Mendel Paper Company

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Learning Objectives

After studying Chapter 1, you will be able to:

Distinguish between �inancial accounting and managerial accounting.

Recognize the primary roles and ethical responsibilities of the management accountant.

De�ine, distinguish, and illustrate key cost concepts.

Understand the differences in cost �lows among service, merchandising, and manufacturing enterprises.

Distinguish between the behavior of variable and �ixed costs and formulate cost functions.

Understand cost terms relating to planning and control.

1 Managerial Accounting and Cost Concepts

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Introduce the concept of contribution margin and its variations.

The Controller’s Work Day: Where Did the Time Go?

It’s early October. Mary Rosen, Controller of Herschel Software Products, has just arrived at her of�ice at about 7:30 a.m. She scans her email messages, checks her electronic calendar, and looks through her in-basket. She says, “Wow, another ‘normal’ day!” She wonders if she’ll make her tennis date with her husband at 6 p.m. Her calendar shows:

9:00 Meet with division head of Customer Support to discuss next year’s budget numbers. Review preliminary budget numbers before meeting.

10:00 Meet with accounting systems analysts to discuss status of a project to improve the �irm’s monthly management “plan versus actual” reporting system.

11:30 Hold a quick session with Marketing Vice-President, Gary Martin, to discuss pricing negotiations with new customer.

12:15 Have working lunch with corporate attorney to discuss customer contract wording for a new product being introduced early next year.

2:00 With budget manager, review September’s actual results and budget comparisons and identify problem areas. Also, review third quarter results before her presentation to the President at Friday’s staff meeting.

4:00 Review a special cost-volume-pro�it study of Herschel Software Products, relative to the �irm’s strategic plan’s pro�itability goals.

Mary also knows that she needs to:

Respond to four email questions about product costs and operating expenses. Talk to Steve Simcha, New Product Development Vice-President, about a serious cost- overrun problem with a new product project. Prepare a presentation on cash �lows for the �irm’s strategic planning meeting next month. Write a memo supporting the spending of $100,000 by the Marketing Vice-President on media contracts.

Every meeting, discussion, and decision that Mary has today, and every day, uses accounting information. She must generate relevant data in the right form and at the right time. She and her fellow managers must understand cost behavior, cost/bene�it analyses, plan versus actual comparisons, and how to use information to achieve Herschel Software Products’ long-term and short-term goals.

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Managers make decisions. Managers select one or more alternatives from a set of choices. Making the best choice depends on the manager’s goals, the expected results from each alternative, and the information available when the decision is made. Decision-making information is the focus of this text. Collecting, classifying, reporting, and analyzing relevant information are fundamental to every action that managers take. Management accountants prepare information for decision makers. In this chapter, the stage is set for discussing how management accountants are involved in decision making. First, we discuss the distinction between �inancial and managerial accounting.

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1.1 The Dual Roles of Accounting Information The accounting system generates the information that satis�ies two reporting needs that coexist within an organization: �inancial accounting and managerial accounting. Figure 1.1 shows the primary interested parties and the typical reports generated to serve these two user groups.

Figure 1.1: Scope of �inancial and managerial accounting

Financial Accounting

Financial accounting is the branch of accounting that organizes accounting information for presentation to interested parties both inside and outside of the organization. The primary �inancial accounting reports are the balance sheet (often called a statement of �inancial position), the income statement, and the statement of cash �lows. The balance sheet is a summary of assets, liabilities, and shareholders’ equity at a speci�ied point in time. The income statement reports revenues and expenses resulting from the company’s operations for a particular time period. The statement of cash �lows shows the sources and uses of cash over a time period for operating, investing, and �inancing activities.

Most businesses are complex, and guidelines (known as generally accepted accounting principles or GAAP) are provided for �inancial reporting. The Financial Accounting Standards Board (FASB), the Securities and Exchange Commission (SEC), and the Public Company Accounting Oversight Board (PCAOB) oversee the development of these principles, corporate �inancial reporting responsibilities, and internal control standards. Internationally, while some countries have developed their own accounting principles, many countries have adopted standards set by the International Accounting Standards Board (IASB).

Owners, Investors, and Creditors Shareholder-owned �irms rely heavily on owners, investors, and creditors (providers of short-term credit and long-term loans) for sources of capital. Shareholders and investors use accounting reports to decide

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whether to buy, sell, or hold the �irm’s stock. Also, creditors assess whether the �irm is able to pay its debts on time.

Taxing Authorities The assessment of many taxes is based on accounting information submitted by the taxpayer. Examples of such taxes include income taxes, sales taxes, use taxes, franchise taxes, excise taxes, property taxes, and gift and estate taxes. In most cases, the dominant taxing authority is the federal government and its tax collection agency, the Internal Revenue Service.

Regulatory Agencies Local, state, and federal agencies regulate a substantial portion of business activity in the United States. Much regulation is implemented through or involves accounting reports.

Industry Associations Most industries have an association that gathers important statistics about the national and international industry. A large part of the information they provide comes from accounting reports provided by member �irms. Examples include corporate annual reports, call reports for banks, and auto dealership sales reports.

Managers and Employees Managers typically have direct vested interests in their �irms’ results. Performance bonuses, stock options, and incentive compensation programs are common. Thus, managers are not passive observers as to how certain transactions are recorded. Firm policies, performance evaluation methods, and compensation systems should encourage managers to act in the best interests of themselves and the �irm as a whole.

The �irm’s executives are responsible to the board of directors and shareholders for the �irm’s �inancial results. Numerous examples of changes in high-level executive positions reaf�irm the importance of achieving strong pro�its to remain in power and employed. Based in part on �inancial statement information, employees make decisions about continued employment, union wage demands and contract negotiations, adequacy of pension plans, and employee stock purchase or savings plans. Pro�it sharing may encourage employees to want the company to be �inancially successful.

Managerial Accounting

Managerial accounting is the branch of accounting that meets managers’ information needs. Whereas �inancial accounting has a backwards focus, i.e., focusing on historical information, managerial accounting focuses more on the future. Because managerial accounting is designed to assist the �irm’s managers in making business decisions, relatively few restrictions are imposed by regulatory bodies and generally accepted accounting principles. Therefore, a manager must de�ine which data are relevant for a particular purpose and which are not.

Differences Between Managerial and Financial Accounting

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Several important differences distinguish managerial accounting from �inancial accounting. First, managerial accounting is not subject to the same rules and principles as is �inancial accounting. In many cases, “common sense” is the most important guide for decision makers.

A second difference is that �inancial accounting relies on accounting principles structured around the accounting equation. Management reports, on the other hand, are designed to meet managers’ needs. These reports often use estimates and forecasts, use different values for the same events, do not balance in a debit/credit sense, and are designed for particular decisions or analyses. The expression “different costs for different purposes” has long been used to describe relevance. Relevant information has an impact on the decision analysis. Irrelevant data have no impact.

Another difference is that managerial accounting focuses on segments of the organization as well as on the whole organization. The primary interest of �inancial accounting is the company as a whole. In managerial accounting, however, the segment is of major importance. Segments may be products, projects, divisions, plants, branches, regions, or any other subset of the business. Tracing or allocating costs, revenues, and assets to segments creates dif�icult issues for managerial accountants.

Two important similarities do exist. The same transaction and accounting information systems are used to generate the data inputs for both �inancial statements and management reports. Therefore, when the system accumulates and classi�ies information, it should do so in formats that accommodate both types of accounting. The other similarity is the manner in which accountants measure costs, de�ine assets, and specify accounting periods. Many concepts underlie accounting information, whether the data are later used for �inancial or managerial reporting. Recording the results of events is often based on rationales that are common to both �inancial and managerial accounting. We must understand what is a common thread and what must be independently collected.

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1.2 Role of the Management Accountant Although the top accounting-oriented people in an organization are the chief �inancial of�icer and the controller, the accounting and �inancial management functions contain a range of jobs. A variety of careers is available as shown in Figure 1.2; these careers can frequently be paths to executive management.

Figure 1.2: Management accounting job titles

A management accountant maintains accounting records, prepares �inancial statements, generates managerial reports and analyses, and coordinates budgeting efforts. The management accountant is an advisor, an internal consultant, and an integral part of management. The controller is responsible for managing the entire accounting function. The controller in�luences management by answering questions like: What information should be reported? What format best displays the information? How can data be collected and processed? By the nature of the job, the management accountant applies management principles and often is a major player in decision making itself.

Certi�ied Management Accountant

The Certi�ied Management Accounting program recognizes a person’s achievement of a speci�ic level of knowledge and professional skill. Becoming a Certi�ied Management Accountant (CMA) is considered an important professional step for anyone desiring to become a management accounting or �inancial executive. The CMA program was founded on the principle that a management accountant is a contributor to and a participant in management.

To qualify for the CMA designation, candidates must pass a comprehensive examination and meet speci�ic educational and professional standards and experience requirements. To remain a CMA, a person must meet continuing educational requirements and adhere to the program’s “Statement of Ethical Professional Practices.” The Institute of Management Accountants (IMA) is the professional organization of management accountants and sponsors the CMA designation.

Ethical Conduct of Management Accountants

Earlier in the chapter, we discussed managers’ needs for accounting information. We assumed that whatever information the accounting system generates is presented and used in an ethical manner. Ethical

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conduct is a necessary asset of a managerial accountant. The credibility of the information provided, analyses done, and opinions offered depends heavily on the reputation of the responsible accountant. Independence, competence, lack of bias or favoritism, trust, and objectivity are key elements in establishing credibility.

While true for all managers, management accountants in particular must maintain integrity and ethical behavior and must make top management aware of unethical behavior on the part of others within the organization. This does not mean the management accountant is a police of�icer. Rather, the management accountant promotes and encourages ethical behavior in all aspects of business life.

Ethical standards of businesspersons have been given much more visibility and scrutiny in recent years. Issues that appear again and again in management careers test the ethical standards of everyone. Among common ethical issues are:

Business practices and policies. Practices that seem harmless on the surface may encourage or require employees or managers to be deceitful or dishonest. Objective reporting. Because situations exist where prejudiced reporting of certain numbers may in�luence decisions, accountants are guided by goals of unbiased reporting and professional judgment. Colleague behavior. Even if we have high ethical standards, people around us may not be so disposed. Many policies and internal controls are in place in organizations to prevent wrongdoing and to encourage proper behavior. In addition, you should not compromise your personal integrity by condoning unethical behavior in others. Competitors. Winning is part of the business “game.” But to do so in a fair environment is critical. Using true product and competitor data; following corporate policies; and abhorring bribes, kickbacks, and other similar payments are easy examples. Many �irms provide behavior guidelines and policies to purchasing and sales personnel who are at particular risk in giving and receiving favors and improper inducements. Tax avoidance and evasion. Tax burdens can be signi�icant. Proper planning and careful use of tax laws to minimize the organization’s tax liability are acceptable. Tax avoidance is legitimate. Inappropriate use of the same laws or use of deceit to hide income or overstate deductions is tax evasion, which is unethical as well as illegal. Con�identiality. Internal data are developed for managers’ use. Disclosures outside the �irm often require review and approvals. Privacy of competitive, personnel, and negotiating data is critical. Negative examples of overheard conversations in elevators, on golf courses, and at lunches that lead to lost business, embarrassment, and lawsuits are unfortunately common. Con�identiality also demands that “insider” information should not be used for anyone’s personal advantage. Appearance of independence. The accountant should be independent in situations where the resulting information is used for analysis and decision making. Independence applies to both actual independence and the appearance of independence. If it appears that the management accountant is biased because of that person’s conduct, associations, or vested interests (possible promotion, salary increases or bonuses, or investments), the information provided is tainted and open to doubt by other decision makers. Corporate loyalty and personal advancement. Many situations exist in which, because of an unethical act, the reputation of the �irm itself is in danger. Alternately, an unethical act may seem to ensure your personal enhancement in some manner. Sometimes reporting an unethical act will endanger the future of the person reporting the act. These are all dif�icult dilemmas, pitting right against wrong, and not always in an obvious way.

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While space and time do not allow us to develop approaches for resolving these problems here, it is clear that ethical issues underlie management accountants’ professional and day-to-day activities. Each person must develop a method of handling ethical problems. Of primary importance is the ability to see an ethical dilemma when it faces us. Once identi�ied, the situation may cause us to request advice. Numerous sources are available for guidance, including:

Personal values. We would like to think that our own value system is “ethical” and provides enough guidance. Clearly, this is our main line of defense against “wrong.” Corporate policies and ethics statements. Many �irms have statements on expected employee behavior or written policies and procedures on how a range of situations should be handled. These statements do set limits or barriers and may describe expected levels of behavior. Some companies also offer ethics seminars and classes to their employees. Laws. “If it’s legal, it must be okay” is often used a basis for de�ining ethical behavior. This is absolutely not true. Laws are developed in a political process, often without much serious consideration for the ethical conduct of any parties involved. It’s highly probable that if the behavior is illegal, it is also unethical. Professional standards. Most professions have developed a statement of ethical standards for their members. Figure 1.3 presents a statement developed for management accountants. These statements are basic standards of behavior and give professional guidance in many areas. Supervisors, internal auditors, and other company of�icials. These are often persons with more experience and broader understanding of con�licting issues and of corporate attitudes. An ethical situation, however, may involve a supervisor or other corporate of�icial, which may make the dilemma much more sensitive and severe. A few companies have created an ombudsperson position to assist employees in handling delicate situations. Counselors from outside of the organization. This is a last resort and generally violates another ethical consideration—con�identiality. While close friends, a spouse, or a personal counselor may seem like logical sources of advice and support, the nature of the dilemma may require con�identiality until all other avenues of resolution are exhausted. Merely consulting outsiders presents serious risks of unauthorized disclosure that may only further complicate an issue.

Even though all of these options may exist, we each need to develop a rational approach to identifying, analyzing, and deciding on ethical issues that confront us. Management accountants must be aware of ethical dilemmas, perhaps more than the typical manager, because of their responsibility for decision- making information and their involvement in many decision-making processes.

The Institute of Management Accountants believes ethics is a cornerstone of its organization and recognizes the importance of providing ethical guidance. The IMA has developed Standards of Ethical Professional Practice. That statement is presented in Figure 1.3. The Standards are broken into four sections: competence, con�identiality, integrity, and credibility. Competence refers to the skills that the accountant brings to the job. Con�identiality is de�ined as protecting the access to and use of information. Integrity focuses primarily on the personal behavior and interactions of the management accountant. Credibility, as de�ined here, is primarily directed toward disclosure of unbiased information.

Figure 1.3: Institute of Management Accountants’ Standards of Ethical Professional Practice

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IMA (Institute of Management Accountants). Reprinted with permission.

Using Cost Information

Much of managerial accounting deals with cost information. Understanding cost behavior and knowing which costs to consider and which to ignore are critical to making decisions in business and in everyday life situations. Managers use cost information in many different ways. Cost data are especially important in these areas:

Planning. Estimating future costs in preparing budgets and in projecting operating activities. Decision making. Considering costs relevant to a wide variety of decision-making processes. Cost control. Measuring costs incurred; comparing these costs with budgets, goals, targets, or standards; and evaluating differences or variances. Income measurement. Determining the costs of products and services sold to determine this time period’s pro�itability for the entire business or some segment of the business, such as a contract, a product, or a customer.

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1.3 The Nature of Cost Cost, broadly de�ined, is the amount of resources given up to gain a speci�ic objective or object. Generally, cost refers to the monetary measurement (exchange price) attached to acquiring goods and services consumed by some activity. A cost need only be incurred and not necessarily be paid for it to be considered a cost. Cash outlays are monetary measurements; occasionally, goods and services are also obtained by exchanging other assets, such as receivables or property, or by taking on debt. A cost object is de�ined as anything for which one accumulates costs. A cost object is the reason for making decisions, costing products, planning spending levels, or evaluating actual performances. It is the “why” of cost analysis.

Business people undertake activities to achieve some output or result. Often these activities incur costs— purchasing materials, hiring people, and renting space—and are known as cost drivers. Determining a product’s cost involves �inding the cause-and-effect connection between inputs and outputs. A cost driver links activities that create outputs with the inputs that are used.

Figure 1.4 presents the fundamental relationship among resources, activities, and products. Activities are at the core of all we do in business. Activities drive the use of resources; from the activities, come products. This is the traditional input-to-output cycle, understanding that work is done in the middle box of Figure 1.4—meaning tasks are performed with labor, machines, or hired resources. Costs are incurred by cost drivers and are assigned to the products. These linkages will be used over and over as we progress through our costing analyses to aid decision making, particularly in Chapter 9.

Figure 1.4: Activity-centered costing relationships

Cost, in many respects, is an elusive term. Cost has meaning only for a particular purpose and situation. Consequently, meaningful use of the term cost requires an adjective—such as incremental, average, or avoidable—to de�ine its use. Each adjective indicates certain attributes, and those attributes dictate the relevance of each cost.

Since costs are resources given up to obtain a speci�ic good or service, that good or service may be consumed or it may still be an asset at the end of an accounting period. In many managerial analyses, the distinction among cost, expense, and asset is clouded. The words cost and expense are used interchangeably, as is done throughout this text. Yet for pro�it measurement, cost dollars imply assets, and expenses are subtracted from revenues.

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1.4 Comparing Service, Merchandising, and Manufacturing Organizations Many similarities exist when we compare service, merchandising, and manufacturing organizations. Providing a service to a client in a law �irm or repairing a washing machine in a �ix-it shop have strong similarities to manufacturing automobiles in spite of different physical and business settings. In service industries, resources are brought together to provide the service, just as they are brought together to create a product in a factory environment.

Differences in measuring pro�its are largely a function of inventoried costs. Service �irms have only supplies inventories. Merchandising �irms buy and sell products and hold merchandise inventories. Manufacturing �irms buy materials and convert these inputs into saleable products. Inventories here include materials, work in process inventory (partially complete products), and �inished goods inventory (completed and ready-to-sell products). Figure 1.5 compares income statements and selected balance sheet accounts for the three business types.

Figure 1.5: Measuring income in service, merchandising, and manufacturing �irms

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Service Organizations

A service organization performs a business activity for a fee. Costs of performing the service may include salaries of professionals and support personnel, supplies, purchased services, and routine costs such as rent and utilities. In Figure 1.5, the expenses of Kalwerisky Consultants, a public relations �irm, are reported as either direct client expenses or operating expenses. Some service organizations report all expenses as operating expenses.

