NOTES

Week one:

Cost Classifications

We begin our study of managerial accounting by focusing on tools and approaches that are useful for internal users of financial statements. Up to this point, we have studied financial accounting, which is geared toward external users, such as stockholders and creditors. Managerial accounting functions are planning, directing, motivating, and controlling. Throughout the rest of the course, we will discuss tools and approaches that can be used by managers in performing these functions.

Cost is the name of the game in managerial accounting. Just as Inuits and Aleuts have numerous words for snow, management accounts have numerous descriptions for various costs. It is important that you learn the technical jargon.

We can classify costs regarding function—manufacturing, selling, administrative, or financial. We can classify costs regarding the objective of the expenditure (according to the goods and services purchased)—wage expense, rent expense, supply expense. We can also classify costs regarding the controllability of the cost. In other words, can managers of a particular segment influence the amount of the cost within a specific period—variable and fixed? Alternatively, we can classify costs regarding their traceability to a particular finished unit of production, and as inventoriable or non-inventoriable (product or period).

In a cost system, costs are accumulated by classification and then accumulated by objective. For example, we can separate manufacturing costs into variable, fixed, and mixed. Then we can accumulate the costs related to products A, B, and C. Through the use of a cost system, management determines such things as which product to make or discontinue, when to manufacture a component or purchase it, what price to charge for a product, whether a department should be expanded, which manager should be promoted, and what happens if 1,000 more units are sold or produced. There is a common theme: “What will happen to financial results if volume, prices, and/or costs are changed?”

Product Cost: Product costs are incurred to produce a product or service. They are inventoriable and are expensed through the cost of goods sold.

Direct Versus Indirect Costs: Costs can also be classified based on their relationship to certain cost objectives. Examples of cost objectives include departments, products, and territories. In terms of cost objective, costs will be either direct or indirect. Direct costs are costs that can be directly traced to a specific cost objective. Direct costs will include costs like raw materials and direct labor (direct labor includes wages that are paid to employees who do the actual labor to produce products, and the labor can be directly traced to products). Indirect costs cannot be traced to a specific product (or cost objective). Factory overhead represents an indirect cost. Overhead includes rent, utilities, depreciation, insurance, property taxes, and supervisory salaries. These costs are not identified with the manufacture of particular products, but rather are common to the firm's overall business activities.

Be careful when categorizing costs as direct or indirect, because the categorization depends on the cost objective. This is a topic for ABC costing that is generally studied in cost accounting courses. I just want you to be aware that, as you progress through additional accounting courses, you may refine the definitions that you have learned in this course. For example, if a particular production area produces three products and has one supervisor, then the supervisor’s salary is an indirect cost for the various products. However, if the corporation was categorizing costs for the various factories, then the supervisor’s salary would be a direct cost.

Product Versus Period Costs: Product costs for a manufacturer would include costs incurred to manufacture a product (direct materials, direct labor, and manufacturing overhead). Product costs for a reseller (i.e., wholesaler or retailer) would include the cost of purchasing the products. When a product is sold, the cost of the product that was sold will be shown on the income statement as cost of goods sold. After production and prior to the sale, these costs appear on the balance sheet as inventory. Period costs are costs that are not incurred to purchase or produce products. Instead, period costs are expenses that are incurred during an operating period and are not tied to the production or purchase of goods. Examples of period costs include advertising and marketing expenses, administrative salaries, rent, and insurance. Period costs appear in the general and administrative section of the income statement.

Product costs can be further broken down into two more categories—prime costs and conversion costs. Prime costs are the direct costs of production. They would be the direct materials and direct labor costs. Conversion costs are composed of items involved in the conversion of the materials into the product—direct labor and manufacturing overhead.

NOTE: Costs can be classified in more than one category. For example, raw material costs are variable (they vary in direct proportion to the quantity of goods manufactured), direct (they are directly related to the product being produced), and product costs.

