) the ending work in process inventory multiplied by its stage of completion. Whereas the equivalent units for the FIFO unit cost represent only work done during the current period, equivalent units for the weighted average method represent all units completed during this period (including work already done in the beginning work in process) plus any work done on ending work in process units.
The weighted average cost method is easier and simpler than FIFO because it does not require tracking the costs in the beginning inventory separately from those costs added during the current period. It is justi�ied on the basis of convenience and simplicity. One can argue that a process which produces identical or similar units should generate the same unit costs from one month to the next. In addition, if beginning and ending inventories do not differ signi�icantly from period to period, the costs per unit are relatively stable. However, the weighted average method commingles costs and production efforts of two time periods. The resulting product costs do not match production management’s measures of inputs and outputs. Thus, many managers view the extra effort for FIFO as worthwhile.
Weighted Average Computational Steps
We apply the same computational steps to the weighted average cost method that we used for the FIFO cost method. A slight difference occurs in the “Costs Accounted for” section of the cost of production report. In this section, costs are distributed to units completed and units in the ending inventory. The weighted average cost method will usually have different unit costs from FIFO.
We continue the example of Shirts Unlimited that we explored earlier in the chapter. For the Cutting Department, we prepared the cost of production report using the FIFO cost method. Now, we apply the weighted average cost method to the data.
Step 1: Determine Flow of Physical Units. Determining the �low of physical units for a department is the same as for the FIFO method:
Units in beginning work in process 4,000
Units started and completed: (12,000 – 2,000 or 14,000 – 4,000) 10,000
Units in ending work in process 2,000
Total units 16,000
Step 2: Calculate Equivalent Units. The weighted average method computes unit costs by aggregating costs to date (for the completed units and ending work in process) and dividing these by work done to date. Thus, to obtain the equivalent units of work done to date on the completed units and ending work in process, we need only consider the 14,000 units completed (4,000 + 10,000) and the 2,000 units in ending work in process. For our example, we would have the following calculation:
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Materials ConversionMaterials Conversion
Units completed: 14,000 × 100% 14,000 14,000
Ending inventory:
2,000 × 100% 2,000
2,000 × 30% 600
Equivalent units of work done to date 16,000 14,600
Step 3: Compute Unit Costs. The unit costs for materials and conversion costs are calculated from the total costs and the equivalent units. The costs for which the Cutting Department will be held accountable are:
Costs Charged to Dept. Materials Conversion Total
Beginning inventory $400,000 $80,000 $480,000
Current month 1,200,000 650,000 1,850,000
Total costs $1,600,000 $730,000 $2,330,000
We calculate unit costs by using the equivalent units from above and dividing them into the total costs:
Unit Costs for May:
Unit cost for materials = $1,600,000 / 16,000 = $100
Unit cost for conversion = $730,000 / 14,600 = $50
These unit costs are identical to those calculated using the FIFO cost method because April’s unit costs were the same as those for May. Usually, some difference will occur in the numbers, but generally not a signi�icant one.
Step 4: Distribute Total Costs to Units. The distribution of costs using the unit costs from Step 3 is as follows:
Costs Charged to Dept. Materials Conversion Total
Completed and transferred to Sewing:
Units 14,000 14,000
Multiplied by cost per unit $100 $50
Costs $1,400,000 $700,000 $2,100,000
Work in process, May 31:
Equivalent units 2,000 600
Multiplied by cost per unit $100 $50
Costs $200,000 $30,000 $230,000
Total costs accounted for $1,600,000 $730,000 $2,330,000
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Step 5: Reconcile the Costs. As shown in Step 3, the total costs charged to the Cutting Department are $2,330,000. After distributing the costs to the units completed and units in the ending inventory, the sum of that distribution should equal $2,330,000. This is con�irmed by the total costs accounted for in Step 4.
Cost of Production Report
The �ive computational steps provide all of the calculations needed to prepare a cost of production report for May. The report prepared under the weighted average cost method appears in Figure 3.7.
Figure 3.7: Cost of production report for Cutting Department (weighted average method)
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Summary & Resources
Chapter Summary In a job cost environment, costs are identi�ied with speci�ic batches or customer orders. In a process cost environment, products are continuously manufactured through a series of departments. Physical units and costs are identi�ied with the departments. Unit costs are used in tracing the costs through the various departments and to the �inished goods inventory account.
Because manufacturing situations will vary from one company to another, modi�ications and adaptations to the cost accounting system must be made. Modi�ied and hybrid cost systems are common. A modi�ied cost system will have some elements of cost using job costs and other elements of cost using process costs. A hybrid cost system will have one department on a job cost basis and another department on a process cost basis.
Unit costs in a process cost system are computed by dividing the appropriate current costs by the related equivalent units. The inventory costing method used is the �irst-in, �irst-out method. This assumes the beginning inventory is completed before new units are completed. Costs incurred are assumed to �low in the same manner. The cost of production report summarizes the costs charged to departments and how the costs are distributed between completed units and ending work in process.
Changes taking place in the manufacturing environment have an impact on a process cost system. Some changes, such as JIT, can simplify the calculation of unit costs.
Key Terms
cost of production report A report that presents information about units, costs charged to the department, and how the costs are accounted for.
equivalent units The theoretical number of units that could have been produced had the resources been applied to units that were started and completed during the period.
�irst-in, �irst-out (FIFO) cost method A process costing method that presumes the beginning inventory is completed before new units are completed.
hybrid cost system One type of cost system is used for one phase of the production process, and another system is used for a subsequent phase.
job cost system A cost system that separately tracks costs associated with each job or product.
job order A cost summary for each job.
just-in-time (JIT) philosophy
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An inventory management approach that seeks to minimize or eliminate inventories.
modi�ied cost system A cost system that has one or more elements of cost using job costing, while the other cost elements use process costing.
operation costing Usage of a modi�ied or hybrid cost system.
process cost system Identi�ication of costs with individual departments for an interval of time; unit costs of a �inal product are the sum of all costs assigned to the product by each department that worked on it.
production order A cost summary for each job.
stage of completion Average percentage of work completed on a unit of product at any point in time.
weighted average cost method A process costing method that averages the costs of the beginning work in process inventory and the current production.
work order A cost summary for each job.
Problem for Review Irene Carol Fisheries raises cutthroat trout for local restaurants and uses a FIFO process cost system. The �ish represent materials. The process involves three ponds: raising, growing, and fattening. Fingerlings are grown after hatching in the raising pond. At a speci�ied point, the �ingerlings are moved to the growing pond, where they mature. After maturing, the �ish are transferred to the fattening pond. The growing pond had 5,000 �ingerlings on April 1 that were 10% complete for the growing pond. During the month, an additional 30,000 �ingerlings were put into the pond. By the end of April, 28,000 �ish had been moved to the fattening pond. The �ingerlings remaining in the growing pond were 30% complete.
Questions:
1. Determine the equivalent units for �ingerlings. 2. Determine the equivalent units for conversion costs.
Solution:
1. Equivalent units for �ingerlings:
Physical �low:
Beginning inventory 5,000
Add units started during month 30,000
Available 35,000
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Minus units completed (28,000)
Ending inventory 7,000
Started and completed:
Units completed 28,000
Minus beginning inventory (5,000)
Units started and completed 23,000
or
Units started 30,000
Minus ending inventory (7,000)
Units started and completed 23,000
Equivalent units for �ingerlings:
To complete beginning inventory: 5,000 × (100% − 100%) 0
Units started and completed: 23,000 × 100% 23,000
Ending inventory: 7,000 × 100% 7,000
Equivalent units 30,000
2. Equivalent units for conversion costs:
To complete beginning inventory: 5,000 × (100% − 10%) 4,500
Units started and complete: 23,000 × 100% 23,000
Ending inventory: 7,000 × 30% 2,100
Equivalent units 29,600
Questions for Review and Discussion 1. Distinguish between a job cost system and a process cost system as to the timing of sales versus
production. 2. What is the focal point for cost accumulation in a process cost system? 3. Distinguish between a modi�ied cost system and a hybrid cost system. 4. What is the purpose of a job, work, or production order? 5. List the �ive computational steps necessary to account for costs in a process cost system. 6. Explain how equivalent units are computed under the FIFO method of process costing. 7. How are the unit costs computed under the FIFO method of process costing? 8. Why are equivalent units for materials usually different from equivalent units for conversion
costs? 9. What accounting report is the major document for a process cost system?
10. How can one check to ensure that cost distribution to completed units and ending inventory has been done properly?
11. How can management use a cost of production report?
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12. Which aspect of determining unit costs in a process cost system is particularly susceptible to manipulation by production managers?
13. Explain how a just-in-time environment can simplify a process cost system. 14. What is the distinction between equivalent units under the FIFO method and equivalent units
under the weighted average method? 15. Under what circumstances will both FIFO and weighted average yield the same equivalent units? 16. On a cost of production report, the costs of units completed and transferred out are treated one
way under the FIFO method and a different way under the weighted average method. Explain this difference.
Exercises 3-1. Physical Flow. Rolnick’s Protective Coating Service specializes in providing protective coating for eyeglasses. The company’s work in process inventory in Operation 1 on July 1 was 2,500 units. During July, 72,000 units were completed in Operation 1 and transferred to Operation 2. The ending work in process inventory in Operation 1 was 3,500 units.
Questions:
1. Compute the number of units started during July. 2. Compute the number of units started and completed. 3. Why is the stage of completion for the work in process inventories irrelevant for these
computations?
3-2. Costs of Finished Units and Work in Process. Henry’s Dry Cleaners uses a FIFO process cost system. Its work in process on December 1 consisted of 8,000 garments, which were 20% complete; $12,800 in processing costs were incurred last month for these garments.
During December, 82,000 garments were started and 78,000 were completed. Processing costs during December amounted to $245,225. The ending work in process was 80% complete.
Question:
Determine the cost of the �inished garments and the cost of the ending work in process.
3-3. Cost of Completed Units. Blair Products of Wellington, New Zealand, produces a kiwi fruit drink and uses a FIFO process cost system. The units and equivalent units (in liters), as well as unit costs, for the Initial Mix Department are as follows:
Materials Conversion
Equivalent units in beginning work in process 6,000 1,200
Units started and completed 40,000 40,000
Equivalent units in ending work in process 3,000 1,800
Unit costs NZ$0.10 NZ$0.20
Questions:
1. Compute the current period costs for: a. Materials.
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b. Conversion costs. 2. If the beginning work in process inventory was valued at NZ$12,600, what would be the cost of
units completed?
3-4. Conversion Costs. The Fabrication Department is the �irst stage of Hiller Company’s production process. Conversion costs in beginning work in process for this department were 70% complete, and in the ending work in process they were 40% complete. Hiller Company uses a FIFO process cost system. Conversion costs data in the Fabrication Department for January are as follows:
Units Conversion Costs
Work in process at January 1 28,000 $ 51,000
Units started and costs incurred during January 153,000 $293,000
Units completed and transferred to next department during January 131,000
Questions:
1. What was the conversion cost of work in process in the Fabrication Department at January 31? 2. What were the conversion costs per equivalent unit last month and this month, respectively?
3-5. Distribution of Total Cost and Ethics. There were 5,000 units in process in the Cutting Department of Grossman & Marcus, Inc., at the beginning of February. These units had materials and conversion costs of $48,000 and were 60% complete for conversion costs. Materials are added at the beginning of the process. During February, 60,000 units were started. The ending inventory for the month totaled 8,000 units, 25% complete for conversion costs. The unit cost calculation shows $4 for materials and $8 for conversion costs. A FIFO process cost system is used.
Questions:
1. Compute the cost of units completed and transferred to the next department. 2. Compute the cost of units in the ending inventory for the month. 3. Why might the production manager wish to in�late the estimate of the degree of completion of the
ending inventory from 25% to 50%? Support your answer with computations.