Essentially, all operating costs incurred by the �irm are period costs; they become expenses of the time period in which the costs are incurred. Receivables, payables, supplies, depreciation, and perhaps costs not yet billed to clients would cause accrual net income to differ from operating cash �low. In a service organization, the problems of measuring performance, such as the pro�itability of speci�ic contracts, and matching direct costs with speci�ic revenues are surprisingly similar to manufacturing cost analyses.

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Internally, �inancial reports for service �irms often separate revenues and expenses by type of service or customer. For example, hospitals track revenues by procedure type and attempt to measure costs of those procedures. Professional �irms, such as accountants, lawyers, and architects, measure the direct costs of performing services by client. Lawyers record time spent on each case, both for billing purposes and for tracing salary costs. In Figure 1.5, Kalwerisky Consultants apparently serves multiple clients and can identify professional time, service costs, and other traceable costs with speci�ic client contracts.

Merchandising Organizations

A merchandising business purchases products for resale. Generally, a merchandising �irm is a link in the physical distribution chain, acting as a wholesaler or retailer. Figure 1.5 presents cost of goods sold on the income statement of Burch�ield Supermarket, a retail grocery store. Again, comprising the reported totals are detailed revenues and costs of sales for various segments, such as produce, hardware, meat, and grocery departments. Merchandise costs are inventoriable or product costs, meaning that they are an asset until sold, after which they become cost of goods sold. All other expenses in the supermarket operation are treated as period costs.

Manufacturing Organizations

Manufacturing generally occurs in a factory, de�ined as a place where resources are brought together to produce a product. Examples include:

Soft-drink bottling company—mixing batches and �illing bottles of root beer University cafeteria—preparing and serving food Print shop—printing a variety of items such as brochures, booklets, and business cards Breakfast cereal manufacturer—processing grains into cereal Automotive assembly plant—joining parts and subassemblies to create a minivan

But, you can see how many service �irms really do “produce” the service using our de�inition of a factory.

Landscaping company—cutting lawns and planting Pharmacy—�illing prescriptions Tax return preparation �irm—preparing tax returns Hospital surgery department—performing heart bypass operations

As Figure 1.5 illustrates, manufacturing �irms have more complexity in determining cost of goods sold. A new portion of the income statement, cost of goods manufactured, is introduced. It includes:

The costs of inputs to the manufacturing process: direct materials, direct labor, and manufacturing overhead Direct materials inventory and work in process inventory needed for factory activities

The sum of the product inputs, manufacturing costs for the period, is called total manufacturing costs.

Figure 1.6 illustrates a simpli�ied version of the Holbrook Products factory. Here resources are brought together for producing aircraft components. An assembly line in the factory is the focus of “manufacturing” activities.

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Materials (primarily parts and components) are purchased for production, and factory employees work to convert parts into �inished products. Many support services are used, and manufacturing overhead costs are incurred for materials handlers, equipment maintenance people, heat, power, employee bene�its, factory accountants, supervisors, and depreciation on equipment and the building.

Figure 1.6: The Holbrook Products factory

In Figure 1.6, the business is divided into of�ice and factory areas. Obviously, this example is simpli�ied and avoids many business complexities. But, it shows:

Product and period costs. Any cost incurred in the manufacturing process is a manufacturing cost, an inventoriable cost, and a product cost. Any cost not involved in the manufacturing process is a nonmanufacturing cost, a noninventoriable cost, and a period cost. Whereas the product costs are treated as inventory until sold, the period costs are treated as expenses immediately or as noninventory assets such as of�ice supplies. Location of inventories. Manufacturing requires three production inventories: materials, work in process, and �inished products. Materials purchases are received and stored in the materials warehouse, and their costs recorded in Materials Inventory. When materials are sent to the factory �loor, direct materials costs are transferred to Work in Process Inventory, which is production that is started but not completed. Completed products are physically sent to the �inished goods warehouse; their work in process costs are moved to Finished Goods Inventory, which are products that are ready for sale to customers. When a sale occurs and is shipped, �inished goods product costs are moved to Cost of Goods Sold, an expense account. Flow of costs and products. Figure 1.6 assumes an assembly process, but many different production systems exist. Materials are added, workers process, and other activities support; a physical �low and a cost �low coexist.

Figure 1.7 compares a factory to a large bucket. When the whistle blows to start the production period, the bucket already has resources in it—beginning work in process inventory. During the period, more resources are poured into the bucket—total manufacturing costs (direct materials used, direct labor, and

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manufacturing overhead). Flowing out of the bucket are all products that are �inished during the period and added to �inished goods inventory. The cost transferred out is called cost of goods manufactured. When the whistle blows to end the period, ending work in process inventory remains in the bucket.

Figure 1.7: The factory as a “bucket” of costs

To illustrate the determination of cost of goods manufactured, suppose work in process inventory of Metz Corporation changed from $21,000 to $23,500 during November. Costs incurred during November were $42,000 for direct materials used, $33,000 for direct labor, and $51,000 for manufacturing overhead. The cost of goods manufactured for November is determined as follows:

Direct materials used $42,000

Direct labor 33,000

Factory overhead 51,000

Total manufacturing costs $126,000

+ beginning work in process 21,000

– ending work in process (23,500)

Cost of goods manufactured $123,500

Note that cost of goods manufactured represents the cost of those goods that were �inished during November. Since $21,000 of costs was incurred prior to November, it must be added to the $126,000 in costs that were incurred during November. Ending work in process of $23,500 must be deducted from the costs incurred during November because this amount represents costs for goods that have not yet been �inished, and the cost of goods manufactured includes only costs pertaining to �inished goods.

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Traditional Groupings of Product Costs

Figure 1.5 illustrates the income measurement for Holbrook Products. Product cost accounting combines three groups of manufacturing costs: direct materials, direct labor, and manufacturing overhead. While automated manufacturing and cost systems can utilize many more or fewer cost groups, these three have historically been used in nearly all manufacturing costing.

Direct materials costs are costs of physical components of the product. The range of materials includes natural resources, such as oil, grain, or lumber, and partially processed components (another company’s �inished product). Often, a complete list of all materials used in a product is prepared and is called a bill of materials. A materials requisition form is used as authorization to transfer direct materials out of the materials storeroom and into the production area. Direct materials issued to production are direct materials used. To determine materials used, begin with materials purchases, add beginning materials inventory, and subtract ending materials inventory. Supplies like nails, glue, lubricants, and paints are usually not worth the effort of tracking as direct materials, so most companies refer to these items as indirect materials, and these are included as part of factory overhead costs. At McDonald’s, potatoes used to make French fries are direct materials, while the salt added to the fries is an indirect material.

Direct labor costs are wages paid to workers who directly process the product. In Figure 1.7, assembly line workers would be direct labor. At McDonald’s, the wages paid to the cooks are direct labor costs.

Factory overhead costs include all manufacturing costs that are not materials or direct labor. Manufacturing overhead, factory burden, and indirect manufacturing costs are other names for these costs. Obviously, a wide variety of costs fall into this category, such as maintenance staff wages, factory managers’ salaries, factory utilities costs, and factory equipment depreciation and repair costs. Hundreds of different cost accounts could be grouped under manufacturing overhead. Certain workers’ tasks could be overhead in one company and direct labor in another. For example, materials handlers and quality control personnel costs could be accounted for as either direct or indirect labor. Generally, if the worker has direct contact with the product or the production process, the cost is direct labor. Generally, support tasks are indirect labor—part of overhead. At McDonald’s, a particular restaurant manager’s salary is an indirect labor cost.

Historically, the three cost groups were assumed to be about equal portions of total product cost. Today, automation reduces direct labor and causes factory overhead to increase. As more production is generated from the same capacity, materials as a percentage of total cost may also increase. Thus, managers have paid more attention to direct materials and overhead costs because they have grown as a portion of total manufacturing costs.

Types of Product Costs Direct materials and direct labor costs are often viewed as direct product costs since they are easily identi�ied with speci�ic products and units of product. Factory overhead is usually thought of as indirect product costs. Factory overhead is not easily traced to speci�ic products or units. For example, the plant manager’s salary cannot be tied to speci�ic product units in a multiproduct factory, since the manager is responsible for all activities in the factory. An exception may exist for a few overhead costs that may be traced to speci�ic products and be considered direct costs. Figure 1.8 illustrates these concepts and shows a dotted line between factory overhead and direct costs to indicate this possibility. At McDonald’s, the cost of hamburger buns is a direct product cost, while the restaurant’s electricity costs are indirect product costs.

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Figure 1.8: Product costs and product cost groups

Direct materials and direct labor are also known as the prime costs of a product. These costs are easily traceable to a speci�ic product. Direct labor and factory overhead are called conversion costs. In the factory, materials are “converted” into �inished product using labor and all of the factory’s supporting resources—overhead costs.

Contemporary Practice 1.1: Survey on Indirect Costs

In a survey of 185 European companies in various industries, respondents ranked the importance of indirect cost categories (other than personnel costs) as follows:

Ranking Cost Category

1 Information Technology

2 Energy

3 Maintenance

4 Fleet Management

5 Marketing

6 Facility Management

7 Freight

8 Logistics

9 Telecommunications

10 Insurance

11 Travel Expenses

12 Tools/Supplies

Source: Wald, A., Schneider, C., Schulze, M. & Mar�leet, F. (2013, November/December). A study on the status quo, current trends, and success factors in cost management. Cost Management, 28–38.

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Calculating Unit Costs Product costing assigns costs to units of product. The approach is to divide the number of units produced into total manufacturing costs to obtain a cost per unit of product. For example, a highly automated factory produces a variety of tablet computers. The same production processes are used for all models with minimal costs to change over the production line. Three million tablet computers are manufactured every month. Different circuit boards distinguish the models. March production data by product line are as follows:

Deluxe Super Deluxe Basic Total

Direct materials costs $3,600,000 $4,200,000 $1,500,000 $9,300,000

Indirect other costs 6,000,000

Total costs $15,300,000

Units produced 120,000 120,000 60,000 300,000

Direct materials costs per unit $30.00 $35.00 $25.00 $31.00

Indirect other costs per unit 20.00 20.00 20.00 20.00

Product cost per unit $50.00 $55.00 $45.00 $51.00

Note: The “Indirect other costs per unit” of $20.00 is obtained from dividing $6,000,000 of “Indirect other costs” by the 300,000 units produced.

The costing approach is to divide the total costs of $15,300,000 by 300,000 tablet computers. However, the $51.00 average cost hides the different direct costs of each model of circuit board. A second approach identi�ies materials costs as direct to each model and averages all other costs over all units. This produces a high cost of $55.00 for Super Deluxe models and a low cost of $45.00 for Basic models. More complex costing is needed if different models use different amounts of resources. The goal is to obtain the most accurate unit cost, given managers’ decision-making needs.

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1.5 Cost Behavior To say that a cost “behaves” in a certain way is somewhat misleading. Costs result from taking actions or from the mere passage of time. Something drives a cost—some activity, decision, or event. Selling one more hamburger involves a burger, a bun, a container, a napkin, and any condiments used. But selling one more hamburger has no impact on supervision, equipment rental, or advertising costs. Building lease expense will not change unless the lease includes a rental payment based on a percentage of sales. Cost behavior, then, is the impact that a cost driver has on a cost.

Which costs can be expected to remain constant when the amount of work activity increases or decreases? Also, which costs increase as more work is performed? If costs are to be estimated and controlled, we need to know whether or not costs will change if conditions change, and, if so, by what amount. Cost behavior is often viewed as a dichotomous pattern—either variable or �ixed. But in the real world, many behavior patterns exist since most costs are not strictly variable or �ixed. Thus, the concepts of semivariable and semi�ixed costs add complexity to cost behavior studies. It may oversimplify the analysis, but a split between variable and �ixed is common and is used frequently.

Variable Costs

A variable cost changes in total in direct proportion to changes in business activity such as units produced or hours worked. A decrease in activity brings a proportional decrease in total variable cost, and vice versa. For example, direct materials costs are usually variable costs since each unit produced requires the same amount of materials. Thus, materials costs change in direct proportion to the number of units manufactured. At McDonald’s, the cost of raw hamburger meat is a variable cost.

A proportional relationship between activity and cost has these important characteristics:

Variable cost is a rate per unit of activity or output. A variable cost per unit remains constant across a reasonable range of activity. The slope of the total variable cost curve is the variable cost per unit—the added cost divided by the added units.

For example, if a product costs $4.00 per unit, the expression $4X yields the total variable cost at X level. Figure 1.9 shows the behavior of variable costs on a per unit basis and in total, and also highlights the variable cost line’s slope.

Figure 1.9: Behavior of variable costs

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Fixed Costs

A �ixed cost is constant in total amount regardless of changes in business activity level. Costs such as the plant manager’s salary, depreciation, insurance, and rent usually remain the same in total regardless of whether the plant is above or below its expected level of operations. At McDonald’s, the cost of heating the restaurant is a �ixed cost since the cost does not change with activity such as labor hours or amount of food prepared.

Important characteristics of a �ixed cost are:

Fixed cost is a lump of costs that is not normally divisible and does not change as activity or volume changes. A �ixed cost remains constant across a reasonable range of activity. The �ixed cost per unit decreases as activity or volume increases and increases as activity or volume decreases.

For example, March’s rent is stated as a dollar amount for that month, not as an amount per unit of output or even per hour of use.

By de�inition, total �ixed costs are constant, causing the �ixed cost per unit to vary at different levels of activity. Figure 1.10 shows the behavior of �ixed costs on a per unit basis and in total. When a company produces a greater number of units, the �ixed cost per unit decreases. Conversely, when fewer units are produced, the �ixed cost per unit increases. This variability of �ixed costs per unit creates problems in product costing. The cost per unit depends on the number of units produced or on level of activity.

Figure 1.10: Behavior of �ixed costs

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Certain �ixed costs can be changed by management action. These are discretionary �ixed costs. Discretionary �ixed costs are expenditures that managers can elect to spend or not to spend. For example, a company might budget the cost of consultants at $20,000 per month for the coming year. But the contract states that the company can cancel the contract at any time. Management maintains discretionary control over the spending. On the other hand, if the contract guarantees the consultant a 12- month relationship and the contract has been signed, a committed �ixed cost has been created. A committed �ixed cost is one over which a manager has no control and must incur. Advertising cost for McDonald’s is a discretionary �ixed cost. Depreciation on McDonald’s restaurant equipment is a committed �ixed cost.

An interesting observation is necessary here. Managers can, with time and intent, change the cost behavior of certain activities. For example, variable direct labor costs can be replaced by a �ixed cost by guaranteeing full-time employment for some period, such as a three-year union contract. Or equipment could be leased on a short-term basis (day-to-day or even hourly) instead of purchased—replacing a �ixed cost with a variable cost. Also, automated equipment with a �ixed rent or depreciation could replace variable-cost manual labor. Thus, we recognize that managers can act to change certain cost behavior, particularly over time.

Contemporary Practice 1.2: Fixed Versus Variable Expenses

“You can get quality people to invent, develop and design products for you on a percentage of the products’ billing—in other words, on a variable expense basis. Many will want to work on upfront fees only, a �ixed expense. Salesmanship on your part can get them to charge your way. If they’re sold on your company, you personally, or the product, they’re more likely to comply with your wishes. Sometimes a compromise is required where you pay a modest upfront fee and a modest percentage on sales of the product.”

Source: Reiss, B. (2010, November 3). Outsourcing turns �ixed costs into variable costs. Entrepreneur. Retrieved from http://www.entrepreneur.com/article/217487 (http://www.entrepreneur.com/article/217487)

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Expressing Variable and Fixed Costs—A Cost Function

Since a variable cost is a rate, it is a function of an independent variable—an activity or output level. Unit variable costs can be converted into total variable costs only by knowing the activity or output level. Fixed costs are �irst expressed as a total, lump sum amount, a constant. Total �ixed costs can be converted into a rate per unit only if the activity or output level is known. In the following example, the cost per unit of $7 and total costs of $700,000 can be found only if the output of 100,000 units is known.

Costs of 100,000 Units Costs of 120,000 Units

Cost per Unit Total Costs Cost per Unit Total Costs

Variable costs $4.00 ⟶ $400,000 $4.00 ⟶ $480,000

Fixed costs 3.00 ⟵ 300,000 2.50 ⟵ 300,000

Total $7.00 $700,000 $6.50 $780,000

If the production level increases to 120,000, both the cost per unit and total costs change. A decrease in the cost per unit from $7 to $6.50 results from spreading �ixed costs of $300,000 over more units— 120,000 instead of 100,000. The increase in total cost equals the variable costs for the additional 20,000 units. A decrease in volume has similar reverse impacts—the cost per unit increases, but total costs decline.

Three factors must generally be known to perform cost analyses:

1. The variable cost rate 2. The �ixed cost amount 3. The level of activity or output

Notice that if we know the bold numbers in the example above and the activity level, we can calculate all other numbers. These factors can be brought together in a cost function—an expression that mathematically links costs, their behavior, and their cost driver. In the example, the expression is:

Total costs = $300,000 + $4(X), where X is the number of units produced.

This cost function can be symbolically shown as:

Total costs = a + b(X), where a is total �ixed costs and b is variable cost per unit.

This is an important formula in managerial accounting. Understanding these relationships can give insight into cost behavior for planning, control, and decision making. By knowing the activity level and cost function, we can calculate either total costs or costs per unit.

Determining the Cost Function Using Total Costs and Activity Levels In this example, let’s assume we know the total costs ($700,000 and $780,000) at both activity levels (100,000 and 120,000 units). How do we obtain the cost function? First, we calculate the variable cost per unit as follows:

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The $4 per unit amount is the variable cost per unit in the cost function. The change in cost from a change in activity yields the slope of the total variable cost line.

To obtain the �ixed cost, which is a in the cost function, we take the total costs at either activity level and subtract the total variable costs at that level, as follows:

$780,000 – ($4 × 120,000 units) = $300,000

or

$700,000 – ($4 × 100,000 units) = $300,000

We now have both a and b. Total cost = $300,000 + $4 (X).

Obtaining the Cost Function Using Per Unit Costs and Activity Levels Using the same example, per unit costs were $7 at the 100,000 units activity level and $6.50 at 120,000 units. First, we calculate total costs at each level by multiplying the cost per unit by the activity level as follows:

$7 per unit × 100,000 = $700,000 and $6.50 per unit × 120,000 = $780,000

Second, we follow the same procedure as shown previously in converting total costs into the cost function. The same calculations could be applied separately to total variable costs for b and to total �ixed costs for a. Calculations at both levels produce the same cost function.