Manufacturing Versus Merchandising

There is a key difference in the way that manufacturers and merchandisers (wholesalers and retailers) account for inventory. The cost of inventory, or product costs, for merchandisers would be the cost of the goods that were purchased for resale. For example, the cost of the Gap's inventory consists of the price that it pays for the clothing and accessory items that it sells. When items are sold, their costs are transferred from inventory on the balance sheet to the cost of goods sold on the income statement.

For manufacturing firms, the cost of goods sold consists of the following three manufacturing costs.

1. Direct materials—the cost of all materials that are purchased and used in the manufacture of the product

2. Direct labor—the wages of employees who manufacture the products, like assembly line workers

3. Indirect manufacturing (overhead)—all costs of production other than direct materials and direct labor; for example, utilities, supplies, supervisors' salaries, property taxes, rent, insurance, and depreciation

Click on image to enlarge

Image Description 

The cost of goods sold algorithm for a manufacturing company is shown below.

Beginning Finished Goods Inventory + Cost of Goods Manufactured = Goods Available for Sale - Ending Finished Goods Inventory

=

Cost of Goods Sold

There are actually three types of inventories for manufacturing firms. The raw materials inventory is similar to the merchandise inventory of a retail firm, in that it is purchased from an outside supplier. The work in process Inventory includes all of the costs applicable to units that have been started into production but are only partially completed. This would include raw materials, direct labor, and allocated overhead. Finally, the finished goods inventory includes all costs related to the production of the finished products awaiting sale. The following chart shows how the costs flow.

Raw Materials Inventory ------> Work in Process Inventory -----> Finished Goods Inventory -----> Cost of Goods Sold

Overhead

Just a few words about overhead are in order. Overhead consists of indirect costs associated with the manufacturing process. Included are such things as indirect materials, indirect labor, depreciation on factory buildings and equipment, insurance on production workers and the factory building and machinery, property or inventory taxes, and maintenance on factory buildings or machinery. These costs are termed to be indirect because it would be too costly to directly relate them to the production of a particular unit or product. The allocation of overhead costs can become extremely difficult and is a large topic in advanced cost accounting courses.

Perhaps the following graphic will help you picture these three inventories better.

Click on the image to enlarge

Image Description 

Cost of Goods Manufactured and Cost of Goods Sold

The cost of goods manufactured represents the total cost of goods produced during a period of time (e.g., a month, quarter, or year). As we have learned, product costs, as opposed to period costs, are the focus in this calculation. So, we need to know or compute the direct materials used, total direct labor, total manufacturing overhead applied (based on a predetermined overhead rate), beginning work-in-process, ending work-in-process, and the total cost of goods completed and transferred to finished goods inventory.

The total cost of goods manufactured for the period then flows into the cost of goods sold section of the income statement. Recall that, instead of the purchases amount that is part of the cost of goods sold for a retail operation, the cost of goods manufactured is used for a manufacturing concern.

Below are the statements of cost of goods manufactured and an income statement that includes a detailed cost of goods sold. They illustrate the calculations of these critical amounts. Please study them and print them out for further study and reference purposes.

XYZ Inc.

Schedule of Cost of Goods Manufactured

For the Year Ended December 31, 20XX

Direct materials used
Beginning raw materials inventory	10,500
Add: Cost of raw materials purchased	75,000
Total raw materials available	85,500
Less: Ending raw mateirals inventory	6,400
Total raw materials used		79,100
Direct labor		135,100
Manufacturing overhead		82,300
Total manufacturing costs		296,500
Add: Beginning work-in-process inventory		5,700
		302,200
Less: Ending work-in-process inventory		11,700
Cost of goods manufactured		$290,500

XYZ Inc.

Income Statement (with Cost of Goods Sold Section)

for the Year Ended December 31, 20XX

Sales			$505,600
Cost of goods sold
Beginning finished goods inventory		$27,400
Cost of goods manufactured		290,500
Total goods available for sale		317,900
Ending finished goods inventory		21,300
Cost of goods sold			296,600
Gross profit			209,000
Operating expenses
Selling expenses
Sales salaries
	$47,100
Depreciation—sales equipment	16,000
Total selling expenses		63,100
Administrative expenses
Office salaries	53,600
Depreciation—office equipment	15,300
Insurance expense	11,300
Office supplies expense	3,100
Total administrative expenses		83,300
Total operating expenses			146,400
Income from operations			62,600
Interest revenue			7,900
Income before taxes			70,500
Income taxes			14,750
Net income			$55,750

Predicting Cost Behavior

On a per unit basis, variable costs do not change with changes in activity levels within the relevant range. In total, however, variable costs will change as activity levels change. Relevant range refers to the range within which the cost assumptions will not change.