3-6. Unit Costs in a Bank. Chittenden Bank of Columbus, Ohio, processes checks in its Check Clearing Department. No materials costs are incurred in this department. On June 1, 4,000 checks in process were 25% complete with an associated processing cost of $200. During June, 100,000 checks were started in process. By the end of June, 70,000 checks had been started and completed. The direct processing costs in June amounted to $18,000. On June 30, the checks in process were one-third complete.
Question:
Assuming a FIFO process cost system, calculate equivalent units and the unit cost of work done during June.
3-7. Cost Distribution. Koniver Products manufactures a vitamin product and uses a FIFO process cost system. On July 1, it had 8,000 units in process that were 25% complete for conversion costs. Materials (a coating) are added at the end of the process. The cost of the beginning work in process was $1,800. July conversion costs were $36,000, and the materials costs were $17,000. Koniver Products started and completed 60,000 units in July. The work in process inventory on July 31 of 10,000 units was 60% complete.
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Questions:
1. What was the total cost of work transferred to the �inished goods inventory in July? 2. Determine the cost of work in process inventory on July 31.
3-8. Equivalent Units—FIFO and Weighted Average. Schroeder’s Photo Lab began the month with 6,000 items in inventory, which averaged 50% complete for materials and 40% complete for conversion costs. At the end of the month, there were 7,000 items in inventory, which averaged 60% complete for materials and 30% complete for conversion costs. During the month, 65,000 items were completed.
Questions:
1. Using the FIFO method, determine the appropriate numbers of equivalent units needed to compute unit costs for materials and for conversion costs.
2. Using the weighted average method, determine the appropriate numbers of equivalent units needed to compute unit costs for materials and for conversion costs.
3-9. Conversion Costs—Weighted Average Cost Method. Abe’s Vineyards grows grapes; after sorting and crating them, it sells the crates of grapes to Madelyn’s Winery. On December 1, Abe’s Vineyards had 10,000 pounds of grapes that were 40% complete for conversion costs. The conversion costs in the beginning work in process inventory were $20,000. In December, 150,000 pounds of grapes were started in process. Conversion costs in December amounted to $790,000. On December 31, 20,000 pounds of grapes were 40% complete for conversion costs. A weighted average process cost system is used.
Questions:
1. Compute the equivalent units (pounds). 2. Determine the conversion costs per pound.
3-10. Cost Distribution—Weighted Average Cost Method. Amy Dee’s Beef Processing Company (“Let us meat your needs”) had work in process at the beginning and end of the year as follows:
Percentage of Completion
Direct Materials Processing Costs
January 1 – 3,000 pounds 40% 10%
December 31 – 2,000 pounds 80% 40%
The company completed 41,000 pounds of �inished products during the year. Costs incurred during the year were: direct materials, $242,600; processing costs, $456,200. Work in process at January 1 was carried at a cost of $16,600 (direct materials, $13,000; processing costs, $8,900).
Questions:
1. Compute the cost of ending work in process using the weighted average method. 2. Compute the cost of �inished products using the weighted average method.
3-11. Total Costs—FIFO and Weighted Average. Le�kove, Inc. manufactures staplers. Materials are added at the beginning of the process; conversion costs are incurred uniformly. Beginning work in process consisted of 6,000 staplers. These units were 65% complete. During the period, the company began
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working on an additional 87,000 staplers, and �inished the period with 9,000 staplers that were 30% complete in ending work in process.
Costs attached to beginning inventory were $7,500 for materials and $9,500 for conversion costs. Costs added during the period were $74,000 for materials and $22,000 for conversion.
Questions:
1. Compute the cost of �inished products and the cost of ending work in process using the FIFO method.
2. Compute the cost of �inished products and the cost of ending work in process using the weighted- average method.
3-12. Unit Costs—FIFO and Weighted Average. Craig’s Diaper Service, located in a medium-sized city in California, is the lone remaining company that cleans cloth diapers in that city. The company currently uses a FIFO method of process costing and has arrived at a unit cost of $0.65. Harold Solomon, the owner, wonders what the unit cost would be with the weighted average method. He has obtained the following information from his accountant:
Equivalent units for the weighted average method 4,780
Equivalent units for FIFO method 5,000
Costs in beginning work in process $800
Question:
Compute the unit cost for the weighted average method.
Problems 3-13. Cost of Production Report. McKemie Robotics, a subsidiary of U.S.-based Kutner Robotics located in Dublin, Ireland, manufactures a small robot that looks like a leprechaun and can be moved by remote control. It can be used as a novelty to serve food and drinks to guests; and, with a special attachment, it can vacuum the carpet.
The materials are all added at the beginning of the Assembly Operation (the �irst operation). Labor and overhead are added during the month. Data for the month of July in the Assembly Operation are as follows:
Units
Work in process, July 1 35,000
Units started in process 250,000
Costs (in U.S. Dollars)
Work in process, July 1:
Materials $240,000
Labor and overhead 80,000
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Units
July costs:
Materials $3,500,000
Labor and overhead 1,457,280
The inventory of work in process on July 1 was complete as to materials but only 25% complete as to labor and overhead. On July 31, the inventory consisted of 20,000 units that were 40% complete with respect to labor and overhead.
Question:
Using FIFO, prepare a cost of production report for the Assembly Operation for the month of July.
3-14. Cost of Production Report and Ethics. The Lipseyville Municipality uses a FIFO process cost system to compute water puri�ication costs. All materials (chemicals) are added at the beginning of the puri�ication process. Data for the month of May are given as follows (units are kiloliters of water):
Units
Work in process, May 1 5,000
Units started in process 120,000
Costs
Work in process, May 1:
Materials $15,000
Labor and overhead 2,500
May’s costs:
Materials $360,000
Labor and overhead 232,000
The beginning work in process was 20% complete for labor and overhead. During the month, 115,000 units were completed, and 10,000 units that were 20% complete as to labor and overhead were in process at May 31.
Questions:
1. Prepare a cost of production report for the month of May. 2. Explain how management might use this cost of production report. 3. What might motivate the production manager to in�late the estimate of the degree of completion
of the ending work in process from 20% to 40%? Support your answer with computations.
3-15. Explanations About a Cost of Production Report. Daniel S. Tryker’s Painting Service receives a continuous �low of clear light bulbs from various manufacturers who want their bulbs painted—typically
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yellow or black. A partial production report, using FIFO, for the month of May is as follows for Department 1 (units are packages of eight bulbs):
Physical Units:
Work in process, May 1 (40% complete) 500
Started and completed 1,700
Work in process, May 31 (50% complete) 300
Total units 2,500
Costs Charged to Department:
Work in process, May 1 $ 800.00
Production costs, May 9,020.00
Total costs charged $9,820.00
Costs Accounted for:
Transferred to Department 2:
Work in process, May 1 $ 800.00
Cost to complete work in process, May 1 1,258.60
Started and completed 7,132.09
$9,190.69
Work in process, May 31 629.30
Total costs accounted for $9,819.99*
*Difference caused by rounding.
Questions:
1. Explain what the above partial cost of production report shows about the quantity �low and the cost �low.
2. Explain why equivalent units are preferred to total units produced in determining costs of units completed and units in ending inventory.
3. What additional information can this report give a manager? 4. Calculate how many units were completed during the month of May.
3-16. Cost of Production Report—Several Months. David Jared Industries is a bottling company that purchases orange juice from growers in Florida and bottles the juice in one-gallon plastic containers for sale to grocery stores. Only in its second year of operations, the company’s accounting system is evolving and has not been fully formalized. A chief accountant, Alan Neal, has been hired to bring order to the paper shuf�ling. In the process, Neal has gathered data to prepare FIFO cost of production reports for Activity Center A for the �irst three months of the current �iscal year (April, May, and June). This information is as follows:
April May June
Gallons:
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April May June
Beginning inventory 10,000 ? ?
Started in production 80,000 65,000 70,000
Completed 70,000 60,000 ?
Ending inventory ? ? 20,000
Stage of completion:
Beginning inventory 60% 30% 70%
Ending inventory 30% 70% 40%
Cost data:
Beginning inventory:
Materials $ 10,000 ? ?
Conversion costs 20,000 ? ?
Current period:
Materials $ 80,000 $ 66,000 $ 70,000
Conversion costs 170,000 142,000 156,000
Materials (orange juice) are added at the beginning of Activity Center A. Conversion costs �low uniformly throughout the process.
Questions:
1. Compute the physical �lows of units (gallons) for each of the three months. 2. Prepare a cost of production report for each of the three months. Round unit costs to four decimal
places and total dollars to the nearest dollar. 3. Analyze the cost of production reports for each month, and comment on production stability and
unit costs for materials and conversion costs.
3-17. Analysis of a Work in Process Account. Garber Pharmaceutical Company manufactures a tablet for allergy sufferers and uses a FIFO process cost system. All ingredients are added at the beginning of the Blending Operation. Conversion costs �low uniformly throughout the process. Tableting and Coating are operations downstream from Blending. Information on the Blending Operation for October is as follows:
Work in Process – Blending Operation
October 1, balance (100,000 units, 40% complete for conversion costs)
$ 151,760 Completed and transferred to Tableting:
Direct materials added (1,000,000 units) $1,310,000 Units – ?
Direct labor costs ? Costs – ?
Factory overhead (applied at 180% of direct labor cost)
$396,000
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Work in Process – Blending Operation
October 31, balance (200,000 units, 70% complete for conversion costs)
?
The October 1 balance consists of the following cost elements:
Direct materials $128,000
Direct labor 8,800
Factory overhead 14,960
Total costs $151,760
Questions:
1. Compute the amount of direct labor cost for the period. 2. Calculate the unit costs for direct materials, direct labor, and factory overhead for the current
month (October). Direct labor and factory overhead should be separate; do not combine them into one �igure.
3. Calculate the unit costs for direct materials, direct labor, and factory overhead in the inventory at the beginning of October.
4. Compare the unit costs computed in Parts (2) and (3). Explain what information this comparison gives to a manager.
3-18. Work in Process Costs—FIFO and Weighted Average. The following data pertain to the Claims Processing Department of Smilgoff Insurance Company, which does not incur any direct materials costs:
Work in process, May 1:
Units (claims) 3,200
Conversion costs (10% complete) $6,900
Units (claims) started in May 13,500
May’s conversion costs $285,000
Work in process, May 31:
Units (claims) 1,900
Stage of completion for conversion costs 60%
Questions:
1. Using the FIFO method, compute the cost of the May 31 work in process. 2. Using the weighted average method, compute the cost of the May 31 work in process.
3-19. Finished Goods and Work in Process Costs—Weighted Average. The following information is available for the Assembly Department of Lerman Enterprises for August:
Units Costs
Work in process, August 1 (70% complete) 5,000
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Units Costs
Direct materials $ 6,000
Direct labor 3,000
Manufacturing overhead 4,000
Total work in process, August 1 $13,000
Started in production during August 20,000
Costs added:
Direct materials $29,000
Direct labor 8,000
Manufacturing overhead 10,000
Total costs added during August $47,000
Work in process, August 31 (80% complete) 3,000
Materials are added at the beginning of the process.
Questions:
1. Compute the total cost of goods transferred out using the weighted average method. 2. Compute the total cost of ending work in process using the weighted average method.
3-20. Work in Process—FIFO and Weighted Average. The Division of Corporate Taxation processes corporate tax returns for a state located in the northeastern United States. Processing costs for this agency were 70% complete as to the beginning work in process and 60% complete as to the ending work in process. Information on processing costs for the month of August is as follows:
Number of Returns Processing Costs
Work in process at August 1 8,000 $ 95,000
Returns started and costs incurred during August 45,000 $666,000
Returns completed during August 49,000
Questions:
1. Using the FIFO method, what amount of processing cost was in work in process at August 31? 2. Using the weighted average method, what amount of processing cost was in work in process at
August 31?
3-21. Cost of Finished Units—FIFO and Weighted Average. The Department of Motor Vehicles processes auto tag applications. All materials costs (i.e., tags) are completed when processing begins. The following information was obtained by the controller, Arthur Kurtz, for October:
The October 1 work in process had 5,000 applications (40% completed) and the following costs:
Direct materials $2,700
Direct labor 16,880
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Overhead 31,400
During October, 11,000 applications were completed, and the following costs were incurred:
Direct materials $5,200
Direct labor 95,775
Overhead 159,925
On October 31, there were 2,400 partially processed applications on hand (80% completed).