One danger in converting total �ixed costs into cost per unit is that the unit cost can be misinterpreted. It might be assumed that $7 is the variable cost—forgetting that the $300,000 is a �ixed cost. At different activity levels, the per unit cost will be different. Even in solving homework problems, students are in danger of missing the impact of volume changes on total costs and unit costs if only costs per unit or total costs are used.

Relevant Range

In Figures 1.9 and 1.10, activity is assumed to start at zero and increase to very high levels. Realistically, the cost function holds only for a much narrower range of activity—a relevant range. A relevant range is the normal range of expected activity. Management does not expect activity to exceed a certain upper bound nor to fall below a lower bound. Production activity is expected to be within this range, and costs are budgeted for these levels. In cost analysis, costs are expected to behave as de�ined within the relevant range. The cost function is assumed to be valid for this range of activity. Usually, past experience establishes the relevant range.

Total �ixed costs are �ixed and total variable costs are variable within the relevant range. In the above example, the volume range was between 100,000 and 120,000 units. The cost function of $300,000 plus $4 per unit is valid between 100,000 and 120,000 units as shown in Figure 1.11. If planned production were 130,000 units, our cost function might not be valid or useful.

Figure 1.11: Cost patterns using a relevant range

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Semivariable and Semi�ixed Costs

Figure 1.12 illustrates cost functions that are neither strictly variable nor �ixed. In the real world, very few costs are truly variable or �ixed. Semivariable costs change but not in direct proportion to the changes in output. Some semivariable costs, called mixed costs, may be broken down into �ixed and variable components, thus making it easier to budget and control costs. Using the cost function techniques shown previously, �ixed and variable parts can be identi�ied. In Example A of Figure 1.12, telephone expenses may include a monthly basic connection fee (�ixed) plus a per-minute charge for each call (variable).

Semi�ixed costs or step-�ixed costs are typi�ied by step increases in costs with changes in activity as shown in Example B. Activity can be increased somewhat without a cost increase. However, at some activity level, additional �ixed cost must be incurred to expand capacity. An example is adding an additional full-time worker when sales increase beyond a certain level. If many narrow steps exist, a step- cost pattern may approximate a variable cost. Or with wide steps, one step may encompass the entire relevant range and the step cost appears as a �ixed cost.

Figure 1.12: Examples of semivariable and semi�ixed cost patterns

Example C shows a cost that increases but at a lower cost per unit as activity increases. An example is increased worker ef�iciency as activity increases, resulting in a lower per unit cost. This is a nonlinear cost. Example D shows a piece-wise linear cost. It is a constant variable rate until a certain activity level is reached, then the variable cost per unit increases. Perhaps an electric utility offers a low per kilowatt rate for the �irst 500 kilowatts and a higher rate beyond that level.

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1.6 Cost Concepts for Planning and Controlling This section introduces terminology relating to traceability and controllability of costs. These concepts are useful for planning and control purposes.

Direct Costs Versus Indirect Costs

Costs are often de�ined as being direct or indirect with respect to a cost object—an activity, a department, or a product. If a cost can be speci�ically identi�ied with a particular cost object, it is traced to the cost object and is considered to be a direct cost. A direct cost is also called a traceable cost. The cost of installing a sunroof on a particular car is a direct cost of that car because it is traceable to that particular car. If no clear link between a cost and the cost object is apparent, the cost is an indirect cost (also called a common cost). For example, the heating cost for a physical therapy center is an indirect cost to each patient being served there.

The same cost can be direct for one purpose and indirect for another. For example, the salary of the St. Louis of�ice manager is a direct cost of that branch. But within the branch of�ice where numerous products are sold, the manager’s salary is an indirect cost of speci�ic products. At McDonald’s, cleaning supplies are a direct cost for a particular restaurant, but corporate legal expenses are an indirect cost for a particular restaurant.

Indirect costs not traceable to particular products or departments may need to be allocated to those cost objects. A cost object may use a resource, but the amount used may not be easily measured. For example, a shoe department occupies 2,000 square feet of a 50,000 square foot store and accounts for 10% of sales and 6% of pro�its. If the rent for the entire store is $300,000 per year, how much should be allocated to the shoe department—$12,000 (space), $18,000 (pro�its), $30,000 (sales), or some other amount? No cost allocation is absolutely correct, and different viewpoints will argue for different allocations. The allocation process should attempt to link the cost, the use of the resource, and the activity or output.

Controllable Costs Versus Noncontrollable Costs

Another important aspect of cost is the distinction between costs that can and cannot be controlled by a given manager. This cost classi�ication, like the direct and indirect cost classi�ication, depends on a point of reference. If a manager is responsible for a cost, that cost is a controllable cost with respect to that manager. If that manager is not responsible for incurring a cost, it is a noncontrollable cost with respect to that manager. The entire cost control system rests on who can control each cost.

All costs are controllable at some level of management. Every cost in an organization is controllable by some manager in that organization. Costs should be planned or budgeted by the manager who has responsibility for that cost. For a McDonald’s restaurant manager, the cost of utilities usage is controllable, while property insurance costs are noncontrollable.

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1.7 Contribution Margin and Its Many Variations Thus far, we have de�ined cost terms. But managerial responsibility for pro�it measurement is even more important. Revenue is added to the analysis. While net pro�it evaluates the entire �irm, determining pro�itability of parts of a �irm requires more precise pro�it measures. The term we use is contribution margin, which is the revenue minus certain costs, a margin. This margin contributes to covering all remaining costs and to earning a net pro�it. Figure 1.13 shows �ive variations used in different situations.

Figure 1.13: Variations of contribution margin

Variable Contribution Margin—Per Unit, Ratio, and Total Dollars

The basic and most common de�inition of contribution margin is sales minus variable costs. Variable contribution margin is a more explicit term because only variable items (revenue and costs) are included in the calculation. This contribution margin contributes towards covering �ixed costs and provides for a net pro�it.

As an example, a salesperson is selling a product for $20 per unit. The �irm buys the item for $12 per unit and pays the salesperson a 10% commission on sales. The �irm expects to sell 10,000 units. Variable contribution margin can be shown as follows:

Variable Contribution Margin

Per Unit Ratio Total Dollars

Sales (10,000 units) $20 100% $200,000

Variable costs:

Costs of sales and commissions ($12 plus 10% of $20) 14 70 140,000

Variable contribution margin $6 30% $60,000

Thus, the contribution margin can be expressed as either $6 per unit, 30% of sales, or $60,000. Depending on the analysis needed, we may use one, two, or all three versions. From total variable contribution margin, we subtract �ixed expenses—the remaining expenses—to arrive at net pro�it.

Controllable and Direct Contribution Margins

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The next contribution margin concept looks at managerial control and is used when a manager has revenue and cost responsibility. Costs controllable by the manager are typically variable costs and controllable �ixed costs. These costs are subtracted from sales to yield controllable contribution margin or controllable margin. This represents the amount available to cover any noncontrollable expenses and includes any company net pro�it. Note that the de�initions of controllable and noncontrollable developed previously are used for both revenue and costs. Controllable contribution margin is used to evaluate managerial performance. However, this is not the net pro�it that the manager generates for the company, since noncontrollable costs must be covered before any net pro�it is earned.

Direct or segment contribution margin or segment margin is a segment’s revenue minus its direct costs. A segment might be a product, a region, or a division. De�initions of direct and indirect were discussed earlier and focus on traceability. As an example, the direct contribution margin of a product line is sales less product-line cost of sales, product-line advertising costs, and any other costs traceable to that product line. The product line’s direct contribution margin is the amount remaining to cover company common costs and to earn company pro�its.

Illustration of All Contribution Margin Concepts

Pearl Engel owns three Burgers Plus locations. Figure 1.14 presents a summary income statement, expanded for the Grand Avenue location. Variable contribution margin is shown in total dollars for each store and also as a ratio for the Grand Avenue store. Direct controllable �ixed expenses include assistant managers’ salaries, maintenance services, and other �ixed costs that the store manager controls. The controllable contribution margin is the pro�it on which the Grand Avenue manager will be evaluated and rewarded (a bonus for meeting pro�it goals or pro�it improvement). Direct noncontrollable �ixed expenses include rent on the building and the outlet manager’s salary, which are probably controlled by Engel.

Figure 1.14: Contribution margin analysis by store

This direct or store contribution margin is used to measure the pro�it performance of each store. Measuring store pro�itability stops at the direct contribution margin. Direct contribution margin is the

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�inest-tuned pro�it measure that is free of allocations. Common corporate expenses, which include Engel’s salary and other corporate expenses, cannot be traced to the three locations.

Contribution margin per unit requires more detail. Engel has set target contribution margins for her three main burger products as follows:

Average for

Cheap Burger Double Burger Triple Burger

Selling price per unit $1.00 $2.00 $3.00

Variable product costs per unit 0.65 1.20 1.50

Variable contribution margin per unit $0.35 $0.80 $1.50

Variable contribution margin ratio 35% 40% 50%

Note that the other variable expenses (probably supplies and condiments) in Figure 1.14 cannot be traced accurately to each product. As shown in Figure 1.14, actual burger margins can be compared across all stores and to margin targets.

Ms. Engel has numerous versions of pro�itability for each location. She will use each to answer speci�ic questions about her products, managers, and stores. Common use of the term contribution margin frequently means variable contribution margin. To avoid misunderstanding, de�ine which contribution margin you are using.

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Summary & Resources

Chapter Summary Accounting information is provided from a system that handles the requirements of two branches of accounting: �inancial accounting and managerial accounting. Financial accounting presents accounting information to parties outside the organization. Managerial accounting organizes accounting information for internal management. Internal reporting is generally directed to the decision areas mentioned earlier.

The ethical conduct and integrity of the management accountant are critical to the success of the accountant’s mission. Ethical situations are common and often complex. Management accountants have a special responsibility to their management colleagues and to themselves to uphold high ethical standards.

Cost analysis and income measurement are equally important to service, merchandising, or manufacturing �irms. Tracing cost �lows is important to understanding the conversion of materials, direct labor, and overhead into a product or service. The cost driver is the link between resources used and outputs.

Different decisions need different costs. A “cost” must have an adjective attached to give it meaning. In general, costs have many attributes, but the three most important ones for using cost concepts are cost behavior, traceability, and controllability.

Variable and �ixed costs behave differently when activity levels change. Variable costs are naturally expressed as a rate; �ixed costs are naturally a lump of costs. Fixed and variable costs can be expressed as a cost function, such as a + b (X), where a is the �ixed cost, b is the variable rate, and X is the level of activity.

Direct costs are traceable; indirect costs are nontraceable. Controllability refers to a speci�ic manager’s authority to incur the cost and responsibility to use the resource generating the cost.

Contribution margin is revenue minus a subset of costs. Variable contribution margin can be expressed as an amount per unit, a ratio, or total dollars. Controllable contribution margin is used to evaluate the manager, and direct or segment contribution margin is used to evaluate the segment.

Key Terms

bill of materials A complete list of all materials used in a product.

Certi�ied Management Accountant (CMA) A person who has passed a qualifying examination sponsored by the Institute of Management Accountants, has met an experience requirement, and participates in continuing education.

committed �ixed cost A �ixed cost over which a manager has no control and must incur.

common cost A cost that has no clear link to a speci�ic cost object.

contribution margin Sales revenue less variable costs.

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controllable contribution margin Variable contribution margin less direct controllable �ixed expenses (represents the amount available to cover any noncontrollable expenses and includes any company net pro�it).

controllable cost A cost that a manager has the ability to in�luence.

controller The person responsible for managing the entire accounting function.

conversion costs Direct labor plus manufacturing overhead (costs incurred to convert raw materials into �inished products).

cost The amount of resource given up to gain a speci�ic objective or object.

cost behavior How a cost changes with changes in business activity.

cost drivers Measures that link activities that create outputs to resources that are used.

cost function An expression that mathematically links costs, their behavior, and their cost driver.

cost object Any purpose for accumulating costs.

cost of goods manufactured Total cost of goods completed during the period.

cost of goods sold The total of direct materials, direct labor, and manufacturing overhead costs associated with the goods that have been sold during the period.

direct contribution margin Controllable contribution margin less direct noncontrollable �ixed expenses (re�lects the amount remaining to cover common costs and earn pro�its).

direct controllable �ixed expenses Fixed expenses that are traceable and that a manager has the ability to in�luence.

direct cost A cost that is traceable to a cost object.

direct labor costs Wages paid to workers who work directly on the product.

direct materials costs Costs of the physical components of the product.

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direct materials used Materials issued to production.

direct noncontrollable �ixed expenses Fixed expenses that are traceable, but that a manager is not able to in�luence.

direct product costs Costs that can be traced to speci�ic products.

discretionary �ixed costs Expenditures that managers can elect to spend or not to spend.

factory overhead costs All manufacturing costs that are not direct materials or direct labor.

�inancial accounting The branch of accounting that organizes accounting information for presentation to interested parties outside of the organization.

�inished goods inventory Products that have been completed and are ready for sale.

�ixed cost A cost that remains constant, regardless of changes in a company’s activity.

indirect cost A cost that has no clear link to a speci�ic cost object.

indirect product costs Manufacturing costs that cannot be traced to a speci�ic product.

management accountant An accountant who prepares information for a company’s decision makers.

managerial accounting The branch of accounting that meets managers’ information needs.

materials inventory Materials that are stored by the company.

mixed cost A cost that contains both variable and �ixed elements.

noncontrollable cost A cost that a manager is not able to in�luence.

nonlinear costs A cost for which the cost function cannot be represented as a straight line.

period costs Operating costs that are expensed in the period in which they are incurred.

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piece-wise linear cost A cost function consisting of connected straight lines with differing slopes.

prime costs Direct materials cost plus direct labor cost.

product costing The process of attaching costs to units of product.

product costs Costs that are treated as assets until the products are sold.

relevant range Normal range of expected activity.

segment contribution margin A segment’s revenues minus its direct costs.

semi�ixed costs Costs that are typi�ied by step increases in costs with changes in activity.

semivariable cost A cost composed of a mixture of �ixed and variable components.

step-�ixed costs Costs that are typi�ied by step increases in costs with changes in activity.

total manufacturing costs The sum of direct materials, direct labor, and factory overhead costs.

traceable cost A cost that can be directly linked to a cost object.

variable contribution margin Sales revenues less all variable expenses.

variable cost A cost that changes in proportion to a change in a company’s activity.

work in process inventory The cost of products that have been started in the manufacturing process but have not yet been completed.

Problem for Review Rabin Corporation operates sales, administrative, and printing activities from a facility in Augusta. It prints, prepares, and mails a wide variety of promotional materials. The following selected costs relate to the �irm’s activities and particularly to the factory’s Mail Preparation Department.

a. Production paper used in Mail Preparation Department b. Hourly wages of production personnel in Mail Preparation Department

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c. Factory property taxes and insurance d. Supplies used, which changes with printing volume in Mail Preparation Department e. Contract signed by Mail Preparation Department manager for an annual maintenance fee on

postage application machinery f. Equipment depreciation in Mail Preparation Department g. Building depreciation h. Sales commissions i. Advertising agency contract costs for a special program j. Annual computer staff; uses the same number of staff all year—half for operations, which includes

the Mail Preparation Department, and half for administrative work

Questions:

Based on reasonable assumptions about Rabin Corporation, classify each cost as:

1. Variable or �ixed cost 2. Controllable or noncontrollable by the supervisor of the Mail Preparation Department 3. Direct or indirect product costs or period costs

Solution:

Cost Behavior Under Control of

Department Manager Product Cost

Cost Item

Variable Cost

Fixed Cost Yes No

Direct Cost

Indirect Cost

Period Cost

(a) X X X

(b) X X X

(c) X X X

(d) X X X

(e) X X X

(f) X X X

(g) X X X

(h) X X X

(i) X X X

(j) X X X* X*

* An allocation between the operations and administration is required.

Questions for Review and Discussion 1. Brie�ly describe three ways in which �inancial accounting and managerial accounting are different.

Name two ways in which they are the same or similar. 2. Brie�ly describe the management accountant’s responsibility for ethical behavior with respect to

competence, con�identiality, integrity, and credibility. 3. What are sources of counsel and guidance on ethical dilemmas available to a manager?

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4. What characteristics distinguish accounting for revenues and expenses for service, merchandising, and manufacturing organizations?

5. What does the mathematical expression $100,000 + $12X mean in terms of measuring product cost?

6. Distinguish among the following terms: cost of goods manufactured, cost of goods sold, and total manufacturing costs.

7. Name the three traditional cost elements in a manufactured product. How can these elements be attached to the product?

8. Identify at least two ways in which �ixed costs pose dif�iculties for cost accountants and managers. 9. (a) In a recent speech, controller Judy Koch said, “I rarely see a real variable cost or a truly �ixed

cost.” What did she mean? (b) She also commented, “Some of my friends de�ine semivariable costs, semi�ixed costs, step costs, and mixed costs differently. Other friends often use these terms interchangeably. And I like all of my friends.” Was she just trying to be funny, or is there truth in her quip? Explain.

11. How can an individual cost be both a direct and an indirect cost? A controllable and a noncontrollable cost? Give examples.

12. Sybil Goldstein supervises the Admissions Department at Tender Care Hospital. The hospital accountant includes Sybil’s salary among the direct expenses in her departmental expense report. Sybil claims she cannot control her own salary; therefore, it should not be in the Admissions Department’s expense report. Is Sybil correct? Explain.

13. We have 15 subsidiaries. All corporate costs are allocated to the subsidiaries. In evaluating the pro�itability of our French subsidiary, we �ind it generates a net loss. Why might this number not be a good indicator of the pro�it contribution that this subsidiary makes to the corporation as a whole?

Exercises 1-1. Ethical Dilemma. You are on your way to lunch and the elevator is packed. Two persons from a �irm that competes with your employer happen to be talking about a business deal that involves one of your customers. Your computer-like mind lists your alternatives: Plug your ears, tell them that you are with a competitor, listen and then delete the information from your brain, immediately go back to the of�ice and act on the new information, or call their supervisor and report the conversation you just overheard. What should you do?

1-2. Ethical Conduct. Comment on the following frequently heard statements about ethical conduct:

a. “You can’t teach ethics. If people don’t know right from wrong by now, they’ll never learn.” b. “It’s legal. My attorney says so. Therefore, it’s okay.” c. “Are you trying to impose your values on me?” d. “I believe in situational ethics. What’s right or wrong depends on the situation.” e. “I can’t be ethical all the time. My competitors would eat me alive!” f. “Everyone does it.”

1-3. Cost Flows in Manufacturing. The following data are from the Westerman Company for August production activities:

Inventories August 1 August 31

Direct materials $18,000 $10,000

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Inventories August 1 August 31

Work in process 12,000 16,000

Finished goods 45,000 38,000

Month of August

Factory overhead $120,000

Cost of goods manufactured ?