Total fixed costs do not change with changes in activity level within the relevant range; on a per unit basis, however, they will change. On a per unit basis, fixed costs will decrease when the activity level increases, and they will increase when the activity level decreases.

Variable Cost Behavior
In Total	Per Unit
Total variable cost increases and decreases in proportion to changes in activity.	Variable cost per unit is constant.

Example: Let’s assume that our company manufactures computers and each computer has a CD writer that costs $50. The per unit and total cost of the CD writers at various levels of activity (e.g., number of computers produced) would be as follows.

Cost per CD Writer (per unit)	Number of Computers Produced	Total Variable Cost—CD Writers
$50	1	$50
$50	10	$500
$50	100	$5,000
$50	200	$10,000
Fixed Cost Behavior
In Total	Per Unit
Total fixed cost is not affected by changes in activity (i.e., total fixed cost remains constant even if activity changes).	Fixed cost per unit decreases as the activity level rises and increases as the activity level falls.

Example: Let’s consider our computer manufacturing company again. The company pays $10,000 per month to rent its factory building. The total and per unit cost of rent at various levels of activity would be represented below.

Rent Cost per Month	Number of Computers Produced	Rent Cost per Computer
$10,000	1	$10,000
$10,000	10	$1,000
$10,000	100	$100
$10,000	200	$50

Relevant range means the range within which the cost assumptions will not change. This is often associated with production capacity. Looking at our computer company again, if they can produce 1 to 1,000 computers at this facility per month, we say that the relevant range for the rent would be 1 to 1,000 units. If we need to produce more than 1,000 units, this would be outside of our relevant range for the rent, and we would then need to acquire additional space for production. This means that our fixed costs related to factory rent would have to change. It is very important that managers keep this information in mind when making planning decisions.

Relevant Costs for Business Decision Making

Managers make financial decisions every day. When making decisions, managers must look at the alternatives. For each alternative, some costs and benefits will be the same and some will be different. Managers only need to look at the costs and benefits that are different. The costs that are the same are not relevant to the decision that needs to be made. The costs and benefits that are different are called relevant costs, meaning that they are important to keep in mind when making business decisions.

Example: Bill is currently employed as a cook, but he has been offered a job as a computer programmer. The revenues and costs are listed for each job, and we can determine the differences between the alternatives, called differential costs and revenues.

	Cook	Computer Programmer	Differential costs and revenues
Monthly salary	$2,000	$2,500	$500
Monthly expenses:
Commuting	40	60	20
Meals	200	200	0
Apartment rent	750	750	0
Uniform rental	0	50	50
Union dues	10	0	(10)
Total monthly expenses	1,000	1,060	60
Net monthly income	$1,000	$1,440	$440

Cost Concepts For Decision Making

Opportunity Costs: Opportunity costs are benefits that are lost if a different alternative is selected. If we select an alternative that does not include this benefit, we do not record it as a cost of that alternative but it is important to consider these benefits when making business decisions.

Example: Jeff works for Harley-Davidson and is paid $200 per day. He would like to take a day off to visit his parents. If he does not have any vacation time available and his time off will be unpaid, the $200 of wages that he will be giving up is the opportunity cost of visiting his parents.

Sunk Cost: Sunk costs are costs that were approved and incurred in the past. These costs cannot be changed by current or future business decisions. Sunk costs would not be relevant costs because we are unable to change them. Thus they do not need to be considered when making business decisions.

Example: Jeff has already purchased tickets for $100 for a Green Bay Packers game that will be on the same day that he plans to visit his parents. If he visits his parents, he will be unable to go to the game. The $100 cost for the tickets is considered a sunk cost and it would not be a relevant cost as he makes his decision on what to do. If he sells the tickets, any amount that he receives would be considered relevant and not a sunk cost. We will learn more about relevant costs and their application to business decisions in a future week.