Questions:
1. Using the FIFO method, determine the cost of completed applications. 2. Using the weighted average method, determine the cost of completed applications.
Case: Wyncote Pipelines
Wyncote Pipelines, Inc., is a liquid petroleum pipeline transportation company. The line running from Corpus Christi to Kansas City is a 30-inch, high-pressure line that moves product at an average of 8 miles per hour. A �illed line contains 28 million barrels of product, which travel an average of 192 miles per day. The line speed can be increased safely to about 280 miles per day or slowed to almost a stop. The line can be �illed to capacity or be partially empty. Over certain segments, the line moves faster than elsewhere as more product is placed in and taken out. The line carries various products, including crude oil of varying weights, home heating oil, and numerous other petroleum products.
As a transportation company, Wyncote Pipelines does not own the products transported. Instead, it is paid a fee for its services based on moving 10,000 barrels (420,000 gallons) of product one mile. The variable cost of running the line is for the 30 pumping stations along the line: the higher the traf�ic, the higher the fuel cost for pumping. The other cost of running the line is overhead cost, which relates to line maintenance. One unit is considered to be moving 10,000 barrels of product one mile.
On April 1, the Corpus Christi to Kansas City line had 1.44 million units in process (18 million barrels that were to be transported an average of 800 miles), which were 60% complete. During the month, the line completed 12 million units of delivered product and had ending units in process of two million units (20 million barrels to be transported 1,000 miles) that were 40% complete. The beginning units in transit had accumulated costs of $8,800,000, of which $2,400,000 were variable costs. During the month, the Corpus Christi to Kansas City line had $33,420,800 in variable costs and $81,168,800 in �ixed costs. The completed deliveries were billed at $134,400,000 for services.
Questions:
1. What is the nature of the costs incurred as to direct materials, direct labor, and variable or �ixed overhead?
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2. Why should this application be considered for a modi�ied process cost system? 3. Compute the equivalent units of production for the Corpus Christi to Kansas City line.
(Round to four places, if needed.) 4. Compute a cost per unit of output for variable and �ixed costs. 5. What were the pro�its before administrative expenses and taxes during April? 6. What were the costs of the units in transit on April 30?
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Learning Objectives
After studying Chapter 4, you will be able to:
Explain the interrelationships among cost drivers, activities, and products in an activity- based cost system, and describe the system’s key components and cost �lows.
Distinguish between the two stages of cost allocation in an activity-based cost system, and apply activity-based costing in a manufacturing setting.
Understand how activity-based costing is extended to nonmanufacturing settings.
Relate activity-based management to activity-based costing.
Describe the key elements of a just-in-time cost system.
4 Activity-Based Costing and Just-In-TimeCosting
houdre/iStock/Thinkstock
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Testing . . . Testing
Cortell Laboratories was formed in 1993 and began its operations in testing various electrical characteristics of integrated circuits sent to it by manufacturers on the west coast. Cortell focused on a strategy of providing quicker turnaround times than had been offered by manufacturers’ labs or other outside labs. The strategy was successful and was marketed well. Within 10 years, Cortell had annual revenues of over $30 million. Pro�it and cash �low, also highly positive, allowed Cortell to self-fund all expansion.
In 2010, Cortell began offering tests for transformers. Within one year, transformer testing was so successful that the lab was now running on three full shifts. In the midst of all this success, Harriet Cortell, the company president, is now faced with a dilemma. The marketing manager, Kitty Cohen, has come to her and argued that testing transformers is much more pro�itable than testing integrated circuits, and therefore, the lab should concentrate more of its resources on marketing and performing transformer tests. To support her argument, Cohen compiled costs and pro�it margins for each testing service. These �igures showed that transformer testing was over 40% more pro�itable than testing integrated circuits. Cortell looked at the overhead allocated to the two types of tests and could hardly believe that each test was assigned the same amount of overhead per test. She knew that testing transformers involved more job orders and required more setups than testing integrated circuits. “Our costing system is not re�lecting the complexity of these tests,” claimed Cortell.
Several months earlier, Cortell had heard about an activity-based cost approach for assigning overhead costs. She immediately contacted the controller, Charlie Kaplan, and asked him to do an activity-based cost analysis.
Two major forces have combined to put great pressure on managerial accountants like Charlie Kaplan to provide improved cost information about their �irms’ products and services. These are global competition and automation in the workplace.
1. Global competitiveness. Most companies in nearly every industry face increased competition from direct competitors, whether from across the street or halfway around the world. Whether the technology is old (making iron and steel) or new (making smart televisions), the needs for accurate and relevant product cost data have grown dramatically. Competitiveness also means knowing the costs of product quality, reliable delivery, and waste (unproductive effort). Cost control takes on new meaning if a competitor can sell an item at a price that is 10% lower than another company’s production cost and still make money on the sale. Increasingly, companies are realizing that traditional volume-based cost systems are not using the “right” variables or collecting cost data in enough detail.
2. Automation of the workplace. Dramatic changes in production have also taken place. Another “industrial revolution” is what some people have called it. Computer power has introduced concepts like computer-aided design (CAD), computer-aided manufacturing (CAM), �lexible
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manufacturing systems (FMS), and robotics. Computer power has allowed precise tasks to be programmed and machines to be designed to do those tasks. Likewise, computer power has enabled production managers to coordinate thousands of events, transactions, and possible courses of action. One outcome is a shift from heavy dependence on labor to technology. Direct labor costs were often a major product cost, and labor activity often re�lected general activity in the plant. Now, in many companies, direct labor is a minor portion of a product’s total cost. Other production costs have grown tremendously because of equipment costs and support personnel needed to coordinate production. New activity measures are needed to link resources used with production activities. The traditional approach of allocating overhead costs using direct labor hours or direct labor cost is no longer relevant in companies that are highly automated.
Competition and automation have focused attention on getting more accurate, timely, and relevant costs for products and services. The concepts are simple and have always been at the heart of cost accounting: Link the cost of resources used to the activity using the resources, and link the activity to the product being produced. Traditionally, the activity measure used most often has been a volume measure: direct labor hours (or dollars). In recent years, there has been a recognition that the complexity of production, rather than volume, is the most important determinant of overhead costs. Cost systems known as activity- based costing re�lect this new orientation.
Consider the following example of a company that manufactures ball-point pens in two different plants. In one plant, plant A, 30,000 identical pens are produced—all with black ink and black casings. In the other plant, plant B, 30,000 similar pens are also produced, but 10,000 have black ink, another 10,000 have blue ink, and the remaining 10,000 contain red ink. Likewise, those in plant B have a variety of casing colors: 8,000 are black, 12,000 are gold, and 10,000 are silver. Since each plant manufactures 30,000 pens, the amount of direct labor hours worked would be expected to be virtually the same in each plant. Therefore, using direct labor to allocate overhead costs to the two plants would result in the same amount of overhead costs assigned to each plant. Yet, plant B clearly consumes more overhead costs such as indirect labor costs relating to more machine changeovers, time spent on purchasing materials, and inventory management time. In other words, plant B manufactures more complex products (i.e., products that involve extra processes), but traditional costing that uses direct labor to allocate overhead costs ignores this complexity. Activity-based costing not only considers volume when assigning overhead costs, but does so in ways that re�lect the complexity of the various products.
This chapter presents the conceptual foundation for activity-based costing as a means of improving the accuracy of assigning costs to cost objectives—primarily to products and services. Many companies that have adopted activity-based cost systems have also instituted just-in-time inventory systems. Later in the chapter, we discuss how adoption of just-in-time inventory systems has affected product costing.
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4.1 Activity-Based Costing Activity-based costing focuses on �inding the cost of producing a product or service. In Chapter 1, we introduced cost of goods manufactured and the three traditional groups of costs: direct materials, direct labor, and factory overhead. In past years, direct materials and direct labor were linked with products because of their obvious direct relationships; all other manufacturing costs were traditionally grouped together in a cost pool as overhead. One activity measure, often direct labor, was used to attach all overhead costs to products. Many different overhead costs were combined and included:
1. Plant supervision and other indirect labor salaries 2. Materials handling costs 3. Plant engineering costs 4. Setup or changeover costs 5. Supplies and indirect materials 6. Depreciation, taxes, and insurance on equipment 7. Energy and other utility costs 8. Repair and maintenance costs
Ideally, every overhead cost item could be traced directly to speci�ic products. This is just not possible. If we produce a million units of different types and sizes of batteries in a factory, can the manager’s $100,000 salary be traced to the different batteries? No. Can we link the manager’s salary to certain factory activities, then link the activity costs to the different batteries? Yes, but only with careful analysis and application. Activity-based costing focuses on distributing costs that managers are unable to clearly identify with speci�ic jobs or products (i.e., indirect costs).
Issues In�luencing Cost Management Systems Design
Product costs are so critical to managerial decisions that greater precision and accuracy are needed today than were demanded in the past. Thus, a major effort is under way in many companies to upgrade their cost systems.
The level of detail that a cost system needs is based on the following considerations:
1. The competitive environment, which will impact the degree of accuracy needed and the toleration of costing errors
2. The homogeneity or heterogeneity of the products or services 3. The complexity of the production process 4. The volumes of each product or service produced 5. The costs of measuring and collecting activity and cost data 6. The impacts that more accurate and relevant data will have on managerial behavior
Detailed cost systems are expensive to design and to operate. Yet the value of better cost information can also be extremely high.
De�inition of Activity-Based Costing
Activity-based costing (ABC) is a system of accounting that focuses on activities performed to produce products or services. Activities become the fundamental cost accumulation points. This is because it is activities such as purchasing, moving materials, and machine setup that cause overhead costs to be
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incurred. Costs are traced to activities, and activities are traced to products based on each product’s use of the activities. We show these relationships for allocating costs in Figure 4.1.
Figure 4.1: An overall view of ABC cost linkage
Under activity-based costing, an effort is made to identify and account for as many costs as possible as direct costs of production. Any cost that can reasonably be traced to a particular product or service is treated as a direct cost. For example, under the traditional cost system, the cost of setup time (the factory downtime incurred in converting equipment from producing one product to another) is included in manufacturing overhead and applied to products on the basis of direct labor hours. Under ABC, setup time might be measured for each product line, and setup costs would be directly assigned to each part or product manufactured.
An ABC system identi�ies the major activities in a production process, aggregates those activities into activity centers, accumulates costs in activity centers, selects cost drivers that link activities to products, and assigns the costs of activities to products. We show this process in Figure 4.2. An activity center is a segment of the organization for which management wants the costs of a set of activities to be reported separately. A mechanism called a cost driver is used for linking a given activity’s pool of costs. A cost driver is an event, action, or activity that results in cost incurrence. It is any factor that causes costs to change. The basic concept is that cost drivers, such as number of purchase orders issued, measure the amount of resources a speci�ic product uses. A cost function is created from the activity’s planned costs and cost driver activity level.
Figure 4.2: An overall view of the ABC process
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Although not always obvious, several different cost drivers could link an activity’s costs and the cost objective. However, only one cost driver is chosen for each cost pool. In the materials handling case in Figure 4.2, four possible cost drivers are listed. Assume that pounds of materials moved is considered to be the most appropriate cost driver. We therefore divide the planned materials handling costs by the planned pounds to be moved. Cost per pound moved is the cost function. Then, the actual pounds handled in the production of a product times the cost per pound moved is the amount of materials handling costs assigned to that product. Again, the overall process is to identify the best cost driver that links costs and activities and then to use that cost driver to link activities with products (or other cost objectives).
Flow of Costs Under Activity-Based Costing
In applying ABC to a speci�ic organization, we follow �ive basic steps:
1. Assemble similar actions into activity centers. 2. Classify costs by activity center and by type of expense. 3. Select cost drivers. 4. Calculate a cost function to link costs and cost drivers with resource use. 5. Assign costs to the cost objective—often the product cost.