Direct materials purchased 80,000

Direct labor 30,000

Questions:

1. What was the cost of direct materials used during August? 2. What was the cost of goods manufactured?

1-4. Cost of Goods Manufactured. The following data are available for Marcellino Enterprises:

March Balances April Balances May Balances

Beginning materials inventory $10,000 $ ? $15,000

Ending materials inventory 8,000 ? 11,000

Beginning work in process inventory 30,000 ? 18,000

Ending work in process inventory 24,000 ? 21,000

Direct labor 20,000

Factory overhead 40,000

Materials purchases 30,000

Question:

Determine the cost of goods manufactured for April.

1-5. Classifying Cost Behavior. Jonah Roberts operates a pizza shop near Bronx University. During critical periods like registration and �inal exams, he is open 24 hours a day. Half of his business is takeout. He has these expenses:

a. Cost of supplies (e.g., napkins, toothpicks, and pizza boxes) b. Cost of dough used in pizzas c. Salary of the supervisor of the overnight shift when needed d. Wages of the delivery persons e. Straight-line depreciation on equipment f. Power costs to operate the ovens g. Monthly lease partially based on sales h. Cost of drinks served i. Insurance premiums covering his equipment j. Equipment maintenance costs

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Question:

Classify each cost as variable, �ixed, semivariable, or semi�ixed. Add any assumptions or comments you need to clarify your answers.

1-6. Searching for Unknowns in Manufacturing Cost Flows. Three Japanese �irms—Kumamoto, Kawasaki, and Kanazawa—produce musical products. Operating results for a recent year follow (all numbers are in millions of yen):

Kumamoto Co. Kawasaki Co. Kanazawa Co.

Sales ¥ ? ¥90,000 ¥ ?

Materials used 15,000 ? 22,000

Direct labor 25,000 20,000 15,000

Factory overhead 60,000 25,000 ?

Total manufacturing costs ? ? ?

Beginning work in process 4,000 9,000 9,000

Ending work in process 12,000 4,000 6,000

Cost of goods manufactured ? 69,000 61,000

Beginning �inished goods 6,000 ? 8,000

Ending �inished goods 21,000 22,000 ?

Cost of goods sold ? ? 68,000

Gross margin ? 24,000 24,000

Operating expenses 25,000 ? 13,000

Net income 6,000 (6,000) ?

Question:

Determine the missing values. Helpful hint: Format a manufacturing cost of sales section, and insert the known amounts.

1-7. Manufacturing Cost Flows. Analyze the following cases:

A. In Jiao Company, costs incurred during November were $25,000 for materials purchased, $50,000 for direct labor, and $60,000 for overhead. Materials inventory changed from $24,000 to $18,000.

Question:

If cost of goods manufactured in November was $129,000 and beginning work in process inventory was $16,000, determine the ending work in process inventory.

B. In Tong Company, the cost of goods sold for November was $186,000, �inished goods inventory decreased from $30,000 to $21,000, and work in process inventory increased from $21,000 to $33,000.

Question:

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Calculate the total manufacturing costs for November.

1-8. Variable Contribution Margin. Bob David’s Lab performs soil tests for toxic chemicals in its laboratory. Data from the third quarter of the past year include:

Selling price $15 per test

Variable lab costs $8 per test

Variable administrative and shipping expenses $3 per test

Total �ixed lab costs $25,000 per quarter

Total �ixed administrative expenses $15,000 per quarter

Tests performed 15,000 tests

Question:

Prepare an income statement showing variable contribution margin plus net income.

1-9. Direct and Controllable Costs. Gus Undheidt is manager of Allergy Relief Services in the Frankfurt, Germany of�ice and has the authority to buy supplies, hire labor, and maintain equipment for the of�ice. Costs in euros for January appearing in the Frankfurt of�ice performance report are:

Home of�ice general manager’s salary allocated to Frankfurt of�ice €3,000

Home of�ice operating expenses allocated to Frankfurt of�ice 2,200

Home of�ice marketing costs allocated to Frankfurt of�ice 1,700

Equipment maintenance charges—Frankfurt of�ice 2,600

Supplies used—Frankfurt of�ice 1,400

Salary—Gus Undheidt 2,500

Labor costs—Frankfurt of�ice 14,600

Home of�ice depreciation allocated to Frankfurt of�ice 1,000

Equipment depreciation—Frankfurt of�ice 2,300

Total €31,300

Questions:

1. Identify costs that can be controlled by Gus Undheidt. 2. Identify costs that can be traced directly to the Frankfurt of�ice. 3. Identify costs allocated to the Frankfurt of�ice from the home of�ice. Suggest a cost driver that

might have been used to allocate these costs at the home of�ice for each cost.

1-10. Ethics in Cost Control. Zoya Arbiser, regional manager of Gold Medal Sports Shops, is reviewing the results of 15 stores in her region. Store managers are moved annually. Each store manager’s income is dependent on the direct contribution margin of that store. For the past year, Store 9 has been managed by a person who has operated several other pro�itable stores in recent years and is about to be promoted to a larger store. Zoya notices several items that bother her.

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1. Store 9 has almost no personnel training expenses relative to other stores. 2. Store 9 has stopped participating in numerous community events that gave the store signi�icant

visibility but did incur substantial expenses. 3. Store 6, where this store manager worked the prior year, has had a severe drop in pro�its due to

higher operating expenses. 4. The advertising budget for Store 9 was spent almost entirely in the �irst four months of the year,

with almost nothing spent in the last several months.

Question:

Comment on a possible negative managerial scenario that the regional manager may be sensing. Might the manager of Store 9 be an exceptional manager? Explain.

1-11. Managing by Contribution Margin. We know the following about March’s results for Location 18 for Alan’s Fine Gold Jewelry, a franchise operation operating in Southern states:

Sales $480,000

Variable cost of jewelry 185,000

Other variable costs 55,000

Controllable �ixed costs 100,000

Direct noncontrollable �ixed costs 85,000

Home of�ice allocated costs 50,000

Questions:

1. Based on what contribution margin number would you evaluate the Location 18 manager? 2. Based on what contribution margin number would you evaluate Location 18?

1-12. Contribution Margin. As a recent marketing graduate of Big Time University, you landed a job with Food Mills, Inc. as product manager for Red Pop. Recent operating results are:

Sales of Red Pop $2,000,000

Variable costs of Red Pop 600,000

Direct noncontrollable �ixed marketing expenses 500,000

Variable selling expenses 300,000

Direct controllable �ixed marketing expenses 100,000

Allocated corporate marketing expenses (percentage of sales) 400,000

Allocated corporate of�ice costs (per employee) 200,000

Questions:

1. Evaluate the pro�itability of Red Pop. 2. What data should be used to evaluate you as manager of Red Pop?

Problems

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1-13. Determining Production Costs. Shirley Brickman knows the following about the production process in her plant:

Department 1: Conversion costs are $200,000. Prime costs are $300,000. Materials purchases are $200,000. Increase in materials inventory is $20,000. Decrease in work in process inventory is $40,000.

Question:

Calculate factory overhead costs.

Department 2: Direct product costs are materials and direct labor. Conversion costs are 300% of materials. Indirect product costs are 50% of conversion costs. Total manufacturing costs are $600,000.

Question:

Calculate materials costs.

Department 3: Conversion costs are 40% of total manufacturing costs. Direct labor is 25% of conversion costs. Factory overhead is $600,000.

Question:

Calculate total manufacturing costs.

1-14. Determining Unknowns. Determine the missing values in the following manufacturing income statement:

2018 2019 2020

Sales $? $118,700 $?

Cost of goods sold:

Direct materials inventory 1/1 $8,000 $? $?

+ Direct materials purchased ? 20,000 30,000

Direct materials available $? $26,000 $?

– Less direct materials inventory 12/31 ? (9,000) (12,000)

Direct materials used $? $? $?

Direct labor 20,000 23,500 ?

Factory overhead 16,000 ? 24,000

Total manufacturing costs $53,000 $ ? $90,900

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2018 2019 2020

+ Work in process inventory 1/1 12,000 18,000 ?

– Work in process inventory 12/31 ? (16,300) (22,300)

Cost of goods manufactured $ ? $63,500 $84,900

+ Finished goods inventory 1/1 ? ? ?

Goods available for sale $62,000 $84,500 $103,200

– Finished goods inventory 12/31 (21,000) ? ?

Cost of goods sold $ ? $ ? $78,200

Gross pro�it $60,000 $? $46,800

1-15. Determining Cost of Goods Sold. Asnien Out�itters makes Artic Hotsuits. The general manager has a special board on his of�ice wall where he writes key statistics. For March, the board shows the following:

Production output 25,000 suits

Materials costs $50,000

Direct labor costs 2,000 hours at $10 per hour

Factory overhead $2 per out�it plus $40,000 per month

Selling expenses $1 per out�it sold plus $50,000 per month

He heard the sales manager brag about selling 22,000 suits this month.

Questions:

1. From the data, what was the cost of producing an Artic Hotsuit in March? 2. What was cost of goods sold in March? 3. What are the total product and period costs that will appear on Asnien Out�itters’ income

statement for March?

1-16. Income Statement Preparation. A partial list of account balances for Ackerman Corporation follows:

Revenue and Expenses: January 1 Inventories:

Purchases of direct materials $140,000 Direct materials $45,000

Direct labor 225,000 Work in process 30,000

Indirect labor 40,000 Finished goods 105,000

Rent – factory 84,000

Depreciation – machinery 35,000 December 31 Inventories:

Insurance – factory 18,000 Direct materials $40,000

Salespersons’ salaries 72,000 Work in process 35,000

Maintenance – machinery 12,000 Finished goods 110,000

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Revenue and Expenses: January 1 Inventories:

Administrative salaries 50,000

Miscellaneous – factory 26,000

Miscellaneous – of�ice 40,000

Sales 850,000

Question:

Prepare an income statement with a cost of goods manufactured section.

1-17. Identifying Cost Patterns. Match the graphs in Figure 1.15 with the numbered descriptions. Indicate any assumptions you are making. The x-axis is activity; the y-axis is total dollars of cost.

Figure 1.15: Summary of cost classi�ications

1. _____ a + b (X), where “a” and “b” are not equal to zero. 2. _____ Straight-line depreciation expense (a classic �ixed cost). 3. _____ Shift supervision salaries (shifts added as demand increases). 4. _____ Municipal utility costs where the rate increases as usage increases. Usage increases with

activity increases. 5. _____ Sales commissions paid to salespersons. 6. _____ Workers’ wages plus overtime premium. Overtime is needed after a certain activity level is

reached. Workers are less ef�icient when they work a lot of overtime.

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7. _____ Water and waste water costs with a �ixed-cost base charge plus a per-gallon rate beyond a certain level.

8. _____ Payroll taxes that are based on the �irst $30,000 of each employee’s wages. All employees earn more than this at high activity levels.

9. _____ Mixed costs within a relevant range. 10. _____ Cost of hourly messenger service for a regional bank with a reduced rate after 2,000 hours of

chargeable time. 11. _____ Wage costs as more hourly telephone callers are added in a telemarketing campaign. 12. _____ Materials costs where cost per pound decreases as larger quantities are purchased.

1-18. Cost Classi�ication. Selected costs associated with a variety of business situations are shown below:

a. Sales commissions of the marketing staff b. Salary of the plant manager c. Lubricating oils for machines d. Brass rods used in making plumbing products e. Property taxes on a building that includes both the factory and home of�ice f. Labor in the repairs and maintenance section g. Salary of the supervisor in the grinding department h. Crude oil used in a re�ining process that results in numerous products i. Wages of artists preparing ads for a grocery chain, working for the grocery chain j. Depreciation on administrative of�ice furniture

k. Salaries of quality assurance personnel who test products during production l. Salaries of software engineers in a production plant using robots

m. Wages of union auto assembly workers guaranteed 2,000 hours of work per year

Question:

Create columns to classify each item by cost behavior (variable, semivariable, or �ixed) with respect to activity; as a product or period cost; and, if it is a product cost, as a direct or indirect product cost.

1-19. Cost Analysis Without Pro�it as a Bottom Line. Riverdale Transport, Inc. runs passenger and freight services between the Cleveland airport and other nearby towns and cities. The owner, Serena Bailey, is an operations-wise manager. She recently heard about a “segment contribution margin” approach at a university continuing education program. Her actual results for the �irst half of this year have just arrived.

Total revenue was $5.0 million, of which $3.5 million was freight traf�ic and $1.5 million was passenger traf�ic. Of the passenger revenue, 60% was generated by Route 1, 30% by Route 2, and 10% by Route 3.

Total direct controllable �ixed costs were $600,000, of which $500,000 was spent on freight traf�ic. Of the remainder, $40,000 could not be traced to speci�ic routes, although it was clearly applicable to passenger traf�ic in general. Routes 1, 2, and 3 incurred costs of $30,000, $18,000, and $12,000, respectively.

Total direct costs not controllable by segment managers were $500,000, of which 80% was traceable to freight traf�ic. Of the 20% traceable to passenger traf�ic, Routes 1, 2, and 3 should be charged $40,000, $20,000, and $15,000, respectively. The balance was not traceable to a speci�ic route.

Total variable costs were $3.2 million, of which $2.0 million was freight traf�ic. Of the $1.2 million traceable to passenger traf�ic, $670,000, $400,000, and $130,000 were incurred by Routes 1, 2, and 3, respectively.

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The common �ixed costs not clearly traceable to any part of the company amounted to $500,000. Serena has always allocated these costs using a percentage of sales basis.

Questions:

1. Serena asks you to prepare an earnings statement that shows the performance of each segment of the �irm by various types of contribution margin.

2. Comment on what the results tell Serena.

Case: Bureau of Business and Economics Research

The Bureau of Business and Economics Research (BBER) at Western State University has contracted with the Fiscal Planning Of�ice (FPO) of the state legislature to do economic analyses and forecasting. Most of the work involves computer operations using a large planning model and databases that the state Department of Commerce has assembled. The contract calls for payment of all direct costs of personnel with limits on the amount of chargeable time per quarter. An overhead rate is applied to personnel charges at 60% of direct personnel costs. This rate is developed by the university to cover common costs of operating the university plus personnel bene�its of the persons working on the project.

Data processing costs are reimbursed on a cost basis and include additional equipment needed to perform the analyses, purchase of modeling software, computer time, and data storage.

An auditor from the state’s Auditor General’s Of�ice has just �inished a routine audit of this contract and has written a report critical of the BBER. Among the items noted are:

1. A large copy machine was leased by BBER to prepare reports for the FPO and charged to the contract. The BBER uses the machine for preparing many other reports for the university, including course materials.

2. Computer time is billed at the “average cost of computing time at priority level.” This rate is approximately eight times the rate faculty and students are charged for work done on the university’s server. The same rate is used for other outside customers of the computer center.

3. Personnel time was billed to the contract using a rate based on the contracting faculty person’s annual salary divided by 250 work days. But the auditor found that the work was actually done by a graduate student earning about 20% of the faculty person’s salary.

4. The software model purchased for FPO contract use has been adapted at low cost to perform analyses for several other BBER corporate clients. It is also used by two faculty members who are doing outside consulting on their own. Corporate clients are charged for the use of the model. The faculty use the model at nights and on weekends when the model is not otherwise used.

Questions:

1. Identify the parties that have an economic interest in these issues. 2. Does the BBER appear to be costing the contract with the FPO fairly? Evaluate each issue,

given the information available.

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Learning Objectives

After studying Chapter 2, you will be able to:

Understand why and how costs are attached to products and services.

Describe how direct materials and direct labor are costed to products.

Explain the use of predetermined overhead rates, calculate plant-wide and departmental factory overhead rates, and identify differences among alternative measures for the denominator in the overhead rate.

Explain why services or products should be costed for pricing purposes by using an overhead rate computed at normal volume levels.

Provide entries for transactions relating to product costing in a normal costing system.

2 Product Costing: Attaching Costs toProducts and Services

kadmy/iStock/Thinkstock

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Describe how to allocate service center costs so that they can be included in overhead rates of operating departments.

Appreciate ethical issues involving cost allocation.

What Is the Cost of a Brake Job?

As a high school wrestling coach working in Florida, Greg Herman satis�ied his love for automobiles by working as an auto mechanic during the summer months. He also found himself occasionally repairing friends’ cars year-round. Demand for his repair expertise began to boom, so Greg invested his savings in a new business, Greg’s Auto Repair.

Greg started his enterprise with a �irm hope of making a pro�it, and he has realized pro�its. However, times are changing. Revenues for this year have reached over $2 million and are expected to increase in the future. Costs are, on the other hand, increasing faster than revenues. Greg does not know what his pro�it margins are for brake jobs, muf�lers, and body work because he has no idea what it costs him to make repairs. Most of his accounting has been a “shoebox approach,” in which receipts, deposit slips, and invoices go into a box. Periodically, a local CPA �irm, Ginsburg & Arogeti, sends a staff accountant to sort the box’s contents and prepare �inancial statements.

Greg needs cost information about repairs, and his accounting system does not provide it. For example, he needs to know: What does it cost to make one repair of each type? Are repair costs higher this month than last month? With pro�its going down, which jobs are losing pro�it margin? And, behind all of these questions is: How should overhead costs be assigned to jobs? Greg needs an accounting system that will provide cost information for his current needs and for the future.

Costs are used to accomplish an assortment of needs: to evaluate the pro�itability of goods and services, to aid in pricing and bidding decisions, to plan and budget operations, to evaluate performance, to control costs, and to establish inventory values for the balance sheet and cost of goods and services sold for the income statement.

This chapter discusses accounting for production costs and presents ways to identify costs with products. Accounting for direct materials and direct labor comes �irst. Then, accounting for factory overhead covers simple to more complex situations. Finally, we discuss how service center costs are included in product cost.

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2.1 Costing of Products and Services The production of goods and services involves resources. As mentioned in Chapter 1, the costs of these resources are typically classi�ied as materials, labor, and factory overhead. The costs are accumulated by jobs or by departments. Then they are assigned to each unit of output (product or service) based on each unit’s use of the resources. These relationships for assigning costs to products or services are depicted in Figure 2.1.

Figure 2.1: A view of cost linkage

The principles underlying product costing are applicable to manufacturing companies and service organizations. For example, a hospital may be interested in determining the cost of a speci�ic medical treatment or the cost of outpatient care. A furniture store may wish to know the costs associated with carrying and selling a particular line of sofas. A building contractor, on the other hand, will accumulate costs by project. If a contractor is constructing a new bridge for the state, for instance, the contractor will identify and trace the costs to the bridge project. A university may be interested in the estimation, measurement, and control of a program to train mathematics teachers. A museum may want to determine the cost of a particular exhibit for a season.