Cost Behavior

We now focus our learning on the cost behavior of an organization's cost structure (variable, fixed, and mixed costs). It is important for us to understand how costs behave so that we can predict how changes will impact profitability. We will also learn a managerial accounting type of income statement called the contribution approach.

Remember, total variable costs will vary proportionately with changes in the activity level. Variable costs on a per unit basis will stay the same and will not change with changes in the activity level (within the relevant range).

Example: We produce cars, and each car requires one battery. Each battery costs $45. The variable cost per unit will be $45. The total variable cost will be the per unit cost of $45 times the number of units produced. Therefore, if we produce 10 units, the total variable cost will be $450. If we produce 1,000 units, the total variable cost will be $45,000.

Fixed costs remain constant in total within the relevant range. On a per unit basis, however, fixed costs will vary with changes in the activity level. If the activity level increases, the fixed cost per unit will decrease. If the activity level decreases, the fixed cost per unit will increase. It is important for managers to consider the relevant range when dealing with fixed costs. For instance, let us say that we are a television manufacturer. Our current facility has a maximum capacity of 10,000 units and we are looking at increasing production to 14,000 units. In this case, we will need to consider the added cost of an additional facility (building costs, equipment costs, etc.) to meet this capacity.

Example: A dentist rents an office for $40,000 per year and activity is measured by the number of patients seen in the year. The total fixed cost will be $40,000 and the fixed cost per unit will be the $40,000 divided by the number of patients seen in the year. So, if the dentist provides services to 1,000 patients, the fixed cost per unit will be $40,000 / 1,000 patients = $40. If the dentist provides services to 5,000 patients, the fixed cost per unit will be $40,000 / 5,000 patients = $8.

Fixed costs can be viewed as either committed or discretionary.

Committed fixed costs are those that are difficult to change in the short term. Some examples are depreciation, property taxes, long-term leases, and so on. It is difficult to reduce committed fixed costs for the short term without affecting the company in the long term.

Discretionary fixed costs are costs that management can change more easily than committed costs. Discretionary costs include things like research and development costs, conventions, training, some marketing costs like advertising, and so forth. These costs generally can be scaled back, if need be, for the short term and possibly for the long term.

Words of Caution

Each company must look at its costs to determine if they are fixed or variable. Sometimes, a cost in one company may be fixed, while in another, it might be variable. It will depend on the specific circumstances.

Mixed costs are costs that are both fixed and variable. It is common for a cost to have fixed and variable components. Many costs are mixed and can be expressed in terms of the cost formula.

Y = a + bX,

Where: Y = Total estimated cost a = The estimated total fixed cost b = The estimated variable cost per unit of activity

X = The amount of activity

You probably remember that this is the algebraic equation for a straight line. Even when the behavior of the underlying cost is not linear, this formula can provide an approximation of the cost function within the relevant range.

Example: A company leases an x-ray machine for $20,000 per year plus $10 per x-ray taken. The $20,000 per year would be the fixed component, and the $10 per x-ray would be the variable component.

For analysis purposes, we must separate the fixed and variable components of mixed costs. There are some management tools that we can use to help us estimate future fixed and variable costs for mixed cost items. Three common methods are the scatter graph method, the high-low method, and least-squares regression method. Once the mixed costs components are separated by one of these or other more statistically advanced methods, we can develop the organization's cost structure for planning and control purposes.

Review

Click here to open the  Cost Behavior Tutorial

You may also want to take the Self-Study Quizzes for Chapters 1 and 2. Links are located in the Assignments tab.

Income Statement

There are two income statement formats that we can work with:traditional format and contribution format income statements. The traditional income statement format is used for external reporting and is the format approved by Generally Accepted Accounting Principles (GAAP). This format looks at function rather than the behavior of the components.

Traditional Income Statement Format (costs organized by function)

* Contains both variable and fixed elements.