These steps are consistent with Figure 4.2.
Step 1: Assemble Similar Actions into Activity Centers. The number of actions performed in any organization can be quite numerous. Although the ideal is to relate the cost of every action to a cost driver and then to the product, the costs of doing this can far exceed the bene�its. Therefore, we combine actions into activity centers. For instance, the actions of placing a product in a box, sealing the box, and then labeling the box can be combined into a packaging activity. Treating collections of actions as activity centers eliminates the need to measure and track the performance of numerous individual actions and costs.
One meaningful way of grouping actions is to classify them with different levels of activities. A common outline is unit-level activities, batch-level activities, product-level activities, and facility-level activities. Figure 4.3 illustrates the four types. Unit-level activities are performed each time a unit is produced or handled. These are repetitive activities. Direct labor or machining activities are examples. Costs of these activities vary with the number of units produced. Batch-level activities are performed each time a batch of goods is produced or handled. Machine setups, order processing, and materials handling are related to batches rather than individual units. The costs of these activities vary according to the number of batches but are common or �ixed for all units in the batch. Product-level activities are those performed as needed to support the production of each different type of product or service. Maintaining bills of materials and routing information, processing engineering changes, and performing testing routines are examples of activities in this category. Facility-level activities are those which simply sustain a facility’s general production process. Examples would include plant supervision and building occupancy. These costs are common to a variety of products and are the most dif�icult to link to product-speci�ic activities. For this reason, many people question whether facility-level costs should be linked to products.
Figure 4.3: Levels of ABC activity groups
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Traditionally, we classify overhead costs as variable or �ixed. Relative to volume of outputs, costs of unit- level activities are predominately variable while costs of the other three levels are predominately �ixed. However, identifying batch-, product-, and facility-level activity centers helps in selecting cost drivers. Often, the cost perspective changes; many costs that are �ixed relative to units of output are now variable relative to the cost driver. This is particularly true for batch- and product-level activities. For instance, setup costs do not vary with the number of units produced, but they do vary with the number of setups performed. Costs of facility-level activities remain primarily in the �ixed category and are often apportioned or allocated to products in some arbitrary manner.
Step 2: Classify Costs by Activity Center and by Type of Expense. Once the actions are grouped into activities, the next step is identifying the costs with the activities. The classifying of cost data at this early point determines the level of detail and the breakdowns of cost data available to management for all cost analysis purposes later. A chart of accounts or a database classi�ication scheme will identify the type of cost by natural classi�ication: salary, postage, telephone, repair, supplies, etc. A second classi�ication will identify the activity center. Often, this is called a cost center. As an example, costs found in accounts such as utilities expense, custodial expense, and building security expense can be combined and assigned to a building operations cost center. An activity center and a cost center are both commonly de�ined as the smallest part of an organization for which costs are accumulated. In fact, in most carefully de�ined cost systems, the terms activity center and cost center can be used interchangeably.
Step 3: Select Cost Drivers. Direct costs can be traced immediately to a product without the need for a cost driver. All other costs need links between cost, activity, and product. Cost drivers are the links. A cost driver can link a pool of costs in an activity center to the product. Or a cost driver can link costs in one activity center to activities in another activity center. Multiple layers of activities can exist. One activity relates to another activity, which may relate to still another activity before relationships to products are identi�ied. Figure 4.4 gives an example of the variety of these relationships. The �irst box at the top is the total costs of manufacturing during a production period. The costs are classi�ied by activity center and by natural expense type. A manager is responsible for each activity center and the costs incurred in that center.
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Figure 4.4: Relationships of activity (cost) centers, cost drivers, cost functions, and product costs
A preliminary stage cost driver links costs of resources consumed (inputs) in one activity center to other activity centers. For instance, service center costs are usually assigned to overhead cost pools in a preliminary stage. A primary stage cost driver links costs in an activity center directly with products. Some costs, such as batch-level activity center costs in Figure 4.4, are initially assigned to a primary stage activity center and only need a single stage assignment process. These primary stage centers may collect reassigned costs from numerous preliminary stage activity centers—based on cost drivers that re�lect activities and resources used.
The activity centers are typically one of four types, as described above. Direct costs of unit-level activity centers are assumed in Figure 4.4 to be always traceable to speci�ic products. Batch-level activity center costs should also be traceable to speci�ic products but often use a cost driver. Product-level activity center costs may be related to a speci�ic product or may be grouped by activities before being assigned to products at the primary stage. Facility-level activity center costs may go through multiple preliminary stages before being assigned to products. For example, instead of assigning costs pertaining to the plant administration activity directly to products, these costs might be assigned in a preliminary stage to other activities such as machining, assembly, and �inishing.
ABC systems differ from traditional volume-based cost accounting systems in the number and variety of cost drivers used to trace costs. Traditional cost accounting systems use very few drivers—often only direct labor hours or dollars, which are related to volume of production. ABC systems, on the other hand, may use a multitude of cost drivers (for many different costs) that relate costs more closely to resources consumed and the activities occurring. In this way, ABC systems re�lect the complexity of production and
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not just volume. Although not comprehensive, Figure 4.5 gives examples of cost drivers that might be found in an ABC system.
Accountants must work with management to discover and identify activities and cost drivers. This is done through interviewing, process observation, simulation, diagramming, and analysis of current information systems.
Figure 4.5: Common cost drivers used in actual ABC systems
Step 4: Calculate a Cost Function. Managers choose a driver for each of the cost pools to determine a rate per cost driver unit, a percentage of other cost amounts, or an allocation percentage. This cost function could be based on either planned or actual costs and activity levels. In Chapter 2, we discussed the creation of predetermined overhead rates using planned costs and activity levels. Using planned activity levels and costs for an example, if costs of the setup activity center cost pool totaled $25,000, if setup hours were the cost driver, and if 500 hours were expected, the cost function would be $50 per setup hour ($25,000 / 500). Costs are then distributed to products as setup hours are incurred. This approach is the same as that discussed in Chapter 2, except for the use of a different type of cost driver.
Step 5: Assign Costs to the Cost Objective. The �inal step is distributing costs to the users of the resources. The cost pool, the cost driver, and the cost function now combine to determine how much cost is charged to each resource user. If this is at a preliminary stage, the users are predominately other activity centers. Thus, a group of costs are now reassigned to other cost pools based on use. If the activity center is at the primary stage, the users are the products themselves. In the setup example, if 60 hours of setup time were used for Product A’s production, $3,000 (60 × $50) would be charged to Product A. All costs entering the manufacturing process during a given time period are eventually assigned to products.
In�luence of Production Complexity
The primary goal of ABC for product costing is to generate accurate product costs. In general, this means the cost accounting system must handle the complexity of production while minimizing possible distortions caused by cost assignment processes. Production complexity plays a signi�icant role in determining whether the costs of two or more activities can be combined and traced to a product by means of a single cost driver and still be assigned accurately. If a company wants more accurate product costs, it must increase the number of activity centers, cost pools, and cost drivers. Since the introduction of a new cost driver in the system has a cost/bene�it value, most companies face a trade-off between more cost drivers, greater detail, and more expensive data processing versus more data aggregation and less
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expensive data processing. Two important issues that affect cost driver selection are product diversity and batch-size diversity.
Product diversity refers to the degree to which each product differs in the number of activities (that is, resources or inputs) required. The greater the difference in how two products use resources or inputs, the greater the distortion a single cost driver will make in tracing costs to these products. For example, producing an ornate bathroom faucet �ixture may consume labor-intensive production resources, while producing a kitchen sink faucet may consume machine-intensive resources. Some products are simply larger than other products. A desktop model computer versus a laptop model computer is one example. The size of the product in�luences how the product is produced and which resources are required.
The complexity of a product is determined by the differences in how a product is manufactured and by the number of options a manufacturer has for its products. Deluxe models and products with many customer options, for example, increase the manufacturing dif�iculty. Each option adds an extension to the production process. However, supervision and other departmental costs are not necessarily in�luenced by these options. Materials inputs may differ by product. Some materials may require more handling from the receiving dock through the storeroom to the production �loor. In other cases, certain materials may require longer machining time or more time in trimming processes. Some products may have multiple stages of production, from raw materials to �inished products. Others are merely assembled from purchased parts.
Batch-size diversity occurs when products are manufactured in different-size batches. Batches refer not only to production orders but also to order quantities of raw materials and to shipping quantities of �inished goods. In an automotive stamping plant, a weekly run of hood stampings for a popular model may be 3,000 units, while a very similar but higher priced model hood may have a biweekly run of 500.
Although we normally think of differing batch sizes when we produce different products, batch-size diversity can also occur with the same product over time. For instance, this week the production order consists of 500 units. Due to an increase in demand, the production schedule for next week calls for 800 units. Just-in-time production encourages producing only what is needed immediately—often smaller batches and more frequently. Frequent batch runs may also require that more attention be given to minimizing setup time and cost. In traditional cost systems, setup costs are added to other overhead costs, losing the separate identity and cost detail of setup activities. In ABC systems, a separate cost pool for setup costs would typically be formed and would be assigned to products using cost drivers such as setup hours or number of setups. Both of these cost drivers re�lect batch-size diversity, with the former measure being more detailed and, thus, often more appropriate.
If computer resources were free and if managers had unlimited amounts of analysis time, more and more detail could be captured and evaluated. Since this is not the case, practical decisions must be made. In large ABC applications, the number of cost drivers (both preliminary and primary) used across an entire facility may be as low as 20 or as high as several hundred. Often, a high percentage of costs are assigned using a small number of drivers. The cost system’s design should allow judgments to be made about the number of cost pools and cost drivers and should allow for cost pools and cost drivers to be changed easily when the need arises.
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4.2 A Comprehensive Activity-Based Costing Example Guttman Cafeterias has just completed the installation of an activity-based cost system. The �irm operates cafeterias within of�ice buildings, factories, hospitals, and other institutions. These cafeterias produce and serve three standard meals: breakfast, lunch, and dinner. Activity centers consist of four support centers and two operating centers. The volume for October is as follows:
Breakfast Lunch Dinner
# of Meals 22,000 15,000 12,000
The activity centers’ traceable costs (i.e., direct costs) for October and cost drivers are as follows:
Activity Center Information
Code Activity Center Materials Labor Other Costs Cost Driver
Support Centers:
120 Occupancy $60,000 Square feet used
130 Data Processing 30,000 Transactions processed
140 Personnel Bene�its 9,000 Payroll cost
220 Materials Handling 16,000 Materials cost
Operating Centers:
410 Cooking $18,000 $10,000 20,000 Cooking hours
420 Serving 14,000 20,000 15,000 Serving hours
Total $32,000 $30,000 $150,000
Activities are grouped and activity centers are determined as a result of special studies. Each activity center has one cost driver. For example, the cost driver selected for Occupancy is square feet of space used by each activity.
The materials and labor costs are directly traceable to the three meals as follows:
Materials Labor
Breakfast:
Cooking $ 1,000 $ 2,000
Serving 4,000 2,000
Lunch:
Cooking 6,000 2,000
Serving 2,000 8,000
Dinner:
Cooking 11,000 6,000
Serving 8,000 10,000
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Materials Labor
Total $32,000 $30,000
As for the other traceable costs, cost drivers are selected after analysis of past cost behavior and activity levels within each activity center (i.e., relationship with resource usage). First, the other costs of the support centers are assigned to the operating centers. This is the preliminary stage allocation.