Regardless of the type of organization, costs are identi�ied as direct costs when they can be readily connected to a cost object. Indirect costs, which cannot as easily be connected to a cost object, must be allocated using some reasonable basis for allocation. Because the principles used in tracing costs are more clearly identi�ied in a manufacturing setting, manufacturing cost methods are often adapted to a wide variety of applications.

We can categorize a manufacturing process as yielding commingled products, fabricated products, or assembled products. Commingled products exist when one unit cannot be distinguished from any other unit. One pound of sugar is indistinguishable from another pound unless contained in some way. Products in this category include �lour, oil, electricity, soft drinks, textiles, processed foods, and paper. Fabricated products involve reshaping materials through a cutting, stamping, or molding operation. Examples include tires, nuts and bolts, sugar-coated breakfast cereals, and silverware. Assembled products bring parts and subassemblies together for an assembly operation. Each product passes through the same assembly operations. Examples include kitchen appliances, calculators, computers, telephones, and pickup trucks.

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2.2 Costing of Direct Costs We now discuss how to determine the costs that are directly traceable to products or jobs. These costs consist of direct materials and direct labor.

Costing of Direct Materials

Materials include the raw materials, purchased parts, and purchased or subcontracted assemblies and subassemblies. Direct materials are those that are identi�ied with the production of a speci�ic product and are easily and economically traced to the product; their costs represent a signi�icant part of the total product cost. All other materials and supplies that become part of a product or are consumed in production are called indirect materials, which are part of factory overhead.

The costs associated with acquiring materials and having them ready for production typically fall into �ive categories:

1. The acquisition cost (purchase price or production cost) of the materials 2. In-transit charges, such as freight, insurance, storage, customs, and duty charges 3. Credits for early payment discounts, cash discounts, and other discounts and allowances 4. The costs of purchasing, receiving, inspecting, and storing activities 5. Miscellaneous items, including income from the sale of scrap and spoiled units, obsolescence, and

other inventory losses

Categories 1 through 3 are typically included in the cost of materials, whether direct or indirect materials. Categories 4 and 5 are treated as factory overhead. We allocate those costs to products with one of the several approaches that will be discussed later in the chapter.

The document that lists all materials needed to produce one unit of each product is the bill of materials, generated by product design engineers. It lists the sequence in which the materials will enter production. Once a decision is made about the quantity of products to produce, the bill of materials is used to determine the amount of materials to be acquired.

T-accounts will be used to illustrate how transactions involving materials and other costs are recorded in the accounts. A T-account is a simpli�ied presentation of an account in the shape of the letter T, enabling one to see the activity that has occurred relating to the account. Suppose that Julz Enterprises, a manufacturer of MP3 players, purchased materials on account for $75,000. Upon receipt of the materials, we increase Materials and Accounts Payable by $75,000 as follows:

Materials Accounts Payable

75,000 75,000

Production managers requisition from the storeroom the materials required for a speci�ic job or product. Thus, each requisition becomes the basis for charging the cost of materials to a speci�ic job or product. A materials requisition form is illustrated in Figure 2.2. Assume that a month’s requisitions at Julz Enterprises show that direct materials costing $60,000 have been transferred from the materials

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inventory to production. The total of $60,000 is moved from Materials to Work in Process. The latter account is the central account for the entry of production costs. The costs of the three cost elements— direct materials, direct labor, and factory overhead—are funneled through this account, as will be shown later. It is, therefore, the control account for all in-process activity. The movement of materials used in production for the month is shown as:

Materials Work in Process

75,000 60,000 60,000

The costs included in the $60,000 are also charged to the various processing departments or jobs that used the materials. These itemizations form the subsidiary ledger for the Work in Process control account.

Figure 2.2: Materials requisition form

Costing of Direct Labor

Factory labor is the total labor cost expended for the bene�it of production. Direct labor can be speci�ically identi�ied with a product in an economically feasible manner. Indirect labor is not readily traced to a product. Because of the changes in the production environment in many companies and the emphasis on a just-in-time philosophy, a new term, value-added direct labor, is being used. Value-added direct labor changes materials into a �inished product. For example, value-added direct labor fabricates parts, assembles products, and �inishes products. Nonvalue-added direct labor moves, inspects, stores, examines, or otherwise handles the product without adding value to the product. For our purposes, we will generally de�ine direct labor as value-added and indirect labor as nonvalue-added, even though the differences are not always clear.

Labor-related costs include the wages and salaries of the employees plus any additional expenditures made by an employer on behalf of an employee. These typically include bonuses, overtime premiums (i.e.,

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the additional wages for overtime), shift differentials, idle time, employer’s payroll taxes, and fringe bene�its. These additional expenditures are usually treated as part of the factory overhead costs. Some of these expenditures cannot easily be traced to individual production orders. Others, such as overtime premiums and shift differentials, are treated as factory overhead, so those products worked on during overtime hours or late shifts are not unfairly penalized.

Labor time tickets or labor time reports will show how much of the labor time and cost is charged to each job or production order. A labor time ticket is illustrated in Figure 2.3. For the sake of simplicity, we will assume that all of Julz Enterprises’ labor is direct labor. Periodically, factory payroll is recorded by a debit to Work in Process, with offsetting credits to Wages Payable, Employees Income Tax Payable, and other liability accounts for payroll deductions. Suppose that during one month, the labor costs for Julz Enterprises were $10,000 and the workers’ take-home pay totaled $7,400. The resulting transaction is shown:

Work in Process Wages Payable

60,000 7,400

10,000

Other Labor Related Payables

2,600

Figure 2.3: Labor time ticket

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2.3 Costing Factory Overhead Factory overhead, unlike direct materials and direct labor, cannot be requisitioned or measured directly as a cost of any particular job, production order, or service. Factory overhead consists of a variety of costs, such as indirect materials, indirect labor, insurance, depreciation, utilities, repair, and maintenance—all of which are indirectly related to the products. The indirect nature of overhead costs with respect to the products or services creates a dif�iculty in identifying production costs with each unit. For our purposes at this point, we take an overall, simpli�ied approach to costing of factory overhead to products in order to convey the concepts involved. Later in the chapter, we explain overhead costs by employing departmental rates.

For the discussion that follows, factory overhead is attached to products or services by means of a cost driver that links costs to products. The cost driver chosen as a basis for overhead allocation should be related logically to both the overhead and the product. If machinery plays an important role in the manufacturing operation, the overhead costs likely consist of power cost, lubrication, maintenance, repairs, depreciation, and other costs closely related to machine operation. The bene�its received by the products can probably be best measured against the cost of the machine hours used in their production. Therefore, these overhead costs should be allocated to the products on the basis of machine hours used to produce the products. For other plants whose operations are more labor intensive than capital intensive, direct labor cost or direct labor hours may be more appropriate for overhead allocation. The most common cost drivers chosen for overhead allocation are direct labor hours and direct labor cost.

The total cost driver activity for the plant is divided into the total overhead cost to obtain an overhead rate. Products then are assigned overhead cost by multiplying the actual quantities of the activity by the rate calculated. Suppose that Julz Enterprises uses direct labor cost to allocate overhead. During the month in the earlier example, for which direct labor cost was $10,000, the total overhead for the plant was $15,000. Consequently, the overhead rate would be 150% of direct labor cost. During that month, the direct labor cost incurred to produce MP3 players amounted to $2,700. Hence, $4,050 ($2,700 × 1.5) of overhead cost would be allocated to the MP3 players.

Predetermined Overhead Rate

Thus far, we have discussed actual costing, where the product costs consist of actual direct materials used, actual direct labor cost, and overhead allocation based on total actual overhead costs and total actual activity. Most companies, however, use a normal cost system or a standard cost system. The latter will be covered in Chapter 8. Normal costing differs from actual costing in that overhead is allocated using a predetermined overhead rate, de�ined as:

Predetermined overhead rate = Budgeted factory overhead ÷ Budgeted cost driver activity

With normal costing, the applied factory overhead is determined by multiplying the predetermined overhead rate by the actual cost driver activity for the job or product. Typically, companies use a one-year time horizon to calculate predetermined overhead rates.

Two major reasons exist for the use of annual rates rather than shorter time periods. The �irst is the timing of factory overhead cost incurrence. For example, air conditioning costs in the summer for many companies in the south tend to be higher than heating costs are in the winter. Should we allocate the higher air conditioning costs to products that were manufactured during the summer? The facilities and workers must be maintained regardless of the weather. In addition, discretionary costs may �luctuate

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widely from month to month. For instance, managers may decide to incur substantial maintenance costs during some months and very little during other months. Because of seasonal and discretionary aspects of overhead, a more stable overhead rate requires a longer time horizon, such as one year.

The second reason for the use of annual rates normal costing is the potential �luctuation in the activity represented by the cost driver. Most companies do not have a constant level of activity every month. For example, employees take vacations during the summer months, operations are scaled back to accommodate major repairs and maintenance, production ceases while a changeover in tooling occurs, or the company is closed for the week between Christmas and New Year’s Day. Normal costing, by using a one-year time horizon for the overhead rate, averages costs over the units of work regardless of when work is performed. Therefore, a product is not penalized because it is produced during a period of low volume.

Calculating an actual overhead rate using a one-year time horizon, pricing and other cost-based decisions could not be done until the end of the year. Clearly, companies cannot operate this way. The use of a predetermined overhead rate allows costs of products and jobs to be calculated throughout the year as necessary. Moreover, a predetermined overhead rate helps managers to prepare bids on major orders or to price business from prospective customers.

To illustrate the application of overhead in a normal cost system, suppose that, for 2018, Bodker Publishing Company has budgeted $50,000 for �ixed overhead costs and $3 per direct labor hour for variable overhead costs. This is its overhead cost function. These budgeted costs correspond to a budget activity of 10,000 direct labor hours. The predetermined overhead rate is computed as:

[$50,000 + $3(10,000)] ÷ 10,000 = $8 per direct labor hour

Assume there were 10,000 direct labor hours worked, at a rate of $10 per hour, during 2018. This results in a debit of $100,000 to the Work in Process account below. Assume also that $95,000 of direct materials were used, which results in a $95,000 debit to Work in Process. During production, various entries were made to cost the individual jobs. We could quite literally add $8 to Work in Process every time one more hour of direct labor is worked. In normal accounting activity, these transfers to Work in Process are done periodically, perhaps weekly or monthly. If done in aggregate, a summary transfer to Work in Process of all overhead applied to all jobs would show the following:

Factory Overhead Work in Process

80,000 100,000

95,000

80,000

As each job goes through production, an overhead charge at the predetermined rate of $8 for each direct labor hour is made to the job. Suppose Bodker Publishing Company published an economics textbook (Job 1018) that required $20,000 of direct materials and 2,000 hours of direct labor at $10 per hour. The completed cost for Job 1018 can be summarized as:

Direct materials $20,000

Direct labor (2,000 hours at $10 per direct labor hour) 20,000

Factory overhead (2,000 hours at $8 per direct labor hour) 16,000

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Total cost $56,000

At its completion, the cost of a job is transferred from Work in Process to Finished Goods. For Job 1018, the transfer would be:

Finished Goods Work in Process

56,000 100,000 56,000

95,000

80,000

Disposition of the Overhead Variance

While the products are costed using a predetermined overhead rate and by crediting the Factory Overhead account, actual overhead costs are incurred and recorded as debits to Factory Overhead. Suppose Bodker Publishing Company incurred actual overhead costs amounting to $81,500 during 2018. These costs included depreciation of $11,500, expired insurance of $10,000, salaries of $40,000, and utilities of $20,000. The entries to record these actual costs are:

Factory Overhead Accumulated Depreciation

81,500 80,000 11,500

Prepaid Insurance Wages Payable

10,000 40,000

Utilities Payable

20,000

Notice that expense accounts were not debited because the above items represent product costs rather than period costs, as discussed in Chapter 1. Nonmanufacturing, or selling and administration, costs are debited to expense accounts. Suppose Bodker Publishing Company had selling expenses of $29,000, of�ice rent of $45,000, executive salaries of $320,000, and of�ice utilities of $33,000. The following entries would be recorded:

Selling Expenses Accounts Payable

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29,000 29,000

Of�ice Rent Expense Rent Payable

45,000 45,000

Salaries Expense Wages Payable

320,000 40,000

320,000

Of�ice Utilities Expense Utilities Payable

33,000 20,000

33,000

Since only $80,000 of factory overhead was applied during 2018, the total actual factory overhead incurred was not charged to jobs. The difference, or variance, of $1,500 can be closed to Cost of Goods Sold at the end of the year, or, if desired, can be allocated to Cost of Goods Sold, Finished Goods, and Work in Process on the basis of their account balances. Since these variances tend to be relatively small, most companies simply close them out to Cost of Goods Sold. Using this approach, Bodker Publishing’s entry to close out the variance is:

Factory Overhead Cost of Goods Sold

81,500 80,000 1,500

1,500

Notice that since we did not attach all $81,500 of spending to our production, Cost of Goods Sold is increased by $1,500.

If too little overhead is costed to the products, as in the above example, the variance is called underapplied or underabsorbed overhead. When this occurs, expenditures for overhead expenses exceed the amount attached to the products during the accounting period. On the other hand, if too much overhead is costed to the products, the variance is called overapplied or overabsorbed overhead. In this situation, more overhead costs are attached to the period’s output than are actually incurred for overhead.

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Overapplied or underapplied overhead can have undesirable consequences such as loss of customers to competitors or charging prices that are below actual full cost.

Underapplied factory overhead means nothing more than the actual costs were not absorbed by the products manufactured. Underapplied overhead occurs in these situations:

1. We produced less than expected. 2. We spent more than expected.

When overhead is overapplied, the variance is credited to (i.e., subtracted from) Cost of Goods Sold. Overapplied overhead occurs in these situations:

1. We produced more than expected. 2. We spent less than expected.

In the Bodker Publishing Company example, 10,000 direct labor hours were worked. This was exactly the amount of activity that was budgeted. Therefore, the reason for the underapplied overhead variance was overspending. According to the company’s cost function ($50,000 + $3 per direct labor hour), spending should have been $80,000 but was actually $81,500.

More detailed reasons for overhead variances are discussed in Chapter 8.

Multiple Overhead Rates

Some reasonable, causal, or bene�icial relationship should exist among the costs accumulated in factory overhead accounts, the cost driver selected, and the products or services to which the costs will be allocated. Simply stated: The activity (as represented by the cost driver) is the link between the output of products or services and factory overhead spending. The implication is that more output requires more activity and, therefore, more overhead spending. For example, if a company uses direct labor hours as a cost driver, factory overhead costs should consist primarily or exclusively of costs that support direct workers. Such costs may include supervision and facilities for work places, as well as travel, training, and fringe bene�its of workers.

In the examples up to this point in the chapter, we have assumed that only one cost driver is appropriate for the total factory overhead. However, diversity of products and services will often result in distorted cost allocations when only one cost driver is used. The greater the differences in products, the greater the diversity that exists in the operations. The more diverse the operations, the more likely it is that one cost driver cannot assign costs to all products fairly. In these situations, departmental overhead rates will assign costs more accurately to products than will one plant-wide overhead rate. A plant-wide factory overhead rate can only be justi�ied for a company making few and similar products.

For an example, consider Fellman & Associates, a company that �inishes furniture for local manufacturers. The furniture passes through two major activity centers that form the two departments in the process: sanding and painting. A summary of direct labor and overhead costs for each department during the last month follows:

Sanding Painting Total

Direct labor $37,000 $26,500 $63,500

Overhead 74,000 79,500 153,500

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Overhead is allocated to products on the basis of direct labor dollars. Dividing the overhead costs by direct labor dollars gives the following departmental and plant-wide overhead rates:

Sanding ($74,000 ÷ $37,000) = 200%

Painting ($79,500 ÷ $26,500) = 300%

Plant-wide ($153,500 ÷ $63,500) = 241.7%

Using the different rates in allocating overhead costs to a job that has $86 of Sanding direct labor and $32 of Painting direct labor (i.e., a total labor cost of $118) gives the following amounts:

Plant-wide overhead rate ($118 × 241.7%) $285.21

Departmental overhead rates:

Sanding ($86 × 200%) $172.00

Painting ($32 × 300%) 96.00 $268.00

The departmental rates allocate costs considering the characteristics of the product or job involved. The plant-wide rate averages all products and jobs.

For Fellman & Associates, the same cost driver was selected for each department. A more common situation is where departments have different cost drivers. For example, a Fabrication Department may use direct labor hours; a Machining Department, machine time; a Production Engineering Department, direct labor cost. As a company considers ways to trace costs to products more accurately, it will look at the production and support activities more closely and choose an appropriate cost driver to allocate the overhead costs.

Alternative Concepts of Volume

When selecting the denominator for the overhead rate, volume can be measured in one of four ways:

1. Ideal capacity 2. Practical capacity 3. Expected volume 4. Normal volume

Ideal capacity is the maximum amount of product that can be manufactured or the maximum service that can be rendered with available facilities. This is often too perfect a goal to be realized, and is generally recognized to be beyond realistic expectations. Certain interruptions and inef�iciencies in production are to be expected.

Practical capacity is full utilization of facilities with allowance made for normal interruptions and inef�iciencies. For example, production will be slowed or stopped at times because of breakdowns, shortages of labor and materials, or retooling. These possibilities are considered in arriving at practical plant capacity.

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Expected volume is the level of operation budgeted or estimated for the current period. This may be at or below practical capacity. It is the level at which management expects to operate during the next month or year.

Normal volume is generally a balance between practical capacity and sales demand in the long run. Over a period of years, the peaks and valleys of customer demand are leveled by averaging, and the average level of plant utilization is considered to be normal volume.

It may seem, at �irst, that overhead per unit should be calculated at the expected level of operation for the next year. Indeed, this is the practice of most companies. However, for product pricing purposes, a better approach is to use the normal volume. Why should normal volume be used when you already know that the company may be operating below that level? After all, a rate computed at the expected level of operation will come closer to costing all of the overhead to the products, and product cost will be more in line with actual cost.