The contribution format income statement is used for internal reporting purposes and is not GAAP approved. The components of this statement format are generally more detailed and costs are organized by behavior (variable and fixed costs are separated). By splitting up these costs, it is much easier to use the statement for planning purposes. For instance, it would be much easier to determine the change in net income if there is a volume change. This would be much more difficult if we are using the traditional format. A contribution format income statement will be set up as follows.

Net Sales - Variable costs = Contribution margin - Fixed costs = Net operating income

Assuming the same data as shown in the traditional income statement above, the contribution margin would differ as follows (notice the breakdown between variable and fixed costs components).

Contribution Approach (costs organized by behavior)

We will elaborate further on the traditional approach and the contribution approach income statements in future readings and lectures.

Week 1 Interactive Quiz

Week 1 Interactive Quiz 

  Week 1 Interactive Quiz

Transcript

Week 2:

Introduction

All companies need to have a good understanding of the cost of the products and services that they provide to their customers. The two most common systems for allocating costs to products and services would be process costing and job-order costing systems. We will be looking at these two systems, how costs are allocated, and the types of companies that will use each system.

· Process costing systems are used by companies that produce multiple units of a single product and each unit of product is the same as the next. Due to the fact that each unit is identical, it is reasonable to assign the same cost to each unit. Following are the types of companies that would use process costing systems. 

· Soft drink manufacturer

· Automaker 

· Consumer goods manufacturer 

· Job-order costing systems are used when a company produces many different products during the period. Generally, the product or service is unique for that specific customer. In this type of situation, costs will be accumulated for each job. Costs directly related to the job will be recorded to the job, and indirect costs will be allocated to the job. Following are the types of companies that would use job-order costing systems. 

· Large-scale construction

· Aircraft manufacturing 

· Movie production

Comparing process costing and job-order costing is depicted below.

Job-Order Costing	Process Costing
1. Multiple different jobs are worked on during a period and each job has different production requirements. 2. Costs are accumulated by individual job. 3. Unit costs are computed by job on the job cost sheet.	1. A single product can be produced on a continuous basis or over a long period of time. All units of product are identical. 2. Costs are accumulated by department. 3. Unit costs are computed by department.

In general, make a note of these differences.

· We use job-order costing when we are working on various jobs or products during a period; we use process costing when we are producing one product during the period.

· With job-order costing, we accumulate and keep track of costs for each job or product; for process costing, costs are recorded to specific departments.

· With job-order costing, average unit costs are computed by job; with process costing, average unit costs are computed for a particular operation or by department.

Job Order Costing

The types of manufacturing costs that are assigned to products using a job-order costing system include two below.

· Direct costs: Direct labor and direct materials; these items can be traced directly to the job or product.

· Indirect costs: Manufacturing overhead costs; these are costs that can’t be directly traced to jobs or products. Indirect costs are allocated to jobs or products.

The accounting department will use a job cost sheet that keeps track of the direct and indirect costs related to a specific job. Let’s look at an example, using the Pearly Corporation. Each job will be assigned a unique job number. Direct materials, direct labor, and manufacturing overhead costs will then be recorded to the specific job as follows.

Direct materials cost: When production begins on a job, a materials requisition form will be completed. The form will identify the type, quantity, and total cost of materials to be taken out of inventory. In addition, the job number (e.g., Job-143) that the materials are for will be identified and these costs will be recorded on the job cost sheet (e.g., Job-143) by the accounting department.

Direct labor costs: Time tickets will be used to keep track of the time that each laborer spends on each job, and the costs will be recorded on the job cost sheets by the accounting department (e.g., Job-143).

Manufacturing overhead: First, we need to select an allocation base to use to allocate the overhead costs. Some examples of allocation bases would be direct labor hours, direct labor dollars, and machine hours. Allocation bases are used because

· it may not be possible or it is difficult to trace these costs to particular jobs;

· manufacturing overhead consists of many different items, ranging from machine parts to production salaries; and

· many types of manufacturing overhead costs are fixed even though output may fluctuate during the year.