Preliminary Stage Allocation
The cost driver data for the preliminary stage cost assignments, where costs are assigned from the four service centers to the two operating centers, are as follows:
Cost Driver Data—Preliminary Stage Allocation
Code Activity Center Cost Driver
Activity Centers Using Resources
410 420
120 Occupancy Square feet used 80,000 40,000
130 Data Processing Transactions processed 120,000 180,000
140 Personnel Bene�its Payroll cost $10,000 $20,000
220 Materials Handling Materials cost $18,000 $14,000
Cost functions for each of the support centers are developed as follows:
Activity Center Calculation Cost Function
Occupancy $60,000/(80,000 + 40,000) $0.50 per square foot
Data Processing $30,000/(120,000 + 180,000) $0.10 per transaction
Personnel Bene�its $9,000/($10,000 + $20,000) 30% of payroll cost
Materials Handling $16,000/(18,000 + $14,000) 50% of materials cost
Using these cost functions, the following costs are assigned to the two operating centers:
Cooking:
$0.50(80,000) + $0.10(120,000) + .30($10,000) + .50($18,000) = $64,000
Serving:
$0.50(40,000) + $0.10(180,000) + .30($20,000) + .50($14,000) = $51,000
Having made these preliminary cost assignments, the operating centers contain both direct costs and costs that have been assigned to them from the support centers. Both of these costs will be then assigned to meals using primary cost drivers.
Primary Stage Allocation
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In the primary stage, costs are assigned from the Cooking and Serving centers to the three meals. The activities and cost drivers are as follows for each meal:
Cost Driver Data—Primary Stage Allocation
Code Activity Center Cost Driver
Cost Driver Activity Linked to Each Meal
Breakfast Lunch Dinner
410 Cooking Cooking hours 2,000 3,000 5,000
420 Serving Serving hours 2,500 1,500 1,000
As can be seen, different meals use different amounts of the resources in each activity center. Overhead cost functions for each of the operating centers are developed as follows:
Activity Center Calculation Overhead Cost Function
Cooking ($20,000 + $64,000)/(2,000 + 3,000 + 5,000) $8.40 per cooking hour
Serving ($15,000 + $51,000)/(2,500 + 1,500 + 1,000) $13.20 per serving hour
Using these cost functions, the following overhead costs are assigned to the three products:
Breakfast: $8.40(2,000) + $13.20(2,500) = $49,800
Lunch: $8.40(3,000) + $13.20(1,500) = $45,000
Dinner: $8.40(5,000) + $13.20(1,000) = $55,200
Materials and labor costs which are directly traceable are added to determine the total meal costs:
Cost Item Breakfast Lunch Dinner
Materials $ 5,000 $ 8,000 $19,000
Labor 4,000 10,000 16,000
Overhead 49,800 45,000 55,200
Total cost $58,800 $63,000 $90,200
Note that the total cost assigned to these meals equals the sum of the costs reported by the �ive activity centers (i.e., $58,800 + $63,000 + $90,200 = $32,000 + $30,000 + $150,000, or $212,000). Per-unit costs for each meal are:
Breakfast: $58,800 / 22,000 = $2.67
Lunch: $63,000 / 15,000 = $4.20
Dinner: $90,200 / 12,000 = $7.52
Comparing ABC to Traditional Volume-Based Costing
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As discussed, traditional volume-based cost systems unfortunately have paid less attention to the cause- and-effect relationships between resources used and production activities. Assume that the prior cost system in use by Guttman Cafeterias assigned overhead costs to meals using labor dollars. This is a common approach to assigning overhead. Let us also assume that the preliminary cost assignment steps are the same under either approach. Since $150,000 of total overhead cost is incurred and total labor cost is $30,000, an overhead rate of $5 ($150,000 / $30,000) for each $1 of labor is added to each product. The product costs would be as follows:
Total Breakfast Lunch Dinner
Direct materials $32,000 $5,000 $8,000 $19,000
Direct labor 30,000 4,000 10,000 16,000
Overhead costs ($5 per DL$) 150,000 20,000 50,000 80,000
Total meal costs $212,000 $29,000 $68,000 $115,000
Number of meals 22,000 15,000 12,000
Traditional cost per unit $1.32 $4.53 $9.58
ABC cost per unit $2.67 $4.20 $7.52
Difference
Traditional minus ABC cost $(1.35) $0.33 $2.06
Percentage of ABC cost (50.6%) 7.9% 27.4%
A dramatic picture appears. Using a cost system very common in many companies today, two of the three products have large cost differences: Breakfast and Dinner. Guttman had overcosted Dinners by 27.4%. This is a far more pro�itable meal than Guttman’s management had thought. Guttman may be losing Dinner business because of its higher-than-necessary selling price. Conversely, Breakfast is less pro�itable than previously thought. With traditional costing, Breakfast received a disproportionately low amount of overhead allocation because its labor cost of $4,000 was much lower than those of Lunch and Dinner ($10,000 and $16,000, respectively). However, Breakfast consumed overhead resources, namely serving hours per unit, comparable to the other two meals. Breakfast prices might need to be raised to cover its actual use of resources.
ABC is also considered superior to volume-based costing when a company’s sales mix includes the following two types of products or services:
High volume, low complexity Low volume, high complexity
To illustrate, suppose Reznick Food Corporation produces 50,000 boxes of “Bland,” a breakfast cereal where each piece has the same shape, color, and �lavor (high volume, low complexity). The company also produces 10,000 boxes of “Wow!,” a cereal having a variety of shapes, colors, and �lavors (low volume, high complexity). Setup costs of $2,000 and materials handling costs of $9,000 are to be assigned to the two cereals. The following activity information is obtained:
“Bland” “Wow!”
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“Bland” “Wow!”
Direct labor hours 25,000 2,500
Production runs 10 20
Materials moves 50 40
Volume-based costing, using direct labor hours, would assign the costs as follows:
“Bland”: ($2,000 + $9,000) × (25,000 / 27,500) = $10,000
“Wow!”: ($2,000 + $9,000) × (2,500 / 27,500) = $1,000
An ABC system would use the number of production runs to assign setup costs and the number of materials moves to assign materials handling costs, as follows:
“Bland”: [$2,000 × (10 / 30)] + [$9,000 × (50 / 90)] = $5,667
“Wow!”: [$2,000 × (20 / 30)] + [$9,000 × (40 / 90)] = $5,333
After dividing these assigned costs by 50,000 boxes for “Bland” and 10,000 boxes for “Wow!,” we obtain the following costs per box:
“Bland” “Wow!”
Volume-based costing $0.20 $0.10
Activity-based costing $0.11 $0.53
Compared to ABC, volume-based costing has overcosted the high volume, low complexity product (“Bland”), while undercosting the low volume, high complexity product (“Wow!”). This distortion is known as product cross-subsidization and has caused companies that use volume-based costing to set high prices for high volume, low complexity products and low prices for low volume, high complexity products. These prices can result in losing customers to competitors for the high volume, low complexity products and incurring operating losses on the low volume, high complexity products. Chrysler experienced this phenomenon and, as a result, now outsources some parts that it previously had manufactured. Signals that companies may be experiencing product cross-subsidization include the inability to break into new markets or to maintain current market share as a result of competitors’ seeming ability to price below cost.
Whether ABC costs are “correct” or not, they would appear to be more accurate than the traditional costs. ABC makes a greater effort to match resource use, costs, activities, and products.
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4.3 ABC and Nonmanufacturing Activities Historically, manufacturing-related costs comprised the bulk of a manufacturing organization’s total costs. Only manufacturing-related costs are considered product costs for external reporting purposes. In recent times, emphasis on accounting for nonmanufacturing costs such as selling, distribution, general administration, and research and development has grown. One reason is that nonmanufacturing costs are a growing portion of companies’ total costs. Another reason is that, due to computerization, it has become less costly to develop alternate accounting systems within a company. Therefore, in addition to the cost system needed for external reporting, companies now �ind it worthwhile to maintain alternate systems more useful for internal purposes such as pricing, control, decision making, and performance evaluation. With the growing emphasis on accounting for nonmanufacturing costs, manufacturing �irms who have adopted ABC for manufacturing-related activities are increasingly expanding their implementation of ABC to include nonmanufacturing activities.
Contemporary Practice 4.1: Communication Plans for ABC Implementation
A survey of ABC implementation was conducted with responses from 166 �inancial controllers at French companies. “According to the survey results, 77 percent of companies that have implemented ABC deployed a communication and information plan for the ABC project during the implementation. The communication plan covers project objectives (88 percent of respondents), ABC methodology (82 percent of respondents), and methods to avoid project failure (13 percent of respondents).”
Source: Rahmouni, A.F.A. & Charaf, K. (2012, November/December). Success of ABC projects in French companies: The in�luence of organizational and technical factors. Cost Management, 12–23.
In addition to manufacturing �irms, the usage of ABC is growing in the service sector. Competitive pressures in industries such as health care, �inancial services, telecommunications, and transportation have led to increased cost consciousness on the part of managers. Not only is ABC being used to assess costs associated with various services, but, increasingly, it is also being used to determine costs associated with particular customers. Customer pro�itability analysis is becoming an increasingly important issue with management.
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4.4 Activity-Based Management Aside from product costing purposes, ABC systems are also used to improve the operations of an organization. This extension of ABC is often referred to as activity-based management (ABM). The ABM philosophy is that the activities identi�ied for ABC can also be used for cost management and performance evaluation purposes.
One aspect of ABM that evolves from activity analysis is the identi�ication and elimination of nonvalue- added costs. Activities and their costs that are eliminated without deterioration of product quality and value can reduce total production time and increase pro�itability. For instance, many companies have adopted just-in-time production systems in an effort to eliminate activities related to storing and handling inventories.
Another aspect of ABM is the determination of ef�iciency and effectiveness measures for all cost- generating activities. Traditionally, accountants have been concerned only with �inancial performance measures. With ABM, performance evaluation of activities has been expanded to include many non�inancial measures. Measures dealing with quality and productivity have become particularly prominent. Indeed, the phenomenon of total quality management is considered part of ABM. Examples of non�inancial quality measures include product defect rates, number of customer complaints, number of engineering change orders, and amount of rework. Examples of non�inancial productivity measures include the ratio of value-added time to total production time, amount of production per day per employee, and square footage required per day per unit of output.
ABM also encompasses innovations such as target costing, continuous improvement, employee empowerment, and benchmarking. These cost management and performance evaluation issues are discussed in detail in Chapter 12. The remainder of this chapter covers an ABM topic that deals with product costing: JIT costing.
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4.5 JIT Costing To reduce nonvalue-added costs, many companies in recent years have adopted just-in-time (JIT) systems. These systems generally have the following characteristics:
1. Raw materials, work in process, and �inished goods inventories are reduced as much as possible, if not eliminated. Costs associated with inventories, such as storage and moving, are considered to add no value to the product. As such, the production system operates on a demand-pull basis. Raw materials are purchased only as demanded by production needs; production is scheduled only as demanded by sales orders.
2. Since little or no inventory buffers exist at various work stations, problems such as defective materials or machine breakdowns not only stop work at that station but also cause shutdowns at subsequent stations. Thus, total quality programs are emphasized in JIT environments.
3. Long-term agreements are negotiated with a small number of suppliers. The criteria for selecting suppliers focus on dependable delivery and quality.
4. Layouts of production facilities are structured in the form of focused factories, i.e., “factories within a factory.” To simplify activities, especially materials handling, machines are grouped in arrangements that allow a worker or a team of workers to perform a variety of sequential operations. These arrangements are often referred to as manufacturing cells.
5. JIT is facilitated by automation in various forms—�lexible manufacturing systems, automated materials handling systems, numerically controlled machines, computer integrated manufacturing systems, etc. Thus, in JIT environments, direct labor cost is usually not signi�icant and sometimes even nonexistent.
Due to these characteristics, �irms with JIT systems sometimes record costs differently from how it is discussed in Chapter 2. Just-in-time (JIT) costing differs from traditional costing with regard to the accounts used and the timing of cost recording. Speci�ically, three major differences exist. First, instead of using separate accounts for Raw Materials and Work in Process, JIT costing combines these into a Raw and In-Process Inventory (RIP) account. The rationale is that the amount of work in process at any particular time will be low.
A second difference is that since direct labor is usually a minor cost item in a JIT setting, no separate account for direct labor in JIT costing is created. Rather, direct labor is combined with overhead into a Conversion Cost account. In some companies, direct labor is actually included in the Overhead account.
