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The cost accounting system builds up the cost of product (or other cost object) by recording to a job cost sheet, a work-inprocess account, or some other appropriate ledger, the direct costs that can be traced to the product, and a share of the overhead
costs, which are allocated to the product by multiplying the overhead rate by the amount of the allocation base identified with
the cost object.
Cost Objects:
Recall that a cost object is anything that we want to know the cost of, such as a product or service.
There is a common convention that can be confusing. We often talk about the cost object (the thing we want to know the cost
of) as one unit of product, because factory managers and product managers speak in terms of unit costs. These managers want to
know the unit cost for product pricing, product sourcing, and performance evaluation purposes. They do not want to talk about
the cost of making 620 units, even if that is the batch size. However, in most batch processes, there would be very little benefit
and enormous additional expense in determining the cost of each unit of product individually. Rather, the accounting system
treats the batch as the cost object, and to derive a unit cost, we divide the cost of the batch by the number of units in the batch.
Hence, loosely speaking, we talk as if a unit of product is the cost object, but more precisely, it is the batch (or the production
run in an assembly-line process, or perhaps one days production in a continuous manufacturing process) that constitutes the
cost object.
Direct Costs:
Management accounting classifies product costs as either direct costs or overhead costs (indirect costs). This distinction is
important because costing systems handle these two types of costs very differently. The distinction is sometimes subtle, because
whether a cost is direct or overhead is a function of the cost object, and also partly a matter of choice on the part of managers
and accountants.
Following are three definitions of direct costs from different accounting textbooks:
Direct costs of a cost object are costs that are related to the cost object and can be traced to it in an economically
feasible way.
Direct costs are costs that can be directly attached to the unit under consideration.
Direct costs are costs that can be traced easily to specific products.
Direct costs are also called prime costs. For manufacturing companies, direct costs usually can be categorized as either
materials or labor.
Direct materials: materials that become part of the finished product and that can be conveniently and economically traced to
specific units (or batches) or product.
Example of direct materials for an apparel manufacturer: fabric. All other materials, such as thread and zippers, are probably
indirect.
Direct labor: costs for labor that can be conveniently and economically traced to a unit (or batch) of product. The following
examples show how the determination of whether a cost is direct or overhead depends on the identification of the cost object:
Electricity
Factory office salaries
Building and machine maintenance
Factory depreciation
The distinction between direct costs and overhead costs relate, in some measure, to the way the accounting system treats the
cost. For example, one apparel manufacturer might track thread using the same methods that are used to track fabric, thus
treating thread as a direct material. Another apparel manufacturer might decide that the cost of thread is immaterial, and does
not warrant the cost and effort to track it as a direct cost. For this company, thread is an overhead cost. Therefore, whether some
costs are direct or overhead depend on a choice made by the manager and the cost accountant.
There are three ways overhead costs can be treated in any decision-making context: (1) they can be ignored, (2) they can be
treated as a lump-sum, or (3) they can be allocated to the products and services (i.e., to the cost objects) to which they relate.
Each of these three alternatives is appropriate, depending on the circumstances and the purpose for which the accounting is
done. However, in this chapter and throughout much of this book, we are concerned with the third alternative: how to allocate
overhead costs to products and services.
Cost Allocation Bases
The allocation base is the link that is used to attach overhead costs to the cost object. In a manufacturing setting, the simplest
allocation base is the number of units produced. For example, if the factory makes 15,000 units, the accounting system can
simply spread the overhead costs evenly over all 15,000 units. The problem with using units as an allocation base, however, is
that if the factory makes a range of different products, those products might differ significantly in their resource utilization. A
deluxe widget might require twice as much labor and 20% more materials than a standard widget, and one might infer that the
deluxe widget also requires more resources that are represented by overhead costs.
Whatever cost allocation base is chosen, it must be a common denominator across all cost objects. For example, a furniture
factory could allocate overhead costs across all products using direct labor hours, because direct labor is incurred by all products
made at the factory. However, it would not seem appropriate to allocate factory overhead based on the quantity of wood used in
each unit, if the factory makes both wood furniture and a line of plastic-molded, because no overhead would be allocated to the
plastic chairs.
Overhead Rates:
The overhead rate is the ratio of cost pool overhead dollars in the numerator, and the total quantity of the allocation base in the
denominator:
Overhead rate
The result represents dollars of overhead per unit of the allocation base. For example, if an apparel factory allocates overhead
based on direct labor hours, the overhead rate represents dollars of overhead per direct labor hour. Assume the overhead rate is
$20 per direct labor hour. Then for every hour that a sewing operator spends working on product, $20 will be allocated to the
products that the sewing operator assembles during that hour.
ZFN Apparel Company, Example of Actual Costing:
The ZFN apparel company in Albuquerque, New Mexico makes jeans and premium chinos. Each product line has its own
assembly line on the factory floor. Overhead costs for the factory for 2005 were $3,300,000. 500,000 jeans and 400,000 chinos
were produced during the year. 500,000 direct labor hours were used: 200,000 for jeans, and 300,000 for chinos. The average
direct labor wage rate was the same on both assembly lines, and was $14 per hour. Denim fabric is used to make jeans, and
chinos are made from a cotton twill fabric. Overhead is allocated using direct labor hours.