The problem with using an overhead rate based on expected, rather than normal, volume is illustrated by the following example. Assume that the normal level of operation for Cherrywood Medical Laboratory is 200,000 labor hours and that 100,000 items can be analyzed in that time. The �ixed overhead for the year is budgeted at $500,000. The normal �ixed overhead per item is then $5, computed as:

But management expects to operate at only 100,000 labor hours next year and to analyze 50,000 items. An overhead rate at expected volume would be $10 per item:

If the lab plans to operate below normal volume, an overhead rate computed at the expected level of operations will result in more �ixed overhead being assigned to each item. If prices are set by adding a markup to total cost, the price will be higher when fewer items are analyzed. With a higher price under competitive conditions, customers may be lost, thereby aggravating a condition when volume is already below normal.

For this reason, the objective is not necessarily to assign all overhead costs to products. The products should bear the normal overhead costs, and any unabsorbed �ixed overhead should be recognized as a period expense. (Overabsorbed �ixed overhead would likewise result in a reduction of period expenses.)

Contemporary Practice 2.1: Denominator Activity Levels Used to Calculate Overhead Rates

A survey of 280 manufacturing companies in Great Britain revealed that 219 companies incorporated overhead allocations into product costs. Of these 219 companies, the following table indicates the types of denominators used in their overhead rates and frequencies of usage:

= = $5 Fixed overhead per item (Budgeted fixed overhead)

(Items analyzed at normal volume) ($500,000) (100,000)

= = $10 Fixed overhead per item (Budgeted fixed overhead)

(Items analyzed at normal volume) ($500,000)

(50,000)

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Type of Denominator FrequencyType of Denominator Frequency

Theoretical maximum capacity 1.8%

Practical capacity 16.9%

Normal capacity 16.0%

This year’s budgeted capacity 53.9%

This year’s actual capacity 4.1%

Last year’s actual capacity 5.5%

Other 1.8%

100%

Source: Brierley, J.A., Cowton, C.J. & Drury, C. (2006). Reasons for adopting different capacity levels in the denominator of overhead rates: A research note. Journal of Applied Management Accounting Research, 53–62.

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2.4 Cost of Providing Services An entity that provides services instead of tangible products may not operate with a formal cost accounting system that traces costs to jobs. Instead, all service job costs are treated as period costs and are often left in their original cost categories such as supplies expense, labor expense, depreciation expense, etc.

Nevertheless, costs will be used to measure performance by type of service and by customer groups. A luxury hotel, for example, may provide a �itness facility for its guests. The cost of supplies used exclusively for the �itness facility, such as rubbing lotions and bandages, along with the salaries and wages of the facility’s employees, such as the manager and exercise class instructors, is identi�ied with the facility’s activities. Also, costs of special equipment used, such as depreciation and maintenance expenses, and other overhead costs increased by operating this service, will be included. These costs can be used as a basis for deciding how much must be added to a guest’s bill to cover all costs and allow for pro�it. Also, does the amount of customer patronage justify continuance of the service? Can other features be provided at a certain cost to attract more customer attention? Properly assigning costs to the �itness facility will give the manager the accounting information needed to answer these questions.

Some service organizations do have formal systems for determining costs associated with jobs. Accounting and legal services are examples where the �irm may want costs accumulated by client number or case. In this situation, each client number or case becomes a job, with costs traced to the individual jobs.

In service organizations having formal job cost systems, inventory accounts such as Work in Process Services or Cost of Unbilled Work are used to re�lect the cost of resources and effort that have been expended, but where the work is not yet completed for the customer. At year-end, or whenever �inancial statements are being prepared, the cost of uncompleted work appears in this type of inventory account rather than in an expense account because the related revenue has not yet been earned. Examples of such situations may include:

A painting contractor is in the midst of a three-week painting job. An engineering �irm is in the early design stage of a four-month project. A web page design �irm has another two days of work before presenting the completed work to its client. A landscaping company has only partially completed its planting of shrubs and �lowers.

When the work is completed, the costs are transferred to an account such as Cost of Completed Jobs or Cost of Services Provided. These accounts are analogous to Cost of Goods Sold for a manufacturing �irm. Since most service �irms do not have �inished goods inventories, there would usually be no account analogous to Finished Goods.

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2.5 A Product Costing Illustration Summarized cost data are presented in this section for Scher Machine Company to illustrate product costing procedures using a normal costing system. Note that the entries given are in composite form. In practice, many repetitious entries are made to record individual transactions that take place during the year. The sequential order of the cost transactions should also be considered. For example, the preparation of the budget for factory overhead and overhead rate calculations are completed before the beginning of the year. The predetermined overhead rate must be calculated from a budget of factory overhead so that products will be assigned the proper overhead cost. Only at the end of the year will the company know that 220,000 direct labor hours were used and that the actual factory overhead cost was $1,336,200. Throughout the year, the company purchases materials and incurs labor and factory overhead costs as products are continually processed, completed, and sold. At the same time, costs are traced to the products and released as expenses when the products are sold.

Scher Machine Company transactions data for the �iscal year ended April 30, 2018, are as follows:

1. Materials purchased during the �iscal year totaled $840,000. 2. Direct materials requisitioned for production cost $631,400. Indirect materials costing $47,200

were also requisitioned. 3. Factory payrolls amounted to $1,874,000. The income taxes withheld from the employees’ wages

totaled $393,400, and the deduction for FICA taxes withheld amounted to $106,600. A distribution of the factory labor cost of $1,874,000 shows that $1,760,000 was direct labor while the remaining $114,000 was indirect labor.

4. Factory overhead at the normal operating level of 250,000 direct labor hours results in an overhead rate of $6 per direct labor hour. During the year, direct labor workers recorded 220,000 labor hours.

5. The factory overhead, in addition to the indirect materials and the indirect labor, amounted to $1,175,000. Included in this amount is depreciation of $120,000 and the employer’s share of FICA taxes of $106,600. The balance of the overhead was acquired through accounts payable.

6. Jobs completed and transferred to stock during the year had costs of $2,945,200. 7. The cost of orders sold during the year was $2,320,000. 8. The Factory Overhead account is closed to Cost of Goods Sold at the end of the �iscal year.

The transactions are entered in the accounts as follows:

1. Purchase of materials. (The cost of each type of materials is also entered on the individual materials inventory cards.)

Materials Accounts Payable

840,000 840,000

2. Materials issued to production. (Requisitions are the basis for entries reducing materials inventory, for posting direct materials costs to each job, and for posting indirect materials costs to Factory Overhead.)

Materials Work in Process

840,000 678,600 631,400

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Factory Overhead

47,200

3. Factory payrolls. (A classi�ication of labor time by jobs is shown on labor time tickets. These tickets are the basis for distributing direct labor costs to individual jobs and for posting indirect labor costs to the factory overhead subsidiary ledger.)

Wages Payable

1,374,000

Employees’ Income Taxes Payable FICA Taxes Payable

393,400 106,600

Work in Process

631,400

1,760,000

Factory Overhead

47,200

114,000

4. Factory overhead applied. (Factory overhead applied to products on direct labor hour basis is: 220,000 hours × $6 rate = $1,320,000.)

Work in Process Factory Overhead

631,400 47,200 1,320,000

1,760,000 114,000

1,320,000

5. Actual factory overhead. (This is in addition to indirect materials and indirect labor.)

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Factory Overhead Accumulated Depreciation

47,200 1,320,000 120,000

114,000

1,175,000

FICA Taxes Payable Accounts Payable

106,600 840,000

948,400

6. Work completed during the year and transferred to stock. (Completed jobs are removed from the �ile of jobs in process and moved to the subsidiary ledger supporting �inished goods inventory. Ending Work in Process is $766,200.)

Work in Process Finished Goods

631,400 2,945,200 2,945,200

1,760,000

1,320,000

766,200

7. The cost of goods sold. (Deductions are recorded in the �inished goods inventory ledger. Entries are also made in records supporting billings to customers for the sales. Ending Finished Goods is $625,200.)

Finished Goods Cost of Goods Sold

2,945,200 2,320,000 2,320,000

625,200

8. Closing of Factory Overhead. (Total actual overhead cost from entries in Items (2), (3), and (5) is $1,336,200. Actual overhead amounting to $16,200 is not absorbed as a part of the product cost. The underapplied overhead is closed to Cost of Goods Sold.)

Factory Overhead Cost of Goods Sold

47,200 1,320,000 2,320,000

114,000 16,200 16,200

1,175,000

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2.6 Service Center Costs Most companies have several departments or functions involved directly or indirectly in producing goods or providing services. The development of departmental overhead rates depends on the interrelationships among these different departments.

Operating departments are organizational units most closely tied to the productive effort that results in products or services to customers. In manufacturing organizations, these units are typically called producing departments. On the other hand, service centers (or support functions) provide supporting services that facilitate the activities of the operating departments. Often, service centers provide support services to one another. Service centers include, for example, maintenance, quality control, cafeterias, internal auditing, personnel, accounting, production planning and control, and medical facilities. Although they do not have a direct relationship to output, service center costs support operating departments, and, therefore, become part of the cost of a �inished product or service. In some limited cases, a service center provides support services for operating departments as well as services for outside customers. Examples include engineering consulting, research and development, computer systems design, copying services, and laboratory work.

Service center costs are allocated to operating departments by means of a cost driver. Any one of a number of cost drivers may be appropriate for calculating a rate depending on the nature of the support activity. Examples of cost drivers that could be used are given in Figure 2.4. The allocated service center costs become part of the total overhead costs of the operating departments. Even costs that are direct materials or direct labor with respect to service centers become overhead costs when allocated to operating departments.

Figure 2.4: Cost drivers used for service centers

Occasionally, companies may not allocate service center costs to operating departments, in order to ensure that the services are fully utilized by the operating managers. Some examples of this phenomenon

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include internal audit departments, credit-check services, libraries, and computer services.

Three common approaches are available for allocating the costs of service centers: direct method, step (sequential) method, and reciprocal method. To illustrate the allocation of service center costs for the �irst two methods, we will use data from the School of Business at Hardknox University. The School of Business wishes to determine overhead costs per credit hour for its graduate and undergraduate programs. We will treat these as the two operating departments. The School of Business has three service centers: Building Services, Staff Services (e.g., of�ice support, computer support, and photocopying), and Administration. Budgeted data for the coming year appear as follows:

Square Feet Occupied Employees Overhead Costs

Service centers:

Building Services 1,000 30 $165,000

Staff Services 2,000 20 90,000

Administration 8,000 20 330,000

Operating departments:

Graduate Program 10,000 30 265,000

Undergraduate Program 20,000 90 420,000

Building Services costs are allocated on square footage of classroom and of�ice space. Staff Services and Administration costs are allocated based on number of employees (i.e., faculty and staff). Budgeted credit hours for the year are 20,000 for the Graduate Program and 60,000 for the Undergraduate Program.

Direct Method

Direct method allocations are made from each service center to operating departments in proportion to activity performed for each. Thus, the direct method does not assign costs to other service centers for work performed for other service centers. Allocation of service center costs uses only those cost drivers pertaining to operating departments. Once the service centers have their costs allocated, operating department overhead rates per unit of activity are calculated.

Space associated with the Graduate Program is 10,000 square feet; for the Undergraduate Program, the space used is 20,000 square feet. The allocation base, therefore, totals 30,000 square feet. Building Services costs are then prorated over the two programs as follows:

Graduate Program 10,000 sq. ft. 1/3 × $165,000 = $55,000

Undergraduate Program 20,000 2/3 × $165,000 = 110,000

Total 30,000 sq. ft. Total cost $165,000

The same approach follows for Staff Services and Administration. These are summarized as follows:

Graduate Program 30 employees 1/4 × $90,000 = $22,500

Undergraduate Program 90 3/4 × $90,000 = 67,500

Total 120 employees Total cost $90,000

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Graduate Program 30 employees 1/4 × $330,000 = $82,500

Undergraduate Program 90 3/4 × $330,000 = 247,500

Total 120 employees Total cost $330,000

Another way to perform these allocations is to divide the service center costs by the cost driver and apply the resulting rate to the operating department usage amount. For example, Building Services would have a rate of $5.50 per square foot ($165,000 ÷ 30,000).

The results of service center allocations and the subsequent calculation of overhead rates for the operating departments are summarized as follows:

Building Services

Staff Services Administration

Graduate Program

Undergraduate Program

Costs $165,000 $90,000 $330,000 $265,000 $420,000

Building Services (165,000) 55,000 110,000

Staff Services (90,000) 22,500 67,500

Administration _______ _______ (330,000) 82,500 247,500

$0 $0 $0 $425,000 $845,000

Credit hours ÷ 20,000 ÷ 60,000

Overhead rate per credit hour

$21.25 $14.08

Step (Sequential) Method

The step (sequential) method is an attempt to consider services performed for other service centers. However, recognition of those services is a one-way process. The service centers are arranged in a sequence, and their costs are allocated one after the other. Once a service center’s costs are allocated, no other costs are allocated back to that service center even though it may use resources of other service centers. The �irst service center’s costs are allocated to all subsequent service centers and operating departments. The second service center’s costs are then allocated to all subsequent service centers and operating departments, but not to the �irst service center. This process continues until all service centers’ costs have been allocated to operating departments. The number of allocation steps will equal the number of service centers.

Since there are three service centers in the Hardknox University School of Business, there are three steps in the allocation process. We begin by allocating the costs of Building Services. The square footage for Staff Services is 2,000, Administration is 8,000, Graduate Program is 10,000, and Undergraduate Program is 20,000. The allocation base, therefore, totals 40,000 square feet. Building Services costs are then prorated over the remaining service centers and operating departments, as follows:

Staff Services 2,000 sq. ft. 5% × $165,000 = $8,250

Administration 8,000 20% × $165,000 = 33,000

Graduate Program 10,000 25% × $165,000 = 41,250

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Undergraduate Program 20,000 50% × $165,000 = 82,500

Total 40,000 sq. ft. Total cost $165,000

Staff Services receives an allocation of Building Services costs. This allocation must be added to the costs already charged to the Staff Services department to determine the allocation of Staff Services costs. The new total Staff Services costs are $98,250 ($90,000 + $8,250). The next step in the allocation process is as follows:

Administration 20 employees 2/14 × $98,250 = $14,035*

Graduate Program 30 3/14 × $98,250 = 21,054

Undergraduate Program 90 9/14 × $98,250 = 63,161

Total 140 employees Total cost $98,250

*This �igure has been rounded down.

After allocating Building Services and Staff Services costs, the Administration costs for the next step of the allocation are $377,035 ($330,000 + $33,000 + $14,035). These costs are allocated as follows:

Graduate Program 30 employees 25% × $377,035 = $94,259

Undergraduate Program 90 75% × $377,035 = 282,776

Total 120 employees Total cost $377,035

The results of service center allocations and the subsequent calculation of overhead rates for the operating departments are summarized as follows:

Building Services

Staff Services Administration

Graduate Program

Undergraduate Program

Costs $165,000 $90,000 $330,000 $265,000 $420,000

Building Services (165,000) 8,250 33,000 41,250 82,500

$0 $98,250

Staff Services (98,250) 14,035 21,054 63,161

$0 $377,035

Administration (377,035) 94,259 282,776

$0 $421,563 $848,437

Credit hours ÷ 20,000 ÷ 60,000

Overhead rate per credit hour

$21.08 $14.14

How do you arrange the order of service centers? The general rule is to sequence service centers according to the amount of services provided to other service centers—going from greatest to least. What constitutes “greatest amount of service”? One interpretation is according to the center serving the greatest number of other service centers. Another is the amount of costs in the service center; the service center

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with the highest costs goes �irst. It is not clear which interpretation should be applied. The real issue is to set up a sequence that will provide reasonable and logical allocations.

Reciprocal Method

Neither the direct method nor the step method of service center allocation recognizes mutual rendering of services among service centers. A third method, the reciprocal method, does consider that service centers can perform services in a mutual fashion for each other. The method, however, is more complex than the direct and step methods because it involves solving simultaneous equations. Speci�ically, the number of simultaneous equations will equal the number of service centers. When this number is large, a computer becomes necessary to solve the equations. For simplicity, we will restrict our analyses to cases of two service centers.

The reciprocal method involves a two-stage procedure:

Stage 1: Set up and solve the following two equations for S1 and S2:

S1 = DC1 + k1S2

S2 = DC2 + k2S1

where:

Si = cost of service center i after the reciprocal allocation (i = 1, 2)

DCi = the direct costs traceable to service center i (i = 1, 2)

k1 = the percentage of S2 cost allocated to S1

k2 = the percentage of S1 cost allocated to S2

Stage 2: Allocate the costs of each service center derived in Stage 1 (i.e., S1 and S2) to all other service centers and operating departments.

To illustrate, suppose Lubel Brothers, Inc. manages real estate properties for various owners. The �irm has two operating departments: Indoor Malls, with directly traceable overhead costs of $200,000 per month, and Outdoor Shopping Centers, with directly traceable overhead costs of $320,000 per month. The departmental overhead rates are based on direct labor hours. There are also two service centers: Storerooms, having directly traceable costs of $48,000 per month, and Custodial Services, having directly traceable costs of $250,000 per month. Storerooms costs are allocated on the basis of number of storeroom requisitions, while Custodial Services costs are allocated on the basis of number of employees. These facts are summarized in the following table:

Department Costs Requisitions Employees Labor Hours

Indoor Malls $200,000 1,000 84 13,000

Outdoor Shopping Centers 320,000 8,000 12 3,000

Storerooms 48,000 — 24 —

Custodial Services 250,000 1,000 — —

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First, we set up the two equations for Stage 1:

S = $48,000 + .2C

C = $250,000 + .1S

where:

S = Cost of Storerooms after the reciprocal allocation

C = Cost of Custodial Services after the reciprocal allocation

The allocation percentages were determined as follows:

Notice that the denominators for calculating the allocation percentages consist of all centers and departments other than the one from which the costs are being allocated. This is so because in Stage 2 the costs will be allocated to all other service centers and operating departments.

We now solve the two equations by �irst substituting the second equation into the �irst:

S = $48,000 + .2($250,000 + .1S)

.98S = $98,000

S = $100,000

Now we obtain C by inserting $100,000 into our second equation:

C = $250,000 + .1($100,000)

C = $260,000

Having solved for S and C, we proceed to Stage 2, where we allocate these costs as follows:

a. Of the $100,000 from S, 10% (1,000/10,000) is allocated to Custodial Services, 10% (1,000/10,000) is also allocated to Indoor Malls, and 80% (8,000/10,000) is allocated to Outdoor Shopping Centers.

b. Of the $260,000 from C, 20% (24/120) is allocated to Storerooms, 70% (84/120) is allocated to Indoor Malls, and 10% (12/120) is allocated to Outdoor Shopping Centers.