The third difference relates to the application of overhead. In traditional environments, overhead is applied to products as they are being produced. As such, overhead is applied to and recorded into the Work in Process account. In JIT costing, overhead is not applied to products until they are completed. No Work in Process account exists to accumulate conversion costs. When products are completed under JIT costing, conversion cost is applied to the Finished Goods account. In more “pure” JIT systems, the conversion cost is applied or added to Cost of Goods Sold, since the goods are sold soon after production is completed. JIT costing is sometimes termed back�lush costing because the product costs are “�lushed” out of the accounting system and are attached to the products only after they are completed. This is the reverse of the traditional approach, which attaches costs to products, via the Work in Process account, as products are being produced.
Just as the Overhead account is closed out in the traditional cost system, the Conversion Cost account in the JIT system is closed out at the end of the period. In Chapter 2 we stated that Overhead should be closed out to Cost of Goods Sold or prorated among Cost of Goods Sold, Work in Process, and Finished Goods. With JIT costing, Conversion Cost would typically be closed out just to Cost of Goods Sold.
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To illustrate JIT costing, suppose that Rosing Tire Center sells, installs, and repairs auto and truck tires. Recently, the company has begun to consider implementing a JIT inventory system. The following transactions occurred during January:
a. Rosing purchased $17,000 of materials. b. All materials purchased were requisitioned for use. c. Rosing incurred direct labor costs of $8,000. d. Actual overhead costs amounted to $125,000. e. Rosing applied conversion (overhead) costs totaling $130,000. This includes $8,000 of direct
labor. f. All jobs were completed. No jobs were in process on January 1.
These transactions would be recorded in a traditional costing system as follows:
Materials Accounts Payable Work in Process
(a) 17,000 (b) 17,000 (a) 17,000 (b) 17,000 (f ) 147,000
(d) 125,000 (c) 8,000
(e) 122,000
Wages Payable Overhead Finished Jobs on Hand
(c) 8,000 (d) 125,000 (e) 122,000 (f ) 147,000
Under JIT costing, no entries are made for transactions (b), (c), and (e). Entry (b) is not necessary because the placement of materials into use is implied in transaction (a) when the materials are �irst received. No separate entry for (c) is made because direct labor ($8,000) is combined with overhead ($125,000) and recorded as a debit to Conversion Cost ($133,000) as part of entry (d). Finally, entry (e) is omitted because conversion cost is not applied until the jobs are completed. The entry for conversion cost application, therefore, becomes part of entry (f ).
The JIT costing system would record the January transactions in the following manner:
Raw and In-Process Inventory Accounts Payable Conversion Cost
(a) 17,000 (f ) 17,000 (a) 17,000 (d) 133,000 (f ) 130,000
(d) 125,000
Wages Payable Finished Jobs on Hand
(d) 8,000 (f ) 147,000
Note that the JIT costing system is much simpler and less expensive than the traditional system because fewer entries are needed.
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Summary & Resources
Chapter Summary Activity-based costing is a system of accounting that focuses on activities performed to produce items or services. The activities are the primary building blocks in cost accumulation. Cost drivers are used to identify costs with activities and to identify activities with products. Preliminary stage cost drivers assign support activity costs to other activity centers. Primary stage cost drivers relate costs of activities to products or services.
In designing an activity-based cost system, �ive basic steps are followed. First, assemble similar actions into activity groups. This process involves categorizing activities as unit level, batch level, product level, and facility level. Second, classify costs by activity group and by expense. Third, select the appropriate preliminary stage and primary stage cost drivers. This process eliminates distortions in cost allocations to products that result from production complexity. Fourth, calculate a cost function to link costs and the cost driver activity. Finally, �ifth, assign costs to the cost objective (often the product cost).
ABC can also be applied to nonmanufacturing activities and to service organizations. Activity-based management involves the analysis of activities for cost management and performance evaluation issues.
JIT costing differs from traditional cost systems in three respects. First, JIT costing does not use a Work in Process account. Second, JIT costing combines direct labor and overhead into one account. Third, in JIT costing, overhead is not applied to products until the products are completed.
Key Terms
activity-based costing (ABC) A system of accounting that focuses on activities performed to produce products or services.
activity-based management (ABM) A management approach that focuses on activities with the objective of improving operations.
activity center A segment of the organization for which management wants the costs of a set of activities to be reported separately.
back�lush costing The costing approach used in JIT systems, in which product costs are “�lushed” out of the accounting system and are attached to the products only after they are completed.
batch-level activities Activities that are performed each time a batch of goods is produced or handled.
batch-size diversity The manufacturing of products in different-size batches.
cost center A responsibility center where control exists over the incurrence of cost.
demand-pull
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A production system in which raw materials are purchased only as demanded by production needs, and production is scheduled only as demanded by sales orders.
facility-level activities Activities that sustain a facility’s general production process.
focused factory A factory layout that permits the production of a single product or family of products.
just-in-time (JIT) costing A method of product costing used for JIT systems.
just-in-time (JIT) systems Systems whose objective is to eliminate waste by producing a product only when it is needed and only in the quantities demanded by customers.
manufacturing cells Machines that are grouped in arrangements that allow a worker or team of workers to perform a variety of sequential operations.
nonvalue-added costs Costs that can be eliminated without deterioration of product quality and value.
preliminary stage cost driver A cost driver in an ABC system that assigns costs from activities to other activities.
primary stage cost driver A cost driver in an ABC system that assigns costs from activities to the cost objectives.
product cross-subsidization Cost distortion resulting from overcosting one product and undercosting another one.
product diversity The degree to which each product differs in the number of activities required.
product-level activities Activities that are performed as needed to support the production of each different type of product or service.
unit-level activities Activities that are performed each time a unit is produced or handled.
Problem for Review Paci�ic Highway Publishing, Inc. publishes two periodicals—North Ryde Post and Macquarie Daily—which involve the following four overhead activities, costs, and cost drivers:
Activity Overhead Cost Activity Driver
Design $275,000 Number of design changes
Receiving 62,000 Number of shipments received
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Activity Overhead Cost Activity Driver
Setup 159,000 Number of setup hours
Shipping 88,000 Number of outgoing shipments
Additional information:
Shipments Received
Setup Hours
Design Changes
Outgoing Shipments
Number of Periodicals
North Ryde Post
800 4,800 30 4,900 140,000
Macquarie Daily
200 800 10 1,400 105,000
Questions:
1. Determine the overhead cost per unit for each periodical if overhead is allocated based on volume of periodicals.
2. Determine the overhead cost per unit for each periodical if overhead is allocated using activity- based costing.
Solution:
1. Volume-based costing:
Total overhead = ($275,000 + $62,000 + $159,000 + $88,000) = $584,000
Allocation to North Ryde Post = (140,000 ÷ 245,000)($584,000) = $333,714
Unit cost for North Ryde Post = $333,714 ÷ 140,000 = $2.38
Allocation to Macquarie Daily = (105,000 ÷ 245,000)($584,000) = $250,286
Unit cost for Macquarie Daily = $250,286 ÷ 105,000 = $2.38
2. Activity-based costing: North Ryde Post
Design ($275,000) (30 ÷ 40) $206,250
Receiving ($62,000) (800 ÷ 1,000) 49,600
Setup ($159,000) (4,800 ÷ 5,600) 136,286
Shipping ($88,000) (4,900 ÷ 6,300) 68,444
Total $460,580
Divided by number of periodicals ÷ 140,000
Overhead cost per unit $3.29
Macquarie Daily
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Macquarie Daily
Design ($275,000) (10 ÷ 40) $68,750
Receiving ($62,000) (200 ÷ 1,000) 12,400
Setup ($159,000) (800 ÷ 5,600) 22,714
Shipping ($88,000) (1,400 ÷ 6,300) 19,556
Total $123,420
Divided by number of periodicals ÷ 105,000
Overhead cost per unit $1.18
Questions for Review and Discussion 1. What is a cost driver? What is its role in tracing costs to products? 2. Identify the �ive basic steps in applying activity-based costing to a costing problem. 3. De�ine an activity center. How many activity centers can exist in one production department?
Explain. 4. Describe the differences among unit-level activities, batch-level activities, and product-level
activities. 5. Explain the difference between a preliminary stage cost driver and a primary stage cost driver. 6. What is meant by product diversity? Why is it important in product costing? 7. What factors have led to an increased emphasis on accounting for nonmanufacturing costs, such
as selling, distribution, general administration, and research and development? 8. How does JIT costing differ from traditional costing? 9. Why is JIT costing sometimes referred to as back�lush costing?
Exercises 4-1. Classi�ication of Activities. Baseman Electronics, Inc. makes avionics equipment for private aircraft manufacturers. The production process takes place in three departments. The following costs were budgeted for February:
Computer programming—production $ 27,000
Custodial wages—plant 4,500
Depreciation—machinery 95,000
Depreciation—plant 60,000
Electricity—machinery 11,600
Electricity—plant 7,400
Engineering design 36,000
Equipment maintenance—wages 14,100
Equipment maintenance—parts and supplies 2,900
Heating—plant 3,200
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Inspection—production 3,800
Insurance—plant 10,000
Property taxes 9,300
Raw materials, components, subassemblies 280,000
Setup wages 19,000
Questions:
1. Identify each of the costs as one of the following: a. A unit-level activity b. A batch-level activity c. A product-level activity d. A facility-level activity
2. Specify an appropriate cost driver for tracing to the products the costs that are associated with the various activity levels previously identi�ied.
4-2. Basic ABC. Starkman Corp. uses activity-based costing and has provided the following data:
Activity Center Cost Drivers Amount of Activity Activity Center Costs
Materials handling Pounds handled 55,000 lbs. $220,000
Painting Units painted 40,000 units $320,000
Assembly Labor hours 6,000 hours $240,000
Job #45 contains 400 units. It weighs 880 pounds and uses 950 hours of labor.
Question:
Compute the total overhead cost that should be assigned to Job #45.
4-3. Primary Stage Assignment. For S. Bierman, Inc., a publisher of magazines, the Materials Handling activity center moved materials for four other activity centers. The cost of materials moved were as follows:
Activity Center Cost of Materials Moved
Receiving $45,000
Typesetting 90,000
Printing 20,000
Shipping 15,000
Materials Handling had $77,000 of direct costs and $49,000 of costs assigned to it from other activity centers. Cost of materials moved is the cost driver.
Question:
Printing will be assigned how much cost from Materials Handling?
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4-4. Overhead Cost Assignment. House of Tradition manufactures two types of hats: Black and White. The overhead activities, costs, and related data are as follows:
Black White Activity Center Costs
Receiving orders 120 180 $ 9,000
Machine hours 3,000 2,000 $90,000
Setups 50 25 $12,000
Shipping orders 250 150 $22,000
Question:
Using activity-based costing, determine the overhead costs assigned to each of the two hats.
4-5. Cost Control With ABC. The Flying Llama Travel Agency of Lima, Peru, budgets its agents’ expenses based on the following activities, cost drivers, and cost functions:
Activities Cost Drivers Cost Functions
Operations Kilometers traveled 0.60 New Sol per kilometer
Entertainment Admission expenses 15.00 New Sol per passenger
Trips Trip agent costs 300.00 New Sol per trip
Juanita Garcia spent 8,200 New Sol in September. She ran 10 trips, had 20 persons per trip, and traveled a total of 4,000 kilometers. Other agents’ spending averaged 8,600 New Sol.
Question:
Using activity-based costing, comment on Garcia’s spending for September. Also, comment on the spending of the other agents.
4-6. Job Costing With Volume-Based Costing and With ABC. Bergen Corporation has four categories of overhead, with expected costs for next year as follows.