Second, we would calculate the predetermined overhead rate. This rate is calculated by dividing the estimated total amount of manufacturing overhead for the coming period by the estimated total quantity of the allocation base for the coming period. When we select an allocation base, we are looking for the driver that causes the manufacturing overhead costs.

Remember This

   Predetermined Overhead Rate = Estimated Total Manufacturing Overhead Costs / Estimated Total Amount of the Allocation Base

Predetermined overhead rates that rely on estimated data are often used because actual overhead costs for the period are not known until the end of the period. In addition, actual overhead costs can fluctuate seasonally, thus misleading decision makers.

Third, the manufacturing overhead is allocated to the jobs and products by taking the predetermined overhead rate times the allocation base amount (this is called a normal costing system).

Remember This

 

   Manufacturing Overhead Application = Actual Amount of the Allocation Base x Predetermined Overhead Rate

For example, assume that the Pearly Corporation applies overhead to jobs based on direct labor hours. For the year, it is estimated that its total overhead costs will be $640,000. The company estimates its total direct labor hours for the year to be 160,000. Job 143 required 8 hours of direct labor at $10.50 per hour and $75 of direct materials.

· Calculating the predetermined overhead rate = $640,000 / 160,000 = $4 per direct labor hour.

· The overhead that will be shown on the job cost sheet for Job-143 will be $32 (8 hours x $4 per hour).

The job cost sheet will show the direct materials, direct labor, and manufacturing overhead for Job-143.

Note: Companies that use job-order cost systems to assign manufacturing costs to products also incur nonmanufacturing costs. Nonmanufacturing costs are considered period costs. Period costs will be expensed in the period in which they were incurred. For example, the costs of sales or administrative expenses are not part of the product cost. These costs, however, should be taken into account when pricing the product to ensure that they are covered!

Over- and Underapplied Overhead

Generally, actual manufacturing overhead costs will not match the amount of overhead that has been applied to jobs (work in process) for the period. This difference is called underapplied overhead or overapplied overhead.

· Underapplied overhead occurs when the amount of overhead applied to jobs is less than the overhead actually incurred.

· Overapplied overhead occurs when the amount of overhead applied to jobs is greater than the overhead actually incurred.

Let's compute underapplied or overapplied overhead for our Pearly Company example. Recall the following information related to this example.

Estimated total overhead costs - $640,000 Estimated total direct labor hours -160,000 Predetermined overhead rate - $4 per direct labor hour

Let’s assume the following.

Actual overhead – $650,000 Actual direct labor hours – 170,000

In this case, the overapplied overhead will be $30,000 and it is calculated as follows.

· Step 1: Calculate the overhead that was applied by taking the actual direct labor hours incurred times the predetermined overhead rate. 170,000 x $4 = $680,000

· Step 2: Compare actual manufacturing costs to the applied overhead for the accounting period = $650,000 - $680,000 = $30,000 Overapplied

Image Description

Disposition of underapplied or overapplied overhead balances

Any remaining balance in the manufacturing overhead account, such as Pearly Company's $30,000 of overapplied overhead, is adjusted in one of the following manners.

· The Cost of Goods Sold is adjusted for the amount that is overapplied or underapplied.

Manufacturing Overhead: 30,000 Cost of Goods Sold: 30,000 To adjust cost of goods sold for overapplied overhead.

· The amount that is overapplied or underapplied can be allocated pro rata to the Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold. Let's look at an example.

Overhead applied to Ending Work in Process = $68,000 Overhead applied to Ending Finished Goods Inventory = $204,000 Overhead applied to Cost of Goods Sold = $408,000 Total = $680,000

· The allocation percentages would then be as they are below.

Work in Process = $68,000 / $680,000 = 10% Finished Goods = $204,000 / $680,000 = 30% Cost of Goods Sold = $408,000 / $680,000 = 60%

· The overapplied overhead would then be allocated by taking the allocation percentage times the amount of the overapplied or underapplied overhead, as follows.

Work in Process = $30,000 x 10% = $3,000 Finished Goods Inventory = $30,000 x 30% = $9,000 Cost of Goods Sold = $30,000 x 60% = $18,000

In the above example, we are assuming that there was only one predetermined overhead rate. In larger companies, it is common to have more than one overhead pool of costs so that they will have multiple predetermined overhead rates that need to be applied. Although using multiple predetermined overhead rates is more complex, the process still works the same way.