The resulting allocations, total operating department overhead costs, and departmental overhead rates are summarized in the following table:

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Storerooms Custodial Services

Indoor Malls

Outdoor Shopping CentersStorerooms

Custodial Services

Indoor Malls

Outdoor Shopping Centers

Costs $48,000 $250,000 $200,000 $320,000

Storerooms (100,000) 10,000 10,000 80,000

Custodial Services 52,000 (260,000) 182,000 26,000

Totals (after allocation) $0 $0 $392,000 $426,000

Direct labor hours ÷ 13,000 ÷ 3,000

Overhead rate per direct labor hour

$30.15 $142.00

All $298,000 of service center costs ($48,000 + $250,000) have been fully allocated to the operating departments. To con�irm: $10,000 + $80,000 + $182,000 + $26,000 = $298,000.

Two other issues in�luence the way we allocate service center costs: treatment of revenues and allocation of costs by behavior. These issues are presented next.

Treatment of Revenues

Most service centers simply incur costs and generate no revenues. A few, such as a cafeteria, may charge employees or other outside parties for the services they perform. Any revenues generated should be offset against the service center costs. For both the direct method and the step method, we allocate the costs less the offset. In this manner, other service centers and operating departments will not be required to bear costs for which the service center has already been reimbursed.

Allocation of Costs by Behavior

Whenever possible, service center costs should be separated into variable and �ixed classi�ications and allocated separately. As a general rule, variable costs should be charged to other service centers and operating departments on the basis of the actual activity that controls the incurrence of the cost involved. The service centers and departments directly responsible for the incurrence of servicing costs are, therefore, required to bear the cost in proportion to their actual usage of the service involved.

The �ixed costs of service centers represent the cost of providing capacity. As such, these costs are most equitably allocated to consuming service centers and operating departments on the basis of predetermined amounts. In this way, the amount of costs allocated is determined in advance of the period in which service is provided. Once determined, the amount does not change from period to period. Typically, the amount allocated is based either on peak-period or long-run average servicing needs. This approach of allocating variable costs on the basis of actual activity and �ixed costs using predetermined percentages is sometimes referred to as the dual-rate method of allocation.

The following example will illustrate undesirable consequences of not separating the allocation of �ixed and variable costs. Suppose that Azer Website Designers has an Administration support center that services two operating centers: Domestic and International. Based on needs forecast by these two operating centers, Azer hired staff and incurred other �ixed costs amounting to $1,200,000 per year. Sixty percent of this cost derived from the needs of Domestic. In addition, Administration incurs costs that vary with the amount of labor hours worked in the operating centers. This averages about $1 per hour.

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In 2018, Domestic worked 400,000 hours and International worked 200,000 hours. If �ixed and variable costs are not separated, the allocation rate is determined as follows:

The 2018 allocations to each of the operating centers would be:

Domestic: $3 per hour × 400,000 hours = $1,200,000

International: $3 per hour × 200,000 hours = $600,000

In 2019, International works the same 200,000 hours, but Domestic’s work drops off to only 100,000 hours. The allocation rate for 2019 would change as follows:

The 2019 allocations to each of the operating centers would be:

Domestic: $5 per hour × 100,000 hours = $500,000

International: $5 per hour × 200,000 hours = $1,000,000

Note that International’s share of costs increased by $400,000 ($1,000,000 – $600,000) even though it worked the same number of hours both years. Because fewer hours were worked in Domestic, the allocation rate increased. This resulted in more �ixed Administration cost charged to International than in the previous year. To avoid this inequity, each year the dual-rate method would assign $720,000 in �ixed cost to Domestic (.6 × $1,200,000) and $480,000 to International (.4 × $1,200,000). These allocations are in accordance with the forecasted needs that generated the total �ixed cost of $1,200,000. For the variable costs, the dual-rate method would assign $1 per hour each year. Thus, with the dual-rate method, International is assigned a total cost of $680,000 each year ($480,000 + $200,000), while Domestic is assigned $1,120,000 in 2018 ($720,000 + $400,000) and $820,000 in 2019 ($720,000 + $100,000).

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2.7 Ethical Issues for Cost Allocation Often, a department or division’s performance is evaluated on the basis of pro�its after overhead costs have been allocated. Consequently, the choice of cost drivers can affect performance evaluation. One wishing to reward some managers and penalize others could attempt to do so by unethically selecting cost drivers that would shift overhead costs to the desired entities.

When the prices of certain services or products are cost-based while others are market-driven, managers are often tempted to shift much of the overhead costs to those cost-based services or products. This can be accomplished by:

1. Including in the overhead cost pool expense items that should not be included (e.g., entertainment expenses unrelated to the business)

2. Arbitrary selection of cost drivers

When using the step method of allocating service costs, another way to shift overhead costs is:

3. Arbitrary ordering of service centers

Clearly, the inclusion of improper expenses is unethical. An example of one such occurrence appears in Contemporary Practice 2.2. The arbitrary selection of cost drivers or of the order of support centers is not as clear. On one hand, management has an obligation to the company’s owners to maximize pro�its using any allowable methods. On the other hand, there is a question of fairness to the parties purchasing the products or services. Moreover, when the government happens to be the other party, the issue extends to one of fairness to taxpayers.

Contemporary Practice 2.2: Overhead Fraud

In 2015, the president of an international engineering consulting company pleaded guilty to defrauding the U.S. Agency for International Development (USAID) with respect to billions of dollars of contracts over nearly a 20-year period. One of the fraudulent activities involved charging all commonly shared overhead expenses, such as rent for the consulting company’s Washington, D.C., of�ice to an account created to capture USAID-related expenses, even though the D.C. of�ice supported many projects unrelated to USAID.

Source: Department of Justice, U.S. Attorney’s Of�ice, District of New Jersey. (2015, May 8). Former Louis Berger Group Inc. Chairman, CEO, and President Sentenced to One Year of Home Con�inement, Fined $4.5 Million, for 20-Year Conspiracy to Defraud Federal Government. Retrieved from https://www.justice.gov/usao-nj/pr/former-louis-berger-group-inc-chairman-ceo-and- president-sentenced-one-year-home (https://www.justice.gov/usao-nj/pr/former-louis-berger-group-inc-chairman-ceo-and-president- sentenced-one-year-home)

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Summary & Resources

Chapter Summary One of the objectives in cost accounting is to determine the cost to provide a given service, to manufacture a given quantity of product, or to complete some project. We accumulate the costs of materials, labor, and overhead separately. Materials are identi�ied as direct or indirect. If direct, the materials are charged directly to the speci�ic product. Indirect materials costs are included in factory overhead costs. Labor costs follow the same type of distinctions.

Factory overhead is budgeted and divided by a cost driver that relates overhead costs to the products. This yields a rate that is used to allocate overhead to services or products. If the overhead consists largely of labor-related costs and labor support costs, such as supervision and fringe bene�it costs, the cost driver selected may be direct labor hours. The cost driver “direct labor hours” serves as a bridge between the product and the overhead costs. On the other hand, machine hours may be more appropriate if a large part of the overhead is lubrication, maintenance, and other costs generally related to machine operation. Other cost drivers may, however, be better links between costs and outputs. Both overhead costs and the cost driver should be budgeted at a normal level of operations rather than just the expected volume for the coming period. Factory overhead rates can be plant-wide or departmental, depending on the diversity of the products.

Actual costs are accumulated, and comparisons of actual and estimated costs for each product help management to control costs. Actual overhead incurred can be compared with the overhead applied to the services or products. If actual factory overhead is less than the overhead applied to products (or if overhead is overapplied), the variance is usually closed out to Cost of Goods Sold.

The overhead costs of operating departments include allocations of service center costs. The direct method allocates service center costs directly to operating departments without any intervening allocations to service centers. The step method involves a sequence of allocations where service center costs are allocated to other service centers as well as operating departments. The reciprocal method simultaneously allocates service center costs among service centers and operating departments. Any revenues earned by service centers should be deducted from the costs allocated. Ideally, variable costs should be allocated separately from �ixed costs.

Key Terms

actual costing A costing system in which product costs consist of actual direct materials used, actual direct labor cost, and actual overhead cost.

applied factory overhead The amount of factory overhead cost determined by the product of the predetermined overhead rate and the actual activity.

assembled products Products produced by bringing parts and subassemblies together.

commingled products Products in which one unit cannot be distinguished from any other unit.

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direct labor Labor that can be speci�ically identi�ied with a product in an economically feasible manner.

direct materials Materials that can be identi�ied with the production of a speci�ic product and are easily and economically traced to the product.

direct method A method of service center cost allocation that assigns costs only to operating departments.

dual-rate method A method of allocating �ixed costs separately from variable costs.

expected volume The amount of activity that is anticipated during the coming month or year.

fabricated products Products that are produced by reshaping materials through a cutting, stamping, or molding operation.

ideal capacity The maximum amount of product that can be manufactured or the maximum service that can be rendered with available facilities.

indirect labor Labor that cannot be speci�ically identi�ied with a product in an economically feasible manner.

indirect materials Materials that cannot be identi�ied with the production of a speci�ic product or are not easily and economically traced to the product.

normal costing A costing system in which product costs consist of actual direct materials used, actual direct labor cost, and applied overhead cost.

normal volume An average level of plant utilization over several years.

operating departments Organizational units most closely tied to the productive effort that results in products or services to customers.

overabsorbed overhead Applied overhead that is greater than the actual amount incurred.

overapplied overhead Applied overhead that is greater than the actual amount incurred.

overhead rate Total overhead cost divided by total cost driver activity.

practical capacity Full utilization of facilities with allowance made for normal interruptions and inef�iciencies.

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predetermined overhead rate An overhead rate developed at the beginning of the year based on estimated costs and estimated activity.

producing departments Operating departments in manufacturing organizations.

reciprocal method A method of assigning service center costs that recognizes mutual services among service centers.

service centers Organizational units that provide supporting services that facilitate the activities of the operating departments.

step (sequential) method A method of assigning service center costs that recognizes services provided to other service centers, but only in a one-directional manner.

support functions Organizational units that provide supporting services that facilitate the activities of the operating departments.

T-account A simpli�ied presentation of an account in the shape of the letter T, enabling one to see the activity that has occurred relating to the account.

underabsorbed overhead Applied overhead that is less than the actual amount incurred.

underapplied overhead Applied overhead that is less than the actual amount incurred.

value-added direct labor Labor that changes materials into a �inished product.

Problem for Review You �ind that the cost records at Oberman Printing Company have been poorly maintained. Some information has been entered, but other information is missing. Fortunately, the information given is correct.

The costs for jobs 686, 687, and 688 are to be determined. The direct materials cost is $528 for Job 686 and $715 for Job 687. The cost of direct materials requisitioned during the month for all other jobs, except Job 688, is $4,820. No jobs were in process at the beginning of the month. The total cost of direct materials requisitioned during the month was $6,913.

Labor is paid at a uniform rate of $10 an hour. Job 686 required 82 direct labor hours, and job 688 required 43 direct labor hours. A total of 760 direct labor hours were worked during the month. The direct labor cost of all other jobs, with the exception of the three jobs being considered, was $5,850.

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Two machine hours are used for each direct labor hour. Overhead is applied at a rate of $4 per machine hour. The actual overhead cost for the month was $6,320. Jobs 686, 687, and 688 were completed during the month.

Questions:

1. Compute the costs for Jobs 686, 687, and 688. Show costs by cost element. 2. Determine the amount of overhead applied to all orders during the month. 3. What was the amount of the underapplied or overapplied overhead? 4. You have received a telephone call from the general manager requesting the total cost per unit on

Job 686. There were 50 units (books) on this order. What is the total cost per unit?

Solution:

1. Costs of job by cost elements: Jobs

686 687 688 Other Total

Direct materials $528 $715 $850* $4,820 $6,913

Direct labor 820 500** 430 5,850 7,600

Applied overhead 656 400 344 4,680 6,080

Total costs $2,004 $1,615 $1,624 $15,350 $20,593

* Direct materials on Job 688:

Total direct materials $6,913

Job 686 $528

Job 687 715

All other jobs 4,820 6,063

Total direct materials $850

** Direct materials on Job 687:

Total direct labor costs: 760 hours × $10 $7,600

Job 686: 82 hours × $10 $820

Job 688: 43 hours × $10 430

All other jobs 5,850 7,100

Total direct labor $500

2. Overhead rate per direct labor hour is $8 (2 machine hours × $4). $8 is 80% of the $10 per hour direct labor cost. Therefore, applied overhead is 80% of direct labor cost.

Applied overhead = 80% × $7,600 direct labor cost = $6,080

3. Underapplied or overapplied overhead: Applied overhead $6,080

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Actual overhead 6,320

Underapplied overhead $240

4. Total cost per unit on Job 686: Total costs on job $2,004

Units on job ÷ 50

Unit cost $40.08

Questions for Review and Discussion 1. Describe brie�ly how costs �low through the accounts for a manufacturer. How would this change

for a service organization? 2. What is the difference between a fabricated product and an assembled product? 3. What is a bill of materials? Why is it important to the acquisition of materials? 4. What are the three criteria for determining whether materials are direct or indirect? 5. Explain why a budget is used in costing factory overhead, rather than assigning actual overhead

cost after the end of the year. 6. What is the basis for selecting a cost driver to be used in costing factory overhead? 7. Explain under what circumstances departmental rates are preferred to a plant-wide factory

overhead rate. 8. Explain the difference between practical capacity and normal volume. 9. What is the difference between a service center and an operating department?

10. How are service center costs allocated to other service centers and operating departments under the direct method? Under the step method?

11. Why is the reciprocal method for service center allocation more justi�iable than the step method or direct method?

Exercises 2-1. Cost of Orders. Hotz Repair Services specializes in the routine maintenance and repair of power lawn mowers and other small machines. Three orders (#721, #722, and #723) were started and completed in March. Materials costing $41 were used on order #721; materials costing $17 were used on order #722; and materials costing $8 were used on order #723. Labor is paid at a uniform rate of $28.50 per hour, and overhead is applied at 80% of labor cost. During the month, 3 labor hours were used for order #721, 2 hours for order #722, and 4 hours for order #723.

Question:

Compute the costs of each order, showing separately the costs of materials, labor, and overhead.

2-2. Overtime and Late-Shift Labor Costs. Rekant Supplies operates its stores on a two-shift basis and pays a late-shift differential of 15% above the regular wage rate of $18 per hour. The company also pays a premium of 50% for overtime work. During the year, work occurred in the following categories:

Number of hours worked during the regular shift 10,000

Number of overtime hours for regular shift workers 300

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Number of hours worked during the late shift 6,000

Questions:

1. Compute the total cost to assign to direct labor. 2. Compute the amount of labor-related cost to assign to overhead.

2-3. Cost of Jobs. David Greene’s Muf�ler Shop (“No appointment necessary—we’ll hear you coming”) uses a normal costing system. Overhead and labor hours were estimated at $42,000 and 6,000 hours, respectively, for 2018. During July 2018, only 40 jobs were �inished. Materials used on these jobs totaled $3,700 and labor costs were $2,700 (at $20 per hour). During 2018, 5,000 labor hours were worked and $38,000 in overhead costs were incurred.

Question:

What is the total cost of the jobs �inished during July?

2-4. Factory Overhead Account Analysis. Blatt Company had estimated overhead costs of $400,000 �ixed and $600,000 variable for 200,000 units it planned to produce this year. The following T-account represents the company’s Factory Overhead account activity for the year:

Factory Overhead

1,125,000 1,200,000

Questions:

1. What was the company’s estimated cost function? 2. How many units were produced this year? 3. How much factory overhead was added to work in process? 4. Was overhead underapplied or overapplied? By how much?

2-5. Applied Overhead. Valenta Towing Service (“We don’t charge an arm and a leg—we want tows”) applies overhead on the basis of labor hours. For 2018, the budgeted overhead was $40,000, based on a volume of 10,000 labor hours. Simon Londe, the controller, indicates that the actual overhead amounted to $47,000, and the actual labor hours totaled 12,000.

Question:

Was overhead underapplied or overapplied? By how much?

2-6. Determination of Direct Labor Cost. Ovadia Company, an Israeli wholesaler of olive wood products, uses a predetermined overhead application rate based on direct labor cost. For the year, Ovadia’s budgeted overhead was 900,000 shekels, based on a volume of 50,000 direct labor hours and a budgeted wage rate of 9 shekels per hour. Actual overhead amounted to 963,000 shekels. For the year, the overapplied overhead was 33,000 shekels.

Question:

Compute the amount of actual direct labor cost for the year.

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2-7. Use of T-Accounts. The Repair Department of Rogin’s Gadget Heaven, a consumer electronics store, uses a normal costing system. The following transactions took place during the year:

a. Purchased raw materials (direct and indirect) on credit for $55,000 b. Used $37,000 of direct materials and $11,000 of indirect materials c. Applied $42,000 of overhead d. Jobs �inished had a total cost of $275,000 e. Overapplied overhead of $3,000 is closed out to Cost of Jobs Delivered

Question:

Provide entries in T-account form for the Repair Department’s transactions during the year.

2-8. Finding Actual Labor Hours. Junko Corporation, a Japanese travel agency, provides the following data for the year:

Budgeted overhead cost ¥20,000,000

Budgeted activity 20,000 labor hours

Actual overhead cost ¥21,500,000

Overapplied overhead ¥800,000

Question:

Determine the amount of labor hours worked at Junko Corporation during the year.

2-9. Analysis of Work in Process. Gelfond’s Book Bindery uses a predetermined overhead rate based on labor cost. The following T-account summarizes January 2018 activity relating to work in process:

Work in Process

1/1/18 Balance 30,000 1/31/18 Jobs completed

120,000

Materials used 50,000

Labor cost 60,000

Overhead applied 40,000

1/31/18 Balance 60,000

Question:

If jobs in the work in process inventory on 1/31/18 contain $10,000 of materials, how much labor cost is in the work in process inventory on 1/31/18?

2-10. Divisional and Facility-wide Overhead Rates. Volova Research Laboratories performs contract research for government and commercial applications. The company is divided into six divisions with appropriate support and ancillary facilities. Each division is housed in its own building within the industrial complex.

The company bills its customers based on costs of research work. Costs included are for direct equipment, direct labor hours, and overhead. The current overhead rate used for billing purposes is the facility-wide

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rate, which is $31.25 per hour for this year. The overhead costs and labor hours by division are as follows:

Overhead (in Thousands) Labor Hours (in Thousands)

Thermal $3,760 160

Solar 13,120 800

Aquatic 2,975 170

Laser 113,400 2,250

Gases 16,471 910

Mechanical 37,290 1,695

Totals $187,016 5,985

Several customers, particularly government agencies, question the overhead rate because it is too high for their projects.