Maintenance $820,000
Materials handling 180,000
Inspection 390,000
Setups 315,000
Job #58 is scheduled for next year and has the following estimates:
Direct materials $82,000
Direct labor (2,000 hours) $97,000
Number of inspections 95
Number of setups 88
Number of machine hours 4,500
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Number of materials moves 185
Sixty thousand direct labor hours are budgeted for next year. Expected activity for the activity-based cost drivers that could be used are:
Machine hours 34,000
Material moves 18,000
Setups 31,000
Quality inspections 37,000
Questions:
1. Determine the total cost of Job #58 if direct labor hours are used as the cost driver for overhead. 2. Determine the total cost of Job #58 if activity-based costing is used.
4-7. Activity Center Rates. The following budgeted activity data and costs are from Chernin Laundromats:
Activity Centers Direct Costs
Support Costs
Percentage of Space Used
Number of Employees
Preliminary centers:
Administration $64,000 20%
Maintenance 75,000
Primary centers:
Washing $123,000 45,000 60% 30
Drying 69,000 88,000 20% 20
Administration uses number of employees as its cost driver. Maintenance uses percentage of space used as its cost driver. Washing uses machine hours as its cost driver and has budgeted 42,300 hours this month. Drying also uses machine hours as its cost driver and has budgeted 40,100 hours this month.
Question:
Find the cost rates that will be used this month in each primary center.
4-8. Product Costing With ABC. Linda Irvin, the controller of Sonya Electronics, wishes to use activity- based costing for a new circuit board produced for personal computers. Irvin has identi�ied the following activities associated with circuit board production and the related conversion costs forecast for the period:
Activity Conversion Cost
Purchasing of parts $ 72,000
Starting the product 90,000
Inserting the components 150,000
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Activity Conversion Cost
Soldering the boards 180,000
Testing the quality 140,000
The cost drivers which Irvin intends to use, as well as the amounts of activity forecast for the period, are:
Activity Cost Driver Cost Driver Amounts
Purchasing of parts Number of parts purchased 12 per board
Starting the product Number of boards started 60,000
Inserting the components Number of insertions 10 per board
Soldering the boards Number of boards soldered 60,000
Testing the quality Number of testing hours 2,000
Each circuit board has anticipated direct materials costs of $36. In addition, each circuit board takes, on average, 15 minutes to test.
Question:
Determine the cost of a circuit board produced by Sonya Electronics.
4-9. Finding Missing Costs. Susan Robinson, the operations manager for Goldie’s Towing Service, is unable to locate the 2018 budget. You have managed to recover the following information for her:
Activity Center Budgeted Overhead Cost Cost Driver
Budgeted Cost Driver Level
Dispatching $14,000 Number of calls 350 calls
Towing 42,000 Towing hours 600 hours
Billing and Collection
15,000 Pages of forms processed
5,000 pages
Miscellaneous ? Labor hours 10,000 hours
Overhead
You have also obtained the following information pertaining to the Southern Region, which you learned was assigned an overhead cost of $9,500:
Labor hours 2,000
Number of calls 50
Towing hours 55
Pages of forms processed 430
Question:
Determine the amount of Miscellaneous Overhead that was budgeted for 2018.
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4-10. Overhead Cost Assignment. Helene’s Tennis Experts is a company that specializes in installing and resurfacing tennis courts. Using ABC, the company has assigned all overhead costs into �ive cost pools. The budgeted amounts for these cost pools and their associated cost drivers are:
Overhead Cost Pool Budgeted Costs Cost Driver
Budgeted Level for Cost Driver
Purchasing and materials- related
$230,000 Materials costs $1,450,000
Engineering 97,000 Engineering hours
5,300 hours
Of�ice and storage rental 125,000 Square feet of jobs
478,500 sq. ft.
Equipment depreciation 150,000 Direct labor cost $998,000
General administration 280,000 Direct labor hours
88,000 hours
The company has just completed resurfacing Thompson Park Tennis Courts, which had the following cost driver data:
Materials cost $39,000
Direct labor cost $15,200
Engineering hours 62
Square feet of jobs 4,100
Direct labor hours 75
Question:
Determine the total overhead cost that would be assigned to Thompson Park Tennis Courts.
4-11. Product Costing With ABC. Budgeted unit costs and production for the two products made by Monica’s Cat Foods, Inc. are as follows:
Kitty Gourmet Cat Yummies
Units of product 375,000 225,000
Direct materials $28 $22
Direct labor $75 $45
Other information for the coming year follows:
Activity Budgeted Costs Cost Driver
Required Units of Cost Drivers
Kitty Gourmet Cat Yummies
Machining $5,550,000 Machine hours 34,000 30,000
Inspection 51,000 Number of batches 500 700
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Activity Budgeted Costs Cost Driver
Required Units of Cost Drivers
Kitty Gourmet Cat Yummies
Shipping 88,000 Number of shipments 100 750
Purchasing 17,000 Number of orders 35 25
Machine setup 360,000 Setup hours 3,200 1,800
Question:
Using ABC, compute the budgeted unit costs for each of the two products made by Monica’s Cat Foods, Inc.
4-12. Preliminary and Primary Stage Allocations. Maryland Forklift Manufacturing produced 100 electric forklifts and 150 propane forklifts during the year. Amy Mitchell, the controller, reported the following traceable costs, other than direct materials and direct labor, for its activity centers:
Activity Center Costs
Plant Administration $ 66,000
Setup Operations 24,000
Materials Handling 47,000
Machining 180,000
Assembly 150,000
Data for the preliminary stage cost assignment are as follows:
Activity Center
Activity Centers Using Resources and Receiving Costs
Setup Operations Machining Assembly
Plant Administration 5% 40% 55%
Materials Handling 65% 35%
Data for the primary stage cost assignment are as follows:
Activity Center
Cost Driver Activity Linked to Each Product
Cost Driver Electric Propane
Setup Operations Number of setups 30 setups 20 setups
Machining Machine hours 250 hours 150 hours
Assembly Labor hours 6,000 hours 9,000 hours
Question:
Determine the overhead cost per unit assigned to each type of forklift.
4-13. Customer Cost With ABC. The following cost data have been accumulated for Shenk Tuxedo Rentals:
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Activity Center Cost Driver Amount of Activity Activity Center CostsActivity Center Cost Driver Amount of Activity Activity Center Costs
Selling Labor hours 825 hours $29,000
Alterations Number altered 200 units 6,500
Cleaning and Preparation Number rented 750 units 16,800
General Overhead Labor hours 825 hours $52,000
Scott Jacobson, a customer, necessitated two hours of selling time. He rented seven tuxedos, and three of them required alterations.
Question:
Compute the total cost that should be assigned to Scott Jacobson.
4-14. Recording Transactions Under JIT Costing. Hyeun-Suk Rhee, owner of Taegu Supply Company in South Korea, which manufactures chopsticks for restaurants, has recently decided to implement a JIT cost system. Transactions (in South Korean won) for August are as follows:
a. Raw materials were purchased at the cost of W950,000. b. All materials purchased were requisitioned for production. c. Direct labor costs of W2,500,000 were incurred. d. Actual factory overhead costs amounted to W6,000,000. e. Applied conversion costs totaled W8,100,000. This included W2,500,000 of direct labor. f. All units were completed.
Question:
Enter the August transactions into T-accounts. Label these entries by the identifying letters.
Problems 4-15. Activities and Cost Drivers for an Employment Agency. Kelsey Relocation Services is an employment agency working speci�ically with mid-level executives looking for new career opportunities or seeking employment after a layoff. The company views its product as placements. These are identi�ied in four categories: employer-paid fee, applicant-paid fee, out-placement contract, and executive-search contract.
The agency incurs a number of costs in performing its services. Those costs are classi�ied as operating expenses as follows:
Acct # Account Title
402 Salaries and Wages
403 Payroll Taxes
404 Employee Bene�its
408 Of�ice Supplies (postage, stationery, etc.)
409 Dues and Publications
410 Utilities
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Acct # Account Title
412 Rent
413 Repairs and Maintenance (contracted from outside)
420 Business Promotion
421 Auto Expenses
422 Travel Expenses
430 Professional Fees
432 Collection Expenses
435 License
441 Property Taxes
444 Insurance Costs
445 State Franchise Tax
447 Bad Debt Expense
448 Depreciation and Amortization
449 Miscellaneous
Questions:
1. Classify each cost as related to unit-level, batch-level, product-level, or facility-level activities. Indicate an appropriate cost driver for each cost.
2. With the information from Part (1), group costs into logical activity groups and specify a cost driver for each activity group.
3. Explain what differences exist between applying activity-based costing to a manufacturing �irm and to an employment agency.
4-16. Cost Estimation With Volume-Based Costing and ABC. Neil’s Customized Gift Service (NCGS) contracts with corporate clients to print their logos and emblems on small giftware items such as pens, cups, calculators, coasters, etc. Cal Nitz, the controller of NCGS, has provided the following information on overhead cost estimates for 2018:
Activity Estimated Cost Cost Driver
Supervision $855,000 Direct labor hours
Power 450,000 Kilowatt hours
Maintenance 720,000 Machine hours
Setups 225,000 Setup hours
The following are estimated 2018 and planned January activity levels of the cost drivers:
Cost Driver Estimated Activity for 2018 Planned Level in Jan. 2018
Direct labor hours 300,000 35,000
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Cost Driver Estimated Activity for 2018 Planned Level in Jan. 2018
Kilowatt hours 150,000 12,000
Machine hours 120,000 10,000
Setup hours 100,000 8,000
Questions:
1. Estimate overhead costs for January 2018 using direct labor hours as the allocation base. 2. Estimate overhead costs for January 2018 using activity-based costing.
4-17. Overhead Cost Assignment – ABC and Overall Rates. Kallus Airlines uses activity-based costing for its ground handling department. The department has assigned all overhead costs into seven activity cost pools. The budgeted amounts and the associated cost drivers for these cost pools are as follows:
Activity Cost Pool Budgeted Costs Cost Driver
Budgeted Level for Cost Driver
Loading and unloading cargo $ 250,000 Pounds of cargo 2,000,000 lbs.
Directing planes to and from gates
110,000 Directing distance 5,500 miles
Loading and unloading baggage
300,000 Bags loaded & unloaded
100,000 bags
Communicating with pilots 80,000 Communication time 2,000 hours
Fueling planes 450,000 Fueling time 10,000 hours
Deicing planes 75,000 Deicing time 1,000 hours
Locating mishandled bags 200,000 Number of inquiries 5,000 inquiries
Total $1,465,000
A �light has just been completed with the following cost driver information available:
Pounds of cargo 40,000
Directing distance (miles) 1.5
Bags loaded & unloaded 200
Communication hours 0.9
Fueling hours 2.2
Deicing hours 0
Number of inquiries 3
Questions:
1. Determine the total overhead cost that would be assigned to the �light. 2. Compare the total overhead cost computed in Part (1) with one obtained by using an overall
overhead rate based on number of bags loaded and unloaded.
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4-18. ABC and Volume-Based Costing for Marketing Studies. Janet Emerson & Associates, a marketing research �irm, uses ABC and has budgeted the following overhead costs and cost drivers (10,000 direct labor hours were budgeted):
Activities Cost Driver Budgeted Cost Budgeted Activity Level
Phoning Number of calls $25,000 80,000
Mailing Number of mailings 15,000 40,000
Personal visits Miles driven 10,000 50,000
The following data were collected on three market research studies completed:
Study #15 Study #19 Study #23
Direct materials cost $ 6,020 $ 5,425 $ 4,885
Direct labor cost $15,660 $12,235 $19,650
Direct labor hours 140 110 175
Number of calls 500 300 700
Number of mailings 7,000 6,000 2,000
Miles driven 900 1,300 1,600
Questions:
1. Using volume-based costing with direct labor hours as the cost driver, calculate the total cost of each of the three studies.
2. Using ABC, calculate the total cost of each of the three studies.
4-19. Two-stage Allocation and Overhead Rates. Radzeli Corp. has provided the following information about overhead costs traceable to its activity centers:
Activity Center Overhead Cost Cost Driver
Maintenance $90,000 Maintenance hours
Receiving 40,000 Receiving orders
Fabrication 150,000 Labor hours
Assembly 280,000 Machine hours
The following activities were reported:
Activity Center Maintenance Hours Receiving Orders Labor Hours Machine Hours
Fabrication 200 30 1700 450
Assembly 800 120 1300 550
Overhead allocations involving Maintenance and Receiving are performed in the preliminary stage; overhead costs for Fabrication and Assembly are assigned to products in the primary stage.