The following journal entries and T-accounts illustrate how the accounting system records the manufacturing activities of the
factory in order to derive product cost information for jeans and chinos. Journal entry (6) to debit overhead to work-in-process
is based on an overhead rate calculated as follows.
$3,300,000 500,000 direct labor hours = $6.60 per direct labor hour.
In practice, the factory would track costs by batch, or perhaps weekly, but to simplify our example, we record only one journal
entry for each type of transaction. We also make the unrealistic assumption that there is no work-in-process at the end of the
period. To focus the presentation on inventory-related accounts, T-accounts for some non-inventory accounts, and the entry to
debit accounts receivable and credit revenue, are omitted.
(1)
Work-in-process: Jeans
$2,500,000
Raw Materials: denim fabric
$2,500,000
(To record materials requisitions for 500,000 yards, for the movement of denim from the receiving
department to the cutting room.)
(3)
Work-in-process: Chinos
$2,160,000
Raw Materials: cotton twill
$2,160,000
(To record materials requisitions for 480,000 yards, for the movement of cotton twill from the
receiving department to the cutting room.)
(4)
Work-in-process: Jeans
$2,800,000
Work-in-process: Chinos
4,200,000
Accrued Sewing Operator Wages
$7,000,000
(To record sewing operator wages for the year: 200,000 hours for jeans, and 300,000 hours for chinos,
at $14 per hour.)
(5)
Factory Overhead
Accounts Payable
Accrued Wages for Indirect Labor
$3,300,000
$1,800,000
900,000
Accumulated Depreciation
600,000
(To record overhead costs incurred during the year, including utilities, depreciation, repairs and
maintenance, and indirect wages and salaries.)
(6)
Work-in-process: Jeans
$1,320,000
Work-in-process: Chinos
1,980,000
Factory Overhead
$3,300,000
(To allocate factory overhead to production, using an overhead rate of $6.60 per direct labor hour.)
(7)
(8)
(9)
(1)
Raw Materials:
Denim Fabric
$3,000,000
$2,500,000
Raw Materials:
Cotton Twill
(2)
(1)
$ 500,000
$2,250,000
$2,160,000
(3)
Factory Overhead
$3,300,000
$3,300,000
(6)
Accrued Sewing
Operator Wages
$7,000,000
(4)
(5)
90,000
$0
Work-in-Process: Jeans
(2)
(4)
(6)
$2,500,000
2,800,000
1,320,000
$0
$6,620,000
Work-in-Process: Chinos
(7)
(3)
(4)
(6)
$6,620,000
$5,296,000
$8,340,000
(9)
(8)
$8,340,000
$7,297,500
$1,042,500
$5,296,000
(9)
Accounts Payable
$5,250,000
1,800,000
(8)
$1,324,000
(9)
$2,160,000
4,200,000
1,980,000
$0
(1)
(5)
$7,297,500
(9)
These amounts, which are used in journal entry (9), can be detailed as follows:
Input
Fabric
Direct labor
Overhead
Total
Jeans
1 yard per jean x $5 per yard = $5.00
0.4 hours per jean x $14 per hour = $5.60
0.4 hours per jean x $6.60 per hour = $2.64
$13.24
Chinos
1.2 yards per chino x $4.50 per yard = $
0.75 hours per chino x $14 per hour = $1
0.75 hours per chino x $6.60 per hour = $
$2
In the above table, the direct labor hours per jean and per chino appear in the lines for both the per-unit direct labor cost and the
per-unit overhead cost, because overhead is allocated based on direct labor hours. If the allocation base had been something
else, such as machine hours, the hours per unit would only appear in the calculation of the direct labor cost.
More overhead is allocated to each pair of chinos than to each pair of pants ($4.95 versus $2.64) because direct labor hours has
been chosen as the allocation base, and each chino requires more direct labor time than each pair of jeans (0.75 hours versus
0.40 hours). Changing the allocation base cannot change the total amount of overhead incurred, but it will usually shift costs
from some products to others. For example, if the allocation base were units of production instead of direct labor hours, the
overhead rate would be:
$3,300,000 900,000 units = $3.67 per unit.
In this case, the total cost per pair of jeans would increase from $13.24 to $14.27, and the total cost per pair of chinos would
decrease from $20.85 to $19.57.
Because the choice of allocation base determines how overhead is allocated across products, product managers usually have
preferences over this choice (because a lower reported product cost results in higher reported product profitability). However,
the companys choice of allocation base should be guided, if possible, by the cause-and-effect relationship between activity on
the factory floor and the incurrence of overhead resources. For example, direct labor hours is a sensible allocation base if the
significant components of overhead increase as direct labor hours increase. More direct labor implies more indirect labor by
human resources and accounting personnel, janitorial staff and other support staff. Also, more direct labor implies more
machine time, which implies more electricity usage, and more repairs and maintenance expense. For these reasons, direct labor
hours is probably a better choice of allocation base than units of product.