Questions:

1. Calculate overhead rates for the overall facility and for each of the six divisions. 2. Show how much overhead would be charged to each of the following projects with a facility-wide

overhead rate and then with divisional rates: a. Project #10106: Soil Conservation of Semi-Arid Lands. (Funded by the U.S. Department of

the Interior.) During the year, this project had 31,400 hours of work recorded. Sixty percent of those hours were from the Thermal Division, and 40% were from the Solar Division.

b. Project #10111: Coal Gasi�ication Project. (Funded 30% by the State of Utah, 50% by the U.S. Department of Energy, and 20% by a private utilities company.) This project absorbed 47,500 hours, of which 23,200 were in the Laser Division and the remaining hours in the Mechanical Division.

3. Which of these two project sponsor groups would have a more legitimate complaint about the overhead rate? Explain.

2-11. Overhead Application with Departmental Rates. Maran & Carson is a print shop specializing in two types of jobs—brochures and booklets. The 2019 budgets for its three departments were as follows:

Overhead Costs Labor Hours

Typesetting $450,000 8,000

Printing 550,000 6,000

Binding 210,000 3,000

The labor hours for each type of job in September totaled as follows:

Brochures Booklets

Typesetting 400 300

Printing 500 200

Binding 0 350

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A normal costing system with departmental overhead rates is used.

Question:

Compute the overhead applied in September to Brochures and Booklets.

2-12. Direct Method and Dual-Rate Allocation. Karon Realty Company has three operating departments (Commercial Real Estate, Residential Real Estate, Apartment Location Service) and two service departments (Administration, Personnel). The budgeted data for the year are as follows:

Overhead Cost Labor Hours Number of Clients Employees

Service departments:

Administration $55,000 12,000 22

Personnel 38,000 8,000 10

Operating departments:

Commercial Real Estate 250,000 35,000 200 60

Residential Real Estate 580,000 60,000 750 125

Apt. Location Services 330,000 40,000 275 90

Administration costs are allocated based on labor hours, and the Personnel allocation is based on number of employees. Sixty percent of the Administration costs are �ixed; the long-run needs of each of the operating departments were considered as being equal when these costs were incurred. The overhead rates in each operating department are based on the number of clients.

Question:

Using the direct method in conjunction with dual-rate allocation, allocate the service departments’ costs to the operating departments, and calculate overhead rates for each operating department.

2-13. Direct and Step Method Allocations. Carl Lee & Sons, a small securities brokerage �irm, has two operating departments relating to types of clients: Individual and Corporate. The �irm also has two service departments: Research and Of�ice Support. Estimated direct costs and percentages of services used by other departments are as follows:

Used by Department

Service Dept. Research Of�ice Support Individual Corporate

Research — 10% 40% 50%

Of�ice Support 20% — 50% 30%

Direct costs $520,000 $440,000 $950,000 $990,000

Questions:

1. Allocate the service departments’ costs to the operating departments, using the direct method. 2. Allocate the service departments’ costs to the operating departments, using the step method.

Allocate Of�ice Support costs before Research costs.

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2-14. Direct and Step Methods. Gorlin Clinic specializes in treatment of ears and eyes in two separate operating departments (no pun intended!). Information about these departments and the clinic’s two service departments follows:

Service Departments Operating Departments

Custodial Administrative Ears Eyes

Number of employees 4 18 33 40

Square footage 1,500 8,000 36,000 39,000

Department direct costs $17,000 $96,000 $258,000 $290,000

Custodial costs are allocated based on square footage, while Administrative costs are allocated based on number of employees.

Questions:

1. Using the direct method, determine the amount of the service departments’ costs that are allocated to each of the operating departments.

2. Using the step method (starting with Custodial), determine the amount of the service departments’ costs that are allocated to each of the operating departments.

2-15. Reciprocal Method and Overhead Rates. Manheim County Amusement Park has two operating centers: Rides & Games (R&G) and Concessions. In addition, there are two support centers: Human Resources (H.R.) and Maintenance. The following data have been obtained:

H.R. Maintenance R&G Concessions

Overhead costs before allocation $60,000 $80,000 $70,000 $25,000

Portions of service by H.R. — 30% 50% 20%

Proportions of service by Maintenance 10% — 60% 30%

Labor hours worked 5,500 5,900 6,400 5,000

Question:

Use the reciprocal method to compute overhead rates for R&G and Concessions.

2-16. Direct, Step, and Reciprocal Methods. Beeber Airlines has two operating departments (Freight and Passenger) and two service centers (Maintenance and Administration). The following table shows June data:

Service Centers Operating Departments

Maintenance Administration Freight Passenger

Cost $630,000 $950,000 $1,800,500 $5,260,470

Labor hours 8,000 9,000 30,000 51,000

Number of employees 40 50 8 200

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Maintenance costs are allocated using labor hours, while Administration costs are allocated using number of employees.

Questions:

1. Using the direct method, determine the total costs of the operating departments. 2. Using the step method with Maintenance costs allocated �irst, determine the total costs of the

operating departments. 3. Using the reciprocal method, determine the total costs of the operating departments.

Problems 2-17. Costs of Individual Orders. During August, Marmarosher Machine Company started production orders 116, 117, and 118. Order 115 was in process at the beginning of the month with direct materials costs of $35,000, direct labor costs of $21,000, and applied factory overhead of $25,200. During the month, direct materials were requisitioned, and direct labor was identi�ied with the orders as follows:

Order No. Direct Materials Direct Labor

115 — $26,000

116 $39,000 45,000

117 53,000 47,000

118 47,000 16,000

Factory overhead is applied to the orders at 120% of direct labor cost. Orders 115, 116, and 117 were completed and sold in August. Order 118 was incomplete on August 31.

Questions:

1. Determine the costs of each order by cost element. 2. What was the total cost of direct materials requisitioned in August and charged to Work in

Process? 3. Determine the cost of goods sold in August. 4. What was the Work in Process balance on August 31?

2-18. Closing the Overhead Account. The service department of Lefton & Pearl Auto Dealership has underapplied overhead of $222,000 for the year. Before closing the appropriate accounts, ending balances for several accounts were as follows:

Revenues $12,860,000

Cost of jobs delivered 8,125,000

Finished jobs on hand 1,230,000

Work in process 1,888,000

Materials inventory 1,035,000

Question:

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On the income statement, what amount should be reported for Cost of Jobs Delivered? Provide answers for both of the acceptable alternatives of closing out the underapplied overhead.

2-19. Cost Flows. Kunis Paddle Shop, Inc. keeps accounting and cost records on a personal computer. During the month of January, data were lost as a result of errors made by a new operator. Fortunately, some data were retrieved and are set forth as follows:

a. The total payroll amounted to $130,000. This balance included $20,000 in indirect labor that was charged to the Factory Overhead account.

b. The debits in the Factory Overhead account totaled $166,000. This amount included the indirect labor from part (a).

c. Factory overhead is applied to the products at 150% of direct labor cost. d. The Work in Process account showed a January 1 balance of $91,000. Materials requisitioned and

charged to Work in Process during the period amounted to $98,000. The balance in Work in Process on January 31 was $82,000.

e. The Finished Goods balance at January 1 was $48,000. f. Cost of Goods Sold had a debit balance of $389,000. This amount did not include underapplied or

overapplied factory overhead.

Questions:

1. From the information given, determine the direct labor and the factory overhead applied to production in January.

2. What was the cost of work completed and transferred to the �inished goods inventory for the month?

3. Determine the �inished goods inventory cost on January 31 before factory overhead is closed out. 4. Determine the underapplied or overapplied factory overhead in January.

2-20. Cost of Work Performed and Completed. Perry Brickman owns and operates Slovin Heating Service. Two overhead rates are used in applying overhead costs to the jobs. One rate is based on direct labor hours, and the other is based on machine hours. The machine is a backhoe used in digging service lines. Overhead costs of operating the backhoe are kept separately, so that only the jobs requiring the use of the backhoe are charged an overhead rate per machine hour. For the year, $126,000 of general overhead costs were budgeted for 6,000 direct labor hours, and $21,600 of backhoe-related overhead costs were budgeted for 1,800 machine hours (hours of backhoe operation).

On February 1, the cost in Work in Process is $440 and consists of only one job, the job for A. Esral. Costs and other data pertaining to jobs worked on during February are:

Direct Materials Direct Labor Labor Hours Machine Hours

A. Esral $ 135 $ 320 16 —

D. Appelrouth 246 560 28 —

M. Spector 230 365 12 5

S. Vogel 84 60 3 —

All other jobs 842 14,000 500 160

Totals $1,537 $15,305 559 165

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All orders were �inished during February with the exception of the Vogel order, which is still in process.

Questions:

1. Compute an overhead rate per direct labor hour and an overhead rate per machine hour. 2. Prepare a summary of costs incurred for work performed in February. 3. Determine the cost of work completed during February.

2-21. Departmental and Plant-Wide Rates. Sloman Products, Inc. has one division that makes rollers for printing presses. The rollers vary in size from 1/4 inch to 8 inches in diameter. Fabrication and Finishing are the two departments within this division. The company uses machine hours as the base for allocating factory overhead costs to products. The budgeted data for the two departments for the coming year are:

Fabrication Finishing Totals

Machine hours 90,000 30,000 120,000

Overhead costs $2,232,000 $252,600 $2,484,600

The machine hours for a batch of 100 units for two different products are given as:

Fabrication Finishing Totals

1/2” roller 4 8 12

6-1/2” roller 9 6 15

The prime costs per batch for these two products are:

1/2” Roller 6-1/2” Roller

Direct materials:

Fabrication $ 18.90 $ 33.40

Finishing 9.70 11.50

Direct labor:

Fabrication 48.10 187.30

Finishing 37.80 32.20

Total prime costs $114.50 $264.40

Questions:

1. Compute the departmental overhead rates for Fabrication and Finishing using machine hours as the cost driver.

2. Compute a plant-wide overhead rate using machine hours as the cost driver. 3. Compute the overhead cost per batch of product assuming:

a. The plant-wide rate. b. The departmental rates.

4. Is the total cost per unit of each product distorted by using a plant-wide rate instead of departmental rates? Explain with supporting computations.

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2-22. Step Method with Revenues. Chaiken Co. has two operating departments (Fabrication and Assembly) and two service centers (Maintenance and Public Relations). Maintenance costs are allocated based on square footage, and Public Relations costs are allocated based on number of employees. Data for December are as follows:

Fabrication Assembly Maintenance Public Relations

Materials $8,500 $8,900 $4,200 $5,500

Labor 6,500 8,400 3,300 3,900

Overhead 5,100 1,800 2,500 3,700

Totals $20,100 $19,100 $10,000 $13,100

In addition to these costs, Public Relations generated revenues of $705. Other data are:

Fabrication Assembly Maintenance Public Relations

Number of employees 37 44 22 30

Square footage 2,800 3,700 2,000 1,400

Question:

Using the step method, determine the total overhead costs of each operating department after allocation of service center costs. Begin the allocation with Maintenance.

2-23. Direct Method and Dual-Rate Allocation. Jeffram Headhunters is an executive search �irm that specializes in two areas—�inancial managers and marketing managers—and has organized its two operating centers around these areas. Data for these operating centers, as well as for three service centers, follow:

Sq. Ft. of Space Number of Employees Personnel Transactions

Operating Centers:

Financial Managers 38,000 470 54

Marketing Managers 33,000 425 41

Service Centers:

Custodial 2,700 30 8

Personnel 2,900 23 7

Administration 4,100 50 11

Budgeted overhead costs for the year and cost driver data are as follows:

Overhead Cost Driver

Financial Managers $158,000 Labor hours

Marketing Managers 144,000 Labor hours

Custodial 63,000 Square feet of space

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Overhead Cost Driver

Personnel 74,000 Personnel transactions

Administration 59,000 Number of employees

Of the Custodial overhead, $20,000 is �ixed. According to the controller, Diane Ram, the �ixed overhead relates to the long-run needs of the two operating centers, as follows:

Financial Managers 70%

Marketing Managers 30%

Each operating center budgeted 12,000 labor hours for the year.

Question:

Using the direct method in conjunction with dual-rate allocation, allocate service centers’ costs to the operating centers, and calculate overhead rates for each operating center.

2-24. Reciprocal Method and Revenues. Unterberger’s Health Club is organized into two operating departments: Programming & Classes and Individual Fitness. There are also two service centers: Janitorial and Cafeteria. Janitorial costs are allocated based on square footage, while Cafeteria costs are allocated based on number of employees. The costs traceable to the operating and service centers during the year were as follows:

Service Centers Operating Departments

Janitorial Cafeteria Programming & Classes Individual Fitness

Materials $10,000 $200,000 $8,000 $5,000

Labor 100,000 300,000 265,000 150,000

Overhead 20,000 40,000 75,000 90,000

Totals $130,000 $540,000 $348,000 $245,000

In addition to the above costs, the Cafeteria generated revenues of $480,000. Other data are as follows:

Service Centers Operating Departments

Janitorial Cafeteria Programming & Classes Individual Fitness

Square footage 1,600 8,000 24,000 32,000

Number of employees 5 14 19 6

Question:

Compute the total overhead costs for each operating department after allocation of service centers’ costs. Use the reciprocal method to allocate the service centers’ costs.

Case: Birnbrey & Bogart Legal Services

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Birnbrey & Bogart Legal Services is a large law of�ice in St. Louis. It is organized into three operating departments: Criminal, Civil, and Personal & Family Services. Support functions include an of�ice support pool and a research center. An administrative function is responsible for managing the entire company. Birnbrey & Bogart follows the practice of allocating support functions to the three operating departments in order to establish a cost-based charge for pricing the various legal services to clients. Administrative costs are not allocated. (They are treated as period costs in the income statement.) But they are recovered through the pro�it margin developed as a percentage of all other costs.

Budgeting for the upcoming �iscal year has resulted in the following costs charged directly to all functions and departments:

Of�ice Support Research Criminal Civil Personal & Family

Salaries and wages $80,000 $120,000 $300,000 $400,000 $100,000

Fringe bene�its 5,600 11,200 30,000 40,000 10,000

Depreciation 8,000 16,000 24,000 32,000 8,000

Supplies 16,000 3,200 4,500 6,000 1,500

The indirect costs that are prorated to administration, support functions, and operating departments are of four varieties: insurance, leasing, utilities, and janitorial services. The following means are used to prorate indirect costs:

a. Insurance costs ($160,000) are for malpractice coverage and for equipment, �ixtures, and furniture. The premium ($36,000) representing coverage on equipment, �ixtures, and furniture is prorated on the basis of book value. The remainder of the $160,000 is for malpractice. Since malpractice relates to people, the proration is based on the number of people in each department.

b. Leasing costs ($96,000) are incurred for the of�ice space occupied by the �irm. Therefore, these costs are prorated based on square footage occupied.

c. Utilities costs ($60,000) are for heat, light, and water. They are prorated on the basis of square footage occupied.

d. Janitorial services ($36,000) to keep the of�ices clean are contracted out. These costs are prorated on square footage.

In allocating the support functions to the operating departments, Of�ice Support is allocated on the basis of of�ice support time. The Research Center is allocated on the basis of salaries and wages. Overhead rates for the operating departments are determined by using salaries and wages in the Criminal and Civil Departments, and staff time in Personal & Family Services. The following budgeted data are available for the allocation bases:

Administration Of�ice Support Research Criminal Civil

Personal & Family

Number of people

2 4 6 4 6 2

Book values $10,000 $70,000 $80,000 $120,000 $160,000 $40,000

Square footage 1,000 2,000 2,000 1,500 2,500 1,000

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Administration Of�ice Support Research Criminal Civil

Personal & Family

Staff time (hours)

4,000 8,500 12,500 9,000 12,500 5,000

Of�ice support time (hours)

500 200 2,000 2,000 3,000 1,000

Questions:

1. Complete the proration of indirect costs to all support functions and operating departments. Show the sum of direct and indirect costs in each function and department.

2. Explain why the proration of indirect costs is necessary. 3. Using the direct method, allocate the service functions’ costs to the operating departments,

and develop the overhead rates for each of the operating departments. (Round dollar allocations to the nearest dollar and overhead rates to four decimal places.)

4. Using the step method, allocate the service functions’ costs to the operating departments, and develop the overhead rates for each of the operating departments. The of�ice support pool is allocated �irst. (Round dollar allocations to the nearest dollar and overhead rates to four decimal places.)

5. Compare the answers in Part (3) and Part (4) and explain why the differences occurred. Is the direct method used in Part (3) or the step method used in Part (4) preferred? Why?

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Practice Problems in Action

Watch the videos below for a step-by-step tutorial on how to solve the following problem using Excel. The videos are best viewed in full-screen mode. For a transcript of the directions included in these tutorial videos click here (https://ne.edgecastcdn.net/0004BA/constellation/PDFs/BUS630_2e/Chapter-2_Tutorial- Transcript_FINAL.pdf) .

Problem Let’s look at another example from furniture manufacturer Fellman & Associates. The company’s two main products are desks and cabinets, each of which has their own department. Desk production uses a few complex parts due to upgrades in technology, but these parts have been found easy to assemble and test. On the other hand, cabinet production uses many standard parts but has a complex assembly and testing process.

A summary of direct labor and overhead costs for each department during the last month is as follows:

Sanding Painting Total

Direct labor $37,000 $26,500 $63,500

Overhead $74,000 $79,500 $153,500

Direct labor is $10/hour for sanding and painting.

Normally, the desks and cabinets are produced in batch sizes of �ive at a time. A production batch of 5 units requires the following number of hours in each department:

Production batch of 5 units requires the following number of hours in each department: Desks Cabinets

Sanding 14 8

Painting 15 37

Desks require direct material costs of $80 per unit, and cabinets require direct material costs of $100 per unit.

Questions 1. Compute the departmental overhead rates using labor hours as the cost driver. 2. Compute a company-wide overhead rate using labor hours as the cost driver. 3. Compute the overhead costs per batch of desks and cabinets, assuming:

a. The departmental rates. b. The company-wide rate.

4. Compute the total costs per unit of desks and cabinets assuming: a. The departmental rates. b. The company-wide rate.

Tutorial

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Video 1: Setting up the spreadsheet and calculating overhead rates using labor hours as the cost driver

Video 2: Calculating company-wide overhead rate using labor hours as the cost driver

Video 3: Calculating the overhead costs per batch of desks and cabinets

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7/30/2019 Print

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Video 4: Calculating total costs per unit of desks and cabinets

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