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Question:
Compute the overhead rates for product costing in Fabrication and Assembly.
4-20. Distortion of Product Pro�itability. The Chromosome Manufacturing Company produces two products, X and Y. The company president, Gene Mutation, is concerned about the �ierce competition in the market for product X. He notes that competitors are selling X for a price well below Chromosome’s price of $12.70. At the same time, he notes that competitors are pricing product Y almost twice as high as Chromosome’s price of $12.50.
Mr. Mutation has obtained the following data for a recent time period:
Product X Product Y
Number of units 11,000 3,000
Direct materials cost per unit $3.23 $3.09
Direct labor cost per unit $2.22 $2.10
Direct labor hours 10,000 2,500
Machine hours 2,100 2,800
Inspection hours 80 100
Purchase orders 10 30
Mr. Mutation has learned that overhead costs are assigned to products on the basis of direct labor hours. The overhead costs for this time period consisted of the following items:
Overhead Cost Item Amount
Inspection costs $16,200
Purchasing costs 8,000
Machine costs 49,000
Total $73,200
Questions:
1. Using direct labor hours to allocate overhead costs, determine the gross margin per unit for each product.
2. Using activity-based costing, determine the gross margin per unit for each product. 3. How do your answers to Parts (1) and (2) help explain the observations made by Gene Mutation
about competitors?
4-21. Preliminary and Primary Stage Allocations. Krohn Movers has a pricing structure that distinguishes between local and out-of-town moving jobs. During the year, the local jobs involved 175,000 miles; and the out-of-town jobs involved 250,000 miles. The following traceable costs are reported by Anita Stein, the controller, for Krohn’s activity centers:
Activity Center Materials Labor Other Costs
#1100 $75,000
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Activity Center Materials Labor Other Costs
#1200 60,000
#2300 25,000
#3100 $36,000 $45,000 80,000
#3200 52,000 88,000 92,000
Data for the preliminary stage cost assignment are as follows (in the order shown):
Activity Center
Activity Centers Using Resources and Receiving Costs
#2300 #3100 #3200
#1100 10% 40% 50%
#1200 25% 60% 15%
#2300 80% 20%
Data for the primary stage cost assignment are as follows:
Activity Center
Jobs Using Resources and Receiving Costs
Local Out-of-Town
#3100 75% 25%
#3200 35% 65%
One-fourth of the materials and labor costs are traceable to local jobs and the remainder to out-of-town jobs.
Question:
Determine the per-mile costs for local jobs and for out-of-town jobs.
4-22. Activity-Based Costing for a Tour Company. Macquarie Tour Company provides tours in Australia and uses an activity-based cost system. The basic 10-day package covers the east coast, including Sydney, Melbourne, Canberra, Brisbane, and the Great Barrier Reef. The deluxe 21-day package adds the outback, west coast, and other areas, including Darwin, Tasmania, Adelaide, Perth, and Alice Springs. Direct labor (drivers, tour guides) and materials costs (e.g., fuel, brochures, various drinks and refreshments) for 2018 were (in Australian dollars):
10-Day Package 21-Day Package
Direct labor A$670,000 A$1,770,000
Materials A$10,800 A$22,400
The following additional information for 2018 was provided by the owner, David Rogut:
Activity Overhead Cost Cost Driver
Activity (Cost Driver) Level
10-Day Package 21-Day Package
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Activity Overhead Cost Cost Driver
Activity (Cost Driver) Level
10-Day Package 21-Day Package
Advertising A$56,700 No. of ads 150 175
Organizing itinerary A$89,300 No. of tours 55 72
Touring A$380,500 No. of tourists 2,725 3,130
Question:
Compute the total cost per tour for each of the two tour packages.
4-23. Recording Transactions under JIT Costing. Phil’s Jewelry Factory manufactures a variety of costume jewelry. The owner, Phil Joseph, has recently decided to implement a JIT cost system. Transactions during September were as follows:
a. Raw materials totaling $45,000 were purchased. b. All materials purchased were requisitioned for production. c. Direct labor costs of $11,000 were incurred. d. Indirect labor costs amounted to $120,000. e. Utilities costs totaled $15,000. f. Other actual factory overhead costs amounted to $85,000. g. Applied conversion costs totaled $221,000. This includes the direct labor costs. h. All units were completed.
Questions:
1. Enter the September transactions into T-accounts. Label these entries by the identifying letters. 2. Determine the amount of overapplied or underapplied conversion cost for the month.
4-24. JIT and Conventional Costing. Sidlow Industrial Products manufactures automated materials- handling systems. The company currently uses a conventional job cost system. During November, the company plans to purchase $96,000 of raw materials. Of this amount, 75% will be used for current production, while the remainder will serve as a buffer in inventory. Direct labor cost is expected to be $18,000 during November, and the actual factory overhead is anticipated to total $85,000. The applied factory overhead is expected to be $90,000. By the end of the month, two materials-handling systems should be completed; no systems were in process at the beginning of the month or at the end of the month.
Anne Glaser, the owner, has been considering the use of a JIT inventory system. If implemented at the beginning of November, only the materials needed for current production would be purchased.
Questions:
1. Using T-accounts, enter the November transactions for the purchase and usage of materials under: a. Conventional costing b. JIT costing
2. Using T-accounts, enter the November transactions for the labor and actual overhead costs under: a. Conventional costing b. JIT costing
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3. Using T-accounts, enter the November transactions for the application of overhead costs and the completion of the materials-handling systems under:
a. Conventional costing b. JIT costing
Case: Druid Valley Apartments
Druid Valley Apartments (DVA) has 18 apartment buildings with a total of 600 units—420 two- bedroom units and 180 one-bedroom units. Also, the complex contains a sports area which has a basketball court, exercise room, tennis court, and two activity rooms. The sports area was used by 475 residents this past year. DVA currently has 1,580 tenants—280 in one-bedroom units and 1,300 in two-bedroom units. The one-bedroom apartments occupy 90,000 square feet, while the two-bedroom apartments occupy 275,000 square feet. The sports area occupies 35,000 square feet.
Jerry Siegel, DVA’s Chief Operations Of�icer, oversees the day-to-day operations of the apartment complex. Doug Ross supervises the sports area. He organizes programs, classes, and other activities. The facilities are managed by Bruce Gaynes, who oversees the staff for building maintenance and grounds. Sylvia Miller does the bookkeeping, and Colleen Weston is the secretary/receptionist.
The following expense report for the past year was given to Jerry Siegel:
Expense Items Amounts
Administrative salaries $ 227,000
Custodial costs 177,000
Maintenance costs 90,000
Instructor/trainer costs 60,000
Grounds costs 55,000
Heat and electricity 42,000
Water 98,000
Of�ice supplies 13,000
Building depreciation 795,000
Equipment depreciation 130,000
Liability and property insurance 720,000
Advertising 51,000
Telephone 17,000
Newsletter 10,000
Interest 20,000
Postage 11,000
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Expense Items Amounts
Miscellaneous 27,000
Total expenses $2,543,000
Siegel wondered what it cost to operate the apartment units and the sports area. He contacted his CPA, Ian Ratner, who convinced him to install an activity-based costing (ABC) system. Siegel engaged Ratner to do this.
After discussions with DVA staff, Ratner developed a list of eight activities that seemed to capture the operations at DVA:
No. Activity
1 Attracting new residents
2 Servicing current residents
3 Maintaining the buildings
4 Maintaining the grounds
5 Cleaning the apartments/sports area
6 Providing recreational programs
7 Collecting rent and fees
8 Sustaining the business
Activity 6, “providing recreational programs,” included classes, personal training, resident meetings, and any other events that took place in the sports area. Activity 8, “sustaining the business,” is a catchall that includes tasks such as accounting, purchasing, general of�ice management, and human resource management.
Ratner’s next task was to assign costs to the eight activities. He asked all DVA administrative personnel to �ill out estimates of how they spent their time, on average, during the past year. These estimates were as follows:
J. Siegel D. Ross B. Gaynes S. Miller C. Weston
Salary: $67,000 $48,000 $44,000 $35,000 $33,000
Activity:
Attracting new residents 10% 5%
Servicing current residents 20% 20% 15% 10%
Maintaining the buildings 5% 30%
Maintaining the grounds 5% 25%
Cleaning the apts./sports area 5% 30%
Providing rec. programs 65%
Collecting rent and fees 10% 60%
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J. Siegel D. Ross B. Gaynes S. Miller C. Weston
Sustaining the business 45% 10% 15% 25% 90%
Total 100% 100% 100% 100% 100%
Some costs were assigned entirely to one activity. These included interest expense, instructor/trainer costs, custodial costs, maintenance costs, and grounds costs. The latter three costs consist of wages to workers as well as various supplies. Of�ice supplies, equipment depreciation, telephone, postage, and miscellaneous expenses were distributed evenly to all eight activities. The remaining costs were assigned as follows:
Cost Assignment
Heat and electricity 10% to activity 1; 20% to activity 2; 40% to activity 6; 10% to activity 7; 20% to activity 8
Water 70% to activity 2; 15% to activity 4; 15% to activity 6
Building depreciation 95% to activity 2; 5% to activity 6
Liability and property insurance
60% to activity 2; 10% to activity 6; the remainder evenly
Advertising 90% to activity 1; 10% to activity 6
Newsletter 75% to activity 2; 25% to activity 6
After this cost assignment, Ratner decided to allocate evenly the costs that had been assigned to activity 8 to the other seven activities. Having done this, he then assigned the costs of these seven activities to the one-bedroom units, two-bedroom units, and sports area using the following cost drivers:
Activities Cost Driver Cost Objects
Attracting new residents Number of units 1-bedroom units, 2-bedroom units
Servicing current residents Number of residents 1-br. units, 2-br. units, sports area
Maintaining the buildings Square footage 1-br. units, 2-br. units, sports area
Maintaining the grounds Square footage 1-br. units, 2-br. units, sports area
Cleaning the apts./sports area Number of residents 1-br. units, 2-br. units, sports area
Providing recreational programs sports area
Collecting rent and fees Number of residents 1-br. units, 2-br. units, sports area
Question:
Determine the total costs assigned to the one-bedroom units, two-bedroom units, and sports area. For the apartment units, also compute the costs per unit. Comment on these costs.
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Practice Problems in Action
Watch the video below for a step-by-step tutorial on how to solve the following problem using Excel. The video is best viewed in full-screen mode. For a transcript of the directions included in this tutorial video click here (https://ne.edgecastcdn.net/0004BA/constellation/PDFs/BUS630_2e/Chapter-4_Tutorial- Transcript_FINAL.pdf) .
Problem A large auto parts manufacturer is organized functionally into three divisions: Operations, Sales, and Administrative. Purchasing, receiving, materials and production control, manufacturing, factory personnel, inventory stores, and shipping activities are under the control of the Chief Of�icer of Operations.
Advertising, market research, and sales are the responsibility of the Director of Sales.
Accounting, budgeting, the �irm's computer center, and general of�ice management are delegated to the corporate controller (Administrative). The following cost categories are found in the company as a whole:
a. Depreciation on factory equipment. b. Assembly foreman's salary. c. Advertising supplies used. d. Direct labor in the Assembly Department. e. Cost of hiring new employees. f. Payroll fringe bene�its for workers in the Shipping Department.
Questions 1. Identify each of the costs with the appropriate division: Operations, Sales, Administrative. 2. Identify each of the costs with one of the following:
a. Unit-level activities b. Batch-level activities c. Product-level activities d. Facility-level activities
Organize these classi�ications by division: Operations, Sales, Administrative. 4. Specify an appropriate cost driver for tracing costs associated with the various levels of activities
to the next cost objective or products, whichever is appropriate.
Tutorial Video: Allocating costs
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