Note: Job-order costing can also be used by service industries. For example, in a public accounting firm, each client represents a job. Each accountant and support staff for the company will record the amount of time spent on each job (client), which will be recorded as a cost for the job. Any other costs that can be directly charged to the client will be recorded to the job (e.g., photocopies, travel, meals, etc.). Overhead costs will be allocated in the same way that was utilized for manufacturing companies.

Review

Transcript

You may also want to take the self-study quiz for Chapter 3; the link is located in the Assignments tab.

Self-check

Print

Select the answer(s) that best match(es) the question.

Question 1 of 3

Assuming Job 101 sold for $750,000, what is the company's Gross Margin on this sale?

Top of Form

A) $260,000 (750,000 sales price - 490,000COGS)

B) $750,000 ($260,000 Sales price - 490,000OCSG)

Bottom of Form

Submit

Process Costing

In a process costing environment, products typically flow in a sequence from one department to another. Costs for process and job-order costing flow in the same manner.

DM, DL, MFG OH -----> WIP -----> FG -----> COGS

Nonetheless, there is a key fundamental difference between process and job-order costing systems: Process costing systems trace and apply manufacturing costs to departments. Each department will have its own work in process account. When the work is completed in one department and moved to the next department, the product costs (direct material, direct labor, and manufacturing overhead) will be taken out of the first department’s work in process account and put into the next department’s work in process account. These costs would be called transferred-in costs.

Image Description

Generally, in any production process, there are always units that have been started but not completed. These partially completed units complicate the determination of a department’s output for a given period and the unit cost that should be assigned to that output. For this reason, we convert these partially completed units into whole units called equivalent units. We compute equivalent units by taking the number of units that are partially completed times the percentage that these units are completed. The basic idea behind this concept is easily explained by saying that if we have two units that are halfway completed, we have one complete unit. For example, if we have 100,000 units and these units are 45% complete, we can say we have 45,000 equivalent units.

There are two methods that can be used to calculate equivalent units. The methods are the weighted average methodand the FIFO method. Let's review each method.

Weighted Average Method

Let's work through an example of the weighted-average method.

Assume that the Walnut Milling Department reported activity for May as follows.

	Units	Cost for Materials	Costs for Conversion
Beginning Work in Process	500	$2,750	$12,200
Units Started	5,000	$24,000	$30,000
Ending Work in Process*	300
Total Cost		$26,750	$42,200
*50% completed for materials, 25% completed for conversion

Computing equivalent units—weighted average method

· Step 1: Determine the number of units that were completed during the period and transferred out in May (would be 500 units from beginning work in process inventory plus the 5,000 units started during the period less 300 units in ending work in process inventory = 5,200 units completed).

· Step 2: Determine the equivalent units of production related to materials that are in the ending Work In Process inventory (150 units = 300 units in ending inventory x 50% completed). This will be added to the units completed that were determined in Step 1 (5,200 units). The total equivalent units for materials = 5,350 (5,200 units completed and transferred from Step 1 plus 150 equivalent units that are in ending inventory).

· Step 3: Determine the equivalent units of production related to conversion costs that are in the ending Work In Process inventory. (75 units = 300 units in ending inventory x 25% completed). This will be added to the units completed that were computed in Step 1 (5,200 units). The total equivalent units for conversion = 5,275 (5,200 units completed and transferred from Step 1 plus 75 equivalent units that are in ending inventory).

· Step 1: Take total costs for materials and divide by the total equivalent units for materials: $26,750 / 5,350 =$5 per equivalent unit for materials 

· Step 2: Take total costs for conversion and divide by the total equivalent units for conversion: $42,200 / 5,275 = $8 per equivalent unit for conversion costs 

Applying costs—weighted average method

· Step 1: Calculate the total costs of the units transferred out. Since all units transferred out are 100% completed, we can add the per unit cost for materials of $5 and the conversion costs of $8. We then multiply the